ECB React: Fade EGB Strength 

Summary 

• The ECB hiked 75bp as expected, but the market has taken Lagarde’s comments as an indication that a deceleration may be on the cards for December. Despite the fact this was later walked back by ECB ‘officials’. 
• QT talk was largely side-stepped, with December being the date at which it will be discussed, although even then a start-date is not expected to be provided. Although not as hawkish as we expected, it suggests only that the QT picture has not changed since September. 

Market Implications 

• The market has pared expectations for tightening too much. Given CPI beats this morning and the net supply picture there is value fading recent EGB strength. 
• With just 100bp of hikes priced into February 2023, there looks also to be value in paying short-end EUR swaps. 

A Surprise Dovish Shift from the ECB – But Will it Last? 

Lagarde came out less hawkish than both the market and we had expected. 

Comments at the press conference focused on the recession risk ahead, but continued to state the need to focus on bringing inflation down. In that regard it was a somewhat confused message. Lagarde stated they may need to hike beyond neutral first (a somewhat less hawkish tone than previously) but continued to stress the upside risk to inflation. Meanwhile comments around the progress made seemed to imply a slowing of hikes, but this was later walked back by ‘ECB officials’. 

The market now prices <70bp come December, followed by 25bp in February , and just 10bp per meeting thereafter. At this stage, with inflation still accelerating this seems overly dovish. 

On TLTROs, the recalibration amounts to a retroactive change to the TLTRO III interest rates, indexing them to the average applicable key ECB interest rate from 23 November. Additional voluntary early repayment dates were added, including one on 16 November (results published 18 November). Expect to see significant repaying at that time, which may drive renewed weakness in EGB short-ends. 

Despite our expectations, the ECB did not discuss QT, but Lagarde stated instead that it would do so for APP holdings in December (current guidance is for PEPP holdings to stay until 2025), with the process for beginning some time after that. Subsequent ‘official’ comments, added that the meeting is not expected to announce an explicit start date for QT.  

The market looks to have priced too little out of the QT profile. The statement comments on the matter were nothing new (albeit also not as hawkish as we had expected). The initial Bloomberg headlines may have added to this sense, having quoted the ECB as aiming to: 

‘reinvest APP proceeds in full for an extended period…’. 

This omitted the important end to the sentence:  

‘…of time past the date when it started raising the key ECB interest rates and, in any case, for as long as necessary to maintain ample liquidity conditions and an appropriate monetary policy stance’. 

 In substance this is little different from Lagarde’s Q&A response in September that:  

‘APP will continue to be reinvested, as long as is appropriate, in order to maintain ample liquidity conditions and an appropriate monetary policy stance.’ 

With the December meeting so important, and the present value of data getting more weight, the releases leading up to that meeting will be especially important. This starts with this morning’s CPI.  

Inflation Continues to Accelerate 

Right now, Eurozone inflation continues to rise, significantly overshooting ECB estimates from only September (Chart 1). On a MoM rate, inflation has continued to trend decently stronger than that rate required to hit 2% per year. When adjusting for historic seasonal factors, this performance has the rate has risen above that of the US and UK suggesting that momentum is far from normalizing (Chart 2). The driver is somewhat idiosyncratic, with Germany set for significant SA beats in September and October, France jumping higher in October, while Spain has begun to soften. 

The ECB seems to be betting on a reversal of this trend, but given so much hangs upon December’s meeting, that would assume a large paring in November inflation. 

Meanwhile, in economic growth, while Lagarde played up the recession risk, in our view the biggest risk to economic growth is the energy supply situation. On this front the immediate term risks appear to have lessened somewhat. Meanwhile, although survey data has deteriorated, the feed through to hard data has not materialized (Chart 3). 

Fade EGB Strength 

EGBs gained across the board following the more dovish lean, with the periphery leading rates in a bull-flattening move. This took 10Y Bund yield to close to 2% and BTP yield back below 4%. 

However, with inflation pressures continuing, we do not see the dovish pivot as being credible just yet. And we do not see the QT comments as substantially different from those provided in September. On this basis, in line with our previous guidance, see value in fading the recent EGB rally, with net-supply weighing on core rates.  

With 2.5% now priced into terminal rate, expect that the market will need to price back additional hikes. Despite the market move, 75bp in December remains our base-case, with a deceleration unlikely to be seen until the start of next year. With just less than 100bp priced in until February, at this stage, paying EUR rates expiring then looks attractive. 

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.)