In a historic move, Christine Lagarde and the European Central Bank (ECB) raised the policy rate for the first time since 2011. In its decision, the Governing Council hiked the key policy rate by 50 bps, choosing to “take a larger first step on its policy rate normalization path than signaled at its previous meeting.”
Further, the ECB stated that there would be additional hikes, perhaps as early as the September 8th meeting.
This decision came shortly after the EURUSD dipped below parity for the first time since 2002, registering a 20- year low of 0.9953 last week; and the publication of this week’s Euro-area inflation at a record 8.6%. Although the parity milestone ruffled feathers in financial markets, the EURUSD has been in a general decline for over 12 months, weakening 10.5% year-to-date and having traded as high as 1.20 levels in Q2 of 2021.
A weakening euro raises the costs of imports and makes it more challenging to manage inflation.
The primary driver of the Euro’s weakness has been the divergence between the Fed’s hawkish stance and the ECB’s wait-and-watch policy, which strengthened capital flows to the greenback. Simply put, investors found better nominal returns in the US. The Ukraine-Russia war, covid closures in China, and political turmoil in key euro bloc member countries also contributed to this downtrend.
In a major boost to the eurozone today, the BBC reported that Nord Stream 1 resumed pumping gas to Europe amid fears that Russia may discontinue deliveries after more than a week of maintenance.
Surprise-ish to the upside
In a rare move, Christine Lagarde had pre-announced the ECB’s intended rate hike of 25 bps, with the hope of arresting the slide in the euro. However, with inflation picking up and a Bloomberg report noting Germany’s first monthly trade deficit since 1991, the Governing Council surprised to the upside with a half-point hike, after keeping rates negative for the past 8 years.
Despite the bank’s communication, there had been market speculation that the ECB may go in for a larger hike due to the Fed’s expected rate increase, and levels of high inflation, which has proved to be the case.
Thus far, the institution had been reluctant to commit to policy normalization and substantially lags behind its global peers.
Policymakers have been hesitant to raise rates since several countries are near-buckling under heavy debt to GDP ratios, and any hike may plunge the eurozone into recession, or worse lead to a lasting debt crisis.
In a somewhat similar situation way back in 2011, the ECB had tightened monetary policy but was forced to reverse course, much like the Fed in 2019, or otherwise risk a deep and wide-reaching recession.
Carsten Brzeski, ING economist was quoted saying “…the very gradual and cautious normalization process the ECB started at the end of last year has simply been too slow and too late.”
Challenging environment for the ECB
Although the Governing Council has kicked off a new rate hike cycle, the currency union is still facing many obstacles.
Other than record levels of inflation, these include slowing economic growth, political turbulence in the Southern states and the roll-out of a new and controversial bond-buying program.
Overall, the European growth picture has been getting bleaker and was revised downwards from 2.7% in May to to 2.6% in June.
A commonly used measure to assess the health of the bloc is the spread between German and Italian 10-year yields.
Diverging bond yields are a major threat to the stability of the eurozone, which was founded on the principle of members acting as a unified currency union with a single monetary policy.
For countries with high debt burdens such as Italy, Spain, Greece and Portugal that benefited from ECB asset purchases, borrowing costs will rise which could stall growth and lead to wider social unrest as well.
Tom Fairless of the WSJ stated that “It also means the ECB could effectively be raising rates for some borrowers while pushing them down or keeping them flat for others,” an inherently destabilizing process.
From the graph below, it is clear that yields have been consistently rising through the year, with the spread standing at 2.29% at the time of writing, having eased somewhat from its peak earlier this year.
Source: Marketwatch
Frederik Ducrozet, head of macroeconomic research at Pictet Wealth Management, said that in the case of diverging yields, the main cause for concern is if “the Governing Council disagrees in terms of intervention levels, asset purchase modalities and legal risks,” since the body is designed to work through a single policy process.
