ECB Policy Rates Not Peaking Yet

by Konstantin Veit of PIMCO, 6/20/23

The European Central Bank (ECB) hikes rates and signals more tightening ahead.

While the ECB raised its deposit facility rate by 25 basis points (bps) to 3.5% at the June meeting, we believe the risks remain skewed towards higher policy rates for longer compared to market expectations. The ECB refrained from communicating unconditional expectations for the future interest rate path but made clear that it expects to raise rates further, including at its next policy meeting in July. It is aiming to bring policy rates to levels sufficiently restrictive to achieve a timely return of inflation to the 2% price stability target.

We continue to believe that a 4% terminal ECB policy rate looks reasonable, though we see some upside risk to this estimate as labor markets have been surprisingly resilient and inflation is likely to remain sticky. We also note the peak rate of 3.9% expected for the deposit facility remains around 30 bps below levels priced before the failure of Silicon Valley Bank in March (according to the OIS (overnight index swap) forward curve). We think the bank-related financial turmoil is unlikely to fundamentally change the ECB’s inflation outlook. We regard 3.75% as the lower end of the terminal rate landing zone for the deposit facility.

Preliminary inflation estimates for the euro area surprised to the downside in May, but underlying price pressures remain firm and the inflation outlook continues to be “too high for too long.” Indeed, euro area headline inflation for May is expected to settle at 6.1% year-over-year (YoY), suggesting the ECB cannot conclude its work is done just yet. Upside risks, especially in terms of the duration of the inflation-adjustment process, arise from still-strong domestic and wage-intensive components of inflation.

Uncertainty, particularly around the medium-term core inflation trajectory, remains elevated. The U.S. experience suggests that core inflation might potentially decline slower than originally envisaged. Core inflation has ridden up the elevator, but might take the stairs down. The economic resilience of the euro area remains a mixed blessing for the ECB, and for inflation to fully normalize back to the 2% target, some cooling in the economy and the labor market is likely needed.

While the near-term direction of European duration remains less certain, we continue to believe European interest rate swaps should outperform core government bonds over time. The confirmed end-to-asset purchase program (APP) reinvestments from July onwards weaken the relative technical picture for government bonds.