Danske Bank anticipates that the European Central Bank (ECB) will announce a 25 basis point rate hike at its upcoming meeting due to ongoing strong inflation momentum. Despite a deteriorating economic outlook since the July meeting, Danske believes that the ECB's sole focus on its inflation mandate will take precedence.

Key Points:

• Rate Hike Expected: Danske Bank predicts a 25 basis point rate hike due to strong inflationary pressures. The market currently prices in only 8 basis points for next week and 17 basis points for future hikes, reflecting a generally more cautious outlook.

• Worsening Economic Conditions: While the economic backdrop has deteriorated since the last meeting in July, the bank expects the ECB's singular focus on inflation will lead it to implement a rate hike.

• Balance Sheet Normalization: Danske Bank also anticipates that the ECB will move forward with the full reinvestment process of the Pandemic Emergency Purchase Programme (PEPP), currently scheduled for December 2024, and that committees will be tasked for an announcement in October.

• Policy Tools: Danske suggests that while balance sheet normalization could serve as a compromise among ECB governing council members, the bank sees the policy rate as the primary tool for calibrating the ECB's monetary policy stance.

Trading Recommendations:

• Prepare for Rate Hike: Investors should consider the possibility of a rate hike and position themselves accordingly, as the current market pricing may not fully reflect this scenario.

• Watch the Inflation Metrics: Continue to monitor inflation data for indications of a stronger or weaker momentum, as this will likely guide ECB policy decisions.

• Focus on October Announcement: Danske Bank suggests that investors should also focus on potential announcements in October regarding the end of the full reinvestment process for PEPP.

Implications:

For Traders:

• Be Cautious of Market Moves: Expect potential volatility in European fixed income and FX markets following any announcements from the ECB.

• Risk Management: Hedge against both inflationary pressures and potential rate hikes.

For Policymakers:

• Communication is Key: A clear communication strategy will be essential in managing market expectations in light of potentially conflicting economic signals.

• Striking a Balance: Policymakers will need to weigh the impact of a rate hike on an already fragile economic recovery.

Conclusion:

Despite a weaker economic outlook and market expectations for a more cautious approach, Danske Bank expects the ECB to go ahead with a 25 basis point rate hike at its next meeting, largely driven by ongoing strong inflation momentum. Investors are advised to prepare for this possibility and pay attention to forthcoming announcements about balance sheet normalization.