European sovereigns: spreads widen as the market advances interest rates hikes.
Following ECB Knot’s commentary during the weekend, the market is quickly advancing interest rate hikes in the euro area for this year. Investors now expect an interest rate hike of 25bps by September. The market reaction gives us a glimpse of what 2022 will look like with a hawkish ECB, which could terminate QE early (around July, as BofA’s research recently indicates) and hikes rates in September. It doesn’t promise anything good for the periphery. An aggressive ECB takes support away from those countries that need it the most for their recovery, provoking a fast tightening of financial conditions in Southern Europe compared to the north. This is an outcome that the central bank definitively wants to avoid not to revive a political crisis in the euro area.
However, the French election is coming in April. With inflation running at the highest ever for the Eurozone, there is the chance that Macron will not be re-elected in favor of euro-skeptics, which also threatens the real existence of the European Union. Within this complex context, the ECB is given the delicate job to take a monetary decision in March, which might sign the bloc's destiny.
Economically, remaining dovish is not an option, as the euro will weaken, weighing on energy prices, thus bringing more inflation.
Therefore, it’s improbable that the central bank will turn dovish, but it is also true that its hawkishness must have a limit. We see the ECB hawkishness limit drawn by the BTPS-Bund spread as it reaches 200bps. Since the end of the European sovereign crisis in 2013, the spread between the two countries broke and sustained above this level only twice: during the 2018 Italian election and the 2020 Covid pandemic. A BTPS-Bund spread above 200bps has been associated with distress levels in the past. It is likely to happen the same this time around, except that the ECB will not prioritize it until the French election is over in April.
This week bond investors are better to focus on ECB’s speakers, starting today with Lagarde speaking at the hearing of the European Parliament’s Economic and Affair Committee. We will also hear from De Cos, Villeroy, Guindos, and Lane throughout the week. The European Commission's economic forecasts released on Thursday are also in focus, which will probably see a revision in growth and inflation forecasts.