Economic and Financial Analysis

Rates

22 January 2021
Rates Spark: hawkish trap
Article

The ECB has undermined the efficacy of its December measures in financial
markets. As inflation recovers this year, rates could price in an abrupt end to
PEPP purchases. We argue that premature tightening is self-defeating. It
would imply higher rates now, and lower rates later in the year.

Source: Shutterstock

Content
- Overnight: fiscal execution risk
- You've been warned, the ECB might not deliver
- Hawkish trap: higher rates now, lower rates later
- Today’s events and market view

Overnight: fiscal execution risk

Senator Collins joined other moderate Republicans Romney and Murkowski in voicing her
discomfort with the size of Biden's 'rescue' fiscal package. Meeting with a bipartisan group of
senators and Biden's national economic adviser Deese should take place next week. Similar
reservations were also expressed by Manchin, a Democrat.
Biden can still resort to the reconciliation budget process that requires only 50 votes to pass the
Senate for some measures but markets would do well to price a somewhat watered down fiscal
agenda in the near term. This chimes with dovish Fed comments of late, and thus with our view
that the sell-off in US Treasuries has entered a consolidation phase. We expect 10Y to hover in
the middle of its 1-1.20% range until clearer signs of an economic rebound emerge.
You've been warned, the ECB might not deliver
Yesterday’s ECB had a definite hawkish tilt that caught financial markets, and ourselves, off
guard. As our economics team rightly foresaw, the central bank stressed downside risk to its
near-term outlook but also a number of positives. On balance, it judged that downside risks are
less pronounced than in December. But it isn’t so much the ECB’s optimism (compared to
December) that surprised, it was the decision to stress that the PEPP €1.85tn asset purchase
envelope needs not be spent in full.

It is later in the year that this statement could come back to haunt
the ECB

In itself, this should not come as a great shock. Schnabel and Lagarde, two of its most influential
members, have stressed this in the past. Nevertheless, the fact that this warning makes it to the
ECB decision statement is an escalation that will exacerbate fears that hawks are seeking to
water down the package announced in December. The sell-off in core and peripheral EUR rates
yesterday was justified in our view, but it is later in the year that this statement could come
back to haunt the ECB.

Hawkish trap: higher rates now, lower rates later

Indeed, as our economics team projects, headline inflation could temporarily move back
towards the ECB’s 2% target later in 2021. Yesterday, the ECB had a golden opportunity to
signal it will look through this ‘mechanical’ increase. It didn’t seize it. Instead it appears to have 
laid a hawkish trap for itself by indicating that it did not feel obliged to deliver on the package
announced in December. Given its history of premature tightening decisions, we would not
blame financial markets for concluding that higher inflation later this year could bring an abrupt
end to PEPP asset purchases.

In the near term, higher EUR rates are in order

With a shorter timeframe in mind, we maintain our view that the ECB is a key player in rates
markets, by keeping both low rates and low rates volatility. This being said, the confidence
bands around our central rates projections (that see -0.05% 10Y swap rate by the end of next
year) have widened. In the near term, higher EUR rates are in order due to lower perceived ECB
resolve. In the medium term, premature tightening has tended to prove self-defeating and we
could end up with lower rates as a result.
Sovereign yields have less reasons to remain low

Source: Refinitiv, ING

Premature tightening has tended to prove self-defeating and we

could end up with lower rates as a result

We would also note that as the chart above shows, the GDP-weighted average yield of
Eurozone government bonds is historically low in outright terms, and relative to swaps. While
the ECB has indicated it assesses the favourability of financial conditions holistically, the above
indictor explains why the ECB feels relaxed about its asset purchases. Our fear is that
yesterday’s ECB meeting will undermine some of the progress made in lowering financing costs
for sovereigns.

Today’s events and market view

The main event today is the release of preliminary PMIs across Europe and the US. So far both
manufacturing and services PMI have confounded expectations of a lockdown-related drop. If
measures have been tightened since December, we have no reason to expect PMIs to be any
less immune to it.
Were this true, it is possible that financial markets take heart from this display of resilience, but
we would argue investors will probably take them with a pinch of salt. Nevertheless, yields are
skewed upward today, especially in the Eurozone as investors re-assess the degree of ECB
support they are pricing in.
The central bank has the opportunity to limit the (so far limited) damage. Last year, many a
press conference was followed the following day by a blog post by its chief economist Philip
Lane in order to clarify the message. Similarly, it has been common for a while now for officials
to anonymously express their disagreement in the press after ECB meeting.

Padhraic Garvey, CFA

Regional Head of Research, Americas
1 646 424 7837
padhraic.garvey@ing.com
Benjamin Schroeder
Senior Rates Strategist
+31 20 563 8955
benjamin.schroder@ing.com

Antoine Bouvet
Senior Rates Strategist
+44 20 7767 6279
antoine.bouvet@ing.com
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