German yields rose and EUR gained three figures against the USD this week to 1.14, as markets priced in an increasingly hawkish ECB. After the ECB Governing Council meeting on Thursday, we changed our call and now expect the ECB to hike rates in December 2022, and again in March 2023 (See ECB Review: New call – ECB to hike in Dec22 and Mar23, 3 February). Based on Lagarde’s comments on the press conference, the ECB GC is more and more concerned about inflation, while seeing growth risks broadly balanced. In several occasions, Lagarde had the opportunity to close the door for a rate hike in 2022 but she intentionally left it open. Same time, Lagarde confirmed ‘sequencing’ indicating that the ECB would only hike rates after ending its net asset purchases (APP). Hence, we still see the current market pricing as too aggressive, as the ECB would have to accelerate the pace of taper in order to be able to hike in September, let alone in the summer.
Tighter financial conditions will be a key market driver in 2022. After last week’s FOMC meeting, we changed our Fed call and now expect five hikes (a total of 125bp) this year and QT in June. The risks are tilted towards more aggressive tightening, and we think that compared to 2015, the Fed is ‘behind the curve’ this time around (See Fed Update: – Different economy, different hiking cycle – a comparison with December 2015, 3 February).
Tighter financial conditions will make life harder for indebted sovereigns, businesses and individuals, and may exacerbate regional divergence in growth and recovery. While developed economies have broadly recovered back to pre-pandemic levels, insufficient vaccine rollout, slow recovery in international tourism and limited fiscal space remain a drag on EM growth. Tighter financial conditions through wider credit spreads and stronger USD will make the external financing environment for EM substantially more challenging at a time when overall debt levels are at historical highs and borrowing needs remain elevated. In Europe, the focus remains on Turkey, where another staggering inflation print was recorded this week (48.7% in January). In the context of looming Fed rate hikes, with an extremely low and negative real interest rate and weak buffers, the Turkish economy remains one of the most vulnerable ones in the EM universe.
Repricing of expected ECB action was the name of the game this week. The curve flattened with a 25bp rise in 2y and a 15bp rise in 10y Bund yields. The futures markets are pricing in the first ECB hike as soon as in July, which we see premature. ECB repricing was the key driver for a higher EUR/USD this week but we think next week’s US inflation print (Thursday) could again turn the attention back to the US. We continue to see EUR as overvalued vs. fundamentals, and maintain our forecast for EUR/USD at 1.08 in 12M.
Next week’s data calendar is pretty light. If the US inflation print surprises on the upside, we think a 50bp hike by the Fed in March is possible. We will also keep a close eye on any comments from FOMC and ECB policymakers, although there are not many speeches in the calendar. China is back from the New Year’s celebrations and a key thing to watch will be whether there’s a pickup in new COVID-19 cases after increased travelling. Also, any headlines on the Russia-Ukraine standoff will be watched closely.
