Macroeconomics
TheECBLetsthe“DataDependent”GenieoutoftheBottle
5 mins
Accommodative Policy Continues …
As expected, the European Central Bank left its policy stance unchanged at Thursday’s meeting. This follows its December meeting, at which it confirmed plans to end the Pandemic Emergency Purchase Programme (PEPP) at the end of March, as well as a glide path for tapered asset purchases until at least the third quarter of 2022. This accommodative policy stance contrasts with recent communications from the Federal Reserve.
…but with a Hawkish Pivot Towards Data Dependence
The ECB executed a hawkish pivot towards “optionality” today, with the policy outlook now more dependent on data. During her press conference, ECB President Lagarde noted the recent softening in activity due to Omicron, higher energy prices, and continued supply chain shortages. Beyond these near-term factors, she set out a constructive outlook for the euro area. The labour market is recovering, with unemployment hitting an all-time low of 7%. This is remarkable given that, unlike the U.S. and UK, labour market participation has largely recovered from the pandemic. There was little sign of overheating in the region’s economy, despite high inflation prints, which she emphasised primarily reflect higher-than-expected energy prices. In light of these macroeconomic developments, the ECB took a “wait and see” approach, with a view to reassessing its outlook in March, based on updated economic projections.
The ECB’s Governing Council Now Sees “Upside Risks” to Inflation
Another highlight from Thursday’s meeting was the acknowledgement that, in addition to higher-than-expected inflation numbers in December and January, the ECB’s Governing Council now sees upside risks to its inflation projection – particularly in the near term. Lagarde highlighted energy and food prices, but noted that price rises were widespread.
Unlike in December, however, Lagarde did not push back against investors’ expectations of multiple rate hikes this year. Rather, she re-emphasised the sequencing of ending asset purchases before raising rates. In light of the glide path for asset purchases set out in December, that would suggest that the ECB is extremely unlikely to raise rates this year.
Finally, President Lagarde highlighted that inflation expectations are rising towards the ECB’s target, and that the labour market has mounted a solid recovery. Both developments are important pre-requisites for bringing euro zone inflation back to the ECB’s 2% target. After years of painful division on the ECB’s Governing Council, one gets the sense that the euro area may finally be within striking distance of achieving that target.
Steady as She Goes?
Our base case remains that the ECB will lag other central banks when it comes to tightening, as it aims to re-anchor inflation expectations and nominal wage growth to levels consistent with its symmetric 2% inflation target. This suggests a gradual taper of asset purchases in 2022 to avoid a cliff-edge effect, followed by rate rises from early 2023.
A key risk is that the ECB becomes a victim of its own success. Today’s meeting signals an ongoing reset of its policy framework against the backdrop of above-trend growth and a healthy labour market. In time, this could lead to an abrupt change of course as the ECB exercises “optionality” and tightens policy more quickly than expected. It could achieve this through more aggressive tapering or through a change in sequencing, such that rate rises could be brought forward even as asset purchases continue.
Investors are Pricing in a Hawkish Pivot
Investors’ reactions to the meeting were consistent with a hawkish pivot: the German yield curve flattened, market-based inflation expectations edged lower, risky assets (including peripheral debt) weakened, and the euro is stronger against other major currencies.
The sell-off at the front end of the German curve was notable. At one point on Thursday, German 2-year yields were up 12 basis points (bps) for the day. This compares with a 17 bps rise for the whole of 2021 until Thursday’s meeting, mainly a reaction to the Fed’s January pivot. We suspect that the violent move on Thursday was, in part, a delayed response to yesterday’s upside surprise in euro area inflation. At the beginning of the year, investors were pricing in a 14 bps rate rise over the next 12 months. Before today’s meeting, investors were pricing in 35 bps of rate hikes. They are now pricing in 57 bps of hikes. We agree with the direction of this move, but we believe that it is overly aggressive.
Figure 1
Investors are pricing in 22 bps more rate hikes in the next 12 months than before Thursday’s meeting.
Bloomberg
A second development consistent with tighter monetary policy was the pricing of eurozone inflation expectations. EUR 10-year inflation swaps rose at a more rapid pace than in the U.S. throughout the pandemic, and they have been range-bound since hitting their October 2021 high. If they follow the same dynamics as in the U.S., the ECB’s hawkish shift could further depress market-based inflation expectations. Indeed, 10-year inflation swaps eased further today, to around 1.94%, a 15 bps drop year-to-date. They have room to re-price even lower, if inflation eventually softens or because of a more hawkish ECB bias.
Figure 2
Market-based EUR inflation expectations look vulnerable to tighter ECB policy. (31 Dec 2019 = 100)
Bloomberg
A final development to note was the strong rally in the euro, relative to the U.S. dollar. One popular trade in 2021 was to buy the U.S. dollar. We have highlighted before that the euro area’s economic outlook in 2022 is bright, even relative to the U.S. But for a currency to reflect such a prospect, investors usually need to see a shift in monetary policy. If today’s shift in ECB messaging is durable, then the euro’s strength could continue.
Figure 3
EUR/USD catches up with the narrowing interest rate differential between Germany and the U.S.
Bloomberg
Conclusion: Beware the Ides of March
Investors are interpreting today’s ECB meeting as a hawkish pivot that will alter its behaviour from “predictable forward guidance” to a more reactive “data dependent” central bank. As a result, both the ECB and investors will be highly sensitive to upcoming data, in particular inflation prints.
We agree with that interpretation and with the shift in market pricing. But Thursday’s re-pricing of the German curve appears overdone to us, especially at the front end. The ECB may try to guide the market away from that pricing, but that will be easier said than done now that the “data dependent” genie is out of the bottle.