Firm ECB stance on interest rates pushes euro up vs. USD, reverses losses against pound

On Thursday, the European Central Bank (ECB) pushed back against market expectations of imminent interest rate cuts by reaffirming that borrowing costs would stay at record highs despite lower inflation forecasts.

The ECB opted to leave interest rates unchanged and did not even hint at a potential reduction.

“Should we lower our guard? We asked ourselves that. No — we should absolutely not lower our guard," ECB President Christine Lagarde told a news conference after the decision. "We did not discuss rate cuts at all. No discussion, no debate," the official said, describing herself as “in COVID recovery mode”.

While recognizing that underlying price pressures were easing, Lagarde noted that domestic inflation, primarily influenced by wage costs within the 20-country euro bloc, was “not budging”.

“We need to better understand what is happening there,” Lagarde said of the wage dynamics, and to what extent additional wage increases might be absorbed by businesses. The role of wages was also noted by Markets.com Chief Market Analyst Neil Wilson in his recent ECB preview.

This cautious tone ran counter to market expectations of interest rate cuts in the first half of next year — a potential reversal from the ten back-to-back increases that ended in September. The ECB did make a smaller policy adjustment by advancing the end of its last remaining bond-buying scheme, a measure implemented in response to the COVID-19 pandemic.

Following the decision, the ECB's deposit rate remains at a historically high 4%, a significant shift from its negative 0.5% position in July 2022. The euro strengthened against the dollar after the announcement, with the EUR to USD exchange rate climbing over 1.05% to 1.099. The euro to GBP rate, after tilting in favour of sterling following the Bank of England’s policy announcement, swung back towards the euro, with the common currency gaining 0.05% against the pound at 0.8625 as of 14:30 GMT.

EU interest rates: Markets forecast cuts to begin in April 2024

Investor expectations prior to the meeting pointed to a potential rate cut in the spring, possibly as early as March. ECB President Christine Lagarde may face challenges in pushing back against rate-cut expectations, especially following the U.S. Federal Reserve's recent signal of imminent lower borrowing costs in the coming year, with indications of up to three cuts earmarked for 2024.

Following the decision, traders adjusted their expectations for ECB rate cuts, now forecasting them to begin in April and totaling 140 basis points next year, compared to the earlier projection of up to 160 basis points.

The ECB's updated economic projections indicate lower inflation and growth, particularly for the next year. Projected headline inflation averages 5.4% in 2023, 2.7% in 2024, 2.1% in 2025, and 1.9% in 2026. Lagarde is likely to emphasize the importance of incoming data, especially on wages, and may echo the view that policymakers should focus on economic data rather than committing to steady rates through mid-2024.

The ECB also took a decision on the future of its Pandemic Emergency Purchase Programme (PEPP), originally slated to run until the end of next year. With markets stabilizing, the ECB announced it would replace maturing bonds only through June and gradually phase out reinvestments in the second half of the year.

Mark Wall, Chief European Economist at Deutsche Bank Research in London, told Reuters that the PEPP decision may have been a step towards a more dovish ECB: 

“Getting the PEPP announcement out of the way now reduces the hurdle to earlier rate cuts in 2024. While the PEPP exit makes it appear like the ECB is not shadowing the Fed’s dovish pivot, it may have subtly opened the door."

Euro forecast: Scotiabank, ING both see EURUSD moving towards 1.10

In a euro forecast issued prior to Thursday’s announcement, Shaun Osborne, Chief FX Strategist at Toronto-based Scotiabank, said the ECB’s pushback against the market’s pricing for interest rate cuts could drive the EUR to USD rate towards 1.10: 

“Refreshed staff forecasts for inflation and growth will give policymakers a little more perspective on the rate outlook but it remains to be seen whether the ECB’s leadership is willing to mimic the Fed and endorse market expectations of an early start to the easing cycle.

Pushback on the market’s pricing for cuts will drive EUR towards 1.10”

Chris Turner, ING’s Global Head of Markets, was in broad agreement with Osborne regarding the EURUSD trajectory in his euro forecast: 

“Our ECB market preview felt there were upside risks to EUR/USD going into this ECB meeting. EUR/USD has already enjoyed a strong rally on the back of the softer US rate view, and assuming the ECB does not fully embrace dovish expectations for next year, we would say the bias for EUR/USD lies towards 1.0945/65 and probably 1.10 multi-day. Over recent months, we have been forecasting EUR/USD to end the year somewhere near 1.07. After last night's Fed shift, we expect EUR/USD ends the year closer to 1.10 now”.

Turner’s colleague Carsten Brzeski, ING’s Global Head of Macro, told Reuters that the ECB’s forecasts, despite their track record, do not justify aggressive rate cuts in 2024: 

"Despite their dismal track record, the ECB’s staff projections will play an increasingly important role again over the coming months. Today’s forecasts show headline inflation at 5.4% in 2023, 2.7% in 2024, 2.1% in 2025 and 1.9% in 2026. GDP growth is expected to come in at 0.6% in 2023, 0.8% for 2024, and 1.5% in both 2025 and 2026. These forecasts would not justify aggressive rate cuts next year. 

For now, we still think that the ECB's shift to full dovishness will be more gradual than markets are pricing in. Today’s policy announcements and the staff projections nicely confirm this”.

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