It’s Getting Tighter

Key Points

• Financial conditions are tightening very fast in the US and in the Euro area.
• The ECB’s anti-fragmentation tool is announced for July. We are worried about the implications of selling bonds from other issuers to offset the support to weaker signatures.
• France can operate with a relative majority in parliament, but the government will have to pick its battles.

The Fed’s 75 basis points hike last week, combined with its projections bringing the policy rate well into restrictive territory by year-end, reflects a willingness to dispel accusations of being behind the curve and to “get on with the job” of taming inflation swiftly, allowing for some relaxation in a not-too-distant future (the projections include rate cuts in 2024). An issue though is that the Fed seems to think that its unusually fast pace of tightening will have only a small impact on unemployment, but that even this small deterioration will be enough to curb inflation decisively. The Fed may believe that merely reducing vacancies, without destroying many actual jobs, would be enough to put pressure on wages. What concerns us though is that financial conditions have already tightened considerably. The average cost of funding of US corporates is now the highest since the end of the Great Financial Crisis of 2008-2009. This will affect business spending decisions in the months ahead. We suspect the Fed is intentionally downplaying the amount of pain its tightening will entail.

In the Euro area funding costs on the corporate bond market are back to their highest level since 2012. The ECB seems to want to bring its policy rate in neutral territory by year-end, but financial conditions for the corporate sector have already hit that range. We always think in terms of the monetary impulse acting with lags, but right now, the expected tightening could transmit very quickly to the economy. Focus is however for now firmly on sovereign funding costs. Although the ECB has managed to pour some water on that fire last week, we reiterate our view that the market underestimates the difficulties faced by the looming anti-fragmentation tool. The implications of offsetting the purchases of bonds from fragile signatures with sales of bonds from other member states concern us.

Governments will have a hard time navigating the reduction in fiscal room for manoeuvre the market tightening will trigger. The French government losing its absolute majority in parliament comes at a delicate time, even if the Constitution helps to operate with a relative majority.