The ECB convinces the markets that it is about to become more dovish

It took what appear to be only slight changes in tone from Christine Lagarde, and the board of governors she leads, to convince investors that the European Central Bank is about to make a major shift. accommodating.

Markets were quick to interpret the ECB President’s acknowledgment at a post-Council press conference on Thursday that the eurozone was likely to head into recession – a conclusion long overdue for most economists – to signify that the region’s rate setters would ease the scale of the rate increases.

Silvia Dall’Angelo, senior economist at US fund manager Federated Hermes, who now expects the ECB’s rate hike cycle to come to a halt after its next vote in December, described the message as “more cautious and less belligerent than in previous meetings”.

Government borrowing costs fell sharply after Lagarde met the press on Thursday afternoon and by the end of the day the euro was back below par with the dollar, erasing some of its recent gains.

The fierce reaction, however, surprised some of the more hawkish members of the ECB’s governing council. “I don’t know what this is based on,” one said. “There are still a lot of things to worry about regarding inflation. If we continue to get high inflation readings, we will need another strong response.

Investors also wondered if they had taken the plunge after German, French and Italian inflation figures all came out hotter than expected on Friday and stronger-than-expected German growth figures also defied forecasts. recession fears.

Signs that major European economies are more resilient than expected will keep pressure on the ECB to raise rates higher, and by Friday afternoon, eurozone government bond prices had given up most Thursday earnings.

At first glance, little has changed in ECB policy political position. It raised its deposit rate by 0.75 percentage points for the second straight time and signaled plans for more increases to come as inflation remained “far too high” at nearly five times its target by 2%.

However, investors are looking for reasons to increase their bets on the major central banks soon becoming less aggressive in their efforts to raise rates.

Canada’s central bank announced a lower-than-expected rate hike of 50 basis points on Wednesday, following a similar move by the Reserve Bank of Australia earlier this month. With the US Federal Reserve set to deliver its fourth consecutive 0.75 percentage point hike next Wednesday, US officials are expected to increasingly slow their pace of rate hikes after November.

For those focused on accommodative change, the ECB has offered plenty of hints of change.

The wording of his statements was slightly less aggressive. Instead of saying it would raise rates “in future meetings” as it did last month, the central bank only said it expected to “raise rates further.” It is no longer a question of “moderate demand” but only of “reduce demand support”. And “substantial progress” has already been made in “removing accommodative monetary policy”.

After pushing back on the idea of ​​a recession last month, Lagarde said this time such a scenario was “much more on the horizon.”

Along with a slight easing of supply bottlenecks, resilient labor markets and increased support from governments to deal with high energy prices, “almost all other indicators point to the downside,” it said. she said, adding that the likelihood of a recession “will be taken into account”. account at our next meeting in December”.

Investors widely interpreted the comments as signaling that the ECB’s next rate hike will be reduced to 0.5 percentage points.

They were even comforted by the ECB’s plans to reduce its balance sheet — a major source of support for financial markets after having quadrupled in size over the last eight years to reach 8.8 billion euros.

Lagarde said she would discuss how to start trimming her bond portfolio by 5 billion euros at the December 15 meeting, while adding that an increase in the cost of her program by 2.1 billion euros euros of ultra-cheap loans to commercial banks was likely to encourage many to repay them. early.

The moves represent a further tightening of monetary policy, but investors viewed them as less hawkish than expected and a way for the central bank to raise rates less than it otherwise would.

Krishna Guha, vice president of US investment bank Evercore ISI, said Lagarde’s announcement that she would begin discussions in December on “the principles” of reducing reinvestments in part of her bond portfolio showed that it was “slowing down the process” of quantitative tightening. that many other central banks have already started.

The ECB was likely to start the process in the first half of next year, but it “could easily be delayed further depending on economic conditions”, he added.

Meanwhile, the ECB’s decision to make its €2.1tn Targeted Longer-Term Refinancing Operations (TLTROs) less attractive could be “a backdoor rate hike”, according to Salomon Fiedler , an economist at the German investment bank Berenberg.

TLTROs were offered to banks at 0.5 percentage points below the ECB deposit rate to encourage them to continue lending during the pandemic. Banks can make a big profit just by handing over the money they borrowed from the central bank to benefit from its sharply rising deposit rate.

But the ECB stops this from November 23, after which the lending rate will follow its deposit rate. Based on previous surveys of banks, ECB officials believe around 600 billion euros in loans could be repaid as early as next month.

This should boost rates in European money markets by 10 billion euros, which have been weighed down by the ECB’s use of its balance sheet. Many short-term rates have yet to reflect the ECB’s increases, sagging below its deposit rate, now at 1.5%.

By releasing the collateral tied to the loans, Fiedler estimated that early repayment by banks could push money market rates up almost 0.5 percentage points towards the ECB’s higher refinancing rate of 2%.

Big banks are increasingly concerned about the lack of high-quality liquid assets in European financial markets and this week the International Capital Market Association, which represents the biggest traders in the bond market, urged the ECB to take action to remedy it.

Andy Hill, senior director of ICMA, said the change in TLTROs announced on Thursday was “mainly positive” as it was likely to release more collateral and it had already raised some rates in the money markets.

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