Christine Lagarde will likely maintain a ‘data-dependent’, ‘meeting-by-meeting’ rhetoric. And she is broadly expected to proceed with her sixth 25-basis-point rate cut in almost as many meetings, bringing policy rates to 2.5%.
But appearances may be deceiving. The stakes are high, and the Frankfurt institution is facing a pacing conundrum. Should it slam the brakes and pause its easing cycle ahead of a potential big turn down the road? Should it accelerate on its path towards the neutral level of interest rate as the growth outlook is concerning? Or does it stick to the current pace, hoping there will be few obstacles ahead?
In recent weeks, Governing Council members have taken diverging views.
Some argue monetary policy is no longer restrictive and that the optimum neutral interest rate is higher than in the past. The increase in mortgage and corporate loans, as well as positive real incomes, support this growth outlook for 2025. Naturally, these ‘hawks’ advocate for a pause in cuts.
The ‘doves’, meanwhile, argue that inflation and wage growth are moving towards target and that risks to economic growth remain. They advocate for a quick journey to a 2% base rate (or lower).
The direction of travel often put forward by Christine Lagarde is no longer clear. The German election could lead to greater fiscal easing, Ukraine's defense will rely more on Europe, and Trump’s policies bring uncertainty.
The ECB will also present its quarterly growth and inflation projections. Considering the level in oil and gas prices, the weak euro and fewer rate cuts being priced in at the time these were made, they’re likely to flag an upside inflation risk and downside growth risk. In this precarious situation, speed matters. Go too fast and you risk economic overheating and inflation. Go too slow and you risk recession. Aligning base rates with the neutral rate is therefore akin to finding a stable cruising speed. But this is also the subject of much debate (discussions these days suggest the neutral rate is somewhere between 1.75% and 2.25%).
Market operators are therefore most interested in the future pace of rate cuts. But the central bank must drive carefully, or risk a reversal of the economic cycle.
Where does this leave us?
Markets expect policy rates will arrive at a neutral level of 2% this summer. And that as we approach the neutral rate, the pace of cuts is likely to slow down. In other words, the question is whether the 2% mark is reached rapidly – i.e. by July – or if it will take more time to get there – i.e. there may be no change to policy rates in April and June. We believe that an additional three interest rate cuts is the minimum they will provide for this year. In such an environment, we favour core government bonds with short to intermediate maturities (2 to 5 years) as they tend to be the most sensitive to changes in monetary policy expectations. This is opposed to short-term maturities, which are more an expression of the timing of cuts, or longer-term maturities, which are sensitive to the trajectory of deficits. Such a position can act as a safe haven should economic growth be deceptive. Hence it marries well with higher performance engines such as credit in a fixed income portfolio, or a mix of credit and equities in a cross-asset portfolio.
