Pressure on Europe

Hawkish Fed puts pressure on Europe

While the ECB can do little to influence the Fed, it’s been trying to convince markets that it’s not going to blindly follow the example of the US.

BY JOHANNA TREECK

It won't just be U.S. Federal Reserve Chair Jay Powell who's in the hot seat Wednesday as he signals the Fed’s latest policy moves. European Central Bank President Christine Lagarde will find herself under fresh pressure from markets to adjust course if the spillover from across the Atlantic starts to threaten the eurozone's nascent recovery.

The Fed’s recent hawkish shift — it is expected to see its first post-pandemic rate increase in March — has already left its mark on eurozone borrowing costs. The key German 10-year bond topped zero last week for the first time since May 2019 and is up by more than 30 basis points in the last month. The rise in the eurozone's ultra-safe benchmark is partially reflecting expectations that the ECB will tighten earlier than it has projected.

And now some analysts are raising the prospect of the Fed taking an even sharper turn toward tightening policy — accelerating the rise in eurozone bond yields.

"We could be in for an even bigger hawkish surprise in the months ahead," Deutsche Bank’s Peter Hooper wrote in a note to clients on January 19. Goldman Sachs economist David Mericle, in a note to clients over the weekend, also cited the risk of the Fed raising rates or reducing its balance sheet more quickly than currently expected.

So far, Lagarde's public comments have shown little concern over rising yields. "It means there’s confidence in growth and in such conditions, rates will increase gradually," she told French radio Tuesday.

Still, the ECB will be mindful that any sharper rise in borrowing costs on the back of a more hawkish Fed can't undermine the region’s recovery. Lagarde has assured that the ECB "will monitor very carefully" favorable financing conditions going forward.

It’s them, not us

While the ECB can do little to influence the Fed, it's been strenuously trying to convince markets that it's not going to blindly follow the example of the U.S., where both core and wage inflation are higher.

Lagarde and her colleagues have instead stuck to the message that eurozone inflation remains more benign, and its economy is more in need of stimulus, than the U.S.'s. On those grounds, they say, the ECB needs to keep on pumping money into markets and ensure that interest rates stay in negative territory for at least one more year.

To make this strategy stick, ECB policymakers are making a lot of hay of forward guidance on future policy, signaling that markets should avoid getting ahead of themselves by betting the central bank will follow the Fed’s lead and start lifting rates this year.

Lagarde uses every opportunity she gets to underline that the ECB has "every reason" to not be as quick or aggressive as the Fed. "We are in very different situations," she said last week.

The ECB’s forward guidance, first signed off in July, says that interest rates will stay rock bottom until inflation stabilizes around 2 percent for the medium term. Within the policy-setting Governing Council, this stance has prompted lively debate, but Lagarde has continued to double down, arguing that the guidance’s conditions for a lift-off are "very unlikely" to be met this year.

Most economists still back that view and expect no rate hikes in 2022. But investors are getting nervous and are now pricing in a 20-basis-point interest rate hike by year-end. Lagarde’s ability to keep a lid on yields with verbal assurances hinges on the Governing Council backing her. That task may be more challenging now, as suggested by the official summary of December’s policy meeting, released last week. It noted that some policymakers warned that inflation “could easily turn out above 2 percent" in 2023 and 2024.

Such expectations call into question the official ECB position, which sees inflation falling even without rate hikes this year. That stance also assumes that too-low inflation is still the biggest enemy the central bank has to fight and that the record-high reading of December eurozone inflation, which clocked in at 5 percent, marks the peak.

Who will buy?

What will be even harder for Lagarde to control is if investors vote with their feet. Higher yields on U.S. debt will compel foreign investors to sell off eurozone bonds, and unless domestic investors step in as new buyers, softer demand will push up yields on eurozone debt. (Bond prices are inverse to yields, so if they fall amid weaker demand, yields rise.)

Increased domestic demand seems very unlikely. The ECB has been the biggest buyer in the market, vacuuming up about €2 trillion worth of government bonds in the past two years. But this year, those purchases could fall to less than half a trillion under the ECB's plans to dial back bond-buying. A resulting drop in demand would put extra pressure on eurozone debt. This is visible already in the inching-up of German bond yields.

There's an even greater risk for heavily indebted eurozone countries, whose sovereign bonds tend to follow Germany. Analysts are warning that those countries could see financing costs spike. Institute for International Finance chief economist Robin Brooks, for example, has pointed out that during the pandemic there was little investor interest, outside of the ECB, in snapping up those countries' debt.

"All issuance was absorbed by the ECB’s purchases," he told POLITICO in November.  "I don't see any enthusiasm among private investors for Italian bonds or Greek bonds."

Should bond yields start rising more sharply and produce a premature tightening of financing conditions, it's not clear how the ECB will react. Last year, when eurozone bond yields rose as the result of spillover from U.S. bond markets, the central bank first boosted its asset purchases and then changed its forward guidance.

This time may be different, warned UniCredit’s chief economics advisor Erik Nielsen. As he sees it, the obvious and right reaction to tightening conditions would be for the ECB to boost demand for bonds by ramping up asset purchases. But given resistance within the Governing Council, it might take some time for policymakers to act.

"At a time when the aversion inside the ECB towards [bond buying] has reached fever-high, the operational reaction by the ECB to imported higher yields might be less straightforward," he said.