Euro zone shares slide 1% after ECB signals rates lift-off

By Susan Mathew and Bansari Mayur Kamdar

(Reuters) - European shares hit two-week lows on Thursday after the European Central Bank signalled a higher interest rate hike in September as it raised its inflation forecast and cut economic growth expectations for the year.

The STOXX euro zone stocks index, which recouped almost all its session losses after the central bank kept its benchmark interest rate unchanged, swiftly reversed course and tumbled 1.6%. All major bourses in Europe fell 1% or more, with Italy's MIB down 1.9%.

The central bank said it would end a long-running bond buying scheme on July 1 and raise rates by 25 basis points - for the first time in a decade - next month and possibly by a bigger margin in September.

"They did add an explicit caveat that they may consider a bigger hike to be warranted in September, depending on the inflation outlook by then," said Bas Van Geffen, senior macro strategist at Rabobank.

"So basically, they are putting more weight on the updated projections in three months from now ... that does make it look a bit more hawkish."

The ECB said inflation was seen averaging 6.8% this year, well above the 5.1% predicted in March as well as its target rate of 2%, while economic growth for the year was cut to 2.8% from a previous forecast of 3.7%.

Bond yields across southern Europe soared. Italy's 10-year bond yield rose more than 20 bps and hit its highest level since 2018.

Losses in Europe were largely broad-based. The region's banks, which would be the primary beneficiary of higher interest rates, also fell 1.2%.

"Banks had a good run up until today when the ECB basically ruled out the possibility of a 50 basis point hike for next month," said David Madden, market analyst at Equiti Capital.

"But that's not to say that the upward trajectory that banks have been on for the last few weeks is going to be derailed."

Investors will now look to U.S. consumer price inflation figures for May, ahead of the Federal Reserve's policy meeting next week. Inflation is seen rising month-on-month and could see money markets start to price in a more hawkish Fed.

The U.S. central bank has signalled rate hikes this month and the next, most likely by 50 basis points, before it pauses for a data check. But bets have risen that more will follow.

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In a post-decision news conference, ECB chief Christine Lagarde said the central bank could deploy new instruments, if necessary, to address fragmentation, an excessive widening of yield spreads that might endanger the transmission of monetary policy across the region.