The Big Idea

Europe | The ECB enters a new phase

and | October 27, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

For the first time since it started tightening in July 2022, the European Central Bank has decided to keep rates on hold. Crisis in the Middle East permitting, the ECB’s October 26 announcement marks the beginning of a new phase where official rates will likely remain at current levels until clear evidence shows inflation finally approaching 2%. The wait could last longer than current market pricing implies, and the return to neutral could happen faster. To capitalize, receive fixed in 2-year forward 2-year EUR swaps or overweight 3- to 7-year EUR sovereigns.

Market pricing

The market now prices in a very small chance of an ECB rate hike at coming meetings and some normalization in monetary policy starting in 2024, which is in line with our baseline scenario. But there are some differences when it comes to timing, pace and ending level of the expected normalization, which leads to some interesting market opportunities. Using the forward €STR rates that cover the upcoming ECB maintenance periods—and bearing in mind that the overnight €STR trades at a spread of around 10 bp below the DFR—the market is already pricing in rate cuts by the June 2024 ECB meeting, starting a very gradual and shallow normalization process that would take official rates to 3% by September 2025. And official rates would stabilize around that level for the coming years (Exhibit 1).

The risk to this pricing is that the ECB could start with those rate cuts later than currently priced—September 2024 is more likely—but also proceed a little faster and deeper than currently priced. At a pace of 25 bp a meeting, the ECB should take the DFR to 2.50% by the second quarter of 2025.

Exhibit 1: Current market expectations for €STR rates versus SAN forecasts

Source: Bloomberg, Santander

Our differences with market pricing point to receiving in 2-year forward 2-year EUR swaps or going overweight the belly of EUR sovereign curves to capitalize. Our view and the trading opportunities around it follow from a close reading of what the ECB has said and our projected path of EUR inflation.

Policy goes on hold

As widely expected, the ECB announced October 26 that it will keep official rates on hold. The central bank sees its cumulative 450 bp of tightening as enough to likely lead to inflation back to the ECB’s goal in a timely manner if maintained for long enough.

The Governing Council’s past interest rate increases continue to be transmitted forcefully into financing conditions. This is increasingly dampening demand and thereby helps push down inflation. –ECB Press Statement, October 26, 2023

The market had already priced in a good chance of an ECB halt in September after August PMI suggested increased downside risks to growth, information that was available to the ECB at its September 2023 meeting. But back then, PMI was just a leading indicator of a potential slowdown when inflation was not clearly declining yet. And that is the likely reason why the ECB decided to continue with rate hikes at that meeting.

Just as it was crucial in the past for the ECB to confirm peak core inflation was in the review mirror to move from “extraordinary” hikes of more than 25 bp a meeting to “ordinary” hikes of 25 bp, now it is crucial for the ECB to ensure that inflation is on a clear downward path (Exhibit 2). The ECB has to show that the risk of renewed inflation, energy prices permitting, had abated before stopping rate hikes. The key point is that it is only now that a clear downward path in core inflation can be confirmed. Note that the preliminary and final EUR CPI numbers were published after the September 14 ECB meeting.

Exhibit 2: EUR core CPI (% YoY) vs. pace of DFR hikes by the ECB (bp/meeting)

Source: Bloomberg, Santander

The ECB has left the door open to hiking again if needed. Further developments in the Middle East or another shock in energy prices seem like the main risks that might bring on another hike. In this connection, the December 14 meeting—when the ECB publishes staff macro projections for 2026 for the first time – is the next risk event to monitor. If the ECB does foresee inflation stabilizing at 2% in 2026, and if none of the risks to energy prices finally materializes, the baseline scenario is that the ECB is already done with rate hikes. To us, the statement of the September 2023 ECB meeting is very revealing, with a new paragraph that states that “rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target.”

Specifically, accounts of the meeting explain that the decision came after ECB Chief Economist Philip Lane presented the results of an analysis that, even if not explicitly mentioned in the minutes, seems to have focused on determining the theoretical terminal rate for the Eurozone. With both “a range of model-based simulations” and “views of external experts” pointing to 3.75% to 4.00% as the appropriate level, it would likely require significant changes to the macroeconomic outlook to make the ECB consider an immediate change to these rate levels.

The focus shifts to non-conventional tools

Even after the EUR PMIs surprised the market in August, they remain in contraction territory, suggesting downside risks to growth persist (Exhibit 3). The ECB has further steps to take with non-conventional monetary policy. Lagarde explained at the European Parliament on September 25, that Eurosystem staff are conducting “a comprehensive review of the operational framework” and they “aim to conclude this review by spring 2024”. This will necessarily lead to some additional tightening of monetary conditions in the Eurozone. The gradual shift towards liquidity withdrawal and its potential impact on monetary conditions—given ongoing downside risk to growth—makes it less likely that rate hikes will continue from here.

