By Katharine Neiss, chief European economist at PGIM Fixed Income
The European Central Bank (ECB) surprised investors with an outsized 50bp rate hike yesterday, taking its policy rate out of negative territory in one fell swoop.
The decision to take rates out of negative territory follows on the heels of its June decision to end open-ended asset purchases and marks the end of an era for the ECB – a policy reset that, in our view, is warranted.
However, the ECB’s Governing Council underwhelmed with its vague announcement of a new tool, known as the transmission protection instrument (TPI). This tool is meant to ensure the even transmission of monetary policy across the euro area.
Our concern is that, as the ECB raises interest rates, these rises are magnified in some countries – such as Italy. In the extreme, uneven rises could threaten a euro area breakup. Clearly the ECB will want to guard against such a situation. But it needs a credible instrument to do so. Yesterday’s lack of detail means that some questions – and hence market vulnerabilities – remain.
Energy crunch to cap rates
The euro area’s energy crisis is becoming more acute by the day. So, the ECB’s outsized move probably reflects its view that the window for rate hikes is narrowing. Moreover, the Governing Council’s unanimous approval of the TPI facilitated yesterday’s aggressive move out of negative territory. Following the Federal Reserve’s playbook with a surprise outsized hike gives the ECB cover for abandoning its guidance of just a few weeks ago.
That said, President Christine Lagarde was clear in her press conference: the accelerated pace of tightening does not signal a change in destination of interest rates, as they ‘progressively move towards neutral’. The ECB has yet to decide, however, what that neutral rate may be.
Our view remains that growth in the euro area will be challenged and this will ultimately limit the extent to which the ECB can raise interest rates. We expect GDP growth in 2023 of 1.3%, with significant risks to the downside. A wave of factors is pushing down on the region’s outlook. This includes the slowdown in global growth, particularly in China, and significantly higher energy prices. The situation could materially worsen still, if Russian energy flows were to suddenly stop.
All this suggests the ECB will need to pause its rate hiking cycle below 1%. If the ECB’s rate hikes take its policy rate well above 1%, it will likely need to reverse them as the energy crunch impacts the real economy.
Investors to crash-test the TPI
The ECB has a history of establishing bond buying programmes. Unfortunately, yesterday’s TPI is off to a vague start, with subjective conditions and processes. Investors may perceive German bunds as ultra-low risk, but the same cannot be said of Portuguese, Italian, Cypriot and Greek government bonds: the highest credit rating among these is BBB – near the bottom rung of the investment grade category. As a result, yields on peripheral government bonds typically fluctuate in concert with investment grade corporate bonds.
Spreads on Italian government bonds initially widened, before recovering pre-ECB meeting levels. However, Greek bonds ended the day wider by more than 10bps. Overall, trading after yesterday’s meeting suggests investors remain unmoved by the TPI programme. They are therefore unlikely to rerate peripheral bonds to tighter spreads unless the ECB shows further commitment and/or action.
Given the vagueness of TPI’s objectives and the mixed success of the ECB’s earlier, ill-defined Securities Markets Programme, investors seem destined to crash-test the TPI. They might do so by pushing spreads wider to probe for the edges of the ECB’s comfort zone.
The ECB took a positive step yesterday towards normalising policy and establishing a safety net for peripheral debt. But it will be challenged to keep markets on an even keel, with threats to euro area growth, inflation, energy security and political stability – as demonstrated by the fall of Mario Draghi’s government in Italy.