ECB: Lift-off, Destination, and BTPs

Published on May 9, 2022
SGH Insight
...For those who may not remember, the ECB stepped in on May 10, 2010, in the depths of the European sovereign debt crisis, to intervene directly in peripheral markets with the Securities Market Program (SMP), then established the European Financial Stability Facility (EFSF), which morphed in 2012 into the never-used Outright Monetary Transactions (OMT) program, and the robust and well-funded European Stability Mechanism (ESM), respectively.
In more recent memory, when peripheral European spreads came under pressure again, this time from a US bond market mini tantrum in March 2020, the ECB enhanced its Asset Purchase Program with a new Pandemic Emergency Purchase Program (PEPP) that gave it the freedom to buy bonds across jurisdictions, with little concern for “capital key” limitations, meaning of course a heavy overweight in Italian bonds.
As things stand, the ECB has committed to reinvesting these PEPP bonds proceeds, and is willing to continue to do so, flexibly if needed, to temper any fragmentation or dislocation across peripheral markets. Furthermore, a version of the PEPP program can be reactivated at any time. To think that the ECB needs to reinvent the wheel, with yet another facility, is failing to listen to what ECB officials are saying, or to acknowledge their success in managing outsize market dislocations, when necessary, for over a decade...

...In a series of reports starting in early March, we wrote that consensus across the European Central Bank was coalescing around an accelerated end to the Asset Purchase Program in July, followed by lift-off from its negative 50 basis point benchmark deposit rate in Q3 of 2022.
We followed that with reports in April flagging how momentum was building in the ECB to pull lift-off into the July 21 Monetary Policy Meeting immediately following the end of APP, which would then open the door to three 25 basis point rate hikes in 2022.
That consensus formation process appears to be now all but complete.
Indeed, without prejudging decisions that are still many months away, key ECB officials from across the policy spectrum have highlighted July as their preferred date for lift-off, along with their expectation that rates will likely be in positive territory by the end of 2022, meaning three 25 basis point hikes by then.
We expect those hikes to come at the July 21 meeting, followed by the September 8 and December 15 quarterly forecasting round meetings, with the intervening October 27 meeting as a live but much less likely option for a fourth 2022 rate hike if desired...
Market Validation
ECB MONETARY POLICY ACCOUNT
Meeting of 13-14 April 2022
Although spreads between sovereign bond yields and risk-free rates had remained broadly stable since the last Governing Council meeting, it was deemed important to address a possible resurgence of fragmentation in euro area financial conditions, if necessary, in order to ensure a continuous transmission of monetary policy throughout the euro area. Reference was made to the “separation principle”, i.e. the idea that the appropriate monetary policy stance could be set independently of the deployment of instruments designed to avoid a sudden disruption of financial markets that could be triggered by a tightening of the stance. The argument was made that flexibility should be a permanent feature of the Governing Council’s toolbox, and all of the ECB’s instruments could be adjusted within the mandate, incorporating flexibility if warranted, to ensure that inflation stabilised at the Governing Council’s 2% target over the medium term. In addition, it was recalled that the reinvestment of assets purchased under the PEPP could be used to address possible episodes of financial market tensions related to the pandemic, if needed.

Bloomberg 5/11/22

Lagarde Joins ECB Officials Signaling July as Rate Liftoff

European Central Bank President Christine
Lagarde said a first interest-rate increase in more than a
decade may follow “weeks” after net bond-buying ends early next
quarter, joining a growing crowd of policy makers signaling a
move as soon as July.
“The first rate hike, informed by the ECB’s forward
guidance on the interest rates, will take place some time after
the end of net asset purchases,” Lagarde said Wednesday.
“We have not yet precisely defined the notion of ‘some
time,’ but I have been very clear that this could mean a period
of only a few weeks,” she said in a speech in Ljubljana,
Slovenia, advocating a “gradual” normalization of monetary
policy after the initial increase.

In a series of reports starting in early March, we wrote that consensus across the European Central Bank was coalescing around an accelerated end to the Asset Purchase Program in July, followed by lift-off from its negative 50 basis point benchmark deposit rate in Q3 of 2022.

We followed that with reports in April flagging how momentum was building in the ECB to pull lift-off into the July 21 Monetary Policy Meeting immediately following the end of APP, which would then open the door to three 25 basis point rate hikes in 2022.

That consensus formation process appears to be now all but complete.

While ECB President Christine Lagarde stopped short of validating expectations for a July lift-off at the last Governing Council meeting on April 14, hewing close to an official line that lift-off could come “weeks, or months” after the end of APP, Council members have been less circumspect since.