Exhibit 3: Recent evolution of Eurozone PMIs—manufacturing versus services

Source: Bloomberg, Santander

The ECB stays put while headline inflation remains at or above 3%

While the ECB keeps focusing on the possibility of hiking again if needed (“data-dependent”) and tries to avoid any expectations of rate cuts any time soon (“not even discussed”), markets are likely to focus on the potential duration of high policy rates and the timing of eventual normalization.

Here, the evolution of inflation will be key. While most models and current market pricing seem to agree that inflation will slow in coming months and trade through (and remain below) 4% by the end of the year, there is still significant uncertainty about the level at which it might stabilise thereafter (at around 3%, or maybe slightly higher?) (Exhibit 4). It might take until August until EUR headline CPI finally breaks below 3% for good. And the ECB seems very unlikely to unwind some of the recent hikes as long as inflation remains “sticky” at 3% or higher levels. Based on information available so far, the ECB might not start cutting rates until September 2024, the first meeting when already-published inflation figures should show inflation below 3%.

Exhibit 4: Market and selected SAN models of headline EUR CPI (% YoY)

Source: Bloomberg, Santander

The path to neutral: cut 25 bp a meeting down to 2.50%

This first rate cut will mark the beginning of a normalization of monetary policy that should take official rates closer to neutral, as inflation stabilizing close to the ECB target would imply that such a restrictive level of official rates is no longer required. Our baseline scenario is a very gradual unwinding of some of the recent hikes, probably at a pace of 25 bp a meeting and with the ECB stopping when the DFR reaches 2.50%; a level that is still slightly above the latest estimates of neutral rates for the Eurozone, as the ECB will likely prefer to ensure monetary policy has not turned into easing in order to prevent medium-term inflation expectations from resurging.

In a nutshell, if inflation declines closer to 2%, the ECB is unlikely to hold the DFR significantly higher than that level, as it would imply official rates remaining in restrictive territory—in real terms they would stand at clearly positive levels—and at that point it would risk slowing down the economy beyond what is required to maintain price stability.

Market opportunities in short-term EUR rates

We see two different risks to current market expectations for rate hikes:

  • On the very short end of the curve and in the very near term, the risk is that unless inflation declines faster than currently expected, the market might eventually reprice the date for the first rate cut. And a longer period of official rates at 4% will likely mean short-term rates declining slightly slower than currently priced. In other words, we might see a brief, moderate spike in very front-end rates.
  • The risk for 2025 and the following years is for official rates declining below levels currently priced in, which could potentially lead to more sizeable movements in the front end of the EUR rates curves. Whether the ECB succeeds in controlling inflation, and therefore whether the tightening cycle ends in coming months and quarters or inflation proves to be out of control and pushes the ECB into tightening for longer, in most scenarios, it is difficult to see official rates exceeding the 3% currently priced in (we recall that the neutral rate for the Eurozone is estimated to be around 2%) for such a long period (2025 and beyond) (Exhibit 5).

Exhibit 5: Selected macroeconomic scenarios and possible changes in conventional monetary policy

Source: Santander

The only scenario where the market might price in official rates in 2025-2026 increasing beyond current forward levels is probably one where the ECB temporarily pauses the tightening cycle in coming months but then needs to resume it later in 2024 (and therefore all the normalization expectations discussed above would be delayed by several quarters). In order to see that happen, inflation would have to appear under control over the next few months (so that the ECB pauses), only to resume its upward trend later, pushing the ECB into hiking rates again. And looking at current market and consensus expectations for inflation, it does not seem the most likely scenario at the moment.

The potential downward movement of the 2-year forward 2-year part of the EUR curve compared to current forward rates seems to be significantly greater than the potential upward movement in shorter tenors if the ECB finally hikes one more time or if the normalization process is delayed until September 2024 (as we also expect). This means that if the ECB finally needs to become more hawkish than currently priced in, the potential upside in 3- to 7-year tenors would probably be limited, while they should decline below current forward rates in most scenarios described above.

The balance of risk-and-reward continues to favor positions that benefit from a downward correction in those expectations for official rates in 2025 and beyond, such as receiving the fixed rate in a 2-year forward 2-year EUR swap or overweighting 3- to 7-year maturities in EUR sovereigns.

Antonio Villarroya
Banco Santander, S.A.

Jose Maria Fernandez
Banco Santander, S.A.


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Antonio Villarroya
Banco Santander S.A.

Jose Maria Fernandez
Banco Santander S.A.

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