ECB Monitor: Dovish Mood Could Persist in Near Term

Go to: Recent Voter Comments ǀ Stress, Surveys and Data

Summary

• ECB hawkishness has been pared lately, despite the main voices continuing to reject that underlying inflation is falling.
• We expect the breakdown of latest inflation print will show that one-off policy has been the main drag on services and core and that the momentum there remains strong.
• Market pricing for a 3.75% terminal rate is receiving support from ECB speakers. We still think it is too low given medium-term dynamics, but dovishness could persist in the near term.

Current ECB Forecasts

Link to Most Recent ECB Meeting Minutes (May 2023)

Will ECB Dovishness Last?

How ECB speakers react to the recent miss in core, headline and services inflation readings will be very important in gauging their future policy reaction. While we believe the underlying picture for inflation is far bleaker than the headline figures suggest (rationale below), the tone of ECB comments has shifted in several important ways:

General Tone Is Less Hawkish

Primarily, the tone of comments has undergone a generic (if modest) shift less hawkish (Chart 1). Hawks have retreated from 50bp hikes but, for the most part (bar Kažimír and Holzmann), not suggested extending the hiking cycle.

Settling on June and July Hikes

Instead, some of the previously more hawkish speakers have rallied around June and July hikes, with less certainty thereafter (as per recent comments from Lithuania’s Šimkus, Ireland’s Makhlouf, the Netherlands’ Knot, and Latvia’s Kazāks – see our table of recent comments).

Some Agreement That Core Inflation Not Necessarily Peaking

From across the spectrum there has been some agreement that core inflation has not yet necessarily peaked. We agree (more details below), as does President Lagarde. Even the doves, who remain more hopeful on the outlook, appear far from declaring victory (as per Italy’s Visco remark that core inflation is still too high and could take time to fall).

Fiscal Policy Remains a Concern

Another theme among the more hawkish voices (Belgium’s Wunsch, Slovenia’s Vasle, Estonia’s Müller) has been a refocus on the fiscal side and the role played there. This is particularly important for the medium-term outlook.

Right now, there seems little appetite for nations to tighten purse strings substantially, despite calls from the European Commission and Lagarde. Moreover, the ultimate EU response to the US Inflation Reduction Act (IRA) has yet to be finalised (so far it includes modest adjustments to State Aid rules). But nations are already reacting. The most recent German scheme is small (c.€3.3bn pa), but with Germany’s Habeck calling out the IRA in its rationale there could be more ahead.

Upside to 3.75% Terminal Rate

By our analysis, ECB policymakers appear to have rallied roughly around market pricing of a 3.75% terminal rate (Charts 2 and 3). While we still expect a higher rate, the relative dovishness can probably persist in the near term.

See here for our full table of recent ECB comments

Core Inflation Not Yet Peaking

Eurozone (EZ) May CPI dropped to +6.1% YoY, while core CPI dropped to +5.3% – both 0.2pp below market expectations. Adding to the dovish feel was the 0.2pp drop in YoY services inflation to +5.0%. That left both core and services roughly on track for a typical May MoM – a far cry from April’s significant beats (MoM core was +0.46pp above typical for the month, while services was c.0.75pp above typical, Chart 4).

However, the breakdown we get on Tuesday will be more important than the headlines. Transport services is likely to have been the main drag on both core and services, having fallen sharply on the back of the German €49 ticket. How much this sector dragged on total core and services inflation will be of most importance.

Recall: last year, when the €9 ticket came out in June, EZ services inflation missed typical MoM changes by -0.25pp. The €49 ticket probably had less effect, but it still constitutes a one-off factor that will not appear in next month’s data. Moreover, the base effects from last year’s €9 ticket should see the YoY accelerate sharply next month (Chart 5).

Coming back to the ECB’s forecast, the YoY headline was a slight miss vs ECB forecasts for the month, while core remains inconsistent with their 2023 forecasts. We still believe an upward revision will be needed at the June meeting.

Mixed Evidence on Impact of Hikes

Lagarde’s focus on policy transmission has made strong reference to M3 growth and the outlook demand within the BLS survey. She has also suggested rate hikes may be driving the weak recent manufacturing demand, although the evidence seems circumstantial.

M3 growth has significantly pared recently, led by a decline in overnight deposits, although how well this feeds into inflation remains to be seen (Chart 6). Meanwhile, although the outlook for loan demand in the BLS has recently deteriorated sharply, momentum in actual lending has proven more resilient; 3M/3M loan growth bounced back in March and April (Chart 7). The growth could still fall, but with the fallout from SVB fading in the market, the ECB may struggle to unequivocally declare that the hikes are having an effect just yet.

Market Implications

The market is pricing a c.3.75% terminal rate, the lower end of our the ‘range of reasonableness’ (Chart 2). This is predominantly driven by near-term data misses (especially in the industrial sector) and the recent CPI miss.

Further out, we still think the ECB will need to hike to at least 4%, driven by a recovering consumer, strong labour market dynamics, and supportive fiscal policy. However, these effects may take time to play out.

Next week’s ECB meeting and the final May inflation readings provide a hawkish risk. The ECB will need to revise its near-term core forecast higher and inflation details should show strong core services momentum. However, the market may be able to overlook this while the ECB’s tone remains optimistic.

Surveys and Financial Conditions Support Hawkishness

Overall, while recent EZ data has underperformed, the strength of services and business hiring intentions, the recent paring in financial market stress (and credit spreads), and the persistent de-anchoring of medium-term inflation expectations paint a hawkish picture (Charts in our appendix):

• EZ systemic stress remains elevated, but below end-2022 levels or those around the SVB shock earlier this year (Chart A1).  
• In the real economy, however, data surprises have collapsed sharply in the EZ, likely driven by the quick end to the China rebound positivity (Chart A3).
• The surveys present a mixed picture. Consumer confidence continues to recover (albeit from low levels), while overall expectations of business orders have dipped again, led by a sharp fall in industry, even as services bounce back (Chart A4). Hiring expectations are more positive, with services particularly strong (Chart A5).
• Finally, inflation expectations remain de-anchored from pre-2022 levels. The paring in consumer 3Y ahead expectations at the most recent CES suggests more that the March spike was a blip, rather than there being a concerted return towards target (Chart A6).

Recent Voter Comments

Appendix: Stress, Surveys and Economic Data

Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)