Trade Update: ECB Preview – 25bp Cut, Dovish Tone, Re-Enter Short ERZ5

Summary

• We expect the ECB to cut 25bp on 12 December.
• It will also update macroeconomic projections, which are likely to see dovish revisions with inflation sustainably at target in H1 2025.
• We expect the ECB to avoid fully opening the way to 50bp cuts, but comments will likely add that they are flexible to acting as needed, that their target is symmetric, and that data will guide the way.
• A stronger dovish shift would be if they refer to risk of an inflation undershoot.
• On the hawkish side, they could push back on market pricing and may refer to fiscal expansion as being the more appropriate response to downside growth risks.
• We expect data to drive policy and see an underpriced risk that Q1 inflation exhibits a bigger bounce-back from target than the ECB hopes.

Market Implications

• We remain dovish on the ECB.
• Trade Update: We re-enter short ERZ5 (we were stopped out earlier in the week) close to the original entry point (98.20), with an unchanged target of 97.9, and a slightly higher stop at 98.33.
• Given the risk of dovish messaging, if the price was to rise back up towards recent highs post-ECB, we would add to the trade.

25bp Cut With Dovish Skew

The ECB will announce policy on 12 December and update its macroeconomic projections. We expect they will cut 25bp with mostly more dovish projections.

We expect growing optimism on the return to target in H1 2025, with some risks flagged still. The ECB may add more dovish wording to keep the doves happy, but we still expect caveats that data will drive decisions ahead, and the path back to a sustainable 2% may bumpier than hoped

We re-enter short ERZ5 at 98.20, targeting 97.90, stopping at 98.33 (we were stopped out of our initial trade earlier in the week after comments from Rehn).

Paving the Way for More Cuts

ECB policymakers broadly appear to support further (see appendix for specific comments). But while Villeroy has made headlines by advocating for discussing a larger cut this month, he lacks majority support.

Dovish Tone Likely

Instead, the greater optimism of sustainably reaching target soon and the growing (though still small in our opinion) risk that inflation will undershoot will likely be reflected by changes in the statement. Possible tweaks are:

• A shift from inflation declining to target ‘in the course of next year’ to ‘in the first half of next year’.
  • This is a very likely change in our view.
  • We would not see this as particularly dovish, given it aligns with recent comments.
• Addition of comments around the target being symmetric/some implication inflation may undershoot also:
  • Possible in our view.
  • We would see this as dovish.
• Addition of comment stating they will take any action needed to fulfil mandate (possible):
  • Likely in our view.
  • We would consider this a relatively weak way to suggest 50bp cuts are possible ahead.
• Some indication that upcoming data will inform the size of policy moves:
  • A slightly stronger version of the one above.

Individually, none of the above would be much of a change (given recent comments). However, the inclusion of several or all, plus a more dovish tone in the presser that stresses that any signs of an undershoot will be counteracted swiftly, could be significant. That could allow the market to more readily price 50bp cuts across next year.

However, the delivery of 50bp cuts (or even the current policy path) depends on the data delivering. We think the Q1 story is highly uncertain with risk of a far larger bounce from target during (more details below).

Possibility of Hawkish Caveats

The hawkish risk would be emphasis that the ECB is not considering cutting below neutral. This seems more likely in the presser than the statement, though, and in essence is nothing new. That the market is pricing an even greater shift below neutral could trigger pushback (as it seemed to be triggering in the last meeting) (Chart 1).

On tariffs and the outlook, comments are likely to be more dovish. But we expect that any comments on possible Trump policy will be muted and as balanced as possible (e.g. trade wars benefit no one, deglobalisation is inflationary, but domestic inflation the focus).

An echoing of recent comments that fiscal policy will need to meet such challenges would be dovish. As the market is currently pricing that rate cuts will be used to fight tariff-driven slowdown.

The Trade

We still see value fading the ECB cuts priced in 2025. Our short ERZ5 trade in our model portfolio briefly touched its stop at the start of the week. This was more unfortunate timing after Rehn’s comments than any substantial change in the structure of the view.

We remain dovish on the ECB. We re-enter short ERZ5 close to the original entry point (98.20), with an unchanged target of 97.9, and a higher stop at 98.33. Given the risk of a dovish tone, if the price was to rise towards recent highs, we would add to the trade.

More Dovish Projections

The projections are likely to be revised more dovish across inflation and growth. However, the labour market tightness could confound in the medium term. Productivity is undershooting their expectations, which could be an issue further out. For now, we expect they just assume productivity bounces back.

Growth – 25/26 to Be Revised Down

The most recent GDP outturns have roughly matched ECB expectations from September despite having run a little lower initially. Excluding volatile Irish GDP, the outturn has been even stronger (Chart 2).

There are obvious headwinds to Eurozone growth emanating from US tariffs. However, market expectations do not yet seem to have reacted too strongly to this, with only modest downward revisions to 2025 and 2026 growth, and 2024 looking slightly rosier (Chart 2). Historically, ECB projections have been slightly more positive than the market but followed a similar pattern, so expect downward revisions to 2025/26 growth.

Inflation to Meet Target Earlier

Inflation strongly missed ECB projections in September, but the gap has closed in October and November (Chart 4). While the market has taken a great deal of comfort from this, we are wary of how sustainable the achievement is given trends in services inflation (Chart 5).

ECB speakers are optimistic on inflation, with expectations now having shifted to meeting the target sustainably by mid-2025. The more central ECB speakers such as Lagarde and Lane acknowledge more evidence is needed that the return is sustainable. The hawks point to risks from services, while the doves see fewer upside risks to the outlook.

I expect the ECB will revise down their forecasts to have inflation meet target in H1 2025. However, they should be wary that headline CPI is suppressed by core and non-core goods. The former is bouncing back, and PPI suggests the latter will continue to rise YoY ahead. If that is the case, then keeping headline inflation capped at 2% may be a challenge (Chart 5).

Labour Market – Employment Beats

The labour market and lack of productivity growth will be a difficult one to square for the ECB. Unemployment is running decently below September estimates (Chart 6), driven predominantly by stronger employment growth (Chart 7).

Labour Market – Some Wages Uncertainty, Productivity Low

Wage growth has undershot ECB forecasts (Chart 8). The ECB will likely look through the one-off driven negotiated Q3 wage beat, but at the same time this still muddies the picture for underlying trend there. There could be some concern that getting a picture of Q4 is needed before taking too much positivity. That will not be available until mid-Feb.

Meanwhile, productivity growth is running slightly below expectations because of anaemic growth and labour hoarding (Chart 9). If this does not pick up it could cause some issues for the medium-term ECB forecasts as it will raise domestic inflation. For now, expect the ECB will continue to assume a strong pick up in productivity as per June and September.

Appendix: Policymaker Comments

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)