The European Central Bank (ECB) today raised its policy rates by 50 basis points (bps), including its deposit rate, which is now 0%, to address high inflation levels in the bloc. This represents the first hike by the ECB since the ill-fated decision to raise rates in 2011 and ends its negative rates regime. The move to front load hikes, in conjunction with slightly more dovish forward guidance, led to a decline of 10 bps in the peak expected policy rate, which now stands at 1.47%. The ECB also announced the approval of the Transmission Protection Instrument (TPI). This ‘anti-fragmentation tool’ is designed to limit ‘unwarranted’ widening in yields between peripheral euro area nations and those in the core.
While there had been a rising expectation in the last week that the ECB may deliver a hike of greater than 25 bps, markets were still modestly surprised. Two- and ten-year Bund yields spiked by 15 bps and 9 bps, respectively, periphery spreads widened, the euro gained 0.8% against the dollar, and equities declined by 0.5%. But these moves largely reversed in subsequent trading.
The introduction of the TPI takes place as spreads between periphery and core sovereign yields have widened. The recent widening is connected to the elevated debt levels of peripheral countries, and the associated rising cost of servicing that debt as interest rates rise. This time last year, the Italian-German ten-year yield spread was 1.08%. Today, that figure stands at 2.24%. Whilst high, this is still below the recent peak, suggesting perhaps that the prospect of the TPI is proving effective. However, it may yet face legal challenges. The ECB highlighted that they would prefer not to have to use this new facility, saying that the flexible reinvestment of redemptions under the Pandemic Emergency Protection Programme (PEPP) remains the first line of defence.
But the calculus of these plans has now been significantly complicated by the breakdown of the incumbent government in Italy. Several of the parties that had supported the technocratic premiership of former ECB President Mario Draghi have withdrawn that support in recent days, culminating in his resignation today. An October election in Italy now seems likely, with current polling suggesting that a right-wing coalition will be in a strong position to form a new administration. While this grouping may not have quite the same depth of Euro-sceptic tendencies as in recent years, it presents a major source of volatility for Italy and the euro area, nonetheless.
With headline and core inflation at 8.6% and 3.7%, respectively, the ECB is in a particularly invidious position with regards to balancing elevated inflation on one hand, and both sluggish economic activity and sovereign default risk on the other. The war in Ukraine presents a number of economic headwinds, though none are as challenging as the elevated energy price environment. The impact of high inflation on consumption, and now the reawakening of Italian political risk, all cloud the European economic outlook.
Thomas O’Mahony, Investment Director, Capital Markets Research