ECB flash: Europe isn't a Laggard anymore

This ECB meeting will go down as the biggest shock delivered by the ECB in many years, however, this meeting was extremely technical and highlights the ECB’s biggest fear: a spike in Southern European bond yields that could trigger another debt crisis.

ECB President Lagarde said that the 50 basis point rise was necessary to anchor inflation expectations and to ensure that demand conditions adjust, so that inflation is brought back to the 2% target. Make no mistake, like the Fed and to a lesser extent the BOE, the ECB is on a laser-focussed mission to bring down its record high inflation rate. The reason: surging inflation is killing German industry, and the Euro-area needs Germany to survive. 

The ECB’s move today was smart: the front-loading of interest rates should buy it some flexibility down the line By hiking rates more than expected today, it can then move to a meeting-by-meeting approach to hiking rates in the future. Ie, if inflation continues to soar, expect some more ballsy rate hikes like we saw today, but if things start to moderate (unlikely) then they could pause. 

By ending the era of negative interest rates, the ECB has also thrown a lifeline to the EUR, one of the most battered currencies vs. the USD. Although its initial surge to $1.0270 has been faded as the day has gone on, by hiking rates in a meaningful way, it is the first defence of the single currency and the first line of attack against a powerful dollar. While some may say that other countries’ mega-hikes in recent months, such as in Australia and Canada, have not done much to stem dollar strength, the EUR is a bigger currency and is an important global reserve currency. Thus, the ECB’s stance, which will also have been designed in part with the euro in. mind, is important for global FX markets and could lead to a slow down in the dollar’s assent for the rest of this year. 

The Transmission Protection Instrument, TPI, was an equally important part of this meeting. The anti-fragmentation tool has been designed to ensure that the ECB’s monetary policy stance is transmitted smoothly across all euro-area countries – read Italy, Spain et al. It is designed to counter “unwarranted and disorderly” market dynamics, however, one thing that it can’t help with is disordered Italian politics, which has come at a terrible time for the ECB. The TPI will allow the Eurosystem to make secondary market purchases of sovereign bonds if they show signs of stress – ie, widening of spreads with German bond yields. However, the ECB has said that the purchases will only be made if the deteriorating financial conditions are not warranted by “country specific fundamentals”. A leaderless Italy is pretty fundamental, in our view, and this is why Italian 10-years are up 8 bps on Thursday. To ensure that the spread between Italian and German bond yields does not get significantly wider, the ECB may have to turn a blind eye to its eligibility criteria from the start. 

The ECB is also reinvesting in full all principal payments from its APP for an extended time after it raises interest rates. It has not put an end date on this, which means that quantitative tightening could be some way off for the ECB as it tries to maintain ample liquidity across the Eurozone. 

The FX market has cottoned on to this at the end of Thursday, and it is why there could be a limit on EUR upside in the short term, even if today’s action by the ECB makes a return to below parity less likely in the short term.

From a growth perspective, this hike, along with helping to maintain liquidity conditions, does not necessarily make a recdession any more likely in the Eurozone, however, if this is the start of an aggressive hiking cycle then it is a different story. We need to wait until September and assess the economic data in the interim to figure that out.