ECB policy rate’s future path is a mystery confounding traders

The European Central Bank (ECB) is puzzling traders who are at a complete loss over the path of policy rates.

Markets are already bracing for rate cuts from the Federal Reserve and Bank of England by 2024, following bets that borrowing costs will peak at 3.25% in the U.S. and almost 2.5% in the U.K. in a year. Meanwhile they see euro-area policy makers barely easing policy even four years from now.

The contrast begs the question over how high Europe’s borrowing costs can go before the ECB starts tightening policy, or the so-called terminal rate.

“We haven’t made up our mind on what the true terminal rate for the ECB is,” said Rohan Khanna, a rates strategist at UBS Group AG, adding “this makes sense given how high the terminal rate pricing has reached for Fed and BOE.”

Next steps
Traders are at least clear over what they think the ECB will do by the end of next year, with forward swaps showing bets that borrowing costs will rise to 1.25% from minus 0.5% currently.

The ECB last raised borrowing costs in 2011. It hiked the deposit rate by a quarter-point twice, lifting it to 0.75% to counter inflation that was deemed too high even amid as a debt crisis engulfed nations in the periphery.

The market may still be uncertain over where the neutral rate is, Bank of America Corp. strategists including Sphia Salim in a client note, referring to the rate that neither restricts nor spurs economic growth.

ECB president Christine Lagarde last week said interest rates will be adjusted gradually. But inflation in the region surged to a record high of 7.5% in March, spurred by a global jump in energy prices after Russia invaded Ukraine and complicating the picture for policy makers. The central bank has to grapple with sky-rocketing prices, while managing the consequence of any tightening on growth as nations emerge from the pandemic restrictions.

Governing Council member Bostjan Vasle offered no clarity in an interview Monday, saying there is no fixed milestone, but that rates could probably be raised above zero throughout the course of next year.

Money markets are already wagering on more than a quarter-point of rate cuts by early 2024 from both the Fed and BOE, with the current tightening cycle seen as a heavy brake on growth longer term.

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