European Central Bank: Hawkish hike – and weaker bonds

The economist view – Melanie Baker and Solomon Unwin

The ECB rate hike decision was no surprise given the energy price backdrop amid the ongoing Middle East conflict. Given plenty of hawkish elements to the language, forecasts and press conference, it’s fair to put a high probability on a further hike this year.  

As expected, the European Central Bank (ECB) hiked rates 25bps (bringing the deposit rate to 2.5%). During the press conference, Lagarde noted that the decision was unanimous and implied it was a “no brainer”.  

It is not hard to understand why they have hiked, given the energy price backdrop. The statement noted that, “The conflict in the Middle East continues to generate inflation pressures, and inflation is set to remain well above target for an extended period.” The ECB also see risks as skewed to the upside of their inflation forecast.  

The conflict in the Middle East continues to generate inflation pressures, and inflation is set to remain well above target for an extended period.

There were plenty of hawkish elements to the language, forecasts and press conference and it is fair to put a high probability on a further hike this year given current energy prices. It is also fair to ask whether they considered hiking more than 25bps at today’s meeting. Again, according to the statement, they will continue to follow a data-dependent and meeting-by-meeting approach.

The staff revised up the inflation forecast

Alongside the decision, the ECB also published new staff projections. While their forecast for inflation is unchanged for 2026, it has been revised up for 2027 and 2028. In 2028, the new headline inflation forecast is 2.1%, with 2.3%Y for core. That compares to 2.0%Y and 2.2%Y respectively in their last set of forecasts from June. Importantly, those forecasts are conditioned on a market implied rate path that incorporates a further two ECB rate hikes, suggesting (if the economy evolves in line with the central case) that further hikes would be needed to bring inflation back to target.

Hawkish hike

Beyond the inflation forecast, there were additional hawkish elements to today’s statement, forecasts and press conference, and the market remained priced for more than three hikes by the middle of 2027 after today's decision:

The market remained priced for more than three hikes by the middle of 2027 after today's decision

• Growth optimism: The staff revised their GDP growth forecasts higher “mainly” reflecting the “greater than expected resilience of the euro area economy” according to the statement.
• Uncomfortable inflation description and outlook: In the opening statement and policy statement: “Inflation is set to remain well above target for an extended period.” And during the Q&A, President Lagarde said that “We believe inflation will be longer lasting than we previously expected.” On top of that, the ECB still see the balance of risk to the inflation forecasts as to the upside.  That cannot be a comfortable place to sit for an inflation-targeting central bank.
• Energy prices are already higher than in the ECB’s adverse scenario: The cut-off date for incorporating information into the scenarios was August 19, and both oil and gas prices have already risen above the peak assumed in both the baseline and adverse scenarios: At the time of writing, the oil price (c.$105 per barrel) and gas price (c.€80 per MWh) are already above the peak oil (c.$100 per barrel) and gas prices (c.€77 per MWh) incorporated into the adverse scenario.

Why didn’t they hike more than 25bps?

Considering all of this, we would not be completely surprised if the Governing Council discussed the possibility a larger move. However, although no journalist explicitly asked whether a 50bps hike was considered, Lagarde repeatedly emphasised the high degree of uncertainty, noting conditions can change “almost overnight”. In our view, that uncertainty is likely key to why the ECB opted against a more aggressive move today.

That uncertainty is likely key to why the ECB opted against a more aggressive move

It wasn’t all hawkish

During the press conference, Lagarde noted that inflation had come in lower than they had previously expected, with the Governing Council particularly “quizzical” about weaker food price inflation, which they have subsequently revised downwards. That likely helps explain why the ECB left its 2026 inflation forecast unchanged at 3.0%, despite revising their inflation forecast higher in 2027 and 2028 and acknowledging stronger-than-expected activity data. 

Staying or going?

Despite multiple journalist questions coming at the question from multiple angles, President Lagarde gave very little away in terms of whether she will be leaving the role early, saying that there is nothing to report.  

Our forecasts – risk of hikes

We did not have further hikes pencilled into our current published rate path. The risks at this juncture, however, are skewed towards further hikes this year with energy prices continuing to move above the levels our forecasts (and even today’s updated ECB forecasts) were conditioned on. Today’s forecasts and language leave them sounding primed to hike again this year (though not necessarily as soon as October) unless energy prices fall significantly (which, to be fair, given the degree of volatility seen this year, is not a small probability).

The fund manager view – Gareth Hill

The initial market reaction to the rate hike by the ECB was somewhat subdued. The move had been fully anticipated and priced by the market following guidance from the previous meeting, movements in oil and natural gas price in the interim and selected comments from ECB members that had prepared the market for further policy tightening.  

However, what followed in the hours after the meeting was anything but subdued. As the market digested the revised inflation and growth forecasts, with the messaging that “inflation is set to remain well above target for an extended period”, further rate hikes were swiftly priced in. This resulted in short end yields in Europe rising by as much as 20bps (0.2%) and yield curves flattening significantly. This was despite Lagarde’s re-assertion of a data-dependent,  'meeting-by-meeting' approach. If this decision was a “no brainer”, then with little prospect of a resolution to the Middle East conflict and a normalisation of oil and gas prices in the short term, further hikes this year could be seen as equally likely. Additional impetus for the sell-off came from a report citing “ECB sources” after the meeting, which suggested that “ECB officials expect more tightening, with October in play”. Such statements have been used in the past which help steer ​markets that may not have fully interpreted the intended messaging from the official statement and subsequent press conference. What is very clear is that, whilst the ECB is “not pre-committing to a particular rate path”, it remains concerned about inflation, particularly the second-round effects, and wants the market to be fully aware that it is prepared to increase rates further into restrictive territory if necessary to address them.

The moves in European sovereign bond markets seen in that afternoon were violent. While part of the move can rightly be attributed to the ECB's messaging, market positioning also appears to have played a role, with some market participants forced to close out positions, further fuelling the sell-off. Now the dust has settled, market pricing has shifted to three further hikes from the ECB by April 2027, taking rates in Europe to 3.25% – comfortably beyond most people’s assessment of ‘neutral’. However, as Lagarde reminded listeners yesterday, the concept of a neutral rate is somewhat nebulous and hard to pin down at any given point.

With the US Fed, the Bank of Japan (BoJ) and the Bank of England (BoE) meeting next week, there is likely further volatility ahead – it remains to be seen whether these central banks are prepared to take assertive action like the ECB. As it stands, a hike next week is fully priced for the BoJ and two-thirds priced for the Fed, with only a small prospect of hike priced from the BoE. We remain of the view that sovereign bonds are attractively priced and believe that an overweight duration is sensible, but are also conscious of prevailing headwinds to markets, so look to identify areas which offer the best value in the medium term.

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