By Yoruk Bahceli and Naomi Rovnick
(Reuters) – Traders’ bets on multiple ECB interest rate cuts this year have barely been shaken by hot U.S. inflation that slashed Federal Reserve easing expectations this week, highlighting a growing investor focus on the divergence between the two regions.
The European Central Bank cemented that conviction on Thursday, signalling that it may soon start cutting rates. President Christine Lagarde stressed the ECB is “data-dependent, not Fed-dependent.”
The bank said a cut would be appropriate if its updated assessment of the economic outlook, due in June, adds to its confidence that inflation is easing.
Highlighting a dovish outlook, some policymakers even thought it was already time to loosen policy on Thursday, Lagarde noted.
The ECB met a day after a third strong month of U.S. inflation prints roiled global markets and underscored the strength of the world’s largest economy. In the euro area, meanwhile, inflation has cooled fast and the economy is sluggish.
European markets took their fair share of Wednesday’s bond market selloff, but traders still see just over a 75% chance of an ECB June rate cut from around 90% before that data.
By the end of 2024 they expect around 75 basis points of cuts, compared with 90 bps previously.
Yet in sharp contrast, traders pushed their bets on a first Federal Reserve Rate cut to September from June and now see just 40 bps of cuts by the end of the year, down from nearly 70 before the U.S. data. UK rate cut bets were also dialled back, meaning traders are more confident the ECB will move first.
Big central banks’ rate cycles usually move in sync.
“The picture in the euro area is a lot cleaner. The narrative in the euro area is a lot easier to read. The data isn’t complicating the ECB’s assessment of what comes next in a way that data in the U.S. is complicating things for the Fed,” said Peter Goves, head of developed market debt sovereign research at MFS Investment Management.
Markets maintaining their conviction in the ECB leading the Fed and cutting rates more sharply is good news for euro zone bonds, but a headwind for the euro.
Euro zone government bonds, while delivering losses so far this year, have continued to outperform their U.S. peers.
The bloc’s bonds have lost investors 1.3% this year, compared with 2.8% in U.S. Treasuries, ICE BofA indexes show.
Germany’s 10-year bond yield, the euro area benchmark, has risen around 40 bps this year, compared with 70 bps in U.S. peers. Bond yields move inversely with prices.
In the clearest sign of divergence, the closely watched gap between 10-year U.S. and German government bond yields rose to its highest since 2019 at more than 210 bps on Wednesday.
Levels above 200 bps hold in the longer term only when Fed and ECB policy paths diverge, ING said.
“Government bonds adore misery and Europe (the economy) is definitely slower than the U.S. which would argue for a better performing bond market in Europe,” said Insight Investment’s head of investment specialists April LaRusse.
Still, U.S. Treasury prices could recover especially if investors underestimate how much the Fed will cut, she added.
CURRENCY HEADACHE?
The picture is more complicated for the euro.
It fell to a two-month low on Thursday at around $1.0706. The currency also tumbled 1% on Wednesday in its biggest daily drop in more than a year as the dollar surged on the inflation data.
The post-inflation jump in Treasury yields now implies the euro dropping to levels below $1.05, MUFG said.
But for now, analysts reckon euro weakening won’t hold back the ECB.
“I didn’t think the U.S. data would shift the course for the ECB, it would only matter if the euro collapses,” said Nordea chief market analyst Jan von Gerich.
The euro dropped below parity against the dollar for a short period during 2022’s energy crisis.
But as a weak euro can potentially feed into euro zone inflation, it’s one to watch at a time when oil prices have risen around 7% since the end of February.
It would have been a bigger problem when inflation was higher, so a weaker euro could become a concern if oil prices increase further, emphasizing their impact, Rabobank senior FX strategist Jane Foley said in a note.
In one sign that more caution is warranted, assuming the ECB does cut rates in June, traders now price in around a 20% chance of a subsequent cut in July, down from around 50% before Wednesday’s U.S. inflation data.
Indeed, some policymakers think the case for a July pause is becoming stronger following the U.S. data, sources told Reuters on Thursday.
“Longer term if the Fed doesn’t go then that might induce a bit of caution in terms of the degree to which they (the ECB) are willing to cut rates,” said Jason Simpson, senior fixed income strategist at State Street Global Advisors SPDR ETF business.
(Reporting by Yoruk Bahceli and Naomi Rovnick; additional reporting by Dhara Ranasinghe and Alun John; editing by Dhara Ranasinghe and Hugh Lawson)
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