The ECB surprised investors with an exceptionally hawkish message at its December policy meeting. President Lagarde was emphatic that interest rates would need to rise significantly more than investors previously expected. In addition, the ECB announced that quantitative tightening would start in March 2023.
The lack of rationale behind this tighter stance and the minimal detail around plans to shrink the ECB’s balance sheet amount to a considerable increase in uncertainty. The sharp adjustment in tone raises the spectre of a Trichet-like policy reversal and loss of credibility.1 That could set the scene for a rocky start for financial markets in 2023.
The ECB adopted a most hawkish stance at its meeting. The question is: why?
As expected, the Bank raised interest rates by 50 basis points (bps), taking its deposit facility rate to 2.0%. But President Lagarde made clear that investors should expect more – much more. In particular: a succession of rate rises is to come, that the level to which rates need to rise is significantly higher than what investors expected, and rates would need to remain restrictive for some time to bring inflation down to target.
The messaging on the outlook for rates was clear, but its rationale less so. ECB staff now projects inflation in the second half of 2025 ― the final year of their medium-term horizon ― to be in line with the ECB’s 2% inflation target.
There also seems to be a disconnect between rate hikes being “data dependent” on one hand and, on the other hand, today’s specific forward guidance on a succession of 50 bps rate rises at forthcoming meetings. Overall, this sharp shift in stance suggests a degree of confidence regarding the inflation outlook that is at odds with weakening economic activity.
The ECB’s latest announcements on quantitative tightening surprised us as well. Instead of outlining principles– such as prioritising the roll-off of corporate bonds over sovereign bonds – and clearly signposting future plans, the ECB announced that it would cease to reinvest €15 billion of maturing assets for four months, starting in March 2023. The lack of rationale and detail around these announcements is an additional source of uncertainty.
In our view, the ECB’s sharply tighter policy stance and increased uncertainty raise the risk to financial stability in the euro area. Significant, sustainably higher interest rates at a time when secondary markets will need to absorb increased government bond issuance could trigger a market revolt. That clash, in turn, could trigger a swift retreat by the ECB, potentially damaging its credibility.
The Bank of England (BoE) also raised interest rates today.
The BoE also raised interest rates by 50 bps today, taking its Bank Rate to 3.5%. But the pace of that rate hike is where the similarities with the ECB end.
In contrast to the ECB’s confident outlook that interest rates need to rise much further, the BoE’s Monetary Policy Committee (MPC) remains more divided. Two members voted against further rate hikes, as the UK economy shows clear signs of weakening. One member voted for a larger rate hike, of 75 bps, against a backdrop of de-anchored inflation expectations and nominal wage growth. Unlike the euro area, both inflation expectations and wage growth are currently running at rates well above the BoE’s 2% inflation target.
Second, the BoE has been signposting its plans for “quantitative tightening” (QT) since the summer of 2020. It set out principles to guide investors well before committing to plans for reducing its balance sheet. Additional flexibility that allows the Bank to adjust the pace of tightening in real time is embedded in those plans, hitting a sweet spot between certainty and responsiveness. Despite the UK’s challenging macroeconomic and policy backdrop, the BoE has managed to steer clear of spooking investors.
Finally, after investors’ reactions to the Truss government’s mini budget, the BoE and the UK Treasury have continued to restore credibility. Alongside today’s policy announcement, the Chancellor of the Exchequer confirmed the MPC’s 2% price stability mandate. In addition, and for the first time, he confirmed that “this government will not change the definition of price stability.”
Market reaction
The ECB’s hawkish message caught investors by surprise. Given the extent of that surprise, their reaction was predictably aggressive.
German Bund yields rose sharply, and the yield curve inverted further. At one point, 2-year German Bund yields rose a significant 30 bps. Indeed, 2-year German Bund yields have reached new cyclical highs and levels not seen since the global financial crisis. Peripheral spreads widened materially as well. At the time of writing, 10-year Italian BTP spreads to German Bunds are 14 bps wider, their widest spread since October 2022.
Corporate credit spreads widened, too. Credit default swaps for euro-denominated high-yield bonds (“iTraxx Crossover”) were 27 bps wider, while the corresponding index for euro-denominated investment-grade corporate bonds (“iTraxx Main”) was 5 bps wider (Figure 1).
Risk assets were also hit hard. At the time of writing, the EuroStoxx 50 index was down 3.5%, a move comparable to the sharpest daily move registered as the war in Ukraine commenced.
Interestingly, the euro weakened versus the U.S. dollar during the day, which reflects two conflicting forces. Interest rate differentials clearly shifted in favour of the euro, but the higher risk premium on euro assets, due to tighter financial conditions, had the opposite effect.
Figure 1
The ECB’s hawkish message led to higher front-end rates and wider spreads during the day
Looking ahead to 2023
Following today’s ECB meeting, multiple indicators point towards a disruptive market environment going into 2023.
First, the message that the ECB is determined to continue increasing interest rates means higher interest rates for longer. That, in turn, implies an elevated risk premium for cash-generating assets that will already be starved of growth in 2023.
Second, the ECB’s QT programme raises serious questions about financial stability. The Bank has used quantitative easing (“QE”) to engineer European government bond markets for years, leaving them illiquid and delicate. The pace of QT announced today is larger than we expected and will act as a drag on risk assets, the reverse of what QE delivered. The combination of higher interest rates and QT raises question marks about fragmentation risks and debt sustainability because it comes at a time when governments are expanding fiscal policy and increasing bond issuance.
Third, the ECB’s message today leaves many questions unanswered, which introduces policy uncertainty that could add to risk premia in asset markets. These questions include investors’ assessment of the terminal policy rate, the possible conflict between forward guidance and data dependency, and the roadmap and details for QT. The latter is particularly worrying as the ECB has little experience with QT. It is, in the Bank’s own words, “a new experiment.”
In the European strategies we manage, we have preferred high-quality spread products, less enthusiastically so after the recent rally in October-November. If the current selloff continues, as we would expect, European investment-grade bonds would be our first port of call to add risk. European high-yield bonds are more sensitive to recession risk, so would need wider spreads for investors to be adequately compensated.
Conclusion
The ECB’s message today was resolutely hawkish, but the Bank has not adequately explained why it changed its reaction function. This introduces uncertainty about how high interest rates may go. It also increases the risk of a “taper tantrum” and concerns about financial stability given the extent of QT. Finally, it has generated policy uncertainty in an environment where the euro area is entering a supply side-driven recession.
As a result, today’s bearish market reaction is understandable. Worryingly, it leaves investors exposed to a further selloff in bonds and risk assets as markets enter the illiquid festive period. With that context, wider spreads might represent a clearer opportunity in investment-grade corporate bonds than in riskier spread products at this stage.
1 Trichet refers to Jean-Claude Trichet, who was ECB President from 2003 to 2011.
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