Traders Position for Aggressive ECB Rate Cuts Amidst Trade War and Euroscepticism
Traders anticipate a more aggressive monetary policy stance from the European Central Bank (ECB) due to economic headwinds stemming from potential US tariffs and political uncertainties within the bloc.
Markets Expect Euro Weakness and Bond Gains
Positioning in the market indicates expectations of a weaker euro (EUR), potentially reaching parity with the US dollar (USD), and gains in bonds as the ECB loosens policy. A quarter-point cut is widely anticipated this Thursday, with traders closely monitoring any shift in the ECB's stance.
ECB to Cut Further if Tariffs Materialize
Markets are pricing in three additional rate cuts through year-end, bringing the deposit rate to 2%. However, some strategists anticipate a wider and faster divergence with the US Federal Reserve (Fed) if US President Donald Trump's threatened trade tariffs come into effect. US levies on European imports could force deeper ECB cuts to support growth, further depreciating the euro. Conversely, the Fed is likely to maintain higher rates to counter potential inflationary pressures from tariffs.
Euro Hedging Costs Surge
Hedging costs against a weaker euro are near their highest levels since June, according to risk reversals, indicating heightened market caution. The demand for options protecting against a euro-dollar parity has more than doubled this month compared to November and December.
Options Bets on Half-Point Cut
Traders have placed substantial options bets on the ECB delivering at least one half-point cut by mid-year, signaling an escalation from prior quarter-point increments. Market participants are also targeting a 2% deposit rate by the middle of the year.
Euro Area Risks and Policy Flip-Flops
However, some policymakers, such as Bank of France Governor François Villeroy de Galhau, have downplayed the need for larger rate cuts. Recent data showing growth in the euro area's private sector in January also provide some relief. Additionally, Trump's policy flip-flops have added uncertainty to currency markets.
Political Challenges and Economic Outlook
Political challenges, including budget negotiations in France and upcoming elections in Germany, contribute to uncertainty within the eurozone. Economic growth is expected to slow to 0.1% in the fourth quarter, according to a Bloomberg poll.
Despite these concerns, some investors remain bullish on core euro area government bonds, citing anchored inflation expectations compared to the US. The Fed is anticipated to leave rates unchanged later on Wednesday.
Deeper ECB Cuts to Counteract Trade Risk
Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International, foresees deeper ECB cuts than currently priced in. He anticipates up to 150 basis points cuts this year, bringing the deposit rate to 1.5%, indicating a more accommodative stance. Ahmed emphasizes that aggressive ECB action is necessary to mitigate trade risks.