A reassessment of inflation expectations has been the main cause of rates falling and raising expectations of first rate cuts at the end of the first quarter of next year. Starting next summer, market indications indicate that the expected general inflation will be set below 2%. In fact, the 2-year inflation swap has fallen to 1.8%.
It is easy to overlook that, at the same time, core inflation is still currently at a high 3.6% year-on-year, giving the ECB enough reason to remain cautious. However, the reaction against the market’s aggressive pricing has been lukewarm at best, and comments from officials have placed cuts in the first half of next year clearly in the realm of possibility. But whether they are probable is a different question. The ECB may decide to let the data be the judge, but at the same time it remains more reluctant to extrapolate to the extent that the market does. Its own inflation forecast may decline next week, but potentially not to the degree that markets are pricing in.
We see a good chance that the rally in initial rates (which currently price in a 75% chance of a cut next March) will stabilize, if not ease somewhat. However, the longer end could see less bullish pressure. In the extreme case, if the Governing Council is too aggressive and ignores the faster disinflationary push, it could lead markets to believe that a policy error is brewing.