Euro weakens ahead of ECB 📌

Today at 01:15 PM BST, the ECB will announce the interest rate levels 📃

• It is expected that the ECB will cut interest rates by 25 basis points.
• The economic situation has worsened since the last meeting.
• Inflation and economic data suggest further interest rate cuts, but Lagarde will confirm that further moves will depend on future data.
• Euro remains under pressure ahead of the decision.

The economic outlook

The economic situation in the eurozone does not inspire optimism, especially when looking at the largest economies, namely Germany and France. The PMI indices have clearly weakened recently. The manufacturing PMI index for the entire eurozone has remained below 50 points since July 2022. The services PMI index is still on the positive side, above 50 points, which indicates expansion. Nevertheless, the composite index is falling below 50 points for the first time since February this year. This situation suggests that economic growth in the entire eurozone until the end of this year will remain flat at best.

After the initial revival of PMI indices at the beginning of this year, we are now observing a return to the downward trend. Interest rate cuts may have come too late for the economy. Source: Bloomberg Finance LP, XTB

Taking into account the expectations regarding the European economy, growth will remain rather flat. Source: Bloomberg Finance LP, XTB

Inflation below target

Consumer Price Index (CPI) inflation for September ultimately fell to 1.7% year-on-year. This is clearly lower than 2.2% year-on-year in August. Although core inflation remains elevated at 2.7% year-on-year, it is still lower than the previous reading of 2.8% year-on-year. If inflation in the next month falls again by 0.1% month-on-month, we can expect a weakening of the annual value, which will be the lowest level since Q1 2021. The clear weakening of inflationary pressure in the eurozone suggests the possibility of a more dovish outlook from the ECB.

Inflation in the eurozone is clearly below target. Source: Bloomberg Finance LP, XTB

Expectations indicate rate cuts now and in December

Market expectations clearly point to a rate cut now and another in December. After that, the ECB is expected to slow down the rate cuts and make decisions at quarterly meetings. Currently, the rate stands at 3.5%, but by the end of this year, it will be 3.0%. Next year, it may reach 2.0%, assuming a rate cut at each quarterly meeting. Ten-year yields suggest that this will be the target level for interest rates.

Market expectations for interest rates. The market suggests reaching 2% by early next year. Source: Bloomberg Finance LP, XTB

Two- and ten-year yields suggest interest rates will reach 2%. On the other hand, in the past, we have seen a premium on bonds at the level of 100-200 basis points compared to the deposit rate. This could suggest a drop to even 1% for the deposit rate. Source: Bloomberg Finance LP, XTB

How will the euro react?

At this point, it is hard to expect bond yields in the eurozone to fall much further, although this could happen with the return of QE in Europe. Therefore, the bottom for the euro may be near, as indicated by U.S. yields, which can be illustrated by the behavior of bond prices (TNOTE). EURUSD is currently testing the area around 1.0850. However, if the ECB further softens its communication, a drop to around 1.0800 cannot be ruled out, with a 78.6% retracement of the last upward wave. If, however, the ECB indicates that rate cuts will be limited and next year’s cuts will be moderate (quarterly), this should work in favor of the euro against the dollar in the long term.