ECB turns hawkish

Frédérique Carrier - RBC Wealth Management

By Frédérique Carrier, Head of Investment Strategy, RBC Wealth Management

The European Central Bank, which had until now ruled out interest rate increases this year, adopted a hawkish tone that took financial markets by surprise. We look at the factors which led to this change, and explain how the eurozone’s strengthened institutions should hold it in good stead for this monetary tightening cycle. We look at portfolio implications.

A surprisingly hawkish tone

Although it left both policy rates and the pace of asset purchases unchanged, the European Central Bank (ECB) adopted a hawkish tilt at its February meeting in a stark reversal of its long-standing position. Markets are now pricing in the first increase in interest rates as early as June, as opposed to December previously, and 0.40 percent in rate hikes by the end of 2022.

The resilience of the eurozone in the face of the omicron wave, tightening labour markets, and increasing inflation all led to this abrupt change of stance. 

A resilient economy

Despite COVID-19 restrictions and supply-chain shortages, eurozone GDP grew 0.3 percent quarter over quarter (q/q) in Q4. While a marked slowdown from the 2.3 percent q/q growth generated in Q3, we think it points to some resilience under difficult circumstances.

The regional contribution to growth has changed markedly, however, with France and Italy driving growth, posting quarterly GDP increases of 0.7 percent and 0.6 percent, respectively. By contrast, the German economy, historically the engine of growth for the bloc, shrank by 0.7 percent in the period, due to supply-chain shortages in the automotive industry. While this performance is disappointing, there are signs manufacturing production started to improve in December. Overall, GDP in 2021 grew 4.6 percent in the eurozone, with seven percent in France, 6.5 percent in Italy, and a more muted 2.8 percent in Germany.

Q1 2022 is off to an encouraging start, with economic activity indicators pointing to continued expansion. Growth is likely to pick up later in the year, as supply-chain shortages ease. For now, the consensus expectation is for above-trend GDP growth of 4.1 percent in 2022, as financial support from the EU recovery fund contributes fully. As such, for the first time in five years the bloc’s economic growth is likely to exceed that of the U.S. However, two factors need to be monitored closely— labour markets and the energy crisis.

Tight labour markets

Labour markets recovered further in December, with the overall unemployment rate falling below its pre-pandemic level, to seven percent, thanks to strong demand. Job vacancies are higher now than in 2019 due to a decline in active participation and reduced cross-border mobility, both caused by the pandemic. There also seems to be a shortage of skills necessary for the green transition.

The European Commission’s euro area Employment Expectations Indicator (EEI), which measures companies’ hiring expectations over the next three months, stands only slightly below its highest level on record, pointing to strong hiring going forward. Should labour demand continue its strong recovery, wage increases, which are currently running at low single-digit levels, could accelerate, at least in some sectors, fuelling inflation.

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