ECB Preview: 50bp, 2023 QT and Hawkish Forecasts

Summary

• ECB policymakers have toned down calls to continue hiking in 75bp clips. Our base case is now 50bp next week. A tail risk remains that more is delivered.
• ECB forecasts for higher medium-term inflation would support this hawkishness.
• On QT, there should be room for a relatively aggressive initial path, but with allowances for less to be rolled off and flexibility to see off fragmentation.

Market Implications

• After having priced down the ECB terminal rate to c.2.8%, there is room for a move back up to 3% and beyond.
• We have been bearish core-EGBs since mid-October. The market has moved against us since then. If the ECB forecasts come out as hawkish as we expect there is strong room for upside. If not, we will reassess our position.

Limited Rationale for a Dovish Twist

The market has now largely priced out the risk of a 75bp hike next week, and with it, taken the terminal rate down to c.2.8%. The former is understandable, given that the pressure from the hawks for 75bp has softened since our last report. However, there is also growing consensus among the major figures (Lagarde, Lane and Schnabel in particular) that loose fiscal policy is raising the risk of medium-term inflation. The ECB now estimates just 15% of fiscal measures are ‘temporary, targeted and tailored’. Meanwhile, policymakers seem reluctant to outright deny the prospect of 75bp. Neutral voice Makhlouf refused to rule it out, while arch-dove Herodotou and neutral de Guindos have stated that data and updated forecasts should determine the size.

Forecasts to be Hawkish

Since the start of the year, ECB inflation forecasts have been overly optimistic (Chart 1).  The Governing Council are aware of this and it is no surprise that speakers (including Lane and Lagarde) have been very reluctant to state that inflation has peaked. The lower-than-expected November CPI print may suggest that price momentum is slowing, but MoM core price changes show this is not the case (Chart 2).

Chart 1: ECB Forecasts Have Been Consistently Poor

Chart 2: EZ Core Inflation Momentum Has Not Fallen

The risk to credibility of assuming another near-term peak, the lack of progress in softening underlying inflation, and the recent rise in European gas prices all point towards the ECB erring on the hawkish side for its inflation forecasts. This would likely mean a further delay in the estimate for peak inflation, and a further rise in end-2024 inflation (which has steadily risen since March). This would align with Lane’s recent comments around second round effects driving inflation through 2024/25.

In sum, the market is pricing out the risk of a 75bp hike too aggressively. While 50bp is our base-case, a larger move would be well justified. Furthermore, there has so far been little to support a decline in terminal rate away from 3%.

Surveys and Data Support Hawkishness

Surveys and data on economic performance also support a more hawkish reaction. 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 (see appendix), helped by strong stock and bond performance. 10Y Bund yield has fallen c.70bp off the highs seen in October, while 10Y BTP/Bund spread is now around 190bp – a level it had not previously seen since June.

2023 QT – ECB Can Leave Room for an Aggressive Profile

The well supported bond markets bring us neatly to the growing calls for a 2023 wind down of the ECB’s balance sheet. ‘Transparency’, ‘predictability’ and ‘gradualness’ are the buzzwords here. And they point towards the ECB providing guidance sooner rather than later. The likelihood is for the ECB to set out a framework next week for a proportion of maturing bond holdings not to be reinvested. The timeframe for this, the scale, and the alignment to the capital key will be important considerations. Given the tranquillity in markets recently and the hawkish outlook, despite these buzzwords, there is room for the ECB to err on the more hawkish side (Q1 2023 potential start, no explicit limit announced, initial attempt to keep to capital key but with possibility of reinvestment skew if un-warranted fragmentation occurs). Whether they can ultimately deliver this is unclear, but for now such an approach makes sense.

The possibility of reinvestment skew and the more hawkish inflation forecasts should put upward pressure on core EGB yields. We previously expected 10Y Bund to break up through 2.5% on the back of imminent QT announcements and heavy supply. So far this has not been the case. The outcome of next week’s ECB will lead us to re-assess the position.

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.)