ECB Policy Transmission Suggests More Hikes Needed

Summary

• Policy transmission (breadth and speed) is a vital factor for the ECB in deciding whether to hike further.
• Our analysis suggests hikes have a broad impact on bank cost of capital and cost of corporate borrowing, but most of this has already fed through.
• Falling M3 has been driven by declines in financial deposits and has not driven sizeable reductions in borrowing in the real economy.
• Corporate borrowing may be being buoyed by front-loaded green investment spend.
• The EZ mortgage market is heterogenous. Capped rent inflation leaves <30% of households exposed to mortgages in the major EZ economies.
• Italy and Spain have already seen most of the rise in mortgage rates feed into their stock. While France and Germany have seen almost no feed through.
• This suggests that there is limited pipeline tightening yet to feed in that the ECB can rely upon in the case of a pause.

Market Implications

• With September decision so uncertain, best value remains to position for higher ECB terminal rate, and fewer cuts than the market is pricing. We like paying 6M fwd 1Y EUR OIS swaps.

How Broad and Fast Is ECB Policy Transmission?

The key crux of to determine whether the ECB pauses in September or continues to tighten:

1. Is core inflation momentum slowing? – we conclude not
2. Are updated forecasts likely to be more dovish? – the data suggests not
3. Is wage inflation feeding into services? – we conclude yes
4. How effective and fast is ECB policy transmission – our focus in this report

ECB policy feeds into the real economy through a number of pipelines which we assess through this report:

• Higher interest rates on bank lending to corporates lowering loan demand.
• Higher deposit rates raising bank cost of capital and lowering loan supply.
• Higher interest rates on mortgages, raising housing costs and reducing disposable income.

We assess each of these pipelines via two approaches:

1. How broad their reach is to the economy?
2. How fast they feed into the economy? (are there pipeline pressures to be felt?)

The broader the effect, and the slower the feed through (within reason), the more dovish ECB policy can afford to be.

Conclusion: ECB Tightening Has Broad Impact, but Pipeline Tightening Looks Limited

From our analysis we find that changes in bank lending rates and bank deposit rates should still affect a very large portion of their respective markets, but that much of this effect has already fed into the stock of loans and deposits (Table 1).

• Corporates are still highly exposed to bank rate rises, but less than in the GFC due to greater capital market access and longer-maturity debt.
• Over half of the rise in cost of bank lending to corporates has already fed in.
• Lending to the real economy (corporate and household) is stable.
• There is a risk (as Lagarde notes, and the ECB encourages) that corporates front-load green investment spending. This could reduce borrowing responsive to interest rates in the near-term.
• Deposits remain a very cheap source of funding for banks, which looks likely to remain the case ahead.
• EZ households are insulated from mortgage rises. Transmission is extremely slow in France and Germany. It is fast in Spain and Italy, but the burden of debt there is lower.

Together this suggests that if the ECB stops hiking the pipeline tightening effects on aggregate demand will be too weak and slow to sufficiently suppress aggregate demand within their time horizon. As such it would be a big risk for the ECB to cease hiking just yet.

Table 1 provides an overview of our analysis. We go into more detail into bank lending to corporates, bank deposit rates and supply, and mortgage rate feed through below.

Corporate Borrowing Is Weathering the Hikes

Breadth of hiking impact: Broad

Speed of transmission: High

European non-financial corporates (NFC) continue to get the majority of their funding via bank debt rather than credit markets. So the impact of rate hikes should be quite broad. But it will be less than it was in the GFC as corporate rely proportionally more on debt capital markets now than then (Chart 1). The borrowing profile has also become longer term. In 2009, 50% of bank debt to NFCs was >5Y duration, while 30% proportion was <1Y, now these are >60% and <20% respectively.

In terms of the rate of passthrough of hiking, by our calculations just over 50% of tightening has passed through to the stock of bank lending (Charts 2 & 3).

Household Deposits Still Provide Cheap Funding for Banks

Breadth of hiking impact: Broad

Speed of transmission: High

Overnight deposit rates remain very low for households (0.27%) and NFCs (0.60%). The total stock of household “agreed maturity” deposits has risen just 74bp since June 2022, while for NFIs it has risen 260bp. Over the same period, the ECB deposit rate has risen 425bp (Chart 4). This lack of feedthrough may be partly because rates on household deposits did not fall to the same extent post-GFC, but it is also likely due to the fact that there is little incentive for banks to pass on the benefits to clients (like households) with limited access to alternatives.

Much has been made of the decline in deposits that has driven M3 down, but this is not a case of households and corporates pulling their money. Instead, it has been driven by a decline in other deposits, mostly those of other monetary financial institutions (MFIs, Chart 5).

The decline in MFI deposits has been partly offset via issuance of predominantly long-term debt (Chart 6). More important is what has happened on the asset side. MFI lending to other MFIs has declined sharply in line with deposits, but lending into the real economy has stabilized. This means the credit impulse has been negative for some time, but (Chart 7). Growth in loans to non-government, non-MFI EZ entities has (similar to deposits) flatlined by comparison.

Limited Hike Feed Through to Household Housing Costs

Breadth of hiking impact: Low

Speed of transmission: Mixed (High in Italy/Spain, Low in France/Germany)

The exposure and feed through of households to rising housing cost varies greatly by country (see table 1 and Chart 8). Importantly, across the major EZ countries, rental inflation has been very low (c.3% growth since the start of 2022). In many cases this is due to legislative caps to rent rises. Contrast this to the UK – which has similar proportions of households mortgaging, renting and owning outright to France, but has seen a far greater rise in renting cost as well as a far greater rise in mortgage rates (Chart 9).

The structure of mortgage fixing varies greatly by country. Spanish and Italian mortgage holders have felt a far larger proportion of the previous hikes than France or Germany (Chart 10). Spain and Italy had higher proportion of variable rates pre-hiking, but the feed through goes beyond what would be explained by this, despite this data coming direct from the ECB. The rise may partly be due to the increase in variable mortgages through the hiking period, but this seems unlikely. Regardless, the conclusion is that the ECB is hiking into very diverse mortgage systems. Lessening the blow of this, Italy and Spain have (proportional to their GDP) the lowest exposures to mortgages, suggesting LTVs are not overly onerous (Chart 11).

Together this suggests that the Eurozone real economies have seen relatively little feed through from tightening so far, but this is not just a case of lags which will eventually feed through. Instead, at the very least, the ECB cannot be even considering cutting rates in the near-term, and will probably need to hike further ahead to sufficiently dampen demand.

We expect at least another 25bps in hikes this year to take the policy rate to 4.0% (with upside risk), and for 2024 cuts to be pushed back until at least H2 2024.

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.)