Indeed, without prejudging decisions that are still many months away, key ECB officials from across the policy spectrum have highlighted July as their preferred date for lift-off, along with their expectation that rates will likely be in positive territory by the end of 2022, meaning three 25 basis point hikes by then.

We expect those hikes to come at the July 21 meeting, followed by the September 8 and December 15 quarterly forecasting round meetings, with the intervening October 27 meeting as a live but much less likely option for a fourth 2022 rate hike if desired.

Setting aside the energy price shocks and soaring headline inflation, eurozone core inflation climbed to 3.5% in April, well above the ECB’s 2% target. And with energy, food, and supply shock price pressures broadening, the need to tackle and bring down inflation from above back down to the 2% target is now apparent to even the most dovish of ECB officials.

Truth be told, it had been clear to many ECB officials for some time already that the conditions for liftoff have been met, despite Chief Economist Philip Lane’s forecasts to the contrary. Now even Lane, after a mea culpa on the forecasts, has come around to the need for imminent lift-off on rates.

That said, the European Central Bank still maintains an institutional dovish bias from past mishaps, and so even as it embarks on a rate hiking cycle communications from officials will stress that this is a “normalization,” and not “tightening” cycle, along with assurances that inflation, growth, and rate cycle dynamics in the eurozone are all quite different than in the United States.

That is all fine, even if a bit of a “straw man” comparison as markets have nowhere close to US pricing built in for Europe. Those assurances, however, work at odds with efforts by the ECB to stem powerful downside pressures on the euro against the dollar, a headache for the central bank as it faces commodity and import price inflation. 

On the margins, a very small number of ECB hawks have raised the possibility of lift-off even as early as at the next Governing Council on June 9, and a similarly small number of market participants seem to be fixated on a June hike. 

That would mean either upending the ECB’s long-established sequencing of rate hikes to follow the end of APP, and with it an upending of the ECB’s credibility and communications in forward guidance, or a decision on the spot to end the APP in June and hike rates at the same time.

That is not going to happen.

More intriguing is the possibility of a series of sequential 25 basis point hikes, as opposed to the leisurely, eighteen-month, 200 basis point “escalator” ride that many ECB officials seem to have in mind for this rate hike cycle. 

Banque de France Governor Francois Villeroy de Galhau, for one, has stepped in to try and shed some early light on the important question of the ECB’s views on the upcoming rate hike cycle, and its potential ultimate destination. This important topic was regrettably subsumed at the last Governing Council meeting by journalist questions over alleged reports of emergency plans by the ECB for a new facility that would step in and buy peripheral, namely Italian, bonds in case of market dislocation.

Noting that the real eurozone neutral interest rate lies probably somewhere between -1% and 0%, and with an inflation target of 2%, Villeroy estimates the nominal short-term neutral rate for the euro to be somewhere between 1% and 2% — and calls it around 1.5%.

He goes on to stress that the ECB is only embarking on a “normalization” process and has little reason to believe from here that it will actually need to “tighten” rates, meaning to take rates above this roughly 1.5% nominal neutral rate level.

That, of course, will depend on how well inflation cooperates, and with it, inflation expectations that after years of missing on the downside of the ECB’s 2% target are now beginning to drift above.

As to that emergency facility the ECB is allegedly working on to contain fragmentation in European sovereign markets, it is, as we have written before, a bit of a non-story that was ginned up by the wires.

For those who may not remember, the ECB stepped in on May 10, 2010, in the depths of the European sovereign debt crisis, to intervene directly in peripheral markets with the Securities Market Program (SMP), then established the European Financial Stability Fund (EFSF), which morphed in 2012 into the never-used Outright Monetary Transactions (OMT) program, and the robust and well-funded European Stability Mechanism (ESM), respectively.

In more recent memory, when peripheral European spreads came under pressure again, this time from a US bond market mini tantrum in March 2020, the ECB enhanced its Asset Purchase Program with a new Pandemic Emergency Purchase Program (PEPP) that gave it the freedom to buy bonds across jurisdictions, with little concern for “capital key” limitations, meaning of course a heavy overweight in Italian bonds.

As things stand, the ECB has committed to reinvesting these PEPP bonds proceeds, and is willing to continue to do so, flexibly if needed, to temper any fragmentation or dislocation across peripheral markets.  Furthermore, a version of the PEPP program can be reactivated at any time. To think that the ECB needs to reinvent the wheel, with yet another facility, is failing to listen to what ECB officials are saying, or to acknowledge their success in managing outsize market dislocations, when necessary, for over a decade.

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