Euro Zone Markets React to ECB's Shift

By Yoruk Bahceli and Dhara Ranasinghe

LONDON (Reuters) – Euro zone markets swung on Thursday after the European Central Bank (ECB) gave up its long-standing hawkish stance, leaving analysts divided on the impact of its rate-cutting signals.

Initially, the outlook seemed positive for markets anticipating rapid rate cuts in 2024 due to a declining economic forecast and potential U.S. tariffs under President-elect Donald Trump, alongside political instability in France and Germany.

The ECB implemented its fourth rate cut of the year on Thursday, no longer committing to keeping policy rates "sufficiently restrictive for as long as necessary" to reduce inflation. The bank expressed confidence that inflation will stabilize at its 2% target sustainably.

However, this was tempered with a warning that the ECB is not adhering to a specific rate trajectory, which caused uncertainty among investors betting on consecutive rate reductions next year. Following ECB President Christine Lagarde's comments, interest-sensitive German two-year yields increased by around 5 basis points, while Italian 10-year yields rose over 10 bps.

Rabobank senior rates strategist Lyn Graham-Taylor noted that markets perceived Lagarde's remarks as more hawkish than anticipated, particularly around the neutral rate, which stimulates neither economic growth nor restriction.

Markets now anticipate the ECB's key rate may drop to approximately 1.75% by the end of 2025, aligning with the lower end of the range Lagarde identified (1.75%-2.5%). Lagarde remarked that the neutral rate is now considered to be "a little higher" than previously thought.

Analysts observed that Lagarde's acknowledgment of persistent high services inflation added to her hawkish tone. The euro fluctuated, initially dropping about 0.3% to $1.0468 before recovering to $1.05 during European trading.

What’s Next?

Despite volatility, the overall sentiment regarding ECB expectations remained stable, with traders still betting on significant rate cuts ahead. They anticipate over 120 basis points in cuts by the end of 2025, only slightly adjusted post-ECB announcement.

Expectations for 50 basis-point reductions at upcoming meetings remain significant, with a 20% chance in January and nearly 30% chance in March.

Some analysts maintain that Lagarde's message was clear. Danske Bank’s chief analyst, Piet Christiansen, pointed out her comments about two-sided inflation risks, weakening labor demand, and potential growth downturns.

Lagarde kept avenues open for market speculation on larger rate cuts while noting further discussions on the neutral rate would take place as it approaches its eventual value.

Frederik Ducrozet of Pictet Wealth Management noted Lagarde's final remarks emphasized inevitability in reaching the neutral rate, reinforcing market direction expectations.

The ECB also revised its growth forecasts down to 1.1% for 2024 and 1.4% for 2026, surpassing a recent Reuters poll anticipating growth rates of 1% and 1.2%, respectively.

ING's Carsten Brzeski cautioned that the ECB might be overemphasizing inflation concerns, given that many believe it acted too late in responding to inflation hikes. He warned policymakers could risk repeating past mistakes by delaying necessary economic responses, particularly in light of new U.S. tariffs that could impact growth.