The ECB has decided to raise interest rates by 25 basis points. Specifically, the institution chaired by Christine Lagarde will carry out this hike at its next meeting on 9th of July, once its asset purchase programme (PEPP) ends on the 1st of July. In this way, the European Central Bank announces the first rate hike in 11 years and anticipates that there will be another hike in September, although it has not detailed the amount. Below, we leave you with the first reactions from fund managers.
Silvia Dall’Angelo, Senior Economist at Federated Hermes Limited
While the ECB did not take any action today, the outcome of today’s meeting had a distinctly hawkish tone. The Governing Council deemed that the conditions that should be satisfied to start a hiking cycle have been met and updated its forward guidance to set out policy normalisation in the coming months.
Net asset purchases will end at the very beginning of July, paving the way to rates lift-off later in the month. Inflation concerns were front and centre. While the ECB preannounced the size of its July hike (0.25%), they left the door open to a larger rate increase in September if the medium-term inflation outlook does not improve.
Overall, it makes sense for the ECB to embark on a gradual normalisation path. Most recent data – the PMIs surveys, notably – suggest the recovery has continued, despite the shock from the war. Inflation has systematically surprised to the upside in recent months; headline inflation hit a new record high of 8.1% in May, with core inflation also overshooting the 2% target by a large margin. The recovery in the labour market has continued at a fast pace, resulting in solid negotiated wages in the first quarter of this year, alerting to the risk of second-round effects. In addition, updated staff projections showed inflation running above target throughout the forecasting horizon, with core inflation projected at 2.3% at the end of the horizon in 2024.
Yet, the ECB’s tightening cycle is unlikely to be plain sailing. The central bank will have to walk a fine line in the face of an adverse, ever evolving growth-inflation trade-off. While inflation might prove stickier and more pervasive than expected, which would call for a more aggressive response by the central bank, downside risks still dominate the economic outlook. The war in Ukraine is still ongoing and escalations – resulting in the disruption of gas provision and energy rationing – could still happen. In addition, as interest rates increase, market fragmentation is likely to emerge, with peripheral sovereign bonds likely to come under additional pressure.
The flexibility of PEPP reinvestments appears as an insufficient tool to deal with such issues and the design of any specific anti-fragmentation tool is a challenging task – which is ongoing behind closed doors. In general, the extraordinary degree of uncertainty surrounding a complicated outlook is a challenge for the apparently straightforward ECB’s forward guidance. Optionality, data-dependence, gradualism and flexibility will indeed remain key as the ECB normalisation process progresses.
Anna Stupnytska, Global macroeconomist at Fidelity International
At its June meeting the ECB was expected to set the stage for monetary policy normalisation which it has delivered in a number of ways. The ECB announced that APP purchases will be concluded as of 1 July 2022. The statement also laid out the path for policy rates, starting with a 25bp hike in July, followed by another hike in September, with the size of that rate increase depending on the updated medium-term inflation outlook.
The path after that is expected to be “gradual but sustained”. The statement also reiterated strong commitment to adjusting PEPP reinvestments in the event of renewed market fragmentation but provided no detail on a potential spread management tool.
Continued upward surprises in European inflation and evidence of its persistence, as well as the Fed’s ‘hostile’ tightening path, are raising pressure on the ECB to frontload policy normalisation. While the risk of de-anchoring in longer-term inflation expectations does not seem high, rapid widening in policy differentials versus the Fed does present challenges for the ECB, with EURUSD re-pricing in the spotlight. But doing too much too soon would arguably be a riskier strategy for the ECB in light of a weakening growth backdrop as well as the risk of peripheral spread fragmentation.
The headwinds related to the war in Ukraine, China’s zero-covid policy and tightening in global financial conditions will continue weighing on the Eurozone’s growth, likely leading to a recession over the next few months. The timing and magnitude, however, largely depends on further developments in these three areas, as well as the fiscal policy response to the energy shock. We believe it will be difficult for the ECB to execute a rapid return of policy rates into positive territory given the growth and fragmentation constraints and the tightening path will be less steep and shorter than what is currently implied by market pricing. While a new spread management tool might help prevent spread fragmentation, it will not be a silver bullet as will likely bring a new set of issues for the ECB, including moral hazard.
Nicolas Forest, global head of fixed income at Candriam
Three important decisions have been made with real market implications. We have had a hawkish message from the ECB that it considers high inflation is becoming a major challenge. Its new projections have dramatically revised inflation to reach 3.5% in 2023 and 2.1% in 2024. The projection for long-term inflation above 2% is unprecedented and reflects a major change within the ECB.
In this context the government council has decided to end net asset purchases under its APP as of 1 July 2022.This is the first step of the monetary policy normalisation. The end of quantitative easing is a clear threat for financial stability. The Italian spread has significantly widened. Even if markets are speculating about a spread control framework, no additional tool has been presented yet. The risk of market fragmentation is therefore significant and there is no doubt that the ECB should offer details about a potential new tool in the coming months.
