ECB on hold - hike on track for December

Economist view

As expected, the European Central Bank (ECB) kept rates on hold with the deposit rate remaining at 2.50%.

Having only raised rates in September, and with something of a lack of urgency coming through in recent ECB commentary, an on-hold decision was widely expected. The ECB continue to see underlying inflation as stable and wages “do not show a material response” to higher energy prices so far”. They judged that they were well positioned to hold at this meeting and wait for more information.

Expect a hike in December

The risks to inflation from energy prices are still very much seen as to the upside and the ECB expect inflation to rise further. We continue to expect a further rate hike from the ECB this year and the signalling in the press conference was clearly supportive of that. President Lagarde said that the Council debated whether to hike this time. They decided that a “measured approach…remained appropriate”. We would interpret “measured pace” as implying a roughly quarterly pace of hikes. Even more pointedly, she said that “unless there were major developments, the direction of travel is quite clear for all of us”.

We continue to expect a further rate hike from the ECB this year.

Still not expecting many hikes

Despite signalling a likely December hike, there were also signs that this is still not the start of a prolonged hiking cycle. 1) Lagarde played down the risk of second round effects, noting that the ECB does not see material risks of second round effects, which have evolved in line with the central forecast despite a larger than expected rise in energy prices. 2) The statement says that financing conditions have tightened, which is likely to weigh on inflation (doing some of the tightening for them).

What will they be watching?

Lagarde went through a long list of data and information they will have before the next meeting, but indicated a special focus on indicators of underlying inflation.

Lagarde leaving

ECB President Lagarde was unsurprisingly also deluged by questions in the press conference on her decision to leave the ECB on 7 February 2027 (the date was made clear in reports ahead of the meeting this morning). She left these questions until the end and made the point that there was no good time to leave and that her term was up anyway in October 2027. Expanding on her rationale, she intriguingly said that she wants freedom of expression on non-monetary policy matters; she talked about the “truth” being damaged and contradicted by misrepresentation; that she thinks her voice can help; and that she doesn’t think she can be comfortable in neutrality at the present time. Given her experience and profile, Lagarde is likely to remain an influential voice after her departure from the ECB.

Fund manager view

Having already raised rates twice in this cycle, most recently at its September meeting, the ECB Governing Council was firmly on the path to taking policy rates towards restrictive territory as it held its latest monetary policy meeting.

With energy prices higher than the previous meeting, focussing on this metric alone could perhaps have led to an expectation of a further hike this time round. However, a lot has happened in the intervening period, not least a significant (further) rise in European sovereign bond yields, a degree of which was driven by concerns over the fiscal outlook for the Eurozone’s second largest economy, France.

A lot has happened… not least a significant rise in European sovereign bond yields, a degree of which was driven by concerns over the fiscal outlook for the Eurozone’s second largest economy, France.

This tightening of financial conditions had been cited by ECB President Lagarde in the weeks prior to the ECB’s October meeting and, coupled with the “measured approach” to monetary policy that has become the mantra for the ECB, the market had pushed back the expectation of the next hike in this cycle to December. Hence the decision not to hike this time came as no surprise to the market. However, the initial reaction to the announcement was for European sovereign bonds to rally, with the market interpreting the accompanying press release as a dovish signal, which referenced “Financing conditions have tightened since the Governing Council’s last meeting”.

Over the course of the press conference that followed, President Lagarde outlined the discussions held by the governing council, with “very special attention” being paid to the potential second round effects of elevated energy prices alongside the increased cost of sovereign financing, arising from higher yields. The decision to hold rates, (described as a “no hiking decision”), was unanimous and the council’s “measured approach” remained appropriate.

However, bonds saw some of their strength retraced as Lagarde made it clear that a further hike in December was very much on the cards with the assertion that, “unless there are any major developments, the direction of travel is quite clear to all of us”. This was as firm a signal as you are likely to get from a central bank that advocates data dependence and is “not pre-committing to a particular rate path”. Post the press conference, a December hike from the ECB was close to 85% priced.

Lagarde was also pressed on France and any concerns that the ECB may have regarding the moves seen in French government bond yields over recent weeks. She would not comment on specific sovereigns, other than to say that yields have risen globally, and countries with high debt levels have to factor this into their fiscal projections, which have to be adopted in plans submitted to Brussels. If any market participants were looking for a signal from the ECB that they would step in to arrest the recent rise in French bond yields, they will have been disappointed. Any comments regarding intervention were limited to a broad confirmation that action would only be taken were the smooth transmission of monetary policy to be at risk, which has not been the case.

Yields have risen globally, and countries with high debt levels have to factor this into their fiscal projections

Overall, the messaging was that the ECB remains committed to achieving its aim to ensure that inflation stabilises at its 2% target in the medium term. While monetary conditions may now be tighter as a result of the previous hikes and the global increase in bond yields, should further hikes be required – which will be clearer by the time of the next meeting in December – the ECB will take the appropriate action.

The announced early end to Lagarde’s tenure as ECB president should not have a material effect on the policy approach of the ECB Governing Council. With much of this tightening already priced by the market, we remain reasonably constructive on the outlook for European sovereign bonds, though we are conscious that bouts of intra-region volatility are likely to persist.

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