Wage Growth and Economic Resilience Challenge Market Expectations for Aggressive ECB Rate Cuts

Summary:

• Resilient Wage Growth: Despite a slowdown, wage growth in the Eurozone remains above the ECB's inflation target, challenging expectations for aggressive rate cuts and indicating persistent inflationary pressures.
• Mixed Economic Signals: While the Eurozone's composite PMI shows modest growth, particularly in the services sector, the overall economic outlook remains weak, especially in manufacturing.
• German Bonds Overpriced: German bonds trade rich relative to economic fundamentals, reflecting overly optimistic market expectations of ECB rate cuts, which may not materialize given the resilient wage growth and ongoing inflation concerns.

Eurozone wage data has provided a boost to the euro, raising expectations for a hawkish shift in the ECB's rate outlook. Long-term Bunds have underperformed their peers, with 10-year Bund yields rising approximately 4 basis points to 2.22%, remaining within the narrow range established since the yen-unwinding selloff. Meanwhile, the U.S. dollar is under pressure, weighed down by dovish signals from the FOMC minutes and a downward revision in U.S. payrolls, which point to a softening jobs market.

Today’s Eurozone data paints a mixed picture: while consistent with a declining inflation outlook, it has not fully convinced markets that the ECB will be able to cut rates three times before the year’s end. Here’s why:

1. Wage Growth: The Eurozone is seeing a significant slowdown in wage growth, with negotiated wages dropping from 4.7% to 3.6% in the second quarter. Although wage growth remains above the ECB's 2% inflation target, the trend suggests a more benign inflation outlook. However, potential wage pressures from unions in the second half of 2024 could complicate the ECB’s ability to cut rates as aggressively as some expect.
2. Economic Activity: August's Eurozone composite PMI rose from 50.2 to 51.2, thanks largely to a boost from French services linked to the Olympics. Despite this, the overall economic outlook remains weak, particularly in the manufacturing sector, which continues to contract. While the services sector shows some resilience, there’s little evidence of a broader economic recovery across the Eurozone. Easing inflation pressures, with falling input prices, may give the ECB room to consider a rate cut in September, but it’s not a certainty.

Don’t Bet Too Heavily on a September ECB Rate Cut

While markets are pricing in a rate cut for September, it’s crucial to remember that the ECB will soon release a new set of macroeconomic projections. These may include downward revisions to growth and upward revisions to inflation. Notably, in the second quarter, core inflation, according to the ECB’s June projections, was expected to drop to 2.7% but instead came in higher at 2.8%. At the same time, real GDP growth fell short of expectations, coming in at 0.3% instead of the projected 0.4%. Given the ECB’s primary mandate to control inflation, it’s unlikely they will revise inflation forecasts upward for the year and still proceed with a rate cut in September. A cut in October seems more plausible.

German Bonds Appear Overpriced Relative to Policy Trajectory

German bonds continue to be overpriced on the back of the release of negotiated pay data as they reflect an optimistic outlook that might not align with the economic reality.

German bonds saw significant gains in the recent quarter, with 2- and 10-year yields dropping nearly 50 basis points to 2.36% and 2.22% respectively from their peak in May. This suggests that investors have become increasingly confident that the European Central Bank (ECB) might ease its policy stance aggressively based on a weakening economic outlook. However, economic growth remains underpinned and strong wage growth indicates persistent inflationary pressures, particularly in services and core inflation, which the ECB is closely monitoring. Resilient in wage growth challenges the market's expectations of aggressive rate cuts.

Ten-year Bund yields remain confined within a narrow range established after the yen carry trade unwind. For yields to break out of this range, they would need to rise above 2.28% to signal an upward trend or fall below 2.17% to continue declining.