ECB Preview: Case Builds for ECB to Hike Beyond Neutral

Summary

• We can see the case for both a 75bp hike and a 50bp hike at next week’s policy meeting. Given the deterioration in inflation outlook, we lean towards 75bp.
• An acceleration in the pace of hikes may, however, come alongside renewed rhetoric from Lagarde that the terminal rate remains where it was before (roughly neutral). We do not find this argument credible.
• QT being discussed in earnest right now seems low risk given the ECB balancing act of accelerating hikes without spreads blowing out.
• Updated inflation forecasts will come with strong upside risks. The base-case will likely show an even greater overshoot in medium-term CPI than previously.

Market Implications

• We see further upside to ECB terminal rate pricing and see value in fading any potential pullback on pricing on Lagarde comments.
• Strong ECB action should add to EGB flattening, supported by the need for the ECB to keep yields relatively restrained into the hiking cycle.

Hawkish Tone Building – For Good Reason

ECB hawkishness has stepped up, and the market is taking notice. The debate around 75bp at next week’s meeting has added a huge amount of fuel to the fire. So, too, is talk of taking the deposit rate to above neutral levels (Chart 1).

There are several clear reasons why we expected this hawkishness:

• With the gas situation in Russia so uncertain, the medium-term inflation outlook has lost its potency. Current inflation is taking greater weight.
• Recent inflation has strongly overshot expectations. Updated inflation forecasts will need to reflect this (Chart 2).
• There is growing evidence that the medium-term inflation outlook has shifted structurally higher. It would not take much to greatly overshoot the ECB’s target.
• EUR has weakened substantially, both trade-weighted and versus the USD since the last meeting.
• TPI should have the power to keep BTP spreads capped (although QT talks are premature).

This May Be a Structural Shift

The increased focus on near-term inflation has been seen from across the spectrum (see appendix for updated ECB policy-maker speakers). Talk of recession is no longer taboo, instead it is seen as a necessary evil by even the doves (see comments from Lane and Stournaras). At the same time, talk of inflation being unanchored is becoming increasingly common. Schnabel summed it up best when she noted that long-standing economic realities are changing, and that there would be more frequent, more persistent shocks. While the ECB rules in consensus, for President Christine Lagarde (a non-economist), the reduced conviction behind the forecasts’ central inflation path will probably allow for a shift in bias away from the more dovish Chief Economist Philip Lane, and towards the more pragmatic Schnabel.

For the meeting ahead, the compounding factors we have mentioned lead us to lean marginally in favour of a 75bp hike. While the guidance provided pre-July is now outdated, it remains the case that as the updated outlook for inflation will be worse, more decisive action needs to be taken. The offset to this is that, as it stands, the majority of ECB speakers have yet to back the move verbally (Chart 3). However, given the support seen so far amongst the most important voters, and the possibility for Lagarde to join them, we see it as the slightly more likely outcome.

A Higher Terminal Rate is Needed – But Lagarde Won’t Admit It

It surprised us after the previous meeting that the market took Lagarde’s comment around the terminal rate being unchanged at face value. Her previous record of guidance has been very poor, and we felt this was likely to prove the same. The market now agrees with us. Further analysis suggests that a far higher terminal rate could be plausible. This is not to say the ECB will need to hike every 6 weeks until inflation hits 2% as Knot suggests (leaving depo rate somewhere between 5-9%), but a move strongly into restrictive levels above 2% is likely.

However, the risk in the near-term is that, in performing another large hike, Lagarde seeks to temper risk of a panic selling of lower credit assets. Consequently, we would not be surprised if she sought, again, to push back on higher terminal pricing.

The Medium-Term Inflation Outlook is Deteriorating

The end of reliance upon Russian energy, and the shift to greener alternatives constitutes a step-change in the structure of European inflation. The assumption that, in the long-term, energy inflation will return to the historic average may no longer be valid. This is hardly a new argument. Board Member Isabel Schnabel said as much back in January. Since then, the situation has deteriorated dramatically (Chart 4).

The current Gazprom restriction on Nord Stream flows shows that regardless of gas storage, Russia will do its best to squeeze Germany and the rest of Europe. The path to energy self-sufficiency likely lies with nuclear and renewables, which require significant upfront costs (the EU estimates €360bn extra pa to reach current goals). Meanwhile the replacement of pipeline gas with LNG is a long-standing solution (into at least 2024), and will still mean paying a premium in a tight supply market (Chart 5 and 6).

Hawkish Tone Does Not Justify QT

While there have been reports that QT will be discussed, we think there seems almost no chance that any action will be taken on this front just yet. Even Latvia’s hawkish Mārtiņš Kazāks does not think now is time to start such. Right now, we would caution that even serious discussion of QT could spook the market during the ECB’s difficult balancing act.

For some time we have warned that the rise in EGB duration supply (particularly in Germany) coinciding with the end of QE, leaves a risk of a generic rise in European yields. Now, with German 10Y trading above 1.5% again, this appears to be in full swing. TPI and PEPP reinvestment skews may prevent a spread blow-out, but will do nothing to prevent higher core yields. With 10Y BTPs now fast approaching 4%, that is a big concern. 4% is not a level that BTPs have sustainably traded above since at least 2013, when Debt/GDP was 20pp lower (Chart 7). This is coming alongside Italian elections, and yet BTP/Bund spread is capped outright and tight beta-adjusted (Chart 8).

If Italian politics creates any new market fears around breaking with EU rules, or talk of QT begins to get more air-time, a spike wider in yields is likely. Therefore, if the ECB is looking to move materially faster in hiking (at 75bp) they will need to counter such forces hard. Ultimately, a return to net-asset purchases (alongside hiking) cannot be completely ruled out.

Position for ECB Hawkishness, EGB Flattening

In sum, the case for an acceleration in ECB hawkishness is building. Once the ECB majority accepts that a deposit rate substantially above neutral rate is necessary, European short-ends will have room to weaken further. Alongside this, we are unconvinced that QT will be considered any time soon, leaving a strong case for further curve flattening.

Appendix: Recent Speaker Comments

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.)