investment insights

Risks in Europe finely balanced as ECB raises rates

Risks in Europe finely balanced as ECB raises rates
Samy Chaar - Chief Economist

Samy Chaar

Chief Economist
Bill Papadakis - Macro Strategist

Bill Papadakis

Macro Strategist

Key takeaways

  • High inflation has forced the ECB to raise interest rates by 50bps – even amid political instability, weak growth and a far-from-resolved energy crisis
  • Although the rate hikes will be somewhat more front-loaded than we previously thought, we still expect the hiking cycle to peak with the deposit rate at 1.25% in early 2023 – with monetary policy stance turning neutral but not restrictive
  • The ECB’s new Transmission Protection Instrument tool, designed to limit spread widening, eased some market concerns – although Italian political instability and potential legal challenges pose non-negligible risks.

Europe is under pressure on multiple fronts – and the timing has been terrible for the European Central Bank. Mario Draghi’s resignation as Italian Prime Minister came the same day the ECB raised interest rates for the first time since 2011, and by a larger than expected 50 basis points. Signs of market strain – notably widening spreads between German and Italian sovereign debt – had already triggered an emergency ECB meeting in June, and a new ‘anti-fragmentation’ tool was announced on 21 July. Meanwhile, relief over Russia’s decision to restart gas flows via the Nord Stream 1 pipeline do not spell an end to Europe’s energy crisis, even if it makes the worst-case scenarios somewhat less likely. Pipeline flows at just 40% of capacity and still insufficient storage levels pose the risk of a serious winter squeeze.

Relief over Russia’s decision to restart gas flows via the Nord Stream 1 pipeline do not spell an end to Europe’s energy crisis, even if it makes the worst-case scenarios somewhat less likely

Inflation forces the ECB’s hand

The ECB had little choice but to raise rates, even amid weakening growth, political instability, and a largely supply-led spike in inflation (higher food and energy prices linked to the war in Ukraine). With headline inflation now running at 8.6%, and price pressures broadening out across more areas of goods and services, the ECB needed to act to prevent expectations of future inflation from rising too high. Except for the Bank of Japan, the ECB is the last major developed market central bank to raise rates. Its policymakers have been relatively slow to respond to rising inflation, and want to avoid falling too far behind the curve.

In implementing a 50bps hike, the ECB has proved that it is willing to take bold action in pursuit of price stability, given the deterioration in the medium-term inflation outlook. It has now dropped its typical forward guidance and will be taking a meeting-by-meeting approach to the path of future rate rises, where President Christine Lagarde confirmed that further hikes will be appropriate.

 

A shallower hiking cycle

We now expect the ECB to front-load more of its rate hikes, following in the path of the US Federal Reserve. Our expectation is for another 50bp increase at its next meeting, in September. Overall, however, we still expect a much shallower hiking cycle in Europe than in the US. We believe that the ECB’s ‘terminal’ or peak rate will be 1.25%, reached in early 2023 – a level at which we judge monetary policy to be roughly neutral, i.e. neither actively encouraging nor restricting growth. This is meaningful in a context where rates started at -0.5% (pre-July’s meeting), and have been in negative territory for eight years. Still, this peak in European interest rates is nowhere near the 3.75% terminal rate we expect in the US. Market expectations have also seen a material repricing lower in recent weeks.

We now expect the ECB to front-load more of its rate hikes. Overall, however, we still expect a much shallower hiking cycle in Europe than in the US

This lower level of rates reflects the fact that the majority of Europe’s inflation is imported, and therefore largely beyond the ECB’s control, and that domestic demand is still below pre-pandemic levels, with few signs of overheating in the labour market.

Amid political turmoil in Italy, markets were also eagerly awaiting the announcement of an ‘anti-fragmentation’ tool, designed to prevent spreads between core and peripheral sovereign bonds from widening too far, thus limiting the effectiveness of monetary policy. The ECB had to be convincing here, with a double blow of rate rises and Mario Draghi’s governing coalition collapsing leading Italian bond (BTP) spreads over German Bunds to widen – having risen by around a quarter in July alone – from 1.85 to 2.33 percentage points. Italian bonds are likely to remain under some pressure until clarity emerges on the political front, with general elections scheduled for 25 September.

Fighting fragmentation

Following the announcement, the ECB now has two tools to limit fragmentation (a third potential one via outright monetary transactions, or OMT, has never been used and looks effectively redundant given the strict conditions attached). The first is flexible reinvestment from its existing pandemic emergency purchase programme (PEPP), although details on what flexibility means are still lacking. The second is its new Transmission Protection Instrument (TPI), which is another way for it to purchase primarily government bonds. On the plus side for markets, TPI purchases can in principle be unlimited, and have no specific conditions attached, other than “to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy.”

However, in order to make a purchase under the TPI, the country issuing the debt must meet four criteria: compliance with the EU fiscal framework; absence of severe macroeconomic imbalances; sustainability of public debt; and sound and sustainable macro policies. The TPI may potentially be subject to legal challenge, in the event that it is viewed as going beyond the mandate of monetary policy with the central bank directly financing governments.

The ideal scenario for the ECB is that the TPI is never activated. However, in the wake of Italy’s government collapse, rising political uncertainty certainly makes a scenario of sharply widening Italian spreads more likely. We would expect even a right-wing government with eurosceptic tendencies to avoid openly breaching the EU fiscal framework and Brussels budget recommendations in a way that puts the ECB’s willingness to activate the TPI into question.

We would expect even a right-wing government with eurosceptic tendencies in Italy to avoid openly breaching the EU fiscal framework and Brussels budget recommendations

Still, this is a downside scenario of non-negligible probability. Another question remains over whether the purchases will be ‘sterilised’, or offset to keep the money supply stable. This remains unclear for now, although the ECB would want to avoid a persistent expansion of its balance sheet because of TPI purchases. And while a credible TPI should mean less stress in peripheral bond markets, it will do nothing for Europe’s broader macroeconomic strains: a supply shock in energy and food, and demand that has yet to rebound from the blow dealt by Covid. 

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