EURUSD surged on less dovish ECB cut & adjustment in spreads

·         Looking ahead, the ECB will cut the repo rate in line with the Fed’s 25 bps pace at each QTR end and may keep it at 2.50% against the Fed’s 2.75% as terminal rate (2026)

·         ECB adjusted the repo rate spread (differential) to pre-COVID levels against the Fed by cutting once in advance in June QTR end

·         Wall Street surged on hopes & hypes of a -50 bps rate cut by the Fed on 18th September and December, but the Fed may cut by -25 bps in each QTR end (normal pace)

·         Gold also surged to a new life time high on the lower US dollar index and increased geo-political tensions over Ukraine and Gaza war

On 12th September (Thursday), some focus of the market was also on the ECB’s monetary policy decision. As unanimously expected, the ECB cuts its interest rate by -25 bps on the deposit facility (DRF-reverse repo) to +3.50%, while cutting interest rates on the marginal lending facility (MLF-repo rate) and reference interest rates on the main refinancing operations (MRO-interbank rate) by -60 bps each to +3.90% and +3.65% respectively. ECB kept rates on hold until June’24 meeting at a 22-year high after 10th consecutive rate hikes till Sep’23 (cumulating +450 bps since July 22).

On Thursday, the ECB cut the policy deposit rate facility (DRF-reverse repo rate) by -25 bps to +3.50%, the marginal lending facility (MLF-repo rate) by -60 bps to +3.90%, and the interbank rate (interest rate on main refinancing operations-MRO) also by -60 bps to +3.65% as highly expected. In the process, ECB has reduced the spread between repo and reverse repo rate (MLF-DRF) to +40 bps (3.90-3.50%) from earlier +75 bps (4.50-3.75%) and also between interbank rate and reverse repo rate (MRO-DRF) to +15 bps (3.65-3.50) from earlier +50 bps (4.25-3.75%). Fed’s spread is +10 bps (repo-reverse repo rate) and -7 bps (interbank-reverse repo rate) against ECB’s +75 bps and +50 bps earlier. ECB now has +40 bps (repo-reverse repo rate) and +15 bps (interbank-reverse repo rate). The normal spread between repo and reverse repo rates for most other global central banks is +25 bps.

On 12th September, the ECB cut the deposit facility rate (DFR) by -25 bps to +3.50% to ease monetary policy restrictions, reflecting an updated inflation outlook and better transmission of policy. Also, the interest rates on the main refinancing operations (MRO) and the marginal lending facility (MLF) were lowered to +3.65% and +3.90% respectively starting from 18th September. The ECB remains committed to bringing inflation back to its 2% target, adjusting rates based on data and economic conditions without committing to a specific rate path. Inflation projections remain in line with previous forecasts: 2.5% in 2024, 2.2% in 2025, and 1.9% in 2026, though a short-term rise is expected as energy price drops fade from annual comparisons. Core inflation is projected to decline from 2.9% in 2023 to 2.0% in 2026, despite slightly higher services inflation. ECB said domestic inflation pressures are still elevated due to rising wages, but moderating labor costs and firm profits help cushion the impact

When banks earn a higher spread between repo and reverse repo rates or between interbank and repo/reverse repo rates, they tend to deploy more funds in lending operations (direct to borrowers or other banks) rather than depositing the same with the central bank to earn a lower risk-free return. As the ECB reduced these spreads despite cutting rates drastically (as it seems) by -60 bps for repo and interbank rates along with an orderly -25 bps for reverse repo rate, it may discourage banks from lending more rather than deploying the excess fund with ECB to earn a risk-free return.

Thus despite cutting repo and interbank lending rates big by -60 bps, the overall stance of the ECB is less dovish; i.e. it’s a dovish cut by the ECB. As usual, after the ECB meeting, ECB sources almost confirmed that the ECB may cut next in Dec’24 (QTR end) unless there are some exigencies (worst economic data) ahead of the October meeting. Thus EIRUSD got some boost Thursday, affecting the dollar index and also boosting Gold to some extent in the process.

But still now spread between the repo (MLF) and reverse repo rate is now +40 bps, which is substantially higher than the normal +25 bps and the Fed’s +10 bps and should encourage banks to lend. Also, the spread between the repo and interbank rate is unchanged at +25 bps (MLF-MRO). For any developed Central Bank, the overnight/short-term secured interbank rate is the main rate at which banks lend to each other for their liquidity management.

