ECB Rate Cut Bets Are Likely to Be Crushed Next Week

As central banks around the world continue to cut interest rates, traders are betting that Christine Lagarde will follow suit and reduce rates at the European Central Bank.

However, Lagarde has been clear that her priority is to stamp out inflation, not to provide stimulus to the economy. This could lead to a clash between those who are betting on lower rates and Lagarde herself.

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ECB President Mario Draghi rebuked investors six weeks ago for underestimating the extent of hikes required to bring soaring prices under control, then repeated the message at the World Economic Forum in Davos this month. Draghi has said that the ECB will need to raise rates more than markets are currently expecting in order to bring inflation back under control. This message has been met with some skepticism from investors, who believe that the ECB may not be able to follow through on its promises.

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Despite warnings of aggressive interest rate hikes in the coming months, investors continued to bet on lower rates by the end of the year, driving up prices for euro-area bonds in January.

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The US Federal Reserve, the Bank of England and the ECB are all due to hold rate-setting meetings next week, and analysts from Nomura Holdings Inc. to Societe Generale SA are in little doubt as to who will strike the most hawkish tone. There is also the danger that Lagarde will add extra frost to her remarks to prompt a market correction if European inflation data comes in milder than forecast.

Nomura economist Andrzej Szczepaniak believes that there will be a showdown between the ECB and markets. He believes that markets are challenging the ECB's mantra of multiple 50 basis point hikes. ECB President Christine Lagarde has said that her policy mantra is "stay the course." She has urged European leaders to maintain their commitment to fiscal discipline and structural reforms in order to ensure economic stability and growth. Lagarde has also stressed the importance of keeping interest rates low in order to support the recovery.

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According to swaps, a half-percentage point rate rise next Thursday is a done deal, which would take the deposit rate to a 15-year high of 2.5%. However, traders see just a 70% chance of another 50 basis point hike in March, and after that they begin to price in cuts to the key rate from around September. This is despite the best efforts of ECB officials. At Davos, Lagarde invited traders who have taken dovish rate bets to revise their position. She said they would be well-advised to do so. Her colleagues, including Dutch central bank chief Klaas Knot, want at least two more half-point rate increases.

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There is some doubt among market participants as to whether the ECB will be able to deliver back-to-back jumbo rate hikes. This is reflected in the swap market, where rates for the second hike have not risen as much as those for the first. Societe Generale strategists believe that the current market pricing is not accurate and that the ECB is likely to stop at 3.75%. They believe that there is upside potential for the market, meaning that it could be priced higher.

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She sees 10-year bund yields trading at 2.5% to 3% in the first half and recommends using options to fade excessive rate-cut pricing. Even after a recent selloff, 10-year German bond yields are more than 30 basis points below a Dec. 30 peak, at 2.25%. And while the market is pricing in about 30 basis points of rate cuts between Sept. 2023 and March 2024, she believes those bets are overdone.

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The European economy appears to be able to handle more interest rate hikes at present. Goldman Sachs economists are now predicting that there will be no recession this year. This is due to factors such as a warmer-than-usual winter in Europe, which has been struggling with energy shortages, and easing supply-chain constraints. The economic outlook in the UK is more challenging than in the US. Traders are less certain that the Bank of England will deliver a half-point hike next week, with swaps indicating a 90% probability. The rate is currently 3.5%.

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"Bunds don't seem to be pricing in all the hikes the ECB needs to carry out," said Gordon Shannon, portfolio manager at TwentyFour Asset Management. He said yields on gilts and Treasuries give a much better reflection of the tightening to come from the BOE and the Fed.

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Inflation data for January is due next week, and if it shows signs of further slowdown, this could lead traders to revise rates lower, resulting in more gains for bonds. Headline inflation has already dropped from a record 10.6% to 9.2%, and economists surveyed by Bloomberg see the pace of price growth dropping to 9%.
A measure which strips out energy and food is also predicted to improve, albeit only slightly. ECB officials have stressed risks around the stubbornness of core inflation, remarking this week that 50 basis-point rate hikes “must be taken unequivocally.”

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Even if data comes in better than expected, the global battle to tame price growth is unpredictable and there could be surprises down the line. For a cautionary tale, traders might look to Australia. This week's data showed that inflation accelerated to the fastest pace in 32 years in the last three months of 2022, exceeding forecasts and prompting money markets to price in an interest-rate hike at next month's central bank meeting.

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Bond bulls may face an inflation setback if Australia and New Zealand are any guide. Inflation in both countries has picked up in recent months, driven by higher energy and food prices. This has led to concerns that central banks may have to raise interest rates sooner than expected to keep inflation in check. The ECB may get a helping hand from the Fed, if US policy makers make it clear that the inflation fight is far from over. This is expected to happen next week when rates are raised.

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According to swaps linked to US central bank meetings, traders expect almost 50 basis points of rate cuts by the end of the year. While signs of a slowdown are mounting, the US economy expanded at a healthy pace in the fourth quarter, and the Fed has repeatedly warned it will leave rates elevated. Florian Ielpo, head of macro at Lombard Odier Investment Managers, believes that the ECB and Fed need to continue emphasizing that the fight against inflation is not over.

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"The job of central bankers is to convince markets that the interest rate cuts that have been priced in are not warranted," he said.