The initial view of markets was that the Russian invasion of Ukraine would greatly reduce the likelihood of an ECB rate hike this year. However, there has since been a remarkable hardening of eurozone interest rate futures contracts.
Indeed, in a complete somersault, markets now expect at least three rate hikes of 25 basis points before the year is out, possibly starting as early as July. The three-month futures contract for July has firmed by 25 basis points since early March.
Meanwhile, the December 2022 rates futures contract has hardened by 70 basis points, with the December 2023 futures moving by 130 basis points.
So not only are markets now pricing in a minimum of three 25-basis point rates hikes for the second half of this year that would take the deposit rate from -0.5% to 0.25%, they are also looking for the ECB to continue raising rates. by a further 125 basis points to 1.5% over the course of 2023.
The ECB decision in March to bring forward the end date for net asset purchases under its quantitative easing program to the third quarter this year, with guidance that rate hikes could begin sometime after, opened the door for policy tightening to begin this year. It has indicated that a decision on the exact timing for the conclusion of net asset purchases would be made at its June policy meeting.
There seems to be a growing consensus among the ECB Council members that asset purchases should end around mid-year. This means that the ECB Council meeting in late July could well deliver a rate hike, and this is now close to being fully priced in by the market.
In this regard, the ECB has emphasized that in the current highly uncertain environment, it will maintain optionality, gradualism and flexibility in regard to the conduct of monetary policy.
Some ECB Council members are very open to the idea of a July hike. However, both the ECB president Christine Lagarde and vice-president Luis de Guindos have indicated that rate increases will depend on incoming data and the ECB’s evolving outlook for the economy and inflation.
The ECB’s next set of macro-economic projections, which are to be issued at the June Council meeting, will be crucial in this regard. In this regard, the flash purchasing managers indices for April released last week were stronger than expected, suggesting that the economy may be proving more resilient than anticipated.
Overall, with inflation elevated, negative ECB interest rates look set to be consigned to the history books by the end of 2022. Further out, the latest IMF forecasts project a marked slowdown in growth in the eurozone economy, with also decelerating rapidly to an average rate of 2.3% next year and 1.8% in 2024 and 2025.
This would not be consistent with a rate-tightening cycle that extended to the end of next year, amounting to 200 basis points.
However, the IMF emphasized the considerable uncertainty around its projections, which it says is well beyond the usual range. It notes that inflation could turn out to be higher than expected, while central banks may need to adjust policy aggressively should rates of consumer price inflation remain persistently elevated.
This chimes with the ECB view that it needs to maintain optionality and on monetary policy given the highly uncertain environment. For now though, with inflation running in the eurozone at 7.4%, the heat is increasing on the ECB to get moving on raising rates before too long.
- Oliver Mangan is chief economist at AIB