In Dec’24, the ECB may further cut all rates (MLF, DRF, and MRO) by -25 bps for the same spread as in Sep’24. Central banks generally target overnight interbank rates (like SOFR for Fed) to align with the official fixed reverse repo rate, so that the interbank funding market runs smoothly and all banks lend to each other for their funding requirement rather than lending from the central bank repo window, which is the last resort for financial stability, especially during QT.

Fed’s SOFR (Secured Overnight Lending Rate) is now around +5.33% against a reverse repo rate of +5.40% and repo rate of +5.50%. During late 2019, even before COVID, there was a brief repo (funding) market crisis due to excessive QT by the Fed (compared to the demand for liquidity) and SOFR jumped to an even +5.40% against the then reverse repo rate of +2.15% and repo rate +2.25% when Fed was trying to normalize through QT and rate hikes. This led to a Fed mini QE even before COVID; after COVID, the Fed introduced ON-RRP to manage banking liquidity in both directions (injections or absorptions) to prevent such a repo market crisis. In the longer run, when such an interbank rate comes closer to the reverse repo rate, the cost of funds for banks also comes lower, which may also push down bond yields and overall cost of borrowing for not only banks but also its borrowing clients.

ECB RATES SPREADS

ECB MLF: +3.90% (REPO RATE)

ECB DFR: +3.50% (REVERSE REPO RATE)

ECB MRO: +3.65% (INTERBANK RATE)

ECB OVERNIGHT INTERBANK RATE

On 13th Mar’24, the ECB formally notified about Changes to the operational framework for implementing monetary policy and technical adjustment in spreads.

Full Text of ECB statement: Monetary policy decisions: 12th Srp’24

Monetary policy decisions

“The Governing Council today decided to lower the deposit facility rate – the rate through which it steers the monetary policy stance – by 25 basis points. Based on the Governing Council’s updated assessment of the inflation outlook, the dynamics of underlying inflation, and the strength of monetary policy transmission, it is now appropriate to take another step in moderating the degree of monetary policy restriction.

Recent inflation data have come in broadly as expected, and the latest ECB staff projections confirm the previous inflation outlook. Staffs see headline inflation averaging 2.5% in 2024, 2.2% in 2025, and 1.9% in 2026, as in the June projections. Inflation is expected to rise again in the latter part of this year, partly because previous sharp falls in energy prices will drop out of the annual rates. Inflation should then decline towards our target over the second half of next year. For core inflation, the projections for 2024 and 2025 have been revised slightly, as services inflation has been higher than expected. At the same time, staff continue to expect a rapid decline in core inflation, from 2.9% this year to 2.3% in 2025 and 2.0% in 2026.

Domestic inflation remains high as wages are still rising at an elevated pace. However, labor cost pressures are moderating, and profits are partially buffering the impact of higher wages on inflation. Financing conditions remain restrictive, and economic activity is still subdued, reflecting weak private consumption and investment. Staff project that the economy will grow by 0.8% in 2024, rising to 1.3% in 2025 and 1.5% in 2026. This is a slight downward revision compared with the June projections, mainly owing to a weaker contribution from domestic demand over the next few quarters.

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.

As announced on 13 March 2024, some changes to the operational framework for implementing monetary policy will take effect from 18 September. In particular, the spread between the interest rate on the main refinancing operations and the deposit facility rate will be set at 15 basis points. The spread between the rate on the marginal lending facility and the rate on the main refinancing operations will remain unchanged at 25 basis points.

Key ECB interest rates

The Governing Council decided to lower the deposit facility rate by 25 basis points. The deposit facility rate is the rate through which the Governing Council steers the monetary policy stance. In addition, as announced on 13 March 2024 following the operational framework review, the spread between the interest rate on the main refinancing operations and the deposit facility rate will be set at 15 basis points. The spread between the rate on the marginal lending facility and the rate on the main refinancing operations will remain unchanged at 25 basis points. Accordingly, the deposit facility rate will be decreased to 3.50%. The interest rates on the main refinancing operations and the marginal lending facility will be decreased to 3.65% and 3.90% respectively. The changes will take effect from 18 September 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 Eurosystem no longer reinvests all of the principal payments from maturing securities purchased under the PEPP, reducing 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, to counter 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: 12th Sep’24

“The Governing Council today decided to lower the deposit facility rate – the rate through which we steer the monetary policy stance – 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 take another step in moderating the degree of monetary policy restriction.

