It Won't Take Much for the ECB to Crush Rate-Cut Bets Next Week

  • In Business
  • 2023-01-28 07:00:00Z
  • By Bloomberg

(Bloomberg) --

Most Read from Bloomberg

  • Adani Rout Crosses $51 Billion as Stocks Plunge by Daily Limits

  • Putin Plans New Ukraine Push Despite Losses as He Prepares for Years of War

  • Americans Fall Behind on Car Payments at Higher Rate Than in 2009

  • We Asked ChatGPT to Make a Market-Beating ETF. Here's What Happened

  • Adani Faces One of Worst Billionaire Wipeouts With Empire Under Siege

The stage is set for a clash between traders betting on interest-rate cuts and Christine Lagarde, who's 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 Bank of England and the ECB are all due to hold rate-setting meetings next week and strategists from Nomura Holdings Inc. to Societe Generale SA are in little doubt as to who will strike the most hawkish tone. There's also the danger 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. "It is clear that markets appear eager to challenge the ECB's 'multiple 50 basis point hikes' mantra."

ECB's Lagarde Says 'Stay the Course' Is Her Policy Mantra

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," Societe Generale strategists including Ninon Bachet wrote in a note on Thursday. "Our economists expect the ECB to stop at 3.75%, with upside risks, meaning that the market can price more."

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 about 30 basis points of rate cuts between Sept. 2023 and March 2024, those bets are overdone, she said.

Resilient Economy

At least for now, the European economy looks able to handle more hikes.

Economists at Goldman Sachs Inc. 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%.

"It doesn't look like bunds have all the hikes the ECB needs to carry out priced in," said Gordon Shannon, portfolio manager at TwentyFour Asset Management. Yields on gilts and Treasuries give a much better reflection of the tightening to come from the BOE and the Fed, he said.

Even so, 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 this week that 50 basis-point rate hikes "must be taken unequivocally."

Far From Over

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 this 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.

Bond Bulls Face Inflation Setback If Australia, NZ Are Any Guide

The ECB may get a helping hand from the Fed, if US policy makers - who are also expected to raise rates next 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.

--With assistance from Naomi Tajitsu and James Hirai.

Most Read from Bloomberg Businessweek

  • How to Be 18 Years Old Again for Only $2 Million a Year

  • The US Hasn't Noticed That China-Made Cars Are Taking Over the World

  • Wind Turbines Taller Than the Statue of Liberty Are Falling Over

  • OpenAI Needs Billions to Keep ChatGPT Running. Enter Microsoft

  • A Bet on a Busted Airline Is Poised for a $100 Million Payoff

©2023 Bloomberg L.P.


More Related News

US Bank Deposits Decline by Most in Nearly a Year
US Bank Deposits Decline by Most in Nearly a Year

(Bloomberg) -- Deposits at US lenders posted the biggest decline in nearly a year during the week when multiple bank failures triggered the latest bout of...

First Republic Whiplashes Investors as Bank Concerns Linger
First Republic Whiplashes Investors as Bank Concerns Linger

(Bloomberg) -- First Republic Bank shares ended lower Friday on the heels of another downgrade and as financial turmoil spread to a European lender...

Riskiest Borrowers Left Behind in US Corporate Bond Rebound
Riskiest Borrowers Left Behind in US Corporate Bond Rebound

(Bloomberg) -- Investors are steering clear of corporate America's most vulnerable borrowers, even as credit markets rally on bets that the worst of the...

Central Banks Shed Most US Debt Since 2014 as Dollar Needs Jump
Central Banks Shed Most US Debt Since 2014 as Dollar Needs Jump

(Bloomberg) -- Foreign central banks liquidated Treasury holdings at the fastest clip in nine years and tapped a key Federal Reserve facility to raise cash...

Bond Traders Bet Fed Will Cut Rates by June as Bank Stress Grows
Bond Traders Bet Fed Will Cut Rates by June as Bank Stress Grows

(Bloomberg) -- Bond traders abandoned wagers that the Federal Reserve will raise interest rates in May and added to bets that its next shift will be a rate...

Leave a Comment

Your email address will not be published. Required fields are marked with *

Cancel reply


Top News: Business