Analysis-Traders step up ECB rate cut bets, sensing shift on inflation front

LONDON (Reuters) - Traders on Thursday piled on bets that the European Bank will cut interest rates from April as they took the view that policymakers are growing more comfortable with the inflation outlook.

After the central bank kept its key rate on hold at a record 4%, ECB chief Christine Lagarde repeated twice in a news conference that it was "premature" to discuss rate cuts.

But with the comments it made on inflation and wages, the bank was seen as appearing less concerned about inflation than before. It was noted that the ECB had removed a mention that "domestic price pressures remain elevated, primarily owing to strong growth in unit labour costs," from its decision, for instance.

Markets took that as a sign the bank is becoming more convinced that wage growth, which it has flagged as the biggest risk to inflation, is slowing, analysts said.

Interest-rate sensitive two-year bond yields fell sharply as traders doubled down on rate cut bets. They now expect more than an 80% chance of a first 25 basis-point (bps) rate cut in April, up from around 60% before the meeting.

They anticipate 140 bps of cuts this year compared with around 130 bps before the meeting.

"The key takeaway for markets is that April is a live meeting," said Danske Bank chief analyst Piet Christiansen.

"Markets are saying, if inflation and wage growth is coming in... they will turn around and guide to a policy rate cut in April," Christiansen added, noting the rally in bonds reflected a lack of ECB pushback against market rate bets.

German and Italian two-year bond yields dropped around 10 bps in their biggest fall in nearly two weeks. The euro fell almost 0.5% to $1.0835.

While rate cut expectations supported bonds, investors cautioned there was little room for further falls in yields, which dropped sharply late last year.

"We think there's been enough of a decline in yields for the moment," said Florian Ielpo, head of macro and multi-asset portfolio manager at Lombard Odier Investment Management.

Ielpo said his firm was underweight bonds and overweight equities, which he said have yet to price in the support to earnings from lower rates.

Lagarde reiterated that the ECB would remain data-dependent and said she stood by her comments last week pointing to a summer rate cut.

She has also previously said she expects enough wage data by "late spring" and chief economist Philip Lane has wanted to see data due in April, which would rule out easing before June.

ABN AMRO and Danske Bank stuck to their call for a June cut on Thursday.

"The market is anticipating quite rapid disinflation from here and the ECB is looking at past data and saying we are not out of the woods yet," said Dario Perkins, managing director of global macro at TS Lombard.

Another risk is the January euro zone inflation print due next Thursday, which could set the tone for how price pressures evolve this year.

RISK OF POLICY ERROR

Investors cautioned that waiting too long to cut rates risked a policy error where the ECB keeps policy too tight for an economy that is weakening.

German business morale unexpectedly worsened in January, declining for the second month in a row as Europe's largest economy struggles to shake off a recession.

ECB projections have long signalled higher inflation than markets. The ECB forecasts 2.7% inflation this year, versus 2.4% expected by a Reuters poll.

Similarly, it has expected higher growth than analysts, seeing the economy expanding 0.8% this year. A Reuters poll puts economic growth at just 0.5%.

"Cutting rates in June means taking the risk of being too late because when you look at growth in the euro zone it is already muted, when you look at inflation it really has declined significantly, so by looking at wages the ECB is taking the risk of falling behind the curve," said Valentine Ainouz, head of global fixed income strategy at the Amundi Investment Institute.

Some banks have flagged the possibility of the ECB having to cut rates by larger, 50 bps increments.

Citi bank said in a note earlier this week that the later rates fall, the further they may have to be cut to compensate for overtightening. It reckons 50 bps rate cuts are a possibility and rates could fall towards 1.5% in 2025.

"Disinflation looks much more rapid in the euro zone than in the US... the ECB is taking the risk of cutting rates too late and that is not completely priced by the market," said Amundi Investment Institute's Ainouz.

(Reporting by Yoruk Bahceli, Naomi Rovnick and Dhara Ranasinghe, writing by Yoruk Bahceli; editing by Dhara Ranasinghe and Hugh Lawson)

By Yoruk Bahceli and Naomi Rovnick