Recent inflation data have come in broadly as expected, and the latest ECB staff projections confirm the previous inflation outlook. Staffs see headline inflation averaging 2.5 percent in 2024, 2.2 percent in 2025 and 1.9 percent in 2026, as in the June projections. Inflation is expected to rise again in the latter part of this year, partly because previous sharp falls in energy prices will drop out of the annual rates. Inflation should then decline towards our target over the second half of next year. For core inflation, the projections for 2024 and 2025 have been revised slightly, as services inflation has been higher than expected. At the same time, staff continue to expect a rapid decline in core inflation, from 2.9 percent this year to 2.3 percent in 2025 and 2.0 percent in 2026.

Domestic inflation remains high as wages are still rising at an elevated pace. However, labor cost pressures are moderating, and profits are partially buffering the impact of higher wages on inflation. Financing conditions remain restrictive, and economic activity is still subdued, reflecting weak private consumption and investment. Staff project that the economy will grow by 0.8 percent in 2024, rising to 1.3 percent in 2025 and 1.5 percent in 2026. This is a slight downward revision compared with the June projections, mainly owing to a weaker contribution from domestic demand over the next few quarters.

We are determined to ensure that inflation returns to our two percent 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 decisions taken today are set out in a press release available on our website. As announced on 13 March 2024, some changes to the operational framework for implementing monetary policy will take effect from 18 September. In particular, the spread between the interest rate on the main refinancing operations and the deposit facility rate will be set at 15 basis points. The spread between the rate on the marginal lending facility and the rate on the main refinancing operations will remain unchanged at 25 basis points.

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

The economy grew by 0.2 percent in the second quarter, after 0.3 percent in the first quarter, falling short of the latest staff projections. The growth stemmed mainly from net exports and government spending. Private domestic demand weakened, as households consumed less, firms cut down business investment and housing investment dropped. While services supported growth, industry and construction contributed negatively. According to survey indicators, the recovery is continuing to face some headwinds.

We expect the recovery to strengthen over time, as rising real incomes allow households to consume more. The gradually fading effects of restrictive monetary policy should support consumption and investment. Exports should also continue contributing to the recovery as global demand rises.

The labor market remains resilient. The unemployment rate was broadly unchanged in July, at 6.4 percent. At the same time, employment growth slowed to 0.2 percent in the second quarter, from 0.3 percent in the first. Recent survey indicators point to a further moderation in demand for labor, and the job vacancy rate has fallen closer to pre-pandemic levels.

Fiscal and structural policies should be aimed at making the economy more productive and competitive, which would help to raise potential growth and reduce price pressures in the medium term. Mario Draghi's report on the future of European competitiveness and Enrico Letta’s report on empowering the Single Market stress the urgent need for reform and provide concrete proposals to make this happen. Implementing the EU’s revised economic governance framework fully, transparently, and without delay will help governments bring down budget deficits and debt ratios on a sustained basis. Governments should now make a strong start in this direction in their medium-term plans for fiscal and structural policies.

Inflation

According to Eurostat’s flash estimate, annual inflation dropped to 2.2 percent in August, from 2.6 percent in July. Energy prices fell at an annual rate of 3.0 percent, after an increase of 1.2 percent in the previous month. Food price inflation went up slightly, to 2.4 percent in August. Goods inflation and services inflation moved in opposite directions. Goods inflation declined to 0.4 percent, from 0.7 percent in July, while services inflation rose, to 4.2 percent from 4.0 percent.

Most measures of underlying inflation were broadly unchanged in July. Domestic inflation edged down only slightly, to 4.4 percent from 4.5 percent in June, with strong price pressures coming especially from wages. Negotiated wage growth will remain high and volatile over the remainder of the year, given the significant role of one-off payments in some countries and the staggered nature of wage adjustments.

At the same time, the overall growth in labor costs is moderating. The growth in compensation per employee fell further to 4.3 percent in the second quarter, the fourth consecutive decline and ECB staff project it to slow markedly again next year. Despite weak productivity, unit labor costs grew less strongly in the second quarter, by 4.6 percent, after 5.2 percent in the first quarter. Staffs expect unit labour cost growth to continue declining over the projection horizon owing to lower wage growth and a recovery in productivity. Finally, profits are continuing to partially offset the inflationary effects of higher labor costs.

