ECB gets hawkish but debt markets get the jitters

The ECB meeting on Thursday went according to analyst expectations. The Bank announced the end of their Asset Purchase Programme on 1st July, and they kept other monetary policy measures unchanged. However, in line with their forward guidance programme, the bank announced that it would indeed be raising interest rates in July and September. The ECB has, finally, joined the rest of the major central banks bar the BOJ and is hiking interest rates to target “undesirably elevated” levels of inflation. The euro bounced initially in response, however, it had weakened by the end of the European session. The the main question now is, will the ECB be brave enough to raise rates by 50 basis points in September or later in the year?

To hike by 50, or not to hike by 50?

The answer to this question is the one that the market was waiting patiently for. We had said that if the ECB had suggested a 50 basis point rate rise was on the cards for July or September, or if the bank ditched the word “gradual” in relation to future ECB rate hikes then the euro would have taken off. However, the canny ECB have muddied the waters slightly when it comes to the market projecting the future path of interest rates: it kept the door open to a 50bp rate hike in September and said that the size of the rate hike then will depend on the medium-term outlook for inflation: “If that deteriorates, a larger increment will be appropriate at the September meeting.” This suggests that further price pressures will force the ECB into hiking rates by 50 basis points in the coming months. We interpret this statement in two ways: firstly, it’s clear that the ECB is armed and ready to hike by 50bps, especially since the ECB has a dismal track record at accurately predicting inflation, the Eurosystem’s CPI projections have repeatedly needed to be revised higher in recent months. Thus, if it looks like the 6.8% projected CPI rate for 2022 and the 3.5% rate for 2023 are too low, then expect the ECB to opt for larger rate hikes. However, the ECB also used the word “gradual” in relation to rate hikes twice in this statement. It clearly stated that “gradualism and flexibility” will be maintained in its conduct of monetary policy. The ECB also said that a “gradual but sustained path of rate increases will be appropriate” after September. Thus, the ECB means business, however, it doesn’t want to shock the market, especially the bond market, with its plan for monetary policy. However, as you will read below, it could be too late for that.  

The outlook for EUR

Initially, EUR/USD had jumped back above the $1.0750 level after ECB President Lagarde said that inflation pressures had broadened and that the Euro-area’s inflation projections had been revised up significantly. She also reiterated that monetary policy “normalisation” will help to bring prices down. Thus, at this stage the ECB President is not expecting to have to tighten monetary policy, normalisation is all that is necessary. However, in recent months we have debated whether the Federal Reserve will need to tighten monetary policy, rather than “normalise” interest rates to deal with the inflation shock that we are currently witnessing. Thus, there is a chance that the market may start to price in the prospect of interest rates needing to rise at a faster pace than the ECB is suggesting, and an actual tightening of monetary policy will be necessary. This is euro positive, in our view, and for EUR/USD we could see it reach $1.10 in the coming weeks, although we could see some short term pullbacks as we did after Lagarde’s speech on Thursday afternoon. A move back below $1.07 could be a buying opportunity in EUR/USD.

Market outlook

Unsurprisingly, European stock markets were subdued on the back of the ECB meeting. The Dax was down nearly 1.3%, and, interestingly, the banking sector was also a key underperformer. Usually the prospect of rising interest rates causes bank stock prices to rise as it allows them to charge more for loans and mortgages. However, there could be a fear that the ECB will not be able to raise rates as fast as they would like after the Italian/ German bond yield spread blew out to its widest level since the peak of the pandemic. The Italian 10-year bond yield surged by nearly 20 basis points in the aftermath of this meeting, the spread between Italian and German 10-year yields is now 2.12%. If this continues to widen, which could, after Lagarde kept the door open to 50bp rate hikes in the future, surge to 2.5%. If spreads do widen to this level, it could lead to stress in peripheral European bond markets, which could lead to the ECB beingless aggressive in hiking rates than they have suggested at this meeting. However, the doves are not in control of the ECB today, instead the fiscally conservative Northern bloc, led by Germany, have got their way and the ECB is now in full hawkish mode. Thus, European stocks may not bounce back on the back of today’s decline, and we could see further broad-based declines into the end of the week.

The prospect of a Eurozone debt crisis is one of the big risks facing the ECB, and something that they will want to avoid. However, inflation remains unbearably high for them, which is why we think that they will maintain their hawkish bias, unless or until, peripheral debt spreads blow out further from here. We will also be watching US CPI on Friday to see if US inflation pressures are easing. If they are not, then it strengthens the hand of the ECB and other major central banks to maintain their rate hiking cycle for the medium term, in our view.