ECB: Having It Both Ways, For Now

As expected, the ECB stuck with its guidance and raised interest rates 50 basis points (bps) at its March policy meeting. However, recent market turmoil has clearly made the central bank cautious.

The ECB has multiple objectives to deliver, including price stability and financial stability. Its communications today demonstrate that it is not stepping back from either. Yes, it raised interest rates to return inflation to target. But it acknowledged that, perhaps, rates shouldn’t go up aggressively, to avoid triggering further market turbulence or tightening financial conditions more than intended.

Our Take on the ECB’s March Meeting: No Trade-off between Inflation and Financial Stability

Today’s ECB decision contains all the key elements we were looking for. First, the bank stuck to a well-telegraphed 50 bps hike to deal with inflation. At the same time, its accompanying announcement acknowledged recent financial market turmoil, so as not to appear tone-deaf.

Second, the bank didn’t mention accelerating the pace of quantitative tightening (QT) beyond Q2 of this year, which we view as the right call. Additionally, today’s policy statement provided reassurance on liquidity tools as well as regulatory and supervisory oversight within the eurozone, strong fundamentals worth highlighting.

Third, the statement and President Lagarde’s comments at the press conference conveyed a notable dovish shift. Both emphasized data dependence and stepped away from signaling successive rate hikes to come. This was an important change and makes it possible that this hike may be the last – for the foreseeable future.

Indeed, a shift in macroeconomic fundamentals could warrant a more dovish approach: credit provision in Europe is relatively bank-based and, other things equal, recent turbulence would therefore map into tighter financial conditions than elsewhere. In our view, it is notable that the ECB emphasized the strength of the monetary transmission mechanism in judging the appropriate path for future interest rates.

Market Reaction

Today’s ECB message was decidedly less hawkish than December’s and qualifies as a dovish 50 bps hike. Also notable was the lack of forward-looking guidance. This was in line with the increased uncertainty mentioned in the press release.

Immediate market reaction welcomed the ECB's "dovish hike." German yields rose slightly, across the curve, after declining materially in the past few days. Front-end rates markets now price in a terminal rate of 3.22% in the cycle, not so different from where they were before the meeting.

Risk assets also behaved well in the immediate aftermath. Peripheral sovereign spreads, which had widened since early March, remained contained before and after today’s meeting. Corporate spreads, in both investment-grade and high-yield (HY) markets, compressed slightly after the meeting. Interestingly, euro-denominated HY credit default swap (CDS) spreads (“iTraxx Crossover”) did not deviate materially from U.S. HY CDS spreads (“CDX HY”). This suggests that the ECB’s decision to hike by 50 bps hasn’t exacerbated risk aversion in eurozone assets (Figure 1). A slight bounce in European equities, together with the stability of bank stocks, corroborated this view.

Figure 1: Eurozone and U.S. high-yield CDS moved in sync after today’s ECB rate hike.

Source: Bloomberg.

Overall, we believe that the ECB decision to hike 50 bps while striking a dovish tone didn’t exacerbate the previous day’s Credit Suisse-driven risk selloff (Figure 2). This is quite an accomplishment given recent market anxiety. Looking ahead, several unresolved issues remain, including the fragility of Credit Suisse/financial stress, the conduct of monetary policy, and the associated macroeconomic and market outcomes.

Figure 2: Today's hike did not raise credit concerns for the wider European bank sector.

Source: Bloomberg.

Conclusion

The ECB’s actions and communications today speak to a more moderate and measured pace of rate rises going forward, which we believe will peak around 3.5% by year-end. In addition, the bank has alternative tools on standby to address market turmoil. Its resolve today could pave the way for the Fed next week.

Market reaction immediately after the ECB’s decision suggest that the bank’s “dovish hike” struck the right tone. Investors appear to lend credence to the ECB’s message that the banking system is resilient. Concerns about Credit Suisse have not escalated to systemic proportions.

However, threading the needle between monetary policy and financial stability will remain a difficult task as long as inflation remains high and Credit Suisse’s solvency issues linger. European risk assets will remain vulnerable until those concerns are resolved.

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