ECB money shift: end of negative interest rates and start of a new monetary cycle

The expectations for the ECB interest rate level for the end of 2022 have therefore increased after the ECB meeting: The markets are now expecting a key interest rate of 1.2% at the end of the year.

Although the possibility of a 50 basis point hike has been discussed for a few days, given the pre-announcement of a 25 basis point hike last month and the ECB’s track record, this represents both a milestone and a break with the past.

This rate hike is both a symbol (coming out of negative interest rates and the largest hike in more than two decades) and a first step: it should be followed by further rate hikes from September, according to macroeconomic policy data Target inflation to 2% in the medium term reduce. Barring a recession, bringing inflation back into that zone more quickly, the ECB should therefore make several additional rate hikes through December.

The expectations for the ECB interest rate level for the end of 2022 have therefore increased after the ECB meeting: The markets are now expecting a key interest rate of 1.2% at the end of the year. In bond markets, Italian 10-year bond yields – up 40 basis points since this week – fell 10 basis points after Christine Lagarde’s press conference, and OAT and Bund yields also fell a few basis points. On the currency side, the euro-dollar parity returned fairly quickly to its pre-conference level (1.018) after rising during Christine Lagarde’s conference. 10-year inflation expectations (included in the price of index-linked bonds) moved closer to the ECB’s long-term target (2.07% at the end of the meeting), falling 5 basis points under the combined effect of monetary tightening and falling energy commodity prices.

The creation of the Transmission Protection Instrument (TPI) is also good news, meeting both the expectations of investors worried about sovereign spreads widening and the necessary monetary policy adjustment. Indeed, the context of high inflation but economic slowdown and widening sovereign risk premia created a monetary policy dilemma that rendered obsolete the previous strategy (a gradual approach of halting asset purchases followed by very gradual rate hikes). This new framework implies both faster rate hikes and controlling the adverse impact of normalizing interest rates on peripheral countries’ premia by increasing the capacity and flexibility of the ECB’s asset purchases.

The resignation of Mario Draghi on the same day of the ECB meeting adds additional tension and we can assume that the widening of the Italian spread (from 40 to 50 basis points since July 20 morning) would have been larger had it not been for the ECB announcement . The summer and this fall’s elections in Italy are likely to fuel risk aversion and keep Italian debt volatility at elevated levels

The way the TPI has been presented – and in particular its selection criteria – aims to show that it does not challenge the EU treaty and the status of the ECB (no direct funding from states) and that “it does not provide an incentive.” for fiscal free-riding and accompanied by eligibility criteria for the lack of an excessive deficit procedure. Frequent reference to the Articles of the Treaty sends a clear message regarding the risk of legal challenges to asset purchase policies. The approval criteria that have been set (which the ECB could possibly evade if they were not blocking conditions but rather assessment elements) bear the seeds of an update of the Stability Pact, insofar as a debt sustainability clause is also mentioned. Uncertainty remains as to what would prompt the ECB to trigger the activation of the TPI and its level.

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