This week, on Thursday 21st of July the ECB will meet to discuss the latest in monetary policy in the Union. The institution chaired by Christine Lagarde will have to decide its next steps to take in regards of the monetary policy. They will have to decide whether the top monetary authority will continue to step up the accelerator with rate hikes, or, on the contrary, maintain a more conservative tone in the face of the dangers of a recession that has already replaced the announced stagflation in a multitude of forecasts.
After today’s news of another record of inflation in the Euro area of 9.6%, the scenario is becoming more and more challenging for Christine Lagarde and the members of the institution.
We have received the first insights from the professionals within the asset management industry to understand what we should expect from this meeting, as well as the possible consequences for the markets.
Konstantin Veit, Portfolio Manager at PIMCO
After having ended net asset purchases in June, the ECB will likely hike interest rates next Thursday, the first rate hikes in the Euro area since 2011. We believe the ECB will hike its policy rates by 25 basis points, signal a 50 basis point increase for September and communicate that further increases in interest rates will likely be appropriate.
The ECB is also expected to unveil the contours of its new anti-fragmentation backstop. We believe the ECB will essentially settle for an Outright Monetary Transactions (OMT)-type facility that allows for interventions in sovereign debt markets in case the Governing Council (GC) establishes that the monetary policy transmission mechanism is impaired. We expect somewhat less onerous conditionality than under the OMT, and purchases to be sterilized so as not to interfere with the overall monetary policy stance.
Investment implications: While the ECB will aim for a smooth normalisation of monetary policy, the macroeconomic configuration remains complex and central bank communication challenges elevated.
Gilles Moëc, chief economist at AXA Investment Managers
The ECB is not going to have it easy. While the interest rate decision – a 25 basis point hike – was previously announced in June, the ECB is expected to unveil the details of its anti-fragmentation tool just as political instability in Rome is causing the Italian spread to widen. Thus, the new framework could be put to the test much earlier than expected.
The ECB has always presented its anti-fragmentation tool as a way to deal with “unwarranted” spread widenings. It is not clear how this notion would be applied in the current circumstances. However, now, beyond short-term gyrations in spreads, it is necessary to connect the two ‘streams’, the risk of recession and fragmentation. If Russia turns off the tap, Italy will be hit harder than many other European countries given its lack of nuclear power and its high dependence on Russian gas. Now, this adds another layer of complexity for the ECB.
Thus, beyond the mechanical effect of a weaker currency on imported inflation, “breaking parity” may be an important psychological moment for the ECB to play into the hands of the hawks, as euro weakness is seen as the price Europe pays for not changing its monetary policy as quickly as in the US. However, we note that there has not been much public outcry for a 25+ basis point hike on July 21 in the recent “ECB speech”. The intention was probably too explicit in the June guidance for a debate to really take off. However, it may well be that, Christine Lagarde should be open to a move of more than 50 basis points in September, depending on inflation dynamics until then, to calm hawkish concerns.
Ulrike Kastens, Economist Europe, DWS
Expectations are high for the European Central Bank’s meeting on July 21, 2022. For the first time in nine years, the ECB has the courage to raise all key interest rates by 25 basis points. However, given the extremely high inflation rates, this is a hesitant reaction. We therefore assume that the ECB will include monetary policy normalization – i.e. further interest rate steps in the course of the year – in its announcement.
The tightening could be more pronounced the more powerful the announced program to combat so-called fragmentation in the eurozone turns out to be. Whether fragmentation, i.e. a “fundamentally unjustified widening of yield spreads,” actually exists is a matter of considerable debate. However, the ECB considers such an instrument necessary to avoid a crisis situation like in 2011 and 2012.
