Invesco: ECB is nearing the end of its tightening cycle

July 28, 2023

Paul Jackson, Chief Economist at Invesco, responds to yesterday's ECB's interest rate hike:

'The ECB governing council increased policy rates by 25 basis points (bps) at its July meeting but gave no guidance about the future path. Initial market reaction brought a decline in the region’s bond yields and the euro.

As widely expected, the ECB Governing Council raised policy rates by 25 bps, taking the Main Refinancing Rate to 4.25% and the Deposit Facility Rate to 3.75%. The ECB says that “Inflation continues to decline but is still expected to remain too high for too long”. That could be interpreted as indicating that more tightening is needed. It also said that “future decisions will ensure that the key ECB interest rates will be set at sufficiently restrictive levels for as long as necessary to achieve a timely return to the 2% medium-term target.”, which leaves the scope for more rate hikes.

Separately, the ECB announced it will now remunerate minimum reserves held by banks at 0%, rather than the at the Deposit Facility Rate. This will negatively impact banking sector revenues.

The ECB’s communication is non-committal about the future path of rates, as was President Lagarde during her press conference. She indicated that the ECB has done enough for now but that the Governing Council may conclude differently at future meetings, depending on data flows (the next meeting is on 14 September). She insisted that the central bank is not in the business of giving forward guidance. Overnight index swaps suggest that markets believe that one more rate hike is possible over the next few meetings but expect no more beyond that (if anything, implied rates over future meetings are slightly below pre-announcement levels).

Broader market reaction suggests there is now more optimism that the ECB is reaching the end of its tightening cycle. At the time of writing EURUSD had fallen to 1.10 from its pre-announcement level of 1.11. Likewise, German government 2-year yields have fallen to 3.00% from 3.08%. 10-year yields have also fallen but not by as much. The EURO STOXX 50 equity index is up by around 2% so far today but there have been minimal gains since the policy announcement.

Looking at both yesterday’s announcement from the US Federal Reserve and that of today from the ECB, markets have reacted positively to anticipated rate hikes accompanied by communication that is at best non-committal and at worst could be interpreted as reserving the right to impose further rate hikes. Perhaps the approach of the peak in rates now feels more tangible.

We think the ECB is nearing the end of its tightening cycle, especially given the ongoing weakening of the Eurozone economy (see recent PMI data) and falling inflation, though we wouldn’t be surprised to see another rate hike this year. Given the nature of the ECB’s mandate and how far behind it has been during this tightening cycle (and that inflation remains higher in the Eurozone than in the US), we suspect the ECB is more likely than the Fed to raise rates again, though that could risk pushing it into overtightening territory. Consequently, we expect EURUSD to continue trending higher, notwithstanding today’s depreciation.'