Despite recent speculation that the ECB could provide a shock hawkish message in the near-term, either by signalling they would hike rates by 50bps at July’s meeting or potentially raise rates earlier at today’s meeting, the central bank has maintained its core messaging that rates won’t rise until July’s meeting and will only exit negative territory at the end of Q3.
Pushing back on market expectations, the ECB took the unusual step to explicitly relay their expectations for their next policy move, stating that the Governing Council “intends to raise the key ECB interest rates by 25 basis points at its July monetary policy meeting”. Instead, the hawkish twist in the ECB’s press statement was more nuanced than markets had necessarily expected. The central bank explained that the potential for a larger-than-25 basis point hike in September depends on how the medium-term inflation outlook progresses ahead of their next forecasting round.
Under our expectation that HICP is set to track higher before peaking in September, we continue to expect the ECB to hike rates by 50bp at their September meeting.
Should the Governing Council opt to continue hiking in 25bp increments at September’s meeting, the expected downturn in growth conditions and the lower estimated neutral rate would likely mean that the central bank miss their window to front-load their hiking cycle, and in turn, run the risk that inflation expectations may become un-anchored.
In response to the rate statement, the single currency quickly erased earlier gains as traders priced out the tail risk of both an earlier rate hike and a 50bp move in July. However, as the press conference drew closer, upwards momentum in EURUSD picked up yet again as rates markets priced in more aggressive moves later on down the line. Once the press conference began, however, the path forward from the ECB became more ambiguous again.
Despite practically confirming that the central bank would embark on a 50bp hike in September should the next batch of projections see 2024 inflation remain at 2.1% or rise higher, President Lagarde stressed that the central bank aims to maintain complete optionality in policy.
In effect, Lagarde highlighted that the Bank’s forward guidance was highly subject to change over the coming months and that markets should take the current message of a 50bp hike at their own peril. By doing so, the market pricing of a 50bp hike at September’s meeting went from being an area of support for the single currency to a source of potential vulnerability.
EURUSD whipsaws as the Lagarde suggests the ECB could underdeliver in September
The theme of opaque forward guidance continued throughout the press conference. Aiming to keep as many monetary policy options on the table, Lagarde dodged questions about neutral rates – which should provide a ceiling for terminal rate pricing in this current environment – along with outlining what the ECB’s mechanism would be to mitigate bond market fragmentation.
On the topic of neutral rates, Lagarde stated that the Governing Council would discuss the theoretical projections once rates exit negative territory and that, despite the widely accepted idea that they have declined over recent years, an estimated range hasn’t been projected. Meanwhile, despite reiterating that the ECB will use PEPP reinvestments flexibly to mitigate market fragmentation, today’s announcement showed little appetite for the central bank to pre-announce its bazooka to tackle peripheral spreads. This makes sense given that the “announcement effect” of such a programme holds weighting in itself, so the ECB are likely to wait until fragmentation increases before unveiling their potential solution. However, the lack of clarity on the potential new programme and a backdrop of tightening eurozone financial conditions means bond traders will likely continue widening peripheral bond spreads in order to find the ECB’s pain points. Today’s bond market price action has already displayed this tactic as back-end BTP yields rose over 10bp more than their German counterpart. Although the rate statement in isolation suggested that 1.07 may be a firm support for EURUSD over the coming weeks, the lack of assurances by President Lagarde stressed that downside risks for EURUSD remain over the coming weeks. In response to today’s event, we remain committed to our month-end EURUSD target of 1.06, with tomorrow’s US CPI report the next hurdle en route.
Testing tolerances: bond traders push the Italian-German 10-year bond spread wider after the ECB warns it will step in to avoid market fragmentation but stops short of specifying how
Simon Harvey, Head of FX Analysis