ECB preview: what comes after today’s cut.
The ECB is expected to deliver its 7th rate cut of this monetary policy cycle on Thursday, and their first consecutive rate cut. The market is expecting a 25bp rate cut which would bring the main refinancing rate down to 2.5%. The market is fully expecting a cut this week, there is a 99% chance of a cut priced in by the futures market. However, the outlook for rates is less clear. The market has reduced the chance of an April rate cut to 51% from 63% earlier this week, as the seismic shift in German fiscal spending may have an impact on future ECB policy.
German bond yields have historical move
The massive boost to German government spending includes loosening all fiscal rules for defense spending, along with a EUR 500bn infrastructure fund to try and reignite Europe’s growth engine, after two years of stagnation. So far, the market thinks that Berlin will be successful. German stocks soared on this news, the Dax rose by more than 3% on Wednesday, while the MDax, the German mid-cap index, rose by more than 6%. There was also a major recalibration in the European bond market. German 10-year yields rose nearly 30 basis points in a single session, the biggest jump since German reunification. The 10-year German yield is still below 3%, but if the rise continues then we could move back to a range around 4%. This would be the highest level since 2006-2008, and is a massive step up for German yields and would undoubtedly have economic consequences.
German fiscal expansion and the ECB
German spending at this rate and the accompanying jump in bond yields will have a major impact on the ECB. Since Christine Lagarde and her predecessors have called for a fiscal response to Europe’s structural issues, this may be welcome news. However, it may impact the long-term direction of ECB monetary policy. On the one hand, it could boost growth over the long term, which could be inflationary. On the other hand, the jump in bond yields comes at the wrong time, as it makes Germany’s fiscal expansion more expensive, so there could be pressure on the ECB to continue with their easing cycle.
The market now expects less than three ECB rate cuts this year; the market had expected more than three cuts earlier this week. There has also been an increase in the ECB’s neutral rate from 1.8% at the start of this week, to 1.97% on Wednesday. The market is also starting to price in rate hikes from early 2026.
The interest rate futures market still needs to get used to the new normal for Germany. Today’s ECB press conference is more important than usual, as we await the ECB’s assessment of what Germany’s potential economic renaissance means for monetary policy.
Euro on fire
Interestingly, Bloomberg’s ECB Speak index has indicated that ECB members had started to sound more hawkish before news on Germany’s fiscal expansion was made public. Although the index remains in negative or ‘dovish’ territory, it is at its highest level for nearly a year. If the ECB shifts to a hawkish/ neutral stance on Thursday, then it may be the trigger that pushes the euro back to $1.10 vs. the USD. EUR/USD has risen more than 2.8% this week, as the dollar sinks, and the euro gets a massive leg up from the sharp rise in bond yields.
Trump likely to feature
The ECB will also need to discuss the impact of President Trump’s economic policies. There is a tone of caution across central banks right now, due to the unknown impact of President Trump’s tariff policies. Will they hinder the EU’s economic recovery and spur inflation? Either way, it will take some time to know the effects of US tariffs on EU exports as they have yet to be formally given a start date. Due to this, there is a chance that the market is pricing in too much loosening from the ECB.
Watch inflation forecasts
The ECB will also release its latest economic forecasts alongside this meeting. If they do not take account of the latest German fiscal expansion, then they are mostly useless, but if they do take account of a German economic recovery over the medium and long term, then we will be watching the inflation forecasts. If the ECB’s CPI forecast is revised higher, this could increase the case for the ECB remaining on hold in the medium term, which is supportive for the euro. Overall, we expect the ECB economic forecasts to include a massive caveat that tariffs could cause severe disruption to global trade flows and thus economic growth. It’s tough to be a central banker these days.
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