ECB: A good monetary policy interest rate decision

If a measure of the effectiveness of central bank communication is the market reaction to a decision to change key policy rates, then the European Central Bank (ECB) performs very well in this regard.

Despite raising rates by 25bps at its June monetary policy meeting, European sovereign bond yields barely moved upon the announcement. Through clear communication at its last meeting and subsequent messaging by ECB governing council committee members in the intervening period, the market was fully prepared for the announcement, and swiftly moved on to look for indications as to the timing and direction of the next move.

The meeting saw a fresh set of inflation (higher) and growth (lower) forecasts, accompanied by a revised set of scenarios produced by the ECB. These now include a “mild” scenario to complement the “adverse” and “severe” projections originally introduced in March to address the heightened uncertainty surrounding the macro-economic impact of the continuing conflict in the Middle East. The decision to raise policy rates was “robust” across all three scenarios, was unanimous, and was a “good monetary policy interest rate decision” and not an “insurance” or a “credibility” hike.

The overriding message remains one of a central bank that is intolerant of excessive inflation, is data dependent, has no pre-determined interest rate path, stands ready to act, and where monetary policy decisions will continue to be made on a meeting-by-meeting basis.

President Christine Lagarde backed this up (when addressing a question in the press conference concerning the ECB needing to avoid being seen as “complacent”), citing the bank’s record of returning inflation to its 2% medium term target over the last 12 months – a strong endorsement, in her view, of the ECB’s credibility and lack of complacency. When asked whether raising rates now was a risk, Lagarde issued a strong response, stating that the main risk would be inaction and not raising rates now in the face of increasing inflation, as it is a “much more difficult situation” to bring out of control inflation back to target. The overriding message remains one of a central bank that is intolerant of excessive inflation, is data dependent, has no pre-determined interest rate path, stands ready to act, and where monetary policy decisions will continue to be made on a meeting-by-meeting basis.

The market appreciates this clarity of communication, as evidenced by the reaction of European sovereign bond yields to developments out of the Middle East; good news is greeted by falling yields (as the market prices less required monetary policy tightening by the ECB), while a deteriorating situation (typically accompanied by increases in the price of oil) sees yields rise, and further policy tightening priced. With elevated uncertainty as a result of geopolitics, having a central bank with a clear reaction function and a commitment to assertive policy action means that markets can have greater faith in the future path of interest rate moves, which is not something that is necessarily true for all central banks.

We see value across European government bonds, but particularly at the shorter end of the maturity spectrum, where close to two further hikes for 2026 are currently priced after the committee’s decision.

We see value across European government bonds, but particularly at the shorter end of the maturity spectrum, where close to two further hikes for 2026 are currently priced after the committee’s decision. Given the messaging of the ECB, and given the current set of incoming data, we feel that while a further hike this year is likely, to price monetary tightening beyond this is somewhat excessive. We have positioned our portfolios to benefit from steeper yield curves in Europe, switching longer dated exposure shorter, and remain constructive on economies such as Spain, who exhibit robust economics and a relatively prudent fiscal outlook.

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