ECB less dovish than expected, but market is not convinced

The ECB’s message may have been less dovish than expected today, but it did not seem to get through to financial markets on Thursday. The euro has barely budged, and the market is still expecting a rate cut in October and December, even though the ECB struck a more hawkish tone than some expected at their meeting on Thursday. They remain focused on inflation, rather than following the Fed by placing less emphasis on inflation and focusing instead on growth.

ECB takes inflation mandate seriously

The ECB staff forecasts suggest that inflation could move higher later this year, and that service price inflation, in particular, could be sticky, which is giving the ECB some cause for concern. The ECB said that they would remain data dependent and would not pre-commit to future rate increases. This suggests that the ECB is taking a very different approach to monetary policy compared to the Fed. The Fed is expected to cut interest rates next week, and also inform the market that they intend to embark on a rate-cutting cycle. The Fed is happy to show the market the path of its future plans for policy action, however, the ECB is not yet willing to follow the Fed and do the same.

Markets doubts ECB’s resolve

The problem for the ECB is that financial markets do not seem to believe that they are still undecided about the future of monetary policy. The interest rate futures market is still pricing in 60bps of rate cuts for the rest of this year, with rate cuts expected in October and in December. Added to this, the euro is still languishing below $1.1050 on the back of this meeting, as FX traders still seem to be unwilling to believe that the ECB will be less dovish than the Federal Reserve. This is because the Eurozone has seen significantly weaker growth than the US, and the headwinds are set to continue. Although EUR/USD is at its highs of the day, it is still close to its lowest level since mid-August.

Data watching

Although the ECB staff forecasts downgraded the growth outlook for the Eurozone, and Lagarde stressed that growth was impacted by weak consumption and investment levels, she still sounded concerned about wage growth in Q3 and would not pre commit to rate cuts. Thus, the September inflation figures will be key to determining the prospect of an October rate cut from the ECB. They are released on 1st October, and we expect the market to react to any upside surprise, as it would suggest that the ECB will refrain from cutting interest rates as aggressively as the market currently expects.

Market calls ECB’s bluff on rate outlook

For now, we think that the market is trying to call the ECB’s bluff and expects them to cut interest rates due to the weak growth outlook for the currency bloc. Bond yields have ticked up on the back of the ECB meeting. Yields on the 2-year French and German bond have risen by 2bps and 3 bps respectively. It seems like bond traders have taken the ECB’s message at face value. However, this has not stopped European shares rallying on Thursday, although they have backed away from their highs in the aftermath of the Lagarde press conference.

Why the ECB will ultimately follow the Fed

The question now is whether the ECB will be forced to cut rates if growth gets worse in the coming weeks. Overall, we do not think that the ECB can diverge from the Fed in a meaningful way in the long term. Whether or not they change their tune at their October meeting could depend on what the Fed says at its meeting next week, and how dovish their message is.