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MARKETS
July 22, 2022

ECB—Testing Times

By Richard A. Booth

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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.

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