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This week’s ECB meeting will open the door to an interest rate hike in July – the first time since 2011. Expect the ECB to announce an end to its bond buying program and that net asset purchases will be completed by the end of the month. This is a necessary step before increasing interest rates. Focus will be on the new ECB staff forecasts. There is no pleasant surprise to expect : a clear downward revision to GDP growth and core inflation above the target longer out are likely. However, the eurozone should avoid entering into recession this year (though a bunch of countries might already be in a technical recession, such as France). GDP forecasts will certainly be revised downward once more before the end of the year. Therefore, don’t over-interpret the new forecasts. The ECB has a track-record of being overly optimistic about growth and its ability to deal with inflation -whether it is too low or too high.
Pay more attention to Christine Lagarde’s press conference. The eurozone CPI topped 8 % year-over-year in May – the highest on record - and the eurozone HICP, which is highly watched by the ECB, reached a new high of 3.8 % in May (with core goods at 4.2 % and services at 3.5 %). This is uncomfortably high. In these conditions, Lagarde has little choice but to deliver an hawkish message this week – meaning higher rates and a stronger euro. The next data to look at closely will be the first estimate of the June eurozone HICP on July 1. ECB hawks might be vocal in favor of a fast tightening pace afterwards. While pressure is undeniably building in favor of a 50 basis point move in July, we doubt the ECB will start its hiking cycle with such a big step. This would be very surprising and inconsistent with Lagarde’s forward guidance (she has recently signaled the ECB’s first moves would take place gradually). We don’t think one data point will make such a difference that the ECB will decide to act stronger in July. A 25 basis point interest hike is a safe and reasonable option, in our view. This has already been priced in the market. This partially explains why downward pressure on the euro exchange rate has eased since mid-May. From September onwards, the ECB is likely to steadily lift the deposit rate – see market forecasts below. For the record, the two last times the ECB hiked interest rates in July, it was just ahead of a recession. But we think the eurozone will avoid it, at least this year.
Discussion will be about financial fragmentation this week too. According to the Financial Times, there is a large consensus within the Governing Council to support a facility to manage sovereign spreads – some sort of OMT 2.0 with light conditionality. Italy is still the main point of worry. Foreign investors have tried to exit the Italian bond market since January (this was not the case in any other Southern European country). This will likely accelerate in the coming months, adding more pressure on Italian sovereign yields. Even the hawks are supporting the idea of a facility because they understand well this is a necessary condition if they want to hike interest rates more aggressively. This new facility would 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. We don’t expect the facility to be officially announced this week. The debate is only starting and some technical work needs to be done as well. An official announcement will probably be made after the summer. This will have much more implications for the eurozone than the tightening cycle. It will help create the required safety cushion the union needs to deal with this new period of economic history characterized by higher nominal rates, lower growth and high inflation for longer.