Ebury: European Central Bank hints at September interest rate cut

July 26, 2019

Policymakers in the Eurozone held interest rates unchanged following its July meeting, defying some of the more bearish expectations that had pencilled in an immediate interest rate cut. The ECB did, however, give its clearest indication yet that it was willing and able to ease policy as soon as its September meeting. Regarding its future policy moves, the bank’s statement noted that ‘the Governing Council expects the key ECB interest rates to remain at their present or lower levels at least through the first half of 2020.’

The addition of the word ‘lower’ to the bank’s previous statement in June marks a significant change in forward guidance that suggests that the bank is ready to follow suit with the Federal Reserve in easing policy at its next meeting. Draghi also suggested that in addition to modifying interest rates, the reintroduction of its quantitative easing programme could be on the cards. The ECB is said to be examining options ‘such as the design of a tiered system for reserve remuneration, and options for the size and composition of potential new net asset purchases.’

President of the ECB Mario Draghi also struck a dovish tone during the bank’s press conference, voicing heightened concerns over the outlook for the Euro Area economy. He stated that significant stimulus was still necessary, while noting that recent data pointed to ‘somewhat weaker growth’ in the second and third quarters. Draghi also claimed that the chances of a rebound in activity in H2 were becoming less likely, highlighting the recent downturn in manufacturing data and growing external downside risks, namely protectionism and the possibility of a hard Brexit.

On the outlook for inflation, Draghi stated that inflationary pressures were ‘muted’ and that the bank would be determined to act should the medium term inflation outlook fall short of the Governing Council’s aim. We have long reiterated that the ECB will maintain an accommodative policy stance so long as Eurozone inflation remains well short of the central bank’s ‘close to, but below 2%’ target. With headline inflation showing no signs whatsoever of trending towards target, the need to act has become increasingly pressing.

We think that the inclusion of the phrase ‘lower levels’ with regards to future interest rates in the ECB’s statement is significant and paves the way for fresh stimulus at the central bank’s next meeting in September, when updated economic projection will be released. This, we believe, will  include a reduction in the bank’s deposit rate and could potentially entail a resumption in the ECB’s asset purchasing programme. Financial markets now seem to be in strong agreement and are pricing in around an 80% implied probability of a rate cut in September, versus around 70% prior to today’s meeting. The Euro did, however, rally as Draghi’s press conference went on. This, we believe, is largely due to the fact that Draghi deliberately avoided explicit questions on both nthe timing and extent of future interest rates moves, while stating that no discussion was had on whether to lower rates at this month’s meeting.

Despite the heightened probability of lower rates from the ECB, we still believe that the likely path for EUR/USD this year is higher. With interest rates in the Eurozone already at or below zero, the Federal Reserve has much more room to lower rates than its European counterpart. Our view that the bar for multiple Fed rate cuts is much lower than that of the European Central Bank should, we believe, provide decent support for the common currency during the remainder of 2019.