Will the ECB deliver its second rate cut?

The ECB is expected to deliver its second rate cut in the cycle this Thursday to take the key deposit rate down to 3.5% from 3.75%. The refinancing rate will likely fall more significantly as the ECB has previously decided to reduce the gap between the refi rate and the deposit rate to 15-bps from the previous setting of 50-bps.

As a result, we are likely to see the refinancing rate decline from 4.25% to 3.65%. This change in the spread between the refinancing rate and the deposit rate will not have any unusual bearing on cash rates as the euribor rate tracks the deposit rate, not the refinancing rate. The market is fully priced for a 25-bps cut this week but, thereafter, is set up to anticipate cuts occurring on a quarterly basis to coincide with the release of new economic forecasts in December, March, June, and September. This sort of quarterly schedule is not uncommon.

It is certainly prevalent in UK pricing as well, and even in the US the market has toyed with this idea when traders and investors speculate that the Fed will be quite cautious. While we feel that a quarterly schedule of rate cuts is very possible if central banks like the ECB are somewhat cautious with wage growth, for instance, still some way above levels that appear consistent with attainment of the inflation target, the risk has to be that the banks cut more quickly.

In the Standard Bank’s view, the ECB skipped a rate cut at the last meeting as some members felt that the bank had erred in pre-committing to the first rate cut back in June because data leading up to the ‘promised’ rate cut seemed to question the wisdom of lowering rates in June. The compromise at the time appeared to be that the June cut would go ahead, but members would agree to refrain from pre-committing to any future rate cuts. If this surreptitious directive remains in place, then we’d expect ECB President Lagarde to refrain from making any comments about future policy at Thursday’s press conference.

However, while no rate-cut ‘promise’ is likely to be forthcoming for the next meeting in October, we’d be reticent to rule it out as the economy is floundering, inflation is becalmed, and, perhaps most importantly of all, wage trends have turned much more supportive of policy easing recently. The upshot is that the Standard Bank’s forecasts for ECB easing are more aggressive than the median view amongst analysts. For instance, it expects the ECB to have trimmed rates by 150-bps to 2% by Q3 next year, which is some 50-bps lower than the median forecast and slightly lower than that priced into the market.

The Standard Bank’s forecasts for ECB easing over the coming year suggest that the policy rate could be as much as 50-bps below the median forecast by other analysts, and we have the same view when it comes to the Federal Reserve. While the Fed will start with a 25-bps rate cut at the September 18th meeting, we look for a step-up to a 50- bps pace as the easing cycle gets going, and hence, in a year’s time we see 225-bps in rate cuts to take the Fed funds target down to 3.0%-3.25%.

However, while it might seem that we are equally convinced of the case for more aggressive Fed easing than many expect, we see ECB cuts as more ‘certain’ given the parlous state of the euro zone economy and the clearer fiscal outlook. For while the euro zone, and other G10 nations are set on a clear path of budgetary consolidation, the same is not true in the US. For even if Democrat candidate Harris were to win, her more cautious fiscal stance relative to Trump might not prevent Congressional action to make the 2017 personal tax cuts permanent should the Republicans take the Senate.

Hence, the Fed could have a trickier time setting policy, and it could be even trickier should Trump emerge victorious and go through with his plan for significant tariff increases. The upshot is that investors in government bonds should err towards the euro zone market, and the UK for that matter, over treasuries. “Don’t get us wrong, we still see US yields falling, particularly at the front end as the Fed eases. It is just that we feel that there are fewer factors that can knock EGBs and gilts out of their stride over the few months”, said the Standard Bank.