Financial markets expect a further increase of 140 basis points in European Central Bank interest rates by the end of the year, suggesting a steady path of increases of half a percent per six-weekly meeting. Worsening economic conditions in the coming months could however lead to an early shortening of the tightening cycle. It is balancing on a thin rope, investors and strategists tell Investment Officer.
The ECB on Thursday announced it will raise interest rates by half a percentage point, a bigger move than the 25 basis points expected. Furthermore, the new crisis instrument TPI will have to reduce the rising interest rate differentials between countries in the eurozone. “The ECB sets the pace, but this strategy has considerable risks,” noted one observer.
Balance between inflation and recession
Patrick Moonen, chief multi asset strategist at NN Investment Partners, says the ECB’s determination means that “it will act as if the economy is moving towards a high inflation regime until there is clear evidence to the contrary”.
“The evidence for this is a clear and broad-based decline in inflation momentum. Because there is a long time lag between monetary policy and its effect on inflation, and because growth is already slowing, this strategy carries a significant risk that central banks will overreach and push the economy (deeper) into recession,” Moonen said.
Paul Jackson, head of asset allocation research at Invesco, thinks it will be a difficult path for the ECB to follow. “The ECB has only just embarked on a tightening process as it weighs the risk of both inflation and recession,” said Jackson.
“The partial resumption of gas deliveries through the Nord Stream 1 gas pipeline from Russia is a reminder of how vulnerable Europe may be to a disruption in gas flows in the coming months.” Markets will remain volatile, according to Jackson.
Transmission Protection Instrument
While there was earlier discussion about the dampening effect of a larger interest rate hike and the negative consequences for highly indebted countries in the eurozone periphery, the ECB has now found a solution. To protect the periphery, and Italy in particular, from the negative effects of higher interest rates, the ECB is now introducing the “Transmission Protection Instrument”, TPI. A new buying programme with the aim of “ensuring that the impact of monetary policy reaches the entire euro area,” said ECB president Christine Lagarde on Thursday,
The main risks are the sustainability of Italy’s public debt - more than 150 percent of GDP, and financial market confidence in its sustainability. The ECB said the TPI can be activated to “counter unwarranted disorderly market dynamics that pose a serious threat to the transmission of monetary policy throughout the euro area”.
Ulrike Kastens, economist for Europe at asset manager DWS, expects the ECB to “not use the new instrument lightly”, even though “the conditionality should give it more support to use it”. However, it is ultimately up to European countries to comply with the rules fiscally, Ulrike stresses, “because only then can they also benefit from asset purchases”.
Crisis in Italy
The policy instrument was adopted on the same day that of the departure of former ECB president Mario Draghi as Prime Minister of Italy. Draghi’s resignation caused political uncertainty in the largest peripheral economy and widened the spreads between Italian and German interest rates before the ECB announcement.
The spread between Italian and German government bonds rose to 243 basis points at the opening of European markets, before falling back to 237 at the time of writing. The FTSE MIB, the main index of the Italian stock exchange, ended the trading day with a limited loss of 0.70 percent. Pressure on spreads and Italian stocks did not ease after the TPI announcement.
Dave Chappell, senior portfolio manager at Columbia Threadneedle Investments, said the collapse of Italy’s 67th cabinet since World War II could not have been worse timed. It could become a significant obstacle to the smooth transmission of monetary policy, in his view.
“On repeated questioning during the press conference, President Lagarde did not dare reveal whether a tightening of financial conditions, driven by self-destructive domestic policies, would justify the application of the new TPI. At this stage, given the lack of contagion from other peripheral yields, we do not think this is the case,” he said.
Market not yet reassured
NNIP’s Moonen said it remains to be seen whether the details of the TPI programme known so far can calm investors’ nerves. In an ideal world, the ECB would announce a credible liquidity backstop with unlimited firepower. In that case, no investor would even think about standing up to the ECB and the ECB would not have to buy any bonds.
“In the real world, however, the ECB faces significant political constraints,” he said. “As its 23-year history clearly shows, these can only be overcome if the pressure to do so is great enough. So the last word on the liquidity buffer may not have been said yet.”