ECB: The Growing Odds of Fifty

Published on July 13, 2022
SGH Insight
Markets have taken to heart European Central Bank President Christine Lagarde’s guidance to expect a modest, 25-basis point hike lift-off from the bank’s negative 0.50% deposit rate at its upcoming Governing Council meeting on Thursday, July 21.
That 25 bp lift-off, as we have written, is expected by ECB officials to be followed almost certainly by 50 basis points at their next meeting in September, with a high likelihood that at least one of the next two meetings of 2022 also results in a 50-basis point hike.
Those expectations, in particular the odds of a 50-basis point hike in July, may rise over the course of the next week, even as the ECB enters a blackout period on communications.
Our understanding is that there is strong and broad consensus across the Governing Council on the need to, at a minimum, get rates above the lower end of the ECB’s roughly 1-2% estimate for nominal neutral rates for the euro zone — in an expeditious fashion.
And so as we wrote in our last ECB report, for all the market concerns over recession and the specter of a severe energy squeeze from Russia over the winter, having come late to the hiking cycle, and with some ground to be made up before rates are “normalized,” the default mode for the ECB in the early part of the cycle will be towards 50 bp hikes, with the penciled in 25 bp lift-off essentially representing a sort of “anomaly” (see SGH 7/5/22; “ECB: Hiking Through a Slowdown”).
In such an environment, we believe the odds for a surprise 50 in July are high, and arguments for a more cautious first-rate hike are increasingly hard to justify, especially with the roll out of an anti-fragmentation backstop that will help allay concerns over an “unwarranted” blow-out in peripheral (Italian) bond spreads now slated for release also on July 21.
Market Validation
Bloomberg 7/21/22

ECB Raises Main Refinancing Rate By 50BPS to 0.5%; Est. 0.250%

European Central Bank raised its main refinancing rate more than economists expected.
Main refinancing rate raised to 0.5% (estimate 0.250%)
38 of 46 economists in Bloomberg's survey expected 0.250%

Dow Jones 7/21/22

ECB Surprises as It Hikes Interest Rate by Half Percentage Point

The European Central Bank announced a larger-than-expected interest-rate increase of half a percentage point and outlined a new plan to buy the debt of Europe's most vulnerable economies, taking bold action to protect the currency union as it navigates the twin threats of skyrocketing inflation and slowing economic growth.
The ECB's surprise move on Thursday takes its key interest rate to zero and ends the bloc's controversial eight-year experiment with negative interest rates.
It suggests that the bank's top officials are increasingly concerned about the threat of persistently high inflation in the eurozone. Officials had telegraphed for weeks that the bank would likely raise rates by only a quarter percentage point this month.
The ECB said it would continue to increase rates toward a more normal level. It also said it had created a new bond-buying program, known as the Transmission Protection Instrument, which will ensure that the bank's interest rates are transmitted smoothly across the currency union. The scale of purchases under the new program will depend on the severity of the risks, the ECB said.

Bloomberg 7/21/22

The euro rallied and European bonds extended declines after the European Central Bank raised rates by 50 basis points.
German 2-year yields rise 17bps to 0.78%

Reuters 7/19/22

European Central Bank policymakers are considering raising interest rates by a bigger-than-expected 50 basis points at their meeting on Thursday to tame record-high inflation, two sources with direct knowledge of the discussion told Reuters.
To cushion the impact of the higher borrowing costs, policymakers are also expected to announce a deal to help indebted countries like Italy on the bond market. The deal will require they stick to European Commission rules on reforms and budget discipline, the sources said.

Bloomberg 7/19/22

The euro jumped to a two-week high and
short-dated bonds slid across Europe as markets priced in a more
aggressive pace of interest-rate hikes from the European Central
Bank.
The common currency rose more than 1.2% after reports that
ECB policy makers may consider a 50-basis-point rate hike at
their meeting on Thursday, larger than the quarter-point move
signaled in June.
That led money markets to bet on almost 50% odds of a half-
point hike this week and more than a percentage point by
September. Shorter maturity bonds led a selloff, with German
two-year yields -- among the most sensitive to changes in policy
-- surging as much as 12 basis points to 0.64%.