This picture has become much more complicated due to news of the political turmoil raging in Italy, with the recent no-confidence motion and ‘failed’ resignation of PM Mario Draghi, a stalwart of European financial trust. Until faith is restored in Italy’s political process, bond yields are only likely to head higher.
In early June, with the announcement that rates would be hiked by 25 bps, yields started diverging immediately, necessitating a new tool that could keep sovereign-bond yields consistent, the Transmission Protection Instrument (TPI).
Anti-fragmentation
In the second major development, the ECB announced the roll-out of a new bond-buying tool called the Transmission Protection Instrument.
The ECB’s press release states that the TPI is a toolkit “for the effective transmission of monetary policy.” In short, the ECB is in a difficult position. It has to tackle a multi-pronged challenge in fighting inflation, preventing growth from stalling or even slipping into a full-blown recession, and keeping bond spreads comparable amid widening political chasms.
With the hiking of rates, there is a fear that periphery members (such as Portugal, Italy, Greece, and Spain) that are suffering from high debt burdens, could see yields (borrowing costs) go up disproportionately compared to core countries (such as Germany and France).
To assure the market that periphery countries will remain creditworthy, the ECB emphasized that with this tool, monetary policy will be “transmitted smoothly across all euro area countries. “
The bank also noted that to operationalize this mechanism, it would purchase public sector bonds (primarily) from countries that need support or “jurisdictions experiencing a deterioration in financing conditions not warranted by country-specific fundamentals.”
As anticipated, there are some conditions that beneficiary countries have to adhere to to avail of assistance. Briefly, the Governing Council would consider the following criteria when deciding whether to activate the TPI:
Complying with the EU Fiscal FrameworkNot having any excessive macroeconomic imbalancesFiscal Sustainability, i.e., the government should be on track to repay its public debt“Sound and sustainable macroeconomic policies”
Interestingly, Lagarde said that “The ECB is capable of going big” to support economies via the TPI, echoing Mario Draghi’s “whatever it takes” moment.
Optimistically, the Governing Council would hope that the mere existence of the TPI (similar to the earlier Outright Monetary Transactions (OMT)) will be sufficient to calm the markets and direct yields to more manageable levels.
However, the straightforward implementation of this strategy is uncertain due to German constitutional constraints, debt-share disputes, criticism of monetary financing, and political upheaval throughout the rest of Europe.
The EURUSD
Since the policy meeting, the euro has been volatile, having risen as high as 1.027 against the dollar, and falling to 1.0177 at the time of writing, just below the day’s opening of 1.0179.
In the prevailing atmosphere, the ECB is forced to act in opposing directions, to curtail inflation as well as continue buying national bonds in a bid to stabilize yields in highly indebted countries.
The ECB’s communication strategy would be a key component in treading this narrow path and preserving the strength of the euro.
Any perceived divergence from this could damage euro prospects in the long run and lead to sovereign risk contagion spiralling out of control. This is because many eurozone governments own securities issued by other member countries, which are themselves struggling with indebtedness and low productivity.
However, if the ECB can continue to tighten given that Lagarde expects “inflation to remain undesirably high for some time”, it will likely see an improvement in currency strength which could further bring down inflation.
That being said, the bitter truth for eurozone officials is that being the global reserve currency, the US Dollar drives the currency pair, with Federal Reserve policy having a disproportionate influence on the strength of the euro. Any rallies in the euro are likely to be short-lived without a considerable change of direction in Fed policy.
With US equities in a bear market, widening trade imbalances, a recent inversion in the yield curve (often a pre-cursor to recession), and today’s reported jobless claims data signalling a cooling labour market, a slowdown in the Fed’s pathway may be on the cards.
Moving ahead, other than monetary decisions, real factors would also have a major bearing on euro prospects, such as exposure to the Ukraine conflict, volatility in food and energy prices, Chinese stimulus during lockdowns and broader energy transition away from Russian sources.
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