Last week saw the most important ECB meeting since the Draghi era. Christine Lagarde could not have been more clear, and this has massive market implications.
There were 3 main points for traders to take away from the meeting:
The ECB foresees core inflation at 4.2% by December 2023
Correct, you read that right. Despite a bunch of interest rate hikes, the ECB thinks core inflation will be still at more than double its target in one year from today. This forecast was just the initial taste of what Lagarde really meant last week: the ECB are going to hike much more than the market expects, as they want to make sure inflation doesn’t become anchored.
Quantitative tightening is going to start in Q1 2023
Again, you read that right: QT in Europe! Despite the initial small starting amount (EUR 15 bn per month), the message is clear: the ECB is setting up the stage for a bigger QT in Q2, and most importantly they want the balance sheet to shrink.
Something to consider: the balance sheet is already shrinking fast (EUR 300bn+ in a few months) due to hefty TLTRO (targeted longer-term refinancing operations) repayments which will also continue next year. QT will pile up on top of that.
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Most importantly: what 3% terminal rate? It must be priced much higher!
As any other central bank trying to fight inflation, the ECB feels it must bring nominal ECB rates above the level of core inflation.
Some basic math for December 2023:
- ECB expected core inflation: 4.2%
- ECB expected deposit rate by markets before the meeting: below 3%
And this is what Lagarde tried to correct: she wants to see markets pricing a much more aggressive ECB, with terminal rates in the 4% area to say the least.
This is paramount important for markets, as it will require tectonic shifts in the bond market and in particular:
- Much higher 2y yields, bringing up also long-end yields
- A much, much flatter yield curve
- Italian bonds under a lot of pressure
Italian yields won’t only suffer from the repricing higher of risk-free rates, but most likely also from spreads widening. Lagarde has literally told the market she is committed to cool down inflation. And that she will send Europe through a serious recession because of that.
According to Alberto Matellan, Chief Economist at MAPFRE Inversion, the ECB is also dealing with an issue of credibility in the markets. The warning from Lagarde could therefore be serious, he thinks, and imply rates will go much higher than some have predicted or expected.
“Companies that have benefited from the expectation of a “pivot” in the last two months could suffer,” Matellan said. “On the other hand, the situation favours companies that are more resilient to a rising rate environment.”
MAPFRE says the consensus forecast for European inflation and ECB rates is incompatible. With inflation expected at 6% by 2023, they do not expect the ECB to stope hikes at 3%. If Lagarde’s speech is correct, the ECB terminal rate should be closer to 4% than 3%. “Thus, it still has a long way to go,” says Matellan. “And liquidity will suffer as well. But that would correct the incoherence we have been talking about.”