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“Up and down the boulevard”

Journey, Don’t Stop Believin’

ECB decision and press conference were very interesting and mark a significant inflection point from the ECB (European Central Bank) – The point at which the ECB officially pivoted from their ‘lower for longer’ policy to a (relatively fast) policy of normalisation. Of course, in reality it has been a slow evolution, rather than a pinpoint inflection, and it remains clear from the recent ECB Governing Council (GC) member narrative that there was a clear consensus for the removal of negative rate policy; and thus this week’s announcement, while significant, is more confirmatory than a discrete policy pivot.

The main points are as follows:

  1. ECB commit to ending APP before July 1st – This is consistent with the forward guidance sequencing that enables a rate hike in July. There will be continued reinvestment of expiring QE assets (from both APP and PEPP programmes), at least beyond the start of rate hikes (and as long as deemed necessary). The flexibility of the PEPP programme to address fragmentation concerns across the region is applicable to all reinvestments.
  2. After a careful consideration, the ECB decided that the three criteria for raising rates have been met. As such, the ECB have indicated that they intend to raise rates 25bps in July and expect to raise rates further in Sept – notably, they clearly emphasise that the Sept rate hike will be of greater magnitude (50bps) if the inflation backdrop remains unchanged or deteriorates
  3. That a gradual sustained path of rate rises beyond September is warranted.

The last point (3.) was effectively highlighted by perhaps the most memorable quote of the day from the President of the European Central Bank, who stated that today’s announcement is “not just a step, it’s a journey”.

On the economic forecasts, the ECB expect inflation to fall from 6.8% in ’22, to 3.5% in ’23 and 2.1% in ’24, notably above target at the forecast horizon - this is the key barometer of the length of the ECB’s ‘journey’, going forward. On growth however, the forecasts are better than the street, especially further out (2.8% in ’22, 2.1% in ’23 and 2.1% in ‘24).

These forecasts are very interesting, not just due to the fact that the growth trajectory appears to bottom out during the forecast horizon, at a rate that is likely still significantly above potential or equilibrium growth, but also due to the breadth of the factors driving the underlying growth narrative. Underlying growth is expected to be supported by (i) the Covid reopening, (ii) a historically tight labour market, (iii) continued fiscal support and (iv) savings built up during the pandemic - all obviously caveated by downside risk scenarios from the war.

You could argue that the President of the ECB issued a ‘whatever it takes’ on inflation in the context of 4 pillars: optionality, data dependency, graduality and flexibility in the conduct of monetary policy.

Yet, it could also be argued that given the context that the ECB has a singular inflation mandate for monetary policy - unlike that of the Federal Reserve System (Fed) whose dual mandate covers not just inflation but also maximum employment - this determination to address inflation is unsurprising. However, there was certainly some disappointment that the ECB did not announce anything further in relation to a backstop transmission mechanism, or a mechanism by which the ECB can counter peripheral spread widening, as rates rise.

Indeed, after the hawkish ECB announcements peripheral bonds sharply underperformed the duration selloff, suggesting that a mechanism to prevent fragmentation may be needed sooner rather than later. I am minded to think (as was the case for the Fed) that the ECB wanted to deliver an important narrative to the market - one that was unanimously agreed by the GC - without complicating the message with additional information about what the ECB may do in the event of an uncomfortable widening of peripheral spreads (a fracture of the transmission mechanism of monetary policy). However, further information about the peripheral spread mechanism may be needed soon.

So, what does this mean for the EUR? In retrospect, it is likely that the ECB meeting held this week will be viewed as a significant milestone - the effective end of Negative Interest Rate Policy (NIRP) in the eurozone. Indeed, it is not that long ago (though admittedly before the Russian invasion of Ukraine) that analysts were keenly focussed on the significant EUR positive capital flows that would be driven into the euro area as a function of an end to NIRP.

Indeed, there are further reasons to be positive the EUR from this week. The Organisation for Economic Co-operation and Development (OECD) growth projections for the next couple of years were largely characterised by their growth downgrades across the board, taking the global growth for 2022 down to 3.0%. However, what was also notable was the fact that the OECD now have growth forecasts for the eurozone above the US in both 2022 and 2023.

In the near term, markets remain very concerned about the trajectory and persistence of US inflation, and as such the emphasis of the ECB reaction function was quickly engulfed by the US CPI concern and the prospect of a redoubled Fed reaction function. Today’s US CPI print added additional urgency to that concern and further undermined the EUR, at the expense of a resurgent USD.

Ultimately, however, we retain a more positive, if increasingly isolated view in the near term, that a global recession is not imminent. The difficulty comes in the fact that there is a very wide array of global economic trajectories at the country level, and with the level of global trade and supply chain dependency between countries, it is not obvious how the sum of the component parts impacts the whole.

We have mentioned on previous occasions, the risk is that the underlying inflation concern in the US has not only driven sharply higher volatility in the US Treasury market, but in doing so it has removed the global safe haven asset. This has undoubtedly driven higher volatility across all asset classes, as capital follows themes with less conviction (even cash has an 8.6% annual inflation penalty - hardly all that safe!). Maybe this is one reason why EMFX has held up so well; with 10y US Treasuries moving 20bps in a day and only offering 3%, perhaps Brazil is not that risky on a yield adjusted basis, offering 13%?

This week, I heard the phrase “the pain trade for markets now is a soft landing, not a hard landing”, a reference to the depth of conviction and positioning in both negative growth scenarios and risk off trades. However, seldom do acute sell offs happen when markets are positioned for them, when cash levels are at record highs. While I am convinced that higher volatility is here to stay, I am still in the camp that markets are too worried about global recession, rather than not enough - and likely positioned as such. Either way, with inflation and volatility at current levels, it is likely to be a bumpy ride!

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    Sources

    ECB , Press Release, June 2022: https://www.ecb.europa.eu/press/pressconf/2022/html/ecb.is220609~abe7c95b19.en.html

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