Stagflation risks are building in the euro area, sharpening the policy dilemma for ECB. With inflation still taking precedence over the clouding growth outlook, we expect ECB to go ahead with its intention to hike all three policy rates by 25bp in July.
The pace of further rate increases will depend on how the economy evolves, but we do not anticipate any guidance for the Q4 monetary policy outlook at the July meeting. As visibility remains low, we expect increased market volatility to persist in the near-term, but still see ECB as priced too aggressively by the market for 2023, especially with the Federal Reserve priced for a 50bp rate cut in 2023. Currently markets are pricing in a tightening of 141bp in 2022 from ECB and another 43bp in 2023. Any frontloading ECB hikes is unlikely to support EUR/USD in our view.
Designing a credible anti-fragmentation tool is key, for markets not to call the bluff on ECB and send Italian yields sharply higher again. We expect the new instrument to be implemented in a flexible manner, with focus on shorter maturities, but without a pre-set intervention amount or timeframe. We also expect purchases to be sterilized in order not to interfere with the monetary policy stance, but we see only a small probability of ECB outright selling bonds.
