June will mark eight years since the ECB decided to break ground and embark on its negative interest rate policy cycle. In what was a vastly different economic environment, the ECB was one of the first the first central banks to combat disinflationary pressures by resorting to bold unconventional measures in attempt to revive the economy. Fast forward to today, the ECB continues to face insurmountable pressure on the other side of the inflation spectrum, however, it has been behind the curve in tackling price pressures. Yet with the persistent rise in inflation, it seems that the ECB is at a tipping point to exit its era of negative rates and deal with the economic effects (i.e. a stagflation scenario) head on.
EU nations, already fragmented in their economic conditions (with respect to GDP growth, unemployment, borrowing costs etc), will diverge in times of crisis. High energy prices no doubt weigh on the overall EU economy, however Germany stands to bear the brunt of the energy shock. Economies like France and Portugal (amongst others) have lower exposure to the fallout from the Ukraine war given the lighter dependency on Russian trade flow. Hence, it’s no surprise that the ECB is deliberate in delaying its tightening cycle as it evaluates the impact of higher rates on battling inflation vs a further decline in economic output and growth – which could be exacerbated by the war in Ukraine.
ECB’s Lagarde continues to resort to a gradual approach in removing policy stimulus by highlighting i) the slower pace of rebound in the EU (than that of the US) and ii) inflation being largely supply shock driven. The upward spiral in inflation however has recently led to a more hawkish pivot from the ECB and aligns with broader market expectations (which calls for higher rates). With ECB discussions of a tightening cycle now underway, the market is pricing in its first rate hike in July (current policy rate is at -0.5%), with a move to positive territory by the end of the year (see Chart 1).
Chart 1: Market Implied ECB Policy Rate (by End of 2022)
If the ECB kicks-off its hiking cycle as expected at the July meeting, there are some inherent risks to consider and their impact to currency markets.
1.Central banks unwound Euro holdings as rates went negative, a swift reversal could be underway
Resorting to negative interest rates was met with a steep sell off in the Euro and led to major central banks unwinding Euro reserves in 2014. The prospect of a positive rates story after almost a decade of negative yields will support the Euro and potentially add a floor to the already weakened currency.
2. Peripheral yield spreads could further widen
Lending rates have historically been low across the Euro zone and ultra-accommodative monetary policy has further narrowed the dispersion across EU nations. However, under a tightening cycle, higher leverage economies (i.e. Italy, Spain, Portugal etc) will be disproportionately impacted and greater credit risk / sovereign stress can cause peripheral yield spreads to widen.
This could lead to greater instability across the Euro zone and place downward pressure on the Euro. The ECB may need to revisit its tightening approach and further ease into it if debt serviceability concerns arise.
3. Rising rates coupled with unsustainably high energy prices could aggravate the economic climate
Energy prices are already at elevated levels and the entire region is feeling the pressure. With the French election now behind us and President Macron remaining in power, his support for EU sanctions on Russian oil could further exacerbate the energy crises and undoubtedly increase the likelihood of a recession.
Although the ECB will likely need to be accepting of stagflation risks in the near-term, a recessionary outlook may be one where it might have to dive back into its monetary toolkit.
The likelihood of a ban on Russian energy exports is wielding its way into market sentiment and inflation expectations. Market-based inflation expectations in the Euro zone have been trailing the US since 2009 (see Chart 2). However, in recent weeks the Euro has caught up and is expected to surpass that of the US given the lingering uncertainty around the oil sanctions and prospect of consumer prices peaking in the US.
Hence, despite heightened risk factors across the globe, near-term market risk remains increasingly concentrated on the trajectory in the Euro zone. The ECB’s delay in curbing inflation widens its monetary divergence with other central banks and continues to weigh on the Euro (hit a 2-year lower vs the dollar).
Chart 2: USD (blue) vs Euro (black) 10-Year Inflation Swaps
With significant uncertainty and rising stagflation risks on the horizon, the challenges for the Euro remain clear. The ECB will take a calculated approach to its tightening cycle as it balances higher rates with sluggish growth. As volatility persists, prudent risk management remains central to navigating market risk.