ECB: That's All Folks?

The ECB yesterday delivered a 25 bps increase in all monetary policy rates. The Bloomberg consensus was narrowly in favour of rates to be kept unchanged, but we note that several forecasters acknowledged that confidence level was low and that a further hike was most definitely possible. The ECB’s own forecasts were updated and are now showing an average headline and core inflation rate for 2023 of 5.6% and 5.1% respectively. They went on to predict that by 2025 inflation should be very close to their 2% target with headline and core at 2.1% and 2.2% respectively. We note that headline inflation projections were revised up in line with energy prices while core projections moved down. In addition, the average levels for 2023 the ECB referred to imply quite a steep fall in inflation in the last four months of the year. Without a doubt the downward revision in core inflation was in no small part a consequence of GDP forecasts also moving down. Growth is now expected to come at 0.7%, 1.0% and 1.5% in 2023, 2024 and 2025, respectively.  In the press conference, Christine Lagarde could have hardly emphasised more that the ECB remains data dependent and that they stand ready to act if the inflation outlook fails to continue to improve. She also, rather understandably, left the door wide open for further adjustments if needed which is not a surprise. There was also acknowledgement of the fact that financing conditions have tightened, which is increasingly having an impact on demand, as reflected in declining credit creation and small contractions in M3. 

Our take is that this is likely to be the ECB’s last rate hike for now. We see economic data for the remainder of the year continuing to weaken, albeit we do not expect a significant recession as we see growth being barely positive. In the meantime, inflation will be materially lower mostly due to the impact of past rate hikes and base effects. This is not an environment that’s conducive for further rate rises considering the monetary policy stance is already considered restrictive. Chistine Lagarde even said that the transmission of monetary policy has been fast compared to previous evidence. This is essentially the “softish” landing we’ve talked about previously and consequently, with the ECB finishing hiking rates, no recession and slower inflation going forward, we think this will be a supportive environment for fixed income assets. 

Rates might well enjoy a calmer period as uncertainty decreases regarding central bank actions albeit the scope for a large rally is likely capped by the fact that curves are inverted, but nevertheless we think it is a good backdrop for rates products. Spreads should also be well supported but given the disparity we see across different credit markets, we tend to believe that those that look cheap will catch up while the rest will simply remain well supported. In the former camp, we would definitely include financials, in particular AT1s but also T2s and senior paper, in addition to European CLOs; the later remain very wide compared to history. High Yield likely belongs in the latter group, however, with spreads that we do not think look particularly cheap nor expensive. We think this part of the market should perform well not least because carry is the highest we have had in years, but spread compression might not be the main driver of returns from here.

In conclusion, we strongly believe that one of the main drags to fixed income assets’ recent performance, i.e. central banks with their fastest hiking cycle in decades, is coming to an end. As such, it will not be long before we see yields in fixed income assets at levels markedly above spot inflation which could translate in investors racing to lock in those yields.