Inflation: does the ECB still have credibility?

In the year to date, we believe the market has been searching for the answers to three questions that will have a large bearing on how we will invest over the next 18 months.

The first is whether there are signs that the thus far rock-solid labour market has cracked.  When there are, it will likely mark the point at which central banks can confidently say that interest rate hikes have found a biting point and when they can finally relax about second-round effects of inflation and the risk of a wage/price spiral.

Recent news about US regional banks running into trouble might suggest this biting point has already been reached and is likely to limit the extent of a further bond market sell-off. This news was not enough, however, for the ECB (European Central Bank) to reverse course on the guidance that it would hike 50bps this week in the face of rising core inflation, so this question remains in play – and critical.

Recession: shallow or deep?

Once we have evidence of labour market weakness, we can begin to address our second principal question: how shallow will any resulting recession be?  Up until this week, the common narrative had been that either we were going to avoid recession entirely, or that any recession was likely to be shallow given the very strong starting point from which we would enter it.  We believe that this narrative is very unstable and very easily challenged. 

Firstly, it is that strong starting point which would likely mean that central banks would be less accommodating in this recession than they have been in previous recessions.  Inflation remains too high and labour markets too strong.  Hikes may cease, but cuts may not be as forthcoming. 

Secondly, it is very easy to say a recession will be shallow when it is a distant prospect, but much more difficult to prove it when it hits. It will take time to prove that the recession has indeed been shallow, whereas it will be easy to assume that is will be more severe.

Recession vs inflation

Finally, further ahead, we will be looking at how much inflation falls during the recession.  This will be key to determining how accommodating monetary policy can become and how quickly central banks will need to return to rate hikes to combat the inflationary upsides once more.

While we continue to grapple with the question of the labour market, the correlation between rates and credit spreads has been unhelpful, meaning owning rates has not been a good hedge for credit portfolios. Correlation has flipped in recent days as bank viability concerns have dominated and this flip would be entrenched by confirmation that the labour market was weakening.

In the meantime, with inflation pricing close to mandate consistent levels, we believe interest rate moves will happen through the real rates channel. This is because central banks remain credible and will continue to signal that they will tighten policy until inflation is clearly moving back towards their goal. As long as credibility remains, real rates will be the release valve and inflation pricing will move sideways.

Recently inflation pricing in Europe moved to levels well above the ECB’s target, suggesting credibility was at risk of being lost.  We believe these moves were more technical in nature and that other indicators such as inflation expectations, rate path pricing and peripheral spreads were not consistent with a loss of credibility.

Subsequently, we expressed this view by going underweight European inflation. Being less liquid than their nominal counterparts, inflation-linked bonds tend to struggle in periods of extreme market volatility. That provides an extra portfolio motivation for being underweight inflation when concerns about the financial system have been escalating.

If you found this blog interesting, you may wish to attend our webinar ‘Charting a path for Euro credit in 2023’ on Tuesday 21 March; more details here.