According to traders, there is a good chance that by opting to deliver a number of aggressive interest rate hikes, the European Central Bank (ECB) is likely to overtighten its monetary policy.
Therefore, euro zone money markets have already begun to price in rate cuts from the ECB in the coming year.
The European Central Bank (ECB) had a policy meeting last week, which saw it increase its deposit rate by a whopping 75 basis points, which saw it reach 0.75%.
The goal of the monetary authority is to ‘frontload’ monetary policy tightening in order to bring down the surging inflation.
Even though the bloc is gearing up for a recession, the central bank said that it would continue to increase interest rates in early 2023 as well.
After the meeting, traders added to bets of bigger moves by the central bank in its next meetings.
Markets have already priced in interest rate hikes of 70 basis points in the bank’s meetings scheduled for October and December.
According to statistics, markets expect the interest rate to reach its peak in mid-2023 at about 2.7%. However, it is because of these sharper expectations that traders are betting the ECB will cut rates.
Money markets believe that by February 2024, the rates will be around 2.6%. Before the meeting of the ECB last week, an interest rate increase of 90 basis points had been priced in by the end of the year.
Money markets had expected the interest rate to reach its peak at 2.2% and they stay steady, but the ECB turned out to be in front-loading mode.
Market analysts said that the central bank was following in the footsteps of the Federal Reserve, which means that there could be more inversion i.e. a rate cut could be expected.
The movements seen in the money markets in the euro zone are similar to what has been seen in the United States.
The Federal Reserve is also in frontloading mode, as it has been hiking interest rates. It has already increased the interest rates by 200 basis points since May.
However, there have been concerns that the aggressive stance of the US central bank will drive the economy into recession.
Therefore, traders have ended up pricing in rate cuts of around 50 basis points by the Fed in the coming year, once the interest rates hit their peak in March at above 4%.
As far as the Euro zone is concerned, economists believe the deposit rate will peak at 1.5%, but most investment banks believe that rate cuts would happen in the next year or 2024.
Since last week, there has been a shift that has seen traders price in a 40% likelihood of a rate cut of 25 basis points by the ECB in February 2024.
However, some analysts said that there were likely going to be multiple rate cuts of 25 basis points instead of a single one.