ECB Prioritizes Fighting Inflation Above Avoiding Recession

The European Central Bank is likely at or very near its peak policy rate, but we don’t expect rate cuts in the near term.

In hiking its deposit rate by a quarter point in September, the European Central Bank (ECB) signalled its commitment to achieving price stability. While this rate increase might not be the last, focus now shifts towards how long rates will stay at that peak. We remain skeptical that the ECB will deliver rate cuts as early as the market expects.

Uncertainty looms over the inflation trajectory. While economic momentum in the euro area has weakened materially, labour markets remain strong and underlying inflation appears sticky. Accordingly, the new ECB staff projections show considerably weaker near-term growth than previously expected, but still above-target inflation in 2025, at 2.1%.

Eurozone headline and core inflation stood at 5.3% in August, according to Eurostat. While headline inflation has halved since its 2022 peak, underlying price pressures remain stubbornly high, driven primarily by domestic factors. For inflation to return to the ECB’s 2% target, additional weakening in the labour market and in the overall economy may be necessary.

The ECB’s asset purchase programme (APP) reinvestments have stopped as planned, as the bank looks to gradually unwind accommodative policy. Also, the ECB might consider an earlier cutback in pandemic emergency purchase programme (PEPP) reinvestments, perhaps as early as this year. Amidst elevated issuance needs, this weakens the relative technical picture for government bonds, and speaks to a rebuild of term premia over time.

Investment implications: We believe European interest rate swaps should continue to outperform core government bonds, and expect the interest rate curves to steepen.