European Central Bank to deliver first rate hike since 2011

Anticipated rate hike the first since 2011

The highly anticipated interest rate hike from the European Central Bank (ECB) is set to be delivered this Thursday.

ECB president, Christine Lagarde, and her team of policy setters have long hinted that the July meeting would be the one at which policy tightening would really begin. Markets are fully convinced that this time is the right one, and the expectations are getting more hawkish by the day.

Yesterday, 34 basis points (bps) were being priced in; a 57% chance of a 30bps hike, and 43% chance of 40bps. Today, it has gone up to 41 bps; 87% chance of 40bps, and 13% chance of 50bps. This may leave the door open for some disappointment if the ECB doesn’t live up to the expectations.

Like the Bank of England (BoE), the ECB may decide it is more appropriate to take it step by step, ensuring the economy can withstand higher interest rates before jumping in the deep end.

Regardless of their choice, it’s a tricky time to try and understand how markets will react to the news. On the one hand, inflation is seen as the greater of two evils at present, and the bank must act to combat soaring prices. If this is the market’s view, then the greater the hike the more bullish for the euro. But if both slowing growth and high inflation are seen as a danger to the Eurozone economies, then a steadier and gradual hiking schedule is likely to be favoured.

EUR/USD

A pair to watch closely on the back of the meeting is EUR/USD, which has been attracting increased attention in the last week as it briefly touched parity for the first time since December 2002.

So far, this psychological level has acted as good support and the pair is picking up a little upside momentum, but, fundamentally, there is still weakness in the euro versus the dollar, and Thursday’s meeting will play a big part in that.

Energy crisis and anti-fragmentation policy

Other central banks around the world have already delivered at least three hikes since the ultra-low rates brought on from the Covid-19 pandemic, but the ECB has been faced with the energy crisis from its over-dependence on Russia, causing soaring prices and making the threat of recession even more real.

Even now, the possibility of a total Russia gas shut-off makes the policy decision for the ECB an even harder balancing act than usual. But not only is the threat of recession a major danger for the Eurozone economy, the central bank also has to deal with fragmentation between the 19 member states.

It must keep inflation close to the 2% target, but it must also be careful that its policy decisions don’t cause the spread in sovereign bond yields to widen drastically, which causes borrowing costs in some regions to be far higher than in others, having a different effect on the economies within the bloc.

To avoid doing so, the ECB is expected to launch a anti-fragmentation tool at its meeting on Thursday, some sort of new bond-buying programme to avoid a large divergence in yields. But it is unclear exactly how this tool will be implemented, and most importantly, how is it going to work alongside tightening policy.

At the emergency meeting the governing council had last month, Lagarde said the anti-fragmentation tool would be rolled out regardless of the level of interest rates, leading to believe both policy tools will be separate, but investors are likely going to want more details as to how exactly this will happen, and the pressure will be on Lagarde to clear up these questions at the press conference on Thursday.