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Summary

• The ECB outlook has moved significantly more hawkish. I expect this to be added to with a far higher near-term core inflation outlook.
• While the fallout from SVB has seen pricing for ECB hiking sharply pared, I see a good chance of this rebounding (assuming there is limited European contagion).
• The fundamental picture should provide room this week for a rise in EUR short-end swap rates versus GBP and with it a rise in EUR/GBP spot.
• In the wake of the bond rally post-SVB we take profit on our short outright BTP, in which we had previously targeted 4.7%, but with a take profit at 4.3%.

Current ECB Forecasts

Link to Most Recent ECB Meeting Minutes (February 2023)

ECB Forecasts Should Support More Hawkishness

I have been hawkish on the ECB for some time. Since February, my base-case has been for them to need to hike north of 3.75% – but they have room to go a lot further than that (more on that below). Thursday will see the ECB update its policy and its forecasts. It will almost certainly mean a 50bp hike and guidance that there is more to come. I have expected 50bp in March and May since the last meeting.

The fallout from Silicon Valley Bank’s (SVB) failure, has included a sharp paring of market pricing for hikes across central banks, taking ECB terminal rate to just 3.75%. There is a lot of uncertainty at the moment, but unless it becomes clear that the risk is systemic and will spread to European banks, I expect the ECB can continue on its hiking path. Updated projections should support the hawkishness. While headline inflation will need to be revised lower, the GDP profile will need to be raised (Charts 1 and 2). The reduction in headline inflation will likely be heavily caveated and any dovishness will be offset by a significantly higher path for near-term core inflation (more details below). The fact that the February’s meeting minutes pointed towards a future 2025 CPI forecast closer to 2% is worth noting. Such an outturn would probably drag down the medium-term core inflation too, which does not seem too credible given recent data.

2023 Core Inflation Above 5%

The near-term profile for core inflation will likely need to be revised significantly higher. By my calculations, to reach the ECB’s current expectation (4.2% in 2023) would need MoM core inflation to return to historical average rates for the rest of the year. This seems highly unlikely given the 0.5ppt beat in February. I view it as likely that 2023 core HICP will be revised up above 5% (Charts 3 and 4). This would be a similar upward revision to that seen in December, which would likely mean a further upward revision to 2024 and possibly 2025 core HICP. This would sit at odds with a lower headline inflation rate and would need some careful explanation. I would expect a strong hawkish market reaction, if core is revised up the way I expect.

Risks from Policymaker Caution

As I had warned previously, there are risks to the hawkish view in the near-term. We are already starting to hear the first grumblings from the doves (Italy’s Visco in particular) at the hikes currently priced in by the market. The offset for now has been a doubling down by the hawks. Austria’s Holzmann has been particularly strong on this front, and (given their track rhetoric) I expect some of the less important hawks will fall in line with this.

The real risk to the dovish-side is that the more neutral voices on the Board (Lagarde, Lane, de Guindos in particular) do not deliver the hawkish tone the market is gunning for. On the face of it they are still in ‘data dependent’, ‘no forward guidance’ mode. Higher core HICP, GDP and wage growth forecasts should give them reason to sound more hawkish, but Lagarde, in particular, has a good record of underdelivering.

The ECB Can Hike Well Beyond 4%

Looking forward, I think the Eurozone is looking into a fundamentally higher rates environment. Even before I turned hawkish on the ECB last year, I wrote a report on how high ECB rates could feasibly go. At that time, I found several key takeaways which continue to hold true:

1. The Taylor-Rule continues to suggest 5% end-horizon neutral rate (Chart 5).
2. Given ECB expectations for core inflation, market pricing would only just push real rates positive over the estimate horizon (Chart 6). If the ECB revises core inflation higher this disparity becomes even more obvious.
3. Eurozone corporates look relatively well positioned to deal with significant ECB hiking. Even if we were to see distressed credit spreads (Chart 7). 

As such, I retain the view that the ECB has the capacity to hike to 4% or beyond, and indeed it may need to do just that. The more important reason why they may not is probably more down to whether government bond spreads can remain relatively well capped (as they have done recently). The new risk of post-SVB bank contagion should also be borne in mind, although it is hard to give it a high weighting until we see something break in Europe. If anything, a more cautious Fed will mean looser EZ financial conditions and the need for the ECB to do more.

Market Implications

The market is pricing c.3.65% terminal rate right now, at the lower end of the ‘range of reasonableness’ that I have held since February (Chart 8). This comes on the back of a sharp re-pricing over the weekend (last week it was at 4%). A significant upward revision in core inflation in the ECB projections could be enough to push this profile higher again. Meanwhile, if the ECB were to revise medium-term core inflation lower I would see value in fading any dovish reaction to this given that it does not seem credible.

Meanwhile, with the UK also set to see labour market data (expected to be in line with MPR) and the Spring Budget (expected to remain fiscally tight into the medium term), there is room for a rise in the 2Y EUR/GBP swap spread and with it a rise in the currency pair (Chart 9).

Given the post-SVB rally in global bonds, we take the opportunity to close our outright short 10Y BTP trade, in line with our previous guidance to take-profit if it fell below 4.3%.

Surveys and Financial Conditions Support Hawkishness

Our expectation for sustained hawkishness is supported by survey and financial condition data (see Appendix). ECB measures of systemic stress continue to decline despite recent sell-offs in periphery and core bonds. Meanwhile, although European economic surprises are now flagging somewhat, they remain positive. Consumer inflation expectations dropped sharply back to levels seen elsewhere. However, the data series is relatively short, and while the rate remains >2%, it is hard to take the outturn as too dovish.

Recent Voter Comments

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.)