EURUSD flat on a hawkish cut by ECB, but slid after mixed NFP

·         Gold tumbled as China/PBOC may slow down sovereign buying; Wall Street wobbled after mixed US NFP/BLS job report

On Thursday (6th June), some focus of the market was on the ECB’s monetary policy decision. As unanimously expected, on Thursday ECB cut all key policy rates by -25 bps after 5 years; i.e. reference interest rates on the main refinancing operations (MRO-interbank rate) to +4.25%; interest rates on the marginal lending facility (MLF-repo rate) to +4.50%, and interest rate on deposit facility (DRF-reverse repo) to +3.75%. ECB kept rates on hold in the previous Apr’24 meeting at a 22-year high (since Oct’08) after 10th consecutive rate hikes till Sep’23 (cumulating +450 bps since July 22).

ECB cuts rates this time after 5-years and also after almost committing the same in the last few weeks by various ECB policymakers (dovish jawboning) and that too before the forthcoming series of EU elections. ECB kept rates unchanged from mid-Sep’23 till mid-June’24; i.e. almost 9-months. As the ECB rate cut in June was largely in the expected line, the EZ bond yield barely moved Wednesday after the rate cut.

Looking ahead, the ECB indicated inflation remains elevated and thus ECB has to keep real policy rates at a sufficiently restrictive range with a data-dependent approach. The latest Eurosystem/ECB staff projections for both headline and core inflation have been revised up for 2024 and 2025. ECB staff now see HICP inflation (total inflation) averaging +2.5% in 2024, +2.2% in 2025 and +1.9% in 2026, while HICP core inflation at +2.8% in 2024, 2.2% in 2025 and 2.0% in 2026 for Eurozone. The real GDP growth is expected to pick up to +0.9% in 2024, +1.4% in 2025 and +1.6% in 2026. Thus ECB projected higher inflation despite rate cuts and refrained from committing any further rate cuts in H2CY24 contrasting the present market odd of another -50 bps. Thus it may be termed a hawkish cut by the ECB. The ECB cuts rates by -25 bps, as highly expected, keeping their stance neutral and data dependent on future moves. The ECB cut rates by 25 basis points as expected but did not signal additional cuts going forward.

ECB MRO-INTERBANK RATE +4.25% (Ref. policy rate)

Full Text of ECB statement: Monetary policy decisions: 6th June’24

“The Governing Council today decided to lower the three key ECB interest rates by 25 basis points. Based on an updated assessment of the inflation outlook, the dynamics of underlying inflation, and the strength of monetary policy transmission, it is now appropriate to moderate the degree of monetary policy restriction after nine months of holding rates steady.

Since the Governing Council meeting in September 2023, inflation has fallen by more than 2.5 percentage points and the inflation outlook has improved markedly. Underlying inflation has also eased, reinforcing the signs that price pressures have weakened, and inflation expectations have declined at all horizons. Monetary policy has kept financing conditions restrictive. By dampening demand and keeping inflation expectations well anchored, this has made a major contribution to bringing inflation back down.

At the same time, despite the progress over recent quarters, domestic price pressures remain strong as wage growth is elevated, and inflation is likely to stay above target well into next year. The latest Eurosystem staff projections for both headline and core inflation have been revised up for 2024 and 2025 compared with the March projections. Staff now sees headline inflation averaging 2.5% in 2024, 2.2% in 2025, and 1.9% in 2026. For inflation excluding energy and food, staff projects an average of 2.8% in 2024, 2.2% in 2025 and 2.0% in 2026. Economic growth is expected to pick up to 0.9% in 2024, 1.4% in 2025 and 1.6% in 2026.

The Governing Council is determined to ensure that inflation returns to its 2% medium-term target in a timely manner. It will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim. The Governing Council will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction. In particular, its interest rate decisions will be based on its assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission. The Governing Council is not pre-committing to a particular rate path.

The Governing Council today also confirmed that it will reduce the Eurosystem’s holdings of securities under the pandemic emergency purchase programme (PEPP) by €7.5 billion per month on average over the second half of the year. The modalities for reducing the PEPP holdings will be broadly in line with those followed under the asset purchase programme (APP).

