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ECB Preview Summary | Europe

Core Content

The European Central Bank (ECB) is expected to maintain a gradual approach to monetary policy in the near term, with a 25 basis point (bp) rate cut anticipated at the January meeting. The ECB's communication is likely to remain unchanged, emphasizing data dependency and a meeting-by-meeting strategy. This suggests that the monetary stance will still be characterized as restrictive, indicating the potential for further rate cuts in 2025.

Economic Outlook

• Growth: The ECB's growth forecasts for the euro area have been revised downward, with 4Q24 growth expected to be slightly lower than anticipated. The overall outlook for 2025 remains cautious, with downside risks still prominent due to domestic and international uncertainties, including German elections and French budget issues.
• Inflation: Despite headline and core inflation being lower than the ECB's December projections, external shocks such as higher energy prices and euro depreciation are expected to push the inflation path above 2% throughout 2025. The ECB may adjust its inflation projections based on these factors, with headline inflation potentially reaching 2.4% Y on average in 2025, up from 2.1% Y projected in December. Core inflation is expected to remain elevated by 5 to 10bp through 2027, as FX shocks are more persistent than energy price shocks.

Policy Decisions

• The ECB has shifted its stance from a restrictive policy to a more neutral approach, with the December meeting marking a clear signal that more rate cuts are the baseline.
• The ECB is likely to continue its gradual rate-cutting cycle, with a 25bp cut in January. The terminal rate is expected to be around 2% by the summer of 2025.
• The March meeting is anticipated to be more significant, as it could incorporate the impact of US trade policies on the euro area's economic outlook, potentially leading to a downward revision in growth projections and a reassessment of the ECB's rate normalization path.

FX Strategy

• EUR/USD is expected to be influenced more by US trade policy than by the ECB meeting itself, with the EUR likely to remain weak due to the ECB's gradual approach.
• We recommend maintaining long EUR/USD positions, targeting 1.08, with a stop at 0.9950.
• EUR positioning is extremely short, which may limit downside risks, especially given the current macroeconomic sentiment.

Rates Strategy

• The market is currently pricing in a series of rate cuts, with the ECB's terminal rate target at around 2% by the summer of 2025.
• The path of least resistance in case of data surprises is likely a flattening of the 2H25 money market curve.
• European duration is seen as cheap, with a long bias recommended. The 10y Bund is currently under significant short positioning, which may lead to a potential upside if macroeconomic conditions improve.

Key Recommendations

• Long EUR/USD: Targeting 1.08 with a stop at 0.9950.
• Long RXH5 133.5/134.5/135.5 call ladder: Entered at 5.7 cents, with a max payout of 94.4 cents.
• Receive 5y5y EUR real yield: Entered at 53bp, targeting a 15-20bp correction, with a stop at 60bp.

Important Disclosures

• Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research, which may result in conflicts of interest.
• Analysts employed by non-U.S. affiliates are not registered with FINRA and may not be subject to FINRA restrictions on communications with a subject company, public appearances, and trading securities held by a research analyst account.

Key Data Releases

• 24-Jan: Flash PMI Jan 2025 (EA composite at 49.9)
• 30-Jan: Preliminary flash estimate 4Q24 GDP (Expected at 0.1%Q)
• 03-Feb: Flash inflation Jan 2025 (Headline: 2.4%Y / Core: 2.6%Y)
• 06-Mar: ECB Governing Council with updated projections 2024-2027
• 03-Jun: ECB Governing Council with updated projections 2024-2027

Conclusion

The ECB is expected to continue its gradual rate-cutting cycle in 2025, with a 25bp cut in January and further cuts likely in March and beyond. Inflation risks remain elevated due to external shocks, particularly energy prices and FX movements, while growth outlook is cautious. EUR/USD is expected to benefit from US trade policy developments, and European duration is seen as undervalued, supporting a long bias in both FX and rates strategies.