Dovish ECB Update Weighs on EUR

1. ECB lifts deposit rate up to 4.00% but signals it could be peak although further hike not ruled out.
2. Focus is shifting to leaving rates at high level for long period.
3. Dovish market reaction as EUR weakens and euro-zone rates fall further out the curve.

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• ECB moves closer to rate peak after latest hike.
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• Last Thursday 14/09/2023, the European Central Bank (ECB) implemented a 25-basis point (bps) interest rate hike during its policy meeting, bringing the deposit rate up to 4.00%. It's worth noting that prior to this meeting, the euro-zone rate market had factored in approximately 16 bps of rate hikes, so this increase was not fully anticipated.
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• In the accompanying policy statement, the ECB acknowledged a persistent decline in inflation. However, the bank expressed concerns that inflation is "still expected to remain too high for too long." To address this, they decided to tighten their monetary policy further to support progress toward their target.
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• In response to the rising energy prices, the ECB's staff raised their inflation projections for this year and the next by 0.2 percentage points, now standing at 5.6% and 3.2%, respectively. Nevertheless, they displayed more optimism regarding inflation, predicting it would approach the target by 2025, as they lowered the inflation projection by 0.1 percentage point to 2.1%. Core inflation forecasts for 2024 and 2025 were also slightly reduced by 0.1 percentage point to 2.9% and 2.2%, respectively.
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• The dimmer outlook for both headline and core inflation toward the end of the ECB's forecast horizon is attributed in part to a weaker growth outlook for the euro-zone. GDP growth projections were significantly revised downward by 0.2 percentage points for 2023, by 0.5 percentage points for 2024, and by 0.1 percentage points for 2025. The ECB attributed this downward revision to tightening financing conditions affecting domestic demand and a deteriorating international trade environment.
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• During the Q&A session, President Lagarde noted that the impact of tightening monetary policy on the euro-zone economy is occurring more rapidly than in previous cycles.
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• The most significant change in the ECB's policy guidance was the statement that "the Governing Council considers that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target." This statement strongly suggests that the ECB is nearing the peak of its rate hike cycle and is leaning towards keeping rates steady for an extended period to help bring inflation back to target. However, President Lagarde mentioned in the press conference that it's premature to declare rates at their peak, leaving the possibility of further rate hikes open if necessary.
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• The updated policy statement also reiterated the ECB's commitment to a "data-dependent" approach in determining the appropriate level and duration of restriction. Given this new guidance and the weaker growth outlook, there is growing confidence that the ECB's deposit rate may have reached its peak at 4.00%. Nevertheless, history has shown that the ECB can be sensitive to rising energy prices, and with inflation already elevated, they may react cautiously to the risk of energy-induced inflation expectations.
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• In summary, the decision to raise rates by 25 bps and signal a higher likelihood of reaching a rate plateau appears to represent a compromise between the more hawkish and dovish members of the ECB's Governing Council.
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• EZ RATE MARKET DOUBTS ECB SIGNAL FOR LONG PERIOD OF HIGH RATES

Source: Bloomberg, Macrobond & MUFG GMR

Market Implications

The market's dovish response to the European Central Bank (ECB) policy update underscores the significance attributed to two key factors:

1. The stronger signal that interest rates may have reached their peak and are more likely to remain unchanged for an extended period.
2. The considerably weaker growth outlook for the euro-zone and reduced inflation projections for 2025.

This reaction has had a more pronounced impact on the foreign exchange (FX) market compared to the euro-zone interest rate market. Specifically, the Euro (EUR) has depreciated by nearly -0.7% against the US Dollar (USD) on the day, leading to a drop in the EUR/USD pair to its lowest levels since the end of May.

The next significant support level is marked by the May low at 1.0635. If this level is breached, it could open the door to a test of the lower boundary of the year-to-date trading range, which extends between 1.0500 and 1.1000.

The decline in EUR/USD momentum has been further amplified by the release of robust US Producer Price Index (PPI) and retail sales data for August. The USD has been bolstered throughout the summer due to expectations of a growing cyclical divergence between the US and other major global economies, including the euro-zone.

While the ECB's policy update has led to an increase in rates at the short end of the euro-zone interest rate curve, especially for the next six months, there has been a decline in rates further out. The implied yield for the end of the following year has decreased by approximately 6 basis points (bps). As a result, the euro-zone rate market is moving closer to pricing in the possibility of three 25bps rate cuts by the end of the subsequent year, currently factoring in 68 bps in cuts. Market participants appear sceptical that the ECB and other major central banks will maintain rates at elevated levels for an extended duration, despite the indications pointing in that direction.

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