The European Central Bank hiked interest rates by 75bps today, bringing the deposit rate to 1.5% and the main refinancing rate to 2%.
Alongside this decision, the ECB also changed the conditions of its latest Targeted Long Term Refinancing Operations (TLTRO III), as in the positive interest rate environment the previous structure offers banks the opportunity to arbitrage the excess liquidity left over from the programme. Under the latest conditions, the interest rate on TLTRO III operations will be indexed to the average applicable key interest rate, in this context the deposit rate. This should force early repayment for applicable loans via higher financing costs, as opposed to developing a two-tiered deposit rate structure. To that end, the ECB is also opening up additional voluntary repayment dates (further details here). The final decision taken by the ECB was on the topic of quantitative tightening. Expectations are largely for the ECB to start passively winding down its Asset Purchasing Programme (APP) in Q1 2023, with no active bond sales expected for some time.
Today, the ECB stated that it “intends to reinvest the principal payments from maturing securities purchased under the APP for an extended period of time past the date when it started raising the key ECB interest rates”.
On a surface level, this sounds slightly more dovish relative to expectations. However, the flexibility in the language along with Lagarde’s statement that the Governing Council will discuss QT at December’s meeting suggests our base case for an announcement in Q1 2023 remains firmly on the table.
Loose lips sink ships… and credibility
While in September’s meeting President Lagarde provided more clarity as to the length of the hiking cycle despite the central bank committing to a “meeting by meeting” approach, her comments in today’s press conference were much less explicit, owing to the risks of providing forward guidance in in this fluid economic environment. However, reading between her statements that the ECB has already made “substantial progress” in nomalising policy and the Governing Council will discuss the key principles of the reduction of APP purchases in December, we are fairly confident that our base case remains intact. That is, as things stand, the ECB is likely to hike rates by a further 50bps in December, taking interest rates to the upper-end of the neutral range, before conducting passive balance sheet reduction in Q1 2023. However, 2% is unlikely to be the terminal rate, and President Lagarde has delineated this concept today too.
Based on the current assessment of the economy, we expect the ECB’s hiking cycle to remain in place in Q1 2023 but for the front-loading process to have concluded.
This means a return to 25bps hikes, and based off of our expectation of a recession in the eurozone economy over Q4 2022 and Q1 2023– a view that is shared among ECB members at present– we expect to see one further hike in Q1. This would take the peak in the ECB’s hiking cycle to 2.25%. This view is starting to be shared by short-term interest rate markets; the 3-month EURIBOR future for January has fallen by 13.5bps to 2.34% while the implied interest rate in the March 2023 swap has fallen from 2.5% to a similar level.
In currency markets, the euro’s reaction to today’s decision highlights how the ECB’s policy stance is unlikely to be supportive for single currency unless fiscal policy shields economic conditions in a much more effective manner without considerably stoking inflation. In the absence of supportive ECB policy, the euro’s prospects of trading above parity is dependent instead on the Fed’s next steps and the impact it will have on broader risk conditions in markets.
Markets come around to our base case of 2.25% in Q1 2023 following today’s ECB decision