Testing Time Coming Early

Key points:

• The ECB will have a tough job on anti-fragmentation as the political crisis in Italy could challenge some of the key features of the tool.
• In the US, the market is already focusing on what happens after the rate hikes.

The ECB is not going to have an easy job this Thursday. While the rate decision itself – a 25 basis points-hike – has been pre-announced in June (and noises from the Governing Council did not point to massive enthusiasm for going bolder – this will in all likelihood wait until September) the central bank is expected to unveil the details of its anti-fragmentation instrument exactly at the moment the resumption of political instability in Rome is triggering a widening of the Italian spread. The new framework could thus be tested much earlier than expected. The features of the ongoing political drama in Italy raises questions on at least two key issues: can conditionality be light, and what exactly are the “right circumstances” under which the tool could be deployed. Indeed, some of the debates currently straining the coalition in Rome are connected to the reform agenda attached to the Next Generation programme, which is widely seen as the right basis for “light conditionality”. Moreover, would the ECB be legitimate in countering a spread widening if it was triggered by a change in the intrinsic risk profile of a member state brought about by domestic political choices? Our concern is that what will come out on Thursday could still be too vague, or too narrow in scope, to signal the market that the “cavalry is coming” quickly to shore up the Italian bond market.

Meanwhile, in the US the “inflation peak” continues to be elusive, especially on core. Still, risk-free rates continue to fall. Investors are already focusing on the medium-term consequences of the Fed action – high recession risks, ultimately forcing rate cuts – while both the market’s and households’ inflation expectations are improving, suggesting the Fed remains fully credible. Yet, the condition for this credibility remains that first the Fed delivers a series of hikes in quick succession. The message from inflation expectations, and the fact that for most businesses, financial conditions remain in restrictive territory despite the recent drop in risk-free rates, should however dampen support for radical options, such as emulating the Bank of Canada’s 100 bps hike last week. Just a few months ago, 75 basis points in one go would have seem reckless. It’s probably safe not to exceed this quantum.