Markets see door wide open for more ECB rate cuts on tariff hit

By Yoruk Bahceli and Dhara Ranasinghe

LONDON (Reuters) -Traders saw the all-clear on Thursday from the European Central Bank to bet on even steeper interest rate cuts ahead, confident the central bank will ease policy further if trade tensions dent a fragile economy.

The ECB cut rates by 25 basis points (bps) for a seventh time this cycle to 2.25%, to bolster an already struggling euro zone economy facing a large hit from U.S. tariffs that have whipsawed markets since President Donald Trump's April 2 reciprocal tariffs.

The euro weakened and government bond yields across the bloc fell sharply as traders reacted to the dovish ECB message.

It stressed a deteriorating growth outlook due to trade tensions that have sparked "exceptional uncertainty" and removed a reference to rates being "restrictive" from its policy statement.

The latter would normally be seen hinting at slower cuts, but came as a relief as ECB chief Christine Lagarde explained, assessing the bank's policy stance against an unobservable neutral rate would be "meaningless" during an economic shock.

The decision was unanimous, while a few weeks ago several governors would have argued for a pause, Lagarde said, a sign of how seriously policymakers take the risks to the economy.

All of that "suggests the ECB is willing to do what is needed," said Barclays's head of euro rates strategy Rohan Khanna.

Traders now see around a 75% chance of a June rate cut, up from roughly 60% before the ECB's decision, according to LSEG data, while pricing from ICAP showed a roughly 90% chance of a June move.

By year-end they see around 65 bps of rate cuts, up from nearly 55 before the decision, according to LSEG, meaning they now reckon three rate cuts rather than two are more likely by then.

Contrast that with less than a full chance of another move this year and the pricing in of a chance of a 2026 hike after the March meeting, as investors bet on Germany's historic fiscal overhaul boosting economic growth and inflation.

German two-year bonds yields, sensitive to monetary policy expectations, dropped as much as 7 bps and Italian equivalents fell to their lowest since 2022. Bond yields move inversely with prices.

WHAT INFLATION?

While the impact of tariffs on inflation looks less clear than on growth, hefty market moves since Trump's latest tariff announcement point to further disinflation.

The euro, which neared parity against the dollar in February, has surged over 9% to around $1.135 since the start of March, which will contain import costs. It trades at an all-time high on a trade-weighted basis.

Oil meanwhile has slumped nearly 10% this month and China, the biggest source of EU imports, is taking the biggest hit from tariffs.

Markets have parked aside any concerns around inflation, with a key gauge of long-term expectations the ECB also tracks showing inflation right at the ECB's 2% target. That's down from 2.2% in March.

Some economists stress the risk that inflation will fall below the ECB's target. Citi, for example, said ahead of the ECB meeting that it sees price growth at 1.6% next year and 1.8% in 2027.

That's a potential headache for the ECB which struggled for years with below target inflation before the COVID-19 pandemic.

A wide range of estimates on the ECB rate outlook speaks to the scale of uncertainty, which could keep euro zone markets volatile.

Indeed, some ECB policymakers see a high chance of a further interest rate cut in June but others are far from deciding before seeing more economic indicators, sources told Reuters.

In markets, some analysts reckon pricing had gone far enough. Steve Ryder, portfolio manager at Aviva Investors, said markets expectations now reflected the downside risk to ECB rates, so the firm was now neutral on European bonds, while Nordea expects the ECB to cut rates just once more to 2%.

Barclays, however expects the ECB to cut rates to 1.25% by October, delivering more cuts than markets anticipate.

And Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, said while a recession was not his baseline scenario, if one did materialise it would require a bigger response.

"Now you can imagine the ECB cutting 100 bps this year but hiking next year," he added.

(Reporting by Yoruk Bahceli and Dhara Ranasinghe; editing by David Evans)