It has taken what seem like only slight changes in tone from Christine Lagarde, and the governing council she heads, to convince investors that the European Central Bank is on the verge of a dovish pivot.
Markets on Thursday quickly took the ECB president’s acknowledgment in a post-council meeting press conference that the eurozone was likely to be heading for recession — long a foregone conclusion for most economists — to mean that the region’s rate-setters would ease the extent of rate rises.
Silvia Dall’Angelo, a senior economist at US fund manager Federated Hermes who now expects the ECB’s rate-hiking cycle to pause after its next vote in December, described the messaging as “more cautious and less hawkish than in previous meetings”.
Government borrowing costs fell sharply after Lagarde met the press on Thursday afternoon and by the end of the day the euro was back below parity with the dollar, erasing some of its recent gains.
The fierce reaction, however, surprised some of the more hawkish members of the ECB governing council. “I don’t know what this is based on,” said one. “There are still lots of things to worry about inflation. If we keep getting high inflation readings, we will need another strong response.”
At first glance, little has changed in the ECB’s policy stance. It lifted its deposit rate by 0.75 percentage points for the second consecutive time and signalled plans for more increases to come, as inflation remained “far too high” at almost five times its 2 per cent target.
However, investors are upping their bets on the major central banks soon becoming less aggressive in their efforts to increase rates.
Canada’s central bank on Wednesday delivered a smaller-than-expected rate rise of 50 basis points, following a similar move by the Reserve Bank of Australia earlier this month. While the US Federal Reserve is expected to deliver its fourth consecutive 0.75 percentage point increase next Wednesday, US officials are increasingly expected to slow their pace of rate rises after November.
For those homing in on dovish changes, the ECB offered plenty of hints of a shift.
The wording of its statements was slightly less aggressive. Instead of saying it would raise rates “over the next several meetings” as it did last month, the central bank only said it expected to “raise rates further”. It is no longer setting out to “dampen demand” but only aiming for “reducing support for demand”. And “substantial progress” has already been made in “withdrawing monetary policy accommodation”.
Having pushed back on the idea of a recession last month, this time Lagarde said such a scenario was “looming much more on the horizon”.
Apart from a slight easing of supply bottlenecks, resilient labour markets and increased support from governments to deal with high energy prices, “pretty much every other indicator is pointing downwards”, she said, adding that the likelihood of a recession “will be taken into account at our next meeting in December”.
Investors widely interpreted these comments as signalling that the ECB’s next rate rise will be reduced to 0.5 percentage points and they now think that, by next September, borrowing costs will be a quarter-point lower than they thought before the ECB made its policy announcement.
They even drew comfort from the ECB’s plans to shrink its balance sheet — a major source of support to financial markets after quadrupling in size over the past eight years to €8.8tn.
Lagarde said it would discuss how to start reducing its €5tn bond portfolio at the December 15 meeting, while adding that an increase in the cost of its €2.1tn programme of ultra-cheap loans to commercial banks was likely to encourage many to repay them early.
These moves represent a further tightening of monetary policy, but investors viewed them as less hawkish than expected and a way for the central bank to raise rates less than it otherwise would.
Krishna Guha, vice-chair at US investment bank Evercore ISI, said Lagarde’s announcement that it would begin discussions in December on “the principles” of reducing reinvestments in part of its bond portfolio showed it was “slow-walking the process” of quantitative tightening that many other central banks have already started.
The ECB was likely to start the process in the first half of next year, but it “could easily be delayed further depending on economic conditions”, he added.
Meanwhile, the ECB’s decision to make its €2.1tn of targeted longer-term refinancing operations (Tltro) less attractive could be “a rate increase through the backdoor”, according to Salomon Fiedler, an economist at German investment bank Berenberg.
Tltros were offered to banks at 0.5 percentage points below the ECB’s deposit rate to encourage them to keep lending during the pandemic. Banks can earn a big profit simply by putting the money they borrowed back at the central bank to benefit from its sharply rising deposit rate.
But the ECB is stopping this from November 23, after which the rate on the loans will track its deposit rate. Based on past surveys of banks, ECB officials think about €600bn of the loans could be repaid as early as next month.
This should boost rates in Europe’s €10tn money markets, which have been weighed down by the ECB’s use of its balance sheet. Many short-term rates are yet to reflect the ECB’s increases, sagging below its deposit rate, now at 1.5 per cent.
By releasing the collateral tied up with the loans, Fiedler estimated early repayment by banks could bring money market rates up almost 0.5 percentage points towards the ECB’s higher refinancing rate of 2 per cent.
Big banks have grown increasingly concerned about a lack of high-quality liquid assets in Europe’s financial markets and this week the International Capital Market Association, which represents the bond market’s biggest traders, urged the ECB to take action to address this.
Andy Hill, senior director at the ICMA, said the change to Tltros announced on Thursday was “mostly positive” because it was likely to free up more collateral and it had already lifted some rates in money markets.
