Insight

European Central Bank Decision

European Central Bank Decision

What happened?

The European Central Bank (ECB) raised its deposit rate by 25bps to 4.0%, the 10th consecutive hike by the central bank. This is likely the end of its hiking cycle, having increased its deposit rate 450bps since July 2022 when the deposit rate was at -0.5%. Should inflation continue to ease, the ECB is unlikely to need further rate hikes, so the focus going forward is how long it will remain at current levels before rates are cut.

Going into the meeting today this was more a possibility than a likelihood. With this rate hike the market is now forecasting the ECB is at peak rate for this cycle, although Christine Lagarde said at the press conference that she could not rule out further hikes at this time.

Data dependency suggests that the ECB still awaits more consistency in the signals from growth and inflation numbers. In our view, slowing growth should put downward pressure on core HICP, even if energy prices hold or push headline up. The hawk-dove ECB debate might then hinge on inflation expectations and some further signals of slowing growth or softening labor markets. We would expect the doves to win out over time, in line with today’s dovish hike.

We learned that ECB staff increased their outlook for headline inflation for this year and next on the back of higher energy prices, with 2023 inflation projected to be 5.6% rather than the June estimate of 5.4%, and 2024 inflation projected to be 3.2%, rather than the June estimate of 3%. However, 2025 inflation was nudged slightly lower, from an estimate of 2.2% in June to 2.1%. Core inflation was also nudged 10bps lower in 2024 and 2025,though unchanged for 2023. GDP forecasts for this year were reduced to 0.7% from 0.9%, and 50bps was taken from next year’s growth forecast.

How have markets reacted? 

Against the USD the Euro initially spiked on the announcement before settling about 0.65% lower than on the morning’s opening. The pattern was the same with sterling although the Euro was 0.1% lower from opening. The 2yr swap was largely unchanged on the announcement as the Eurostoxx 600 was up 1.2% from the open.

Why is it important to investors? What are the investment implications? 

If the ECB has reached its terminal rate in the current tightening cycle, the next question investors will be asking is how long short-term interest rates will remain this high, which will ultimately depend on the outlook for economic growth and inflation in the Euro area. With interest rates the highest in the Euro area in recent history, investors might find a good deal of reward relative to risk in Euro area fixed income if the economy and inflation continue to decelerate, necessitating rate cuts sooner rather than later.

What is our outlook on the situation?

Excess savings in the Euro area have essentially been depleted now, in contrast to the US and Japan where some still remain. With monetary policy this tight, inflation is likely to fall faster than projected by the ECB (with leading indicators such as money growth and factory prices confirming), which might cause them to cut prior to current market pricing.

What are the risks to our view?

That inflation rebounds higher and the ECB prioritises price stability. Or that the ECB simply considers inflation risk to be a bigger concern even if inflation does not rebound materially. Changes in the current ECB inflation forecast reveal expectations of a delayed fall towards target inflation into 2025 despite reductions in the growth forecast. This could be read as a signal that policy will shift to a hold rather than an easing bias from now through much of 2024, even though President Lagarde’s comments were taken as dovish.

Either scenario would further depress economic activity at a time when Germany, the region’s largest economy, is already in recession and PMI surveys are suggesting France is to follow. This would likely be negative for European equities, especially cyclical sectors.

Another energy supply shock stemming from the Ukraine war, which investors should keep on their radar, would also be a key risk to our views – it could push headline inflation back up again and depress growth. If there were new energy price controls or budgetary subsidies once again, as in the 2022-23 winter, it might push up not just headline inflation but also support non-energy spending and thereby slow or reverse the decline in core HICP, requiring the ECB to stay on hold or even return to a tightening bias. 

Investment risks   

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

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