(ING Global Economics Team)
Risk sentiment may drive direction, but the European Central Bank could set the tone for curve dynamics today. Irrespective of the size of today’s hike, the urge to front load tightening is growing as the window of opportunity closes. We see delivery risk on part of the anti-fragmentation tool as Italian politics have markets looking to the ECB as an anchor.
Increasingly difficult backdrop for today’s ECB decision
The backdrop for the ECB meeting is not made easier by recent political and geopolitical developments. With a view to the war in Russia, more aggressive rhetoric of late has dashed any hopes to find a diplomatic solution anytime soon. There should be some relief as gas flows through Nord Stream 1 resumed today, though likely only to the reduced capacity of 40% as already seen before delivery was pauseed. If anything, there can be no guarantee that European dependency on Russian gas will not be used as leverage further down the road. An energy crunch over winter still looms large.
In Italy hopes of Prime Minister Draghi remaining at the helm of the government were dashed and snap elections this autumn now look likely. While winning the confidence vote, abstentions by the three large parties had signalled a lack of support to extend the life of the coalition government. Draghi is expected to announce his resignation today.
Our three main questions going into the ECB meeting
Today’s ECB meeting will set the tone for rates markets over summer. In our earlier preview we highlighted three important questions to which markets will seek answers from President Lagarde today – and recent headlines and developments have nudged market expectations already to some degree.
Will the ECB front-load hikes? Going into today’s ECB decision markets are still pricing a more than one-in-three chance for a larger 50bp hike. The perceived chances of a larger move had shot up, briefly to 50%, after newswire reports on Tuesday suggested the Governing Council was still looking at a 50bp hike, despite having prominently signalled in June the intention to hike by 25bp today. If only to save face, the ECB may still opt to proceed as was signalled, but especially after this week’s reports we suspect that the focus would then quickly turn to the possibility of an even larger than 50bp hike at the September meeting.
The money market curve already reflects market expectations of an increasingly front loaded tightening with 170bp worth of hikes now pressed into 2022 with its four remaining ECB meetings including today’s. 2023 is seeing less than 40bp worth of tightening.
Finally time to flatten? The ECB’s gradualism had allowed the EUR curve to maintain a relative steepness over its peer markets. But it has been looking increasingly out of place amid persistent high inflation pressures. While we think market expectations of ECB tightening are overdone, the ECB signalling growing willingness to front load would help justify keeping the front-end elevated for longer even as recession draws closer and the energy crisis still looms. The reaction to the ECB background stories had already instilled a flattening to the wider curve, though in an overall bearish dynamic.
Can the ECB keep sovereign spreads in check? The ECB’s plans for a new anti-fragmentation tool have been pushed into the spotlight by the unfolding political turmoil in Italy. The key 10Y BTP/Bund spread has already widened to noticeably above 200bp again, though given the circumstance that is a still benign outcome we think. That means it may still reflect hopes that the ECB will outline a sufficiently generous tool to rein in spreads.
To us that points to potential for disappointment today. The anti-fragmentation tool is a legal and political minefield, and the ECB has experienced as much with its previous bond buying tools. Normally that would argue for playing for more time. If not, the question still remains whether a widening on the back of political risk and fear of fiscal slippage is ‘unwarranted’, triggering the ECB’s new tool.
This is by far not an exhaustive set of questions. Recall for instance the reports of the ECB looking into changing the terms of the TLTROs to reduce banks’ possibility of arbitrage as key rates are lifted. It might have been a test balloon, but we would not be surprised to see questions arising in the press conference.