Rates Spark: inflation, inflation, inflation

ECB President Lagarde neatly summed up in three words what is front and centre of market concerns and has also dominated discussions at the Council meeting – inflation, inflation, inflation. Our economists have summed up the meeting here.

Some Governing Council members think inflation could stay above the ECB’s target in 2023

While admitting its inflation forecast is likely too optimisticly low, upon dissecting its drivers the ECB still comes to the conclusion that high inflation will be transitory. And according to that analysis the currently implied lift-off by markets is inconsistent with the forward guidance, so Lagarde said. Caveat being that no one can tell for sure when supply chains will be unclogged, when energy prices will stabilize. And those second-round effects in wages will have to closely monitored, too. In that sense no one is any smarter as only time will tell who is right.

According to a Bloomberg background report on the meeting even some Governing Council members think inflation could stay above the ECB’s target in 2023. And if not even the Governing Council can bring it on itself to directly and openly rebuke market pricing of early rates hikes – “it is not for me to say” Lagarde said on the topic – one cannot blame markets for hardly paring their aggressive pricing in the wake of the press conference.

We would still very much challenge the notion of hikes already happening in 2022

While we would still very much challenge the notion of hikes already happening in 2022, we do note that periphery bond spreads appear to have finally woken up to the possibility of ECB asset buying support waning faster than anticipated. The key 10Y Italy/Bund spread widened by around 7bp on the day, although concurrent supply activities may be partially to blame, too. We think spreads should be most sensitive to any changes in the propects of ECB asset purchases.

As inflation and policy tightening is going to remain in the global headlines for the foreseeable future the upward pressure on rates will persist with the tendency for curves to flatten. In EUR it may be only slower than elsewhere, but it will likely be caught in the slipstream as global central banks announce their policy tightening next week.

That the Fed will announce the beginning of tapering its bond purchases looks like a done deal our economists think. But the currently flagged timeline of having bond purchases end by mid-year could even be accelerated as inflation pressures are still set to rise and economy itself is exiting the third quarter soft patch. As such still more room for the belly of the yield curve to lead the way higher.

Markets are convinced that the BoE will hike rates next week after the BoE made clear that inflation was its chief concern. While we believe the market is overestimating the extent of the subsequent policy tightening, it may take some time for that correction to materialise.

Among all the aggressive pricing of policy responses there is also the notion of policy errors in the making

But we do note that among all the aggressive pricing of policy responses there is also the notion of policy errors in the making resonating in curve moves and shapes. Perhaps most obvious in the hump shape of the UK money market curve. It sees the Bank Rate peaking above 1% by end 2022/early 2023 before gradually trailing lower again. Long end curve flattening, outright yield drops as front ends price in more tightening can reflect similar concerns, especially in the case where real yields are pushed lower and thus long term growth expectations as occurred over the past weeks in EUR rates.