Why the ECB Will Keep Hiking

 Summary

• Recent reports suggested the ECB may be ready to slow hikes come March. The market has duly priced this.
• However, data and policymaker comments suggest otherwise. I reiterate my expectation for ECB hawkishness.
• BoE data has not provided the dovish momentum I had expected. Nevertheless, on balance, the outturns still indicate a dovish pivot ahead.

Market Implications

• The monetary policy environment adds to our conviction for a lower BoE terminal rate and higher ECB rate (than priced). This could feed into higher EUR/GBP.

Introduction

Last month, I argued for a February BoE dovish pivot and for the ECB to maintain its hawkish lean (Table 1). Since then, both assertions have come under some strain from policymaker comments and data releases, but both remain my central case.

ECB – Dispelling Dovish Dissent

Last week saw the release of the ECB’s December meeting minutes. It revealed a discussion largely in line with my long-standing expectation that the hawks come to dominate the discourse. The main takeaways were:

• 50bp was presented by Chief Economist Lane as allowing for a ‘longer period’ of tightening. This was accepted provided the message was altered to say rates would rise significantly at a sustained pace.
• The concurrence of announcing quantitative tightening (QT) and the consequent risk of market disorder also supported the smaller move.
• 75bp was favoured by a ‘large number’, the rationale being:
  • Inflation persistence in forecasts suggests demand (not just supply) factors.
  • Forecasting this, but not taking strong action, would hurt ECB credibility.
• Some wanted the asset purchase programme (APP) reduction to be faster. Again, the moderation was justified by preventing bond fragmentation.

In short, hawks drove the discussion, with compromises needed to moderate their demands. In that context, have we seen anything since that would change the prognosis?

If anything, the data has supported more hawkishness. The feared bond market fragmentation has not materialised; credit spreads have materially tightened (Chart 1). Meanwhile, European economic data has delivered consistent positive surprises (Chart 2).

Meanwhile, Eurozone core inflation remains strong, with no sign yet of peaking. In turn, this has fed into higher expectations of future inflation and hence second-round price/wage effects (Chart 3). Consumer and business sentiments have bounced on the declining chance for a near-term recession; the lower risk of a near-term energy shortage helped (Chart 4).

Reports suggest the more dovish ECB members are annoyed by President Christine Lagarde’s approach. In truth, who isn’t? But in the context of strong inflation and bouncing sentiment, that Lagarde, Philip Lane and other important members have rejected the need to slow is unsurprising.

For now, I still expect the ECB will hike 50bps in February and March, and deposit rate will peak somewhere north of 3.50%.

BoE: Expect February Pivot, But It Is Not a Done Deal Yet…

In the UK, I have been expecting the Bank of England (BoE) to pause hiking soon, with February’s updated monetary policy review (MPR) the likeliest time. The arguments for hawkishness have long faded.  

However, last week’s data releases (for the labour market, inflation and retail sales) have provided a more mixed picture.

Labour market data was mixed. Rises in claimant count (4.0%) and labour market participation (63.1%) were dovish (Chart 5). But beats in regular pay growth (6.4% YoY) and employment growth were hawkish (Chart 6). The surveys continue to point to a turn in labour market conditions, but without the hard data evidence the BoE may be cautious in changing tack too quickly.

Meanwhile, December inflation data suggested a further normalising of core inflation (Chart 7). A lack of typical discounting in clothing was one reason the number did not fall further, but otherwise the data is showing that the breadth of inflation has decreased remarkably – in December, only five inflation segments posted above-average MoM readings (Chart 8).

UK Retail Sales continued to decline in December at -1.1% MoM (ex fuel), far below the consensus of +0.4%. Excluding the brief collapses driven by lockdown, the volume of sales is near its lowest since around 2019 (Chart 9).

Retail sales is not the most important factor for the BoE. But along with recent data on the burden of mortgage costs for first-time buyers (39% of salary, a new post-GFC high), it aligns closely with our longstanding forecast that households will face serious pressure this year. That will be a growing concern for the MPC ahead.

Governor Andrew Bailey commented last week he was not endorsing 4.5% terminal but not actively pushing back on it either. That leaves my expectation for a 4-4.25% terminal rate in play still; my base case is for a 50bp hike in February.

The Market Implications

My last report highlighted that a rise in the EUR/GBP 2Y swap spread (2Y EUR swap less 2Y GBP swap) could drive a rise in EUR/GBP. This view performed well for much of the period between December and now. But in the last week, the pairing relinquished much of its gains after the reports of ECB dovishness.

I expect there is currently little backing for dovishness within the ECB. If correct, I expect the recent EUR/GBP weakness to reverse.

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.)