Global Economy & Markets, Weekly Roundup 09/05/23
The ECB increased interest rates to 3.25% and is expected to discontinue the reinvestments under the APP as of July 2023
Key Takeaways
The ECB on May 4th decelerated the pace of interest rate hikes to +25 bps, instead of +50 bps steps in each of the past three meetings, as the transmission of monetary tightening to financing conditions has been forceful, inter alia via tighter bank lending standards and lower loan demand. Following cumulative rate increases of 375 bps since July 2022, the Deposit Facility Rate (DFR) now stands at 3.25%.
Looking forward, President Lagarde noted that the ECB has more ground to cover regarding interest rates due to strong underlying inflation pressures. Market pricing (according to overnight index swaps) now points to roughly additional hikes of +50 bps for euro policy interest rates, broadly unchanged compared with pre-ECB meeting estimates.
At the same time, the ECB will discontinue the reinvestments under the Asset Purchase Programme (€3.2 trillion, with zero Greek Government Bond holdings) as of July 2023. The APP portfolio is expected to decline by circa €300 billion in the next twelve months or 3.5% of euro area marketable long-term government debt. The ECB will continue to reinvest maturing bonds under the Pandemic Emergency Purchase Programme (€1.7 trillion, with €38 billion Greek Government Bond holdings) at least until the end of 2024.
2-Year German Government bond yields moved lower in the past week by circa 20 bps to 2.54% and 10-Year yields decreased by 5 bps to 2.25%, while euro area periphery bond spreads were broadly unperturbed by the ECB’s decision to halt APP reinvestments. The Greek/German 10-Year bond yield spread narrowed by 10 bps to 174 bps, while the Italian/German 10-Year yield spread widened slightly by 5 bps to 191 bps.
The Federal Reserve proceeded with a 25 basis points increase in the federal funds rate on May 3rd, to a range of 5.0% - 5.25%. At the same time, the Fed removed the reference in the post-meeting statement that anticipates that further increases may be appropriate, suggesting that Fed delivered on Wednesday the final interest rate hike of a historically aggressive cycle (cumulative tightening of +500 bps since March 2022).
The latest Fed Bank Lending Survey (May 8th) adds to the case for a pause, with banks further tightening their loan standards and loan demand heading south, particularly for commercial real estate (CRE) loans.
Contrary to Fed guidance, investors’ expectations now point to roughly 75 basis points of FFR cuts in the next six months (see graph below). With sticky core inflation (three-month annualized rate of 5.0%) and strong, albeit cooling, job growth (three-month NFP gains of 222k) market expectations for rate cuts could turn wrong, hurting elevated equity multiples (S&P500 price-to-earnings ratio of 18x versus a 15-year average of 16x) and supporting demand for short-term fixed income securities, which offer yields of circa 5%.
The US political saga regarding the debt limit ($31.4 tn), increasingly gathers attention. According to Yellen, the government’s ability to borrow using extraordinary measures could be exhausted as early as June 1st. The debt ceiling debate could add volatility as we approach the June deadline.
Key Takeaways
The ECB on May 4th decelerated the pace of interest rate hikes to +25 bps, instead of +50 bps steps in each of the past three meetings, as the transmission of monetary tightening to financing conditions has been forceful, inter alia via tighter bank lending standards and lower loan demand. Following cumulative rate increases of 375 bps since July 2022, the Deposit Facility Rate (DFR) now stands at 3.25%.
Looking forward, President Lagarde noted that the ECB has more ground to cover regarding interest rates due to strong underlying inflation pressures. Market pricing (according to overnight index swaps) now points to roughly additional hikes of +50 bps for euro policy interest rates, broadly unchanged compared with pre-ECB meeting estimates.
At the same time, the ECB will discontinue the reinvestments under the Asset Purchase Programme (€3.2 trillion, with zero Greek Government Bond holdings) as of July 2023. The APP portfolio is expected to decline by circa €300 billion in the next twelve months or 3.5% of euro area marketable long-term government debt. The ECB will continue to reinvest maturing bonds under the Pandemic Emergency Purchase Programme (€1.7 trillion, with €38 billion Greek Government Bond holdings) at least until the end of 2024.
2-Year German Government bond yields moved lower in the past week by circa 20 bps to 2.54% and 10-Year yields decreased by 5 bps to 2.25%, while euro area periphery bond spreads were broadly unperturbed by the ECB’s decision to halt APP reinvestments. The Greek/German 10-Year bond yield spread narrowed by 10 bps to 174 bps, while the Italian/German 10-Year yield spread widened slightly by 5 bps to 191 bps.
The Federal Reserve proceeded with a 25 basis points increase in the federal funds rate on May 3rd, to a range of 5.0% - 5.25%. At the same time, the Fed removed the reference in the post-meeting statement that anticipates that further increases may be appropriate, suggesting that Fed delivered on Wednesday the final interest rate hike of a historically aggressive cycle (cumulative tightening of +500 bps since March 2022).
The latest Fed Bank Lending Survey (May 8th) adds to the case for a pause, with banks further tightening their loan standards and loan demand heading south, particularly for commercial real estate (CRE) loans.
Contrary to Fed guidance, investors’ expectations now point to roughly 75 basis points of FFR cuts in the next six months (see graph below). With sticky core inflation (three-month annualized rate of 5.0%) and strong, albeit cooling, job growth (three-month NFP gains of 222k) market expectations for rate cuts could turn wrong, hurting elevated equity multiples (S&P500 price-to-earnings ratio of 18x versus a 15-year average of 16x) and supporting demand for short-term fixed income securities, which offer yields of circa 5%.
The US political saga regarding the debt limit ($31.4 tn), increasingly gathers attention. According to Yellen, the government’s ability to borrow using extraordinary measures could be exhausted as early as June 1st. The debt ceiling debate could add volatility as we approach the June deadline.