Tonight's interest rate cut is a foregone conclusion. Will the ECB send a dovish signal of consecutive rate cuts?

With inflation slowing down and the deteriorating economic outlook, there is almost no dispute in the market about the ECB's rate cut tonight, but it is unclear whether the ECB will continue to cut rates rapidly after September.

On Thursday, September 12th, Beijing time, the European Central Bank will announce its interest rate decision at 20:15, followed by ECB President Lagarde holding a monetary policy press conference at 20:45. Previously, the ECB cut rates by 25 basis points to 3.75% in June and remained unchanged in July.

Analysts Ruben Segura-Cayuela and his team at Bank of America released a report stating that Bank of America believes the ECB will cut rates by another 25 basis points and may adopt a dovish tone of rapid and consecutive rate cuts. However, they may also argue: Compared to previous guidance, it appears that European economic growth will be lower, short-term core inflation slightly higher, but the medium-term outlook remains broadly unchanged. Given the soft future internal demand, confidence in the normalization path of inflation in the euro area has strengthened, with inflation expected to approach 2% by the end of 2025. This leaves room for faster rate cuts.

Bank of America also stated that the Euro to Dollar exchange rate will not be greatly affected, and investors should focus on longer-term rather than short-term ECB rate trades, becoming the party accepting floating rates in single-market or cross-market trades.

Rate cut tonight a certainty? Eurozone economic weakness becomes consensus

There is almost no dispute in the market about the ECB's rate cut tonight. Holger Schmieding, Chief Economist at Berenberg Bank, stated in an email:

Recently, almost all ECB speakers have clearly indicated their desire to lower rates. Even Joachim Nagel, the Bundesbank President who is usually considered a hawkish member of the ECB Governing Council, has stated that he would also support a rate cut unless economic data consistently show it is not warranted.

Bank of America believes that the market has fully digested the ECB's 25 basis point rate cut in June, and at tonight's meeting, the ECB will cut rates by another 25 basis points, narrowing the rate corridor, but the ECB will not adjust its forward guidance. At the same time, Bank of America expects the ECB to cut rates by 125 basis points in 2025, with two additional rate cuts in the first half of 2026.

So, why is the market widely convinced that the ECB will cut rates tonight? Because the Eurozone's inflation is slowing down, and economic weakness has become a consensus.

Currently, the Eurozone inflation rate has declined, with overall inflation data in August hitting a three-year low of 2.2%.

The Eurozone's August manufacturing PMI has dropped to an 8-month low, marking the largest contraction this year. Some analysts believe that the manufacturing woes in the Eurozone will eventually drag down the services sector.

Germany, the largest economy in Europe, is experiencing a worsening recession, with the composite PMI contracting for two consecutive months. Analysts predict that Germany's GDP for the full year of 2024 is unlikely to show any growth

Will the ECB Cut Interest Rates Rapidly and Continuously?

According to foreign media reports, a key point of discussion among ECB policymakers is whether to cut interest rates rapidly, with a general inclination towards dovishness. However, as interest rates approach 3%, divergences are starting to emerge.

Nevertheless, the ECB will not disclose too much information about its next steps, as the ECB recently insisted that it will not pre-signal future decisions, which will depend entirely on upcoming data. Additionally, the ECB committee needs to remain cautious as price pressures in the euro area's service sector remain stubborn, and wages are rising rapidly.

While overall inflation in the euro area is mentioned to be decreasing, price pressures in the euro area remain strong, with service price inflation staying high and core inflation rate still above 2.8%.

Clearly, the extent and pace of ECB interest rate cuts will depend crucially on subsequent economic data in the euro area.

Bank of America Merrill Lynch predicts that short-term economic growth in the euro area may slightly decline, inflation may rise slightly in 2024, but the medium-term outlook remains unchanged. If there is a significant or unexpected downturn in European economic data, it could pave the way for a rate cut in October.

Some economists also believe that the short-term economic growth prospects in the euro area will be more challenging than in July. Analyst Anatoli Annenkov from Societe Generale in France stated:

In the most recent data, the most concerning aspect is the weakening business confidence in the euro area, with the service sector also appearing to be in an unstable state. In the second quarter, the euro area lacked domestic demand, and the weakness in manufacturing may spread and begin to have a greater impact on the previously robust labor market.

Therefore, Bank of America Merrill Lynch believes that at tonight's meeting, the ECB may both signal a dovish stance of rapid and continuous interest rate cuts, and argue that compared to previous guidance, the current outlook for European economic growth is lower, short-term core inflation is slightly higher, but the medium-term outlook remains broadly unchanged. With weak future domestic demand, confidence in the euro area's inflation normalization path has strengthened, and by the end of 2025, inflation will be close to 2%. This leaves room for faster rate cuts.

Some analysts expect that after tonight's rate cut, the ECB will keep rates unchanged in October, and cut rates again in December, maintaining this pace until rates reach 2.5% one year later—many market participants believe this is the neutral rate for the euro area, neither restraining nor stimulating the economy.

Will the Euro Fall to Parity with the Dollar?

With market expectations of a near rate cut by the Fed and ongoing rate cuts by the ECB, there are diverging views on the exchange rate trend in the forex market.

Morgan Stanley strategist David Adams suggests taking short positions on euro against the dollar options, as he expects that if the ECB continues to cut rates, the euro could fall to 1.02 by the end of the year, as the economic outlook in the euro area is uncertain, especially with the weakness in Germany's manufacturing sector creating headwinds for the euro Currently, the euro is trading at 1.1 against the US dollar.

Some analysts also predict that the euro will rise, with the euro against the US dollar expected to rise to 1.11 by the end of the year.

Bank of America Merrill Lynch predicts that the euro is less affected by the policies of the Federal Reserve and the European Central Bank, as market expectations for interest rate cuts by both have already been fully priced in. Therefore, investors should focus on longer-term rather than short-term interest rate trades at the ECB, becoming the party accepting floating rates in single or cross-market trades