Market Wire - ECB Telegraphs Quarter-Point July Rate Hike, Euro Climbs

The European Central Bank fired the starting gun on its first hiking cycle since 2011, announcing it expected to raise its key interest rates by 25 basis points at the July meeting, with a larger increment possible in September “if the medium-term inflation outlook persists or deteriorates”. In the widely-anticipated decision, the central bank left its main benchmarks unchanged and said net bond buying under the asset purchase programme would come to an end on July 1, clearing the way for rate increases. 

Inflation projections rose, with price growth now seen hitting 6.8 percent by the end of the year, and 3.5 percent in 2023. Inflation is now expected to run at 2.1 percent in 2024 - a hawkish upgrade from the earlier 1.9 percent estimate. 

Growth forecasts for this year slumped, from 3.7 percent to 2.8 percent in 2022, and from 2.8 percent to 2.1 percent in 2023. But 2024 was revised up, from 1.6 to 2.1 percent. 

The official statement carried no formal mention of a new mechanism to contain fragmentation risks, but policymakers noted additional purchases of Greek bonds could be made under the Bank’s still-active pandemic emergency purchase programme. Since the beginning of the year, yields on ten-year Italian government debt have jumped by 2.2 percent and the spread between German and Italian debt in that tenor has increased by almost 75 basis points. A failure to reverse these trends could lead to worries about growth and debt sustainability in the periphery.

The dust is still settling - and conditions could shift during President Lagarde’s press conference in a few minutes - but current pricing suggests markets expect Europe’s monetary mandarins to raise rates in 25 basis point increments at each of the remaining meetings this year, with the deposit rate hitting 0.75 percent in December. Odds on a 50 basis point move at the September meeting are at better than coin-toss levels. 

The euro is climbing as we go to pixels, reflecting a modest rise in rate expectations. Yield differentials between 2-year European government bonds and their US equivalents have tightened sharply over the last months, potentially building momentum for a move above the 1.10 mark at some point in the coming weeks. 

But the euro area is facing deep and growing uncertainties. Consumer sentiment is plumbing record lows, and rising commodity prices - exacerbated by ever-tighter restrictions on Russian oil - could demolish business confidence over the months to come. The European Central Bank could be poised to continue a long tradition of raising rates just as the economy topples into recession.