The ECB can’t wait any longer

Comments by Franck Dixmier, Global CIO Fixed Income at AllianzGI, ahead of the ECB meeting on 21 July 2022?

Key Take Aways:

• Long overdue, the ECB is expected to act forcefully at its next policy meeting, with an initial rate hike of 50 bp. With inflation continuing to rise, and the euro falling against the dollar, the ECB has no choice but to take strong action.
• Christine Lagarde is also expected to give details on the anti-fragmentation tool announced in June. Any doubt in the markets about the ECB’s determination to use an ad-hoc mechanism would fuel the rise in spreads between euro-zone countries.

The European Central Bank is lagging far behind in the normalisation of its monetary policy and cannot wait to raise interest rates any longer. Christine Lagarde, its president, should therefore adopt a hawkish tone and finally take action, with an initial rate hike of 50 basis points, contrary to the 25 bp anticipated by the markets. Indeed, it is difficult to imagine spending the summer in negative rate territory when inflation is still rising in the euro zone – reaching 8.6%[i] in May with a peak still ahead. The fall of the euro against the dollar – which increases the price of raw materials – is an additional argument for the ECB to show its determination.

Furthermore, the ECB should not interpret the sharp drop in inflation expectations in recent weeks as a relief from the pressure to raise rates fast and hard. Admittedly, the five-year/five-year inflation swap fell to 2% in mid-July after peaking at 2.50%[ii] in early May; 2% is the ECB’s target and close to the levels reached before the invasion of Ukraine. But this drop is fragile. It is more the result of market mechanisms – which give more importance to the risks of recession than to inflation – than the result of a real conviction that inflation is back to levels close to the ECB’s mandate. The risk of expectations becoming unanchored has not disappeared, and the ECB cannot let its guard down.

Finally, to wait any longer would be to risk replacing the concept of “normalisation” of monetary policy – the approach preferred by the ECB – with that of “restrictive monetary policy”. The latter would likely require even more determined action.

The ECB should also give details on the anti-fragmentation tool announced at the emergency meeting on 15 June. This announcement was well understood by the markets, and allowed the compression of BTP/bund spreads from a high of 240 bp[iii] in mid-June to 185 bp in early July.

Investors are waiting for the announcement to be made official in order to understand the details and scope of the scheme. But the risk cannot be ruled out that President Lagarde will limit herself to making statements, while the Bundesbank is already expressing reservations about the legitimacy of such a mechanism. However, it would be naive to think that a simple announcement would be enough to maintain spreads compatible with the proper transmission of monetary policy. If there is the slightest doubt about the central bank’s willingness to implement a mechanism for potentially unlimited amounts, the markets could sanction the ECB by testing its determination. If this meeting does not provide official confirmation, the risk of market disappointment will be high, with the result that spreads will be under pressure.

In terms of market impact, we believe that the next ECB meeting should continue to maintain high volatility in the fixed-income markets; after the impressive bond rally of the last few weeks, a 50 bp hike accompanied by a forceful speech from the ECB should push yields higher.

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[i] Source: Eurostat, June 2022

[ii] Source: Bloomberg, May 2022

[iii] Source: Bloomberg, July 2022