Europe | Monetary Policy & Inflation | Politics & Geopolitics
Summary
- The ECB is set to hike by 25bp on Thursday and release more information on its transmission protection mechanism (spread tightening tool).
- Russian gas supply and Italian politics pose a risk to the outlook. Assuming these risks fade, we expect the ECB to lean hawkish on the outlook, opening the way for 50bp in September and at future meetings.
- Real economic activity and medium-term inflation pressures remain relatively strong.
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Summary
- The ECB is set to hike by 25bp on Thursday and release more information on its transmission protection mechanism (spread tightening tool).
- Russian gas supply and Italian politics pose a risk to the outlook. Assuming these risks fade, we expect the ECB to lean hawkish on the outlook, opening the way for 50bp in September and at future meetings.
- Real economic activity and medium-term inflation pressures remain relatively strong.
A Difficult Situation for the ECB
The ECB is in a bind. Inflation is rising, the economy is deteriorating, Europe’s energy supply is unclear, and political uncertainty has reached Italy again. The Governing Council want to tighten. However, they panicked when the spread between Italian government bond (BTP) yields and German bund yields widened back in June. This suggests limited willingness to hike aggressively. We expect a 25bp hike.
Inflation Keeps Getting Worse
Since the ECB’s last meeting in June, inflation has continued to track higher, led by energy (Chart 1). Meanwhile, real economic activity remains relatively strong.
Two Key Risks Ahead
Two risks currently affect the outlook. The first is Italian political uncertainty. This is pressuring benchmark BTP bonds and widening the yield spread with German Bunds. The headlines out of parliament today seem more positive, but there are still key votes that Italian PM Mario Draghi will need to pass before the worry dissipates completely.
The second risk is Russian gas supply. Russia recently shut a key pipeline, Nord Stream 1, for maintenance. While reports suggest a more permanent closure will be averted, recent comments from Russia suggest it will re-open at significantly reduced capacity on Thursday.
By the time ECB President Christine Lagarde makes her statement, there will be more clarity. Assuming neither issue escalates, she will have the ammo to re-affirm her commitment to the previously laid out path. Expect a 25bp hike, with potentially a hawkish lean for future use of 50bp steps.
What Could Stop the ECB Hiking?
Should the gas supply stoppage extend beyond the current deadline of Thursday (the day gas should resume), the outlook for hikes (and the economy in general) will nose-dive. However, even in such a risk-off situation, we would expect the ECB to continue with the initial hike, with the capacity to reverse the move if the stoppage is extended significantly further.
Could They Hike 50bp?
The hawks have not let up on their wish to move in larger steps. But that push has apparently come alongside a concession on the size of the initial step. Given the current risk outlook, we think there is little probability of a 50bp rise just yet, but a stronger chance of its use in the future.
Expect Disappointment on Anti-Frag
The ECB need to deliver a tangible tool for capping spread widening (their so-called transmission protection mechanism, TPM). However, the Governing Council lacks unity, limiting the ECB’s capacity to do so. Under President Christine Lagarde, the ECB has a track record of underdelivering (at least at first). There is little reason to expect much else this time.
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.)