Snapshot

ECB plays catch-up as it ends era of negative rates


The European Central Bank (ECB) has raised its interest rates for the first time in 11 years and it has done so in an urgent manner.

Despite signalling a 25 basis points (bps) rise at its last governing council meeting, the ECB opted for a more aggressive 50 bps increase instead, taking the deposit rate up to zero, the main refinancing rate to 0.50% and the marginal lending facility rate to 0.75%.

The move is historically significant as it also ends the era of negative interest rates, which began controversially in the summer of 2014.

The ECB stated that the larger rise was warranted as inflation developments had become more concerning, including the depreciation of the euro. Inflation hit a new record high for the monetary union, reaching 8.6% y/y in June.

The ECB also mentioned that while economic indicators suggested that growth was slowing, the labour market remains very robust with unemployment at record lows. This raises the risk of wages rising in response to higher inflation, which could then raise price pressures further. A slowdown in demand is therefore warranted.

The direction of rates is set, but the end-point is still unknown

Investors were a little surprised by the size of the increase in rates. Consensus forecasts had expected a 25bps rise, but money markets had priced a 40bps increase – which suggests a 60% chance of the eventual 50bps rise. Interestingly, despite the more hawkish move, the euro has fallen back from the initial rally against most other currencies, while government bond yields have also fallen back, suggesting concerns.

This may be because the ECB has effectively cancelled its previous promise to raise interest rates by 50 bps at its September meeting if inflation conditions did not improve. The change in language does not rule out another similar, or indeed larger rate rise, but it does raise the risk that by September, the interest rates could end up exactly where they were previously expected to reach.

The more dovish guidance for September may have been part of the compromise within the governing council to push for the more immediate larger increase. The ECB states that it will be data dependent from meeting to meeting, which really should mean several more large rate rises to come. The statement from the bank also suggested that the move today does not impact the final level where interest rates will settle at, although ECB president Christine Lagarde did admit that the committee does not know where the final level, or “terminal rate” will be. Only that interest rates are set to rise further.

What about the anti-fragmentation tool?

One of the constraints to raising interest rates that the ECB is now happy to openly discuss was the impact on weaker member states often referred to as the periphery. Italy in particular was drawn into focus as investors demanded a lower price (higher yield), to compensate for the more risky fundamentals, especially after the ECB had ended its biased support through its QE programmes.

At its last official meeting, the ECB announced that it plans to use the maturing assets from the pandemic emergency purchase programme (PEPP) to stop spreads widening further. This was not enough at the time to stop bond vigilantes driving Italian yields higher. The ECB then returned with an emergency meeting on 15 June to promise a new anti-fragmentation tool that would work in addition to the repurposed use of PEPP assets.

The ECB unveiled its new tool called the Transmission Protection Instrument (TPI), which would be used effectively stop bond spreads widening too far. In an attempt to deter a legal challenge (which will almost certainly follow), a long list of opaque and largely meaningless criteria and “safeguards” were added. However, as Lagarde made very clear, the ultimate discretion is with the governing council.

What matters for investors is that no limit is being placed on the use of this tool at this time, but then again, there is no commitment to a size for the fund. It appears from the market’s reaction that investors were less than impressed. The spread between 10-year Italian and German government bond yields widened following the announcement. It is clear that the ECB hopes that the TPI will be like the outright monetary transactions (OMT) programme. A tool that was unveiled by previous ECB Mario Draghi in 2012 to help peripheral governments, which ultimately succeeded without ever being used.

What is happening in Rome?

The role of Draghi in aiding Italy’s debt crisis may have started over a decade ago, but it appears that it is drawing to an end. Investors’ have been very focused on the ECB’s response as the political situation in Italy has deteriorated substantially.

Italian prime minister Mario Draghi has tended his resignation for the second time in a week, after he initially lost the support of the Five-Star Movement from the coalition government, then he resigned again after failing to secure a vote of confidence in parliament, which was requested by president Mattarella.

It is now very likely that Mattarella will accept Draghi’s (second) resignation, and move to dissolve parliament to allow for fresh elections in either September or October. An election was due to take place in the spring of next year. The downside of the earlier election is that it is likely to reduce the time available for the government to produce a budget this autumn, and so meaningful tax and spending changes are now unlikely. This could jeopardise Italy attempt to satisfy the European Commission in order to release the next tranche of funding from the NextGenEU programme.

The latest opinion polls have the Brothers of Italy (Fdl) party in the lead, making the party’s leader Giorgia Meloni, favourite to become the next (and first female) prime minister. However, the populist right-wing nationalist party will surely clash with the European Union, which will concern investors.

Fdl have in the past called for a renegotiation of the eurozone and EU treaties, which may not be as extreme as for example the “Italexit” party (self-explanatory), but probably not the direction best taken when the EU is offering around 5% of Italy’s GDP in new investment funding, and the ECB heavily subsiding Italy’s debt.

Conclusions

The ECB should continue to raise interest rates at a steady and accelerated pace to reduce the risk inflation becoming entrenched. The Schroders forecast has the main refinancing interest rate reaching 1% by the end of this year, but it now appears that a target of 1.5% may be more appropriate.

The political upheaval in Italy will re-introduce market volatility, and will certainly test the resolve of the ECB, in when, rather than whether, it steps in to bail Italy out yet again.