The European Central Bank (ECB) surprised investors with a hawkish message from its policy meeting today. It backed that message up with a clear roadmap for the coming months, out of net asset purchases and out of negative interest rates.
The ECB was less clear on how it would contain Italian government bond spreads if they widen again. Investors’ reaction remained muted, for now. But potential flashpoints loom on the horizon, such as a sudden halt in Russian gas or elections in Italy in 2023. These could create considerable strains on the monetary union.
Our view remains that, because of a weakening economy, the ECB won’t follow through on the aggressive pace of tightening that investors expect in 2023.
The End of an Era
The ECB’s decision today confirms that it will end net asset purchases at the end of this month. In addition, the bank indicated that it will raise its policy rate in July and September, leading it out of negative territory for the first time in over a decade.
Most investors expected the broad contours of this near-term normalisation. But the ECB surprised many by essentially confirming a substantial 50 basis points (bps) rate increase in September — barring a significant weakening in the inflation outlook.
During her press conference, ECB President Lagarde indicated that the Governing Council’s decision was unanimous. Such unanimity confirms our view that policymakers see these changes as a “policy reset”, and that they no longer deem net asset purchases and negative rates necessary.
Moreover, the Governing Council’s hawkish messaging probably aims to contain rises in inflation expectations or wage growth above levels consistent with the ECB’s 2% inflation target.
Actions Speak Louder than Words
Today’s policy statement was silent on a rumoured “backstop” facility to reduce peripheral government bond spreads. Unsurprisingly, journalists repeatedly asked President Lagarde about the ECB’s commitment to the monetary union’s cohesion. Her words demonstrated the ECB’s clear commitment, but the lack of detail remains a risk.
For now, the widening in Italian bond spreads appears contained. But this risk will remain live for the foreseeable future. Europe’s energy crisis could worsen, and Italy is particularly vulnerable to a sudden halt in energy from Russia. The bottom line is that the lack of a credible backstop could constrain the ECB’s proposed normalisation.
How High Can Interest Rates Go?
It remains an open question if the euro area economy can withstand interest rates significantly above 0%. The shock of Russia invading Ukraine has yet to feed through to the real economy. We expect further pressure on the economy in coming quarters as the boost from post-pandemic reopening fades, global growth slows, and tighter financial conditions continue to take hold. The ECB’s updated projection for 2023 GPD growth, at 2.1%, strikes us as optimistic. We estimate euro area GDP growth at 1.3% next year.
This economic picture suggests that the ECB’s policy rate will rise faster than previously expected in coming months. However, it will be capped at close to 1% one year from now – considerably lower than investors currently expect.
Market Reaction and Investment Implications
Today’s hawkish tilt raised investors’ expectations of ECB tightening beyond the six-month horizon. As a result, safe rates (German government bond yields) rose across the yield curve. It is notable that, since Russia’s invasion began, German two-year Bund yields have risen more than two-year US Treasury yields (Figure 1). This reflects the level of concern about European inflation.
But growth prospects are more challenged in the euro area than in the US. In our view, that backdrop suggests that investors’ current pricing of ECB policy is too aggressive. It is difficult to know when the rise in euro area yields will reverse, given the short-term risk of higher inflation, but we believe that German yields are likely to fall over the medium term.
German 2-year Government Bond Yields Have Risen More than 2-year U.S. Treasury Yields Since Russia Invaded Ukraine (bps).
PGIM Fixed Income, Bloomberg.
The unexpected rise in safe rates against the backdrop of weakening growth is bad news for risk assets. Unsurprisingly, equity prices weakened and credit spreads widened today. Euro high-yield bond spreads1 had already widened more than U.S. high-yield spreads this year, and that gap extended after today’s ECB meeting (Figure 2).
Euro high-yield credit default swap (CDS) spreads widened relative to US high-yield CDS spreads after today’s ECB meeting.
PGIM Fixed Income, Bloomberg.
Beyond obvious concerns about stagflation and tighter monetary policy, today’s ECB meeting also raised questions about financial stability. As interest rates rise, so does the risk that the eurozone might fragment.
Market participants are used to the ECB dealing with this risk against a backdrop of low inflation and easy monetary policy. But this time peripheral spreads are widening as financial conditions tighten (Figure 3).
It is concerning that the ECB couldn’t convince investors that it has a plan to deal with fragmentation risk as financial conditions tighten. Worse, the ECB suggested that tighter financial conditions are desirable to reduce what it sees as excessive valuations in certain asset markets.
Looking ahead, this view paints a dismal picture for risk assets. As long as the fight against inflation compromises the euro area’s financial stability, risk premia are likely to widen. These include peripheral countries’ bond spreads, corporate credit spreads and other risk premia.
Peripheral Government Bond Spreads Have Widened as Financial Conditions Have Tightened (bps).
PGIM Fixed Income, Bloomberg.
The ECB’s hawkish surprise today aims to contain inflation expectations and wage growth. As a result, we expect rates to rise faster in coming months than investors expected until now.
But the ECB’s ability to raise rates is capped by the absence of a detailed plan to contain peripheral bond spreads. Weak economic growth and subdued wage growth also mean that, 12 months from now, interest rates will probably be lower than the aggressive tightening that investors currently expect.
In financial markets, today’s hawkish surprise lifted bond yields across the yield curve and hurt risk assets. In our analysis, however, investors in safe rates (German government bonds) are pricing in an overly aggressive path for policy rates and too upbeat a growth outlook.
As a result, we see value in holding German bonds. By contrast, bonds of peripheral euro governments, corporate bonds and other risk assets remain vulnerable. The combination of high inflation, weakening growth and tighter financial conditions warrant investor caution.
1We proxy euro high-yield bond spreads by credit default swaps (CDS) in Figure 2.
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