ECB Monitor: Dovish Mood Could Persist in Near-Term

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Summary

• ECB hawkishness has been somewhat pared lately, despite the main voices continuing to reject the idea that underlying inflation is falling.
• Understanding the detail of the most recent inflation print will be important. We expect it will show that one-off policy has been the main drag on services and core, and the momentum there remains strong.
• Market pricing for a 3.75% terminal rate is receiving support from ECB speakers. We still think it is too low given medium-term dynamics, but there is room for the dovishness to persist in the near-term.
• On this basis, we continue to see value positioning for periphery/semi-core bull-tightening, expressed as long 10Y BTP vs 10Y OAT (target: 100bp).

Current ECB Forecasts

Link to Most Recent ECB Meeting Minutes (May 2023)

Will ECB Dovishness Last?

How ECB speakers react to the recent miss in core, headline and services inflation readings will prove an interesting theme going forward. While we believe the underlying picture for inflation is far less positive than the headline figures suggest (rationale below), the tone has shifted in several important ways:

General Tone is less Hawkish

First and foremost, there has been a generic (if modest) shift less hawkish in the tone of comments (Chart 1). Notable is that hawks have walked back from 50bp hikes but for the most part (bar Kažimír and Holzmann) not suggested that the hiking cycle should be extended.

Settling on June and July Hikes

Instead there has been a rally by some of the previously more hawkish speakers around June and July hikes with less certainty thereafter (as per recent comments from Lithuania’s Šimkus, Ireland’s Makhlouf, the Netherlands’ Knot, and Latvia’s Kazāks).

Some Agreement that Core Inflation Not Necessarily Peaking

From across the spectrum there has been some agreement that core inflation has not yet necessarily peaked. We agree (more details below), as does President Lagarde. Even the doves, who remain more hopeful on the outlook, appear far from declaring victory (as per Italy’s Visco remark that core inflation is still too high and could take time to fall).

Fiscal Policy Remains a Concern

Another theme among the more hawkish voices (Belgium’s Wunsch, Slovenia’s Vasle, Estonia’s Müller) has been the re-focusing on the fiscal side, and the role played there. This is particularly important for the medium-term outlook. Right now, there seems little appetite for nations to tighten purse strings substantially, despite calls from the European Commission and Lagarde. Moreover, the ultimate EU response to the US Inflation Reduction Act (IRA) has yet to be finalised (so far it includes modest adjustments to State Aid rules). But nations are already reacting. The most recent German scheme is small (c.€3.3bn pa), but with Germany’s Habeck calling out the IRA in its rationale there could be more ahead.

Upside to 3.75% Terminal Rate

By our analysis, ECB policymakers appear to have rallied roughly around market pricing – of a 3.75% terminal rate (Charts 2 and 3). While our expectation remains that more will need to be done than this, in the near-term the relative dovishness can probably persist.

See here for our full table of recent ECB comments

Core Inflation Not Yet Peaking

Eurozone (EZ) May CPI dropped to +6.1% YoY, while core CPI dropped to +5.3%, both 0.2pp below market expectations. Adding to the dovish feel was the 0.2pp drop in YoY services inflation to +5.0%. That left both core and services roughly on track for a typical May MoM – a far cry from the significant beats seen prior (April MoM core was +0.46pp above typical for the month, while services was c.0.75pp above typical, Chart 4).

However, the breakdown we get next Tuesday will be more important than the headlines. Transport services is likely to have been the main drag on both core and services, having fallen sharply on the back of the German €49 ticket. Its impact will be of most importance.

Recall: last year, when the €9 ticket came out in June, EZ services inflation missed typical MoM changes by -0.25pp. The €49 ticket probably had less effect, but it still constitutes a one-off factor that will not appear in the next month’s data. Moreover, the base-effects from last year’s €9 ticket should see the YoY accelerate sharply next month (Chart 5).

Coming back to the ECB’s forecast, the YoY headline was a slight miss vs ECB forecasts for the month, while core continues to run inconsistent with their 2023 forecasts. We still believe an upward revision will be needed at the June meeting.

Mixed Evidence on Hikes’ Impact

Lagarde’s focus on policy transmission has made strong reference to M3 growth and the outlook demand within the BLS survey. She has also made suggestion that the weak recent manufacturing demand may be driven by rate hikes biting.

M3 growth has significantly pared back recently, led by a decline in overnight deposits although how well this feeds into inflation remains to be seen (Chart 6). Meanwhile, although the outlook for loan demand in the BLS has recently deteriorated sharply, momentum in actual lending has proven more resilient; 3M/3M loan growth bounced back in March and April (Chart 7). This is not to say that the growth will not fall ahead, but with the fallout from SVB fading in the market, it may be hard for the ECB to unequivocally declare the hikes are having an effect just yet.

Market Implications

The market is pricing a c.3.75% terminal rate, the lower end of our the ‘range of reasonableness’ (Chart 2). This is predominantly driven by near-term data misses (especially in the industrial sector) as well as the recent CPI miss.

Further out, our lean remains that the ECB will need to hike to at least 4%, driven by a recovering consumer, strong labour market dynamics, and supportive fiscal policy. However, these effects may take some time to play out. As such, we stand tactically bullish EGBs right now. Within this, there is room for periphery outperformance versus semi-core, which we see best represented long 10Y BTP vs 10Y OAT (target: 100bp).

Next week’s ECB meeting and the final May inflation readings provide a hawkish risk to this (the ECB will need to revise its near-term core forecast higher and inflation details should show strong core services momentum), but the market may be able to overlook this while the ECB’s tone remains optimistic.

Surveys and Financial Conditions Support Hawkishness

Overall, while recent data has underperformed in the EZ, the strength of services and of business hiring intentions, the recent paring in financial market stress (and credit spreads), and the persistent de-anchoring of medium-term inflation expectations paint a hawkish picture (Charts in our appendix):

• EZ systemic stress remains elevated, but below elevated levels at the end of last year, or around the SVB shock earlier this year (Chart A1).  
• In the real economy, however, data surprises have collapsed sharply in the EZ, likely driven by the quick end to the China rebound positivity (Chart A3).
• The surveys present a mixed picture. Consumer confidence continues to recover (albeit from low levels), while overall expectations of business orders have dipped back down, led by a sharp fall in industry, even as services bounce back (Chart A4). Hiring expectations paint a more positive picture, with services looking particularly strong (Chart A5).
• Finally, inflation expectations remain de-anchored from pre-2022 levels. The paring in consumer 3Y ahead expectations at the most recent CES suggests more that the March spike was a blip, rather than there being a concerted return towards target (Chart A6).

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.)