By Katharine Neiss, Chief European Economist for PGIM Fixed Income
We have had a raft of euro area data that puts us more firmly in the 25bp rate hike camp for Thursday’s meeting. EA GDP last week coming in broadly in line with Consensus at a tepid 0.1%. Today we got the results of the Q1 Bank Lending Survey, which show signs of a double whammy hit from tighter monetary policy on credit demand as well as spillover from US banking sector fragilities on credit supply. Some of the numbers in the survey are eye catching. For example, net demand for loans from firms fell more strongly than expected and at any time since the global financial crisis. Finally, today offered no surprises on inflation. As expected, the flash April data showed inflation moving broadly sideways. Core inflation was broadly unchanged, though that is an improvement on its previous upward march. Most notably perhaps is that food inflation has started to come off, a sign that the indirect effect of higher energy prices is now starting to fall back.
Core inflation may soon follow. All of that gives more conviction to our 25bp hike call for Thursday’s ECB meeting. The market had been pushing closer to 50bps and a terminal rate of 3.75% following some ECB Governing Council members calling for another 50bp hike. But these data to us suggest the ECB is more likely step down from 50bp to 25bps hikes, not least to reflect a more cautious approach to continued US banking sector fragilities. To satisfy the more hawkish members of the ECB Governing Council, we expect an announcement that balance sheet run off is accelerated in the second half of this year. Flexible PEPP reinvestment is expected to remain in place, with TPI as a backstop, to help put a ceiling on Italian spreads.
Threading the Needle of Price and Financial Stability Is Becoming Harder for the ECB
By Guillermo Felices, Global Investment Strategist for PGIM Fixed Income
Euro risky assets have been remarkably resilient following the bout of banks’ stress in mid-March. Both EUR IG and HY spreads are tighter and eurozone equity prices are higher since then. Government bond prices have also been calm. German bond yields fell rapidly in mid-March on higher risk aversion and expectations of less ECB tightening, but they have been gradually marching higher since. Today’s Q1 bank lending survey data is a reminder that monetary policy tightening is having a significant effect on credit conditions. As in the U.S., survey based credit conditions indicators tend to lead the business cycle and when they deteriorate sharply, asset prices usually notice.
The tricky assessment is the timing of the inflection point in markets. This is a classic late cycle dynamics, where the economy continues to enjoy momentum, especially in the aftermath of the pandemic and most notably in the periphery. But at the same time tighter monetary and credit conditions are starting to work their way through the economy. European asset have largely ignored the early signs of economic deterioration. It’s difficult to be precise about the turning points, especially when corporate and macro fundamentals remain solid. Our sense is that markets are complacent about the nascent risks and therefore vulnerable to negative news. Investors know the outlook is gradually deteriorating, and are defensively positioned. Perversely, that gives the illusion of calm as sellers are scarce and there is little new supply of corporate credit. Markets need trigger points for these benign equilibria to re-price, and the obvious event to watch for likely upsets is the ECB meeting on Thursday. Threading the needle of price and financial stability is becoming harder for the ECB and this makes Thursday’s meeting particularly interesting.
ECB: Data Point to a 25 Basis Point Rate Hike
Picture: Katharine Neiss and Guillermo Felices (Quelle: PGIM Fixed Income)