The ECB Delivers a (Final?) Dovish Hike

Today’s interest rate decision was a coin toss between a hawkish pause or a dovish hike, and the ECB delivered the latter. Citing inflation that remains too high and a weakening economy, the Bank’s signal was that policy rates are unlikely to rise from here. But as economic weakness broadens, the risk is that the ECB has gone too far. And its message of higher rates for longer—without sufficiently defusing concerns that it might speed up its balance sheet contraction—could trigger fragmentation risk in Italy. The ECB will need to steer a careful course from here, surrounded by shark-infested waters.

Our Take on the Meeting

The ECB raised its deposit rate to 4.0% today, an all-time high since the launch of the euro. It cited uncomfortably high headline inflation of more than 5% as the key driver of its decision. Higher interest rates signal concern among ECB policymakers that underlying inflation could become embedded. That would make it harder to get back to the Bank’s 2% target. Despite the backdrop of uncomfortably high inflation, the ECB recognised that the euro area economy is cooling. So, reflecting the recent data flow, it downgraded its outlook for GDP growth to 0.7% in 2023 and 1.0% in 2024. It maintained its projection for underlying inflation in 2023 at 5.1% and lowered its projection for 2024 to 2.9%. These downgrades are a strong signal that interest rates are unlikely to rise further. That said, the Bank is keen to message that interest rates will need to remain higher for longer. We therefore don’t expect rate cuts until the data reveals a compelling downward trend in underlying inflation. The ECB lowered its outlook for GDP growth in 2024 to 1.0%, but we view this as still too optimistic. Economic activity is weakening across the board, and the manufacturing slowdown is spilling over into services. Our base case calls for GDP growth of 0.5% in 2024, which is below consensus and half the ECB’s forecast. Indeed, today’s hike could tip the economic balance: it risks triggering a rapid economic slowdown and below-target inflation in the medium term. To top it off, President Lagarde said there had been no discussion of ending the Bank’s pandemic emergency purchase programme (PEPP) reinvestments. This was a less forceful reply than we had expected in light of investor nervousness towards Italy. Looking ahead, our base case is for stagnant growth in the euro area, coupled with high inflation and limited relief in terms of lower ECB rates. How the economy evolves from here is highly uncertain, but in our view, the balance has shifted to the downside.

Investor Reaction: All Is Well―For Now

Today’s ECB decision had little impact on government bonds, as investors had already priced in at least one more hike sometime this year. The bond market’s initial reaction was for interest rates to head lower, and 10-year German Bund yields fell around 10 basis points (bps. There were two causes for this reaction. First, the ECB mentioned no additional balance sheet tweaks. In addition, its monetary policy statement used explicit language to show that it is probably done hiking rates:

"Based on its current assessment, the Governing Council considers that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target."

Investors had also priced in a small risk that the ECB might tweak its PEPP reinvestments, which could have been negative for Italian government bonds (BTPs). That tweak failed to materialize, so BTP yields narrowed to Germany’s.

Figure 1: The ECB’s 0.25 percentage point hike matched what investors were expecting to happen in the next three months (%).

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Source: PGIM Fixed Income.

Figure 2: The ECB’s decision led to lower long-dated yields, lower inflation expectations, and tighter spreads for Italian government bonds over German government bonds (pp).

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Source: PGIM Fixed Income. In the near term, Thursday's ECB decision may, counterintuitively, support bond markets. It signals a serious commitment to fighting inflation in the face of weakening euro area growth. That puts a lid on term yields and helps reduce volatility in European government bonds. Separately, robust U.S. activity is helping global risk appetite. European risk assets, including corporate bonds, may well benefit from that combination: lower volatility means tighter euro spreads and higher equity prices. But the ECB’s decision to hike in the face of weak growth raises questions about possible medium-term damage to the euro area economy. Is the ECB overtightening? Probably. But, for now, risk markets are pushing that problem down the road. Investors dislike inflation-related volatility, so the less of that, the better. 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