ECB Watch: Timing the rate cutting cycle

It was clear straight away that the first few weeks of 2024 will be about ECB vs. market. Interest rate markets loaded up ECB rate cutting bets on a substantial scale late in 2023. As a result, the two year Overnight Index Swap (OIS) - a popular proxy for key rate expectations - declined by 100 bp during the final quarter of the year. Financial conditions loosened - the real yield curve declined. Thus, the ECB's monetary policy stance turned less restrictive without the ECB's doing. Only a couple of weeks earlier - in September - the ECB Governing Council agreed on an "insurance" key rate hike to avert any doubt of the ECB's commitment to its price stability mandate. Back then, the ECB deposit rate reached its current level of 4%. The scene was set for the ECB to press every button to talk interest rates up.

And indeed, in early 2024 the rebound in market interest rates came. Year-to-date, the German sovereign yield curve increased by an average of 25 bp. The two most important voices out of the ECB Governing Council - President Lagarde and Chief Economist Lane - came forward and, by one way or the other, expressed concerns regarding a first rate cut before summer. This was before the ECB's January rate setting meeting, when markets were flirting with a first rate cut in March. Job done? Not really! The market was still way off compared to what the ECB was communicating. Thus, it was widely expected that the January meeting will bring the next blow. We too expected the ECB to continue, or even step up, its verbal interventions (see ECB Watch: Stemming against markets (and data?)). But it should come different. Apparently, the Governing Council found no common ground to step up against the market. Instead, the ECB reaffirmed its data (not date) dependent approach (see ECB Watch: The unsaid often weighs more heavily). As inflation optimism was at the heart of the market's rate cutting bets anyway, yields declined as a result. Markets probably remembered Schnabel's opening quote by Keynes to an interview in early December: "When the facts change, I change my mind."

Market's rate cutting bets have receded year-to-date but remain ambitious

* based on short-term forwards of the €STR OIS curve transformed to reflect the ECB deposit rate

Source: LSEG, RBI/Raiffeisen Research

Market's rate cutting bets have receded year-to-date but remain ambitious

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* based on short-term forwards of the €STR OIS curve transformed to reflect the ECB deposit rate

Source: LSEG, RBI/Raiffeisen Research

Did the facts change? Yes and No! Inflation has fallen markedly over the second half of 2023. While euro area inflation averaged 5.5% in 2023, it started the year at 8.6% and ended at 2.9% yoy. In January 2024, the flash estimate points towards another small decline to 2.8% yoy. Further, momentum indicators, such as the 3-months annualized rate, show inflation to have already fallen below 2% by the end of 2023 - both for headline and core inflation. Thus, one could argue that returning to price stability is only a matter of time until year-on-year inflation rates converge to momentum indicators.

Not so fast, there might be a big if! First, inflation data from November might turn out to be a disinflationary outlier, making current momentum indicators based on 3-months annualized rates look too optimistic. Second, already the details of the January flash release indicate a pickup in momentum in those segments the ECB is most closely watching: core services. And even in year-on-year terms core services inflation has been stable at 4% for three months straight. This indicates that there is still some persistence of inflation stemming from wages. Thus, while the decrease of inflation to 2% is ongoing and slightly ahead of schedule, it will still take some time until inflation reaches its target.

In March we will get a new round of inflation forecasts by the ECB. So far, the current forecast set (from December) has covered the last few months' developments rather well, with inflation having been reported only slightly below the ECB's numbers. It is likely that the new forecasts will once again deliver a downward revision. Some technical assumptions, gas price futures in particular, have declined since the December cut-off date. Besides energy, much focus will be on the ECB's view on wage growth. Given that core services inflation remains the part of inflation which is most sticky, a broad based return to price stability hinges on whether excessive wage growth keeps core services inflation elevated. Disinflation in core inflation has mainly come from core goods, which strongly benefitted from supply bottlenecks easing. The violence against western cargo ships in the Red Sea / Gulf of Aden poses risks to the strong disinflationary momentum of core goods. So far, this is not visible in consumer price inflation but nevertheless justifies careful monitoring.

Short-term inflation momentum is back on target - will it remain there?

Based on seasonally adjusted HICP time series as provided by the ECB. Last data point: December 2023.

Source: LSEG, ECB, RBI/Raiffeisen Research

Short-term inflation momentum is back on target - will it remain there?

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Based on seasonally adjusted HICP time series as provided by the ECB. Last data point: December 2023.

Source: LSEG, ECB, RBI/Raiffeisen Research

One thing is clear. "High-for-longer" is for the history books, but we have never been true believers anyway (see ECB Watch: High for (how much) longer? 9-12-24 months?!). Yet, one should not jump from one extreme narrative to the other. In spite of being data dependent, the ECB will not cut key rates on the first sight of good data. The Fed is currently building a good case that the ECB might follow. A continuous series of good data is necessary to build enough confidence that inflation is sustainably on its way to the 2% target. With risks towards core services inflation still present, we do share the view that the ECB will want to collect more (wage) data before embarking on a rate cutting cycle. Still, we do see the disinflation trend intact. June, therefore, seems to be a plausible candidate for a first "rate cutting meeting". Also a first move in April cannot be fully excluded but would not be our base case. In our view, the rate cutting cycle will be gradual, with a 25 bp rate cut per quarter. Inflation is moving towards 2% not in spite but because of the ECB's restrictive stance. Thus, loosening the monetary policy stance too quickly would, in our view, not be the most prudent way to secure price stability over the medium-term, particularly when the soft-landing proves to hold.

Apropos soft-landing and risks to our outlook. Our current baseline is built upon the view that the euro area economy is turning for the better. 2024 should see a pickup in economic momentum predominantly driven by private consumption/real wage gains. Should the euro area economy turn for the worse and the stagnation turn into a (true) recession, the ECB might act sooner and, more importantly, the pace will be faster. A similar consequence can be expected should the disinflation trend gain more momentum with measures of underlying inflation falling below 2%. In this case, it should not take long before the ECB will remember the challenges it faced to revive the stubbornly low inflation of the 2010s. On the other side of the spectrum, the ECB cutting cycle might be delayed should geopolitical risks materialize and spark another supply driven inflation shock which once again pushes (medium-term) inflation expectations up. Political risks are omnipresent in 2024, with a further broadening of the crisis in the Middle East being the most probable candidate as of today.

Looking at the broader interest rate market besides only ECB key rates, our views have not changed from those we outlined in mid-December (see Euro Area Central Bank Insights: Market versus ECB - who is right?). The somewhat earlier start to the ECB's rate cutting cycle (Q2 instead of Q3), however, has the consequence that our forecasts for short-term money market rates (€STR, Euribor curve) plus short-term benchmark yields and IRS (2-year) needed fine-tuning too and are, thus, somewhat lower than our previous forecasts.

Benchmark yields have turned direction for good in late 2023 - volatility remains

Source: LSEG, RBI/Raiffeisen Research

Benchmark yields have turned direction for good in late 2023 - volatility remains

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Source: LSEG, RBI/Raiffeisen Research