ECB – Regime shift.
The ECB formalized its hawkish turn (partially anticipated by interviews of MPC members over the past few weeks) at the June meeting last week. The central bank guided for a 25bp hike in July, followed by a (likely) 50bp move in September and a “sustained” hiking cycle after that. Inflation projections have been updated, with headline marked above 7% for 2022, and core inflation above target for the whole forecast horizon (2.3% in 2024). Growth forecasts have been revised lower but remain above consensus for 2022. The message thus came across hawkish, as inflation concerns are clearly outpacing data concerns, and the ECB moving quickly to avoid running behind other central banks. With current guidance, it is likely for the policy rate to hit 1% in 2022 and 2% in 2023. Front-end rates already price this outcome. Still, flat curves and 5y bunds at 1.4% suggest risks remain on the terminal rate. If inflation continues to surprise on the upside, the return of the ECB to an inflation-watcher role suggests medium term expectations on policy rates have room to move higher.
Periphery risk – Back in focus.
At the meeting, the ECB refrained from giving details on the “anti-fragmentation tool”, that many are anticipating as a way to fight spread widening. As a result, BTP-bund spread started widening again, and now stands at 230, the highest level in the past three years. Overall, we think the ECB will continue to remain reactive on spreads. Spreads are gradually reverting back to their longer term level, after having being muted for the past years. The central bank will thus have a reactive approach to it, and intervene only at “emergency levels”, or when the pace of volatility becomes unsustainable. A twist of current instruments is insufficient to support periphery markets. The ECB will thus need to add to its tools in order to defend spreads. Markets are thus likely to challenge the ECB in the short term, and quick moves in periphery spreads are likely, shorter term. Overall, we would note that the technicals in BTPs are better than in 2011 and 2018. The ECB holds roughly a third of the stock of Italian debt, and foreigners hold a much lower share. Italian public debt ex ECB holdings is roughly 110% of GDP. It is thus likely to see an acceleration in BTP vol, but the defense mechanisms vs European systemic risk are arguably higher than they have been in the past crises, making ultimate tail risk lower.
US CPI – False start.
In the US, May CPI surprised on the upside. Monthly inflation registered a 1% increase, leading headline to 8.6%. Core inflation increased 0.6%, with yoy print at 6%. Energy and food were the main contributors, both directly and indirectly via a strong increase in goods inflation. Services are more muted, with the monthly print actually decreasing in May. Shelter inflation remains elevated. Data suggest that core good disinflation and energy are slower than expected, and rent inflation remains high. With this data, the notion of an inflation peak in summer will not be challenged, but the fall in inflation should be slower than expected, with chances of inflation ending the year just below 6% now being much higher than earlier on. As a result, the Fed will need to come up with a strong message on Wednesday, probably adding another 50bp hike in September, and strengthening the guidance for medium term hikes. A sustained US cycle makes it harder for other central banks to follow at the same pace, so upward pressure on the US Dollar may persist a bit longer. Overall, we continue to think upside risks to the priced terminal rates persist. On this point and a broader market view, please see our recently published Algebris Bullet.
Algebris Investments’ Global Credit Team
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