Traders See ECB’s Window to Hike Narrowing Before It Even Starts
(Bloomberg) — Investor fears are rife that the European Central Bank is running out of runway to raise interest rates before it’s even begun.
Combating the quickest inflation since the euro’s introduction, officials plan to kick off a “sustained” cycle of hikes on Thursday with a quarter-point increase — the first since 2011 as years of stimulus finally draw to a close.
But as traders digest a possible shutoff in Russian energy supplies to Europe, a fresh political storm in Italy and an economy that’s teetering on the edge of recession, expectations for how far the ECB can push are already dwindling. Bearish bets on the euro are near levels seen as the pandemic struck in 2020.
The ECB is already trailing the Federal Reserve in raising borrowing costs as it tackles the strongest price surge in a generation, a divergence that knocked the euro to below parity with the dollar for the first time in two decades this week.
The shock from a halt in gas flows and an even slower pace of tightening risks dragging the common currency to as low as $0.9, according to Nomura Holdings Inc. and BCA Research Inc. In that scenario, UBS Group AG strategists see 10-year bund yields rallying to 0% by year-end from 1.1% now, ending their brief foray into positive territory.
Next week’s planned rate move by the ECB would only bring the deposit rate to minus 0.25%. For Dominic Bunning, senior foreign-exchange strategist at HSBC Holdings Plc, policy makers may struggle to make significant headway higher in the coming months.
“You’d think they can maybe get to 0.5% early next year, but the window is closing very fast,” he said. “Europe is slowing regardless of what the ECB is doing.”
Traders are now pricing 155 basis points of tightening by year-end — down from a peak of more than 190 basis points in mid-June.
While there have been some calls from within the ECB to start with a more forceful half-point step, that’s considered unlikely as it would contradict guidance and could harm credibility. A hike of that size remains the base case for September, with traders’ focus switching to what comes later.
Key to how the ECB can proceed will be a new instrument to snuff out unwarranted jitters on government-bond markets as borrowing costs rise. Work on the backstop, which is expected to be unveiled at next week’s meeting, was stepped up last month after a jump in yields in indebted Italy evoked memories of the euro zone’s sovereign-debt crisis.
“What the market wants is concrete affirmation of the tool,” said Gareth Hill, portfolio manager at Royal London Asset Management. “If the ECB doesn’t give enough detail, it may take fright.”
Scope for disappointment is high, with Italian Prime Minister Mario Draghi’s offer to resign making sentiment more sensitive still. The spread between the nation’s 10-year debt and that of Germany is now about 215 basis points — the highest in a month.
Failure to present a “comprehensive and credible” tool would widen that gap, Commerzbank AG strategists said in a report to clients. They see the spread retesting this year’s high of 240 basis points.
Investors are just as concerned about the outlook for energy. The continent’s economic fortunes hinge on whether natural gas supplies from Russia resume after maintenance on a key pipeline that’s due to finish Thursday.
Euro-zone growth forecasts are already being cut. The region now faces “significantly slower” expansion and a bigger and more enduring cost-of-living shock than just two months ago, the European Commission said this week.
The euro is reflecting that grim outlook, with its decline complicating the ECB’s fight with inflation that’s now more than four times the 2% goal. Bank of France Governor Francois Villeroy de Galhau said policy makers are watching the drop because of its effect on prices.
The overall picture amounts to a toxic mix for the ECB, which despite embarking on rate hikes four months after the Fed may end up stopping sooner, according to Alex Brazier, deputy head of Blackrock’s Investment Institute.
“We expect the energy shock to weigh on demand in the euro area — much more than in the US,” he told Bloomberg TV. “The ECB will pivot at some point away from its determination to raise rates this year toward ultimately living with a bit more inflation.”
- The ECB’s policy decision on Thursday dominates the schedule with the first hike since 2011 expected to be a quarter-point and money markets also betting on a 20% probability of a half-point increase
- Details of a new anti-fragmentation tool to deal with any repercussions from higher borrowing costs are also expected to be revealed. Note the new scheduled publication time of 1:15pm London, followed by President Christine Lagarde’s news conference 30 minutes later
- Bond sales from Germany, France, Spain and Belgium are expected to total about 24 billion euros ($24.2 billion), according to Commerzbank AG. The UK is selling 5.5 billion pounds ($6.5 billion) of notes maturing in 2025 and 2039
- Euro-area, German and UK manufacturing and services PMI numbers for July will offer the latest clues on the respective economies. The UK will also publish June inflation and retails sales figures