- April meeting: No further acceleration of stimulus withdrawal was hinted at by the ECB in April. It confirmed both the previous guidance on QE (likely to end in Q3) and the policy sequence, with interest rates to rise at “some time” after QE ends. The ECB is likely to implement a gradual rate normalisation after the end of QE in an ever more data-dependent environment, given high uncertainty regarding the fallout of the Ukrainian conflict on growth and inflation. Flexibility has been emphasised as a valuable means to preserve the transmission of monetary policy and avoid fragmentation. We expect QE to end in Q3, as announced, followed by rate normalisation, with two hikes before year-end, followed by another in Q1 2023. When compared to markets, we remain in the cautious camp, as our macroeconomic projections attach an higher probability to a technical recession, at least in countries such as Germany and Italy, which are more dependent on energy supply and prices. Inflation is the ECB's top priority. The Governing Council is more sensitive to the risk of record inflation than to the growth slowdown. The ECB stands ready to act in the event of deteriorating growth prospects. However, we do not expect it to be proactive on this. We expect the ECB to allow government bond yields to rise and spreads to widen before shifting its monetary policy stance. For now, the ECB believes that financing conditions should remain accommodative despite the recent tightening.
- Market reaction and investment implications: After Lagarde’s somewhat dovish press conference, European equity gained, with the Euro Stoxx 50 index up 0.5% on the day. Eurozone government bond curves steepened and peripheral spreads widened, with the ten-year Germany-Italy spread at 164bp. The euro weakened against the dollar, to 1.08 from 1.09. The ECB remains on a path to monetary policy normalisation, but behind the curve, with less room regarding growth than the Fed, given the ongoing economic slowdown in the Eurozone. The ECB has been preparing market participants regarding action through its forward guidance, driving up the ten-year Bund yield. The 0.8% level reached on the ten-year Bund yield is an important technical level that could lead to some consolidation near term. We are neutral on peripheral debt (specifically on Italy) for two reasons: Italy entered 2022 on strong footing, but the European growth slowdown will now be a drag for the country in the uncomfortable context of a huge debt pile. The silver lining is that the effects of the increase in the debt-to-GDP ratio which magnified during the Covid-19 crisis will be smoothed by an extension of its average debt maturity during the last QE exercise and a large decrease in the cost of debt, from around 4.5% to some 2.0% over the past 14 years. In addition, current rate and credit spread levels offer improved entry points after market retracement, reducing the relative appeal of Italian debt for investors hunting for extra yield. Regarding corporate bond markets, fundamentals remain favourable. Valuations remain slightly expensive despite some correction in Q1. Technically, the end of QE will put pressure on prices, but corporates will probably be able to adjust their issuance accordingly. The economic slowdown should affect earnings, which could drive spreads wider. However, we expect such widenings to be slow and smoothed by regular inflows of ALM-driven investors. On currency markets, we expect the euro to weaken against the dollar to 1.02 over the next six months, weighed on by the US-EU growth differential and the widening of US-EU short-term and real rate differentials.