In Davos it has become clear that the European Central Bank (ECB) does not seem willing to stop the tightening of financial conditions in the euro zone or to reverse course in its monetary policy. On the contrary, the internal dissensions within the governing council revealed yesterday in the minutes of the December meeting lean towards the most aggressive extreme, or ‘hawkish’ in financial jargon. There was a division between those who defended raising interest rates a lot (half a percentage point) and those who promoted doing it even more (75 basis points).
The truth is that the two main camps reached a point of consensus on the proposal of the chief economist, Philip Lane, that apparently the option of 50 basis points, announce the start of the balance reduction and establish an aggression orientation for the next meetings , a speech that was interpreted a month ago by Christine Lagarde and has been repeated this Thursday from Davos. The president has nipped in the bud the speculation that this week pointed to a relaxation with a mantra that is repeated over and over again: inflation is still too high.
The stock markets suffered on Thursday before the jug of cold water in the expectations of the ECB and the bonds also accused the change of climate with a new increase in yields motivated by sales and falls in prices, which move in the opposite way to profitability . But the index that will best reflect the degree of market surprise will once again be the Euribor. The benchmark for 12-month wholesale lending among European banks has remained almost stuck at around 3.3% since the start of 2023. But Lagarde’s endorsement of a more aggressive rate stance may unstuck it today.
The Euribor reaction to Davos and the ECB minutes
The 12-month Euribor marked 2023 lows this Thursday at 3.30% after its maximum of 3.37% on January 11, levels that have not been seen since mid-December 2008. Operators discount that this Friday will produce a new rise on the way to the level of 3.5%. In year-on-year terms, this would mean a spread of up to 400 basis points.
The ECB has marked in red the orientation of two rate hikes of an additional 50 basis points in February and March. Interbank rates have been quick to adjust to expectations of past movements and often trade at a premium or overprice depending on central bank guidance. For this reason, it is now trading 80 basis points above the official rate of 2.5%, which will rise again to 3% on February 2 if the script is fulfilled.
The ECB seeks – as stated in the minutes – to prevent the markets from relaxing and beginning to discount a pause in the rate cycle or, even, rate cuts in the near future. The monetary authority wants to keep the yield curve rising to avoid the decoupling between what it says and does with what economic agents and investors believe it is going to do.
The analysis presented to the governors at the meeting on December 15 was unequivocal. “Real rates were back in negative territory for all tenors up to ten years. Market participants’ expectations that central banks would cut policy rates soon after reaching the terminal rate had led to a decline in long yields term in relation to short-term returns,” the document states.
The ECB also discussed an issue that could raise blisters this 2023 among European governments, such as the balance of public accounts, that is, that countries comply with fiscal rules in their budgets. “It will be highly highlighted that the current fiscal response was not sufficiently targeted, which was creating challenges with respect to the prospects for sound public finances and monetary policy. With a continued relaxation of fiscal rules in 2023, it is likely that fiscal deficits were higher than projected,” warns the institution, which has been the main buyer of public debt since 2020.
During the meeting, ECB members “widely agreed” with Lane’s proposal to communicate key principles for reducing the asset purchase portfolio (APP). As of March 2023, the portfolio will decrease at a rate of 15,000 million euros per month by not reinvesting the repayments of the debt that the agency has in its portfolio. The measure is part of a new step in the normalization of the ECB’s monetary policy stance to control inflation. However, that move will mean that states will have less participation from their biggest buyer in upcoming debt auctions.