German Fiscal Policy Shift Creates Turbulence for ECB Rate Outlook

LONDON (Reuters) – A significant transformation in German fiscal policy has intensified uncertainty for traders attempting to predict the pace at which the European Central Bank (ECB) will reduce interest rates for the remainder of the year. This uncertainty was further underscored by a recent change in the bank’s guidance, which was announced on Thursday.

ECB Rate Cuts and Policy Changes

The ECB implemented a rate cut of 25 basis points, bringing the rate down to 2.50%. This marks the sixth reduction since last June. However, the bank’s latest statement indicated that monetary policy is becoming “meaningfully less restrictive,” a shift from the previous characterization of being “restrictive.” This change has bolstered traders’ confidence, who had already begun to scale back their expectations for ECB rate cuts following a deal from Germany’s coalition partners on Tuesday. This deal aims to establish a substantial 500 billion euro ($541.40 billion) infrastructure fund and reform borrowing restrictions, primarily to enhance defense spending.

Market Reactions and Predictions

Vasileios Gkionakis, a senior economist at Aviva Investors, commented, “We could have potentially one more cut, a maximum of two,” emphasizing that the ECB’s change in language signals a potential end to rate cuts. Following the ECB’s meeting, traders adjusted their predictions for an April rate cut, now estimating less than a 50% chance of a quarter-point reduction, down from over 60% the previous week.

Moreover, policymakers are increasingly considering the possibility of pausing rate cuts in April, pending further clarity on trade and fiscal policies, as reported by sources to Reuters.

Impact on the Euro and Bond Yields

The euro experienced a surge, reaching $1.0854 on Thursday, the highest level since November 6, following the U.S. presidential election. This increase is significantly above the near $1.01 levels observed in February, which were influenced by tariff concerns. Additionally, Germany’s bond yields, serving as the benchmark for the eurozone, are poised for their most substantial weekly increase since the early 1990s, as markets prepare for a potential rise in borrowing.

Inflation Expectations and Future Rate Hikes

Remarkably, traders have begun to factor in the possibility that the ECB may raise rates again next year, driven by the fiscal boost’s potential to elevate inflation. Currently, there is an estimated 40% chance of a rate hike by September 2026. While specific details regarding the German proposal remain scarce and it did not influence the ECB’s decision on Thursday, it has further complicated the monetary policy outlook, which analysts had already deemed uncertain.

Mark Dowding, chief investment officer at RBC BlueBay Asset Management, stated, “If you throw that much money into an economy, you are going to get quite a difference. It also means inflation will be higher.” Following Germany’s announcement, a key market gauge of inflation expectations surged, trading at approximately 2.22%, slightly above the ECB’s 2% target. This gauge recorded its largest daily increase on record on Wednesday, according to LSEG data dating back to 2013.

Conclusion: A Shift in Market Dynamics

For market participants, the uncertainty surrounding the ECB’s forthcoming actions represents a significant departure from the previously anticipated certainty of rate cuts at every ECB meeting since October. The ECB has cited trade uncertainty as a contributing factor to ongoing investment weakness, leading to a downward revision of its growth forecasts. As the situation evolves, traders and analysts alike will be closely monitoring developments in both fiscal policy and the ECB’s response to these changes. For more details, visit the original article.