ECB wage data - can I get a raise?

The European Central Bank (ECB) will almost certainly start their rates cutting cycle next month. Supportive inflation data and clear guidance from the governing council has driven market implied probabilities of a June cut to almost 100%, with little in the way to derail that.

The main hurdle for the ECB, as Christine Lagarde highlighted back in January, was the first quarter wage data. Similar to the Federal Reserve (Fed) albeit to a lesser extent, the eurozone has been struggling with sticky services inflation given labour markets that remain tight, with the eurozone unemployment rate hovering around all-time lows. In the minutes from April’s meeting, the governing council mention the tight correlation between wages and the inflation rate in wage-sensitive sectors, noting that services inflation is unlikely to see a large drop until 2025 when they are expecting a more meaningful deceleration in wage growth. It is important to mention that the labour market in the US is a lot more flexible than in Europe. Negotiated yearly, or even multi-yearly wage packages are a lot more common in Europe which usually translates to a delayed reaction in wage inflation compared to the US. Post Covid, this is exactly what happened with US wages exhibiting steep upward trends close to a year earlier than in Europe according to Indeed Wage Tracker.  Analogously, the peak in wage inflation was reached some months later in Europe.

Determining wage growth accurately in Europe is trickier than in the US given the disparity of country level reporting and negotiating trends, so the ECB looks at a number of measures to underpin their view. Wage pressures in 2023 moderated, but still remained above the level that is consistent with the ECB’s 2% inflation goal. According to the latest ECB minutes, annual growth in compensation per employee decelerated to 4.6% in the fourth quarter versus 5.1% in the third quarter, whilst growth in compensation per hour slowed from 5% to 4.4%. The wages and salaries component of the labour cost indicator had decreased to 3.3% in the fourth quarter, from 5.1% the prior quarter, whilst annual unit labour cost growth had fallen from 6.5% to 5.8% over the same period (albeit remaining high, driven by relatively weak productivity growth).  Negotiated wage growth, including one off payments, declined as well from 4.7% in the third quarter to 4.5% at the end of the year.

The ECB expects to see first quarter negotiated wage growth next week, before receiving more wage data just after their monetary policy meeting in June. The data we have seen for the first quarter so far has been mixed, with Germany in particular showing a potential bump to start the year, although the expected path of negotiated wages is expected to soften to 4.3% given more positive data outside of Germany. Some forward looking wage trackers are also showing some signs of easing – the ECB points towards the Indeed Wage Tracker as one, which tracks job adverts across Europe. The early indications are that April (the first bit of second quarter data we have seen) is seeing further signs of easing, with German advertised wages rising 3.39% YoY, down from 4.65% at the beginning of the year and overall European wages in April slowing to 3.02%, 1% lower than the YoY rate at the end of last year.

This should keep the ECB cautiously optimistic about the path of services inflation as we move through the year, although by the ECB’s own admission wage growth this year is still expected to remain above the level that is consistent with their inflation goal. The direction of nominal wage growth will be key therefore in understanding not when the first cut will likely happen (which we know with some certainty now), but what that cutting path will look like going forward. In an environment of improving growth, low unemployment and wage growth that is slowly normalising, we see little need for the ECB to cut aggressively in 2024, and see market pricing of approximately 3 cuts as roughly fair for this year.

In addition to this, whilst President Lagarde talked about ECB independence at last month’s press conference, the discussions since then from many governing council members has highlighted some caution about moving too far ahead of the Fed once the cutting cycle begins. This will of course depend on how much the data diverges in the coming quarters, but in practice means that the spread difference in 2024 rate cut pricing between the US and Europe will be capped.  However, we think there is room for this to diverge from current levels of 24bps (i.e the market is pricing in approximately 2.80 cuts from the ECB and 1.84 cuts from the US).

Ultimately, given the improving macro backdrop in Europe and the slightly better inflation trends, European government bond volatility has been lower this year than it has been in the US, driving strong outperformance in some European credit markets, particularly financials and ABS. Given all-in yields that still remain attractive, we view European credit as a ripe arena to go credit picking in.