Europe | Monetary Policy & Inflation | Rates
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
- A higher depo rate and steeper EUR curves point towards strategic outperformance of European banks.
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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
- 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 there will depend on how fast the window of hawkishness closes.
The market is now pricing around eight hikes in the next 12 months, only one hike less than the Fed over the same period. This looks greatly overdone given the risks the economy faces. That said, there might yet be further room to go before this hawkish trade capitulates.
The prospect of a hike at this meeting is low. The ECB has largely tied its hands on this front with its policy sequencing (ending APP before hiking). 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 will likely 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.
- Mapping out the policy path beyond the exit from negative depo.
- 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.
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 necessary. Halting APP sooner than expected is also possible, particularly if it comes alongside stronger rhetoric for a future ‘anti-fragmentation’ programme. The forecast option 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 declined across the Eurozone, while business sentiment, too, is coming down (albeit slower). Higher inflation forecasts will weigh on household spending and business investment, while slower global growth will dampen export demand. Further downside surprises from the war are also possible.
APP to End Imminently
The end of APP is imminent. Credit spreads are not currently breaking out (Chart 3). On a beta-adjusted basis they are tight. If the end of APP did come sooner than expected we would not read too much into it affecting the timeline of hiking (an intra-meeting hike seems unlikely while the ECB denies 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). 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.
To fight off the risk of a spread blowout, the ECB can refer to its upcoming ‘anti fragmentation’, ‘crisis tool’. Details on this have been scant, and the ECB will likely provide more on Thursday. Such a programme would likely involve buying bonds flexibly. On this basis providing too many details may limit their ability to act later. As such, an ‘as much as it takes’ style statement would probably suffice for now.
EZ Banks to Benefit
Structurally, we are entering into a period of higher, steeper European rates curves. This 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 5). We reaffirm our long EUR banks trade vs other European stocks.