skip navigation

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

July 22, 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 2022. This publication is the property of Western Asset and is intended for the sole use of its clients, consultants, and other intended recipients. It should not be forwarded to any other person. Contents herein should be treated as confidential and proprietary information. This material may not be reproduced or used in any form or medium without express written permission.
Past results are not indicative of future investment results. This publication is for informational purposes only and reflects the current opinions of Western Asset. Information contained herein is believed to be accurate, but cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice. Employees and/or clients of Western Asset may have a position in the securities mentioned. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. It is your responsibility to be aware of and observe the applicable laws and regulations of your country of residence.
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 Licence 303160. Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary Authority of Singapore. Western Asset Management Company Ltd is a registered Financial Instruments Business Operator and regulated by the Financial Services Agency of Japan. 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.