ECB Preview: Hawkish Surprise a Risk

Summary

• We expect Lagarde to affirm the path to a 0% depo rate by end-Q3, with a strong risk of a hawkish surprise in tone.
• The end of APP will be set out – likely late June/early July. We see some risk of a sooner end, but we would not expect this to pre-empt an intra-meeting hike.
• New information on the ‘anti fragmentation’ crisis tool is likely, but the ECB will probably stay vague on the details.
• ECB forecasts will be revised to reflect a higher, later peak in inflation and lower growth (with downside risks).

Market Implications

• The ECB policy path points towards higher, steeper EGB curves.
• 12m ECB hike pricing is overly aggressive. The best value lies in fading vs Fed pricing.
• A higher depo rate and steeper EUR curves point towards strategic outperformance of European banks.

Path to 0% is Set Out – Now Lagarde Could Go Further

ECB doves have now rallied around President Christine Lagarde’s push for ending negative rates by the end of Q3. The performance of Lagarde’s previous attempts at forward guidance have been mixed to say the least, but this time the path out to the end of Q3 looks pretty credible – and stands as our base case.

Positive surprises to May inflation across the Eurozone last week supported the hawkish tone. While the ECB should be looking more at the medium-term outlook (which will be updated at the meeting), these most recent outturns point towards a later, higher peak in prices than had been expected. And they increase the political pressure to act now (Chart 1).

*EU Harmonized measure

ECB Pricing Looks Toppy – But Near-Term Risk of Hawkish Surprise

There is now a strong majority within the ECB for lifting the deposit rate out of negative territory by the end of Q3. And the trajectory looks increasingly like they will end up aiming towards a neutral rate of 1-2% thereafter. Whether they reach anywhere near those levels will be determined by how fast the window of hawkishness closes (i.e., how fast the Eurozone economy weakens and how fast inflation fades). Significant progress before those two factors begin to shift seems unlikely, although the inflation peak has shifted higher than most expected.

The market is now pricing around eight hikes in the next 12 months (probably slightly less if adjusted for term premium), only one hike less than the Fed over the same period. This is up from seven hikes last week and six the week before. This looks greatly overdone given the risks the economy faces, and we continue to see strategic value positioning for relative Fed hawkishness. That said, there might yet be further room to go before this hawkish trade capitulates. A hawkish surprise this meeting is looking more likely.

The prospect of a hike at the meeting remains distant. The ECB has largely tied its hands on this front with its policy sequencing (ending APP before hiking). However, there is room for hawkishness within the APP timeline. The end of QE will almost certainly be announced, with the likelihood being an end in late June or early July (in line with previous comments), which leaves July as the lift-off date for hiking.

Given May’s EZ CPI print (8.1% headline YoY, core: 3.8%) and the ECB’s inability to hike immediately, Lagarde could come out hawkish to quell complaints that the ECB has fallen well behind the curve (a charge she continues to deny).

A hawkish tone could come in various forms, including:

• Leaving a 50bp hike (either in July or September) on the table.
• More explicitly mapping out the path of policy after the exit from negative depo (e.g., suggesting that ‘normal’ policy means ‘neutral’ policy).
• Halting APP immediately or within the next few weeks.
• Revising the forecasts upwards so CPI sits above 2% into the end of the forecast horizon (i.e., that they are seeing longer-term inflation impulses that will need to be addressed in coming meetings).

Of these, the first two would be easy steps for the ECB given they require no immediate action. And they would be easy to walk back later if conditions deteriorate. Halting APP sooner than market expectations is also possible, particularly if it comes alongside stronger rhetoric for a future ‘anti-fragmentation’ programme. The last is perhaps the least likely given it would be an admission that the ECB has dropped the ball and is behind the curve.

Forecasts to Show Higher Inflation, Slower Growth

The existing ECB baseline forecasts from March will be changed substantially at the meeting (Table 1). ECB speakers have stated realized data looks more like the ‘Adverse’ scenario they laid out then, but it is now looking more like the ‘Severe’ one (Chart 2).

Future growth will also be revised down. Consumer confidence numbers have continued to decline across the Eurozone, while business sentiment, too, is coming down (albeit slower). The higher forecasts for inflation will weigh on household appetite to spend and business expectations for investment. Meanwhile, slower global growth (US and China in particular) will dampen export demand. Further downside surprises from the war are also possible.

APP to End Imminently

APP will be ending imminently. Credit spreads are not currently breaking out (Chart 3). On a beta-adjusted basis they are tight. The market is probably looking for an end-June/early-July APP end, but it could come sooner. We would not read too much into that with regard to hiking schedule (an intra-meeting hike seems unlikely while the ECB continues to deny it is behind the curve).

Capped spreads do not tell the whole picture, though. In outright yield terms, the cost of debt is rising fast. Corporate as well as periphery EGB debt has grown substantially more expensive to issue (Chart 4). For now, this is a flow rather than stock issue. But as time passes, the sustainability of the post-pandemic levels of debt will become more of an issue. The ending of TLTRO attractive terms will add to this rise in funding cost, making bank financing more expensive, and raising the quantity of bank bond issuance.

To fight off the risk of a spreads blowout, the ECB can continue to refer to their upcoming ‘anti fragmentation’, ‘crisis tool’. Details on this are scant, and the ECB may provide more to quell the risk of a post-APP blowout. However, we have little expectation on this front. Such a programme would likely involve buying bonds, and ascribing numbers to this now would only risk undershooting market expectations. An ‘as much as it takes’ style statement would probably be much more effective.

EGB Steepening and EZ Banks to Benefit

Structurally, we are entering into a period in which by far the biggest buyer of European sovereign debt (the ECB) since 2020 is pulling out. Meanwhile, on the back of the war in Ukraine, and the slowing growth rate, bond issuance will remain relatively heavy. This will be a step-change from the previous situation and should provide legs for significantly higher and steeper EGB curves (Chart 5).

At the same time, higher, steeper European rates curves and the exit from negative rates policy will be a dynamic shift within European banks. It will allow them to earn much higher margins from their lending activities (Chart 6). We reaffirm our long EUR banks trade vs other European stocks.

Finally, we see risks of a hawkish surprise and would be loath to fade outright ECB pricing in this context. But positioning for relatively more Fed hiking than ECB hiking over the next 12 months looks increasingly attractive. The spread there is now down to just 25bp (Chart 7).

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. He holds a BA in Economics from Durham University, and an MSc in Economics & Social History from the University of Oxford.

(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.)