Another rate cut The ECB will likely deliver a 25bp rate cut next week. With the deposit rate at, or close to, the upper bound of a likely neutral range, the ECB will probably want to buy optionality regarding the timing of its next cut. We expect the pace of rate reduction to slow from 2Q25 and still project that the deposit rate will decline to 1.75% by year-end.
Market reaction If the ECB were to signal a slowdown in easing following the expected rate cut next week, market reaction would probably be contained as this scenario is broadly priced in. EGB reaction will also depend on the new set of forecasts, which we regard as slightly hawkish. The euro has recently shown resilience to the downside.
Next Thursday, the ECB will almost certainly cut interest rates by a further 25bp, lowering the deposit rate from 2.75% to 2.50%. This would take the cumulative size of rate cuts for this cycle to 150bp. While the decision itself will probably be rather uncontroversial, the meeting promises to be interesting, and markets will focus squarely on any hints about the future trajectory of monetary policy. As interest rates are approaching a likely neutral area, the ECB will probably signal that further easing might be appropriate but will switch off the autopilot and leave all options open with respect to the timing of the next cut(s). In line with this expectation, we think the current reference to restrictive monetary policy will be tweaked.
Three developments stand out, in our view. First, higher energy prices are likely to lift the ECB’s inflation forecast for this year. The revision will not be large, from 2.1% to 2.2-2.3%, but it will delay the time when inflation converges sustainably towards the ECB’s goal, making it hard to predict whether this will happen this year or in early 2026. Implications of such revision for the monetary policy outlook would probably be limited, as the ECB’s December forecast for core inflation remains on track while the growth forecast for this year is likely to be lowered further, from 1.1% to 0.9%, amid heightened trade uncertainty and a weakening labour market. At the margin, however, the forecast revisions might have a slightly hawkish aftertaste.
Second, the hawks in the Governing Council (GC) have started to challenge the ECB’s de facto autopilot easing. Last week, Isabel Schnabel, an influential hawkish voice in the GC, called for a discussion on whether to pause or at least slow down the pace of rate cuts. This is not overly surprising, as Schnabel has long argued that a neutral range for the deposit rate probably lies in the 2-3% area, which is above the 1.75-2.25% estimate recently provided by ECB staff. While she will almost certainly back a 25bp cut next week that will push the deposit rate in the middle of her 2-3% range, she will probably push for changes in ECB rhetoric to suggest that monetary policy should tread carefully, and that further rate reductions should not be taken for granted given the high uncertainty surrounding real-time estimates of the neutral level of rates. Interestingly, other hawkish GC members, such as Joachim Nagel and Pierre Wunsch, share some of Schnabel’s concerns but have been somewhat less vocal and appear less concerned about the upside risks to the inflation outlook.
Third, a rapid change of the geopolitical landscape will likely force Europe to embark on a significant increase in military outlays over the coming years. The size, timing and features of any increase in defence spending (and its financing) are currently very uncertain, as are the prospects for a ceasefire in Ukraine as talks between Trump and Putin accelerate. For now, these developments are unlikely to materially affect the GC’s assessment of the growth and inflation outlook, and the risks surrounding it.
Overall, we expect the discussion will heat up within the GC on what to do after next week’s cut as hawks start challenging the view that interest rates will have to continue to decline at a steady pace of 25bp per meeting. We think that the ECB will slow the pace of cuts to a quarterly frequency from 2Q25, but this is a close call, as the decisions of the GC will depend not only on the macro data but also on the geopolitical news, particularly any announcement with respect to tariffs. If trade tensions were to rise materially, the ECB would have to keep easing at a steady pace. We confirm our view that the deposit rate will decline to 1.75% by year-end as growth risks increasingly outweigh inflation risks.
Fixed-income markets are awaiting the second ECB meeting of the year after experiencing a month characterized by economic surprises and an intense flow of news. Eurozone rates have declined following the January meeting, reflecting disappointing 4Q24 GDP data and quite a dovish tone at the ECB press conference. Curves are slightly steeper overall than they were a month ago and government bonds have moderately cheapened relative to swaps. The decrease in rates has been due to a similar decline in both real-yield and inflation-expectation components. For reference, the 5Y real rate (computed using nominal and inflation swaps) has declined by 15bp to 0.33% and the 5Y inflation swap rate to 1.87% from 1.97%, with the decline in commodity prices supporting this move.
OIS forward rates are indicating a depo rate of below 2% by the end of this year, which will be tested by the upcoming meeting. If the ECB sounds more hawkish than expected, we see risks of an upward correction following the recent decline in rates. In any case, a slowdown in rate cuts is currently priced in and we do not expect significant upward pressure on short-dated rates if Ms. Lagarde were to suggest caution about further easing going forward.
The new economic forecasts will be particularly scrutinized, especially due to the great uncertainty to the economic outlook brought about by the trade war. It will be interesting to see whether markets will react more to a higher inflation forecast or to a lower growth figure. While the initial reaction might be negative for EGBs, we see more downside risks to growth than upside risks for inflation through 2025, which would translate into a constructive view towards EGBs at these levels.
