Pressed by persistently high inflation in the eurozone, the European Central Bank on Thursday may opt to double up on the 25 basis point rate hike that it has flagged already. Financial markets are increasingly bracing themselves for such a major increase, citing among others the euro’s recent weakness against the dollar.
In Tuesday’s trading, the euro jumped back above 1.02 dollars amid market talk of such a bigger-than-anticipated rate hike. Eurozone inflation, as measured by Eurostat’s Consumer Price Index, on Tuesday was confirmed at 8.6 percent for June, up from 8.1 percent in May. Due to surging fuel and food prices inflation is expected to remain high in the coming months.
"We are looking for the ECB to abandon its forward guidance and hike the deposit rate by 50bp on Thursday because inflation conditions have deteriorated, the growth outlook won’t allow the ECB to hike rates for an extended period of time and thus requires a front-loaded hiking cycle, and the ECB’s hiking cycle is starting from such a low base," said Simon Harvey, head of FX analysis at Monex Europe.
The ECB will raise interest rates on Thursday for the first time since 2011 in an effort to quell rising prices in the eurozone and bring inflation back under control at a moment when Europe faces the prospect of a recession, political turmoil in Italy is heating up and Russia may decide to keep the valves on its gas export pipeline to Germany closed.
In her high-profile speech at the 28 June ECB Forum in Sintra, Portugal, ECB president Christine Lagarde clearly flagged that the ECB will raise its three key interest rates by 25 basis points on 21 July, and that another hike - possibly 50 basis points - foreseen for its September meeting.
Inflation remains high post-Sintra
ECB officials have not spoken publicly since Lagarde’s Sintra speech. During these three weeks, fresh inflation data shows the costs of living in the eurozone continued to increase. Eurozone inflation has exceeded the ECB’s inflation target of 2 percent for almost a year now. The ECB also is said to have access to important eurozone PMI data which is due to be made public on Friday.
Since her Sintra speech, several investment banks, including ABN Amro and Nomura, have concluded that a eurozone recession is looming, also given that German manufacturing industries will face production challenges if Russia will not resume its gas exports on Friday after maintenance on the Nordstream 1 pipeline has been completed.
An economic slowdown in the Eurozone eurozone could make it more difficult for the ECB to continue along its projected rate hike trajectory later this year. So far, the ECB has said it was encouraged by high levels of employment and continued economic growth.
UBS sees room for 50 bps surprise
Berenberg economist Salomon Fiedler said he believes that the “explicit confirmation” by Lagarde in Sintra made it unlikely that the ECB on Thursday will raise rates by a heftier 50 basis points instead.
Lionel Oster, fixed income portfolio manager at UBS, however sees room for such a surprise, citing, among other factors, euro weakness against the dollar.
“Delivering a strong first hike would help the EUR strengthen, just like the Swiss franc did after the Swiss National Bank unexpectedly hiked rates by 50 bps earlier this year,” Oster said in a note to clients.
The ECB on Thursday also will provide more information about its “special tool” to address convergence of spreads between government bonds in the eurozone. The political turmoil in recent days, with prime minister Mario Draghi requesting his resignation, has again led to a spike in the spread between German bunds and Italian BTPs. By lunchtime Tuesday that spread traded at 210 basis points, up from last week’s low of 194 and below last month’s peak of 237.
For UBS, the introduction of such a “spread management tool”, officially named “Transmission Protection Mechanism”, or TPM, lends weight to the arguments of hawks in the ECB. “This tool is still in its infancy but could represent a way for the more hawkish side of the ECB board to negotiate a 50 bps initial hike in exchange for the creation of a tool that would skew support to some assets/markets over others.”
Political support for bigger hike
A third reason why the ECB may opt to hike by a surprise 50 basis points is expected support from the political landscape. “Politicians have been under pressure to tackle inflation,” Oster said. “Measures have been taken in some countries to cap energy prices, but these measures are temporary by nature. A strong signal from the ECB would probably be welcome in most of Europe’s capitals.”
So far, financial markets have priced in a 50 basis point hike, but only for September. Peter Goves, fixed income analyst at MFS said even a 25 basis point hike on Thursday would be a major step. “Especially in this volatile market the expectation is that the central bank will stick to its plan,” he said. “However, the ill-timed political crisis in Italy may cause spreads to stay wide - TPM or not.”
German financial daily Die Welt this week took aim at the ECB policy and the TPM tool. It said the central bank risks losing its status as a defender of price stability in the eurozone by procrastinating rate hikes out of fear of harming Italy’s debt-laden economy. “The ECB would thus finally become Europe's bad bank for all junk paper,” it wrote. “Now the euro becomes the lira, and the ECB finally becomes a bad bank.”
Opportunity for ECB?
Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, said the Italian crisis may also provide the ECB with an opportunity to clarify its strategy and to press Italy into accepting the European reforms agenda.
"Needless to say, Italy’s political turbulences aren’t helping," he said. "A self-inflicted political crisis in Italy is the textbook case of a situation where the ECB should not intervene. ECB members are likely to unanimously agree that a necessary condition for a member state to be eligible to the TPM will be for the government to comply with the European reforms agenda. In other words, the ECB may unveil a bold anti-fragmentation tool while putting the ball back in Italy’s court."
Annual inflation in Europe, by Eurostat:
Related articles on Investment Officer Luxembourg:
- Crisis in Italy brings back fears of eurozone crisis
- 'Defending eurozone spreads clears path for rate hikes'
- As Eurozone spreads shrink, ECB gets the benefit of doubt
