Why we expect the ECB to tread carefully on interest rates

Comments by Franck Dixmier , Global CIO Fixed Income at AllianzGI, ahead of the ECB monetary policy meeting on 25 January.

• We expect the European Central Bank to affirm its cautious approach to the first rate cut, given that inflation is not yet on a credible path towards its 2% price stability target.
• The battle against inflation is not yet won, with core inflation still up by 3.4% in December year-on-year and the potential for more inflationary pressure from wage rises this year.
• We think the ECB's cautious stance should fuel the ongoing correction in bond yields, even if the upside potential for long-term rates remains limited.

At the end of 2023, the market's perception that the US Federal Reserve and European Central Bank (ECB) had finished raising rates fuelled a bond rally as investors became increasingly confident of imminent central bank rate cuts. At the peak of these expectations, at the end of December, the market estimated the ECB would make just over seven cuts, each of 25 basis points (bp), in 2024, with investors placing a 72% likelihood of a first cut in March 2024.[1]

Since then, several ECB members have argued for a longer timetable of rate cuts than anticipated by investors. Those members range from the more hawkish members of the Governing Council, such as board members Robert Holzmann and Joachim Nagel, to the more moderate Chief Economist Philip Lane. These repeated warnings have helped to moderate market expectations. But those expectations are still high: on 19 January, the market was anticipating almost six rate cuts, with an 80% probability of a first rate cut in April.[2]

We expect Thursday’s monetary policy meeting to affirm the ECB's cautious stance.

The ECB should reiterate that it will only initiate a rate-cutting cycle when it is completely confident that inflation will return to its 2% price stability target on a sustainable basis.

But we are not there yet:

• After hitting a low of +2.4% year-on-year at the end of November, consumer prices rose by +2.9% in December.
• Core inflation was still up by 3.4% year-on-year in December.[3]

And upside risks remain:

• Wage increases are still on the cards this year, after a rise of more than 5% in 2023 in the euro zone.
• Geopolitical tensions, particularly in the Red Sea, and the additional costs arising from impediments to maritime traffic.

The realisation that the ECB is adopting a very cautious stance should fuel the ongoing correction in bond yields, even if the upside potential for long-term yields remains limited against a backdrop of very strong investor appetite for bonds. Investor interest in bonds can be seen in the considerable demand for primary issues at the start of the year. After reducing our duration exposure during the December rally to return to a neutral position on euro rates, we are exploiting any weakness in the market to add to duration.

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[1] Bloomberg, 27 December 2023

[2] Bloomberg, 19 January 2024

[3] Eurostat, January 2024

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