ECB set to follow the Fed and Bank of England

Jonathan Marriott, Chief Investment Officer

This week’s ECB meeting made no change to its key interest rates and confirmed the end to net asset purchases, under its asset purchase programme (APP), on the 1^st July. However, it also announced that it would raise key interest rates by 0.25% for the first time in eleven years at the 21^st July meeting. All this was expected by the market. However, the statement had a more hawkish tone to it, suggesting that a 0.5% shift was possible at the September meeting “if medium term inflation persists or deteriorates”. This may be followed by a number of further rate rises. Despite this tone, they kept their options open saying that “the Governing Council will maintain optionality, data-dependence, gradualism and flexibility in the conduct of monetary policy”. Ultimately adopting a tighter stance but allowing them room to change their mind. In 2011 there were two 0.25% rate rises which were reversed the following year. It appears that this time the ECB is set on a more extended period of tightening. This triggered a rise in bond yields particularly for the lesser quality issuers.

While 10-year German bund yields rose 0.09%, Italian Government bond yields rose 0.22%. This extended a spread widening that has persisted as interest rate expectations rose. This year the German bund yield has risen by 1.6%, meanwhile the 10 year Italian bond has risen by 2.48%. When Italy wants to borrow for ten years it will have to pay 3.66% where Germany only pays 1.42%. For Greece it is even worse with borrowing costs nearly three times that of Germany. The ECB noted this and noted that they could be flexible in reinvesting maturities from the pandemic emergency purchase programme. They singled out Greece as a special case suggesting they could continue to help their pandemic recovery process.

The revisions to the ECB economic projections reflected higher inflation and lower growth expectations. This emphasises the problem that many central banks are facing at the moment. They can slow demand but can do little about the constraints on supply that are driving inflation. For the ECB, this is made more complicated by the divergence of economies across the Euro zone. This week we have seen a fire at a US gas plant and a further rise in oil and gas prices which will not help the picture. If the blockade of the Ukranian Black Sea ports continues, then we will see food shortages, particularly in poorer countries. A steep rise in interest rates will slow growth further but, given inflation well above the 2% target, rate rises may continue until slowing growth impacts the longer-term outlook for inflation giving them a chance to pause the rate rises.

Elsewhere, we have the US Federal Reserve and Bank of England meetings to come next week. As I write, we are waiting for the latest US Consumer Price Inflation (CPI) figures which may influence the Fed decision. The Federal Reserve is expected to raise rates 0.5% this month and again in September. However, they have a more complex mandate with a target for full employment as well as stable prices. At the moment the employment situation is strong but if this weakens in the autumn, they may end up slowing the tightening path that they seem set on at present.

The Bank of England is also expected to raise rates 0.25% next week. With inflation higher than wage growth real incomes are falling. We are already seeing strike action on the railways and may see wider industrial action as we go through the summer. Boris Johnson survived a confidence vote this week but remains under pressure and will be looking to boost his popularity post ‘partygate’. Given that, he is hardly likely to agree with a former conservative Chancellor who said a recession and high unemployment was a price worth paying to keep inflation under control. We have already seen a tax on oil companies to pay for help with heating bills. This week we have seen an extension to the right to buy scheme. We may see more moves to help with the cost of living and tax cuts which many Conservative MPs have been calling for. The theory is that falling real income constrains spending and economic growth and ultimately slows inflation. If the government counters this with measures that provide a fiscal stimulus then they make reaching the Bank of England inflation target harder. The danger is that if there is excess stimulus to counter the cost of living crisis the Bank may have to tighten more.

While inflation is high now, the ECB, the BOE and the Fed all expect inflation to fall back towards target in the next two years. They are all going to raise interest rates further but a resolution to the war in Ukraine may have more impact on food and energy costs than interest rates. Steep interest rate rises have been priced into bond markets but if growth slows these may not come to pass. This is particularly true in the US where bonds provide a hedge against the risk of inflation in balanced portfolios. From an equity point of view, with rising costs and interest rate rises, it remains important to invest in companies with low leverage and the power to pass prices rises on.