The ECB’s dilemma: is the fight against inflation worth a political crisis?
Senior Fixed Income Strategist
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?
Latest Market Insights
Outrageous Predictions 2023: The War Economy
- The constantly growing global need for energy drives the world's richest to huddle up and launch a R&D project in a size the world hasn't seen since the Manhattan Project gave the US the first atomic bomb.
French President Macron resignsThe political stalemate in France and the rise of Marie Le Pen following the 2022 elections corners President Macron, forcing him to give up on politics and resign from his position. At least for now.
Gold rockets to USD 3,000 as central banks fail on inflation mandateAs markets and central banks realise that the idea that inflation is transitory is wrong, and that prices will remain higher for longer, gold is sent through the roof, hitting a price tag of USD 3,000
EU Army forces EU down path to full unionWith continued challenges in the region and a US military that isn't aggressively enacting its former role as global policeman, the European Union agrees to create its own armed forces, bringing the whole region closer.
A country agrees to ban all meat production by 2030In an effort to become one of the global leaders on the path to net-zero emissions, one country decides to not only put a heavy tax on meat, but to ban domestic production entirely.
UK holds UnBrexit referendumFollowing a recession and domestic pressure, the United Kingdom is thrown into political turmoil that will end with a vote to wind back Brexit.
Widespread price controls are introduced to cap official inflationHistory tells us that with the war economy comes rationing and price controls. And this time is no different, as policymakers introduce strict price controls that lead to a range of unintended consequences.
OPEC+ & Chindia walk out of the IMF, agree to trade with new reserve assetSanctions against Russia have caused widespread turmoil due to US Dollar moves in countries across the globe that don't consider the US an ally. To relieve themselves from this, they leave the IMF and create a new reserve asset.
USDJPY fixed to the USD at 200 as Japan overhauls financial systemFollowing the challenges that faced the Japanese Yen in 2022, the Bank of Japan attempts to keep the currency from sliding. Unsuccessful on the long-term, Japan will launch a reset of its entire financial system.
Tax haven ban kills private equityWith the war economy comes an increased focus on national interests and sovereign nations' ability to assert themselves. In that regard, the OECD countries turn their attention on tax havens and pull the big guns out, banning them altogether.