Money markets are increasingly speculating that the European Central Bank (ECB) might make a significant interest rate cut in December, prompted by disappointing economic data. However, analysts predict that the bank will continue its cautious approach to rate reductions due to ongoing inflationary pressures.
After weak business activity indicators were released on Thursday, market participants raised their expectations for the ECB’s next move. Currently, money markets are pricing in a 50% probability that the ECB will reduce interest rates by half a percentage point in December. However, ECB officials appear split on whether such a drastic cut is necessary.
Government Bond Yields Hit Yearly Lows
Following the lackluster business activity reports for October, major European government bond yields dropped significantly, reaching yearly lows. These yield fluctuations typically indicate market expectations for the ECB’s interest rate decisions, especially for short-term bonds. The yield on 2-year German and French government bonds, which are particularly sensitive to rate changes, fell to yearly lows before slightly rebounding, reflecting traders’ growing anticipation of a larger rate cut.
According to flash estimates from S&P Global, the manufacturing Purchasing Manager Index (PMI) for both France and Germany has been contracting for over two years as of October, though there has been a slight improvement in Germany’s figures. France’s services PMI is expected to dip back into contraction after two months of growth, hinting that the economic boost from the Paris Olympics was short-lived. This, combined with a significant drop in headline inflation in September, has increased the likelihood of a steeper rate cut by the ECB in December, following consecutive cuts in September and October—the first in 13 years.
The eurozone’s annual inflation fell to 1.8% in September, the lowest in three years and below the ECB’s 2% target. However, core inflation, which excludes volatile items like food and energy, remained relatively high at 2.7%. The upcoming consumer price index for October, set to be released next week, will be pivotal for market sentiment.
Michael McCarthy, a market strategist and chief commercial officer at Moomoo Australia, noted that eurozone inflation still poses “substantial upside risk.” He anticipates that next week’s core inflation figure for October could rise to 2.8%, and if it exceeds expectations, it could lead to a sharp shift in interest rate markets.
ECB Officials Debate Rate Cut Options
ECB officials are currently divided on whether to pursue a quarter-percentage-point or half-percentage-point rate cut. However, they all share confidence that inflation will eventually return to target. ECB President Christine Lagarde stated in a Bloomberg TV interview that the pace of any adjustments would be guided by both past and anticipated data.
Some Governing Council members, like Mario Centeno from Portugal and François Villeroy de Galhau from France, believe that economic risks currently outweigh inflation concerns. Conversely, others, such as Klaas Knot from the Netherlands and Pierre Wunsch from Belgium, take a more hawkish stance, arguing that a 50 basis point cut would be premature unless economic conditions worsen further. A slight majority of officials seem to favor a gradual approach rather than a more aggressive move.
In addition to inflation data, key eurozone economies will release their third-quarter Gross Domestic Product (GDP) figures next week, providing further insights into the region’s economic outlook. The IMF has downgraded its forecast for the euro area’s economic growth to 0.8% in 2024 and 1.2% in 2025, down 0.1% and 0.3% from its July predictions.
Dilin Wu, a research strategist at Pepperstone, expressed skepticism about the likelihood of a 50 basis point rate cut in December, especially after the recent back-to-back cuts. She acknowledged the challenging economic climate, stating that such a significant reduction could potentially lead to increased market volatility.