ECB kicks off hiking cycle

The European Central Bank hiked rates overnight for the first time since 2011, with a 50bps hike to its main policy rates, taking the deposit facility to 0%, ahead of market expectations of -0.25%. The large kick-off to the ECB’s normalisation of policy comes from an “updated assessment of inflation risks” and the bank signalled that “further normalisation of interest rates will be appropriate.” The ECB also seems to have dropped its commitment to forward guidance, saying decisions would be taken on a “meeting by meeting approach.” In commentary after the decision, ECB president Christine Lagarde noted that risks to inflation are to the upside and that prices could be “undesirably high for some time” and also explicitly mentioned EURUSD weakness as a contributor to high inflation.

The bank also announced its new antifragmentation tool, the Transmission Protection Instrument, which will not be “restricted ex-ante”, offering a potentially limitless ability to respond to financing crises hitting Eurozone economies. According to the ECB’s statement, the “scale of TPI purchases depends on the severity of the risks.” However, details on what would actually trigger the use of the TPI weren’t laid out with ECB president Christine Lagarde noting that use of the TPI will be at the “discretion of the Governing Council”. That ambiguity will be a risk to eurozone assets: yields on Italian bonds jumped 15bps on the 10yr to 3.533%, aggravated by the resignation of Mario Draghi as prime minister. The ECB seems unlikely to accept political change as a reason to make use of the TPI.

Market reaction to the hike announcement and the TPI was initially strongly positive in EURUSD with the pair spiking to almost 1.028 before quickly fading those gains and closing a little above the 1.020 level. The lack of clarity on the implementation and scale of the TPI will be a risk in the near-term EURUSD has moved lower in early trade today. We still hold our view that EURUSD will end Q3 at 1.05 before edging higher over the rest of the year.

With the ECB effectively abandoning forward guidance, policy will be more responsive to the ebbs and flows of economic data. Inflation in the Eurozone is high at 8.6% in June and is likely to remain so as energy costs across the bloc stay elevated. That to us warrants further hikes over the next several meetings although the ECB may prefer to use 25bps hikes after hitting the market with a large kick-off. We expect 25bps hikes at the September and October ECB meetings, taking the deposit rate to 0.5% by the end of the year before at least two more hikes in 2023. However, with the Eurozone facing down a pending recession, the ECB will need to balance the risks of choking off economic activity too quickly if inflation does start to move closer to target levels.