ECB Preview: Pause Now, Option to Hike Again Later

Summary

• We expect the ECB will hold deposit rate steady at 4.0%, this week.
• Following recent data, upside risks to terminal rate have softened. But, the ECB will push back on near-term cuts and leave the door open to more hikes.
• Bank lending survey adds to the dovish sentiment, with tightening credit standards and declining loan demand.
• Inflation data is settling down, but wage growth remains strong. Wage-intensive services inflation is capped by lower accommodation prices. If this settles down, we could see hawkishness peek through.
• Fiscal policy announcements remain a risk. With manufacturing in dire straits, the risk of new government support in 2024 is elevated.
• Despite the recent rise in real rates, EZ financial conditions continue to loosen. There is a growing risk that PEPP reinvestments will end sooner than end-2024.
• We expect to hear more about the ECB’s framework review. This could have important implications for the size of the ECB balance sheet. Recent discussions have added to fears the minimum reserve requirement could be raised from 1% to >2%. A large rise could have negative implications for policy transmission.

Market Implications

• We do not expect the ECB will hike again before year-end, but with almost nothing priced in there is still value paying December 2023 ECB-dated OIS.

Outlook More Balanced – But Market Still Underpricing Hikes

We expect the ECB to hold the deposit rate at 4.0% this week, having delivered a 25bp hike at the last meeting. We correctly anticipated the previous hike, on the basis that upside risks to the inflation outlook remained strong. Since then, the outlook has become much more balanced. In particular, inflation reads have undershot ECB September forecasts, with wage intensive services inflation momentum dropping on a decline in accommodation prices (Charts 1 & 2).

The ECB will want to see this trend continue ahead (beyond December at least) before taking too much positivity. The risk is that within wage-intensive service sectors (as in the UK),  accommodation price volatility has driven much of the recent trend. It remains to be seen whether other sectors’ return to normality has stalled or not (Chart 3). Wage growth will be a big factor in this.

In our opinion, the market is under-pricing the risk of further ECB hiking. Medium-term risks to inflation remain in the form of fiscal pressures, energy prices and wage growth. And while we do not expect the ECB to hike again before year-end, with almost nothing priced in, there is still value paying December 2023 ECB-dated OIS.

ECB Cautious on Declaring Victory – Pushing Back on Cuts

Policymaker comments have had a number of key themes recently (see end section for full overview):

• Recent inflation has been roughly in line with forecasts, giving them comfort that hikes have been sufficient. This has supported the patient crowd.
• Rate cuts will not be considered soon. Even the doves are pushing for patience rather than loosening. General consensus is that inflation needs to move sustainably down towards target before cuts are considered. Stournaras would want inflation below 3% first, others like Lane make it contingent on Q1 wage pressures softening. That would probably place the doves’ earliest path for cuts at early H2.
• It is too early to declare victory on inflation. Upside risk remain. Hawks Wunsch and Vujcic fear disinflation slows around +3.0-3.5%, with wage pressures a big driver of this.
• Energy inflation risks are to the upside, especially with Middle East tensions (doves de Guindos & Herodotou have noted this).
• Door should be left open to more hikes – this has been the view of 10/25 members (Chart 4). Expect that this is the line Lagarde peddles too.

Wage Pressures Are a Concern

Lane has been unequivocal that he would not consider Eurozone inflation to be on a trajectory for 2% until he has seen signs in Q1 2024 that wage growth is declining. Fears of wage growth are widespread (Schnabel has spoken of it recently). Corporate profits are also a risk. They began to drop in the latest data, but if we were to start seeing greater pass-through of input costs to services (as September and October German PMIs suggest), that could be a concern (Chart 5).

Inflation expectations will remain high on the agenda, given its link to wage negotiations. On this front, the surveys remain relatively de-anchored from normality (Chart 6).

Yields Are Higher, but FCI Is Loosening

Bond yields are much higher than they were at the last meeting. However, policymakers seem relatively calm on the back of this. The consensus seems to be that because it is US rates driven it is less of an issue, and that the widening in Italian spreads is simply a reflection of poor fiscal choices there (from our perspective it seems more beta-driven than Italy-specific). Despite the selling, ECB measures of financial conditions have continued to loosen (Chart 7).

Higher Government Deficits Are a Risk Ahead

The risk of governments running larger deficits remains high. Rising populism in the Eurozone has a multi-faceted impact on fiscal policy. It raises the attractiveness of offsetting household pain and has driven increased focus on corporate profits. The former we have already seen in more expansive French and Italian 2024 deficit forecasts. We expect the German deficit will end up larger than currently forecast, too. Meanwhile, greater corporate profit taxation could drive higher pass through of costs to consumers (see our point on wage growth).

We expect that the tone regarding bond yield spreads will revolve around this issue – that the market will punish imprudent fiscal policy.

High Risk of More QT Talk

Given the general lack of concern towards the recent rates sell-off, and the fact that spreads remain relatively contained, it is likely some mention is made of discussions around PEPP. A decent number of hawkish smaller NCB heads have recently spoken in favour of at least discussing an earlier end to PEPP reinvestments (Chart 8). The more important hawkish NCBs have been silent, as has the Executive Committee, but overall, the ECB seems quite content with how the initial phase went. There has been some pushback on the need to discuss from the likes of de Guindos, and more dovish members have played up the value of PEPP reinvestments to prevent fragmentation, but if it does not make an appearance in the statement, it is sure to make one in the Q&A.

The bond sell-off is likely to get a mention in the statement and presser given the break-out that EUR real rates have seen since the last meeting will be worth noting, but at this stage it does not look likely to seriously concern the Governing Council.

Discussion of Operational Framework Review

The ECB is set to announce the results of its operational framework review by year-end. This will pertain to how it will steer short-term interest rates while winding down excess reserves (currently a de-facto ‘floor system’ at depo-rate due to the quantum of excess liquidity) and the path for excess reserves. It is highly likely at least some of this will be touched on.

While the discussion is a technical one, the impact could be quite important:

• The decision on how to control short-term rates (floor vs corridor) will ultimately determine how large a balance sheet the ECB needs to retain. Hawks such as Holzmann appear to back a full normalisation of BS and with it a return to a wider corridor. At this stage that seems difficult to achieve. The floor system seems more feasible. Schnabel has written on how this might be achieved. In brief, the ECB could either retain a large bond holding, which could be used to fulfil secondary objectives (like Paris Agreement); or it could offer regular collateralised lending operations. It seems likely that they will ultimately fall onto a mix of both, with widened access to funding for non-banks also likely.
• The related discussion on the minimum reserve requirement (1% since 2012, but with comments suggesting it could be raised up to 3-4%) would have a large impact on bank funding and profitability. An unintended consequence of a large rise could be banks shifting away from short- to long-term funding, which could soften the transmission of monetary policy (if banks no longer seek to attract as high a quantum of depositors). A rise back to 2% (the MRR pre-2012) could be the middle ground solution.

Recent Policymaker Comments

Note: Rehn (Finland) has been replaced by Välimäki. Visco (Italy) will be replaced by Panetta (Executive Board) on 1 November, who in turn is set to be replaced by Piero Cipollone (Deputy Governor of Bank of Italy).

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.)