ECB Preview: 75bp and a Hawkish Lean

Summary

• The stage is set for another 75bp hike on Thursday. The rationale for tightening has continued to build since the last meeting, so a more hawkish twist could be possible.
• Within this, there is the tail risk of a larger hike, and the likelihood of emphasizing discussions around QT, even though the Eurozone’s ultimate capacity for QT may be relatively limited.
• TLTROs will likely be made less beneficial to European banks in line with recent media reports.

Market Implications

• A hawkish surprise should provide some moderate strength for EUR, while helping to sustain EGB weakness.
• The TLTRO announcement is largely priced into the banking sector. But it could add further to BTP weakness (particularly short-end) given the Italian banks’ high usage of the facility.

Hawkish Tone Building – For Good Reason

This week the ECB is likely to do another significant rate hike. 75bp is pretty much baked in, but given the hawkish tone, and the ECB’s recent willingness to surprise, a 100bps hike cannot be ruled out. Current inflation is a big reason for the hawkishness. Consensus suggests Eurozone October CPI will come around +0.8% MoM, far in excess of a 2% annualized rate (Chart 1).

Before the September meeting, we set out our case for why hawkishness was set to build. At that meeting, and in the time since, the ECB duly delivered. In line with our expectation, the market is now pricing a 3% terminal rate, and a break above 2% by year-end. For now, the same rationale for hawkishness holds (see below bullets). That suggests to us that the ECB will hike 75bp on Thursday and again in December if inflationary dynamics have not improved. Similarly, on the balance sheet, the risk is now that Lagarde more explicitly points towards QT being discussed and coming in 2023 (she previously said ‘once normalization was complete’).

• The EU’s gas supply situation appears to be easing in the near term. Nevertheless, a difficult winter still remains ahead (ENTSOG still estimate a cold winter without demand reduction would drive storage close to zero), and the medium-term energy situation remains uncertain. And as such, current inflation will continue to receive the most weight in monetary policy deliberations. Moreover, while gas price has dropped significantly from the highs, it remains significantly above pre-war prices. Outlook remains a tail risk, but the rosier near-term picture means less reason for the ECB to decelerate the pace of tightening.
• Recent inflation has continued to overshoot expectations. The ECB’s September inflation forecasts already look stale (Chart 2). Hawkish.
• EURUSD has continued to weaken since the last meeting, although trade-weighted it is broadly unchanged (Chart 3). Hawkish.
• BTP/Bund spreads remain surprisingly capped given the rise in outright yields. Little to dissuade hawkishness.
• The economic picture has deteriorated, but this does not seem sufficient to trigger a dovish pivot just yet (more information below).

Surveys and Sentiment – Bad But Not Enough to Slow Hikes

The measures of stress and the surveys we look at point towards a deteriorating economic outlook and elevated systemic stress across the Eurozone (see: Appendix). However, the lack of feed through from surveys to hard data, and the relative stability of market indicators offsets the bearishness. Inflation expectations continue to rise, but do not yet appear to be significantly unanchored.

How Far Can the ECB Get With QT?

The ECB hawks (and even some of the more neutral members) have been increasingly talking up the prospects for passive QT beginning next year. This remains a big risk to European assets, particularly core EGBs, where net-supply is already looking heavy. At this stage, given the inflation pressures and the relatively benign spread picture, we expect President Lagarde will continue to add to the QT momentum at her press conference.

Unsurprisingly, the periphery would likely suffer the worst from QT and the consequent heavier EGB duration supply picture. Core yields rising will drag periphery up which could ultimately lead to questions of debt sustainability. There is already dissatisfaction with the rapid tightening from the likes of Italian PM Meloni and French President Macron. If the market begins to seriously price in a wind down in ECB assets, then expect this tone will grow further.

For now, expect that Lagarde can mention the prospect of QT without too much market panic, but ultimately we would not be surprised if it ends up being another promise she ends up walking back..

The Trouble with TLTROs

With rates likely to rise at least 75bp, the ECB is reportedly reviewing a number of options to limit the benefit banks see from their TLTRO loans. While this is likely already priced into European bank stocks, the severity of the change remains unknown.

Market implication.

The likely 75bp hike by the ECB, and hawkish lean should provide near-term support for EUR, particularly against the likes of GBP, where hawkishness is fading and a lot of positivity is already being priced in.

In rates, signs of continued willingness to frontload hikes, and a move towards QT should sustain recent upward pressure on yields. Further weakness in BTPs and periphery debt could be seen as a result of TLTRO changes. Italian banks have been among the largest drawers of the facilities, so early bank repayments could hit BTPs (where they parked the money), particularly those expiring June 2023 (when the majority of TLTROs expire).

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.

(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.)