European Central Bank officials, on two key fronts, face a much easier decision than their counterparts at the US Federal Reserve when the Governing Council convenes on Thursday for its March monetary policy meeting.
First, when measured against their respective outlooks for core inflation this year, a reasonable metric in our view, the ECB is not nearly where the Fed is on rates, and the ECB’s long-signaled decision to hike 50 basis points on Thursday, from 2.5% to 3.0%, is from an economic and monetary policy perspective still a clear no-brainer.
For their respective upcoming meetings, while there can be plenty of debate over whether the Fed has already overtightened, or needs to hold, or needs to tighten further on rates, with Euro area core inflation running well above 5%, there is no reasonable basis whatsoever to argue that the ECB will have “overtightened” at 3% if they go ahead as planned with a 50 bp hike.
Indeed, the staff forecasts as you may recall we expect will incorporate the significantly higher rates that were priced into markets as recently as early last week, before the rapid SVB and Signature Bank wobble, bankruptcies, and market meltdown, to show an inflation outlook that is closer to the ECB’s medium term target of 2% than December’s forecasts. Those December forecasts, just three months ago, galvanized ECB President Christine Lagarde to push for a “significant” repricing in market expectations for rates, and these higher market rates will only just allow for the staff to finally not have to raise its inflation forecasts yet again.
The wildcard is the contagion now from across the Atlantic on the financial stability side, in the near term, and in the more medium term a question of whether and how much the US banking sector wobble is the harbinger or even accelerant of a downturn in lending and real economy activity that will wash over onto Europe’s shores from the global tightening cycle.
The answer to the medium-term financial contagion question is yet unclear but given the monetary stance of the ECB (see point 1), is largely moot to the decision on Thursday on whether to hike by 50, 25, or not at all. Those potential risks can easily be acknowledged by a Governing Council that will leave its next decision, in May, entirely “data dependent” as opposed to signaling another 50 bp hike to follow, to 3.5%.
And while markets had by last week priced a near certainty of a third 50 bp hike in May, we had written that the ECB was leaning towards leaving its optionality open after this Thursday, even if we felt that another 50 bp hike was where they would likely end up on a forecast that incorporated 4% short term rates into its inflation projections and outlook. In other words, it’s not like there needs to be much hawk-dove drama (we called it a “Manichaean Struggle”) to back away from explicitly signaling another 50 bp hike to follow this one.
As to the immediate financial stability contagion, the ECB is also in a far easier decision making position than the Fed in that its banking sector is generally more reliant on traditional, if not more boring, lending as a source of revenue than their high-flying counterparts in the United States. Indeed, the proverbial dog that has not barked, and which is not barking, for the European banking sector through this extraordinarily rapid rate hike cycle is the much-ballyhooed exposure to Italian BTPs, and sovereign risk, and all of the legacy 2012 problems.
That said, European banking stocks have been one of the favorite macro trades for investors recently, and we think the Silicon Valley and Signature Bank issues are emblematic of problems that are deeply entrenched in the US banking system and investment culture writ large.
When markets started to price in late last week increasing odds of an imminent collapse of the California based Silicon Valley Bank, the largest US bank failure since the 2008 Global Financial Crisis, the strains were explained in part as a result of SVB’s “idiosyncratic” situation.
That was, in essence, SVB’s exposure to the high-flying tech sector, compounded by management’s decision against this highly interest rate sensitive loan book and deposit base to grab for yield in the equally rate sensitive mortgage bonds, which then all proceeded to collapse in value as the Federal Reserve finally started to get serious about hiking rates to tackle inflation.
For markets, the real problem arose with the weekend bailout that included a shotgun resolution simultaneously of the New York based Signature Bank along with California’s SVB.
Signature, it turns out, had gotten in similar dire straits on an asset-liability mismatch through exposure to the crypto markets, which Congress and regulators have often threatened to regulate, but which for reasons we will leave unsaid they have failed to do yet.
Greed and reckless behavior, once systemically entrenched, will manifest in many different forms.
Today markets, and far more worrisome depositors, are concerned that an entire swathe of small or middle tier American banks may also be similarly exposed out on the risk curve.
This is, of course, the first financial crisis in memory with inflation as a real problem, yet some analysts and banks are already calling for a rate cut at this meeting or soon after by the Fed! Likewise, traders are chomping at the bit to invest in the next bank that might be bailed out of its equity stress by the authorities, as the Fed, FDIC, and Treasury postpone the day of reckoning on marking to market these books to avert a systemic and disastrous run on banks.
It all simply reinforces and confirms that twenty-five years of policy malpractice, from elected officials to corporate leaders to monetary and fiscal authorities quick to take the short sighted and politically popular choice, has fostered a psychology of risk taking and greed that will take another generational shock to root out.
Or as my builder used to tell me after the financial crisis, in the word of his grandpa, “you can’t pretend that you’re surprised when the dog eats the steak you left sitting out on the kitchen table.”
It will be a tough space for this Fed to navigate – we never said it would be easy. For its part, we expect the ECB will for now stay the course, with a cautious eye on US financial markets.
President and CEO
SGH Macro Advisors, LLC