The July 25th European Central Bank will be very much a live meeting as the markets price in more or less a coinflip between holding rates at -0.4 percent, or a 10 basis points cut to -0.5%. 

Chart 1: Overnight Interest Swap (OIS) futures market pricing of ECB rate cuts for the rest of 2019

Source: Bloomberg

The chart also reveals the real question is (according to OIS futures market pricing, at least), is not if the ECB is going to cut rates, but when.

We indeed expect the ECB to cut the rates by 10 basis points in the July meeting, justified by cratering inflation expectations and soggy economic data.

We expect Mario Draghi will start preparing for a dovish legacy by keeping all options open, reminiscent of his “whatever it takes” speech in 2014 and stressing that both further rate cuts and a re-opening of the Asset Purchasing Program remain part of the ECB’s toolkit.

The number one thing the ECB wants to prevent is inflation expectations being anchored at extremely low levels, which would bring the Eurozone frighteningly close to a deflationary spiral again, just like in 2014.

The near-record low inflation expectations indicated by 5year-5year inflation swaps will spike nerves into the ECB members, justifying aggressive action now before these inflation expectations slip further down towards the realm of doomful deflation.

Additionally, Purchasing Manager Indices suggest that inflation pressures have moderated as retreating demand forces companies to compete more on price.

This is then the main channel through which the weaker performance of the manufacturing industry (mostly the export-oriented part, and mostly in Germany) cause more dovishness in the ECB’s rate-setting monetary policy.

Simultaneously, activity indicators and disappointing retail sales data (again in Germany, and in Italy) suggest the consumer may be able to pick up the baton manufacturing dropped, but definitely not run with it.

Chart 2: EURUSD threatens to drop below two year range



Source: Bloomberg

Draghi has plenty of reasons to leave his successor Chrisitine Lagarde in a dovish bind with inflation expectations plummeting, while the macroeconomic situation is worsening and external risks (trade war, Brexit) remaining stubbornly present.

A rate cut and words will be sufficient for now, but don’t be surprised if he leaves Lagarde with even lower interest rate level and a an APP about to reboot when he hands her the ECB scepter in October.


Author: Bart Hordijk, FX Market Analyst at Monex Europe.