A clear path in a crisis?

European Central Bank

In a week that has, in some ways, redefined some of the key assumptions that underpin financial markets (particularly if you are an Additional-Tier 1 bond holder), and with the Eurozone facing a “Lehman moment” in the collapse and acquisition of Credit Suisse by UBS, the ECB has stayed the course it has laid out for the past several months. The Governing Council continued the programme of rate hikes in the face of what has been an extremely tumultuous week across global financial markets raising the deposit rate by 0.50%. The parallels being drawn between the failures of Silicon Valley Bank (SVB) and Credit Suisse and that of Lehman Bros. in 2008 have been rife in the financial press. . The question is: are these two events really comparable? The key message from the ECB press conference was contrary to this commentary, stating that the current members of the Governing Council “[were] around in 2008, [and] have a clear recollection of what happened ... the banking sector is currently in a much, much stronger position”.

The statement from the ECB Governing Council post-meeting highlighted that the bank was closely monitoring market conditions and was ready to step in with support if necessary to bolster financial security. One notable omission from the post-meeting commentary was the lack of a statement on the path of rates going forward. In the last few meetings, Lagarde has been crystal clear with the guidance that rate hikes would continue at the next few meetings, providing clarity to financial markets. This could be early signs of some maneuvering on behalf of the bank toward a reduced pace of hikes. But Lagarde stressed, “We know that if our baseline were to persist when the uncertainty reduces, then we have a lot more ground to cover”.

The balancing act being undertaken by the central bank is a delicate one after inflation eased slightly in February (down from 8.6% to 8.5%). But underlying price growth continued to accelerate on a surge in services costs up to 5.6% (0.3% above economist expectations). The tricky rise in core inflation highlights that, despite recent headlines, inflation is still very much a factor in guiding policy decisions and cannot be discounted at this stage. The hope from policymakers is that inflation will ease in coming months following a drop in energy prices (further compounded by the banking crisis which caused oil prices to fall to a 15-month low).

Bank of England

The BoE voted 7-2 to raise the U.K. base rate by 0.25% to 4.25%, aligning itself closely to the path set by the Federal Reserve earlier this week. The two dissenters voted for no change illustrating concerns of continued hikes on financial stability given the events evolving in the banking sector. The post-meeting press release highlighted that, “The MPC’s remit is clear that the inflation target applies at all times, reflecting the primacy of price stability in the U.K. monetary policy framework… Monetary policy will ensure that, as the adjustment to these shocks continues, CPI inflation will return to the 2% target sustainably in the medium term”.

While the BoE has proceeded in a manner more akin to its U.S. counterparts as opposed to its European neighbors, the challenges faced in the U.K. are very different to those faced in America. As a result of the relative size and isolation of the U.K., the inflation picture is considerably worse than it is elsewhere, being primarily driven by domestic price pressures which tend to be more persistent. CPI saw an unexpected rise to 10.4% from 10.1% in the 12 months to February, and some might find the U.K.’s response a bit confused when compared to the clear messaging from the ECB. Despite Andrew Bailey’s insistence that any decision will be data driven, it may be hard to reconcile a reduction in the pace of hikes in the face of the highest inflation in the G7. This is particularly at odds with the accompanying attestations that, “the U.K. banking system maintains robust capital and strong liquidity positions and is well placed to continue supporting the economy in a wide range of economic scenarios, including in a period of higher interest rates”.

U.K. energy prices have begun to fall away when compared with prior highs, which has provided a significant easing of inflation pressure across several sectors. The BoE believes this will be a factor in the U.K. avoiding a technical recession in 2023. There was notable optimism in the meeting minutes that the economy could grow through Q2 vs. expectations of a contraction in the February report. The revised expectation is “real household disposable income could remain broadly flat in the near term, rather than falling significantly as had been expected previously”.

Part of the inflation shock in February has reignited the well-trodden Brexit debate as prices of cucumbers, tomatoes, and salad rose amid severe shortages and rationing across the U.K. last month. Eurosceptics have pointed to unseasonably cold weather in southern Europe while pro-EU members highlighted the fact that there was a notable lack of empty shelves in EU nations. Some supermarket chiefs have warned that the U.K. is being deprioritized for deliveries when supplies are tight as a result of Brexit red tape.

Market reaction to the announcement was muted with GBP swap broadly unchanged; the 3-year GBP swap rate was 3.98%, the 5-year GBP swap 3.72%, and the 10-year GBP swap 3.41%. Markets are pricing in 35 bps of hikes by the end of the year, and the peak of projected rises came down by 9 bps when compared to yesterday’s numbers. Expectations are that central banks may need to start cutting rates sooner than anticipated following the banking crisis of recent weeks.