Markets slightly boost bets on ECB rate cuts, Italy's debt risk premium falls

Money market participants boosted their bets on future rate cuts while the risk premium on Italian debt hit its lowest level since April 2022 on Friday after dovish remarks from European Central Bank President Christine Lagarde.

Money market participants boosted their bets on future rate cuts while the risk premium on Italian debt hit its lowest level since April 2022 on Friday after dovish remarks from European Central Bank President Christine Lagarde. The lack of pushback against the market pricing of future policy rates and less concerned statements about inflation after Thursday’s ECB policy meeting was a green light to price in faster and deeper monetary easing, analysts said.

ECB euro short-term rate forwards priced 143 basis points of rate cuts in 2024, from around 140 bps late on Thursday and 130 before the ECB press conference. The ECB held interest rates at a record-high 4% on Thursday and reaffirmed its commitment to fighting inflation even as the time to start easing borrowing costs approaches.

Germany's 10-year government bond yield, the euro area's benchmark, dropped one basis point (bp) to 2.28%. Italy's 10-year government bond yield, the benchmark for the euro area periphery, fell 2 bps to 3.80%.

The gap between Italian and German 10-year yields was last at 151 bps, after hitting its lowest level since April 2022 at 149.30 bps. The ECB said it will continue to reinvest, in full, the principal payments from maturing securities purchased under the Pandemic Emergency Purchase Programme (PEPP) during the first half of 2024, in a move that will support peripheral bonds.

The central bank can use PEPP reinvestments to buy bonds of highly indebted countries. Analysts argued that a very gradual phasing out of PEPP reinvestments the ECB announced in mid-December supported bonds of the most indebted countries.

Bond prices move inversely with yields. The Italian-German yield spread dropped from 185 bps on Dec. 14 to around 150 bps early this week.

Analysts said that on Thursday ECB president Lagarde had cautiously laid the ground for a policy pivot, with the wording expressing higher confidence in inflation's downward path. However, she also said that more reassuring data would be needed and that rate cuts were not discussed.

The incoming wage figures and economic projections at the March 7 meeting will be key for the timing of the rate cut. "Whether intentionally or not, the Governing Council opened the door today to an early rate cut (March or April)," Citi economists said in a research note.

"We are now turning towards communication by individual governors to confirm or not this dovish inflexion in policy," they added. "Any pushback in the coming days may reveal the true depth of dovishness." Money markets priced an almost 85% chance of a first 25 bps rate cut in April and an around 20% chance in March.

ECB hawk Martins Kazaks said on Friday the worst mistake would be cutting rates too early. Market participants label as hawks central bank officials inclined to advocate a tight monetary policy to control inflation, while doves focus more on economic growth and the labour market.

Lithuanian policymaker Gediminas Simkus said on Friday a cut in 2024 was almost certain, but unlikely in March. Euro zone inflation could fall faster than expected this year, a raft of surveys and indicators showed on Friday.

ECB policymakers are open to a change in their rhetoric at their next meeting, paving the way for an interest rate cut, possibly in June, if upcoming data confirms inflation has been vanquished, four sources told Reuters.