skip navigation
Blog

Stay up to date on timely topics and market events. Subscribe to our Blog now.

MARKETS
22 July 2022

ECB—Testing Times

By Richard A. Booth

Stay up to date on timely topics and market events. Subscribe to our Blog now.

The market has been pricing 100 bps of hikes from the European Central Bank (ECB) between July and September of this year for some time, with market expectations shifting earlier this week to price the possibility of a 50-bp hike in July at roughly 50%, despite the Governing Council’s previously stated intention to start with a 25-bp hike. Thus, the first ECB rate-based policy tightening since 2011, announced on July 21, was a clear signal of intent to ward off the current high level of inflation and to deliver the blueprint of a new policy tool designed to ensure the effective transmission of monetary policy across all eurozone countries. There are two ways to think about the 50-bp hike.

First, it may be considered as a concession to the hawks for the speedy approval of the Transmission Policy Instrument (TPI) and/or a belief in the effectiveness of this tool, thus allowing a larger first move. Interestingly, the punchier start to the tightening process did not result in higher expectations for the peak ECB rate (still around 1.50%) and the pricing for the next meeting in September moved closer to 50 bps rather than the 75 bps priced pre-meeting. We believe this was a result of ECB President Christine Lagarde’s clear message that the conditional forward guidance given in June no longer applies and policy decisions will follow a meeting-by-meeting approach. This will likely keep front-end volatility elevated—with a more meaningful slowdown in activity or a worsening in the energy situation skewing the next policy decision lower or higher spot inflation pushing it higher.

Second, regarding the TPI, this was always going to have to balance potency with legality concerns. Hence purchases are not restricted ex-ante (i.e., unlimited firepower), with the scale conditional on the risks facing policy transmission. The eligibility criteria cite four main conditions: EU fiscal framework compliance, no severe macroeconomic imbalances, fiscal sustainability and sound macroeconomic policies. We believe that these are relatively easy to fulfill but it’s not unreasonable to think that a new government with unorthodox macroeconomic policies could lead to some questioning its eligibility.

Markets will always want clear indications about what could trigger the decision by the ECB to activate the new tool. The language, as you might expect, was less than clear. TPI “can be activated to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area.” The two key words are “unwarranted” and “disorderly.” For example, should bank-lending criteria tighten markedly in one country, this could clearly pose a threat to monetary policy transmission. Deciding whether this is unwarranted is trickier. Perhaps if that country had fewer bad loans than the eurozone aggregate?

Regarding the term disorderly, was the 36-bp intraday move in German government bonds seen last month as such? When markets feel unsure about triggers they typically seek to push the boundaries to gauge the policy response. Yesterday’s announcement of new elections in Italy could provide added impetus to do so, possibility leaving the spread between the yields of Italian and German government bonds vulnerable to further widening.

Our view on the likely interest rate decisions for the upcoming meetings is broadly in line with current market pricing and hence we have moved to a more neutral duration stance in global portfolios, having been underweight in the first half of the year during which yields have moved substantially higher. With volatility elevated given the uncertain economic outlook, and with the market quite possibly deciding to test where the trigger points for action under TPI may be, we expect to continue to adjust our duration and curve stance.

© Western Asset Management Company, LLC 2024. The information contained in these materials ("the materials") is intended for the exclusive use of the designated recipient ("the recipient"). This information is proprietary and confidential and may contain commercially sensitive information, and may not be copied, reproduced or republished, in whole or in part, without the prior written consent of Western Asset Management Company ("Western Asset").
Past performance does not predict future returns. These materials should not be deemed to be a prediction or projection of future performance. These materials are intended for investment professionals including professional clients, eligible counterparties, and qualified investors only.
These materials have been produced for illustrative and informational purposes only. These materials contain Western Asset's opinions and beliefs as of the date designated on the materials; these views are subject to change and may not reflect real-time market developments and investment views.
Third party data may be used throughout the materials, and this data is believed to be accurate to the best of Western Asset's knowledge at the time of publication, but cannot be guaranteed. These materials may also contain strategy or product awards or rankings from independent third parties or industry publications which are based on unbiased quantitative and/or qualitative information determined independently by each third party or publication. In some cases, Western Asset may subscribe to these third party's standard industry services or publications. These standard subscriptions and services are available to all asset managers and do not influence rankings or awards in any way.
Investment strategies or products discussed herein may involve a high degree of risk, including the loss of some or all capital. Investments in any products or strategies described in these materials may be volatile, and investors should have the financial ability and willingness to accept such risks.
Unless otherwise noted, investment performance contained in these materials is reflective of a strategy composite. All other strategy data and information included in these materials reflects a representative portfolio which is an account in the composite that Western Asset believes most closely reflects the current portfolio management style of the strategy. Performance is not a consideration in the selection of the representative portfolio. The characteristics of the representative portfolio shown may differ from other accounts in the composite. Information regarding the representative portfolio and the other accounts in the composite are available upon request. Statements in these materials should not be considered investment advice. References, either general or specific, to securities and/or issuers in the materials are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendation to purchase or sell such securities. Employees and/or clients of Western Asset may have a position in the securities or issuers mentioned.
These materials are not intended to provide, and should not be relied on for, accounting, legal, tax, investment or other advice. The recipient should consult its own counsel, accountant, investment, tax, and any other advisers for this advice, including economic risks and merits, related to making an investment with Western Asset. The recipient is responsible for observing the applicable laws and regulations of their country of residence.
Founded in 1971, Western Asset Management Company is a global fixed-income investment manager with offices in Pasadena, New York, London, Singapore, Tokyo, Melbourne, São Paulo, Hong Kong, and Zürich. Western Asset is a wholly owned subsidiary of Franklin Resources, Inc. but operates autonomously. Western Asset is comprised of six legal entities across the globe, each with distinct regional registrations: Western Asset Management Company, LLC, a registered Investment Adviser with the Securities and Exchange Commission; Western Asset Management Company Distribuidora de Títulos e Valores Mobiliários Limitada is authorized and regulated by Comissão de Valores Mobiliários and Brazilian Central Bank; Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services License 303160; Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services License for fund management and regulated by the Monetary Authority of Singapore; Western Asset Management Company Ltd, a registered Financial Instruments Business Operator and regulated by the Financial Services Agency of Japan; and Western Asset Management Company Limited is authorised and regulated by the Financial Conduct Authority ("FCA") (FRN 145930). This communication is intended for distribution to Professional Clients only if deemed to be a financial promotion in the UK as defined by the FCA. This communication may also be intended for certain EEA countries where Western Asset has been granted permission to do so. For the current list of the approved EEA countries please contact Western Asset at +44 (0)20 7422 3000.