The disinflation process should be supported by receding labor cost pressures and the past monetary policy tightening gradually feeding through to consumer prices. Most measures of longer-term inflation expectations stand at around 2 percent, and the market-based measures have fallen closer to that level since our July meeting.

Risk assessment

The risks to economic growth remain tilted to the downside. Lower demand for euro-area exports owing for instance to 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 lagged effects of monetary policy tightening 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 declined markedly since our July meeting, mostly owing to a weaker outlook for global growth and reduced concerns about inflation pressures. Tensions in global markets over the summer led to a temporary tightening of financial conditions in the riskier market segments.

Overall, financing costs remain restrictive as our past policy rate increases continue to work their way through the transmission chain. The average interest rates on new loans to firms and on new mortgages stayed high in July, at 5.1 and 3.8 percent respectively.

Credit growth remains sluggish amid weak demand. Bank lending to firms grew at an annual rate of 0.6 percent in July, down slightly from June, and growth in loans to households edged up to 0.5 percent. Broad money – as measured by M3 – grew by 2.3 percent in July, the same rate as in June.

Conclusion

The Governing Council today decided to lower the deposit facility rate by 25 basis points. We are determined to ensure that inflation returns to our two percent 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): 12th Sep’24

·         ECB Cuts Rates By 25bps (As Expected); Projects Worsening Stagflation (Higher inflation, lower GDP growths and higher unemployment)

·         ECB Interbank Interest Rate (MRO-Interbank rate) Actual 3.65% (Forecast 3.65%, Previous 4.25%)

·         ECB Deposit Rate (DRF-Reverse Repo)) Actual 3.50% (Forecast 3.5%, Previous 3.75%)

·         ECB Marginal Lending Interest Rate (MRF-Repo rate) Actual 3.90% (Forecast 3.90%, Previous 4.50%)

·         MRO-DFR rate spread now +15 bps vs earlier +40 bps

·         MLF-MRO rate spread remains at +25 bps vs earlier +25 bps

·         Labor cost pressures are moderating

·         We will be sufficiently restrictive for as long as needed

·         No commitment of any kind (rate cut) about October

·         There’s a relatively short time to the October meeting

·         Inflation is to rise again in Q4

·         September will deliver low inflation readings

·         The declining path for rates is pretty obvious

·         Domestic inflation is not satisfactory

·         We have reinforced confidence in the solidity, and robustness of projections.

·         Inflation will drop to 2% in 2025

·         Data comforts us that we're heading to target

·         The decision was unanimous

·         Credit growth is sluggish amid weak demand

·         Financing costs remain restrictive

·         Risks to growth are skewed to the downside

·         Unit labor costs to continue declining

·         Overall labor cost growth is moderating

·         Negotiated wage growth will remain high and volatile for the rest of 2024

·         Fiscal and structural policies should aim at productivity

·         Surveys point to further moderation in demand for labor

·         The labor market is resilient

·         Fading monetary policy restrictions should support the economy

·         I expect recovery to strengthen over time as wages rise

·         Based on surveys, recovery is facing headwinds

·         Recent inflation data have come in broadly as expected, and the latest ECB staff projections confirm the previous inflation outlook.

·         Financing conditions remain restrictive, and economic activity is still subdued.

·         Labor cost pressures are moderating, and profits are partially buffering the impact of higher wages on inflation.

·         The 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.

·         Inflation (HICP CPI) is forecast 2.5% in 2024, 2.2% in 2025 and 1.9% in 2026, as in the June projections.

·         In particular, our 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 will continue to follow a data-dependent and meeting-by-meeting approach to determining the appropriate level and duration of restriction.

·         Domestic inflation remains high as wages are still rising at an elevated pace.

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

·         The inflation outlook, core, and transmission to define the rate path

·         At the same time, staff continue to expect a rapid decline in core inflation, from 2.9% this year to 2.3% in 2025 and 2.0% in 2026

·         The governing council is determined to ensure that inflation returns to its 2% medium-term target in a timely manner

·         Inflation is expected to rise again in the latter part of this year

·         Recent inflation data is broadly as expected

·         Staff see headline inflation averaging 2.5% in 2024, 2.2% in 2025 and 1.9% in 2026, as in June projections

·         Staff project that the economy will grow by 0.8% in 2024, rising to 1.3% in 2025 and 1.5% in 2026

·         ECB to regularly review how TLTROs contribute to policy stance

·         Recent inflation data have come in broadly as expected, and the latest ECB staff projections confirm the previous inflation outlook

·         The ECB is not pre-committing to a particular rate path

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

Customary ECB Sources (after ECB meeting): Forward Guidance

·         ECB officials have not ruled out a rate cut at the October meeting Given the downside risk in economic growth in the EU

·         But an Oct rate cut is unlikely for now, a move before December would take exceptional negative growth surprises

On Friday (13th September), ECB’s Reinesch said:

·         If the baseline holds, there will be a series of ECB cuts

·         The path towards 2% inflation will be very bumpy

On Friday (13th September), ECB's Holzmann said:

·         +2.5% is probably close to the neutral rate (DRF ?)

