The European Central Bank releases signals of more-than-expected easing, traders bet on the start of an aggressive rate-cutting cycle

According to Zhitong Finance APP, on Thursday, traders captured clear easing signals from the European Central Bank's policy signals, betting on larger rate cuts in the future, confident that the central bank would further loosen policies as trade tensions impact the fragile economy.

On that day, the European Central Bank lowered the benchmark interest rate by 25 basis points to 2.25%, marking the seventh rate cut in this cycle, aimed at boosting the already struggling Eurozone economy—an economy facing severe shocks from U.S. tariffs since President Trump implemented reciprocal tariffs on April 2.

As traders interpreted the European Central Bank's dovish stance, the euro weakened, and bond yields in Eurozone countries plummeted.

The European Central Bank emphasized in its policy statement that trade tensions have worsened growth prospects and caused "extraordinary uncertainty," while removing references to interest rates being at "restrictive levels." The latter is typically seen as a signal to slow the pace of rate cuts, but ECB President Christine Lagarde explained that assessing policy stance using unobservable neutral rates during economic shocks is "meaningless," which reassured the market.

Lagarde stated that the decision was unanimously approved, while several committee members had advocated for a pause in rate cuts just weeks ago, highlighting policymakers' concern over economic risks. Rohan Khanna, head of Euro interest rate strategy at Barclays, pointed out that all these signs "indicate the ECB's willingness to take necessary measures."

According to LSEG data, traders currently estimate the probability of a rate cut in June at about 75%, up from 60% before the ECB's decision.

Pricing from ICAP shows a probability of about 90% for action in June. LSEG data indicates that traders expect cumulative rate cuts of about 65 basis points by the end of the year, up from nearly 55 basis points before the decision, suggesting that the market currently anticipates three rate cuts rather than two before the end of the year.

This contrasts sharply with the situation following the March meeting—when the market expected less than a full rate cut for the remainder of the year and even priced in the possibility of a rate hike in 2026, as investors anticipated that Germany's historic fiscal reforms would boost economic growth and inflation.

The yield on German two-year bonds, sensitive to monetary policy expectations, plummeted by 7 basis points, while the yield on Italian bonds fell to its lowest level since 2022 (bond yields move inversely to prices).

Inflation Puzzle

Although the impact of tariffs on inflation is not as clear as on growth, the severe market volatility since Trump's latest tariff announcement points to further deflationary pressures.

The euro to U.S. dollar exchange rate has surged over 9% since early March to about 1.135 dollars (the rate was close to parity in February), which will suppress import costs. On a trade-weighted basis, the euro is currently at a historical high At the same time, international oil prices have plunged nearly 10% this month, while China, as the largest source of imports for the European Union, is bearing the brunt of the tariffs.

The market has temporarily set aside concerns about inflation, with a key long-term inflation expectation indicator tracked by the European Central Bank showing that price increases are just at its 2% target level, down from 2.2% in March.

Some economists emphasize the risk that inflation may fall below the central bank's target. For example, Citigroup predicted before the European Central Bank meeting that inflation in the Eurozone would drop to 1.6% next year and 1.8% by 2027. This poses a potential challenge for the European Central Bank, which struggled for years with inflation below its target before the COVID-19 pandemic.

The broad predictions regarding the European Central Bank's interest rate outlook reflect significant uncertainty, which may keep the Eurozone market in a volatile pattern. Reuters has learned that some European Central Bank policymakers believe there is a high probability of further rate cuts in June, while others prefer to wait for more core economic indicators before making a decision.

On the market side, some analysts believe that current pricing has fully reflected expectations. Steve Ryder, a portfolio manager at AXA, stated that the market's expectations have now reflected the downside risk of European Central Bank interest rates, so the company currently holds a neutral position on European bonds.

Nordea Bank expects the European Central Bank to cut rates only once more to 2%. However, Barclays predicts that the European Central Bank will lower rates to 1.25% before October, with the cut exceeding market expectations.

Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, pointed out that while an economic recession is not its baseline scenario, a more robust policy response would be needed if a recession becomes a reality. "It is now conceivable that the European Central Bank could cut rates by 100 basis points this year, but may raise rates next year," he added.