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Market Update

No surprises as inflation persists

May 11, 2023


The European Central Bank (ECB) increased its main deposit rate by 25 basis points to 3.25%, but signaled that it would slow down the pace of its monetary policy tightening in light of weak economic growth and banks tightening credit access.

The Bank of England (BoE) similarly increased its base rate by 25 basis points to 4.50% in the face of stubbornly high inflation, particularly in food and drink prices. The rise was far from certain following the previous Monetary Policy Committee (MPC) meeting where they agreed to monitor for “evidence of more persistent [inflationary] pressures” before hiking again.

Key takeaways

  • ECB President Christine Lagarde referenced future "policy decisions," suggesting that more than one additional rate rise could be on the cards. Some policymakers expected two or even three further hikes.
  • The ECB's comments came after the U.S. Federal Reserve raised its benchmark rate by a quarter of a percentage point, but contrary to the ECB, the Fed hinted that this may be the last hike in this cycle.
  • The BoE has had its hand forced by persistent price pressures to hike by a further 0.25%, taking the BOE rate to 4.50%.
  • Market participants have questioned the BoE’s reliability of inflation forecasts as evidence mounts that high inflation rates are becoming entrenched in the wider economy.

European Central Bank

As expected, the ECB and BoE have made safe moves at their latest meetings due to inflation not abating at a rate that would make policymakers comfortable. Upticks in core inflation at the last report dates in both the U.K. and eurozone have made market participants nervous as they pair with a slow-moving banking crisis in the U.S. and reduced GDP numbers in the eurozone. Germany, which has historically been the powerhouse of EU growth, slightly lowered its growth forecast for 2024 to 1.60% from 1.80% as persistent headwinds bite. A slight shift in the ECB's approach was noticed by close observers of these meetings, with only a 0.25% rate rise and a looser commitment to additional hikes. This marks a small pivot in the narrative seen at the previous few meetings.

Despite the dovish turn, President Christine Lagarde stated that the ECB was more confident in the path of its future hikes than both the Federal Reserve and BOE, stating in no uncertain terms that “We are not pausing, that is very clear.” While U.S. and U.K. policymakers are taking a more dovish stance on the pace of future rises, the EU Governing Council believe their work is not yet complete. In addition to the hike, it was also announced that the ECB would stop reinvesting the proceeds from maturing bonds into one of its quantitative easing programmes, effectively doubling the pace of balance sheet reduction.

While we have not yet seen meaningful evidence of contagion from the U.S. banking crisis spilling into the EU, the ECB will be keenly aware that they are walking a tightrope in preserving financial stability while combatting inflation. They will want to avoid a blow-out in sovereign yields as a result of an overzealous approach, putting unnecessary pressure on parts of the EU financial system - which have historically been vulnerable partners in times of financial stress. A marked reduction in bank lending is also a point of concern for policymakers as memories of the 2008 credit crunch are still fresh in many peoples' minds.

EUR swap rates spiked after the meeting but have now dropped back to pre-meeting levels. The 3-year EUR swap rate was 3.01%, the 5-year EUR swap 2.84%, and the 10-year 2.87%. Markets are pricing in 0.45% of hikes by the end of the year, with rates starting to tail off in Q4.

Bank of England

On May 11, 2023, the BoE raised interest rates to 4.50%. This marks the 12th consecutive increase since the central bank began raising rates in December 2021. The decision to raise rates was not certain after the MPC March meeting. However, official data in the past month showed that inflation in March was much higher than expected, at 10.10% compared to the BoE's forecast of 9.20% in February. Coupled with other economic indicators and signs of wage pressures, many economists believe that the BoE has enough evidence to justify the rate hike.

The MPC voted 7-2 in favour of the 0.25% rise with the two dissenters voting for no change. Key takeaways from the post-announcement press release detailed the banks' concerns with “second-round effects” of increases in wages and domestic prices compounding inflation. The fear is that these may take longer to unwind than they did to emerge. CPI is expected to fall sharply in April as the Bank hopes that the fall in wholesale energy prices will start to have a lagged impact on the reduction of food price inflation. The Bank was clear in its messaging that any future rates decisions would be “data-driven.”

One, perhaps surprising, takeaway from the meeting was that the BoE now expects the U.K. economy to be 2.25% larger in three years time, avoiding a recession which was predicted in February. This represents the biggest upward revision to GDP forecasts since the Bank gained independence in 1997. The optimistic outlook hinges on global growth being stronger than expected in the medium-term, due to reduced fuel and energy costs and fiscal support measures mentioned in the Spring Budget. Whether this is realistic given the U.K.’s issues with labour market participation and the post-Brexit period, the weakest 20-year period of growth since 1938 remains to be seen.

Following the announcement, GBP swap rates were broadly unchanged, reflecting its predictable nature. The 3-year GBP swap rate was 4.26%, the 5-year GBP swap 3.99%, and the 10-year GBP swap 3.74%. Markets are pricing in an additional 0.40% of hikes by the end of the year, reflecting continued uncertainty when it comes to the inflation picture.

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