European Central Bank Holds Firm on Interest Rates

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European Central Bank (ECB) officials have responded to market optimism regarding imminent interest rate cuts with measured caution, aligning themselves closely with their American counterparts.

Despite a drop in inflation from a peak of over 10% in late 2022 to the latest reading of 2.9%, it is widely anticipated that the ECB will maintain its deposit rate at a record high of 4%. While this level of inflation is only just above the central bank’s 2% target, officials have been quick to counter speculation that borrowing costs may be reduced to 2.5% by the end of the year, in order to avoid a resurgence of price pressures.

In an interview over the weekend, ECB Chief Economist Philip Lane highlighted the risks associated with prematurely normalizing interest rates. He warned that such a move could potentially trigger another wave of inflation, necessitating further interest rate hikes – a far worse scenario than the current one.

Other central bank officials have echoed these sentiments. Joachim Nagel, President of the Bundesbank, stated that it was premature to discuss rate cuts, while Austria’s central bank Governor Robert Holzmann went even further, stating that no rate cuts should be expected at all in 2024.

However, Governor of the Bank of France Governing Francois Villeroy de Galhau offered a slightly more optimistic view. While he suggested that borrowing costs may be lowered this year, he emphasized the ECB’s inclination for patience, indicating a potential delay in implementing any rate cuts.

Jim Reid, a strategist at Deutsche Bank, observed that the consistent messaging from various speakers on the hawk-dove spectrum did not indicate any intentions for a rate cut in the first quarter.

As investors eagerly await the outcome of the ECB’s monetary policy meeting on January 25, it appears that officials are firmly committed to maintaining stability and avoiding hasty decisions that could have detrimental consequences.

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Monetary Policy Pressures Equities in Germany and UK

The monetary-policy sensitive 2-year German government yield has risen by 8 basis points since the start of the week, reaching 2.60%. This increase has put pressure on equities and caused the DAX index to approach a one-month low.

Investors, however, still anticipate at least a 25 basis point cut of the European Central Bank’s (ECB) deposit rate by the April meeting, as of early Tuesday.

In the United Kingdom, the 2-year gilt yield remained relatively unchanged at 4.161% following the release of labor data. The data revealed that wage growth in Britain had slowed to 6.5% in the three months to November, down from 7.2% in the three months to October.

According to Jack Meaning, U.K. chief economist at Barclays, the data showed regular private-sector wage growth on a 3-month to 3-month-annualized basis of 2.5%, which is now below the rate consistent with the Bank of England’s 2% inflation target.

However, Andrzej Szczepaniak, Europe economist at Nomura, believes that the jobs report supports his view that the Bank of England can wait a bit longer before beginning its cutting cycle, despite market expectations.

“Markets are almost fully priced for May as the first cut versus our view that the Bank will want to hold on a bit longer and begin to cut only in August, taking more time to enable the Monetary Policy Committee to be certain that pent-up inflationary pressures are all out of the pipes,” added Szczepaniak.

The decline in yields has also affected sterling, which has eased by 0.8% to £1.2625. James Harte, an analyst at Tickmill Group, mentioned that traders should keep an eye on the latest UK CPI readings on Wednesday as they have the potential to drive GBP lower if a further fall is observed.

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