What happened
The European Central Bank (ECB) raised interest rates as expected at its February meeting, but added a new line to the monetary policy statement that attempted to harden the Governing Council’s forward guidance for future rate hikes. The statement reiterated that interest rates "will still have to rise significantly at a steady pace" and that the Governing Council maintains a data dependent, meeting-by-meeting approach. However, in addition, February’s statement now says that the Council “intends” to make another half-point hike at its March meeting, at which point the Council will “evaluate the subsequent path” of policy.
President Lagarde followed up this overly complicated messaging at the Press Conference, stating that on the one hand the risks to the inflation outlook have become more balanced (versus the previous view that there were upside risks), while on the other that inflation is still “far too high” particularly when looking at measures of underlying inflation. Nevertheless, when explicitly pressed on the “intended” follow up hike, Lagarde equivocated, allowing yields across European Government bond markets to fall significantly.
As for February’s policy decisions, the ECB raised all its policy interest rates by half a percentage point, bringing the deposit rate to 2.5 per cent, in line with expectations before the meeting. The ECB also announced it will reduce its holdings of assets bought as part of its asset purchase programme by €15 billion per month on average between March and June. Re-investments into corporate bonds will be tilted more strongly towards companies with better climate performance.
Our interpretation
Since the December meeting, the ECB has faced a slew of largely positive news. Europe's outlook has improved on the back of warmer winter temperatures, meaning the worst growth fears induced by the energy crisis are now out of the way. Europe's GDP growth came in at 0.1 per cent for the fourth quarter of 2022, showing the economy avoided contraction, although there was significant regional differentiation, with France and Spain expanding and Germany and Italy contracting. While the composition of growth points to pronounced consumption weakness, President Lagarde and the Governing Council seem to be looking through this, focusing instead on the headline growth surprise and the still high and sticky core inflation numbers. These two factors go some way to explaining why the Council remained in hawkish mode at this meeting and pre-committed to another half-point hike at the March meeting.
Outlook
With the winter recession avoided, the outlook now shifts to the prospect of a policy-induced recession later in the year. We believe this is a likely outcome given the scale of the tightening the bank has delivered to date, the further rate hikes and quantitative tightening (i.e., the sale of securities the ECB previously bought) still to come, as well as the real income shock and the effects of the energy crisis still working their way through the system. The bank lending channel already points to significantly tight financing conditions for both the corporate sector and households.
The key question for us is about the depth of the upcoming recession, which we think will be dictated by the ECB’s actions. As a result of the recent meeting, we now believe that the ECB will follow the path set out for them by market pricing and hike to 3.25 per cent. This is likely to be an overly restrictive stance for the Euro area, and as a result, the ECB will run the risk of inducing more damage to growth as well as reigniting concerns about the sustainability of peripheral countries' debt. The key factor that will determine whether these risks emerge will be how long the ECB remains at this high rate.
Asset Allocation views
We remain slightly underweight global equities as the coming growth slowdown makes us wary of equity risk at a time when equities appear to be priced for a more benign outcome. We prefer the relative safety of government bonds, which benefit from falling interest rate volatility and should offer portfolios a degree of protection from the challenging times ahead.
