ECB Preview: Strong Case for a Hawkish Surprise

Summary

• The market has taken back much of its pricing for ECB tightening following the invasion of Ukraine.
• However, the ECB will struggle to strike a dovish tone when near-term inflation is so far above target and the medium-term drivers are building.
• Credit spreads remain well anchored, and expanded EU spending will help. This leaves the ECB room to wind down asset purchases faster than the market expects.
• We retain a base case of €40bn pm APP, but with risks strongly skewed towards a lower number.

Market Implications

• A more hawkish tone on asset purchases plus a strong inflation outlook should open the door for more steepening in EGB curves.
• Steepening curves support European bank performance versus broader European equities.

Introduction

The European Central Bank (ECB) will meet this Thursday needing to balance several issues. Firstly, they face high and growing near-term price pressures. Secondly, they must watch and pre-empt any signs of second-round inflation effects (from wage and price setting). And thirdly, they must ensure credit spreads do not blow out.

Against this backdrop, they must also reassure the market that they are maintaining flexibility to react to the rapidly developing war in Ukraine.

Market Pricing

The market had previously priced in too much hawkishness around hiking. Now, however, the market seems to be taking the ECB’s ability to respond ‘flexibly’ to the invasion of Ukraine a little too dovishly.

We continue to see net-asset purchases ending in Q3 or Q4, setting up for a hike shortly after.

A Strong Case for Winding Down Asset Purchases

The ECB must establish the asset purchase path at the meeting given the imminent end of net-PEPP. The market is looking for a tick up to €40bn pm in regular APP to offset this somewhat, with a six-month winddown thereafter. Room exists for them to do less. A smaller tick up (say to €30bn pm) and a faster reduction are realistic options.

Our rationale is that there is currently a limited need for more QE. Credit spreads have remained well anchored through the Russia/Ukraine risk (Chart 1). Perhaps more importantly, the outright yields of credit are nowhere near oppressive. The reported joint EU spending will further support this fact.

Inflation Pressures Are High and Rising

Meanwhile, underlying inflation is growing, with core CPI consistently surprising on the upside. High PPI inflation is squeezing corporate margins, which companies will eventually pass onto the consumer (Chart 2).

These pressures will mount with the squeezing of Russian commodity exports by SWIFT removal and sanctions. This will not just be the case in natural gas and oil markets but also agricultural products (e.g., wheat and fertilisers) and industrial and metals (e.g., nickel, titanium, palladium and platinum).

The ECB is in a bind over their forecasts. In December, they were able to keep forecast inflation below target in the medium term, assuming a decently downward sloping oil curve. That left headline HICP at 3.2% in 2022 and 1.8% in 2023 and 2024. As ECB policymaker Isabel Schnabel showed in her 6 January speech, even holding oil constant at that time would have pushed medium-term inflation to the edge of the ECB’s target (Chart 3). We have since seen a clear, significant overshoot versus futures pricing or a flat profile.

It Is Hard to See Medium-Term Inflation Sub-2%

The near-term inflation forecast will need to be revised decently higher. Despite this, comments from ECB chief economist Philip Lane suggested that the medium term will remain sub-2% at the March meeting. Making this case will be hard, particularly if the outlook includes the effects of the war and the sanctions (as Lane has stated).

GDP Forecast Lowered, but Fiscal Spend to Support

On the output side, the commodity shock, the cut in exports (albeit modest), and the invasion-driven rise in uncertainty will all mean strong downside risks to growth. Early comments by Lane suggest that a ‘worst-case’ modelled scenario could drop real GDP growth this year by 1pp. We think that is probably too bullish, given it would still leave 2022 growth at around 3% – double the 1.5% average from 1992-2019. Add in the expected fiscal support, and again, Lagarde will struggle to argue that such easy policy is warranted.

Banks Set to Gain

With pricing around a hike pared back, inflation expectations high and growing, and QE reduced, the stage will be set for a re-steepening in European rates curves. As we have stated previously, this re-steepening of curves leaves banks well positioned to profit from higher net-interest margins. We re-affirm our expectations for European banks to outperform equities through the period ahead.

(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.)