The European Central Bank raised interest rates last Thursday for the first time in 11 years (September 2011), joining steps already taken by the U.S. Federal Reserve and other major central banks?around the world. This first ECB hike has been 50 bps, it was above the market consensus and breaking its own guidance for a 25 basis point move released at the previous meeting. I am not surprised, and I also think the President of the ECB held a good Q&A session. We won’t need an emergency meeting this time.
The President was relaxed, and she knew the message she was going to transmit was strong. But what was this message? Well, by reading through the official monetary policy statement and listening carefully the words of Madame Lagarde ( she acknowledged how her words are scrupulously scrutinized, this is also a positive) we remain pleasantly surprised by the following : the move of 50 bps was necessary due to the perception of a growing risk of a medium term overshoot in inflation, the TPI ( Transmission Protection Instrument) has been approved with unanimous consent and it is for all member States. It does not have limit ex ante, it is big, it ultimately depends on an assessment of the Governing Council of the European Central Bank (the criteria are an important element but they are notably but not exclusively able to dictate when the TPI is activated and by how much).
In line with what I hoped they would do, they passed the message to the markets that the European Central Bank is there without providing many details that would have complicated the picture. The Bank is vigilant, aimed at shielding periphery spreads, but not only, against unwarranted and disorderly widening in a moment when monetary policy is normalised. This is the ultimate and the most powerful toolkit they could have designed after the first line of defence represented by the PEPP reinvestment. The TPI is entirely under the discretion of the ECB. Good job. Let the markets guess where the bar to activate the TPI is.
Finally: it was not possible to continue with negative official rates when inflation is running at 8,6%YoY. The front loading of this 50 basis point move was correct because it was supported at the same time by the approval of the TPI instrument. The monetary policy needed to change because the ECB was very much behind the curve and the inflation dynamics.
Some considerations for the future:
- The markets don’t have a forward guidance. The ECB decides month by month depending on data and it is able to change decision in a 30 day span like they did in this last Central Bank meeting. The information released between June and July did not justify the shift from 25 to 50 bp, but they did it anyway. They bought cheap optionality for the future. Smart move.
- By not having a forward guidance, the markets are left guessing the neutral or terminal rate. This has consequences for the shape of the swap curve: short end, belly and 10-30Y.
- The peripheral spreads will widen slowly under the surveillance of the ECB. When people compare the current situation with Draghi’s intervention which re-established calm after the turbulence of the PIIGS crisis, they forget to mention that Europe was threatened by deflation concerns from 2014 to 2016. It was normal at that time to expect the government spreads to continue to tighten after the initial support of ECB. We are now, obviously, in a different moment when monetary policy is changing after an exaggerated long time of low rates. Spreads will widen especially for a country like Italy which has the biggest share of government debt in Europe with fundamentals not always appreciated by financial markets (putting politics to one side).
- The current spreads and yield levels of Italy, Spain, Portugal, Greece are not a cause for concern. I insist on the point that it is the volatility and the timeframe when the volatility on yields occurs that are crucial and they are the most important considerations which undermine investor confidence. The yield movement in six months of 2022 has been excessive. We need a pause for going wider in a quarter from now. The possible widening will be in the 125-150 range.
- Tactically, I continue to prefer spreads widening and flattening trades on the swap and credit curve: 5s10s, 5s30s and even the more difficult 10s30s. On the ECB terminal rate, I opt for a less aggressive ECB than the markets’ opinion, but the front end of the curve remains the most difficult area to trade. The downside risks to the growth outlook are increasing week after week, and the ECB’s recently published Bank Lending Survey points to a significant tightening in credit conditions for the corporates. I expect a smoother normalization of monetary policy, and this will flatten the swap curve. The credit risk premia on their side, might not tighten for a while and wise portfolio decisions will be key factor for performance. With very few exceptions, I am not negatively skewed toward any sector or market beta names, and I simply like investing the money where the risk is rightly remunerated (short duration for Bs and long duration for BBs and IG). A decent cushion will shield from a generic credit scenario where downgrades will outnumber the upgrades and where the rate of default will go slightly up. The right decisions will generate alpha and will make the investors happy.
Author: Sergio Grasso, Director at iason
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