31 JAN, 2023
By RankiaPro Europe
The ECB’s first meeting of the year will take place on February 2. A meeting in which Christine Lagarde, president of the European Central Bank, is expected to raise interest rates by 50 basis points; although fund managers are especially focused on what will be the central bank’s roadmap for the upcoming meetings. Below, we leave you with the perspectives of the sector’s entities before the meeting is held.
We expect a 50bp rate hike. A promise is a promise! European Central Bank (ECB) President Christine Lagarde committed at the last policy meeting in December to deliver a 50 basis points (bp) hike in February. This is what the markets are 100% expecting and what we are waiting for.
In the short term, the path is clear. The minutes of the last meeting indicated a commitment by the Governing Council to raise rates by 50bp at the next two meetings in February and March, in return for a 50bp hike in December, probably the result of a compromise when the more hawkish members were arguing for 75bp.
The markets have taken these perspectives on board. At the 2 February meeting, investors’ attention will therefore be less focused on the magnitude of the announced rate hike than on indications of their trajectory at the following meetings.
Investors expect a terminal rate of 3.25% to be reached before the summer. This expectation for the entire monetary tightening cycle seems too moderate. Therefore, we expect a clarification from Christine Lagarde, who should remain faithful to the hawkish message hammered out for weeks. She should reiterate that inflation, especially core inflation, remains too high and reaffirm the absolute necessity for the ECB to continue to act over time to bring it down to a level more compatible with its price stability objective.
Given the latest leading indicators in the eurozone, which show a certain resilience of the economy, the ECB has regained some room for maneuvering in implementing a more restrictive monetary policy.
Therefore, the next meeting looks hawkish. It should help recalibrate upwards expectations of future ECB rate hikes and could lead to pressure on bond yields.
With core inflation showing no signs of deceleration, wages remaining on an upward trend and growth expectations being revised higher, there is no doubt that the ECB will bring deposit rates to 2.5% on 2 February. Especially as a 50 basis points (bps) hike is largely telegraphed by its forward guidance, provided it can be trusted – a source of much debate among investors!
The key point at issue, therefore, is not “if” but “how long” will this 50 bps hiking period last. Perhaps two meetings, per the 75 bps hiking period? Will it go beyond March? Will we, from now on, transition towards a 25 bps hiking period?
We deem that Ms Lagarde is likely to remain consistent with the hawkish stance considering the European economy has surprised to the upside since her final stand of 2022 and expectations of where interest rates will end in this hiking cycle have moved lower, along with downward surprises on gas prices.
Attention is also expected to shift towards the details of the Quantitative Tightening program. Indeed the winding down of the balance sheet has the potential to raise some eyebrows. With the ECB having announced a pace of tightening of €15bn per month to begin with, but yet to announce how this will affect the different bond market segments (the ECB has purchased government bonds, corporate bonds and covered bonds) and the different issuers (a wide variety of countries with differing economic realities), questions need to be answered.
While the US Federal Reserve is expected to raise key interest rates by only 25 basis points next week, the European Central Bank is still far away from further slowing the pace of interest rate hikes. It is true that the inflation rate in the euro zone is likely to fall below the 9% mark in January, now that energy prices have eased also thanks to government measures. However, there are no signs of easing in the underlying price trend. The core rate was already 5.2% in December 2022. However, higher costs are likely to have prompted many companies to push through further price increases, particularly at the start of the year. As a result, the core rate could rise further toward 5.5% in the coming months. All this argues in favor of further rate hikes: 50 basis points are set in February, in our opinion. In her monetary policy communication, ECB President Lagarde is also likely to announce an unchanged, more restrictive monetary policy course. This would then also argue in favor of another rate hike of 50 basis points in March.
The ECB’s hawkish comments this week are hardly surprising in light of recent economic data and inflation developments. The eurozone economy has performed better than expected through the energy crisis – stagnation for a couple of quarters at the turn of the year seems now to be more likely than outright GDP contraction. Granted, good luck has played a role as winter temperatures have been mild so far, but preparedness and the long tail of post-Covid recovery dynamics have also underpinned economic resilience. A multi-year fiscal plan mainly targeting the most vulnerable eurozone members and, more recently, the quick re-opening of the Chinese economy are sources of upside risk to the eurozone economic outlook, although we expect global spill-overs from this stage of the recovery in China to be limited.
In the short-term the ECB’s path is set and rates will increase further in coming months. A 50 basis point rate hike is baked in for their meeting next week, and it is unlikely to be the last one, unless the updated March forecasts provide a dramatically different outlook for inflation and growth compared to December. Further down the line, downside risks to the growth outlook are still pronounced, primarily stemming from structurally higher energy prices and a slowdown – possibly a recession – in the US later this year. Eventually, data developments will dictate how long and how far the ECB’s tightening will go. As central banks are slow moving and data provides a backwards-looking picture of the economic situation, there is a risk the ECB will end up over-tightening.
