January ECB cheat sheet: Expect the expected

This Thursday’s ECB decision will almost certainly be a 25bp rate cut. Governing Council members have given very strong hints that rates would be lowered again in their latest comments, most recently in Davos. Our baseline view is that President Christine Lagarde will broadly repeat December’s communication and her Davos forward guidance. That includes reiterating that rates wil remain in restrictive territory and while not pre-committing to a specific easing path, sticky December inflation should not prevent the policy message from staying dovish, signalling further gradual easing this year.

The rates market is viewing a cut at the upcoming meeting as a near done deal. The same goes for the following March meeting, with a total of 47bp of easing discounted by then, which would take the deposit facility rate to 2.5%. This is all in tune with comments from ECB officials pointing to further gradual easing. But it's beyond the first quarter that the outlook gets less certain. The market sees the ECB at 2.25% in June with a decent chance of another cut to 2% before the end of the year.

Expectations late last year had seen the ECB cut down to at least 1.75%. Since then, to a degree spillover effects from the US but also a refocus on stickier inflation and energy price dynamics had turned the pricing more hawkish. After Friday’s better-than-expected eurozone PMIs, markets found another reason to price a more cautious advance by the ECB as the neutral territory is approached. But we have already seen some expression of doubts surrounding the December forecasts in the ECB minutes. More hints along those lines could push rates lower again.

Overall, we believe the balance of risks points towards lower rates again at these levels. With the ECB only starting to enter the broader range of neutral estimates, the expectations of the next couple of cuts will serve as an anchor. The upside appears more capped by the uncertainty stemming from US policies.

EUR/USD is retesting levels above 1.050 as markets have now priced out a good portion of the protectionism risk premium associated with President Donald Trump’s tariff threat. Things on this matter can change overnight, as Trump often switched from friendly to hostile towards his trading partners without warning, but the longer eurozone and China are spared tariffs, the harder it will be for USD to regain momentum.

If the tail risk of US protectionism is getting thinner, there are lingering dampening eurozone-specific factors that will, in our view, prevent the euro from rallying much beyond the positioning re-adjustment. Eurozone growth remains concerning and political events this year can easily unnerve markets. Most importantly, we expect Thursday's ECB decision to show a resolutely dovish Governing Council that will keep a lid on any hawkish repricing of rate expectations even if inflation proves sticky at the next release.

We expect EUR/USD to hover around 1.050-1.060 in the short term, although the ECB could trigger a small correction on Thursday.