Macro: Sandcastle economics
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The ECB will choose inflation over the economy at this week’s monetary policy meeting
Althea Spinozzi
Head of Fixed Income Strategy
Summary: The ECB will stick to its hawkish bias despite recent Eurozone economic data pointing to a fast deterioration of the bloc's economy. The medium-term symmetrical inflation target framework introduced in 2021 allows the central bank to act forcefully in case of recession. Therefore, the ECB will likely bring the deposit rate to 4% by September or October and start its rate-cutting cycle by the second quarter of 2024. That means more flattening of the German yield curve as 2-year Schatz yields move towards 3.5% and 10-year Bund yields adjust lower amid increased chances of a recession.
Thursday's ECB rate hike is taken for granted. However, the market is starting to doubt that the central bank will be able to hike rates again in the fall.
Data indicates we are going towards a recession. Monday’s German manufacturing PMI dropped to 2008 lows. Today’s ECB’s Bank Lending Survey showed that credit standards tightened further and that demand for loans decreased sharply in the second quarter of 2023.
Yet, inflation remains a problem with the Eurozone headline and core CPI at 5.5%. Not only, but on Friday, economists expect the German monthly CPI to show a 0.3% pick up in prices in July, which, if annualized, returns a figure almost double the central bank's target.
The question is whether the Governing Council will feel confident to continue to hike rates after this week’s meeting, bringing the peak terminal rate to 4%.
Hence, we see three possible scenarios playing out:
- Neutral meeting: 25bps rate hike, balance sheet policies unchanged. Indications of another data-dependent rate hike if needed.
- Hawkish meeting: 25bps rate hike, balance sheet policies unchanged. Lagarde focuses on wages, indicating that at least one more rate hike is warranted to fight inflation.
- Dovish meeting: 25bps rate hike, balance sheet policies unchanged. Lagarde signals that this might be the last rate hike and that inflation will continue to fall as economic activity slows.
The market widely expects the ECB to remain neutral and data-dependent (option 1). However, there is a chance that ECB will stick its guns with a hawkish message (option 2).
The reason for that lies within the medium-term symmetrical inflation target concept introduced by the ECB in 2021. According to such a framework, inflation is equally undesirable when it rises above or drops below the 2% target. With "medium term," the central bank refers to the fact that it will not focus on short-run inflation dynamics, in which deviations are inevitable.
Although the ECB inflation target has been raised within the new framework (before, the inflation target was "below, but close to, 2%”), adopting such a strategy was essentially a dovish move. Indeed, it is changing how the central bank looks at the effective lower bound rate -the concept that policy rates cannot drift too far into negative territory while there is no cap regarding how high the ECB can raise them. In short, the ECB has assured that in a recession, where recovery is slow, it can forcefully cut rates and prolong accommodative monetary policies to avoid persistently low inflation, as we have experienced in the past ten years.
The above leads us to think that the ECB might prefer to hike now and cut aggressively later because they need to solve a problem first before jumping onto the other. Hence, unless the economy is in a dire state, a peak ECB terminal rate of 4% remains in the cards, and the ECB will prefer to stick to its hawkish stance rather than show its dovish fears.
What are the short-term consequences of a hawkish ECB?
More flattening of the German yield curve. If the ECB sticks to its hawkish stance, the market will price another rate hike in September or October. That means that 2-year Schatz yields will resume their rise towards 3.5%. However, the belly of the curve and long-term yields might adjust lower as the chances of an imminent recession increase. Bond futures will need to advance rate cut expectations, moving the first rate cut from June to April next year.
The periphery is to outperform core European sovereigns.
Similarly to what we have done with US Treasuries, we calculate EU sovereign bonds' total performance considering capital and income gains from holding these securities until the end of this and the following year. To do that, we assume that economists weighted average yield forecasts are realized (source: Bloomberg.)
Considering a holding period from today until the end of 2023, 10-year Spanish Bonos are estimated to return more than 4%. Looking at 2-year EU sovereigns, Italian BTPs are expected to return 2.7% by year-end, thanks to their coupon of nearly 3%.
Yet, if the holding period is increased to the end of next year, in the 2-year Italian BTPS are expected to overperform peers returning more than 7% thanks to their high coupon. When looking at 10-year sovereign, Spanish Bonos remain the most profitable, expected to return more than 10%.
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