Key ECB interest rates

The Governing Council decided to lower the three key ECB interest rates by 25 basis points. Accordingly, the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will be decreased to 4.25%, 4.50% and 3.75% respectively, with effect from 12 June 2024.

Asset purchase programme (APP) and pandemic emergency purchase programme (PEPP)

The APP portfolio is declining at a measured and predictable pace, as the Eurosystem no longer reinvests the principal payments from maturing securities.

The Governing Council will continue to reinvest, in full, the principal payments from maturing securities purchased under the PEPP until the end of June 2024. Over the second half of the year, it will reduce the PEPP portfolio by €7.5 billion per month on average. The Governing Council intends to discontinue reinvestments under the PEPP at the end of 2024.

The Governing Council will continue applying flexibility in reinvesting redemptions coming due in the PEPP portfolio, with a view to countering risks to the monetary policy transmission mechanism related to the pandemic.

Refinancing operations

As banks are repaying the amounts borrowed under the targeted longer-term refinancing operations, the Governing Council will regularly assess how targeted lending operations and their ongoing repayment are contributing to its monetary policy stance.

***

The Governing Council stands ready to adjust all of its instruments within its mandate to ensure that inflation returns to its 2% target over the medium term and to preserve the smooth functioning of monetary policy transmission. Moreover, the Transmission Protection Instrument is available to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across all euro area countries, thus allowing the Governing Council to more effectively deliver on its price stability mandate.”

Text of the opening statement by ECB President Lagarde: 6th June’24

The Governing Council today decided to lower the three key ECB interest rates by 25 basis points. Based on our updated assessment of the inflation outlook, the dynamics of underlying inflation, and the strength of monetary policy transmission, it is now appropriate to moderate the degree of monetary policy restriction after nine months of holding rates steady. Since our meeting in September 2023, inflation has fallen by more than 2.5 percentage points and the inflation outlook has improved markedly. Underlying inflation has also eased, reinforcing the signs that price pressures have weakened, and inflation expectations have declined at all horizons. Monetary policy has kept financing conditions restrictive. By dampening demand and keeping inflation expectations well anchored, this has made a major contribution to bringing inflation back down.

At the same time, despite the progress over recent quarters, domestic price pressures remain strong as wage growth is elevated, and inflation is likely to stay above target well into next year. The latest Eurosystem staff projections for both headline and core inflation have been revised up for 2024 and 2025 compared with the March projections. Staff now sees headline inflation averaging 2.5 percent in 2024, 2.2 percent in 2025 and 1.9 percent in 2026. For inflation excluding energy and food, staff projects an average of 2.8 percent in 2024, 2.2 percent in 2025 and 2.0 percent in 2026. Economic growth is expected to pick up to 0.9 percent in 2024, 1.4 percent in 2025 and 1.6 percent in 2026.

We are determined to ensure that inflation returns to our two per cent medium-term target in a timely manner. We will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim. We will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission. We are not pre-committing to a particular rate path.

The Governing Council today also confirmed that it will reduce the Eurosystem’s holdings of securities under the pandemic emergency purchase programme (PEPP) by €7.5 billion per month on average over the second half of the year. The modalities for reducing the PEPP holdings will be broadly in line with those followed under the asset purchase programme (APP).

The decisions taken today are set out in a press release available on our website.

I will now outline in more detail how we see the economy and inflation developing and will then explain our assessment of financial and monetary conditions.

Economic activity

After five quarters of stagnation, the euro area economy grew by 0.3 percent over the first quarter of 2024. The services sector is expanding, and manufacturing is showing signs of stabilization at low levels. We expect the economy to continue to recover as higher wages and improved terms of trade push up real incomes. Stronger exports should also support growth over the coming quarters, as global demand for goods and services rises. Finally, monetary policy should exert less of a drag on demand over time.

Employment rose by 0.3 percent in the first quarter of this year, with around 500,000 new jobs created, and surveys point to continued job growth in the near term. The unemployment rate edged down to 6.4 percent in April, its lowest level since the start of the euro. Companies are still posting many job vacancies, though slightly fewer than before.

