ECB Preview: 50bp Now and in March, Upside Risk for Terminal Rate

Summary

• I expect the European Central Bank (ECB) will deliver a 50bp hike at the 2 February meeting, with a likelihood that President Lagarde telegraphs the same to come in March.
• Core inflation momentum is persistent, and medium-term inflation risks are rising. There is little rationale at this stage for a more dovish tone.
• On QT, the path ahead has been well established. The ECB will be wary of how the market reacts when it begins in March. At this stage, there is little value for them in providing guidance further out.

Market Implications

• I continue to expect an ECB terminal rate of 3.5% or higher. Consequently, there is value fading short-end EGBs.
• Even with a soft QT profile, net-issuance in periphery should remain heavy. There is value positioning for BTP/Bund widening from this stage.

50bp Now and in March

At its last meeting, the ECB laid out a particularly hawkish set of forecasts , in line with our longstanding expectation (Chart 1). I expect 50bp to be delivered at the 2 February meeting and at the March meeting, with likelihood for further hikes thereafter (Chart 2).

Headline Eurozone CPI undershot expectation, but given the fact this was largely energy driven should make it largely immaterial to the ECB. Instead, the more important dynamic ahead is the fact that core inflation has yet to peak, and that upward pressures on medium-term inflation remain strong (wage growth, energy transition and fiscal support in particular).

None of these issues are news to the ECB’s Governing Council (GC), and none of them have improved since the last meeting:

• Forward looking wage growth continued to accelerate through Q4 (Chart 3).
• Long-term energy security remains an issue – while no one knows for certain how Europe will long-term replace Russian gas, whether it is via LNG, renewables or nuclear it is almost certain to be more expensive than the cheap piped gas it relied on previously. Schnabel had noted this risk even before Russia’s invasion.
• Upward surprises in GDP – the ECB is currently looking for -0.2% growth in Q4 2022. The market is looking for a flat trajectory. Meanwhile, the bounce in PMIs suggests the profile further out could be higher than ECB estimates (Chart 4).
• Expansive fiscal policy continues to sit at odds with monetary policy. Non-targeted government spending has the ECB concerned – it accounts for 80% of 2023 energy measures.

In the near-term, given the upside risks to medium term inflation, it is more likely that worsening market conditions, rather than economic fundamentals, are the reason for more cautious ECB tightening. The risk of a spread blow out on the QT announcement was a reason for 50bp rather than 75bp in December. However, since the last meeting, this risk has dropped. Instead, we have seen a consistent re-tightening across credit spreads, with the brief widening post-December ECB meeting having entirely faded (Chart 5). A large portion of the spread tightening has been on the back of Federal Reserve (Fed) dovishness. Meanwhile, measures of systemic stress remain far from their peak (see appendix). If FOMC dovishness continues next week, it will be easy for the ECB to continue to tighten.

Unlikely to See Dovish Forward Guidance

Despite President Lagarde’s assertion that she does not give forward guidance, that is exactly what she has continued to provide at press conferences. The current indication she has provided (in line with my view) is for 50bp hikes to continue in March. While her track record for having to walk-back statements is well documented, at this stage, there is not a lot of reason why she should drop this guidance. She may also hint at continuing to hike thereafter (my expectation), but it is more likely that she falls back to the ‘data dependent’ line while also stressing the difference in stage that the ECB and Fed are at.

In sum, the market continues to under-price the probability that the ECB continues to hike aggressively ahead (Chart 6). A terminal rate 3.5% or higher would be more in line with my view.

Little Expectation for New QT Info

At this stage, there is little reason to expect any additional guidance for the pace of QT operations with the €15bn pm run down to be re-evaluated in June. The market is currently looking for the rate to rise to €20bn pm in Q3, and €25bn in Q4. Given the profile of APP maturities, there is not a lot of upside to this in 2023 without active sales (Chart 6). Until the rolldown has begun, and the ECB is satisfied with market reaction, there is little need for guidance to the upside.

Market conditions remain benign, but there is little reason for the ECB to add much colour to the discussion of the QT profile. Even as it stands, heavy net-issuance in the periphery should keep the BTP/Bund spread widening.

Surveys and Data Support Hawkishness

Surveys and data on economic performance support continued hawkishness. Economic surprise data increasingly suggests European outperformance versus China and the US, while survey results across expected employment, industry orders and consumer confidence all look to have found a bottom recently (see appendix graphs).

Meanwhile, systemic stress has retreated from the highs, helped by strong stock and bond performance. Finally, inflation expectations are showing more significant signs of de-anchoring. This, alongside accelerating wage growth, could add fire to fears of more persistent inflation pressures.

Appendix: Surveys and 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.

(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.)