In doing so, it has fueled high expectations among market participants, which now need to be met. We do not expect the program to be limited in time. Possible asset purchases are also likely to be sterilized to avoid a renewed expansion of the ECB’s balance sheet. But as with the SMP (Security Markets Programme) and OMT (Outright Monetary Transactions), monetary and fiscal policy are likely to be mixed. The ECB would only be allowed to buy bonds from individual countries if they meet certain fiscal conditions. However, strict conditions and rules as with the OMT are not to be expected; rather, the central bank could be satisfied with declarations of intent. This could make the new program legally contestable in the medium term. It is also unclear whether the instrument will actually be used or whether the announcement effect will be sufficient to narrow the spread.
At this landmark meeting, communication will once again be of great importance – not least because of the weakness of the euro. In the past, the ECB has mostly succeeded in meeting the market’s expectations.
Vincent Chaigneau, Head of Macro and Market Research, Generali Investments
ECB task of leaning against fragmentation much harder now. The ECB has a single primary mandate – inflation – in contrast to the Fed (inflation and employment). Yet the ECB has always considered the stability of the euro area as a top of priority – it is the essence of its mere existence.
There was no conflict of objectives when inflation was consistently too low. The ECB could then print money and buy bonds, to safeguard the EA against the risk of deflation and/or fragmentation risks. The situation today is far more complicated as printing money would be seen as contrary to bringing inflation back towards the 2% target. This brings into focus the questions about the ability of the ECB to separate tools, e.g. allocate rate hikes to the inflation target and bond programmes to financial stability.
Arguably the ECB has a strong track-record on fighting financial fragmentation, but this was in a very different environment. We fear that flexibility around PEPP re-investment – say around EUR 20bn per month – will not be enough in case of serious market test, even if the ECB accepts some front loading (reinvesting even before se-lected issues come to maturity), which does not seem to be part of the initial set-up. We will be looking at the details of potential new programme, whatever its inspiration (SMP or OMT). The details to be watched include the seniority issues (SMP purchases were senior, i.e. failing to bring any relief to investors in case of restructuring) and the conditionality of the programme.
We remain to be convinced about the ECB’s political and legal capacity to reallocate its gigantic balance sheet. The original flaws of the monetary union remain – banking union is unfinished business, no fiscal union – and the solidarity shown with NGEU may be lacking again if and when selected countries face market pressure. We take a cautious approach on non-core exposure as this political resolve may be tested at a time of deteriorating debt sustainability metrics: real yields rising, real GDP growth falling and selected governments facing a near impossible trinity: how to finance energy and military transition while ensuring public debt remains sustainable and the social and political environment stable.
Martin Wolburg, senior economist at Generali Investments
Markets are anxious on ECB to detail the fragmentation tool
At Thursday’s policy meeting the ECB Governing Council will finally start key rate normalisation. It pre-announced a 25 bps hikes but given among other factors a record-high inflation of 8.6% yoy in June the risks are clearly tilted to a 50 bps hike.
Beyond that President Lagarde should make clear that the hiking cycle has just started but that timing and extend of future rate hikes depends on the expected growth-inflation mix. Markets will hence carefully listen to comments about recession risks.
The ECB’s already announced new anti-fragmentation tool will take a center stage. So far hardly any details are known and we expect the ECB to at least become much more concrete if not already release the design of the new tool. We see the risk that it does not match high-flying market expectations. In such a case peripheral debt could come under pressure
François Rimeu, Senior Strategist, La Française AM
At the July meeting, the European Central Bank (ECB) will confirm its policy sequencing. The main focus will be the anti-fragmentation scheme named “Transmission Protection Mechanism”.
As preannounced, the ECB will increase its three key interest rates by 25 bps after having ended its Asset Purchase Programme (APP) on 1 July; we do not expect the ECB to surprise markets with a 50-bps move.
The overall tone will in our view remain very hawkish considering the latest inflation figures and the downward pressure on the exchange rate.
We also expect President Lagarde to reiterate that the pace of policy tightening will be guided by optionality, data-dependence, gradualism, and flexibility. She will confirm that the key ECB interest rates will rise again in September, with the calibration of this rate increase depending on the updated medium-term inflation outlook.
