ECB Review: Slower for Longer?

Summary

• We had expected the European Central Bank (ECB) to hike 50bp, but instead they delivered only 25bp, in line with market pricing and consensus expectation.
• They also announced the planned end to APP re-investments in July – which was not too surprising.
• What was a surprise is that the statement doubled down on their March medium-term forecasts – our view remains that their forecast for inflation will need to be significantly increased in June – ECB surveys support this likelihood.
• President Lagarde’s presser was surprisingly hawkish despite the smaller hike and commitment to the March forecasts.
• We think the market is underpricing ECB hawkishness. Our terminal rate expectation remains unchanged at >4%.

Market Impact

• We see good value in positioning for future ECB hawkishness and a capitulation on their core inflation forecasts. Short 10Y Bund looks attractive now on that front – we target 2.5% Bund yield.

25bp Hikes for Longer

The ECB’s decision to slow hikes to 25bp (from 50bp previously) was a dovish outturn versus my expectation, as was the re-commitment to medium term inflation at the levels suggested in March (close to target by 2025). The press conference had a somewhat hawkish tone, but from here I see a strong risk they remain anchored to 25bp hikes. At this stage, I continue to expect they will need to do more than the market is pricing to deal with strong inflation. My expectation for terminal rate >4% remains unchanged – it will just take a little longer (Chart 1).

It was difficult to reconcile the relative hawkishness Lagarde expressed in the press conference, in particular her affirmation that there was ‘ground to cover’, with the downshift to 25bp. Bearing in mind that this line was explicitly based on the current data and current forecasts it begs the question of why would they not do more now?

The recent ECB Bank Lending Survey (BLS) clearly played a strong role in the deceleration in the pace of rate hikes, but again the reduction in loan demand and tightening in credit conditions were caveated in the presser as showing only the first signs of rates feed through, not the second side (the effect on the real economy). We won’t get a view of the Q2 survey until end-July so a continuation of fading banking sector market volatility and strong real economy data (service sector and employment in particular) should allow more hawkishness to creep back in.

The recent drop in YoY core could also have played a role, although  (as we have previously discussed) it was hardly a strong sign of flagging momentum, although optically a falling YoY rate may have encouraged the dovishness (Chart 3).

Lagarde seemed to put quite a bit of weight on the fact they are between forecasts, but also that the medium-term March forecasts hold for now. By my calculations that seems a long-shot, and I continue to expect a revision higher in core inflation at the June refresh. The most recent ECB professional forecaster survey suggests this is an increasingly popular view. It showed that professional forecaster expectations for 2024/25 now sit about where the ECB’s were last December. A revision back up in June would be a big capitulation, but one that is increasingly likely.

Watching for Opportunities to Enter 10Y Bund

The expectation that the ECB will need to be more hawkish than the market is pricing can be expressed in several ways. Simplest would be to fade Feb-2024 ECB pricing (which the market is already pricing to include cuts – see Chart 1). An alternative would be via going short core EGBs. 10Y Bund has rallied since end-April, largely following the move in USTs into the risk-off and equity sell-off (Chart 6). While this risk-off feel may persist for some time, the Bund is now closing in on levels that look attractive to go short.

If inflation ultimately comes to be more persistent than is being priced, EGB weakness should return. Right now, German 10Y BE inflation is down to 2.2%, 40bp down from where it was pre-SVB and 20bp down on where it was before the latest Eurozone inflation outturn. If, as we expect, the ECB comes to revise back up the medium-term picture in June, supported by near-term inflation releases, there is strong room for this to return towards the upper-end of the recent range (c.2.5%) and take 10Y Bund yield with it (Chart 7).

The risks to this view are if underlying inflation begins to fall sharply in line with ECB forecasts. Final April German inflation next week (10 May) could provide some insights on this front.

At this stage we see value going outright short 10Y Bund targeting 2.5%, with a stop loss at 2.1%. At this moment, the CTD 10Y trades at 2.246% and its 3 month roll and carry are -1bp and +2bp respectively.

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.)