National fiscal and structural policies should aim at making the economy more productive and competitive, which would help to raise potential growth and reduce price pressures in the medium term. Effective, speedy and full implementation of the Next Generation EU programme, progress towards capital markets union and the completion of the banking union, and a strengthening of the Single Market would help foster innovation and increase investment in the green and digital transitions. Implementing the EU’s revised economic governance framework fully and without delay will help governments bring down budget deficits and debt ratios on a sustained basis.

Inflation

Annual inflation rose to 2.6 percent in May, from 2.4 percent in April, according to Eurostat’s flash estimate. Food price inflation declined to 2.6 per cent. Energy price inflation increased to 0.3 percent, after recording negative annual rates for a year. Goods price inflation continued to decrease in May, to 0.8 per cent. By contrast, services price inflation rose markedly, to 4.1 percent from 3.7 percent in April.

Most measures of underlying inflation declined further in April, the last month for which data are available, confirming the picture of gradually diminishing price pressures. However, domestic inflation remains high. Wages are still rising at an elevated pace, making up for the past inflation surge. Owing to the staggered nature of the wage adjustment process and the important role of one-off payments, labor costs will likely fluctuate over the near term, as seen in the pick-up in negotiated wages in the first quarter. At the same time, forward-looking indicators signal that wage growth will moderate over the course of the year. Profits are absorbing part of the pronounced rise in unit labor costs, which reduces its inflationary effects.

Inflation is expected to fluctuate around current levels for the rest of the year, including due to energy-related base effects. It is then expected to decline towards our target over the second half of next year, owing to weaker growth in labor costs, the unfolding effects of our restrictive monetary policy, and the fading impact of the energy crisis and the pandemic. Measures of longer-term inflation expectations have remained broadly stable, with most standing at around 2 percent.

Risk assessment

The risks to economic growth are balanced in the near term but remain tilted to the downside over the medium term. A weaker world economy or an escalation in trade tensions between major economies would weigh on euro area growth. Russia’s unjustified war against Ukraine and the tragic conflict in the Middle East are major sources of geopolitical risk. This may result in firms and households becoming less confident about the future and global trade being disrupted.

Growth could also be lower if the effects of monetary policy turn out stronger than expected. Growth could be higher if inflation comes down more quickly than expected and rising confidence and real incomes mean that spending increases by more than anticipated, or if the world economy grows more strongly than expected.

Inflation could turn out higher than anticipated if wages or profits increase by more than expected. Upside risks to inflation also stem from the heightened geopolitical tensions, which could push energy prices and freight costs higher in the near term and disrupt global trade. Moreover, extreme weather events, and the unfolding climate crisis more broadly, could drive up food prices. By contrast, inflation may surprise on the downside if monetary policy dampens demand more than expected, or if the economic environment in the rest of the world worsens unexpectedly.

Financial and monetary conditions

Market interest rates have risen since our April meeting. Financing costs have plateaued at restrictive levels as our past policy rate increases have worked their way through the financial system. The average interest rates on new loans to firms and on new mortgages were unchanged in April, at 5.2 percent and 3.8 percent respectively.

Credit dynamics remain weak. Bank lending to firms grew at an annual rate of 0.3 percent in April, down slightly from the previous month. Loans to households continued to grow at 0.2 percent on an annual basis. The annual growth in broad money – as measured by M3 – rose to 1.3 percent in April, from 0.9 percent in March.

In line with our monetary policy strategy, the Governing Council thoroughly assessed the links between monetary policy and financial stability. Euro area banks remain resilient. The improving economic outlook has fostered financial stability but heightened geopolitical risks cloud the horizon. An unexpected tightening of global financing conditions could prompt a repricing of financial and non-financial assets, with negative effects on the wider economy. Macro-prudential policy remains the first line of defense against the build-up of financial vulnerabilities. The measures that are currently in place or will soon take effect are helping to keep the financial system resilient.

Conclusion

The Governing Council today decided to lower the three key ECB interest rates by 25 basis points. We are determined to ensure that inflation returns to our two per cent medium-term target in a timely manner. We will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim. We will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction. In particular, our interest rate decisions will be based on our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission. We are not pre-committing to a particular rate path.

