ECB rate hikes unlikely to curb inflation as Eurozone yields jump

Soaring Eurozone inflation is forcing the ECB's hand whilst economic conditions would still warrant a more accommodative stance. The expected 75 basis point (bps) rate increases by the end of the year are meant to remove monetary policy from the mix of factors fueling inflation which, however, is likely to make further inroads into the economy as supply-side pressures persist. Meanwhile, European yield curves are shifting upwards, and spreads are likely to widen further between the Eurozone's core and periphery as investors grasp for safety.

Much is already priced in by the market on future ECB moves as the central bank gears up for its first rate hike in years. While no move is expected this week, the first one is likely to come in July. The ECB is keen on bringing its policy rate to neutral while walking a tightrope between keeping growth alive and reigning in inflation. As the war in Ukraine drags on and commodity prices keep climbing, the Eurozone economy is slowing down. There is a risk of a deeper slowdown that may end in a recession if additional commodity supply side shortages translate into even higher energy prices, which would require growth-stimulating measures. However, rampant inflation requires a tightening of the screws for now. The good thing is that Eurozone wages have not reacted to inflation pressures yet, arguing in favor of a moderate policy normalization pace. Nevertheless, union officials could be starting conversations soon as workers face squeezes from wage cuts in real terms this year due to increasing food and utility prices.

Even if the ECB is unlikely to surprise the market with more aggressive rate hikes, the current speed of yield curve shifts and yield increases across all major European debt markets is worrisome to investors. For example, since the beginning of the year, the German yield curve has shifted up by 120 bps between 6 months and 10 years maturities¹ causing significant losses in debt portfolios. Since govies of core European countries are considered safe-haven assets, this move has had severe repercussions across the entire European debt market landscape. Moreover, the spread between core and periphery government bonds has increased since the beginning of the year. For example, the spread between Italian and German sovereigns has increased to 200 bps with the 10-year BTP now yielding 3.4%². This raises questions on debt sustainability and growth prospects in Italy as the country prepares for elections next year. However, as we enter unchartered territory marked by a sharp u-turn in central bank policy, the ECB could consider the option of supporting the European periphery with targeted bond purchasing programs should stability really come under threat.

Rate hikes might be the ECB's only option but they are unlikely to tackle the source of inflation (supply shortages) and its spread into core inflation components. This is because none of the factors that are driving inflation seem to have dissolved yet. For inflation to really subside, either the Russia-Ukraine war, commodity prices, COVID or COVID-induced supply chain bottlenecks or, ideally, a combination of those would have to resolve. Alternatively, aggressive monetary tightening by central banks could put a stop to it, which, however, would most likely come at the expense of growth and trigger a recession.

The ECB is constrained by its primary objective, price stability, which in practical terms means controlling inflation and creating a soft landing for the economy. This is becoming ever more doubtful for the Eurozone, while sovereign debt markets are no longer as safe as they used to be with inflation at 8%³. Bond investors have had to accept losses not only on the duration side but also on the spread side with drawdowns that resemble those seen in equity markets recently. As a result, broad diversification across various asset classes within solid multi-asset frameworks seem the only way forward. These portfolios can manage varying correlation levels between assets and make use of multiple sources of return while markets transition through this tumultuous phase. In addition, the short end of European yield curves could present investors with opportunities because the ECB as well as the Fed are unlikely to be able to hike rates as aggressively as currently reflected by the market. However, the rate-hiking narrative by central banks is likely to continue up until September when a more realistic assessment on growth and inflation can be made.