ECB Preview: A Disputed 25bp Rate Cut

• Next week, the ECB is set to cut rates for the fourth time this year. Unlike the previous three cuts, the outcome of next week’s rate decision is not given as 1) the restrictive policy stance, 2) the deteriorating growth outlook, and 3) inflation at target has opened discussions of a 50bp cut. While a 50bp cut will certainly be discussed, we judge that the ECB will ultimately deliver a 25bp rate cut, and guide that they are open to any size of rate cuts at future meetings, subject to the incoming data. A 25bp cut next week will bring the ECB’s deposit rate to 3.0%. In the coming year, we expect a string of rate cuts, leading to a terminal rate of 1.5% being reached in September 2025.
• We expect a benign market reaction, even if Lagarde decides to twist guidance towards an increasing likelihood of a faster rate of normalisation.

Change guidance of policy restrictiveness

Since last year, the ECB has included a reference that it aims to keep monetary policy ‘sufficiently restrictive’ for as long as necessary. Following the disinflationary process that has gained traction through 2024, the updated staff projections next week are likely to forecast inflation on target from 2025 and onwards. Thus, whether monetary policy should stay restrictive is likely going to be debated. We believe that the slightly hawkish bias in the ECB’s communication is set to change as the need for a restrictive monetary policy stance in the Eurozone is no longer obvious. But the camps inside the GC are obviously divided. In a recent interview the ECB’s Schnabel said that in her view the restrictive part of the monetary policy stance is already fading. At the same time, we see the dovish camp, for example Villeroy, saying that there ‘won’t be any reasons’ for policy to remain restrictive.

A 25 or a 50bp rate cut? It is not the most important question

With activity indicators looking bleak heading into 2025, the case for a 50bp rate cut has strengthened, as the starting-point for financial conditions is restrictive based on most measures. However, given the ECB’s sole inflation mandate, and the ‘political’ aspect of having a gradual rate cutting cycle, we believe it will favour a 25bp rate cut.

However, whether the ECB will deliver a 25bp rate cut or 50bp rate cut in December is not that important in isolation, as the communication around it will be key as well. There seem to be diverging views on how to cut the cake. Most recently, Schnabel’s interview clearly suggested that she would opt for a 25bp rate cut, as would Vujcic, while others such as Lane, Villeroy and Centeno are more open to discussing a 50bp rate cut.

That said, rather than focusing on the rate cut next week, we should focus on where the policy rate will end in this cutting cycle, albeit we do not expect any verbal guidance on this. Markets may though interpret a 50bp cut as a signal of a lower terminal rate – and that may even be a signal that the ECB wants to send.

But as we do assume the ECB does not want a hawkish reaction from markets, leading to tighter financial conditions, we expect it to opt for a dovish 25bp cut, focusing on the communication on a potential jumbo cut.

Macro data since the October meeting has mainly given ammunition to the doves

Since the October meeting, the momentum in underlying inflation has fallen further and growth indicators have weakened. The composite PMI indicator declined sharply to 48.3 in November mainly driven by the service sector, which is now also in contractionary territory. Data indicates that the eurozone’s two largest economies, Germany and France, are likely to contract in Q4 while Spain should drive aggregate euro area growth together with Portugal and Greece. The deteriorating growth indicators combined with rising political uncertainty since the October meeting have mainly given ammunition to the dovish members of the ECB. However, the hawks’ last battalion, namely the labour market, continues to show resistance with the unemployment rate remaining at a record low of 6.3% in October and the national account data showing increased employment in Q3.

Underlying inflation has eased further

While headline inflation has increased from the three-year low in September, mainly reflecting base effects, the underlying momentum has continued to ease. The average month-on-month increase in seasonally adjusted core inflation has been 0.14% in the past three months, which is well in line with 2% annualised inflation. Importantly, the lower momentum in underlying inflation has been driven by service inflation where momentum is also quickly approaching the 2% target, according to the ECB’s own seasonally adjusted data. Hence, inflation developments have clearly also supported the doves in the ECB. For the hawks, an argument for a cautious cutting approach is wage growth that remains elevated given the tight labour market. Negotiated wage growth increased to 5.4% y/y in Q3, albeit largely driven by one-off payments, and has averaged 4.6% so far this year, compared to 4.4% in 2023.

Staff projections to show lower growth and inflation

We expect the ECB staff to take note of the recent easing in the momentum of underlying inflation and incorporate this into a lower forecast for core inflation next year relative to the forecast in September. We expect core inflation to be revised down to 2.2% y/y in 2025 (from 2.1%) and headline inflation to 2.1% y/y (from 2.2%). Oil futures were 6% lower at the cut-off date for the staff projections compared to December, but gas and electricity futures were higher, so we expect only a marginal reduction in the headline forecast. We expect the growth forecast to be revised down in 2025 to 1.1% y/y from 1.3% y/y due to the continued struggles in the manufacturing sector combined with cautious consumers and a weak German economy. In contrast to the ECB’s previous projections, consumers continue to have an elevated savings rate, which prevents consumption from picking up in the near term. The new staff projections will also include an additional year, albeit we do not attach significant weight to those projections given their embedded uncertainties.

Limited FX market reaction on 25bp rate cut

Speculation around a 50bp cut has diminished, with markets now largely positioned for a 25bp move, with only 27bp priced in. However, the post-decision communication will be crucial, given divisions within the Governing Council that could drive a range of market responses.

We view a dovish 25bp cut, where the ECB signals flexibility to adjust the size of future cuts, as the most likely scenario. Such an outcome would likely have a limited impact on EUR/USD, and with the probability of a jumbo cut still being priced in markets. However, should the ECB indicate a preference for continuing the easing cycle in 25bp increments, market pricing could shift, potentially triggering a hawkish response and a moderate EUR/USD rally, albeit given the meeting-by-meeting approach and thereby keeping full flexibility about future monetary policy decisions, we see that as a low probability outcome. By contrast, a 50bp cut – an outcome we believe is underappreciated despite weak euro area growth and inflation – would likely prompt significant EUR depreciation, with EUR/USD potentially dropping sharply.

Looking ahead, the Fed’s December meeting is likely to have a more decisive impact on EUR/USD’s near-term trajectory, with Friday’s US jobs report a critical input. While markets currently assign a decent probability to a Fed pause, we expect a 25bp cut. If this materialises, it should help contain further EUR/USD downside into year-end. Seasonal trends and our short-term valuation models support this view, as EUR/USD appears oversold after its sharp decline since October. We expect the pair to close the year at around 1.06.

From a strategic perspective, we maintain our bearish EUR/USD outlook, driven by the relatively stronger US growth narrative. Our 12M target remains 1.01, making parity a plausible level over the coming year. On the rates side, we note that the significant decline in rates over the past month has brought the spot level for long swap rates close to our 12- month forecast, thus offering a very limited declining profile from here, see more in Yield Outlook – Transatlantic decoupling but not for much longer, 28 November 2024. We do not expect a signal from the ECB to address the French spread widening to peers.