Yesterday’s meeting of the European Central Bank’s (ECB) Governing Council was possibly the most hotly anticipated one of the year so far.
Market opinion was evenly divided as to whether the ECB would increase interest rates for the tenth consecutive time, or pause to take stock of the impact on the European economy of the 425 basis points (4.25%) of hiking since July last year.
What changed?
They had economic data – which the ECB had stated will be the key driver of monetary policy decisions for the immediate future – softened sufficiently to afford them the opportunity of halting the tightening cycle, or was further tightening justified to achieve their mandate of returning inflation to the 2.00% target over the medium term? A possible hint to their decision was given a day before the meeting as a press report from ’ECB sources’ revealed that their revised forecast of inflation in 2024 had been increased to over 3.00%, which saw the market immediately re-price its probability of another hike from below 50% to close to 70%.
The market was right, as the ECB elected to raise all its key interest rates by a further 25bps (0.25%) taking the main refinancing rate to 4.5%. However, the market interpreted this as a dovish hike, with European government bonds across all maturities rallying post the rate hike decision. A key driver of this was a passage in the accompanying press release which stated that “the Governing Council considers that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target.” This was interpreted by the market that peak ECB rates have now been reached. When pressed on this in the press conference following the announcement, ECB President Christine Lagarde was at pains to stress that this was based on a current assessment of economic data and financial markets and did not necessarily mean that the hiking cycle was over – future decisions would still be driven by incoming data. The decision to raise rates was not unanimous across all governing council members, but there was a “solid majority” who were in favour of raising rates.
In a fillip for peripheral European government debt markets, and in particular Italy, which has seen yield spreads over core European government debt increase over recent weeks, the ECB re-stated its commitment to continue re-investing coupons and maturity proceeds from bonds bought under its pandemic emergency purchase programme (PEPP) program until at least the end of 2024. There had been some speculation the ECB may look to start reducing its holdings of bonds bought under this program (which had been skewed toward peripheral markets) as early as the end of this year.
Revised ECB staff forecasts now have average inflation in the euro area at 5.60% in 2023, 3.20% in 2024 and 2.10% in 2025 – upward revisions to previous forecasts for 2023 and 2024, reflecting a higher path for energy prices, and downward revision for 2025. Forecasts for inflation excluding energy and food were revised down for 2023, 2024 and 2025, citing the Governing Council’s past interest rates as a key driver, an assessment that their policy is working. As a result of the cumulative tightening in monetary conditions, ECB staff have significantly lowered their growth projections for the euro area economy – though the forecasts for the next 3 years all remain in positive territory. This hit to economic growth is a necessary, if painful, condition to get inflation back to target.
So where does this leave markets?
It is now very clear that, absent a significant shock, the end of the tightening cycle in Europe is close, and we may already have reached peak rates. This should provide support to yields at the shorter end of the maturity spectrum, but the question remains as to whether the inflationary genie has truly been returned to its bottle, and whether there is sufficient term premia offered by longer dated bonds to justify investing further out. We recognise that there are likely to be further bouts of volatility in markets, as they try to second guess policy responses to economic data releases and remain well equipped to take advantage of any such periods through nimble, active management across a number of diversified investment strategies.
Focus now turns to the policy decisions of the US Federal Reserve and the Bank of England next week.
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