·         Economic activity is increasingly in line with the ECB's forecast

·         October might not be the time for another cut

·         Uncertainty is now significantly smaller

·         There could be room for another rate cut in December

·         Monetary policy is on a good trajectory

·         Sees room for more interest rate cuts

·         Eurozone borrowing costs could fall to 2.5% by mid-2025

Further, on 14th September, ECB’s Makhlouf said:

·         ECB is not pre-committing to a particular rate path

On 15th September (Sunday), ECB President Lagarde again talked:

·         If there's a significant change to the baseline, we will reassess

·         We will look at data for rate moves

·         We're determined to reach our inflation target

On 16th September (Monday), ECB’s Kazimir said:

·         Economic recovery has been disappointingly weak

·         We are not on the path to cutting rates each meeting

·         There is still more risk that inflation will exceed the outlook

·         September was the right decision: no rush beyond

·         There is no rush to cut rates, it's safest to wait for the outlook to become clearer

·         The next move must almost surely wait until December

·         Rate cuts aren't a magic fix for the economy

·         It would take a significant shift in outlook for the ECB to cut in October

·         ECB will almost surely have to wait until December for the next rate cut

·         There is very little new info in the pipeline before the October meeting

·         Will almost surely wait until December for the next rate cut

On 16th September (Monday), ECB’s VP de Guindos said:

·         The integration of financial flows within the EU has regressed and is not keeping pace with economic integration

·         Markets will focus more on fiscal policy; we need to send a signal of medium-term sustainability of public accounts

·         Eurozone countries with debt above 100% of GDP will have to make adjustments

·         The increase in banks' profitability is not sustainable in the long run, we expect it to slow down in the near future

·         We expect the ECB's balance sheet to decrease by around €40 bln per month, as liquidity in the financial market is being reduced.

·         We want to keep all options open when it comes to interest rate decisions, we expect inflation will fall in September but there will be a rebound in Q4.

·         Our projections show inflation will hover around 2% by the end of 2025

·         We expect a significant slowdown in the growth of labor costs next year

·         Inflation in services remains our main concern

·         Inflation increase in services is still resisting

·         We'll decide on rates meeting by meeting

·         We don't have a pre-determined path for rates

·         Our projections show that inflation by the end of 2025 will hover around the 2% target

On 16th September (Monday), ECB’s Lane said:

·         Incoming data on wages and profits have been in line with expectations

·         Negotiated wage growth will remain high and volatile over the remainder of the year

·         A gradual approach to dialing back restrictiveness will be appropriate if the incoming data are in line with the baseline projection

·         We will also look at the possible enhancements to the existing analytical toolkit, including forecasting techniques

·         We should retain optionality about the speed of adjustment

·         We'll act meeting by meeting, guided by data

On 16th September (Monday), ECB’s Kazaks said:

·         Interest rates will continue to be lowered

·         There is no big reason to disagree with rate bets for 2025

Conclusions:

In Aug’24, the annual Euro Zone HICP Core CPI (w/o energy, food, alcohol, and tobacco) was around +2.8%, unchanged sequentially, after a substantial decline from recent top +5.7% in Mar’23 amid lower oil/energy prices (indirect transmission to core inflation).

The 6M and YTM rolling average of EZ Core CPI is now around +2.8% and +2.9% against the +5.0% average in 2023, while the YTM sequential (m/m) rate is now around +0.3%; i.e. annualized rate is almost around +3.8%. The rapid fall in annual core CPI is a favorable base effect, which may reverse in Q4CY24 and early 2025.

