The European Central Bank (ECB) left policy rates unchanged at 4% in October, ending a streak of 10 hikes over 14 months that pushed up its main rate by 450 basis points. While we may not have seen the last increase, the focus has shifted towards when the ECB might start to cut. We remain skeptical that the ECB will deliver rate cuts as early as the market expects.

Although economic momentum in the euro area is weak, labour markets remain in good shape and underlying inflation appears sticky. Accordingly, while the latest quarterly ECB staff projections show considerably weaker near-term growth than expected earlier in the year, they still feature above-target inflation in 2025, at 2.1%. There remains significant uncertainty around the medium-term inflation trajectory.

Eurozone headline inflation, which stood at 4.3% in September according to Eurostat, has more than halved since its double-digit peak in October 2022. Still, underlying price pressures remain elevated, driven primarily by domestic factors. While inflation is moderating overall, additional weakening in the labour market and in the overall economy may be necessary for a full return to the ECB’s 2% target.

The ECB terminated asset purchase programme (APP) reinvestments in July. While no decision was taken at the October meeting, the ECB will likely aim for an earlier cutback in pandemic emergency purchase programme (PEPP) reinvestments than current guidance suggests. Amidst elevated issuance needs, this weakens the relative technical picture for government bonds, and speaks to a rebuild of term premia over time.

As for investment implications, while the ECB could be slow to cut rates, the combination of tight monetary policy and expectations of increasing supply as central banks unwind their balance sheets has boosted yields relative to historical levels and other asset classes. This yield “cushion” may create a compelling opportunity for investors to construct relatively resilient portfolios, without taking on a lot of risk. We believe European duration looks increasingly attractive, European interest rate swaps should continue to outperform core government bonds, and we expect the back end of interest rate curves to underperform.

Interest rates: Activity is weak but inflation remains above target

The ECB believes that a deposit facility rate between about 3.75% and 4.00% should be consistent with a return of inflation to target within the medium-term horizon – so long as it is maintained for long enough. Nevertheless, policymakers emphasized their data-dependent, meeting-by-meeting approach, driven by a regular assessment of the inflation outlook, the dynamics of underlying inflation, and the strength of monetary policy transmission.

Immediately following the ECB meeting, markets were pricing in only about 2 basis points of hikes in December, with rate cuts starting in the first half of next year. While we believe the peak policy rate priced into financial markets looks reasonable, we remain skeptical that the ECB will deliver rate cuts so early, given persistent inflation dynamics. We believe two rate cuts in the second half of 2024 constitute a reasonable baseline.

The euro area consumer price inflation release for September contained some good news. It showed that while inflation remains above target, core prices are moving in the right direction. Headline inflation fell to 4.3% year-over-year (YoY) from 5.2% in August, while core inflation eased to 4.5% YoY versus 5.3% in August. Both prints were below consensus. Over the past three months, the average sequential core print was 0.26% month-over-month (MoM), or about 3% annualized.

In addition, while the labour market remains tight, it is starting to show some signs of softening. Employment growth has slowed and forward-looking indicators point to further moderation ahead. Moreover, some wage indicators suggest that pay pressures have started to ease as headline inflation falls. A wage growth slowdown remains important to allow a durable return of inflation to 2%, so information about wage settlements for 2024 will be crucial, though many countries will not release this information until next spring.

The eurozone composite PMI rose modestly in September to 47.2, but it remains weak and consistent with mildly negative growth of around -1% annualized. Overall, the picture remains one of stagnant growth, and slowing but still above-target inflation.

ECB balance sheet: No changes in October, but watch this space

The ECB maintained its balance sheet guidance at the October meeting, and still intends to reinvest PEPP maturities until at least the end of 2024. Flexible PEPP reinvestments remain the first line of defense against fragmentation risk (i.e., the potential for various euro area sovereign yields to shift or respond differently to ECB policy), which could destabilize markets.

Uncertainty around the reform of the euro area fiscal rules, the recent long-end-driven sell-off in yields, and euro area sovereign spread widening, tilted the odds against any major decision at the October meeting. However, we believe the ECB is aiming for an earlier cutback in PEPP reinvestments than current guidance suggests, as inflation remains above target and pandemic-related considerations are less prevalent.

We do not anticipate the ECB to categorically rule out selling bond holdings, but envision a continued focus on a gradual and orderly passive reduction of reinvestments. ECB reinvestment policy will also be influenced by the shape of a new operational framework for steering short-term interest rates, including the size of a structural bond portfolio. The ECB currently aims to conclude this review by spring 2024.