Hikes continue but signs of easing on the horizon?

The ECB continued its programme of rate hikes at the 2 February meeting, giving credence to the hawkish tone following the prior meeting from policymakers who made it clear that the rate hiking cycle was not done yet. The governing council intends to keep rates at “sufficiently restrictive” levels to ensure a timely return to the inflation target of 2.00%. The ECB also decided on the modalities for reducing the Eurosystem’s holdings of securities under the asset purchase programme (APP). The target is to reduce total holdings (currently €3.4T) by €15B per month from March to June 2023.

One key takeaway from the press release was the commitment to at least one further 0.50% increase in March, taking it out of lockstep with the Federal Reserve and the BoE who have both signaled a slower pace of increases going forward. Lagarde also stressed that rates may still need to rise “significantly”. The ECB seemed to take the view that despite the reduction of headline inflation, more intervention was required to minimise its impact on the broader market.

The Euro area economy grew 0.10% in December 2022, which was a key point made in the press conference as evidence that there is enough impetus in the underlying economy to support higher rates. The easing of supply bottlenecks and full order books, as well as a surge of activity in the hospitality sector, were given by President Lagarde as examples of economic resilience. There was also a push to reduce government subsidies in the energy sector to avoid potential inflationary consequences given the steep drop in energy prices because of warm weather and larger than expected gas reserves across the bloc.

The language used in both the press release and the following conference emphasized that inflation pressures remain strong as a result of energy-related price contagion spreading throughout the wider economy. Wages are also continuing to rise quickly across the eurozone in response to demands from workers but remain within expected levels. In spite of this, the IMF projects that GDP in the euro region is expected to expand 0.70% this year, albeit down from 3.50% in 2022.

Seemingly, the rates market disagrees with the ECB’s commentary as EUR swap rates fell sharply across the curve following the announcement; the 3-year EUR swap rate was down 0.21% to 2.81%, the 5-year EUR swap rate was down 0.20% to 2.64%, and the 10-year EUR swap rate was down 0.18% to 2.62%. The guidance is that rates will increase by a further 0.50% at the next meeting in March. The projected peak 3-month EURIBOR fell from 3.43% to 3.27%.

The BoE voted 7-2 to raise the U.K. base rate by 0.50% to 4.00%, but, crucially, in its decision statement, the MPC opened the door to a reduction in the pace of hikes going forward, suggesting that smaller hikes may be on the cards. The two dissenters voted for no change, suggesting that the worst-case fears of runaway inflation are behind us as we move into 2023. One thing that stood out was the omission of the word “forcefully” from the BoE’s commentary around their response to inflation, suggesting more confidence in the market’s response to current measures.

The key driver for the pivot in messaging away from the hardline response was the relative strength of November GDP figures which defied analyst expectations by indicating a small amount (0.10%) of growth. This razor-thin margin marked the second consecutive month of growth and forced the BoE to re-evaluate their earlier projections of a protracted and painful recession. The current view is that the recession, while still the base case scenario, will be shallower and shorter than anticipated late last year. The IMF has taken a slightly dimmer view on the U.K.’s prospects and is currently projecting that the U.K. economy will be in a worse position by the end of the year than even that of Russia.

The BoE stressed that any future MPC meetings would be guided by the available economic data at that time. Current assumptions project a rapid decrease in inflation across 2023 reaching a level of 3.00% by Q1 2024. GDP is projected to fall throughout 2023, meeting the technical definition of recession, but the decline in output is expected to be less severe than projected in the November report.

A reduction in fuel prices drove 12-month CPI inflation down to 10.5% in December (from 10.70% in November). Core CPI inflation, excluding energy, food, beverages, and tobacco had remained unchanged at 6.30%. Core goods inflation had fallen by more than had been anticipated to 5.80%, but services inflation had surprised to the upside, rising to a 30-year high of 6.80%. Sterling weakened following the BoE announcement, trading 0.45% lower against the euro and 0.36% lower against the dollar.

Markets are pricing in a 0.21% rate increase at the next MPC meeting in February. This is 0.08% lower than pre-meeting projections of 0.29%. The peak projected SONIA rate also came down by 0.08% when compared to yesterday’s numbers.

GBP swap rates fell following the announcement; the 3-year GBP swap rate was down 0.05% to 3.65%, the 5-year GBP swap rate was down 0.03% to 3.41%, and the 10-year GBP swap rate was down 0.03% to 3.22%.