EUR Rates: The ECB is a few steps behind the Fed
As market participants debate over a 25bps or 50bps hike this week from the European Central Bank (ECB), we seek to put some considerations into perspective. First, the ECB is a few steps behind the Fed in the current cycle. While the Fed hiked in March 2022, the ECB only started in July. Logically, it suggests that the ECB has more leeway to hike rates than the Fed. We can also compare the terminal rate pricing for the two central banks. If the Fed delivers the last 25bps hike this cycle as widely expected, the Fed funds rate upper bound would reach the peak of the 2004/06 cycle at 5.25%. Similarly, pricing from EUR swaps indicate a reasonable chance that the ECB’s refi rate would peak at 4.25% in October (the peak seen in the 2005/08 cycle). Second, inflation appears to be more of a problem in Europe, with headline YoY CPI still close to 7%. Accordingly, even as base effects drive inflation lower, elevated prints would still provide sufficient justification for further hikes for several more months. We also note that breakevens are relatively buoyant for Germany compared to the US. Third, market conditions appear relatively benign in the Eurozone. Peripheral spreads are contained thus far and there does not appear to be the same level of banking system stress that impacted the US. Judging from the much milder inversion seen in the German Bund curve and the state of the Eurozone economy, it does seem that the ECB may be able to keep rates higher for longer than the Fed. However, with a terminal rate of 4.25% already priced, it is not clear if there will be much upside to short-dated EUR rates.
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