Communication key for Fed and ECB

The announcements at the European Central Bank and Federal Reserve monetary policy meetings this week should not surprise the markets, which are expecting rate hikes of 50bp for the former and 25bp for the latter. Instead, investors will likely be attentive to the central banks’ communications and their indications about the future path of rate hikes.

ECB

KEY TAKEAWAYS?

• We expect a 50bp rate hike, as previously announced by Christine Lagarde
• The ECB president is expected to continue to hammer home her hawkish message, while investors' expectations of the terminal rate remain too moderate.
• The meeting should lead to an upward revision of future rate hike expectations, which could put pressure on bond yields.

A promise is a promise! European Central Bank (ECB) President Christine Lagarde committed at the last policy meeting in December to deliver a 50 basis points (bp) hike in February. This is what the markets are 100% expecting and what we are waiting for.

In the short term, the path is clear. The minutes of the last meeting indicated a commitment by the Governing Council to raise rates by 50bp at the next two meetings in February and March, in return for a 50bp hike in December, probably the result of a compromise when the more hawkish members were arguing for 75bp.

The markets have taken these perspectives on board. At the 2 February meeting, investors' attention will therefore be less focused on the magnitude of the announced rate hike than on indications of their trajectory at the following meetings.

Investors expect a terminal rate of 3.50% to be reached before the summer. This expectation for the entire monetary tightening cycle seems too moderate. Therefore, we expect a clarification from Christine Lagarde, who should remain faithful to the hawkish message hammered out for weeks.?She should reiterate that inflation, especially core inflation, remains too high and reaffirm the absolute necessity for the ECB to continue to act over time to bring it down to a level more compatible with its price stability objective.

Given the latest leading indicators[1] ?in the euro zone, which show a certain resilience of the economy, the ECB has regained some room for manoeuvre in implementing a more restrictive monetary policy.

Therefore, the next meeting looks hawkish. It should help recalibrate upwards expectations of future ECB rate hikes and could lead to pressure on bond yields.

?Fed

• We expect the Fed to announce a 25bp rate hike at the next FOMC meeting
• With core inflation remaining high, we expect no complacency from the Fed, which should reaffirm its commitment to keep rates high for a long time
• Market expectations of a 5% terminal rate in the summer, followed by a rate cut in the second half of the year, seem too complacent.

After four 75bp hikes followed by one 50bp hike at the last Federal Open Market Committee (FOMC) meeting, the Fed should move to a more modest pace as it approaches its terminal rate. We expect a 25bp hike at the 1 February meeting.

With this 25bp step perfectly anticipated by the markets, investors may instead focus on Jerome Powell's communication for the next steps.

Inflation has indeed fallen significantly in recent months. After peaking at 9% in June 2022, headline inflation[2] stood at +6.5% year-on-year at the end of December.?Core personal consumption expenditures (PCE)[3], the Fed's preferred measure of inflation, reached +4.4% at the end of December, confirming its deceleration from a peak of +5.20% at the end of September 2022. ?But if recent trends validate that the inflation peak is behind us in the US, core inflation remains high, in a context where economic activity continues to show some resilience.

As a result, we do not expect any complacency from the Fed. It should reaffirm its willingness to keep rates high for a long time to come, in order to ensure a sustainable decline in inflation towards its price stability objective.

Market expectations include two additional 25bp hikes over the next few meetings to reach a terminal rate of 5% in Q2 2023, followed by almost 75bp of rate cuts over the second half of this year. To us, this seems to underestimate the Fed's willingness to maintain restrictive conditions for longer. The meeting is likely to generate volatility, including an upward recalibration of short-term rate expectations over 2023. The impact should be more significant on the short end of Treasuries, which is less protected than the long end.

[1] Eurozone Manufacturing PMI. The PMI indices in the euro zone were at higher levels than expected in January (composite PMI at 50.2 against 49.8 expected and 49.3 in December)

[2] Consumer Price Index, Bureau of Labor Statistics, January 2023

[3] Personal consumption expenditures price index, source: Bureau of Economic Analysis, January 2023

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