ECB : A clear roadmap for the summer holiday, more uncertainty from September onwards
Head of Macro Analysis
Summary: The European Central Bank (ECB) confirmed they will hike interest rates at the July meeting by 25 basis points. This is a done-deal. Uncertainty remains regarding the scope of the hiking cycle after the summer. This will depend mostly from the evolution of the HICP and inflation expectations. The eurozone is likely to exit the era of negative rates (this was economic nonsense) by the end of Q3 this year. We think the hiking cycle could be shorter with fewer hikes than the money market expects, especially if growth continues to slowdown in the second part of the year. The risk of recession is low this year. But the eurozone is undoubtedly facing economic stagnation.
What was announced
« It’s not just a step. It’s a journey » - ECB President Christine Lagarde
We are a bit puzzled by today’s ECB meeting. The ECB clearly confirmed they will hike rates by 25 basis points at the July meeting. This is the first time in memory that a G10 central bank explicitly tells us the amount they intend to hike at the next meeting. Fed President Jerome Powell hinted at a 50 basis points interest hike in June, for instance. But it was not presented as a done-deal. He kept some optionality. This is surprising the ECB decided to tie their hands, for no real gain. The ECB is more uncertain regarding the September meeting. Lagarde said they could move by 50 basis points, depending on the inflation backdrop. Beyond September, the ECB appears committed to a gradual rate path – a less hawkish outlook taking into consideration the risk of lower growth (especially if the cost of living continues to rise, thus pushing consumption down. Real incomes are expected to drop in most eurozone countries this year, according to the OECD, sometimes quite sharply, like in Greece with a drop of 7 %). We don’t comment much on the new ECB staff forecasts. The inflation forecasts for this year are already outdated. Forecasts for 2023 and 2024 will likely be revised upward for inflation and downward for GDP growth by year-end. This is certainly the right moment to be humble and acknowledge that inflation is so sticky that we are unable to forecast it even for the next three months.
What is missing
The ECB is here to close spreads – see below chart
The ECB wrongly believed that by going with the safe option of a 25 basis points interest hike in July, the Italian bond market would give them a break. It hasn’t happened that way, unfortunately. Immediately after the press conference, the core/periphery spread widened significantly. Italy’s 10-year government yield was 23 basis points higher. The gap between the German and the Italian 10-year government bond yields widened further (220 basis points). We are back in the danger zone. But this is no time to panic yet. We are still far from levels which would trigger a market intervention. However, we believe that the ECB will have no other choice but to provide news about an anti-fragmentation facility at the July meeting. No doing so would push spreads higher at the worst time ever, when volumes are getting dangerously lower. This anti-fragmentation facility is a must-have for the ECB in order to speed up the tightening process if needed (that’s why the idea is supported by hawks) and to avoid a repeat of the 2012 sovereign debt crisis. However, this won’t be easy. Designing such a weapon is complex. All the pre-existing solutions (Securities Market Programme and Outright Monetary Transactions) come with major political and technical drawbacks. We think the easiest option would be to implement some kind of OMT 2.0 with soft conditionality. But further discussions are needed. This would ideally come on top of the €200bn of firepower coming from bringing forward PEPP reinvestments by one year (referring to the Pandemic Emergency Purchase Programme launched at the start of the outbreak in March 2020). Though this amount is significant, this is only a first line of defense. It would do too little to avoid financial fragmentation within the eurozone if this happens. In many regards, the design and the implementation of an anti-fragmentation facility is much more important for the future of the eurozone than the short-term pace of interest rates.
Inflation expectations will be the key driver from September onwards
· The first estimate of the June eurozone HICP will be on 1 July. In May, it reached a new high of 3.8 % year-over-year (with core goods at 4.2 % and services at 3.5 %). This is uncomfortably high. A new jump would increase pressure in favor of a 50 basis points move in September.
· From September onwards, expect that market-based and survey-based inflation expectations (SPF) will be the main drivers of policy normalisation. At today’s conference, Lagarde mentioned « initial signs » of inflation expectations getting de-anchored. This draws a lot of market expectations. But the central bank’s hawkishness might vanish fast if GDP growth continues to slow down. The ECB will navigate in a very complicated economic environment from Q3 onwards – lower investment, gloomy consumption and inflation well-above the target for longer. Expect tough discussions between hawks and doves within the Governing council and a more uncertain pace of monetary policy normalisation.
· Expect the eurozone to exit negative rates by the end of Q3 this year. The era of negative rates was a costly anomaly for the financial sector. This is positive news. We are getting back to normal. But we think the market is probably over-estimating the pace of monetary policy tightening in the medium-term in the eurozone. We think that lower growth could push the ECB to slow the hiking cycle sooner than expected.
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