Traders Up ECB Tightening Bets as Sources Warn Rates Could Go “Restrictive”

Key Points

• Traders upped their ECB tightening bets on Monday after sources said policymakers see an increased risk of rates going restrictive.
• Implied Euribor future yields suggest the ECB’s benchmark rate moving above 2.05% by December and above 2.5% next June.
• Bundesbank’s Nagel warned that further “clear” steps would be needed if inflation lingers.

Traders on Monday upped their bets that the ECB will raise interest rates more aggressively between now and the end of Q1 2023, in response to hawkish commentary from the influential head of German’s Bundesbank Joachim Nagel over the weekend and commentary in the financial press from ECB sources.

According to Eurozone Euribor futures markets, the ECB is seen lifting interest rates to just above 2.05% by the year’s end. That compares to expectations that rates would rise to around 1.85% by the end of the year as recently as the start of the month.

Further Clear Steps Needed if Inflation Lingers

In wake of the ECB’s record large 75 bps rate hike last week that saw the bank lift its benchmark interest rate to 0.75% last Thursday, Nagel was quoted by Bloomberg as saying on German radio that further “clear” steps would be needed on interest rates if inflation continues to linger. YoY headline inflation may surpass 10% by December, Nagel warned, though he also said he expects it to ease next year.

Meanwhile, unnamed ECB sources speaking to Reuters over the weekend said that policymakers at the bank see an increasing risk that they will be forced into lifting interest rates above 2.0% and into so-called “restrictive territory” amid their ongoing efforts to contain record-high Eurozone inflation.

The sources warned that the ECB would likely signal an intention to take rates into restrictive territory if the ECB’s next economic forecasts, out this December, project headline CPI that is still above the bank’s 2.0% target in 2025.

Money Markets Increasingly Betting on Front-loaded ECB Tightening Cycle

Eurozone money markets are already wagering that the ECB will take interest rates into moderately restrictive territory in 2023, reflective of expectations that, given developments in Eurozone energy markets this year, inflation looks set to linger for some time yet.

Euribor futures imply that, by next March, the ECB will have taken interest rates to slightly above 2.4%. That’s up from expectations for rates to have hit around 2.25% by March as recently as the start of the month.

The Euribor futures chain implies rates then topping out at just above 2.5% next June, before sliding slightly back to around 2.4% by next December. These expectations are broadly unchanged since the start of the month, implying that money markets while leaving ECB terminal interest rates bets unchanged, have increasingly shifted their expectations towards a more front-loaded ECB rate hiking cycle.

Euro Rallies, But Sustained Turnaround Unlikely

In wake of last Thursday’s 75 bps rate hike (ECB front-loading in action), such moves in money market expectations aren’t too surprising. The euro on Monday hit its highest against the US dollar in nearly one month when if came close to testing 1.0200 and was last trading with gains of about 0.9% on the day in the 1.0130 area.

Positive news regarding recent Ukrainian military success, with Russian forces having lost significant ground in recent days in the northeastern Kharkiv region, is also contributing to euro upside on Monday. But analysts are reluctant to bet on a sustained turnaround in the euro’s fortunes, with the currency still 11% down on the year versus the buck.

While the ECB is getting more hawkish, it looks set to be tightening into an energy crisis-induced recession. Meanwhile, while recent military developments in Ukraine might mean the conflict is closer to ending than previously thought, that doesn’t necessarily mean an end to Europe’s Russia/energy woes anytime soon.