ECB Policy Rates Not Peaking Yet
While the ECB raised its deposit facility rate by 25 basis points (bps) to 3.5% at the June meeting, we believe the risks remain skewed towards higher policy rates for longer compared to market expectations. The ECB refrained from communicating unconditional expectations for the future interest rate path, but made clear that it expects to raise rates further, including at its next policy meeting in July. It is aiming to bring policy rates to levels sufficiently restrictive to achieve a timely return of inflation to the 2% price stability target.
We continue to believe that a 4% terminal ECB policy rate looks reasonable, though we see some upside risk to this estimate as labour markets have been surprisingly resilient and inflation is likely to remain sticky. We also note the peak rate of 3.9% expected for the deposit facility remains around 30 bps below levels priced in before the failure of Silicon Valley Bank in March (according to the OIS (overnight index swap) forward curve). We think the bank-related financial turmoil is unlikely to fundamentally change the ECB’s inflation outlook. We regard 3.75% as the lower end of the terminal rate landing zone for the deposit facility.
Preliminary inflation estimates for the euro area surprised to the downside in May, but underlying price pressures remain firm and the inflation outlook continues to be “too high for too long.” Indeed, euro area headline inflation for May is expected to settle at 6.1% year-over-year (YoY), suggesting the ECB cannot conclude its work is done just yet. Upside risks, especially in terms of the duration of the inflation-adjustment process, arise from still-strong domestic and wage-intensive components of inflation.
Uncertainty, particularly around the medium-term core inflation trajectory, remains elevated. The U.S. experience suggests that core inflation might potentially decline slower than originally envisaged. Core inflation has ridden up the elevator, but might take the stairs down. The economic resilience of the euro area remains a mixed blessing for the ECB, and for inflation to fully normalize back to the 2% target, some cooling in the economy and in the labour market is likely needed.
While the near-term direction of European duration remains less certain, we continue to believe European interest rate swaps should outperform core government bonds over time. The confirmed end to asset purchase programme (APP) reinvestments from July onwards weakens the relative technical picture for government bonds.
The terminal rate: Labour market strength suggests upside risks
In March, the ECB projected annual average headline inflation to be 2.1% in 2025, marginally above target, and did not see YoY inflation rates returning to 2% until 3Q 2025. Given data over the last three months, new ECB staff macroeconomic projections for June paint a similar (but slightly worse) inflation picture compared to March. Most important, the ECB does not expect to achieve its inflation target over the full projection horizon, and sees headline inflation in 2025 at 2.2%.
Preliminary May euro area headline inflation fell 0.9 percentage point to 6.1% YoY, and core inflation fell 0.3 percentage point to 5.3% YoY. The core print was softer than in recent months, which was welcome news following months of upside surprises. Nevertheless, data suggests that indicators of underlying inflationary pressures remain elevated and, although some show signs of moderation, there is no distinct evidence that underlying inflation in the euro area has peaked. The ECB remains particularly concerned about the tight labour market, which shows no signs of easing.
The ECB June projections expect growth in compensation per employee to be running at 3.9% YoY in 2025 after peaking at 5.3% in 2023, well above its long-run average of 2.1%. The euro area unemployment rate fell 0.1% to 6.5% in April, a record low and a full point below its pre-pandemic level, and the ECB expects it to decline further.
The balance sheet: a step-up in tightening, with more to come
As expected, the ECB confirmed it will cease APP reinvestments from July, while continuing pandemic emergency purchase programme (PEPP) reinvestments in full. Flexible PEPP reinvestments remain the first line of defense on the anti-fragmentation front, and the ECB currently intends to reinvest PEPP maturities until at least the end of 2024. While we do not rule out the ECB aiming for an earlier cutback in PEPP reinvestments at some stage, we would expect more progress on the reduction of the APP portfolio and greater visibility on the terminal policy rate to constitute necessary conditions for a departure from the current PEPP reinvestment guidance.
Reports suggest the ECB believes that the full wind-up of APP reinvestments will eventually be equivalent to around 25 bps in deposit facility rate tightening, and worth around 60 bps on 10-year euro area government bond yields. Assuming APP reinvestments end from July onwards, the reduction in bond holdings implies a quantitative tightening (QT) of around €310 billion between July 2023 and May 2024.
Additionally, a full runoff of the outstanding €1.1 trillion targeted longer-term refinancing operations (TLTRO) would see the ECB balance sheet shrink by around 14% by the end of 2024. As such, TLTRO maturities and early repayments will constitute the lion’s share of the ECB’s balance sheet reduction over the next one and a half years, with €477 billion TLTRO maturities due this month.
Over the longer run, ECB reinvestment policy will also be influenced by the shape of a new operational framework for steering short-term interest rates, including the size of a structural bond portfolio.
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