Comments by Franck Dixmier, Global CIO Fixed Income, AllianzGI.
After a significant round of rate hikes over the past year, the ECB is fine-tuning its monetary policy, but we still expect further rises in the months to come.
- The ECB is expected to announce a further rate hike at its meeting on 15 June, with a 25 basis points increase likely to be followed by another 25 basis points increase in July.
- Despite the euro zone’s technical entry into recession, inflationary pressures are still persistent, and the ECB must continue its monetary tightening to maintain its credibility and anchor inflation expectations in the market.
- It is too early for investors to build long duration positions in the euro zone yield market.
After 375 basis points of rate hikes since July 2022, the European Central Bank is fine-tuning its monetary policy. The eurozone economy is slowing, as confirmed by the latest activity figures. In fact, the euro zone has technically entered recession. However, inflationary pressures are still persistent. Although year-on-year price rises slowed at the end of May, with headline inflation at +6.1%5 compared with +7% in April, the level of core inflation, at +5.3% compared with +5.6% in April, remains too high for the ECB to lower its guard.
In fact, the ECB incorporates three key factors into its reaction function:
- The level of core inflation – changes in the costs of goods and services minus those from the food and energy sectors.
- The trend in core inflation
- The correct transmission of monetary policy. In other words, how the central bank’s changes to monetary policy flow through to economic activity and inflation.
On this last point, the ECB has received some good news: demand is slowing, as shown by the weakness of retail sales6 in the euro zone in April (+0% month-on-month and -2.6% year-on-year). However, the upward pressure on wages fuelled by a robust labour market, combined with companies’ still high pricing power, suggest that the deceleration in underlying inflation will be very gradual.
Consequently, we expect the ECB to continue raising rates, with a 25 basis points increase at the meeting on 15 June, probably followed by a further 25 basis points in July. Markets anticipate this scenario.
In the longer term, the ECB can be satisfied with two indicators: three-year consumer inflation expectations in the euro zone 7remain very moderate (at +2.5% compared with +2.9% previously), and inflation expectations in the market are solidly anchored (with a 5y5y inflation swap at 2.48%8). The ECB’s credibility has not been undermined in the fight against rising prices. However, this long-term credibility is the result of its short-term determination to continue monetary tightening. On this monetary tightening point there is no room for compromise.
Given the persistence of core inflation, we believe that market expectations are not taking sufficient account of the potential for further rate rises in this cycle of monetary tightening. Therefore, it is too early for investors to build long duration positions in the euro zone yield market.