She will likely reaffirm the ECB’s very strong commitment to act against unwarranted fragmentation. The ECB will also provide more details about the so called “Transmission Protection Mechanism”, its new bond-buying program. We expect this plan to be unlimited, with light conditionalities and 100% sterilized. It will be a difficult exercise in communications for the ECB, with a lot of questions around this new plan: what does “light conditionality mean exactly? What are the “right” circumstances under which the tool could be deployed? Is the ECB going to favor specific parts of the curve?
We also expect the ECB to confirm discussions to modify TLTRO (Targeted longer-term refinancing operations) III eligibility requirements given the accelerated pace of monetary policy normalization.
All in all, the main risk would be to see the ECB fall short of market expectations regarding the new plan. The ECB has a difficult exercise in communications, especially given new political turmoil in Italy. Ahead of this meeting, we remain cautious on peripheral bond spreads, and we still see a potential for more flattening across European curves.
Karsten Junius, Chief Economist, J. Safra Sarasin SAM
We believe that markets underestimate the risk of a 50bp rate hike by the ECB next week and overestimate the details of a possible anti-fragmentation tool the ECB might present. Higher inflation rates, a lower exchange rate and persistent labour shortages argue in our view for a stronger rate hike than the 25bp that the ECB has pre-announced so far.
We believe that the ECB should realize that its forward guidance is again hindering it from shifting to the most adequate policy stance. It should abandon “forward guidance” as a main policy tool and frontload policy hikes similar to other central banks.
We expect the ECB to hike its key policy rates by 50bp at its coming meeting on Thursday – despite its previous indication to hike by 25bp only and even though money markets are pricing a mere “32bp” move – hence only a slight chance of a larger hike. Compared to the last ECB-meeting, the inflation environment has deteriorated clearly again in the short and medium term. Q2 average inflation came in at 8.0% and there is only a small chance that it would fall below that in Q3. This compares with 7.5% for Q2 and 7.3% for Q3, which the ECB forecasted during their latest staff macroeconomic projections in June.
Moreover, cost pressures from the producer side are building up. Since the beginning of 2021, producer prices rose by 41.8% while consumer prices increased by 11.1% “only”. This means that there are still substantial cost pressures in the pipeline that corporations will want to pass on, or that are weighing on their profitability. Importantly, it’s not only the contributions from food and energy prices that are increasing strongly, but increasingly those of non-energy industrial goods and of services as well.
Peter Goves, Fixed-Income Research Analyst, MFS Investment Management
Given how widely the ECB has telegraphed its near-term policy normalization plan, a 25bp hike this week looks like more or less a done deal. This lift-off will be the first time the ECB has hiked since 2011 and will take the deposit rate from -0.5% to -0.25%. We expect another hike at the September meeting, where a “larger increment” may be appropriate.
However, this is all largely known and priced. What holds more prominence for market movements are the details around the new anti-fragmentation tool, now referred to as the TPM (Transmission Protection Mechanism). It is plausible a full-blown tool may not be operational yet, but Lagarde is highly likely to provide some details regarding its mechanics and applicability. Of course, the idiosyncratic political developments in Italy are ill timed which could keep spreads wide despite this new ECB initiative.
There has been very little in ECB commentary to suggest a departure from the pre-announced roadmap for July. Given the uncertain backdrop and that this will be the first hike in a decade, it’s likely the ECB will stick to its plan: to hike by 25bp this week. A hawkish twist however could come from any steer about subsequent hikes and its line on inflation.
Phillipe Waechter, Chief Economist at Ostrum AM
The first point of the summer will be the rise in ECB interest rates on 21 July. The associated message will be important. Since the ECB seminar in Sintra, expectations on monetary policy have been downgraded by investors.
The central bank is caught between the strong rise in inflation (8.6% in June) and the strong risk of recession resulting from the significant losses in consumer purchasing power but also from questions about Europe’s supply of Russian gas. The ECB seemed hesitant, and no one expects it to be as proactive in its fight against inflation as it was a few months ago. This is a real source of fragility for the euro.
