The European Central Bank is ready to cut interest rates

The decision of the European Central Bank was in line with investors' expectations. Interest rates and balance sheet reduction plans remained unchanged. However, the bank has clearly softened its communication. Although there was no clear signal of an interest rate cut in June, there was a clear signal Christine Lagarde has prepared the markets for this eventuality, which resulted in a significant weakening of the euro. What's next for the prospects for this currency?

There are 3 interest rate cuts in play

Probability of cutting interest rates in June by the European Central Bank is currently 90%, although earlier, before the decision, these chances were estimated at 70%. During a press conference, Christine Lagarde said that by June the bank will receive all the necessary data and forecasts to be able to decide on the normalization of monetary policy. Between the lines it means that the bank signals the first reduction in interest rates. The market is currently pricing in three cuts from the ECB this year, which would bring the deposit rate down from the current 3% to 4%. This would still mean that monetary policy will remain restrictive, so the threat of a second wave of inflation will remain limited.

At the same time, in order to reduce the risk of a second wave, the bank will most likely not decide to cut interest rates for the second time in July, but will postpone such a decision to September to check how the data reacted to the first cut. In addition, from the middle of this year the central bank will be there reduced the balance of the pandemic PEPP asset purchase program by limiting reinvestment. Moreover, reinvestments according to the plan are to be stopped at the end of this year. This means that policy will remain relatively neutral, with rates being cut and the balance sheet constrained.

The Euro exchange rate is in retreat

Nevertheless, the euro reacted clearly negatively to information about the upcoming reduction. The EUR/USD pair fell below the level of 1,0700 today, although this is partly the result of a divergence arising from the Fed's overtone. Currently, the date of the first cut by the Federal Reserve is postponed to September, while ECB bankers such as Kazaks and Stournaras indicate that This is a good moment to cut and a good moment to break away from the trend set by the Fed.

EUR/USD is quoted below the level of 1,0700, while USD/PLN is growing quite noticeably and at the moment we are paying PLN 3,9956 for the dollar. In turn, the zloty remains strong against the euro and the EUR/PLN pair is at PLN 4,2658. We pay PLN 4,3783 for a franc and PLN 4,9996 for a pound.

Source: Michał Stajniak CFA, XTB