The European Central Bank on Thursday is poised to increase interest rates again. Economists and fixed income specialists expect a hike of 50 basis points - following two consecutive 75 point hikes - with markets watching for official signals that point towards further rate hikes next year.
This week sees three important central bank meetings. Next to the ECB, the Federal Reserve will communicate on dollar interest rates, on Wednesday, and the Bank of England has scheduled a policy meeting Thursday at which it also is expected to announce a 50 basis point increase.
Tricky time
“These meetings come at a tricky time as rates markets have rallied sharply in recent months. US, Germany and UK 10y yields have fallen by 80bp, 60bp, 140bp, respectively since their October peaks,” said Guillermo Felices, global investment strategist at PGIM Fixed Income. “At the same time, risky assets have rallied strongly, as investors are assuming that inflation is less of a threat and that central banks can downshift on the tightening paths. This has left the market vulnerable to hawkish surprises.”
The ECB also will release key balance sheet reduction principles, with the most likely implication being a passive reduction of its standard asset purchase program holdings, starting around the second quarter next year.
Pimco portfolio manager Konstantin Veit expects the ECB will hike policy rates 50 basis points, while expecting a transition towards moving in 25 basis point increments next year, as the hiking cycle pivots from policy normalisation to policy tightening.
“There remains considerable uncertainty where a neutral policy rate for the Euro area might be, but anything between 1.25% and 2.0% in nominal terms seems plausible,” said Veit in a note to investors. “Current market pricing suggests a somewhat restrictive destination for the ECB, with a peak policy rate of 2.9% around the middle of next year.”
Downshift
Simon Harvey at Monex Europe expects the ECB to downshift the pace of its hiking cycle this week with a 50 basis points hike that will take the deposit rate to 2 percent. “With the deposit rate now closer to the upper bound of its estimated neutral range, which we estimate to be between 1-2%, the economic outlook still warrants further monetary tightening, albeit at a slower pace as to avoid exacerbating the expected economic contraction.”
Harvey, in a note to clients, pointed out that, since the ECB’s last policy meeting in October, economic growth conditions have proven more resilient than analysts expected, highlighted by the fact that Germany’s economy avoided entering recession as early as Q3.
Furthermore, inflation data has started to moderate from a potential peak in October. Germany’s headline rate fell from 10.4 percent to 10.0 percent in November, with Spain’s also continuing to moderate to 6.6 percent year-on-year from a much earlier peak of 10.7 percent in July. “Nonetheless, the eurozone’s economic outlook remains far worse than the ECB forecasted back in its last staff projections in September,” Harvey said.
Softer ECB communications
Money also noted “the recent softening” in the tone of ECB communications. “We think a 75bps hike, which would clearly take ECB policy into restrictive territory, would be too unpalatable for the ECB doves,” Harvey said. “Still tight labour market conditions suggest that core services inflation is likely to remain high over the course of 2023. The risks that persistent inflationary pressures push the ECB into a third 75bps hike therefore remains and is reflected in the swaps market with an assigned probability of 20%.”
Pimco’s Veit believes the ECB will likely transition towards moving in more conventional 25 basis point increments next year, as the hiking cycle pivots from policy normalisation to policy tightening and inflationary pressures are expected to gradually subside.
ECB economic projections outline a near term growth path with potentially a mild and short recession starting in the fourth quarter of this year, with two consecutive quarters of negative growth, followed by a recovery that gains steam during the summer and into end-2023.