ECB speeds up pace of easing as EUR continues to weaken

• ECB lowers policy rate for second consecutive policy meeting by 0.25 point to 3.25%.
• ECB indicates that disinflation process is well on track, and that risks to downside are starting to outweigh those to upside for inflation outlook.
• It leaves the door open to another back-to-back cut in December.
• Faster pace of ECB easing is already well priced helping to dampen scale of EUR sell-off.

ECB speeds up pace of monetary easing   

The ECB decided to lower the deposit rate for the second consecutive policy meeting by 0.25 point 3.25%. It is the third rate cut in the current easing cycle, and the first back-to-back rate cut. The accompanying policy statement revealed that the decision to speed up the pace of easing was justified by the updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission. The ECB has become more confident that incoming information on inflation is showing that the “disinflationary process is well on track”. It follows the sharper than expected slowdown for euro-zone inflation in September when the headline rate fell back below their target to 1.8%.  The ECB also added that the inflation outlook was affected by “recent downside surprises in indicators of economic activity”. Leading indicators of economic activity in the euro-zone including the latest PMI surveys for September have been signalling the economic recovery is losing upward momentum in the second half of this year. 

In the accompanying press conference President Lagarde added that the euro-zone economy was “somewhat weaker” than expected with latest data pointing to “sluggish growth”. The ECB is sticking to their view that the euro-zone economy should strengthen over time driven by a gradual recovery in household spending. As a result, the ECB still judges that risks to growth are titled to the “downside”. These downside risks include any hardening of trade barriers if say Donald Trump was to win the US election, weaker global demand, geopolitical risks and the lagged impact of previous monetary tightening if it proves to be stronger than expected. On inflation front, President Lagarde added most underlying measures of inflation had dropped or held. Inflation is expected to temporarily pick back up in the coming months before dropping to target in the next year. The ECB remains wary of upside risks to inflation from heightened geopolitical tensions in the Middle East that could disrupt global energy supplies and trade. However, the most important comment for market participants was that “risks to inflation maybe are a bit more on the downside, not upside”. It sends a stronger signal that ECB will keep lowering to rates as it places more weight on addressing downside inflation risks.       

The ECB’s official forward guidance in the policy statement was left unchanged from the last policy meeting in September. The ECB continued to signal that it will keep policy rates sufficiently restrictive for as long as necessary to return inflation to their 2% medium-term target in a timely manner. The Governing Council will continue to follow a data dependent and meeting-by-meeting approach to determining the appropriate level of restriction, and is not pre-committing to a particular rate path. While they did no directly signal that another rate cut is likely as soon as the next meeting in December, the comment that risks to inflation are a bit more on the downside now than upside suggests another back-to-back rate cut will be forthcoming if the euro-zone growth and inflation data remains weak heading into year end.       

ECB MENTIONS INFLATION LESS IN POLICY STATEMENT

Source: Bloomberg, Macrobond & MUFG GMR

Market Implications

The EUR has initially weakened modestly in response to today’s ECB policy update resulting in EUR/USD falling back closer to the 1.0800-level. The EUR has been undermined by the ECB expressing more concern over the loss of growth momentum in the euro-zone, and indicating that risks to the inflation outlook are starting to become weighted to the downside than upside. It provides encouragement to market participants expecting the ECB to deliver another back-to-back rate cut in December if backed up by further soft activity and inflation data in the coming months. President Lagarde noted that the ECB must be nimble and attentive to incoming data. The rising probability of Donald Trump winning the US election would add to downside risks for the euro-one economy and the EUR. According to Polymarket, the probability of Donald Trump wining has just risen back above 60% providing a tailwind for a stronger USD alongside further evidence that the US economy and consumer remained strong in Q3.

One saving grace for the EUR which is preventing a bigger sell-off is that the euro-zone rate market is already well priced for the faster pace of ECB easing to continue. Another 0.25 point rate cut is more than fully priced in for December and 142bps of cuts in total by the end of next year that would lower the deposit rate closer to 1.75%.  However, there was no indication in the press conference that the ECB was considering whether to deliver larger 50bps rate cuts that could have triggered a further dovish repricing of the euro-zone rate curve and bigger EUR sell-off.           

YIELD SPREADS MOVING AGAINST EUR VS. USD

Source: Bloomberg, Macrobond & MUFG GMR