Markets see high chance of further ECB rate cuts due to tariff shock

The European Central Bank said on Thursday that traders are confident it will ease policy further if trade tensions undermine a fragile economy, betting on further big rate cuts ahead.

The European Central Bank cut interest rates by 25 basis points to 2.25% for the seventh time this cycle in an effort to support the already struggling eurozone economy. The eurozone economy has been hit hard by U.S. tariffs since U.S. President Trump implemented reciprocal tariffs on April 2.

The euro weakened and euro zone government bond yields fell sharply as traders reacted to dovish comments from the European Central Bank.

The central bank stressed that trade tensions were causing "significant uncertainty" and worsening the outlook for economic growth, and removed a reference to interest rates being "restrictive" from its policy statement.

The latter would typically signal a slower pace of rate cuts, but there was some relief when ECB President Christine Lagarde explained that it was "meaningless" to assess the central bank's policy stance based on the unobservable neutral rate during an economic shock.

Lagarde said the decision was unanimous, whereas a few weeks ago several board members would have advocated for a pause, showing how seriously policymakers are taking economic risks.

All this "shows the ECB is willing to do what is necessary," said Rohan Khanna, head of euro rates strategy at Barclays.

Traders are now pricing in about a 75% chance of a rate cut in June, up from around 60% before the ECB decision, according to the London Stock Exchange, while ICAP pricing puts the chance of a June cut at about 90%.

The LSE said they expect rates to be cut by around 65 basis points by the end of the year, up from nearly 55 basis points before the decision, meaning they now estimate three rate cuts rather than two by the end of the year are more likely.

By contrast, another rate hike this year is unlikely, and after the March meeting, markets had already priced in a 2026 increase as investors bet Germany's historic fiscal reforms will boost growth and inflation.

Germany's two-year bond yield, which is sensitive to monetary policy expectations, fell as much as 7 basis points, while Italy's two-year bond yield fell to its lowest level since 2022. Bond yields move inversely to prices.

While the impact of tariffs on inflation is less clear than their impact on economic growth, the sharp market moves since Trump's latest tariff announcement suggest that inflation will fall further.

The euro, which was close to parity with the dollar in February, has surged more than 9% since early March to around $1.135, which will curb import costs. On a trade-weighted basis, it is trading at its highest level ever.

Meanwhile, oil prices have fallen nearly 10% this month, while China, the EU’s largest source of imports, has been hit hardest by tariffs.

Markets have put aside concerns about inflation, with a key gauge of long-term expectations tracked by the ECB showing inflation right at the ECB’s 2% target. That figure was down from 2.2% in March.

Some economists have highlighted the risk of inflation falling below the ECB's target. For example, Citigroup said ahead of the ECB meeting that it expects price growth to be 1.6% next year and 1.8% in 2027.

That's a potential headache for the European Central Bank, which had been struggling with below-target inflation for years before the coronavirus pandemic.

The wide range of estimates for the ECB's interest rate outlook reflects the level of uncertainty that is likely to keep eurozone markets volatile.

In fact, some ECB policymakers see a high chance of a further rate cut in June, but others are far from making a decision until they see more economic indicators, sources told Reuters.

In the market, some analysts believe that pricing is already high enough. Steve Ryder, portfolio manager at Aviva Investors, said market expectations currently reflect downside risks to ECB rates, so the firm is currently neutral on European bonds, while Nordea expects the ECB to cut rates again to 2%.

However, Barclays expects the ECB to cut interest rates to 1.25% by October, a bigger cut than the market expects.

Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, said that while a recession was not his base case, a stronger response would be needed if one occurred.

He added: "Now you could imagine the ECB cutting rates by 100 basis points this year but raising them next year."