The Case for Peak Hawkishness

IN THIS PUBLICATION:

ECB President unexpectedly pivoted towards a tightening stance.
US inflation data continues to surprise to the upside.
H1 2022 could see peak inflation, peak economic growth, and peak hawkishness.

The ECB’s Pivot

For a full year, Christine Lagarde, President of the European Central Bank (ECB), actively refused to engage in conversations about the path of future monetary policy, despite the looming specter of higher inflation across the region.

That all changed in the first month of 2022 with her comments about the ‘normalization of our monetary policy’. It wasn’t a full-scale pivot to hawkishness of the Powell type in the second half of 2021, but it was enough for forward-looking European funding rates (EONIA) to explode higher.

This led European yields to surge higher across all maturities. German 10-year (Bund) yields moved into positive territory for the first time since 2019.

For Europe, higher interest rates are a double-edged sword:

Banks want higher yields to help improve their net interest margins (NIMs – the difference between what a bank receives and pays in interest) and therefore profitability, which in turn helps to pay down some of their debts.
But, for many banks, their debts are so large that the gains in profitability are more than offset by the rise in financing costs implied by higher interest rates.

This is one reason why many investors think the ECB can never meaningfully raise interest rates, which also helps explain the surprise reaction at Lagarde’s sudden change of heart.

European inflation is also not the same as US inflation. The primary driver of inflation in Europe has been energy prices (and food), but core inflation has stayed relatively low:

European energy prices have fallen more than 50% from their highs, but remain elevated. Underinvestment in traditional energy sources and the geopolitical tensions around the Nord Stream 2 pipeline will persist, but prices may have already peaked.

Independently of this, there is very little that higher rates can do to address this specific problem, and more broadly speaking, it’s our stance that rates will have a minimal effect on exogenous geopolitical or supply chain related inflation (as we’ve highlighted in a previous Markets Update).
European wage inflation, on the other hand, has remained relatively low, at about 2%, even while US wage inflation, measured as average hourly earnings, has headed toward 6%.

Therefore, the ECB (and the markets) may have performed a premature repricing of rates, reacting hawkishly to forms of inflation over which they have no control (supply-chain driven), at a time when global growth may be about to falter, something Tim has been tweeting about over the last few months.