The European Central Bank releases unexpectedly loose signal, traders bet on the start of an aggressive interest rate cut cycle.

On Thursday, traders captured a clear indication of easing from the European Central Bank's policy signals, betting on a larger rate cut in the future, convinced that the central bank will further relax its policies in the face of a fragile economy impacted by trade tensions. The European Central Bank cut its benchmark interest rate by 25 basis points to 2.25%, marking the seventh rate cut in this cycle, aimed at boosting the struggling eurozone economy - which has been facing severe market impacts since the US imposed tariffs on April 2. With traders interpreting the dovish stance of the European Central Bank, the Euro weakened and bond yields across the Eurozone countries saw significant declines. In its policy statement, the European Central Bank emphasized that trade tensions have deteriorated growth prospects and caused "exceptional uncertainty," while also removing the reference to interest rates being at a "restrictive level." The latter is often seen as a signal to slow down the pace of rate cuts, but ECB President Lagarde explained that evaluating policy stance with unobservable neutral interest rates during an economic shock period is "meaningless," a statement that reassured the markets. Lagarde stated that the decision was reached unanimously, while several members of the board had advocated for a delay in rate cuts just weeks ago, highlighting the policymakers' level of concern for economic risks. Rohan Khanna, Barclays' Euro Rates Strategy Chief, pointed out that all these signs "indicate that the ECB is willing to take necessary measures." According to LSEG data, traders currently estimate a 75% probability of a rate cut in June, higher than the 60% before the ECB decision. ICAP's pricing indicates a 90% probability of action in June. LSEG data shows that traders expect a cumulative rate cut of about 65 basis points by the end of the year, higher than the nearly 55 basis points before the decision, indicating that the market currently expects three rate cuts by the end of the year rather than two. This is in stark contrast to the market predictions after the March meeting - at that time, the market predicted less than one complete rate cut for the rest of the year, and even pricing the possibility of an interest rate hike in 2026, as investors expected historic fiscal reforms in Germany to boost economic growth and inflation. German two-year bond yields, sensitive to monetary policy expectations, fell sharply by 7 basis points, while Italian bond yields fell to their lowest levels since 2022 (bond yields and prices move in opposite directions). Inflation puzzle Although the impact of tariffs on inflation is not as clear as on growth, the recent market volatility since Trump's latest tariff statement indicates further deflationary pressure. The Euro to US Dollar exchange rate has surged over 9% since early March to around $1.135 (at one point in February, the rate was close to parity), which will suppress import costs. According to trade-weighted calculations, the Euro is currently at historical highs. Meanwhile, international oil prices plummeted by nearly 10% this month, with China, as the largest import source for the EU, bearing the brunt of tariff impacts. The market has temporarily set aside concerns about inflation, as a key long-term inflation expectation index tracked by the European Central Bank is exactly at its 2% target level, slightly down from 2.2% in March. Some economists emphasize the risk of inflation falling below the central bank's target. For example, Citigroup predicted before the ECB meeting that Eurozone inflation would fall to 1.6% next year and 1.8% in 2027. This poses a potential challenge for the European Central Bank - before the COVID-19 pandemic, the bank had long struggled with inflation below target levels. Widespread predictions about the future of European Central Bank interest rates reflect significant uncertainty, which could keep the Eurozone markets in a volatile state. Reuters learned that some ECB decision-makers believe there is a high probability of a further rate cut in June, while other members prefer to hold off on a decision until more key economic indicators are seen. On the market side, some analysts believe that current pricing already fully reflects expectations. Steve Ryder, portfolio manager at Axa Investment, stated that the market's expectations already reflect the downside risks of European Central Bank rates, so the company currently maintains a neutral position on Eurozone bonds. Nordea expects the European Central Bank to only cut rates once more to 2%. However, Barclays expects the ECB to cut rates to 1.25% before October, a move that exceeds market expectations. Frederik Ducrozet, Head of Macro Economic Research at Pictet Wealth Management, pointed out that while recession is not the baseline scenario, if it becomes a reality, a more forceful policy response will be needed. "Now it is conceivable that the ECB will cut rates by 100 basis points this year, but may raise them next year," he added.