The European Central Bank (ECB) believes its current monetary policy is on the right track. The policies are now considered neutral. The ECB aims to control inflation to support growth. The ECB has set the neutral interest rate between 1.75% and 2.25%. Right now, the policy rate is at 2.00%. Depending on upcoming economic data, a potential rate cut could happen before the year ends. The ECB’s current position lies within the neutral range, allowing flexibility based on new data. By placing the policy rate at the midpoint of the neutral range, between 1.75% and 2.25%, the ECB shows a careful approach rather than a restrictive one. Inflation is the main focus, and any future changes will depend on overall price trends or shifts in domestic and global demand. Policymakers want to balance the effects of past tightening without acting too quickly in the opposite direction. Lagarde’s recent comments indicate confidence in slowing inflation but express caution about the future, particularly regarding energy and wages. This suggests a readiness to adjust: if inflation falls and economic activity slows more than expected, easing could return sooner. Markets are adjusting their expectations, with short-dated rate futures indicating a slight downward revision by December. Swaps suggest a softer outlook for early Q4, but there is some hesitance. This cautious repricing shows low confidence, which fits the ECB’s data-driven strategy. A significant shift in risk would be premature until a consistent trend emerges. For those anticipating price swings around rate announcements, current conditions call for quick reactions. The yield curve indicates low uncertainty about terminal rates, but timing risks are still a factor. In simple terms, the market generally agrees on where rates should go, but the journey has some bumps. This makes near-term options more appealing compared to direct positions. The situation is further complicated by differing opinions among board members. Some are hesitant about easing before salaries reflect a downward trend. Visco noted last month that domestic inflation drivers have remained stubborn, especially in services, making aggressive loosening unlikely. We believe any changes in this direction will be gradual, supported by several data points. Meanwhile, real yields have been quietly rising. This tightens conditions without needing to adjust headline rates, which is important for volatility models. Implied rates on eurozone options have eased, showing lower realized volatility, but they are still higher than historical averages since 2015. This is also evident in spread trades, especially those trying to anticipate a disinflationary shift. One should also consider the peripheral debt markets. They have experienced tension even with stable sovereign spreads. Traders should stay alert for any indirect tightening, especially if quantitative tightening (QT) continues. The trajectory of the balance sheet could cause short bursts of correlation across asset classes, with long-dated options proving more resilient than expected. Finally, we anticipate tighter liquidity conditions as we approach late summer due to the seasonal cutting back of reserves and renewed TLTRO repayments. This emphasizes the need to watch near-term funding pressures, even in an otherwise steady rate environment. Adjusting hedges for these conditions could be more crucial than pursuing minor rate forecasts in the coming weeks.

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