PIMCO – ECB Preview: Meeting by meeting

After raising interest rates to 0% at its July monetary policy meeting, we expect the ECB to raise policy rates another 50 basis points at its September meeting and communicate that further rate hikes of interest will be appropriate.

We believe that the Governing Council (GC) will strive to bring its policy rates back into neutral territory within a reasonable period of time and we therefore expect further policy rate hikes of 50 basis points in October and December.

We believe the GC will make it clear that a neutral policy framework may not be appropriate under all conditions, and we expect a transition to 25 basis point increases next year as the bull cycle pivots. from policy normalization to policy tightening.

The ECB seems determined to put the fight against inflation ahead of growth concerns, the macroeconomic configuration remains complex and the political risks high.

Additional thoughts:

Interest Rates: More relevant than the precise course of rate hikes will be the destination. The market is looking for rate hikes of around 175 basis points by the end of the year and another 50 basis points in the first half of next year. There remains considerable uncertainty about the position of a neutral policy rate for the Eurozone, but around 1.5% in nominal terms also seems reasonable compared to other jurisdictions in developed markets, such as the United Kingdom or United States. Current market prices therefore suggest somewhat restrictive territory for the ECB, with a maximum policy rate of 2.25% towards the middle of next year. While July’s 50 basis point bigger than previously indicated hike was characterized as frontloading without changing the valuation of the terminal rate in the up cycle, and while we don’t think the ECB will provide much guidance regarding the potential destination of interest at this stage, we believe the GC will make it clear that a neutral policy framework may not be appropriate under all conditions, particularly in the face of high one-off inflation threatening to unanchor inflation expectations medium term. Along these lines, ECB Chief Economist Philip Lane recently reiterated that cyclical factors may require policy rates to move above or below neutral for inflation to stabilize in the future. objective. The ECB will also publish new quarterly macroeconomic projections, in which we expect another round of substantial downward revisions to growth and upwards to inflation. The GC’s lower confidence in its macroeconomic projections has increased in recent months, suggesting policy decisions may be somewhat less sensitive to staff projections relative to history, and instead more influenced by spot inflation as well as by the more direct factors of average growth. – forward inflation, such as changes in wages and various measures of inflation expectations. GC members argued for greater persistence in the inflation process than in models where parameters were held at values ​​that had been estimated in a low inflation environment, even though these values ​​were likely to change over time. inflation was rising. Therefore, we think the ECB will be reluctant to slow the pace of rate hikes until the peak of inflation is judged behind, and, having started the hikes at a 50 basis point pace, there seems little reasons to change this pace as long as the monetary policy stance remains accommodative. Lane argued for a steady pace, neither too slow nor too fast, to bridge the gap with the terminal rate. We believe the ECB will likely move to 25 basis point increments next year as the up cycle pivots from policy normalization to policy tightening.

Quantitative tightening: With respect to the Pandemic Emergency Purchase Program (PEPP), the GC currently intends to reinvest principal payments of securities maturing until at least the end of 2024 Regarding the Standard Asset Purchase Program (APP), the GC currently intends to reinvest principal payments of maturing securities for an extended period after the date it begins to raise rates. interests of the ECB. We believe that a discussion on APP reinvestments will begin reasonably soon, also in light of the advanced balance sheet reduction strategies of the Fed and the Bank of England (BoE). Passively ending reinvestments would drain liquidity without adding collateral to the system, while actively selling bonds would swap reserves for collateral, making high-quality bonds available and helping to reduce collateral scarcity. APP buybacks of public sector assets are estimated at around €22 billion per month from August 2022 to July 2023, while they averaged around €16.5 billion per month between August 2021 and July 2022. Board member Schnabel recently said she couldn’t govern “someone who will talk about it” at the September meeting, and while we don’t think the ECB will sell aggressive government bond holdings anytime soon, we expect communication regarding the size of the ECB’s balance sheet at one of the upcoming policy meetings as the ECB moves policy rates towards the extreme lower end of the neutral range estimates. In the same vein, a liquidation of the targeted longer-term refinancing operations (TLTROs) would cause the ECB’s balance sheet to shrink by around 24% until the end of 2024.

TLTRO, remuneration of reserves and additional facilities: At its July general policy meeting, the ECB said that “as part of the normalization of its policy, the Governing Council will assess options for remuneration of excess liquidity”. No details were provided, but we expect a decision on reserve compensation to be made as early as the September meeting. Chair Lagarde referred to the part of the statement on compensation for reserves when responding to a question about possible changes to TLTRO rates during the Q&A, which suggests that the ECB consider offsetting the profit for banks of the favorable conditions of the TLTRO via a reduction in the average rate of remuneration of the reserve. Since the rate applied to TLTRO borrowings after June 2022 is the average deposit facility rate over the life of the operation, banks still have a carry incentive to maintain their TLTRO liquidity as the borrowing rate would be lower than the rate applied to central bank deposits during rate hikes. In our baseline scenario, we believe that the ECB will not change the terms of the TLTRO and expect that most bank reserves will be remunerated at the deposit facility rate, except for a part of the reserves linked to TLTRO borrowings. . This should incentivize banks to prepay some of their TLTRO borrowings, especially money taken solely for arbitrage purposes. Refunds of the money taken for arbitration should have little impact on the markets, as these funds sat idle in the various national central banks and never circulated in the money markets. The normalization of key interest rates in a context of excess liquidity of 4.5 billion euros and scarcity of guarantees risks harming the transmission of monetary policy. We therefore expect the ECB to explore options to better control money market rates, potentially modeled on the Fed’s reverse repo facility. While we don’t believe an announcement is imminent, medium-term options include a new secured or unsecured vehicle available to market participants without access to the ECB’s deposit facility, or large-scale issuance very short-term ECB debt certificates. Although issued to banks, ECB debt certificates are eligible for trading in the secondary market where they could be acquired by non-banks. A large issuance of ECB debt certificates would increase the amount of high-quality collateral in the system and would have to be accepted by all bond lenders, including the German Bundesbank under its securities lending program.
Source: By Konstantin Veit, Portfolio Manager at PIMCO