In any case, we stand ready to adjust all of our instruments within our mandate to ensure that inflation returns to our medium-term target and to preserve the smooth functioning of monetary policy transmission.

Highlights of ECB policy and President Lagarde’s comments during Q&A (Presser): 6th June’24

·         ECB Interest Rate Actual 4.25% (Forecast 4.25%, Previous 4.50%)

·         ECB Deposit Rate Actual 3.75% (Forecast 3.75%, Previous 4.00%)

·         Latest Eurosystem staff projections for both headline and core inflation have been revised up for 2024 and 2025 compared with March projections

·         Since the ECB meeting in September 2023, inflation has fallen by more than 2.5 percentage points and the inflation outlook has improved markedly

·         The ECB today also confirmed that it will reduce the Eurosystem’s holdings of securities under the Pandemic Emergency Purchase Programme (PEPP) by €7.5 billion per month on average over the second half of the year

·         Interest rate decisions will be based on its assessment of the inflation outlook in light of incoming economic and financial data, dynamics of underlying inflation, and strength of monetary policy transmission

·         The ECB will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction

·         We will keep policy rates sufficiently restrictive for as long as necessary to achieve this aim

·         For inflation excluding energy and food, staff project an average of 2.8% in 2024, 2.2% in 2025 and 2.0% in 2026

·         The ECB will continue to reinvest, in full, principal payments from maturing securities purchased under PEPP until the end of June 2024

·         Modalities for reducing PEPP holdings will be broadly in line with those followed under APP

·         Over the second half of the year, it will reduce the PEPP portfolio by €7.5 billion per month on average

·         By dampening demand and keeping inflation expectations well anchored, this has made a major contribution to bringing inflation back down

·         The decision was almost unanimous apart from one governor

·         We have more data at projection round meetings

·         Are we moving into the dialing-back phase? I wouldn't volunteer that

·         We're more restrictive in real terms than back in September

·         The rate cut today is justified by confidence in the path ahead

·         There will be other bumps on the road

·         Some bumps can be anticipated; like the base effect

·         The next few months will be bumpy

·         Wages matter enormously

·         We will need more data to constantly confirm the disinflationary path

·         Euro-area banks remain resilient

·         The ECB is ready to adjust all instruments as needed

·         The cut was justified by confidence in the path ahead

·         Confidence in inflation increased over the last months

·         Most measures of underlying inflation dropped in April

·         Price pressures are gradually diminishing

·         Wages are rising at an elevated pace

·         The staggered nature of the wage adjustment process and labor costs will likely fluctuate in the near term

·         Profits are absorbing parts of the rise in unit labor cost

·         Inflation is to fluctuate around the current levels for the rest of the year

·         Inflation will then decline towards the target in 2H25

·         Risks to growth tilted to the downside over the medium term but balanced in the near term

·         Credit dynamics remain weak

·         We are not pre-committing to a particular rate path

·         Manufacturing showing signs of stabilization

·         I expect the economy to continue to recover

·         Stronger exports are to support growth in coming quarters

·         The recovery is to be supported by rising real incomes

·         Surveys point to job growth in the near term

·         Exports are to support growth

·         ECB forecasts assume 2024 oil price of $83.8/barrel

·         ECB forecasts assume a 2025 oil price of $78/barrel

·         ECB forecasts assume a 2026 oil price of $74.5/barrel

·         ECB's Holzmann was the lone dissenter in Thursday's policy meeting

·         ECB's Holzmann confirms he dissented on the rate cut vote on Thursday

·         Inflation to reach 2% one quarter later than seen in March

·         German Finance Minister Lindner: The ECB rate cut is a good signal for the economy

·         Sources: ECB all but rules out a July cut. A September but is unclear

·         ECB governors see July rate cut as unlikely, focus now on September – Sources

·         A few ECB hawks said they might have supported holding rates if there had not been a commitment, as some ECB hawks argued that committing to a June rate cut too early was a mistake – Sources

·         Some ECB hawks argued not commuting to the June rate hike too early was a mistake