We expect the ECB to hike interest rates by 50bp to 2.5% at its Governing Council meeting this Thursday. The pace of hiking is not expected to slow down anytime soon and another 50bp hike is also likely to be delivered in March as the ECB is clearly on a mission to bring inflation down from the current elevated levels.
Markets are pricing in nearly 150bp of cumulative policy rates hikes by the early summer and a pause until year-end. We suspect the ECB will reiterate its hawkish message in February as there are still uncertainties regarding underlying inflationary pressures and a change of tone would undermine the ECB’s credibility and inflation would completely lose its anchor.
Risks around future inflation remain high, and we can probably see the peak for headline inflation being behind us, but core inflation might still have some room to grow, with pass-through effects of higher energy prices filtering through the price formation chain. Despite falling risks of recession due to the combination of the slight improvement in purchasing power, reduced supply constraints and picking up demand from China, the impact of tighter monetary policy need to filter through the economy via slower investments and possibly a contraction in housing activity. In a nutshell, the overall picture remains blurred but the hawks at the ECB Governing Council will continue to emphasise the need to keep rates in restrictive territory to avoid inflationary expectations to get out of control.
Notably, the ECB is – like other Central Banks in the DM space – hiking at a stage where GDP growth is still running below potential (despite the less dire energy situation) and more tightening will be delivered until inflation rolls over and there are signs that underlying inflationary pressures are stabilising. In such a scenario, we still see risks of higher yields across the German curve in the short run, especially if the ECB manages to re-affirm its credibility at its February meeting.
As for QT, we expect the ECB to announce some ‘technical’ details about the active selling flows starting in March (for example: sale will follow the capital keys) but there will not be further indications on how QT will continue beyond the second quarter of this year. We anticipate more details on QT to emerge only in March when the ECB will have more evidence on how the Eurozone financial conditions will look like with some additional policy tightening.
Seasonal gifts were delivered this week with central banks in the Eurozone, Mexico, Philippines, Switzerland, the UK, and the US all handing out 50 basis point (bps) rate hikes. Norway delivered a 25bps rate hike and Taiwan provided a 12.5bps rate hike. Commentary remained broadly hawkish, however both the UK and the US acknowledged that inflation has likely peaked for the cycle, softening the market reaction to the rhetoric.
The largest surprise came from the European Central Bank (ECB). In a press conference this past week, President Lagarde communicated that we should expect the ECB to raise interest rates at a 50bps pace for a period of time. The ECB downgraded growth expectations for 2023, with recession expected to occur from Q4 2022 to Q1 2023 as a result of the energy crisis and tighter financial conditions. However, ECB policy makers seem far more concerned with inflation risks, significantly revising next year’s inflation forecast and predicting numbers above the 2% target in the new 2025 forecast (see Chart of the Week).
This week, the impact of the contrasting stages of the Fed’s and the ECB’s policy cycles were felt; European assets underperformed as financial conditions tightened. The 10-year German Bund was higher in yield by 24bps, in contrast to the US 10-year Treasury, which was lower by 8bps. European credit and equities underperformed, and the euro ended the week 1% stronger against the US dollar.
We think the Governing Council (GC) will make clear that a restrictive policy setting might be warranted for longer than the market currently expects. The ECB will also release reinvestment reduction details, but we do not foresee any market moving surprises versus the broad principles released at its December meeting.
Inflation data for December point to a persistent build-up of underlying price pressures even as energy price inflation has started to subside from high levels. The ECB remains concerned about wage dynamics, fiscal policy and market based financial conditions. After peaking in 2023, the ECB still expects growth in compensation per employee to be running at 3.9% year over year in 2025, well above its long-run average of 2.1%. Fiscal policy is seen as not targeted enough, and market based financial conditions might continue to encourage the ECB to maintain its hawkish posture, especially as the market prices rate cuts already in the second half of this year.
If the recent underlying economic resilience of the Euro area persists, the prospect of the ECB having to tighten policy more than currently priced in financial markets might eventually come into sharper relief. For inflation to fully normalize back to the ECB’s 2% price stability target, some cooling in the economy and in the labor market is likely needed.
The institutional Euro area setup suggests limited scope for the ECB to think about trade-offs between quantitative tightening (QT) and policy rates, arguing for any bond holding reduction exercise essentially taking the shape of a fairly mechanical background programme.
At the upcoming meeting the GC will announce the detailed parameters for reducing the APP holdings, and we do not expect any market moving surprises in those details. We expect the ECB to apply the overall reduction proportionately across the four APP portfolios, essentially by scaling down the reinvestments implied by the ECB’s existing approach by around 50%.