Europe | Monetary Policy & Inflation | UK
- European Central Bank (ECB) and Bank of England (BOE) policies are in play – understanding market pricing of ECB and BOE expectations is critical.
- Euro and sterling overnight index swaps (OIS) markets are the key to gauging market pricing of ECB and BOE policy expectations.
- After already raising rates, both the ECB’s Governing Council (GC) and the BOE’s Monetary Policy Committee (MPC) are expected to continue on their respective tightening paths.
- Threats of a severe economic slowdown in both the Eurozone (EZ) and UK mean pricing ECB and BOE policy will remain challenging.
- Expect elevated volatility to dominate short-end interest rate markets in coming months.
Alongside the US Federal Reserve and other central banks, both the ECB and BOE are taking part in the current global tightening cycle. This piece, the second in a series, will look at how markets price ECB and BOE policy.
As with the Fed, knowing how rates traders price the policy path will be a key advantage for investors and traders. It not only reveals how traders are positioned; it can be a gauge of sentiment and even an indicator of further market moves.
ECB Policy – The Challenges, and How It Is Priced
The Battle Against Inflation
Elevated inflation is a global problem, and the EZ is not immune to its grip.
The runaway prices are a particularly acute challenge for the ECB. Unlike the Fed, which has a dual mandate of price stability and maximum sustainable employment, the ECB has a single mandate: to maintain price stability. The ECB defines price stability as 2% inflation over the medium term, which it targets with its monetary policy.
However, the most recent EZ inflation data (for July 2022) came in at 8.9%, far above the ECB’s mandated target. This overshoot prompted the bank to raise interest rates by 50 basis points (bps) last month – a contractionary move that it hopes will stem inflation. And analysts expect more hikes as early as the next policy meeting in September.
The ECB’s challenge is that elevated inflation is combined with a bleak economic outlook. There are fears of a deep economic recession in the EZ. While the single mandate dictates that the ECB focuses exclusively on reducing inflation to its target level, the prospect of raising rates into a recession is daunting.
How Does the Market Price ECB Policy?
Traders use overnight index swaps (OIS), an over-the-counter (OTC) instrument that is ultra-sensitive to ECB policy. Euro-denominated OIS are known as the euro short-term rate (€STR). €STR fixes every day as a spread to the ECB Deposit Rate (currently at 0%). Given an abundance of liquidity in the Eurosystem, the daily €STR fixing has been trading increasingly below the ECB Deposit Rate, and now sits ~8bps below it (-0.08%).
Determining what market expectations are for each ECB meeting is relatively simple. There is an €STR curve extending several years forward. To calculate ‘what is priced’ for any specific ECB meeting, traders employ forward/forward €STRs. The difference between the current fixing and the forward fixings provides a granular meeting-to-meeting overview of market expectations.
BOE Policy – The Challenges, And How It Is Priced
Inflation in the UK
Like the EZ, inflation in the UK is far too high, with the most recent reading coming in at 10.1%. And like the ECB, the BOE has a single mandate – a government-set inflation target of 2%. The BOE’s policy response has been to raise Bank Rate – the rate it charges wholesale banks to borrow money from it – by a cumulative 165bps since November 2021. Bank Rate is currently 1.75%.
The BOE’s challenge is like the ECB’s. UK inflation is rising as the country’s economic outlook grows increasingly grim. As in the EZ, fears are mounting of a deep economic recession in the UK. The BOE expects the UK to fall into recession this year. Despite this, as with the ECB, the BOE’s single mandate dictates that the central bank focuses exclusively on reducing inflation back to target. Raising rates into a recession is as daunting for the BOE as for the ECB.
How Does the Market Price BOE Policy?
Traders in the UK use sterling OIS, which are ultra-sensitive to the BOE policy. Sterling-denominated OIS are known as the Sterling Overnight Index Average (SONIA). SONIA fixes every day as a spread to the BOE Bank Rate (currently at 1.75%). Given an abundance of liquidity within the Sterling Monetary Framework, the daily SONIA fixing has been consistently ~6bps below Bank Rate since March this year (a 1bp greater spread than before hiking began).
As with ECB pricing, determining market expectations for each BOE meeting is relatively simple. There is a SONIA curve extending several years forward. To calculate ‘what is priced’ for any specific BOE meeting, traders employ forward/forward SONIAs. The difference between the current fixing and the forward fixings provides a granular meeting-to-meeting overview of market expectations. (Interestingly, the BOE also include the market-implied path for rate hikes as their assumption for base rate.)
What Is Priced Now?
The market expects the ECB to raise rates materially in the coming months. This is calculated by using €STR forwards – taking the implied rate expectation for the liquidity maintenance period associated with each ECB meeting from the €STR forwards and comparing these ‘implieds’ to the current €STR fixing (Chart 1). This methodology clearly shows almost 200bps of further rate rises are expected by the end of July 2023. And, for the next meeting on 8 September specifically, 54bps of tightening is priced. That means a 50bp rate hike is fully priced, with a small chance of a bigger move.
The market expects the BOE to be even more aggressive than the ECB in tightening policy. Using a similar calculation methodology for MPC-dated forward SONIAS (as with ECB and €STR forwards above), we find another ~250bps of further rate rises are expected by the end of August next year (Chart 2). And, for the next meeting on 15 September specifically, the market is currently fully pricing a 50bp hike by the BOE.
What Comes Next?
The challenges facing both the ECB and BOE are clear: tightening monetary policy to combat too-high inflation in the face of unavoidable economic slowdowns. And these challenges will lead to elevated volatility and shifting market perceptions of the respective interest rate paths in the EZ and UK.
In that environment, monitoring the EUR and GBP OIS markets will be a key tool for investors seeking to determine how these paths will unfold. Recent months have seen wild gyrations in market pricing. Expect more of the same in coming months.