No let up for the ECB

Comments by Franck Dixmier, Global CIO Fixed Income at AllianzGI.

The European Central Bank may have switched off autopilot, but inflation remains high, so we still expect another interest rate rise at its September meeting. Markets seem unprepared – a rate increase could lead to further surges in fixed-income yields.

• We expect the European Central Bank to raise rates by 25bp at its meeting on Thursday 14 September.
• Despite a slowdown in the euro zone economy, underlying inflation remains too high to justify a pause.
• The markets do not seem prepared for this hike, which should further fuel the rise in yields seen over the summer.

Having raised rates by a total of 425 basis points (bp) since July 2022, the European Central Bank (ECB) is no longer on autopilot. It has two options: pause or continue to tighten monetary conditions.

In the past, investors could gain insights into future monetary policy by analysing the bank’s forward guidance. But the uncertain outlook has prompted the ECB to favour a “meeting-by-meeting” approach. ​ Therefore, we need to look at the three key parameters of the ECB’s reaction function.¹

• Underlying inflation. Inflation is still too high, at 5.3%² year-on-year in August. This level is all the more worrying given that a price-wage loop has been set in motion in the euro zone, against a backdrop of zero or negative productivity gains. Any rise in wages is reflected in unit labour costs and passed on by companies in their prices. Moreover, the upward trend in wages – labour costs rose around 5% year-on-year in Q1 – is set to continue in 2024.³
• Medium-term inflation expectations. Growth and inflation forecasts will be announced at the September meeting, but we expect an upward revision to the inflation outlook, which should incorporate the recent rise in oil prices.
• Good monetary policy transmission. Monetary policy is working, and the activity data published this summer confirmed the slowing trend in the euro zone economy, with the Services PMI for August at 47.9, joining the Manufacturing PMI (43.5), which is contracting for the first time in 2023.⁴ Credit is less buoyant, both for households (+1.3% in July over one year compared with +1.7% in June) and for businesses (+2.2% in July over one year compared with +3% in June). ⁵

However, we believe that this deceleration in euro zone growth is not yet sufficiently worrying to warrant a pause, while inflation levels are still far from the ECB’s target. Another worrying factor for the central bank is that market confidence in its ability to achieve its objectives is gradually being eroded, with inflation expectations slightly off track (the 5y5y inflation swap stands at 2.60%).⁶

Therefore, the time is right to continue tightening monetary conditions, and ECB President Christine Lagarde is expected to announce a 25bp increase at the September meeting.

Investors have clearly understood the “higher-for-longer” theme. However, with markets pricing in a 65% probability of only a further 25bp hike this year, they may be underestimating the potential for future rate rises. Therefore, investors seem unprepared, and the hike could further fuel the rise in yields seen over the summer.

_{1 Monetary policy reaction functions can provide insights into the factors influencing monetary policy decisions.}

_{2 Eurostat, August 2023}

_{3 Eurostat, June 2023}

_{4 S&P Global, August 2023}

_{5 ECB, August 2023}

_{6 Bloomberg, 7 September 2023}