ECB Ends Negative Interest Rate Era with a Bang

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Eurozone Market Update

The European Central Bank (ECB) hiked rates for the first time since 2011 by a drastic 50 bps to 0.0% at its July meeting. This is the first time since 2014 that the ECB has not set a negative interest rate. The hike was double the signalled 25 basis points (bps) rise expected due to the deterioration of the ECB’s inflation outlook. President Lagarde suggested it represented a front-loading of the cycle rather than an increase in the terminal rate.
The ECB also announced its Transmission Protection Instrument anti-fragmentation tool to support member states’ economies as they attempt to combat high inflation across the eurozone. Currently, as measured by overnight index swaps, the implied interest rate in the eurozone by year-end will be 0.88%.

UK Market Update

UK Prime Minister Boris Johnson resigned in July. While this creates some uncertainty regarding future monetary policy, the market focused on the ongoing economic recovery and near-term policy. Bank of England (BoE) Governor Andrew Bailey reiterated the desire to bring inflation closer to the 2% target and hinted at a more considerable rate hike next month. July’s economic data supports a more drastic hike at the August BoE meeting — May’s GDP growth of 0.5% beat expectations of 0.1%, giving the bank more room to manoeuvre on the scale of the hike, as June’s annual CPI inflation beat predictions to hit 9.4%. The UK’s implied interest rate by the end of 2022 fell from 2.70% on 1 July to 2.63% by month-end.

US Market Update

The Federal Reserve (Fed) made a second consecutive 75 bps hike in July, despite market speculation of a 100 bps rise, as annual CPI inflation hit 9.1% in June. While Fed Chair Powell said another 75 bps hike “could be appropriate,” he repeatedly endorsed the Fed’s June Summary of Economic Projections as a good indication of current thinking. This implies another 100 bps of tightening this year, over three meetings, making 50 bps a strong base case for September. Current Fed funds futures contracts are pricing in a 25% probability of a 75 bps hike in September. Meanwhile, the advance Q2 GDP estimate of -0.9% shocked market expectations of 0.4%. This second consecutive negative quarter indicates the US economy is now in recession (see Chart of the Month).

Looking ahead

In August, we will maintain liquidity for September’s Fed and ECB meetings. We continue to expect growth to be a much more significant headwind in the second half of the year — Q2’s negative US GDP print is early evidence of this. The ongoing uncertainty over Europe’s gas supply from Russia is a major focal point, as any significant cut in supply will result in recession. The BoE meets in the first week of August, and the change in rhetoric makes a 50 bps hike now the base case. The outcome of the UK Conservative Party leadership process will be important to our interest rate outlook given the different approaches to economic policy from candidates Rishi Sunak and Liz Truss. The risks are elevated with potential tax cuts resulting in higher inflation and growth, leading to further rate hikes.

Chart of the Month: Post-pandemic US GDP recovery over with a second consecutive negative quarter

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