Overview
What happened
The ECB hiked interest rates by 75bp at its September meeting, in line with market pricing which indicated a 75bp hike was slightly more likely than 50bp. This move was accompanied, or in fact necessitated, by significant upward revisions to the inflation outlook, with inflation now standing at 2.3% in 2024, despite simultaneous downgrades to growth forecasts. President Lagarde sent a number of hawkish messages during the press conference, signalling further tightening to come over the "next several meetings" and suggesting the possibility of rates rising beyond the terminal rate (without specifying what that might be) if necessary.
Our interpretation
As the global energy crisis unfolds with Europe bearing the brunt, the ECB has taken the opportunity to frontload policy tightening before economic damage from the energy shock becomes too large. The ECB's aggressive action and tone send a clear message that - for the time being - its concerns about the de-anchoring of inflation expectations and erosion of its credibility exceed fears of recession. Squeezing in a jumbo hike at today's meeting was particularly important for the ECB's credibility in light of increasing downward pressure on the euro and upward pressure on bond yields in recent days. Judging from post-meeting market action, however, the ECB has not done enough to relieve those pressures.
Outlook
For now, the ECB hawks rule. Lagarde's guidance suggests hiking may continue into the year end and extend well into 2023, potentially going above the terminal rate (which is believed to be around 1.5%). While this messaging might well be a necessary part of the process to tame inflation expectations, we believe this steep hiking path will be hard to implement in practice, not least because of the multiple moving parts impacting Europe's economic outlook. The ECB's window for further hikes is closing fast as the reality of the energy shock and a challenging China outlook take their toll.
While we continue to expect the ECB to abandon its hiking cycle later in the year, we note that the macro outlook in Europe remains highly uncertain and will crucially depend on the size and composition of fiscal responses, which - together with developments in the euro and peripheral spreads - will shape the ECB’s path from here.
Asset allocation views
We remain underweight equities and credit and have a strong overweight to cash. Within equity regions, we maintain our underweight to Europe given the recession risk stemming from continued energy disruptions and the ECB's hawkishness. We recently downgraded government bonds to neutral to reflect global central bank hawkishness against moderating market expectations. Within government bonds, we are overweight Bunds on our expectations of an earlier end to the ECB hiking cycle but are reviewing this position given the importance markets are placing on inflation versus growth.
