By Francesco Canepa and Balazs Koranyi
FRANKFURT – The European Central Bank is struggling to convince financial markets of its commitment to keeping interest rates at rock bottom but could gain the upper hand if it sticks to its message and follows through with it at next month’s policy meeting.
Markets have priced in a rate hike next year and pushed up borrowing costs for big debtors like Italy, defying the ECB‘s pledge to keep credit easy through a surge in inflation that it expects will subside in 2022.
After failing to persuade traders at her news conference last week, ECB President Christine Lagarde engaged in a more forceful rearguard action on Wednesday, saying a rate rise next year was “very unlikely”.
Euro zone bond yields fell after Lagarde spoke, with German 10-year yields hitting their lowest in around a month. [GVD/EUR]
“The biggest difference to last week is that she gave a time reference this time, and this should drive market rates lower,” said Piet P.H. Christiansen, chief strategist at Danske Bank.
Investors this week forced the Reserve Bank of Australia to ditch a pledge to keep its benchmark 2024 bond yield near zero and are pricing in a Bank of England rate hike on Thursday.
They had viewed the ECB as the next shoe to drop.
But the central bank for the 19-country euro zone remains the master of its own destiny, having made any rate rise conditional on inflation stabilising at 2%.
To quash such bets, all the ECB needs is for its updated forecasts due in December to show inflation easing back below its 2% target by 2024. Economists polled by Reuters see inflation at 1.6% in 2024, meaning that is likely.
“Despite the current inflation surge, the outlook for inflation over the medium term remains subdued, and thus these three conditions are very unlikely to be satisfied next year,” Lagarde said in her speech in Lisbon on Wednesday.
That message can be hammered home in December if the ECB extends its Asset Purchase Programme through next year, ensuring support for the euro zone government bond market even after the Pandemic Emergency Purchase Programme expires, likely in March.
Hawks on the Governing Council are growing impatient with inflation, which could make such a fresh commitment to easy policy a hard sell for Lagarde.
But it would be the last nail in the coffin for bets on a rate hike next year, as the ECB has said it will not jack up the cost of money until after the APP ends.
“We don’t think the sequencing will change so we don’t think it’s reasonable to expect a rate hike next year,” BNP Paribas’ chief global economist Luigi Speranza said.
Backstopping Italy, one of the world’s biggest debtors and the main target of speculation in the euro zone whenever markets become turbulent, may be the ECB‘s toughest challenge.
The spread between Italian and German bonds hit its highest level in a year earlier this week at 130 basis points, an unwelcome development as the ECB tries to keep financing conditions easy throughout the currency bloc.
“The bigger problem would be a persistent widening in BTP-Bund spread,” said Pictet strategist Frederik Ducrozet. “The pain threshold is probably higher and closer to 200 basis points but if it’s only Italy moving and not Spain then it becomes harder to say there’s fragmentation.”
For now, PEPP allows the ECB to ramp up purchases when and where it sees fit. Investors have probably been reminded of that in the past two days, with yields and the spread coming off highs.
But the 1.85 trillion euro PEPP is likely to be retired in March, leaving only the less flexible APP in place.
Currently running at a relatively modest 20 billion euros per month, the APP follows national quotas, which were a key condition to win approval from the European Court of Justice and the German constitutional court.
French central bank chief Francois Villeroy de Galhau has already called for some flexibility in spreading purchases over time, and analysts expect this to take the form of an ‘envelope’ of cash to be deployed when needed.
“They’ll be monitoring the spread, which they can address with an additional APP envelope,” said Pictet’s Ducrozet.
This may make it more digestible for the hawks, who are wary of any further commitment to large-scale bond buying. But a similar move failed to calm markets in March 2020, forcing the ECB to eventually launch the more nimble PEPP.
Unsurprisingly, governors from more indebted southern European countries – and many analysts – are calling for some of that flexibility to be carried over to the APP.
“PEPP flexibility has proven valuable so it would be important to keep some of that flexibility in the existing programmes.” BNP‘s Speranza said.