Euro Poised for a Fundamental Change

The European Central Bank will cut rates in the second quarter of the year and will continue to cut borrowing costs during the second half of the year if recent central bank rhetoric is to be believed. The financial markets certainly think that this is the most likely scenario and that is going to weigh on the euro in the weeks and months ahead.

Euro Area Inflation is Seen Falling Further

The latest ECB Staff Projections suggest the inflation will continue to fall further over the coming months and quarters with energy inflation ‘projected to remain in negative territory for most of 2024’, while food inflation is expected to ‘decline strongly from 10.9% in 2023 to an average of 3.2% in 2024’. With price pressures receding quickly, the European Central Bank now has added confidence, and flexibility, on the timing of their first interest rate cut.

Euro area HICP inflation

Source: European Central Bank

Euro Area Growth to Remain Tepid this Year

Euro Area growth is set to remain weak this year, according to a range of official forecasters, with the latest ECB projections suggesting a tepid 0.6% recovery for 2024. Recent data showed that the Euro Area economy expanded by a downwardly revised 0.4% in 2023, hampered by weak demand and elevated borrowing costs. The Euro Area’s largest member state, and the prior growth engine of the 19-member block, Germany, has been unable to boost economic activity to anything like its previous levels and is seen growing by just 0.2% in 2024. Recent comments from German Economic Minister Robert Habeck suggest that the economy is ‘in tricky waters and that Germany is coming out of the crisis ‘more slowly than we had hoped’, adding to fears that the German economy is flatlining. The German government originally forecast GDP growth of 1.3% in 2024. The German economy has been hit hard by weak export growth due to lower global demand and its prior dependence on Russian oil and gas. Germany ceased importing Russian oil and gas in late 2022 after Russia invaded Ukraine.

Will the ECB Start Cutting Rates in June?

At the last ECB Monetary Policy meeting in March, President Christine Lagarde admitted that while the Governing Council have not discussed rate cuts, they have begun ‘discussing the dialling back of our restrictive policy’. Ms. Lagarde also added that the central bank is making progress on pushing inflation towards target. ‘And we are more confident as a result. But we are not sufficiently confident, and we clearly need more evidence, more data…We will know a little more in April, but we will know a lot more in June’. This referencing of the June meeting saw market expectations of a rate cut at the end of H1 jump. Financial markets are currently showing a 64% chance of a 25-basis point move at the June 6th meeting, while the market is currently undecided if the ECB will cut three or four times this year.

ECB – Probability Distribution

Source: Refinitiv, Prepared by Nick Cawley

With inflation moving further lower, and with growth weak at best, the ECB will start the process of unwinding its restrictive monetary policy at the June meeting, with a very real possibility of an additional cut at the July meeting before the August holiday season kicks in. The ECB will not be the only major central bank to start lowering borrowing costs this year, but it is very likely that they will be the first and this will leave the Euro vulnerable to additional bouts of weakness in the months ahead.

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