Could euro area CPIs unsettle the ECB rate cut expectations? – Preview

Jan 2, 2024 at 10:04 am GMT- Achilleas Georgolopoulos

• New year starts with the December inflation report testing ECB’s hawkishness

• Market looks for a sizeable pickup in CPI, creating doubt about the rate cuts priced in

• German CPI figure released on Thursday; the euro area aggregate on Friday 10:00 GMT

The new year starts on a rather high note

With market participants recovering from the well-earned festive break, 2024 starts on a rather high note. In the US, the labour market statistics could be a rough awakening for the sleepy market while in the euro area the preliminary inflation report for December could set the scene for an eventful month.

Taking a step back and at the last ECB meeting President Lagarde poured cold water over the aggressively dovish rate expectations. Armed with the latest staff projections pointing to core inflation remaining north of 2% in 2025, at 2.3% to be exact, Lagarde was quite clear that rate cuts were not discussed as the Governing Council needs more time to understand underlying wage developments.

Despite this hawkish appearance, the market is still pricing in 155bps rate cuts for 2024 with the first 25 bps rate move expected at the April 11 meeting. As a comparison, the market has pencilled in 151bps of easing this year by the Fed with the first rate cut seen at the May meeting, despite the obviously much stronger US economy.

With the Fed’s Powell opening the door for rate cuts in 2024, the rhetoric divergence allowed euro bulls to stage a good upmove and record a new 5-month high amidst a very low liquidity period. However, for this move to morph into a new medium-term trend, euro bulls need consistently stronger economic data releases going forward.

Inflation report in the foreground again

Both the ECB and the market are clearly very interested in growth prospects, especially as the relevant data prints following the December ECB gathering were mixed. On Thursday, we will get the final print for the December Services PMI surveys, but the focus will also be on the preliminary inflation report for December.

The German CPI details will be released on Thursday with the market expecting a strong 3.8% year-on-year print. This could be the first sizeable jump in headline inflation following the impressive slowdown from the record high 8.8% yearly change recorded in November 2022, just 13 months ago. Such an outcome could also confirm the repeated rhetoric from ECB officials that inflation could rebound in the first half of 2024.

The euro area inflation report is expected on Friday 10.00 GMT with headline CPI also seen jumping to a 3% year-on-year increase, from 2.4% in November. More importantly, the core indicator is expected to edge slightly lower to 3.5%, but with a low degree of confidence as market forecasts vary from 3.2% to 4%.

These inflation levels are still too high and inconsistent with a central bank on the brink of cutting rates. President Lagarde was quite clear that both core and domestic inflation prints have not been dropping as aggressively and as persistently as the headline figure due to wages, thus further complicating the ECB outlook for 2024.

Euro to benefit from a strong inflation report

As already mentioned, the euro has been staging a decent rally against the US dollar since the October lows. It is currently trading at a key area, which has been making the bulls’ lives difficult since February 2023. An upside surprise at this week's inflation figure, especially at the core indicator, could add credence to President Lagarde’s rhetoric at the last ECB gathering. As such, we could see euro-dollar climbing even further, towards the 1.1184 level.

On the flip side, a weak set of data releases would support the ballooning dovish market expectations and potentially undermine the current euro-dollar rally. Euro bears could stage a decisive move below the busy 1.0825-1.0864 area in their attempt to retake market control.