By Yoruk Bahceli
(Reuters) – Traders firmed up their bets on Wednesday that the European Central Bank would pause hiking interest rates in September as euro zone business activity contracted much more than expected, pointing to deepening pain for the bloc’s stumbling economy.
Traders now price in a roughly 40% chance of a 25 basis point move in September compared with a more than 50% chance they saw only on Tuesday.
That suggests they now lean towards a pause in the ECB’s record-paced tightening cycle that has lifted rates from deep in negative territory to 3.75% in just a year.
German business activity contracted at the fastest pace in over three years in August and much more than analysts expected, data showed on Wednesday, deepening the downturn in business activity far more than thought across the euro zone.
Euro zone government bond yields, recently propped up by a resilient U.S. economy, tumbled, while the euro fell to more than a two-month low against the dollar and investors also scaled back their expectations for where ECB rates will peak.
“The PMI suggests that it’s back to the pre-summer narrative of lower rates,” said Piet Christiansen, chief analyst at Danske Bank.
Germany’s 10-year yield, the benchmark for the euro area, dropped as much as 12 basis points to 2.53%, the lowest since Aug. 10.
Hit by the receding rate hike expectations, the euro fell to as low as $1.0812 and 84.93 pence. It has lost 1.7% against the dollar this month.
Wednesday’s moves highlight how the euro zone’s weaker economy and outlook for borrowing costs diverges from resilience in the United States. Strong U.S. data this month has prompted expectations that interest rates will remain higher for longer.
That sent U.S. Treasury yields to their highest in over a decade and lifted borrowing costs higher globally, with Germany’s 10-year yield rising to 2.72%, its highest since March.
Highlighting the contrast in outlooks, U.S. Treasury yields were on Wednesday trading with the highest yield relative to Germany’s since December at 173 bps, a headwind to the euro.
The two-year German bond yield, sensitive to interest rate expectations, was last down 9 basis points to 3%.
Italy’s 10-year bond yield, a proxy for the bloc’s riskier borrowers, dropped as much as 12 bps to 4.20%.
“The weakening in services might reveal that monetary transmission is stronger than the hawks were expecting,” said Mark Wall, chief European economist at Deutsche Bank, referring to ECB governing council members who have favoured tighter monetary policy.
“We are expecting the ECB to pause in September, but it is not clear that inflation is where the ECB wants it yet. A pause should not be misinterpreted as the peak.”
Markets also scaled back bets on further hikes for the rest of the year but still see just under a 60% chance of a 25 bps hike by December that will put the ECB’s deposit rate at 4%.
Key to investor expectations from the ECB will be euro zone inflation data due next Thursday.
“There’s many indicators that suggest that we could have had the last hike but if you just look at inflation, which is the (ECB’s) key mandate… that is not a done deal,” Christiansen at Danske Bank said.
(Reporting by Yoruk Bahceli and Samuel Indyk, additional reporting by Stefano Rebaudo; editing by Dhara Ranasinghe and Tomasz Janowski)
