Where Next for EUR Rates?

And just like that, the first quarter of 2024 has drawn to a close. We began the year by warning of the risks to the aggressive cutting cycle priced into interest rate curves (see here: Interest Rates 2024: Risks and Expectations) – much has changed in rates markets since then. The ECB’s second meeting of the year last week presents a timely opportunity to check in on our continental neighbours and consider the future trajectory of European rates and their potential impact on broader macroeconomic markets.

At the start of the year, markets were pricing Eurozone depo rates at 2.5% by year-end, some 150bps lower than where they were (and still are). Roll forward to now and the markets have indeed moderated – now calling for rates at just under 3%. Several factors have driven this repricing: central bank rhetoric, economic data out of Europe, global rate repricing, to name a few.

Early in 2024, President Lagarde was very clear in her messaging – it was too early to declare victory over inflation, and cutting rates too soon posed a greater risk to economic stability than keeping them elevated. This messaging was echoed around the world, with the Fed and the Bank of England pushing similar lines. However, the recent ECB meeting has signalled a subtle shift. While Lagarde’s language remained very similar to the previous meeting – and she maintained that more data was required to be confident enough to start cutting – the revisions to inflation projections portrayed a committee already quietly confident. Lowered core and headline inflation forecasts for 2024, 2025 and 2026 fuelled market optimism that the battle against inflation had indeed been won. As a result, we saw year end rate expectations fall some 15-20bps following the meeting – effectively adding an additional cut to expectations.

While the rate curve looks more sensible than in January, pricing of over 100bps of cuts still feels too aggressive in our view. The ECB has all but confirmed that the first hike will not occur before June. Lagarde stated “We clearly need more evidence and more data. We will know a little more in April, but we will know a lot more in June”. Her comments imply that the ECB will have to cut by 25bps in every meeting bar one, and this will get them to 100bps, current pricing is for some measure of cut in every meeting from June onward. Though possible, this would be quite the about turn from the current conservative ECB Committee which prioritizes inflation control and avoiding excessive rate cuts.

Recent economic data bolsters our view – the most recent CPI figures exceeded economist forecasts, with core inflation still unable to dip below 3%. On the growth front, positivity is a little lacking – though PMIs remain in contractionary territory in the Eurozone, they have been climbing in recent months and, pertinently, outperforming economist expectations. Similarly, the influential ZEW Expectations of Economic Growth surveys, though still low, have climbed for seven consecutive months and have beaten economist expectations each time. These forward-looking indicators point toward an improving picture and should give the ECB the confidence it needs to leave rates higher in an effort to address sticky inflation.

These developments will have implications on hedgers and will alter the costs associated with removing macro risks. One standout opportunity, as we have discussed previously, is the downward sloping yield curve – it presents a near-term opportunity for those looking to remove floating rate risk. To demonstrate the size of the opportunity, a 3y EUR cap currently costs approximately EUR 1.5mio per 100mio notional. If one cut, 25bps, was to be priced out of the curve, the value of this cap would increase by some EUR 325,000 and perhaps more. The FX market is equally interesting. Following the recent ECB meeting, seen as dovish by markets, the euro dropped against the dollar initially (lower rates, weaker euro) but rebounded quickly and ended the day stronger. This is driven by large long positions in USD and aligns with our general view that the USD is currently overvalued and may weaken over the medium to long term (see here: 2024 Outlook). If the rates markets in Europe were to price out more cuts, we could very well see this euro strength continue over the course of the year.

Next week’s meetings by the Fed and the BoE will help develop the global macro picture for the rest of the year. The markets continue to present opportunities and risks for macro risk hedgers – a robust risk framework and closely monitoring market developments will offer market participants the best chance of success.