Will Recession Fears Trigger a Dovish Turn from the ECB?


Significant changes in the economic environment since the October meeting suggest that the European Central Bank may adopt a more dovish tone this Thursday. In our opinion, a change in communication is justified, but the bank will likely be very cautious not to strengthen already aggressive market expectations regarding interest rate cuts. With effective communication from the bank, the common currency has a chance to strengthen after the meeting.

Investors’ expectations regarding the easing of monetary policy in the euro zone have significantly increased over the past two months, due to weak data on economic activity and a further decrease in price pressure. This was particularly visible at the end of November, following the publication of the latest inflation report. Currently, the markets anticipate the initiation of cuts as early as March (priced in at 60%) totaling a 130 bp reduction by 2024.

Recession fears in the Eurozone persist

The November inflation reading drew attention. Both measures fell much stronger than expected – the main one from 2.9% to 2.4%, the core from 4.2% to 3.6%. These values, especially the latter, are still too high, but the main measure is currently diverging from the target by less than 0.5 pp. – This indicates progress in fighting inflation.

Economic activity indicators in the eurozone, published with a significant delay, indicate that the economy is on the brink of a shallow recession or is already experiencing it. Several survey data recently indicate some improvement in the situation, but PMI indicators are close to recent lows and clearly below the 50-point boundary separating contraction and expansion. Recent loan data also confirm that the bank’s policy is effectively limiting demand, which is detrimental to economic growth but positive for inflation prospects. The fragile state of demand in the common bloc and the scale of the recent drop in price dynamics suggest that a reversal of monetary policy may start in the not too distant future.

The ECB has to some extent admitted that the economic reality has changed. The hawkish wing of the bank has been quiet for some time, and perhaps its most important representative, Isabel Schnabel, suggested in a recent interview that interest rate hikes are not on the agenda. The minutes from the bank’s October meeting also contained dovish tones. Besides confirming that the bank’s baseline scenario does not include further rate hikes, they suggested increasing concerns about economic prospects.

The ECB will pivot, but gradually

Data on economic activity published since the last meeting will not likely dispel the ECB’s growth concerns. The HICP inflation report could allow some optimism in relation to price dynamics and in our opinion embolden the Governing Council to make a slight adjustment in tone towards dovish.

At the same time, we believe it is too early for a significant U-turn in the bank’s policy, and moves in this direction will likely be very gradual, especially considering that the ECB is known as one of the most cautious central banks in G10.

Probable cautious communication without forward guidance

In our opinion, President Christine Lagarde will try not to reveal much during her press conference and will avoid conveying anything that could be considered forward guidance. While she cannot deny the progress in fighting inflation, she might try to soften the message, suggesting that the fight is not yet won and emphasizing the uncertainty about prospects.

In terms of growth, she may also decide not to sound too pessimistic, noticing uncertain signs that the worst may be behind us, or at least that some survey data is moving in the right direction. It is possible that she may also push back aggressive market pricing for interest rate cuts, which could be key for the euro’s response. A clear indication that it is too early to consider cuts would likely support the common currency.

Also, comments regarding reinvestments under the Pandemic Emergency Purchase Programme (PEPP) could draw the market’s attention. They are supposed to continue at least until the end of 2024, but recent comments from Lagarde suggest that this will soon be under discussion – we would not be surprised if this topic emerged during the December meeting.

Beyond the tone of Lagarde’s messages, the revised macroeconomic projections will be important for the market. The focus will be on the scale of cuts in growth and inflation forecasts in the medium term and new long-term perspectives, as the first forecasts for 2026 will appear.

EUR/USD with a chance to strengthen

Considering the drastic change in ECB rate cut expectations that has taken place in recent weeks, the bar for a dovish surprise seems very high. It’s hard to imagine how the ECB could significantly increase market expectations for policy easing. This suggests that the risk profile for the euro ahead of the meeting is skewed upward. Nevertheless, we cannot entirely rule out small losses for the common currency if Lagarde does not manage communication appropriately or if “sources linked to the ECB” undermine the position presented at the meeting, as has happened with worrying regularity recently.

The ECB’s policy decision will be announced on Thursday (14.12) at 14:15, and the press conference will start 30 minutes later.

Author: Roman Ziruk; Matthew Ryan, CFA – Ebury analysts