Annalisa Piazza (MFS Investment Management) | The ECB is committed to continue to increase rates significantly, at a steady pace and to keep rates in restrictive territory until the medium inflation target returns to target. The central bank announced that it will start quantitative tightening (QT) related to the APP at the beginning of March 2023, with a “measured and predictable pace”, allowing the Eurosystem balance sheet to decline by €15 billion per month on average until the end of Q2-23. The announcement of details for the first stage of QT is somehow of a surprise but allows markets to start to price in future moves in net supply in advance. The predictability is a tool to avoid jerky moves in markets and allows better transmission of monetary policy.
The change of tone on the forward guidance led to a sharp move up in yields across all EMU curves and periphery spreads widened quite a bit (around 10bp). That said, the short end of the curve is not pricing in a much more hawkish scenario than what priced back in late October (before the recent US-led rally) and long-dated German yields are around 30bp lower that the recent relative peak. The market is implicitly suggesting the ECB terminal rate is somewhere between 3 and 3.25%. Risks of a recessions are priced into the long end of the curves despite the ECB baseline scenario for a shallow recession.
The ECB seems to be extremely concerned about inflation expectations running out of control and Lagarde kept mentioning how food and energy continue to represent upside pressure (due to possible second round effects into other parts of the HICP basket). Projections of a shallow recession seem too optimistic to us, also considering the energy crisis is far from being over. Until next summer, it will be hard to assess whether gas issues will be better or worse than now. Until then, the outlook remains very blurred.
Core rates had participated in a global rally going into this meeting. Coupled with refreshed hawkishness, money markets are adjusting to the ECB’s ongoing determination. Lagarde insisted that further significant hikes are likely which will leave core rates grappling to interpret this. All in all, risks to previous assumptions of a terminal rate of 3.0% are now probably skewed to the upside, despite the growth downturn. As such, we believe the flattening is justified but equally we’re mindful of just how inverted the curve now is. Coupled with a growth slowdown and shifts in bond supply, it looks like the path of least resistance is for a further drift wider in spreads going into the new year. We target BTP/Bund spreads at 220bp at the end of Q1-23.
