Analysing the ECB’s “dovish” pivot

The ECB hiked interest rates by 75 basis points on Thursday, however this sent the euro hurtling back below parity versus the USD, as the market took some changes to the accompanying statement and a subtle shift in tone from the ECB President Christine Lagarde, to mean that the bank would make smaller rate hikes going forward and could potentially pause hiking rates after the December meeting. The market’s inference that the ECB was embarking on a dovish pivot surprised the most hawkish of the ECB’s central bankers who could not understand why the market thought the ECB had gone soft on inflation. They argue that ECB President Lagarde clearly stated that decisions would be made on a month-by-month basis and that inflation was too high. A mere 24 hours later post the ECB meeting and EUR/USD is trying to break back above parity after news that Germany had defied recession fears and its economy had grown by 0.3% last quarter. This leads to two questions: 1, is there now a pattern emerging where central banks are scaling back their expectations for rate hikes? Will the Fed and the BOE follow suit next week, after the BOC and RBA surprised with smaller than expected rate hikes earlier this month? 2, is the market premature in expecting a pivot when the economy is not on its knees?

Crucial tweaks to the ECB statement

Looking at the second point first, the market took Lagarde’s comments that a recession is looming for the Eurozone as a change of heart from the ECB: that they would ease the pace and extent of interest rate increases going forward. However, this did not stop the ECB from hiking rates by 75bps on Thursday or from talking about the need to bring down high levels of inflation. Some tweaks to the latest ECB statement were also less aggressive in their tone:

·      It removed the statement that it would hike rates further over the next several months, instead saying that rates would rise “further”.

·      Rather than “dampening demand”, the ECB now wants to reduce support for demand.

·      The statement also reads that substantial progress has now been made in withdrawing monetary support.

German GDP deals a nasty surprise to the “dovish” ECB

So, how does this fit with the more resilient German GDP data? The 0.3% expansion was driven by growth in private consumption, which has picked up the slack as manufacturing gets hammered by high energy costs and supply chain woes. This is the first time in 2022 that German growth has beaten Spain and France. However, the question now is how stable is a resilient German consumer, and will they be able to protect German economic growth as its industrial model undergoes an existential crisis? The IMF is predicting that Germany’s economy will contract by 0.3% next year, the largest decline for any G20 country apart from Russia. It is worth noting that Q3 GDP is looking in the rear-view mirror, and challenges remain in the future. EU business sentiment fell to its lowest level for 2 years and Germany reported the largest decline among the EU’s largest economies. These leading economic indicators point to further weakening of the German economy in the coming months, which is why the ECB is wary of hiking rates too far too fast, lest it breaks the currency bloc’s largest economy.  However, if the economic data continues to surprise on the upside, then the ECB could be left with a headache.

It is worth noting that the ECB is not alone when it comes to pedalling back on the prospect of higher interest rates in future. The bond market crisis in the UK earlier this month has made Western economies with high debt levels cautious about the recent pace of rate increases even as inflation remains sky high. Canada has some of the highest private debt levels in the world, Australia’s housing market is built on a mountain of debt, and if it comes crashing down then it could trigger a collapse in the housing market and a long-lasting and deep recession. Thus, there is an international impulse for lower interest rates after the UK’s mini economic crisis highlighted the vulnerabilities for economies laden with high debt levels.

The ECB takes the easy route to monetary tightening

The ECB also focussed attention on its measures to tighten monetary policy without hiking interest rates: for example, by informing the market that it would announce plans to shrink its EUR 8.8trn balance sheet at the next meeting in December, and by making its EUR 2.1 trn TLTRO loans programme less attractive for European banks, which caused Eurozone banking stocks to fall on Thursday. These should all reduce the monetary supply within the Eurozone, which is another form of monetary policy tightening, albeit gentler than the harsh impact of directly raising interest rates. However, the wool can’t be pulled over investors’ eyes by the ECB, everyone knows that quantitative tightening risks causing a UK-style economic crisis on steroids to the economies of Italy, Greece and elsewhere, since the ECB has been the main purchaser of their sovereign bonds for years. The ECB cannot quickly turn off this tap. Thus, by announcing plans to start discussions on QT at the ECB’s meeting in December this highlights the snail’s pace the ECB is taking when it comes to kicking off QT. Overall, we expect ECB to continue to lag its counterparts in terms of making a plan to reduce the size of its balance sheet.

FX: starting to believe the dovish narrative from central banks

What does this mean for markets? Essentially, inflation could be higher for longer, which is bad news for firms that cannot pass on price increases, and could weigh on stock prices in the coming months. Sticky inflation takes some time to bring down and with Eurozone interest rates currently at 1.5% and an extra 50bps of tightening priced in for December, this may not be enough to bring sticky price inflation down in the currency bloc in the medium term. Thus, the ECB may need to reverse its dovish pivot and continue to hike interest rates to approx. 100 bps above neutral if it is serious about reversing inflation. So far, the market is divided on what to expect going forward from the ECB. On the one hand, the FX market has run with the ECB “dovish pivot” story and EUR/USD is still below parity, we expect this pair to hover around parity for the medium term, and for EUR upside to be limited given the policy uncertainty that has been unleashed by the ECB.

Confusing central bank comms are likely to weigh on stocks and bonds

The fluctuating ECB and the uncertainty that this causes is reflected in the bond market. 10-year German Bund yields fell below 2% at one point on Thursday, however, a day later they are up by nearly 20 basis points. This is a sign that the bond market does not fully buy the ECB pivot narrative: how can the ECB be taken seriously if they pivot now when Germany’s growth is rising, and inflation remains close to 10%. Surely the ECB can’t abandon its mandate? Thus, if central banks want to reinforce their commitment to bringing down inflation, they will need to come out in force in the next few weeks to neutralise their dovish comments – that includes the ECB, BOE and the Fed. Either they do that, or they accept that they can’t influence inflation and that they will have to raise their inflation target levels. Uncertainty and mixed communication from the world’s leading central banks are likely to be bad for stocks, so it could be another wild ride into year end.