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The European Central Bank is trying to catch up with the Fed in fighting inflation with aggressive rate hikes. On Thursday, the eurozone’s central bank hiked rates by 0.75 basis points, on the upper end of market expectations. That follows a 0.50 basis-point rate hike in June, ahead of market expectations.
Traders and investors couldn’t figure out what to make out of ECB’s hawkish stance.
On the one hand, higher interest rates signal the end of free money in the eurozone, and that ECB is serious about bringing inflation. That’s a good thing for Wall Street, as lower inflation down the road means lower interest rates and higher valuations for risky assets.
On the other hand, higher interest rates mean that the eurozone’s central bank is willing to sacrifice economic growth for lower inflation, according to Thomas Verbraken, an executive director at MSCI Research.
“The ECB’s monetary tightening had been behind the curve, but today’s decisive 75 basis-point rate hike shows that the central bank is committed to bringing inflation down,” he told International Business Times in an email. “It seems the risk of entrenched inflation is now outweighing the risk of an economic slowdown in their policy decisions.”
But trading lower inflation for an economic slowdown or even an outright recession could be bad for risky assets, especially for cyclical shares trading in major exchanges.
“The fight against inflation has turned into an ‘Inflation vs. Recession’ bout,” said James James Demmert of Main Street Research in an email to IBT.
“Can these central banks slow economies enough to wipe out inflation without creating a recession or prolonged growth? This is not a positive for risk assets.”
The mixed impact of the ECB’s hawkish policy on risky assets could explain the choppy trade on Wall Street for most of the trading session on Thursday.
In addition to being behind the curve, Verbraken sees the ECB as under pressure to raise rates by foreign currency markets, due to the rising U.S. interest rates and a stronger dollar—weaker euro. That’s something that have added fuel to the eurozone inflation as European consumers have to pay more for imported products like food and energy, the critical factors behind the price hikes seen last year.
Nonetheless, he sees ECB’s policies as bringing inflation under control.
“Although realized inflation is trending upwards, market-implied expectations would see inflation plunge to levels close to the ECB’s target of 2% a year from now,” Verbraken said. “If that turns out to be true, the big question for investors is how rough the landing will be in terms of economic slowdown.”
But that could come at the cost of heightened volatility in the bond market as MSCI sees deterioration compared to last year.
“The EUR Overnight Index Swap has been flattening significantly in recent months, and the 30Y-5Y slope is already in negative territory,” Verbraken said. “As this could be a forewarning of economic troubles ahead, investors will pay close attention to this indicator.”
Verbraken is particularly concerned with the growing spread between Italian and German borrowing, which could complicate the ECB’s goal of bringing down inflation.
James Bentley, Director of Financial Markets Online, a forex training platform, is concerned about Italy’s debt, which could threaten European unity.
“With Italy’s debt mountain almost at the point of no return, the stage is set for relations to sour further between the bloc’s major economies,” he told IBT. “In other words, it could be about to turn ugly.”
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