By Katharine Neiss, chief European economist at PGIM Fixed Income
The ECB will end net asset purchases at the end of this month and is set to raise its policy rate in July and September – leading it out of negative territory for the first time in over a decade.
Most investors expected the broad contours of this near-term normalisation. But the ECB surprised many by essentially confirming a substantial 50bps rate increase in September – barring a significant weakening in the inflation outlook.
The unanimous decision confirms our view policymakers see these changes as a ‘policy reset’, and that they no longer deem net asset purchases and negative rates necessary. However, it remains an open question if the euro area economy can withstand interest rates significantly above 0%. The shock of Russia invading Ukraine has yet to feed through to the real economy.
We expect further pressure on the economy in coming quarters as the boost from post-pandemic reopening fades, global growth slows, and tighter financial conditions continue to take hold. The ECB’s updated projection for 2023 GPD growth, at 2.1%, strikes us as optimistic. We estimate euro area GDP growth at 1.3% next year.
This economic picture suggests the ECB’s policy rate will rise faster than previously expected in coming months. However, it will be capped at close to 1% one year from now – considerably lower than investors currently expect. In our view, investors’ current pricing of ECB policy is too aggressive. It is difficult to know when the rise in euro area yields will reverse, given the short-term risk of higher inflation, but we believe German yields are likely to fall over the medium term.
Risks of eurozone fragmentation
Beyond obvious concerns about stagflation and tighter monetary policy, there are also questions about financial stability. As interest rates rise, so does the risk the eurozone might fragment. Market participants are used to the ECB dealing with this risk against a backdrop of low inflation and easy monetary policy. But this time peripheral spreads are widening as financial conditions tighten.
The ECB has not convinced investors it has a plan to deal with fragmentation risk as financial conditions tighten. Worse, the ECB suggested tighter financial conditions are desirable to reduce what it sees as excessive valuations in certain asset markets.
This view paints a dismal picture for risk assets. As long as the fight against inflation compromises the euro area’s financial stability, risk premia are likely to widen. These include peripheral country bond spreads, corporate credit spreads and other risk premia.
In sum, the ECB’s ability to raise rates is capped by the absence of a detailed plan to contain peripheral bond spreads. One year from now, interest rates will probably be lower than the aggressive tightening that investors currently expect. Investors in safe rates – German government bonds – are pricing in an overly aggressive path for policy rates and too upbeat a growth outlook.
As a result, we see value in holding German bonds. By contrast, bonds of peripheral euro governments, corporate bonds and other risk assets remain vulnerable. The combination of high inflation, weakening growth and tighter financial conditions warrant investor caution.