Analysis-ECB dents traders' hopes for October rate cut

By Yoruk Bahceli and Naomi Rovnick

(Reuters) - Traders pared back their bets on back-to-back rate cuts from the European Central Bank for the rest of the year on Thursday, as policymakers provided little clarity on how willing they were to double down on monetary easing.

Sources also told Reuters shortly after the ECB meeting that ended on Thursday that a further rate cut at the central bank's next meeting in October was unlikely barring a major deterioration in the outlook for growth.

The bank earlier cut rates for the second time this cycle, reducing its key deposit rate to 3.50% as expected, but it reiterated that services inflation remains high and it would keep rates sufficiently restrictive for as long as necessary.

ECB chief Christine Lagarde said the rate path was not predetermined and that the central bank would decide rates meeting by meeting, with no pre-commitments.

Traders pared back bets on another 25 bps cut then to around 20%, from over 30% prior to the meeting.

For the whole year, in addition to Thursday's move, they now expect 33 bps of cuts, down from 36 bps earlier on Thursday.

"Lagarde did exactly what she wants to do - not rock the boat in markets," said Danske Bank chief analyst Piet Christiansen.

"It seems like she's happy with the current market pricing of roughly 25 basis points (cuts) per quarter for now."

Euro zone government bond yields shot up as traders curbed their rate cut expectations.

Germany's two-year yield, sensitive to those changes, rose nearly 10 bps on the day in its biggest daily jump in nearly a month.

The euro, edged higher, last trading up 0.25% at $1.10393, European stocks ended Thursday in positive territory.

DIVERGENCE

With traders much more confident in back-to-back rate cuts from the U.S. Federal Reserve starting next Wednesday, focus was on how ECB divergence from its Atlantic peer would impact markets.

Traders expect around 100 bps of Fed rate cuts this year starting with a 25 bps move, meaning they also see a jumbo 50 bps cut at one of three meetings.

By the end of next year, traders reckon the Fed will have delivered 10 25-basis-point cuts while the ECB will deliver six.

With the currency impact the main channel through which Fed moves would impact the ECB's thinking, analysts said the ECB would have to be mindful of euro strength.

A stronger currency could bring an unwelcome tightening in financial conditions for the bloc's sluggish economy.

One factor that could help raise the stakes for the ECB's October meeting could be an "aggressive" Fed decision next week, said Danske Bank's Christiansen, though markets see around a 20% chance of a 50 bps cut now.

Yet despite fewer cuts on the card from the ECB, analysts see little gain ahead for the euro. A Reuters poll recently forecast it would rise to just $1.11 by end-February and $1.12 in a year, not far from a peak it touched in August.

Anyone long the euro would be "relying on an essentially pro-growth environment where the rest of the world is outperforming the U.S.," said James Athey, fixed interest fund manager at Marlborough.

Some investors said euro zone government bonds, which have underperformed U.S. Treasuries with yields falling less this summer, had more potential to rally.

"The safest part (of the bond market) is in Europe," said Mario Baronci, multi-asset fund manager at Fidelity International.

"If you look at the U.S. curve the market has discounted about 250 bps of cuts in a couple of years. It's a lot. So, I prefer to be in Europe."

And as the ECB revised down its growth expectations for this year and next, citing weaker domestic demand, but still saw inflation reaching its 2% target in the second half of 2025, some investors focused on the risk that the ECB could be too slow to ease policy.

Indeed, the bloc's recovery has been sluggish and Germany's economy shrank in the second quarter.

"If the ECB is slow to cut rates, the economy is not going to get the boost it needs," said Principal Asset Management's chief global strategist Seema Shah.

"From a fundamental perspective, Europe is not as interesting a proposition for investing as other parts of the world," said Shah, whose firm is underweight European equities.

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