ECB's Dovish Interest Rate Hike And The Subsequent Challenges On The Horizon: A Comprehensive Examination

On Thursday, the European Central Bank hiked for the 10th time their interest rates by 25 basis points to 4%, the highest since 2001, defying the market expectations of a pause. According to Lagarde, some colleagues would have preferred to pause instead, but in the end it was decided to press forward in the fight against stubbornly high inflation that has been plaguing consumers anyway, even as worries grow that higher borrowing costs could help push the economy into recession. Also, the ECB cut its outlook for the euro area growth this year to 0.7%, and revised up the inflation outlook instead.

It’s not surprising that Lagarde attempted to downplay the dovish nature of the hike: it would make no sense from a strategic point of view for the ECB to commit to a rate peak, as they need the flexibility to respond if inflation surges again. However, looking at recent economic data coming from the Eurozone, it’s my belief this was indeed a dovish hike. Indeed, the major European economies - Germany, France, Spain, and Italy, saw shrinking activity in August in the service sector, even at the tail end of a strong tourism summer, and that comes on the top of a slowdown in global manufacturing that is hitting Germany particularly hard. The unemployment is still at a record low of 6.4%, but one has to wonder how long will this continue to be the case.

The market reaction was far from being positive, as the euro sold off by over 0.6%. Usually, when a G10 currency declines on a rate hike it means that traders are more worried about growth than inflation, and that’s exactly the case here. Also, traders started to price in cuts in the first half of 2024, challenging the bank’s “higher for longer” signal in the face of a souring economy. However, despite the market sentiment, I remain skeptic about the ECB’s willingness to deliver rate cuts so early, especially in light of the persistent inflationary pressures being experienced.

The only way to keep the euro from falling more would be the ECB adopting a more aggressive stance than the Fed, but given the strong economic data the United States are constantly delivering, this looks more like a well-constructed joke than an actual possibility.

However, the ECB’s monetary toolkit extends beyond just interest rate adjustments. The ECB’s recent actions also include the cessation of Asset Purchase Program (APP) reinvestments as part of its strategy to gradually unwind accomodative policies. Additionally, there is speculation that the ECB may accelerate the reduction of the Pandemic Emergency Purchase Program (PEPP) reinvestments as well, possibly as early as this year: this change in policy direction weakens the technical outlook for government bonds, and hints at the rebuilding of term premia over time. While the ECB has maintained its balance sheet guidance until at least the end of 2024, the possibility of earlier PEPP reinvestment cutbacks is a point of contention.

Some have speculated about the possibility of increasing the minimum reserve ratio from its current 1%, but such a move remains unlikely in the current environment of ample excess liquidity. Additionally, the ECB may contemplate revising its guidance on the remuneration of domestic government deposits. At the moment, the ceiling is set at €STR minus 20 basis points, but the ECB might encourage a reduction in these deposits by lowering the remuneration rate further: if anything, the recent decision by the Bundesbank to remunerate these deposits at 0% underscores the evolving dynamics of this policy.

If you enjoyed this article, be sure to follow me on Twitter at @MrnllMtt for more insights and updates. 

Market News and Data brought to you by Benzinga APIs
Posted In: EurozoneEconomicsMarketsGeneralcontributorsEuropean Central BankExpert Ideas
Benzinga simplifies the market for smarter investing

Trade confidently with insights and alerts from analyst ratings, free reports and breaking news that affects the stocks you care about.

Join Now: Free!