Economics & Growth | Europe | Rates | Trade Idea
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Summary
- We expect the ECB will cut 25bp this week, in line with consensus.
- For now, tariffs are dominating all else. In our view, the hawks are overly sanguine about inflation returning sustainably to target.
- However, hawkishness may not gain traction near-term given tariff fears and suppressed energy prices.
- The labour market continues to tighten (as we had warned), and there remains geopolitical risks to energy prices.
- As such, there is heightened risk that the ECB cuts further than it should this year and needs to hike back in subsequent years.
Market Implications
- In our model portfolio:
- We were stopped out of our short ERZ5 trade through the tariff volatility.
- We choose to close our 10Y EUR swap payer at a modest profit.
- It is too early/uncertain to fade ECB cuts. But we are looking at ways to play them overcutting.
- We will assess fading the decline in the medium-term EUR inflation swap rate and in ERZ5/Z6 steepeners.
25bp Cut Now, Little Value Fading Dovishness
We expect the ECB will almost certainly cut policy rates by 25bp this week. We had previously been hawkish on the ECB vs market pricing, but the tariff situation is dominating all other themes. ECB speakers (save Holzmann) have unsurprisingly rallied around the need for more easing (see appendix for all recent comments).
Further out, ECB policymakers may be overly sanguine on the return to target. However, regardless of medium-term inflation, it appears to be the case that they will continue to cut if they believe it necessary to steer the Eurozone through the tariff crisis. They have largely stopped asking whether they are ‘at neutral’ and may soon expand to asking ‘do we need to be accommodative?’.
On this basis, we see little value in looking to fade near-term ECB cuts (Chart 1). We were stopped out of our short ERZ5.
Further out the curve, we retain the view that EUR rates should be higher but now is not the time for positioning this way. We therefore cease paying 10Y EUR swap in our model portfolio, taking modest profit at c.2.50% (having entered at 2.43%).
Given our core hawkish view (more on this below), ahead we will assess ways to play the possibility of ECB over-cutting this year. One option would be to fade some of the decline in priced medium-term EUR inflation (5Y EUR inflation down to 1.62%, 30bp below 1 April’s level, Chart 2). An alternative would be an ERZ5/Z6 steepener.
Inflation May Not Be Beaten Yet
The ECB is unlikely to ignore rising medium-term inflation forever, particularly if near-term tariff fears fade, or inflation heats up again. In brief, our concerns are:
- Deglobalisation is (all else equal) inflationary – unless the EU is open to industrial wipe out via Chinese imports – 25% tariffs on €21bn US imports would raise CPI 0.07ppt but have longer-term impacts too.
- Energy prices are subdued right now, but could easily bounce back on geopolitics (US, Iran, Russia, and Algeria all potential sources of volatility).
- The Eurozone labour market remains very tight. As we warned, the unemployment rate continues to decline (Chart 3).
- Domestic demand (already suppressed) is more important in driving growth and prices than global trade. Relief there would overwhelm tariff impacts.
- Inflation has not yet been defeated – it remains too high in far too many countries (Chart 4). Services inflation YTD continues overshooting pre-2020 ranges (Chart 5).
Appendix – Recent Policymaker Comments
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