3 MAY, 2023
By Constanza Ramos
Tomorrow, Thursday 4 May, the European Central Bank will meet. At this meeting, the market expects ECB President Christine Lagarde to raise interest rates by 25 basis points, although fund managers are particularly focused on the central bank’s roadmap for the upcoming meetings. Below, we leave you with the international fund managers’ outlook ahead of the meeting.
Underlying price pressures remain firm, with eurozone core inflation reaching a new high of 5.7% in March.
We expect the European Central Bank to raise policy rates by 25 basis points at its May meeting and, as in March, to refrain from communicating unconditional expectations about the future path of interest rates.
Although the ECB could unveil its plan for reinvestments of the asset purchase program (APP) from July onwards as early as May, we believe that this decision will rather be taken in June.
While the US Federal Reserve is almost at the end of its monetary policy tightening cycle, the ECB is still far from any pivot.
As ECB Chief Economist Philip Lane pointed out in mid-April, the decision to raise rates at the 4 May meeting must take into account future developments in inflation and its core component, as well as the appropriate transmission of monetary policy.
Consequently, the national inflation statistics published on 28 April and the total and core inflation figures published on 2 May remain inconsistent with the ECB’s price stability objective. Indeed, headline inflation at the end of April increased slightly to 7%, compared to +6.9% in March (after a peak of 10.6% in October 2022), and core inflation remains high at 5.6%, compared to 5.7% in March. The outlook does not point to a near-term slowdown either, as wage growth remains strong in the euro area (as in the case of recently negotiated agreements in the German public sector).
The bank lending survey published on 2 May reveals a further slowdown in credit distribution. However, tensions in the eurozone banking sector have eased considerably and should not play a key role in the ECB’s decision-making, which should focus more on the inflation outlook.
There is a clear market consensus that the ECB should raise rates on 4 May, according to recent statements by Council members. But there will be debate about the size of the hike.
We believe the ECB could raise rates by 25 basis points and signal its intention to hike further. The policy tightening induced by the mandatory repayment of the targeted longer-term refinancing operations (TLTROs) in June (amounting to EUR 480 billion) should prompt the ECB to adopt a gradual, step-by-step approach. But its determination should remain intact.
Investors anticipate a rate hike, and the ECB’s decision on 4 May is not expected to surprise them.
The ECB’s action plan is very different from that of the Fed. As its president has stated, much remains to be done, while the Fed has practically finished. The market expects at least a 25 basis point hike that would put the target rate at 3.25 % but does not rule out 50 basis points. It also expects terminal rates close to 3.75 % in the third quarter, before an eventual downward turn at the end of the year. However, core inflation in the euro area has not yet started a downward trajectory, which leaves the door open to hikes beyond this date. Lagarde will not be able to say much about this timeframe. Upcoming inflation data will serve as a guide.
Inflation data released yesterday suggest that the European Central Bank could slow the pace of its policy rate hikes by up to 25 basis points at its next meeting tomorrow, Thursday. The deposit rate would then move from 3% to 3.25%. Admittedly, the inflation rate is still too high. It rose from 6.9% to 7% in April 2023. However, for the first time in several months, the underlying rate fell from 5.7% in March to 5.6%. Still, we cannot relax as, according to our calculations, the underlying rate is likely to remain well above the 5% mark in the coming months.
Moreover, data on lending and credit conditions show that the ECB’s tighter monetary policy is being transmitted to the real economy. After credit conditions already tightened in recent quarters, they increased again in the April survey. Moreover, banks expect a further sharp decline in demand in the coming months. Moreover, the proportion of rejected loans is also rising. All this suggests that most ECB members are likely to be more comfortable with a smaller increase in policy rates. However, this should not be confused with a faster end to rate hikes. The ECB remains data-dependent and rate hikes are likely to continue. It is likely to reiterate this at Thursday’s ECB meeting.
We expect a 25 basis point hike in May and June to bring terminal rates to 3.5%. That said, the ECB’s upcoming bank lending survey and the evolution of core inflation will set the tone for future decisions. We expect further tightening of financial conditions (already at the tightest level since 2011) and a slight improvement in core inflation over the next 3-6 months. In case these data surprise in different directions and the growth outlook looks more optimistic than currently expected, we would revise our call for further policy action accordingly. It is our firm conviction that the ECB is indeed data-dependent, now that it is nearing the end of its tightening cycle and the impact of past policy measures should be fully transmitted to the real economy.
Markets currently price final interest rates between 3.75% and 4%, and policy rates are expected to remain broadly stable until early 2024. Therefore, this week’s policy decision is unlikely to trigger large falls, unless the ECB re-commits to 50bp (or more) hikes in the near future. We are cautious about initiating further bullish trades in the underlying euro curves as the market will wait until there are signs of moderation in core inflation before starting to price in rate cuts by the ECB. That said, a more neutral duration stance makes sense given what the market is already pricing in.
The ECB could also announce quantitative tightening at this week’s meeting. Given the minimal impact of the reduction in the reinvestment of APP proceeds on yields and spreads, the Governing Council could commit to further steps in the direction of withdrawing liquidity in the system (i.e. stopping APP reinvestments in the second half of the year). Such a decision would make hawks happy, as the overall policy stance would be tightened, without affecting policy rates (which remain the primary tool of monetary policy maneuver at this stage) too much. That said, there seems to be broad agreement to maintain the reinvestment of the PEPP which offers flexibility to the ECB to avoid unnecessary fragmentation and further distortion in the transmission mechanism that is currently a key pillar in its policy decision. June will be crucial, with the expiry of the TLTROs, which could put further pressure on lending conditions. In this regard, the ECB should be extremely cautious with the timing of its policy decisions (not only on the rate front), as it could lead to unjustified negative circles.