Talks between Russia and Ukraine in Turkey should serve as a reality check to markets' recently found optimism. The ECB meets today but is confined to a passive role as the geopolitical crisis evolves in close proximity. More removed, the Fed stays in the driving seat, underscored by today's US CPI.
Light at the end of the tunnel?
Bond yields continued to rise as markets remained more optimistic about a possible diplomatic solution to the conflict in Ukraine. Through to peak 10Y, Bund yields have risen more than 30bp since the start of the week, and if one looks at 10Y swap rates, absolute levels are even above pre-crisis levels.
As severe ‘crisis valuations’ are further unwound, it opens the view to the underlying monetary policy challenges. For the Fed that should be clearly highlighted by another record CPI print today. And markets are indeed back to pricing in chances of even more than six 25bp rate hikes this year.
A better risk backdrop may leave more room for EUR rates to focus on today’s ECB meeting. Amid the crisis markets had looked primed for a more dovish tone from the central bank today but, alongside improving sentiment, markets have also moved back to fully discounting a first ECB rate hike before the end of the year.
Money markets are back to pricing rate hikes
Image Source: Refinitiv, ING
ECB may sound more cautious ...
Uncertainty has given greater importance to optionality and flexibility
Inflation remains the ECB’s primary concern and the desire to normalize policy should have grown only stronger since February. Net PEPP buying will thus very likely still end with March, but heightened uncertainty has given even greater importance to "optionality" and "flexibility", which President Lagarde is likely to stress at the press conference again. The ECB’s February guidance foresaw APP being ramped up to €40bn per month in 2Q and we still see a good chance that the ECB will stick to this plan, but may not be as committed to old plans beyond that.
Our economists now think the ECB could announce to decrease net asset purchases starting in May by between €5bn and €10bn per month, and avoiding signaling a concrete end date to its net asset purchases. There is also speculation that the ECB could remove guidance that net buying will end “shortly before” raising key rates to give it even more flexibility.
... but the desire to normalize policy has grown only stronger
Sovereign spreads have usually served as a good indicator for market expectations regarding the ECB’s plans for its asset purchase programs. However, that notion has been diluted to a degree by liquid sovereign bond markets more generally – in this case also Italian bonds – benefiting from a flight to safety, as well as more recently by speculation surrounding a possible joint EU fiscal response to counter the fallout from the geopolitical crisis, akin to what was seen in response to the pandemic.
Money markets discounting rate hikes again, but 10Y Italy/Bund is at its tightest since early February
While money markets are back to discounting rate hikes, the benchmark 10Y Italy-Bund spread is at 146bp and thus at its tightest levels since early February – just before the ECB’s hawkish turnaround at the February meeting. Even if the ECB maintains a more cautious tone today, in our view this underscores the precarious situation for spreads, as by its own reading markets still believe in the ECB's normalization drive, and delaying plans to eventually end net-QE does not mean they are abandoned.
Faster hikes and tighter spreads: Markets want to have it both ways lately
Image Source: Refinitiv, ING
Today's events and market view
Improving risk sentiment has driven rates higher, but today’s events offer important reality checks.
Recent headlines have given rise to more optimistic views that a diplomatic solution to the conflict in Ukraine can be found. This puts today’s meeting of Russian and Ukrainian foreign ministers in Turkey squarely in the center of attention.
Amid the crisis, the ECB has been downgraded to a more reactive role, neatly captured in the ECB’s emphasis on optionality and flexibility. Even though the underlying desire to normalize policy should only have grown stronger since February, it is unlikely that recent headlines are enough to warrant abandoning that caution at today’s ECB meeting.
Concerning the EUR rates markets’ hopes for a joint EU fiscal response to the geopolitical crisis, today’s EU summit in Versailles could bring more clarity. Should market hopes be further dampened following earlier dismissal by EU officials, it may add to a reversal of this week’s rates sell-off.
Still in the driving seat is the Fed, even if the Fed Chair promised to be more “nimble” amid greater uncertainty. Today’s US CPI inflation reading which could even reach 8% should reinforce views of six Fed hikes being possible this year, as we expect.
In European supply, Ireland sells €1bn in 10Y and 15Y bonds. In the US, the Treasury will auction 30Y bonds.
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