Soft-ish landing (with luck)

Key points

• The Bank of England’s hike accompanied by the forecast of a recession next year should be a warning for central banks elsewhere in their quest for a “painless tightening”.
• We bring forward our call for the ECB lift-off to July, but we think the ECB won’t be able to go very far into normalization. The absence of solution to fragmentation is a major issue, and Italy is already feeling some pain.  

The UK often has to deal with exaggerated versions of the woes faced by all developed nations. The Bank of England’s decision last week to hike its policy rate while revising down its GDP forecasts for next year in recession territory should be a warning to central banks elsewhere. The Fed, upon hiking rates by 50 basis points and telegraphing more is to come is now talking about delivering a “soft-ish landing” for the economy. Maybe some doubts are creeping in at the Fed on its capacity to deliver the “race to neutral rate” without triggering an outsized slowdown, but it’s still very tentative. The deterioration in hiring intentions reflected in the ISM surveys should however be taken seriously. A lot rests on the labor market.

Meanwhile, it seems that a growing number of the ECB Governing Council members want to accelerate the normalization of monetary policy. We explore here in some details a new speech by Banque de France Governor Villeroy de Galhau. Last week we mentioned the possibility that the first ECB rate hike would occur in July, but conditional on strong dataflow in the coming two months which we didn’t – and still don’t – believe is likely. However, given the flurry of new statements from the central bank, we are now making this our baseline. We reverse the “burden of proof”. Instead of seeing a July hike only if the data in May and June is strong, we now think it would take an abysmally bad data flow for the ECB to wait any longer. Yet, while we bring the timing of the lift-off forward, we pencil in only two hikes this year, followed by a long pause once the depo rate is back to zero. We don’t think the Euro area can escape much tougher macro conditions in the second half of the year which will ultimately stay the hand of the ECB.

A key issue in our view is that there is still no solution – neither on the central bank side, nor on the governments’ via a deepening of debt mutualization – to fragmentation risks in the Euro area. We look with some concern at the elevation in the Italian sovereign spread and the rise in the absolute level of yields there. While 3.1% may not seem like much for an Italian 10-year yield given the history of the local bond market, the rise in the funding costs of the government may make it more difficult to respond to a further deterioration in the economy, especially if wholesale energy prices flare up again if a new sanction package is put together by the EU.