Sunset Market Commentary

Markets

The ECB received some last-minute input at the very moment policymakers were discussing the monetary course. Q1 GDP numbers showed the Euro area economy unexpectedly slowing to a 0.1% quarterly growth pace (0.8% y/y). Details are not available yet but its arguably not an ideal situation, particularly since Q1 only captures one month of the Iranian conflict and the ensuing energy price surge. The latter resulted in higher CPI with the April number, also on tap today, accelerating from 2.5% to 3% – the fastest pace since mid-2023. Energy prices soared from 5.1% to 10.9% (y/y) with monthly dynamics, although slowing from an eyepopping 7% in March, coming in at 3%. With oil prices (June contract) today temporarily hitting a post-war high of as much as $126 we could see further pressure in the month(s) ahead. Non-energy industrial goods inflation quickened too, from 0.5% to 0.8% to hit the highest in two years. Services inflation eased from 3.2% to 3%, allowing for a minor fall in core inflation to 2.2%. Accelerating actual headline inflation is to be combined with the April PMIs and a slew of other soft data that pointed at sharply intensifying price pressures going forward, and puts the ECB in a tough spot.

Frankfurt kept the policy rate unchanged at 2%. The status quo was unanimous but was discussed alongside the option of a rate hike, both at length and in depth. This suggests that there is appetite for such a move, though not enough (yet). The statement noted that incoming data has been broadly consistent with the outlook. However, upside inflation and downside growth risks have intensified. Going into the conflict, inflation was around 2% and the economy resilient. The ECB states that it is well positioned to navigate through this shock, of which the impact for the medium-term inflation outlook and economy depends on the intensity and duration and the scale of its indirect and second-round effects. The statement offered little clues for policy going forward hike and neither would Lagarde confirm (nor reject, though) market pricing for a June hike. She instead referred to the three-pronged reaction function specified at the ECB and its Watchers Conference. In terms of where the ECB is according to the three scenarios outlined in March, Lagarde only wanted to note that they are “certainly moving away” from the baseline without saying if that’s closer to the base or the adverse case. We’ll have to wait until June for that. Asked why the ECB is not acting to its baseline scenario, which embedded two rate hikes and sees inflation just barely easing back to 2%, Lagarde said that they are in a position to wait it out before acting immediately because they are not seeing second round effects so far. In addition, anticipative market positioning is doing some of the tightening work already. But at least Lagarde thinks she “knows which direction they are headed at”. The market reaction was an extremely muted one. A sudden intraday drop in oil prices in fact triggered the biggest (and only) move of the day, dragging European yields up to 10 bps lower at the front. EUR/USD is trading little changed around 1.17. The US dumped a batch of eco data in between the ECB announcement and press conference but triggered additional volatility. Q1 growth fell slightly short of expectations with 2% Q/Q annualized. Imports was a major drag though, subtracting 2.62% ppts, while all other major categories contributed: personal consumption added 1.08 ppts, investments 1.48 ppts and exports 1.32%. Quarterly PCE data surprised to the downside on a headline level (3.6% vs 3.9% and from 3.7%) but to the upside when looking at the core (4.3% vs 4.1% and from 2.7%), the latter being the fastest since Q1 2023.

The Bank of England today left its policy rate unchanged at 3.75% in 8-1 vote. Huw Pill preferred to raise the rate to 4%. Governor Bailey labeled the decision as an ‘active hold’. In its quarterly report the BoE replaced central forecasts by three scenarios with different paths for energy prices and potential second round effects. Even as the BoE sees inflation above current 3.3% for the remainder of this year, the MPC made a balanced assessment. There is a material risk of second round-effects which policy needs to lean against via higher interest rates. But at the same time, the bank also elaborated on a further loosening of labour market conditions, a weakening of the economy and a tightening of financial conditions since the start of the conflict. The BoE in this respect finds itself in a difficult position where it has to balance the cost of doing too much vs too little. The balanced approach (and an intraday decline in the oil price) caused markets to scale back expectations for a June BoE rate hike to about 65% from 80% yesterday evening. Gilt yields ease between 10 bps (2-y) and 5 bps (30-y). Sterling gains modestly (EUR/GBP 0.865).