When the Music Stops

It happened in 2019. Answer number 38 given by Madame Lagarde for the appointment of the President of ECB, Committee on Economic and Monetary affairs:

“Communication has become a core tool of central bank policy; it is essential for the effectiveness of monetary policy in steering expectations; it also helps to build credibility and ensure accountability…. A new frontier in central bank communications: the general public; beyond the traditional expert audience.”

This statement is absolutely fair and I hope the new course of ECB has been “understood by the people whom central bank ultimately serves” (the words are taken from the same answer).

Economists, strategists, and market professionals understood probably slightly less or did not see the hurricane arriving on Thursday in their government and credit books, followed by another typhoon on Friday.

On Friday there were difficulties in finding the right levels in credit bonds and for the first time credit ETFs started to get in on the action hitting the bids in the street. Bank trading desks, with the new rules of trading and capital requirements, have limited capacity to accommodate large flows in a widening market.

We had a very aggressive bear-flattening led by the very front-end combined with substantial sovereign spread widening. Italy, as usual, suffered it the most. We know this: not only in yield but also in asset swap spread.

The Q&A session after the ECB decision on Thursday was extremely hawkish, unexpected in its tone and much stronger than the official communique released after the Government Council decision.

Before last week, the ECB's baseline scenario was that there would be no policy rate hike before 2023 and the expectations were split between 1H and 2H of next year. The arguments for the thesis can be summarized here:

1. last statements from the President of European Central bank (she now likes the conditionalities),
2. there are no wage pressures in Europe so far and the ECB has no control over energy prices which are expected to decline in the second part of 2022,
3. QE is still continuing and any interest rate rise would require a stop of net asset purchases( the APP is still an open ended program while the PEPP will be stopped in March); this was confirmed by Philip Lane, member of Executive Board of the ECB at the end of January and in a certain way reaffirmed in the Q&A session
4. the new ECB projections will be available only in March and although they will be likely upsized in the revision of the short term inflation expectations, 2023 should still see the CPI below the 2% YoY ECB target.

Now the markets have heard the new hawkish tone of the ECB and the little tolerance to look through the current high inflation rates. The CPI numbers for December and January, released after the December meeting, have been negative readings at 5% and 5,1% above the Central Bank old projections and they weighted in the Government Council Debate.

I am not surprised by last week’s turbulence. Like all others, I struggle to fully understand the smooth words of Madame Lagarde (I continue having these problems since the “entangled speeches” of Wim Duisenberg more than 20 years ago) but I was waiting for this volatility and for what still lies ahead. The complacency of November and December in European markets was not justified. This is more true in a context where the FED and BOE are moving. I have tried to explain my line of thoughts in all previous posts and warned about the risks.

But I have, of course, some questions:

1) How far an interest rate path hike will go the if inflation is still expected to return below 2% in 2023 and 2024? Stripping out energy and other volatile components like food, where will the core inflation rate be? The ECB decisions are always focused on a medium-term perspective scenario.

2) Are we sure the APP will be stopped and not continued even in a scenario of official interest rate changes? I will elaborate it better in point number 5 below.

3) Do we need to risk the same uncertainties of rate hikes similar to July 2008 and 2011? The interest rate rises in 2011, during the Trichet Presidency, were also driven by high energy prices. Draghi reversed the trend at the end of 2011 showing the two increases were policy mistakes.

4) What will be the policy action on the TLTRO? The natural reduction of the excess liquidity and the potential increase in the tiering could likely having an impact on short-term markets. What will the size of TLTRO 4 be? How are TLTROs contributing to the Central Bank monetary stance?

5) Europe is different from the USA.?In Europe the recent change in tone of the ECB has significantly shaken the Government bond prices pushing the yields higher. The credit market is strongly linked to the gyrations of the public market and this is not what happens in US. Probably Lagarde’s words have been misinterpreted by the markets, but the tone of the credit market changed 4 tones for the worse. The transmission of monetary policy in Europe takes place also in the public markets and in the level of yields. Letting government bond yields go wider with volatility is going to affect the level of financing of many companies and this is already a monetary policy restriction. Over the last two years many companies tapped the HY market for their financing needs. It will be a problem to close that financing channel too early and too abruptly. The APP is a monetary policy tool, it should be analyzed in that context. Let’s see.

The answers for the above questions should help a portfolio allocation and tactical trading positioning.

Author: Sergio Grasso - Director at Iason Consulting - [email protected]