Traders are increasingly predicting that the European Central Bank (ECB) will postpone its plans for interest rate hikes in September. This comes as business activity in Europe experiences sharp contractions, indicating further economic struggles. The probability of a 25 basis point rate increase in September has dropped to around 40% compared to over 50% just the day before, suggesting a leaning towards a pause in the ECB’s rapid tightening cycle. Downturns in business activity in Germany, as well as an unexpected contraction in British business activity, have deepened concerns across the euro zone.

The downturn in business activity in Europe has resulted in a drop in bond yields in the euro zone and Britain. The euro has fallen to its lowest level against the dollar in over two months, while sterling has also decreased significantly. The declining rate hike expectations have highlighted the difference in economic fortunes between Europe and the US, as strong US data has led to expectations of higher interest rates for a longer period. In contrast, European Treasury yields have experienced larger drops, contributing to a headwind for the euro.

The latest data from the Purchasing Managers’ Index (PMI) suggests a return to the pre-summer narrative of lower interest rates. Citi economists have stated that there is a significant risk that the ECB has overtightened, and they have reduced the chances of a September rate hike. Similarly, JPMorgan expects the ECB to pause in September, joining a majority of economists who also predict a pause. While expectations have been scaled back, two more 25 basis point rate hikes are still anticipated from the Bank of England (BoE) to tackle higher inflation. Overall, the outlook for interest rates in Europe remains uncertain, with next week’s euro zone inflation data likely to influence investor expectations.

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