Central bank decisions in Europe – March 2022

The outcome of the Bank of England (BoE) meeting last week was unsurprising. The market, however, focused on the accompanying commentary with the vote split reflecting a material shift in stance from the rate-setters. Rewind back to February when four of the nine members voted for a more aggressive 50 bps hike in the bank rate (versus the 25 bps which went through). The market immediately reflected their hawkish mood and priced in more increases.

This week saw the third hike from the Monetary Policy Committee (MPC), as expected at 25 bps, taking rates back to their pre-pandemic level of 75 bps. However, this time there was almost unanimity with eight of the nine members voting for a rise, with the single dissenter voting this time for no change.

The tone of the message afterwards reflected the turnaround, with the market hanging onto the language shift from further tightening being ‘likely’ (February) to further tightening may be ‘appropriate’.

In the U.K. Government Bond market, the shorter end of the yield curve had the biggest move with the 2-year yield down more than 10 bps. The market is now reducing its expectations for the number of hikes this year — from six further increases to five.

On the face of it, this seems contrary to the inflation picture. Before the meeting, U.K. CPI was predicted to peak at 7.25%. That number is now 8%, with the risk to upside. Some forecasters are expecting that U.K. inflation could even hit double digits by the end of 2022.

As we discussed in our recent market update webinar, we have to remember the other monetary tightening lever — quantitative tightening. In the second quarter, the BoE will start this process, unwinding its £20B corporate bond holdings. Once rates reach 1%, (likely at the next meeting on 5 May), this is the threshold at which they consider the active sale of the £850B gilt portfolio — this will have the same effect as multiple interest rate increases (depending on the speed of the sales/unwind).

In interpreting the market reaction, too much tightening was priced in after the February meeting. With events since then, the picture has changed significantly.

Below are the charts of the GBP SONIA forward curves and the 3- and 5-year swap rates. The forward curve is still steep at the short end but less steep than it was a month ago. The 3- and 5-year swap rates were down circa 6–8 bps on the day. This has been a welcome relief for borrowers who have been trying to lock in rates in the face of ever-increasing levels in the past few weeks.

The week prior we had the European Central Bank (ECB) announcement, which resulted in no change in policy (as expected) but with a significant amount of information on plans for winding down the asset purchase program. This was deemed a more hawkish announcement. The ECB could halt net bond purchases in the third quarter of this year, ahead of a potential interest rate rise at the end of the year. Like the BoE, the decision was not a consensus view among the ECB governing council members. The risk to growth is high with the fallout from the war a large unknown. However, for now, the risks of inflation are deemed to be the bigger concern. The ECB has raised their forecast for inflation this year from 3.2% to 5.1%, and their ‘severe scenario’ has inflation at 7.1%.

What is also emerging in the economic data is the divergence in the economic positions within the Eurozone and increasing concerns that the ‘one size fits all’ monetary policy is not appropriate. For example, Inflation in Italy, measured by the PPI (Producer Price Index), is materially higher. The chart below shows the month- on-month change since January 2021 — yes, that final month does say 41.8%.

This raises concerns about the stability of the Eurozone and is already recognised by the ECB in President Christine Lagarde’s statements. In addressing the potential ‘financial fragmentation’ across Europe, meaning that some countries are experiencing significant increases in financing costs compared to others. Lagarde assured markets that the ECB could ‘design and develop new instruments’ to secure monetary policy transmission throughout the Eurozone.

The charts below show the current position on the EURIBOR forward curve with higher rates across all terms compared to a month ago. This is also reflected in the EUR 3- and 5-year swap rates in the second chart below. In the face of no change in the central bank rate, the 3-year EUR swap has moved from (-50 bps) to +43 bps in a year. After such a prolonged period of negative interest rates this shift is taking some getting used to for EUR borrowers.