·         No cut seen in July at the ECB

·         Markets price in 59 bps of ECB rate cuts in 2024, from 64 bps before the ECB statement

·         Traders maintain ECB rate cut bets, see 40bps more this year

Conclusions:

In May’24, the annual Euro Zone Core CPI (w/o energy, food, alcohol, and tobacco) was around +2.9% from +2.7% sequentially, which was the lowest since Feb’22 after a consecutive decline from recent top +5.7% in Mar’23 amid lower oil/energy prices. The 6M and YTM rolling average of EZ Core CPI is now around +3.0% against the +5.0% average in 2023, while the YTM sequential (m/m) rate is now around +0.4%; i.e. annualized rate is almost around +4.8%.

The EZ service inflation has also stuck around +4.0% for the last 6 months on average, and real GDP growth is around +0.4% in 2023 (y/y) against an average of 1.7% in 2018-19 (pre-COVID). The trend rate of EZ real GDP growth should be around +2.0%. In Q1CY24, the EZ real GDP growth was around +0.4% (y/y), while the average unemployment rate was around 6.5%. Overall it’s a stagflation-like scenario for the Eurozone economy due to excessive fiscal austerity.

Although ECB President Lagarde was less confident in the April meeting for the disinflation pace (like the Fed), ECB/Lagarde sounded suddenly confident enough just before the EZ election and began jawboning/preparing the market for the June rate cut despite it still unclear whether the Fed will cut from Sep’24 or even from Dec’24.

Europe/EU is the real victim of the Russia-Ukraine and Israel-Hamas war as it’s an import-oriented economy for both fuel and food; i.e. imported inflation is the main issue here amid weaker EURUSD. Euro Area economy may be now in a stagflation-like situation (lower/negative economic growth and higher inflation). Apart from supply chain disruptions, Eurozone core inflation was also boosted by wage growth, pent-up demand, especially for services, and increasing pricing power of producers. EU is the biggest loser of the lingering Russia-Ukraine/NATO war/proxy war as it’s a net importer of both food and fuel coupled with other commodities and a weaker EUR.

As per Taylor’s rule, for the Eurozone:

Recommended policy repo rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(5.0-2.00) =0+2+3.0=5.0%

Here for EU /ECB

A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= Estimated average core inflation=5.0% (for 2023~4.95%)

The repo rate of the ECB is now at +4.50% against Taylor’s rule suggestion of +5.0%. Even if we adjust the -1% real GDP output gap (2023 growth around +0.4% against potential/desired run rate 1.50-2.00%), the desired repo rate for 2024 should be around +4.00%. Growing real policy divergence between the Fed and ECB along with a stagflation-like scenario in the EU is keeping EURUSD under stress, causing more imported inflation as the EU depends on both fuel and food imports.

Thus despite the ECB narrative of translantic divergence and one symbolic rate cut of -25 bps, in the longer term, the ECB may have to follow the Fed in real policy action, whatever may be the narrative.

Both ECB and BOC delivered a cut in June, which may be assuming a similar move by the Fed in July in line with Mar’24 dot-plots of the Fed. But the Fed may not cut before the Nov’24 US election and the focus will be now on 12th June dot-plots of Fed, whether the Fed sticks to the -75 bps rate cuts narrative in H2CY24 or reduce it to -50 bps (Sep-Dec’24) or even no rate cuts in 2024.

If the Fed indeed goes for -50 or -75 bps rate cuts in H2CY24, the ECB may go for further rate cuts of -50 bps in September and December; but if the Fed does not indicate any rate cuts at all in 2024, then it would be very difficult for both ECB and BOE to go for further rate cuts in Q3 and Q4CY24.

Technical trading levels: EURUSD

Whatever the narrative, technically EURUSD (1.0900) now has to sustain above 1.09500 for any further rally to 1.10000* and  1.11500/1.11800-1.12500/1.13000* and 1/14500-1.17400 in the coming days; otherwise sustaining below 1.09300, may again fall to 1.08600/1.07900-1.07700/1.06700 and 1.06000/1.05300/1.05000* and even 1.0000/0.95000 in the coming days (in case ECB goes for further rate cuts despite Fed being on hold).