ECB Monitor: 25bp Now and in September, Nuance in BLS & PMIs

Go to: Stress, Surveys and Economic Data

Summary

• The ECB is expected to hike 25bp this week and point towards data dependence at its meeting in September (focus on core inflation, policy transmission, and forecasts).
• Poor PMIs and declining loan demand in the Q2 bank lending survey will provide ammo for the doves, but there is nuance to the numbers.
• We expect they will hike again in September, and the hawks will rally around sustaining high rates, and not cutting in 2024.
• Surveys and data continue to support hawkishness.

Current ECB Forecasts

25bp Now, Data Dependent in September

We expect (uncontroversially) the ECB to hike 25bp at their July meeting, with references to September’s meeting decision likely to be that the decision then will depend on the data and updated forecasts at that time. We continue to expect a 25bp September hike. The ECB’s focus remains:

• Policy transmission: comments are likely to land on the dovish side, albeit with nuances,
• Underlying inflation:  it remains an issue, hard to declare victory yet,
• September forecasts: they are unlikely to improve too much until the labour market loosens.

The ECB shifted hawkish at their last meeting. Now, a 4.0% terminal rate is largely being priced by the market (in line with our longstanding view). Notably, this level was defended even in the face of the recent negative data (more on that below). However, the market’s keenness to price cuts in 2024 sits at odds with our belief that the ECB will hold rates at elevated levels to tackle strong medium-term inflationary pressures (Chart 1).

PMI Data Exaggerates Downside

The pricing of cuts by July 2024 makes sense if the economy deteriorates significantly by then, but it is hard to see that at this moment. One driving factor of market negativity is the continued drop in PMIs, particularly in the German manufacturing reading which hit levels associated with COVID- or GFC-style crashes. However, since 2020, PMIs have dislocated from reality (and other surveys). Re-basing for the volatility that we have seen since then, and it looks more like a slowdown than a crash (Chart 2). The fact that the surveys continue to show employment growth is probably more telling, given that it is ULC that are driving medium-term core CPI overshoots in the ECB’s forecasts (see forecasts above).

We continue to see value fading the 2024 cuts priced in by the market.

BLS – Good News for the Doves, But With Nuance

Policy transmission is a key point. Lane spoke recently on three mechanisms of amplification of transmission: balance sheet effects (house price and asset declines), bank-lending (supply/demand for loans), and the risk-taking channel (risk-paring in a high-interest environment).

Doubtless, the cost of interest on loans has risen substantially since hiking started. Rates on new loans (ex-RCFs and collateralised loans) have risen around 3.3ppt since early 2022, while the stock has risen by about 1.9ppt, suggesting that most of the rise has already fed into corporate lending. For mortgages, the feed through is much slower.

I do not expect the ECB will take much comfort from the wealth effect. Q1 saw house prices fall back, but this is hardly new news. Meanwhile, home ownership varies greatly by country and the effect itself is not that well understood, so it is unlikely to be relied upon too much by the ECB.

The Q2 ECB’s Bank Lending Survey was an important rationale for the recent dovish market moves. It showed a remarkable drop in enterprise loan demand and continued decline in mortgage demand. However, while the survey has been very negative recently, actual bank corporate lending has been comparatively robust (Chart 3). Mortgage demand may in be a more worrying situation, with the most recent data showing a continued significant decline in borrowing there (Chart 4).

With this in mind, the more interesting result from the BLS may be the reduced tightening in credit conditions for enterprise loans and mortgages. Only in consumer credit (a much smaller part of total bank lending) did credit condition tightening accelerate, driven by reduced bank risk tolerance. If we see credit conditions continue to stabilise, that could be a concerning sign for those hoping historic ECB pricing is feeding through strongly. For now, they likely take comfort from the weakness in manufacturing (which Lagarde sees as more reactive to the tightening), but the loosening in financial conditions will bear watching (see appendix graphs).

Hawks Data Dependent in September, Nothing New

Much has been made of the recent comments by hawks Nagel (Germany) and Knot (the Netherlands) on the fact that a hike then would be ‘data-dependent’. This, alongside the recent dovish shifts in the US and UK curves, has suppressed the expectations of the ECB terminal rate (Chart 1). However, we think it best not to read too much into these comments, recall: they were saying something similar in early June, too (before the hawkish pivot). If anything, it shows the hawks moving in line with Lagarde. Going forward, we expect that the hawks will be keen to reiterate the need for keeping rates high – pushing back on cuts priced.

Surveys and Financial Conditions Support Hawkishness

We find that surveys and data important to the ECB (in our appendix) remain hawkish:

• EZ systemic stress has begun to fall back, decently down from H2 2022 highs or the highs seen post-SVB (Chart A1). HAWKISH
• Market pricing remains around 4% (our base case), however, the cuts priced 12 months ahead can fade. HAWKISH
• Data surprises remain suppressed but have bounced more recently (Chart A3). DOVISH
• Consumer confidence continues to recover (albeit it remains at low levels), while overall expectations of business orders remain down (Chart A4). DOVISH
• Hiring/employment remains positive (Chart A5). The labour market remains tight (Chart A5). HAWKISH

Inflation expectations remain de-anchored from pre-2022 levels (Chart A6). HAWKISH

Appendix: Stress, Surveys and Economic Data

Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)