(Bloomberg Opinion) -- Thursday's European Central Bank meeting was supposed to be something of a sleeper. The December review had already clearly laid out its most significant decision: the gradual replacement of its gargantuan pandemic support program. However, persistent inflation and political events in Italy are unsettling the usually calm waters of the European government bond market.
Some soothing words are needed from President Christine Lagarde at the press conference to play down expectations for any interest rate hike this year. The markets have already figured in 20 basis points by yearend. The governing council needs to navigate this tricky situation with care because failure to tamp down those expectations now could easily lead to an unnecessary crisis later. Lagarde will not want to extinguish all pricing in of higher rates for sometime next year but she needs to push back carefully but firmly on more immediate and overblown market fears. It may be timely to issue a subtle reminder of the considerable arsenal of the ECB's QE bond-buying power.
There's some shakiness emanating from the political arena. On the face of it, an immediate crisis has been averted in Italy with both Mario Draghi staying on as prime minister and Sergio Matterella remaining as president for now. Unfortunately, it took a protracted messy process to end up there — and that reminded investors of the perennial problem of unstable Italian governments. The condition will rear up again next year, with elections to be held before June 2023. Italian 10-year yields, having initially fallen on Monday, quickly lost any gains.
Investors are also aware that not far over the horizon is the French presidential election in April. So, the political risk premium is being priced back in across Europe. French 10-year yields are at the highest since early 2019.
It doesn't help either that bedrock German bunds are also pushing higher in yields, with the benchmark 10-year again hovering close to moving from negative to positive returns. More importantly, the German two-year yield is now above the official ECB deposit rate of -0.5% for the first time since 2015. This is being driven by January's German consumer prices printing at 5.1% annually, much stronger than the 4.3% forecast. Though this was lower than December's 5.7%, the pattern of German CPI is not dissimilar to that seen recently in the U.S., with repeated upside surprises which led Fed Chair Jerome Powell to request the “transitory” label be ditched.
The ECB had banked on euro area inflation — largely driven by energy prices — peaking in November but it ticked up again to 5% in December. Now, there are worrying signs of persistent price gains in January, with France and Belgium also missing to the upside. Spanish prices rose 6.1%, well above the 5.5% survey forecast. All this means that, instead of the ECB's December forecast for first quarter euro area inflation of 4.1%, it may well have a 5 handle instead. That will prompt heavy upward revisions at the next quarterly review in March.
Will the governing council bring forward its deliberately distant “very unlikely this year” interest rate increase? With both the Fed and the Bank of England firmly on rate-hiking path, the spillover into higher euro yields may be hard to resist. Yet, euro area inflation — although temporarily elevated — should still return below the ECB's 2% target next year unless wage pressures build too rapidly. Chief Economist Philip Lane sees no evidence of that happening yet.
The wild card is energy prices, which may turn disruptive if the Ukraine dispute escalates. But barring the kind of sharp rises seen during 2021, the annual inflation rate is likely to be back below target. The euro area does not face quite the same longer-term pressures that the consumer -driven economies of the U.S and U.K. do. It can and should take a slower path toward reducing monetary stimulus especially as the 800 billion euro NextGeneration EU recovery fund has yet to kick in fully.
The ECB has long been masterful at buying time and the silky rhetorical skills of Lagarde will be required once again to convince traders the ECB is sticking to its clearly laid out plans for this year — despite the bumps in the road.
More from Bloomberg Opinion:
-
Ending High Inflation Won't Be Pretty: Abramowicz and Authers
-
Fed Does What's Expected, Not What's Needed: Mohamed El-Erian
-
Canada Traders Got Too Far Over Their Skis: Robert Burgess
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.
©2022 Bloomberg L.P.
Essential Business Intelligence, Sharp Market Insights, Practical Personal Finance Advice, Daily Fuel, Gold and Silver Prices and Latest Stories — On NDTV Profit.
