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ECB Expected to Hike, Then What?

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There is pretty much a near unanimous consensus that the ECB will hike by 25bps tomorrow. But that doesn’t mean there can’t be an important surprise for the markets. The post rate press conference is likely to be the center of attention, with investors looking to see what the chances are of a rate hike at the next meeting.

About 80% of economists expect one more rate hike in July, and from there the ECB will enter pause mode. They point to the combination of weaker economic data and slowing inflation has made the case stronger for the doves recently. But the ECB’s projections still show inflation remaining above target for another two years. Those forecasts are expected to be reiterated at this meeting.

Too high for too long

The minutes from the last ECB meeting were seen as practically predicting a rate hike at the next. A phrase from the monetary policy statement caught media attention and has been repeated by ECB President Lagarde over the last month. She keeps warning that inflation is “too high for too long”, which is understood to represent the argument for raising rates.

Traders will be looking to see if there is a change in that rhetoric. If Lagarde doesn’t use that phrase or a variation, it might be understood that the hawkish push is coming to an end. The contrarian view, or dovish position has another oft-repeated phrase: That policy has gone “most of the way” to reach the target. This is generally understood to indicate a preference for at most one more rate hike. Should Lagarde use a phrase similar to that, many traders could come to the conclusion that July will be the last rate hike.

What other surprises can there be?

Aside from the rate hike, the other main policy the ECB has for controlling inflation is shrinking the balance sheet. The current program already envisions rolling-off debt as it matures. The balance sheet is expected to shrink to €6.8T from the current €7.7T, meaning that the ECB will tighten by about €900B over the course of the next six months. That’s not as aggressive as the Fed’s policy of $95B/month, but is a substantial amount that could support yields and the Euro.

If the ECB wanted to get even more aggressive in tackling inflation, it could announce that it will start actively selling bonds. This could significantly surprise the markets, with few economists talking about it as a possibility. The increase in yields might initially support the Euro, but would also push up the amount of non realized losses that European banks hold. That could increase the risk of the EU having a banking crisis similar to the US, which is why it’s often discounted as a policy that the ECB will likely take.

The market reaction

The market has pretty much priced in two more rate hikes and then a pause. The ECB has few options to surprise the market to the upside, with things like a 50bps not even hinted at by any officials. That makes them quite unlikely.

There is, however, plenty of room to surprise to the downside. The range spans from Lagarde’s tone at the presser, to the staff projections significantly cutting the outlook for inflation. This could be exacerbated if the Fed comes out as more aggressive than anticipated.

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