The ECB will start to hike its key interest rate by 25bps in July and potentially 50bps by September. This is the end of negative rates and the beginning of a gradual and sustainable path. This is a major challenge to start the normalisation process at this point of the cycle.
Lower liquidity, less bonds purchases and higher rates is a perfect menu for a hot summer. It’s important to stay selective and flexible.
Ulrike Kastens, Economist Europe at DWS
After more than 11 years, the ECB plans to raise key interest rates for the first time in July. Surprisingly the date and level have already been fixed in advance, as key interest rates are to be raised by 25 basis points. This deprives the ECB of any room for maneuver for the upcoming meeting.
This also raises the question of why the ECB has not already taken this step today. Furthermore, it plans to raise key rates in September. At 50 basis points, it could then be more substantial than in July, if the current inflation trend persists, which is to be assumed.
The ECB anticipates that a gradual but sustained path of further increases in interest rates will be appropriate beyond September 2022. At this point, this seems to be merely a compromise within the ECB’s governing council. But how long can they stick to it? In our opinion, the ECB’s narrative is not conclusive. On the one hand, it itself observes a broadening of the inflation trend and sees signs of wages picking up, thus calling into question its own projections for the core rate of 3.3 percent for 2022 and 2.8 percent for 2023. In our view, inflationary pressures are likely to be more persistent, forcing the ECB to raise rates more rapidly and aggressively. The U.S. Federal Reserve could be a role model in this respect.
Wolfgang Bauer, Fund Manager at M&G’s Public Fixed Income Team
The ECB paves the way for a 0.25% increase in interest rates at their next meeting and a sustained path of further hikes thereafter. Keeping interest rates at their historic lows for any longer, against the backdrop of rampant inflation in Europe, would have been very hard to justify. Ultimately, the ECB’s credibility is on the line.
The central bank is already attracting criticism for not having started to normalise monetary policy much earlier. That’s easily said with the benefit of hindsight, of course. However, due to the complex economic dynamics throughout the pandemic, for which there was no blueprint to follow, it’s probably wise to cut the ECB some slack and refrain from overly harsh criticism.
While the ECB’s comments about future rate hikes dominate the headlines today, one should not underestimate the significance of the impending end of net asset purchases. Throughout the past years, asset purchase programmes have been the ECB’s primary tool to bolster sentiment and thus reinstate financial market stability in moments of crisis. Without net purchases, markets operate without a safety net, which could lead to periods of heightened volatility going forward.
The ECB left the door open with regards to resuming purchases under the pandemic emergency purchase programme (PEPP) in the event of renewed market fallout related to the pandemic. Considering the inflation backdrop, I reckon the bar is very high to backtrack from the asset purchase exit, though. In my view, it would need a major deterioration of economic fundamentals and a precipitous market correction to put asset purchases back on the agenda. So, in a way, the central bank put is far out-of-the-money.
Alberto Matellan, Chief Economist at MAPFRE AM in Madrid
The ECB has three different enemies to fight at the same time: 1) the symptom, which is the evolution of spreads. So far, not yet as alarming as in other moments, 2) the real sickness, which is the indebtedness and lack of growth of some European countries. This can be traced back to very origin of the European Union, but particularly to monetary policies carried out since 2010. And 3) inflation itself, which risks amplifying the two above.
There is no obvious solution. Now, from the comfortable position of looking at the rear view mirror, it seems that the ECB measures devoted to support financial stability in the period 2010-2021 might have been ill advised. But it is equally true that such measures were designed to support the situation temporarily until a deeper solution came from the political arena.
Although all of the above looks scary, we are still far from a full fledged blow up. The current consensus points to a moderation of inflation in late 2022 and a limit to ECB hikes in the range of 1.5%.
Lale Akoner, Senior Economist BNY Mellon Investment Management
As expected, the ECB will move rates back into positive territory this year, ending an 8-year negative rate and QE policy era, signaling a 25 bp rate hike in July and a possible 50-bp increase in September. The main question in the euro area revolves around what the ECB will do to contain rising spreads on euro area periphery sovereign bonds as financial conditions tighten.
The response from the periphery does complicate the ECB’s policy function but we think they will be attentive to risks in the periphery.
Most notably, during today’s decision, there were no details on how the ECB would deal with fragmentation issues in the continent, which led to periphery spread widening to 2-year highs and a dovish interpretation from the market due to the possibility of future fiscal support to fight fragmentation. Latest composite PMI index remained above 50 mark which does suggest continued economic growth. Latest German business climate index also indicated optimism and remain higher than levels during eurozone’s sovereign debt crisis.
The ECB takes comfort in continued resilience of economic activity when deciding to raise rates in July. That said, the ECB will likely remain data dependent to gauge whether tight policy risks demand destruction and recession. In markets, we expect bond yields to rise and curves to flatten. We also expect the EUR to remain weak against the USD as the ECB is still behind the curve in tightening policy vs the FED and face more intense stagflationary forces compared to the US economy