One hike done, but don’t bet on a long cycle

Yesterday, the European Central Bank (ECB) delivered a widely expected 25 basis point (bp) rate hike. becoming the first major central bank in developed markets to have raised rates in response to the Iran conflict. ECB president Christine Lagarde struck a neutral tone in the press conference, highlighting that this was not an insurance or risk management hike, but one that was needed, due to the broadening indirect effects of higher oil prices. She left the door open for further rate hikes, while remaining uncommitted to a specific timeline, emphasising the ECB would follow the data and did not have “a predetermined path”.

The most noteworthy output from yesterday’s meeting was the updated Eurosystem staff projections. Baseline growth was revised slightly lower to 0.8% for this year and 1.2% for next. While the “adverse scenario” projections have growth at 0.7% and 0.9% over these two years, the “severe scenario” would see growth fall to 0.5% and 0.4%. However, we believe these projections are too high given the assumptions included in these scenarios.

The adverse scenario includes oil prices at $122 per barrel and gas prices at €60 per MWh (compared to €45 per MWh at the time of the ECB forecasts). Under this scenario, commodity prices are expected to remain 20% to 30% higher than the baseline scenario for the entire forecast horizon (December 2028). In the severe scenario, oil and gas reach $166 per barrel and €98 per MWh.

Under those conditions, the Eurozone and many other countries would very likely fall into a recession. This would lead to demand destruction, which in turn should put downward pressure on prices. Consequently, we think unemployment would increase, and workers’ bargaining power to push through wage increases would be weaker as the labour market softens. We do not see the ECB tightening monetary policy if these conditions materialised; instead, monetary easing is the more probable outcome.

Bunds rallied from early morning yesterday and continued to rally after the press conference, aided by Trump’s comments on an imminent deal with Iran. This is telling. It suggests to us that there is a plausible scenario that bunds perform well even if the ECB hikes again. The curve already anticipates monetary policy rates peaking at just under 3% in 12 months’ time - although this is more of an average of scenarios priced in than a base case. 

So, it shouldn’t come as a surprise to any bund investor should we see further moves. But also, if a deal is reached and oil prices continue to decline, the case for future increases in inflation expectations weakens rapidly, even if oil spot prices remain markedly higher than at the beginning of the year. It could well be the case that markets start pricing in a relatively quick reversal of these hikes. When combined with the ECB’s optimistic growth projections, we conclude that bunds could perform reasonably well even if the ECB raises rates again.

Taking all this into account, it is difficult to see the bund curve pricing in any additional hikes, given the potential downside for growth should a more severe escalation in the Middle East occur. Although there are other factors driving government bond curves, including fiscal spending and the supply it brings to the market, the adjustment across curves in recent months has already been significant. While our base case remains that a resolution will be reached and a recession is unlikely, we have used the recent backup in yields to opportunistically extend duration, particularly with credit spreads back to their tights.