Markets have taken to heart European Central Bank President Christine Lagarde’s guidance to expect a modest, 25-basis point hike lift-off from the bank’s negative 0.50% deposit rate at its upcoming Governing Council meeting on Thursday, July 21. 

That 25 bp lift-off, as we have written, is expected by ECB officials to be followed almost certainly by 50 basis points at their next meeting in September, with a high likelihood that at least one of the next two meetings of 2022 also results in a 50-basis point hike.

Those expectations, in particular the odds of a 50-basis point hike in July, may rise over the course of the next week, even as the ECB enters a blackout period on communications.

Our understanding is that there is strong and broad consensus across the Governing Council on the need to, at a minimum, get rates above the lower end of the ECB’s roughly 1-2% estimate for nominal neutral rates for the euro zone — in an expeditious fashion. 

And so as we wrote in our last ECB report, for all the market concerns over recession and the specter of a severe energy squeeze from Russia over the winter, having come late to the hiking cycle, and with some ground to be made up before rates are “normalized,” the default mode for the ECB in the early part of the cycle will be towards 50 bp hikes, with the penciled in 25 bp lift-off essentially representing a sort of “anomaly” (see SGH 7/5/22; “ECB: Hiking Through a Slowdown”).

In such an environment, we believe the odds for a surprise 50 in July are high, and arguments for a more cautious first-rate hike are increasingly hard to justify, especially with the roll out of an anti-fragmentation backstop that will help allay concerns over an “unwarranted” blow-out in peripheral (Italian) bond spreads now slated for release also on July 21.

That leaves an argument that a 50-bp hike could be more broadly destabilizing and surprise markets. 

This argument, in our view, and counting some of the major financial institutions as our clients, is wide of the mark, and increasingly so. Indeed, we cannot begin to count how many clients have asked over the past weeks why the ECB would not hike 50 basis points from this deeply negative deposit rate.

Furthermore, one might argue that in an environment where major global central banks need to show strong resolve in their fight against inflation, concerns over “surprising markets” with a 50-basis point hike should probably not even be a factor, certainly not a driving factor, for the ECB. While there is only one week until the July meeting, we suspect markets could very easily start to price this optionality in – assuming that even matters. 

That leaves internal consensus as the real obstacle to a 50-bp lift-off. 

Here, grumbling from some of the Governing Council members over the 25 to 50, July to September acceleration compromise path has been relegated mainly to the sidelines. That muted opposition, however, is more a reflection of a diplomatic desire not to re-open a consensus agreement rather than a reflection of any strong buy-in regarding the wisdom of hiking 25 bps when the ECB is clearly still some distance from neutral.

Indeed, while less vocal, we believe the argument for 50 bps in July has more fellow travelers within the GC than has been manifested in public speeches. It is, after all, hard to argue that it is not the proper policy response, and if anything, a potential risk point on growth in the winter or next year even while inflation remains elevated adds to the case for the ECB to front-load the “no-brainer” hikes expeditiously and normalize while it can.

As things stand, ECB officials believe that inflation should, at some point soon, hopefully peak — pointing to the drops registered already in various commodity prices. 

Europe is of course much more affected by such external inflation drivers than the US, and there are signs already that there may be some modest pullback and demand destruction on the consumption side as well that is, unfortunately, also due to high inflation.

But even if inflation as hoped does finally start to peak, ECB officials expect it will still stay at uncomfortably elevated levels for some months, perhaps as high as in the 8% range. 

Any relief that inflation may not have spiked to 10% as had been feared is of course not an argument for a go-slow start to normalization. Perhaps more to the point, there also appears to be little confidence among skeptical ECB officials that the September forecast revision round will show an improvement over an already optimistic June staff forecast penciling inflation at barely over 2% in 2024, with only the most modest of tightening.

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