ECB does 50: a show of confidence or a policy mistake?

The ECB stood firm on Thursday, and after signalling their willingness to hike interest rates yet again by 50 basis points, they duly delivered this hike on Thursday. Eurozone interest rates now stand at 3%, their highest level since late 2008, and the ECB also said that it would continue to wind down its asset purchase programme. This was a surprise for some, who had expected the ECB to pause rate hikes until the stress in the financial sector had eased, however, ECB President Christine Lagarde stayed firm to her message that price stability is financial stability. One of the most telling comments from her press conference is that monetary policy can be used to fight inflation, there are other tools to fight financial sector instability.

The long term effect of the ECB’s decision

The message was loud and clear, the question now is, will this decision have any long-term ramifications for global financial markets, and could it cause more problems for Europe’s banking sector? To gauge the immediate impact, we look at three metrics: 1, the Eurostoxx banking index, 2, Italian bond yields and 3, ECB interest rate expectations. The Banking index had started its day with a decent rally, however, that has since drained away, largely because questions remain about the future of Credit Suisse, and the ECB’s super-sized rate hike. The index is now close to its lowest level since January. Thus, even though there are some elements of stress in the financial sector, longer term holders of European banking stocks have not seen their portfolios get decimated.  In the aftermath of the ECB meeting, Deutsche bank is down more than 2%, Soc Gen is down some 1.75%, BNP Paribas is roughly flat, while Italy’s UniCredit is up 1.25%. We think the weakness could be short lived because on the back of this ECB meeting, the market is not pricing in any more rate hikes.

The end of ECB rate hikes, for now

The latest interest rate probability for the Eurozone using overnight interest rate swaps, sees rates peaking at 3.07% in June, so relatively unchanged, with only 15 basis points of cuts priced in by February 2024. Thus, the market thinks that we have reached the peak for European interest rate hikes, and even though today’s decision was a hawkish “shock”, the overall tone of the meeting was more dovish than in recent months.

Will the Fed follow in the ECB’s footsteps?

As the first central bank to meet post the collapse of SVB, the ECB’s decision to hike interest rates by 50 basis points is seen as a bellwether, could it lead to the Fed following suit when it meets next week? Yesterday there was a less than 50% chance that US rates would rise by 25 basis points next week, today the probability is back above 70%, which suggests that the market thinks the Fed, like the ECB, will continue to fight inflation, even if regional banks across the US and Credit Suisse are under stress. The question now is, did the ECB stick to its guns and hike 50 basis points because it thinks that the stress in baning stocks is a storm in a teacup and the rate decision was a sign of confidence in the resilience of the financial sector? Or was it because the ECB is such a juggernaut that it could not be turned around in time to switch to a lower rate hike or no rate hike, after signalling for weeks that it was ready to hike by 50 bps?

No guarantees on Fed decision

It will take time to work out which is which. There are more calls for the US regulators to guarantee the deposits of all small banks in the US, lest further deposit flight to the large banks causes another one to collapse. However, for now, that support is not forthcoming. Thus, it is easy to envisage a scenario, where stress in the US regional banking sector gets so bad, that the Fed needs to adjust their policy expectations before next week’s meeting. The outlook remains murky, and is changing on a day-to-day basis, thus we think that it is too early to make any calls about the Fed meeting right now.

Italy remains resilient to ECB rate hikes

Elsewhere, Italian bond yields have fallen today, they are a good measure of stress in the peripheral sovereign debt space. What is interesting is that many people would have expected debt-burdened Italy to struggle under the burden of ECB rate increases, but that has not been the case. Instead, it’s the well-capitalised and hedged European banks that have taken the brunt.

Why the ECB may not be done hiking

The ECB’s economic outlook included some revisions: it now expects lower than expected inflation for 2023, revising it down to 5.3% from 6.3% in December, and to 2.9% for 2024. However, core inflation was revised higher at 4.6%, if the deposit rate stays at 3% and core inflation remains sticky, this runs the risk of longer-term inflation expectations becoming de-anchored. Thus, if we see the banking crisis calm down in the coming weeks, it’s perfectly plausible to see the ECB resume rate hikes down the line. Its growth forecasts were also revised down a notch to 2.1%, which is still a healthy rate of growth for the currency bloc.

Overall, this remains an uncertain time, as reflected in the EUR/USD price, which has remained relatively stable post the ECB meeting. It is currently trading just below the $1.06 handle. We think that today’s meeting is marginally bearish for the euro and mildly bullish for stocks and European bonds. Credit Suisse’s stock price is also in recovery mode after the SNB’s liquidity lifeline, although it has given back some earlier gains and is trading up 4% at the time of writing. The focus will now shift to the Fed next week, and after an extremely turbulent week, markets could be quiet on Friday.