The stage is set for a clash between traders betting on interest rate cuts and Christine Lagarde, who is ready — once again — to hammer home the need to stamp out inflation.
The European Central Bank president 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.
Regardless, euro-area bonds rallied in January as investors resisted warnings of aggressive tightening in the coming months and continued to price a decline in rates by year-end.
The US Federal Reserve, the ECB, and the Bank of England are all due to hold rate-setting meetings this week and strategists from Nomura Holdings to Société Générale are in little doubt as to who will strike the most hawkish tone. There’s also the danger Christine Lagarde will add extra frost to her remarks to prompt a market correction should European inflation data come in milder than forecast.
“We expect a showdown between the ECB and markets,” said Nomura economist Andrzej Szczepaniak.
Swaps indicate 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%.
Yet traders see just a 70% chance of another 50 basis point hike in March and then begin to price in cuts to the key rate from around September. That’s despite the best efforts of ECB officials.
At Davos, Lagarde invited traders who’ve taken dovish rate wagers “to revise their position. 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.
“The current market pricing is not coherent,” Société Générale strategists including Ninon Bachet wrote in a note on Thursday.
At least for now, the European economy looks able to handle more hikes.
Economists at Goldman Sachs no longer predict a recession this year as factors including a warmer-than-usual winter in energy-strapped Europe and easing supply-chain constraints boost optimism.
Compare that with the UK, where the economic outlook is more challenging.
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%.
January inflation data due next week could embolden traders to revise rates pricing lower if there are signs of a further slowdown — triggering 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 including Gediminas Simkus have stressed risks around the stubbornness of core inflation, remarking last week that 50 basis-point rate hikes “must be taken unequivocally”.
But even if the data comes in better than expected, the global battle to tame price growth is unpredictable and there could be surprises down the line. Traders might look to Australia for a cautionary tale.
Data there last week showed 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.
The ECB may get a helping hand from the Fed, if US policy makers — who are also expected to raise rates this week — make it clear the inflation fight is far from over.
Swaps linked to US central bank meetings imply traders expect almost 50 basis points of rate cuts by the end of the year. While signs of a slowdown are mounting — the Fed has delivered 425 basis points of hikes compared with 250 basis points from the ECB — the US economy expanded at a healthy pace in the fourth quarter, and the Fed has repeatedly warned it will leave rates elevated.
According to Florian Ielpo, head of macro at Lombard Odier Investment Managers, the ECB and Fed need to keep ramming home the message that the war on inflation isn’t over.
“Their job is to convince markets that the rate cuts that have been priced have no place to be there,” he said.