The EZ service inflation has also stuck around +4.0% for the last 8 months on average, still quite elevated against pre-COVID levels of +2.0%. Also, EZ rent inflation surged to +3.0% recently after hovering around +2.7% since early 2024 and quite elevated compared to +1.3% on average in pre-COVID times. The rise in service/housing/rent inflation may be due to robust travel & tourism amid a warm winter and pleasant summer this year coupled with a post-COVID boost and also increasing immigration/workers/labor force coupled with higher population, equivalent to almost the entire US population around 350M. This is creating higher demand for renting and housing, while supply remains constrained and boozing inflation.

The EZ 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 +1.3% (y/y), while the average unemployment rate was around 6.5%. Overall it continues to be a stagflation-like scenario for the Eurozone economy (despite a decade of negative real interest rate) due to excessive fiscal austerity, and lower productivity, almost half of the US; average pre-COVID EZ unemployment rate of around 7% is almost double that of the US even after some fiscal measures to suppress the actual unemployment in EZ, which may be around double-digit, if correctly measured.

The ideal average EZ unemployment rate should be around 4.5% (minimum unemployment rate) against US 3.5%. The present 6MRA is 6.5%, which is although is on the lower side since at least 1995, still structurally very high compared to US/AE amid almost double-digit figures in Spain, Greece, Sweden, France, Italy etc due to lack of sufficient manufacturing activities and over-reliance of travel & tourism. Industrial countries/state like Germany has an unemployment rate of around 3.4%, in line with AE/US. Despite, the unusually high unemployment rate, coupled with excessive dole money (unemployment & social security benefit-Helicopter money/Rabin Hood politics), decades of fiscal austerity to create additional economic activities are causing higher inflation/stagflation and lower productivity.

As per Taylor’s rule, for the Eurozone:

Recommended policy repo rate (I) = A+B+(C+D)*(E-B) =0.50+2.00+ (0+0)*(3.0-2.00) =0.50+2+1.0=3.50%

Here for EU /ECB

A=desired real interest rate=0.50; 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=3.0% (for 2024).

The repo rate (MLF) of the ECB is now at +3.90% against Taylor’s rule suggestion of +3.50% in 2025. Further, if we adjust the -1.0% real GDP output gap or similar excess unemployment rate on average the desired terminal repo rate (MLF) should be around +2.50%. 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 June for domestic political/election compulsion, in the longer term, the ECB may have to follow the Fed in real policy action, whatever may be the narrative.

Overall, the ECB has already clarified back in mid-March’24 that it will change the spread between its key policy rates in Sep’24 policy, so that the effective short-term interbank rate (MRO) aligns with the underlying reverse repo (DFR) and repo (MLF) rate:

·         MRO-DFR rate spread now +15 bps vs earlier +50 bps

·         MLF-MRO rate spread remains at +25 bps vs earlier +25 bps

Thus going forward, from Dec’24 ECB may continue to cut its three key policy rates (MLF, DRF, and MRO) by -25 bps (in line with Fed) at each QTR end like it did in June and Sep’24 for the next two years (2025-26) to maintain the above spread until at least 2026.

Bottom line:

ECB has done a one-time technical adjustment in all its three key policy rates as announced on 13th Mar’24 and also in line with market expectations. Thus overall positive impact on EURUSD and EU/German bonds was quite limited as going forward the ECB will also gradually cut rates in line with the Fed’s 25 bps pace; not any jumbo rate cuts for repo rate (MLF) and interbank rate (MRO). The ECB may at least keep the pre-COVID spread of -25 bps with the Fed’s repo rate. Thus ECB may keep its repo rate (MLF) at +2.50% against Fed’s +2.75% by 2026 or early 2027 as a longer-term neutral terminal rate assuming average core inflation around +2.0%. In that scenario, the ECB       may maintain reverse repo (DRF) at +2.10% and MRO (interbank rate) at +2.25% or may also keep DRF at +2.25% against MLF +2.50% (by reducing spread from presently unusually high 40 bps to normal 25 bps) and MRO +2.40%.

Weekly-Technical trading levels: EURUSD

Whatever the narrative, technically EURUSD (1.11300) now has to sustain above 1.11600 for any further Rally to 1.11700*/1.11800-1.12500/1.13000* and even 1.14500-1.17400 in the coming days; otherwise sustaining below 1.11500/1.11300-1.11200/1.11000, may again fall to 1.10500/1.10000-1.09500/1.09000 and further to 1.08600/1.07900-1.07700/1.06700 and 1.06000/1.05300/1.05000* in the coming days; present normal trading range: 1.12300-1.10000-1.08200.