Monitoring the ECB: Terminal Rate Above 3.75%?

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Summary

• As expected, the ECB hiked hawkishly. The market is now pricing a 3.5% terminal rate. For some time, my expectation for some time has been for the ECB to hike beyond there and I now move my central case to 3.75%.
• But, while speakers remain hawkish, until the end of month final CPI data there may be little momentum to move pricing higher.

Current ECB Forecasts

Link to Most Recent ECB Meeting Minutes (Dec 22)

Upside Risk to Terminal Rate, but Watch the Data

The ECB hiked hawkishly in February. The market badly misread the outcome, pricing dovishness, which we saw strong value in fading. This has now largely occurred. I have long been hawkish the ECB, and my target terminal rate since the start of the year has been >3.5%. The market is now fully pricing the lower end of this trajectory: roughly 50bp in March, 25bp in May and 25bp in June. I expect the ECB will need to hike beyond there, with 50bp in May my expectation (terminal rate >3.75%), but we may need to wait for the data before the next leg higher in pricing (Chart 2).

ECB speakers have struck a strongly hawkish line since the February meeting, doubling down on Lagarde’s ‘forward guidance/not forward guidance’ of ‘staying the course’. My updated hawkometer and summary of ECB speaker comments reflects this (Chart 1 and appendix).

The likes of Vice President de Guindos (neutral), Latvia’s Kazāks (hawk) and Croatia’s Vujčić (hawk) are all already discussing prospects for hiking in May, while the Netherlands’ Knot (hawk), Belgium’s Wunsch (hawk), Lithuania’s Šimkus (neutral/hawk) and Slovakia’s Kažimír (hawk) have highlighted the explicit prospect of 50bp. I lean towards the hawks’ expectation for several reasons (discussed below), but the market is unlikely to price as much until we have seen the final January CPI reading (23 February).

Why 50bp in May?

• The ECB will update its forecasts in March. These forecasts will largely determine the rate of hiking in March and May. Hawkish March forecasts likely means erring on the hawkish side until at least June.
• By the time they come to refresh forecasts in March, economic output data will likely still be strong, while the ECB will have only had sight of January’s final inflation and February’s preliminary – this will be insufficient to justify significantly more dovish projections (Chart 3).

Surveys and Financial Conditions Support Hawkishness

Our expectation for sustained hawkishness is supported by survey and financial condition data (see Appendix). ECB measures of systemic stress continue to decline despite recent sell-offs in periphery and core bonds. Meanwhile, European economic surprises have continued to diverge positively from China and the US, while surveys across businesses and consumers in activity and employment show increasing signs of recovery. Meanwhile, inflation expectations continue to rise, with clear signs of medium-term de-anchoring versus historic trend.

As a result, while the case for dovishness could build if inflation began to slip, consensus within the voting members should begin to turn towards the deterioration of the medium-term outlook.

Recent Voter Comments

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.)