Week Ahead: Will the ECB make history?

The big question of the week is whether the ECB has the guts to hike interest rates by 75 basis points after a record high HCIP inflation rate in August of 9.1%, a German inflation rate of 7.9%, soaring inflation expectations and a return to the May low of 6.9% for the unemployment rate. The Eurozone economy is facing unimaginable headwinds right now, yet the ECB’s mandate is to keep inflation around 2%. We will find out how the ECB responds to its impossible task on Thursday when it will announce its policy decision at 1215 BST, with president Lagarde’s press conference at 1245 BST. Analysts are currently expecting a 0.5% rate hike from the ECB, that would lift the rate on the deposit facility to 0.5%, from zero. This is the ECB’s main policy rate, and if the ECB does as the analysts expect, this would be the highest rate of interest in the Euro area since 2011.

Inflation expectations keep ECB awake at night

The problem for the Eurozone is not that the economy can’t take this higher rate of interest, after all rates will still be only 0.5%, it is what this higher interest rate signifies that has the biggest market impact. It suggests that the ECB is following the US Federal Reserve in throwing its weight behind the fight against inflation. In this monetary policy environment, growth comes second, as the major central banks try to put the inflation genie back in the bottle. The ECB has a real problem on its hands, its own survey showed that inflation expectations in the Eurozone continue to rise. Inflation expectations for the year ahead remained at 5% for July, however, expectations for 3-years ahead rose to 3% vs. 2.8% in June. At the same time expectations for economic growth and for employment in the next year all fell. And this is the least of the Eurozone’s problems.

Europe’s perfect storm

At the same time as the ECB ponders a 75bp rate hike, the Eurozone is facing a perfect storm right now. There has been a huge drought and heatwave that poses a serious threat to the future of the euro-area: to transport and supply chains, to tourism and to the need for a speedier reaction to climate change. There are mounting signs of a deep recession brewing, Italian bond yields are highlighting the weakness in parts of Europe’s finances and there are threats to the Eurozone’s fiscal rules. The spread between Italian and German 10-year bond yields edged higher on Friday, hitting 2.36%, this is uncomfortably close to the 2.5% threshold that is considered a sign of stress in Italy’s bond market. On top of this, Italy will head to the polls on 25th September, with Italy’s right-wing coalition set to win the upcoming election with ease. It could even take the two thirds majority needed to change the Italian constitution without a vote, according to the latest polls. This could see Italy stop adhering to EU rules, leading to a crisis at the heart of the Eurozone project at the same time as it is fighting multiple other fights, including with Russia over the supply of natural gas.

Why the German government has helped the ECB to hike by 75bps this week

The continued Eurozone support for Ukraine after the Russian invasion, has led to an energy crisis, which has spiralled over the weekend. On Friday, Russia announced that it would no longer supply gas through the Nord Stream 1 pipeline, which is expected to cause a massive spike in the price of natural gas when the markets open on Monday. This is adding to the troubled legacy left by Angela Merkel, who time will likely show led Europe’s largest economy to become too reliant on Russia for its energy needs. President Putin is now exploiting that, as his announcement on Friday showed. At the weekend, the German government announced a new EUR 65BN package of measures to ease the threat of rising energy prices that will include one off payments to the most vulnerable, accompanied by tax breaks for energy intensive businesses. This fiscal support could make it easier for the ECB to tighten the monetary screws, knowing that as they fight inflation, Eurozone governments are trying to prop up growth. Germany is also planning a windfall tax on energy company profits, which would help to mitigate the size of this support package, something Britain should watch carefully. To date, Germany has spent EUR 100BN to protect the public from rising energy bills, which compares with the EUR 300bn in the fight against Covid. Since this crisis is on par with the Covid crisis, there could be the more support needed, especially if the protests on the streets of the Czech Republic are replicated elsewhere.

What’s next for the euro

Overall, at this stage, we are amazed that the euro has not fallen further through parity with the US dollar. However, there are signs that things could turn nasty for the euro. The CFTC euro speculative positioning data for last week showed an increase in the number of short positions in the euro, they are now at their largest level since 2020. The fact that this happened at the same time as the ECB is potentially weighing a 75bp rate hike, the joint largest in its history, is also a worrying sign for the long term direction of the single currency. The euro is not weakening further in our view, because most of the world is in bad economic shape and other G7 currencies have suffered as the dollar has surged this year. However, we expect this to change as we progress through the winter months. This is when the economic frost will hit from the surge in energy prices, and also Europe’s vulnerability when it comes to energy supply. We expect a large downward revision for the ECB’s Eurozone growth forecasts  this week, which could focus minds away from the bad news for sterling, and towards the bad news for the euro. Thus, looking ahead, we see a deeper decline through parity for EUR/USD, and EUR/GBP could be nearing a top, after reaching its highest level since January late last week.

Italy is the weakest link

Another key trigger for a selloff in the euro, in our view, would be a decisive win for the Italian right at this month’s general election. If that happens then the future of the Eurozone is at stake in the long term.  In the short term, it could lead to fractious relations between member states at a time when they need to work together to fight the energy crisis, and the Russians. Overall, as we lead up to the ECB meeting this week, things are looking dire for the euro-area.