ECB: A Major Disconnect with Markets

Published on November 30, 2022
SGH Insight
There is a major disconnect between market expectations and pricing, and the policy rate European Central Bank officials increasingly feel will be needed to bring inflation back down to their 2% target.

Markets have for some time converged, and remain converged, around a 3% “terminal rate” for this hiking cycle, pricing it today at around 2.8% after the drop in eurozone headline inflation readings from 10.6% in October to 10.0% in November.

As things stand, however, the ECB is likely to raise rates into the 3.5% to 4.0% range next year and look to keep them there for a while to bring inflation back down to target...

...Similarly, while analysts are keenly focused on the interplay and political tradeoffs between the start of the ECB’s balance sheet reduction and magnitude of the next interest rate hike, that kind of fine tuning of policy is now a bit of a red herring.

We expect that the ECB will not dally around with a previously planned, and widely expected, two-step process of rolling out the broad contours for shrinking its balance sheet on December 15, to be agreed and implemented at their subsequent meeting in February (some analysts are expecting even later than that).

We expect the ECB will move forward imminently with its balance sheet reduction program, and will agree, announce, and roll out the details of that program at its upcoming December 15 meeting, to take effect as soon as feasible...

Market Validation
Bloomberg 2/24/23

European bonds tumbled and money market traders added to European Central Bank rate hike bets after data showed the US economy is running hotter than expected.
German two-year yields — among the most sensitive to changes in monetary policy — rose as much as 13 basis points on Friday to above 3% for the first time since 2008. Money markets now price the ECB deposit rate to peak at around 3.87% later this year compared to around 3.5% at the beginning of the year.


Bloomberg 12/15/22

*LAGARDE: ECB NEEDS TO DO MORE ON RATES THAN MARKETS PRICE
*LAGARDE: MARKET RATE BETS DON'T ALLOW ECB TO REACH 2% GOAL
*LAGARDE: ANYONE THINKING ECB IS PIVOTING IS WRONG

Yet more tough language from Lagarde as she again flags the possibility of several 50 basis points hikes. It shouldn’t be regarded as the new normal, but in current circumstances it’s the right approach, she says. “We need to take this fight and continue the battle against inflation.”

In response to Alex’s first question whether 3% is a fair assumption for a terminal rate, Lagarde says that staff projections do not allow a return to 2% inflation target in a timely manner. More needs to be done and as a result new market expectations will “hopefully” be embedded in future projections, she says.

ECB Monetary policy statement 12/15/22

The key ECB interest rates are the Governing Council’s primary tool for setting the monetary policy stance. The Governing Council today also discussed principles for normalising the Eurosystem’s monetary policy securities holdings. From the beginning of March 2023 onwards, the asset purchase programme (APP) portfolio will decline at a measured and predictable pace, as the Eurosystem will not reinvest all of the principal payments from maturing securities. The decline will amount to €15 billion per month on average until the end of the second quarter of 2023 and its subsequent pace will be determined over time.



There is a major disconnect between market expectations and pricing, and the policy rate European Central Bank officials increasingly feel will be needed to bring inflation back down to their 2% target.

Markets have for some time converged, and remain converged, around a 3% “terminal rate” for this hiking cycle, pricing it today at around 2.8% after the drop in eurozone headline inflation readings from 10.6% in October to 10.0% in November.

As things stand, however, the ECB is likely to raise rates into the 3.5% to 4.0% range next year and look to keep them there for a while to bring inflation back down to target.

This, more than anything, will color the debate in the Governing Council when it next meets on December 15, including on the near-term decision over whether to hike by 50 basis points or by 75 bps. In a series of reports starting on November 21, we switched our call for that meeting to 75 bps, and we continue to expect that.

Similarly, while analysts are keenly focused on the interplay and political tradeoffs between the start of the ECB’s balance sheet reduction and magnitude of the next interest rate hike, that kind of fine tuning of policy is now a bit of a red herring.

We expect that the ECB will not dally around with a previously planned, and widely expected, two-step process of rolling out the broad contours for shrinking its balance sheet on December 15, to be agreed and implemented at their subsequent meeting in February (some analysts are expecting even later than that).

We expect the ECB will move forward imminently with its balance sheet reduction program, and will agree, announce, and roll out the details of that program at its upcoming December 15 meeting, to take effect as soon as feasible.

Our rate call for the upcoming meeting is with full acknowledgment that there will be some resistance to another “outsized” hike at the upcoming meeting, as many officials had been hoping to decelerate from the last two 75 bp hikes and we suspect will still demonstrate a preference for a “denormalization” away from 75 bps and onto admittedly still aggressive 50 bp increments.

ECB President Christine Lagarde, aware that the strong and near unanimous consensus on the appropriate policy to date may fray a bit as the ECB gets deeper into its tightening cycle, has flagged the possibility of a more divided Council, and that future decisions may even be put to a formal vote instead of being decided by broad consent as they have until now.

That is for obvious reasons not a preferred outcome, and the hawks within the Council will be making the case that there is virtually no risk of “overdoing” it on rates at this juncture, as some might have seen another 75 bp hike just a few weeks ago.

With the target drifting farther away, the time to step down is not now, and with the more severe downside growth concerns to some extent dissipated, the ECB is looking at perhaps a mild recession at most. The risk of underdelivering on rates, however, is still very real.

Today’s November inflation release, while providing some relief on the headline figures, will do little if anything at all to change this narrative. Core inflation – those underlying pressures that the ECB has been so concerned about – remain unchanged at 5% and is following the traditional pattern of lagging headline inflation, but then remaining stickier and more problematic even as headline starts to come down.

With core expected to stay on a 4% handle for some time, for the ECB, that means rates will need to be restrictive, and remain restrictive for some time, a “possibility” that Board members have increasingly been flagging to both markets and we suspect to their counterparts across the Eurosystem as well.

And here, the construct of “neutral” being somewhere in the mid-2% handle, meaning that 3% or 3.25% would be restrictive, has become stale, with the landing zone looking to be more in the 3.5-4.0% range.

It may behoove markets to remember where the ECB came from, which included a fairly stable period from around 2003-2007 of roughly 2% inflation, with 3% policy rates. Now, beside the transitory elements of inflation, the ECB will be facing core inflation at 4%, even perhaps dropping to 3%, for quite some time.

As to inflationary pressures going into 2023, while the latest November figures showed a deceleration in headline rates, a good deal of that drop came from a large downward revision to the Dutch accounting for retail energy prices. While that revision may be reflected in models, it does not reflect any change to inflation dynamics on the ground.

On the all-important energy front, for example, wholesale natural gas prices have come down, but the futures still point to elevated prices ahead. Perhaps much more to the point, the ECB expects there will be significant and continued pass through of high wholesale prices now on a retail basis – but one example of the pipeline pressures and underlying inflationary risks that many ECB officials have been increasingly concerned about.

Assuming headline inflation does peak soon, as has long been hoped, by February or March the Governing Council will have greater visibility as to how successful they are being in turning core around as well.

As things stand, our base case outlook is for a 75-basis point hike in December, to bring rates up to 2.25%, a January start to balance sheet reduction, followed by 50 bps on February 2, with rates ending up sometime in 2023 between 3.5% and 4%

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