Rates: How to convey a hawkish message against macro headwinds

A subdued macro outlook is keeping a lid on ECB hike expectations and this has led to real interest rates, a measure of how the market perceives the ECB’s policy stance, dropping considerably since July. In fact, as the ECB’s Isabel Schnabel pointed out recently, the level of real interest rates out the curve has fallen to levels that also prevailed at the ECB meeting in February, if not even lower.  

With the ECB preaching data dependency, it has curbed its ability to make credible commitments with regards to the rates outlook, despite its pledge to keep policies sufficiently restrictive to achieve its inflation goals.  

This is why we see the balance of risks still tilted to a hike this week – actions speak louder than words. The market is attaching only a 40% probability to a hike, highlighting some potential to surprise the market. But the market does see an overall probability for a hike at 70% before year-end, which suggests much of the repricing could just be pulling forward future hike expectations, but not necessarily embracing further tightening on top of that. After all, the macro story has not changed and even in the ECB’s own deliberations this week, the weakening backdrop could gain a greater weight. 

Markets could sense that this is the likely end of the hiking cycle. Still, the ECB may want to counter the notion that this is the end of its overall inflation-fighting endeavours. The degree to which this is successful will determine how much of a curve bear flattening we get in the event of a hike. A renewed focus on quantitative tightening could help to prop up longer rates on a relative basis. Other means of tightening, such as adjusting the minimum reserve ratios (some ECB members such as Bundesbank President Joachim Nagel see room for action here) would probably have less impact on longer rates.