A tale of two rate cuts

By Kathleen Brooks, Research director at XTB 

This note is a story of two rate cuts. Firstly, it’s the story of why the ECB has cut today and why it will cut again at its next meeting in December. It’s also the story of two different reasons for cutting interest rates. Last month, the Fed took the indulgent decision to cut rates by 50bp, not because it had to, but because it wanted to protect the soft economic landing. Today, the ECB had no choice to cut, as the growth and inflation  outlooks deteriorate further. 

The ECB had to cut rates because the sharp slowdown in economic growth is threatening deflation, which is now a risk for the region, as some economies like Italy and Ireland already have inflation rates that are close to zero. Christine Lagarde et al at the ECB are now concerned that the wave of disappointing economic data will weigh on future readings of inflation. 

The ECB’s Lagarde said that it would still assess economic data between now and December before making up her mind about a cut at the end of the year. However, with growth and inflation both looking weak, and the ECB confident that the disinflation process is taking hold, it makes an assumed rate cut next month the most likely outcome.  If the data continues to disappoint then we could also see back to back cuts after December and into Q1 2025. The ECB said that it sees the risks to the Eurozone economy tilted to the downside, and some members see the risk of inflation undershooting the target 2% rate in the medium term, which could require successive rate cuts to avoid. 

The reason the ECB did not cut rates by 50bps today and follow the Fed, is due to two reasons. Firstly, inflation rates in the currency bloc are mixed. For example, inflation rates in Belgium and the Netherlands are still above the target rate. Secondly, by only cutting rates by 25bps today, it gives the ECB more room to cut rates down the line, since the nominal interest rate in the Eurozone is already lower than it is in the US and the UK. 

Today’s rate cut was unanimous. Only a few weeks ago no one expected a rate cut from the ECB at this meeting, with December more likely. This highlights how rapidly the situation has changed. 

EUR/USD has dropped 30 points on the back of this meeting. The euro is lower by more than 1.2% in the last 5 days and there could be more downside to come. The German 2 year yield, which is sensitive to ECB rate changes, fell another 7 bps today. We think that there is already a lot priced in to German bonds, and this could limit more downside. 

However, this does not mean that euro downside will slow from here. EURUSD has crossed below key Fibonacci support at $1.0835, added to this, the dollar is likely to remain strong due to a strong growth outlook and in the lead up to the US presidential election. Below $1.0800, the next key support level is $1.05 for EURUSD. 

Lagarde made multiple references to former ECB President Mario Draghi’s blueprint for the Eurozone growth document. This document includes long term structural shifts that the Eurozone should make to boost growth and productivity in the future. A few rate cuts from the ECB may not be enough to spur Eurozone growth in the medium term, since many of the economic struggles that the currency bloc faces are structural and are not easily solved. Thus, it is not a given that the economic data will pick up, which is why the ECB is right to be worried.