Monex Europe: 25bps hike most likely for both ECB and Fed

Monex Europe: 25bps hike most likely for both ECB and Fed

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In Monex Europe’s Week Ahead, Simon Harvey, Head of FX Analysis, wrote a preview commentary on the upcoming Fed and ECB decisions.

25bps the likeliest avenue for the ECB although a 50bp hike can’t be fully discounted

Speculation over the ECB’s next steps has been rife ever since March’s inflation data showed core inflation was yet to peak. While financial stability concerns initially restricted markets from pricing the possibility of a 50bp hike, as they receded throughout the month expectations of such a move advanced.

The reflating of the ECB’s implied policy path was aided in part too by the Governing Council hawks, who took to the press to open the door for a final 50bps hike and to suggest that the terminal rate could be as high as 4%. Peaking at just a 32.6% probability, swap traders never truly bought into the possibility of such an outcome, however.

This is largely because of the uncertainty around financial conditions and whether core inflation data for April, released just prior to the ECB’s next decision, would meet the burden of proof required for such actions. While there were initial signs within second-tier data that suggested the balance of power within the Governing Council remained with the hawks, such as strong preliminary PMI data for April and evidence that firms were passing on higher staff costs to consumers amid an improved demand backdrop, ultimately core inflation data out of Spain and Germany for April didn’t reach the burden of proof required to make a 50bp hike the likeliest outcome.

Although a 50bp hike can’t be fully discounted should the official eurozone core HICP reading on Tuesday show signs of persistence and the ECB’s Bank Lending Survey show negligible fallout from March’s banking crisis, we don’t think any decision to hike rates by 50bps will sway the implicit terminal rate in any case, which we estimate at 3.75%.

In our view the Fed will hike by 25bp, and signal a conditional pause

As we have previously noted, the most likely outcome for the upcoming meeting will be a 25bp hike, and for the Fed to signal a pause to assess economic conditions as they continue to evolve over coming months. We, like policymakers, see risks to the outlook for the US economy as increasingly two-sided and subject to elevated uncertainty, with the currently unknown tightness of credit conditions and a mixed picture being painted by data making it hard to pin down the cumulative impact of monetary policy.

The risk of overtightening from both policy and emerging financial stresses now weighs against the risks of under tightening and sticky inflation, and a wait and see approach from here on out appears to us as the most prudent course of action.

With that said, policymakers will have access to the quarterly Senior Loan Officer survey to make use of in their deliberations. This release, only distributed to markets two days after the rate decision, will greatly clarify the degree to which credit conditions have tightened in the US, and should give both officials and the markets greater certainty on the path for the US economy. In the absence of this information, the likely outcome for the dollar isn’t totally clear, either.

This should offset any boost to risk assets from a likely termination in the Fed’s hiking cycle. In addition, the signalling impact of an imminent pause in the hiking cycle and the potential repercussions of overtightening in the event of a hawkish 25bp hike means the dollar reaction may not be as clear cut as in previous Fed meetings.