Quarterly Outlook
Macro Outlook: The US rate cut cycle has begun
Peter Garnry
Chief Investment Strategist
The Fed started the US rate cut cycle in Q3 and in this macro outlook we will explore how the rate c...
The ECB’s dilemma: is the fight against inflation worth a political crisis?
Althea Spinozzi
Head of Fixed Income Strategy
Summary: An interest rate hike in 2022 means that purchases under the APP program will need to end earlier than what was announced by the ECB yesterday. Suppose the central bank’s economic forecasts in March come close to fulfilling conditions. In that case, they might provide room to stop bond buying early and begin with a hiking cycle. Yet, the biggest challenge for the ECB will be the sudden widening of sovereign spreads in the periphery. Particularly alarming is the fast rise in BTPS-Bund spread, which rose above 150bps for the first time since September 2020. If such spread continues to rise, it could renew political tensions between Rome and Brussels as financing conditions will be deteriorating faster in Italy than in Germany. At that point, the question is whether the ECB will sacrifice political stability and growth to fight inflation.
Let’s be fair. Joining late the central banks’ tightening party might prove painful for the euro bloc. An ECB behind the curve means a weaker euro, which would welcome more inflation. That’s why yesterday, the ECB decided to keep its options open without pushing back on interest rate hikes this year.
The market grasped the central bank's intentions and quickly advanced rate hikes. Now, money markets are pricing a 10bps rate hike in July and four throughout the year. The move has been so sudden that it caused yields to rise sharply across the euro area. Most notably, five-year German yields broke above 0% for the first time since May 2018.
However, rate hikes might not begin that early. Indeed, during the press conference, Lagarde referred several times to sequencing: the ECB will not hike interest rates before ending purchases under the APP program. Although the central bank confirmed that the APP program will run until the end of the year, there is growing speculation that the new set of ECB's forecasts due in March will come close to fulfilling conditions. That would allow the central bank to stop bond purchases early, thus beginning with interest rates hikes in 2022. Although it is possible for this to happen, the periphery could create some issues that might hinder the central bank's ability to follow this path.
Lagarde said yesterday that sovereign spreads are not a problem because they remain stable. Yet, the BTPS-Bund spread spiked and broke above 150bps for the first time since September 2020. It is a sign that the more aggressive the ECB will be, the wider the BTPS-bund spread will get, entering dangerous territory when it approaches 200bps.
Since the end of the European sovereign crisis in 2013, the BTPS-Bund spread widened above 200bps and sustained above this level only twice: during the 2018 election and the Covid pandemic. The problem with wide sovereign spreads is that financing conditions are deteriorating faster in certain countries of the euro bloc versus Germany. It won't get unnoticed by politicians and could renew political tensions in the euro area.
In that case, will the ECB continue the fight against inflation, or would it stall its tightening agenda to save the euro area from another economic and political crisis?
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