Chart 1 illustrates that the market anticipates it will take at least two years for the ECB to reach the neutral rate, indicating a prolonged period of restrictive policy. ECB Chief Economist Philip Lane’s recent comments underscore this cautious approach: “We still need to be restrictive all year long.” The consensus view of one rate cut per quarter points to a gradual path to normalisation. A key question for the upcoming meeting is whether the ECB will signal another rate cut in July.

Chart 2: ECB balance sheet as a percentage of European GDP

Source: CIO Office, Bloomberg

Even though ECB President Christine Lagarde stated on April 11th that “the size of our balance sheet has significantly reduced already,” Chart 2 shows that the ECB balance sheet relative to European GDP is still well above pre-pandemic levels. Therefore, significant discussions or actions regarding the balance sheet are unlikely at this meeting.

Chart 3 illustrates the current significant differential between U.S. and Eurozone short-term rates. This disparity can put downward pressure on the euro, making European exports cheaper but increasing the cost of imports priced in dollars. If the current gap remains stable, the EUR/USD exchange rate should remain relatively steady. The paths of ECB and Fed monetary policies are closely aligned according to market expectations, mitigating the risk of significant fluctuations.

However, as the ECB begins to cut rates,it must carefully consider the implications of potentially widening the interest rate gap with the U.S. Too aggressive a rate-cutting cycle could lead to a sharp depreciation of the euro, undermining the ECB’s inflation control efforts. Conversely, maintaining too restrictive a policy could stifle economic growth within the Eurozone.

The ECB needs to navigate this landscape carefully. While the first-rate cut is intended to reduce some of the current restrictiveness, the policy must still remain sufficiently tight to prevent the euro from depreciating too rapidly. A balanced, data-driven approach will be crucial to manage these economic forces and ensure sustainable growth while keeping inflation in check.

The short end of the yield curve stands to benefit the most from the ECB’s anticipated actions, provided the central bank does not adopt an overly cautious tone. Recent data on European wages and inflation does not support a rapid succession of rate cuts. The long end of the curve may see limited benefits, given that the European yield curve is still inverted by 36 basis points. Additionally, European financial conditions are highly accommodative, near their peak levels according to the Bloomberg Eurozone Financial Conditions Index. The ECB is unlikely to maintain such favorable conditions indefinitely.

However, if President Lagarde hints at a consistent pace of rate cuts in future meetings, the 10-year German yield could respond positively. Nonetheless, our base case scenario is that the ECB will remain highly data-dependent and cautious.

As the ECB navigates this delicate balance, monetary policy adjustments will aim to support economic growth without destabilising the economy. If successful, these adjustments could lead to a steepening of the European yield curve, a development eagerly anticipated by investors for some time. The ECB’s careful, data-driven approach will be crucial in managing these interconnected economic factors and ensuring a sustainable recovery.