ECB announces accelerated taper schedule, opens door to earlier rate hikes. Commodity currencies stronger. Equities lower across the board as risk appetite retrenches

Global rates are higher overnight after the ECB set out an accelerated tapering schedule and opened the door to earlier rate hikes, despite the ongoing war in Ukraine.  European rates have seen big moves higher, especially in the periphery, while the US 10-year rate has punched through 2%.  Equity markets are weaker, by 1-2% in the US and 3-4% in Europe, amidst the prospect of monetary policy tightening and no breakthrough in Russia-Ukraine talks.  The EUR has fallen overnight, despite the hawkish surprise from the ECB, while commodity currencies are stronger, the NZD trading up towards 0.6865.  Yesterday saw new cycle highs in NZ 10-year rates and those moves should extend this morning given overnight moves.

European rates have surged higher overnight after the ECB outlined an accelerated tapering schedule and opened door for earlier rate hikes, possibly as soon as July.  The ECB said bond purchases would be €40b in April, falling to €30b in May and then €20b in June (previously, the ECB had said purchases would be €20b in Q4).  Lagarde said QE bond purchases could then end in Q3, subject to the economic outlook.  Rate hikes would happen only “some time ” after bond purchases had stopped but, repeatedly pressed by journalists to clarify what this meant, Lagarde said it could be anything from a week to some months later.  Some analysts think the ECB could stop QE at the end of June which would potentially open the door to a 25bps rate hike as soon as the July meeting, something markets now see as around a 30% chance.  The market has almost fully priced a 25bps hike by September, with 42bps in total priced by the end of the year, which is more tightening than what was expected immediately prior to Russia’s invasion of Ukraine.

While Lagarde framed the decision as creating ‘optionality’, the accelerated tapering schedule was a surprise to a market which had expected the ECB to be cautious amidst the uncertainty associated with the Russia-Ukraine war.  The war, and associated surge in commodity prices, has created a difficult trade-off for central banks which are dealing with greater near-term inflationary pressure but weaker growth outlooks.  The ECB’s actions suggest it is more concerned about keeping a lid on inflation and inflation expectations.

European bond yields rose sharply after the ECB statement, especially the peripheral bond markets such as Italy which have been big beneficiaries of the ECB’s QE programme.  On the day, the German 10-year rate was 6bps higher, to 0.27%, while Spain’s 10-year rate was 12bps higher and Italy’s 22bps.  The biggest moves on the German curve were at the short-end, with the 2-year rate moving 11bps higher, to -0.38%, as the market brought forward ECB rate hike expectations.  The moves have flowed through to the US market, with the US 10-year rate increasing 5bps, to 2.0%, back to near its recent multi-year high.

The currency market reaction to the ECB has been more fleeting.  The EUR spiked higher, briefly trading above 1.11, but it has since given back all those gains, and some, and is now down around 0.8% on the day, back below 1.10, with the market returning focus to the ongoing Russia-Ukraine conflict.  It’s also possible the FX market is more focused on the negative impacts of ECB tightening on European growth than it is about the prospect for higher yields on European fixed income.

There was no breakthrough or ceasefire agreed in talks between the Russian and Ukraine foreign ministers in Turkey.  In the meantime, Russian forces continue to shell Ukrainian cities.  Meanwhile, Russian Foreign Minister Lavrov claimed, without providing any evidence, that Ukraine was developing biological weapons with US support, which the US has labelled “preposterous.”

Equities are weaker across the board overnight, with investors wary of central banks tightening monetary policy into a weaker growth outlook.  The S&P500 is down 1.3% while the NASDAQ is down just over 2%.  It has been a sea of red in European equities too, ranging from -3% on the German DAX to -4% on Italy’s MIB index.  Volatility remains extremely elevated.

The US CPI release matched market expectations, with headline inflation hitting a fresh 40-year high of 7.9% y/y and core inflation 6.4%.  Shelter inflation continues to run hot, with rents and ‘owner’s equivalent rent’, which together comprise ~40% of the core CPI index, increasing 0.5% higher in February.  Shelter inflation is considered a more persistent inflationary factor and is running at 4.8% y/y, its highest annual rate since the early 1990s.  Likewise, the Cleveland Fed’s trimmed mean CPI rose to a new all-time high (post 1984) of 5.7% y/y, indicating that inflationary pressures are broad-based.  Economists expect headline inflation to breach 8% in March, owing to the spike in oil prices, before moderating over the remainder of the year.  The key question is how quickly inflation falls from uncomfortably high levels and where it settles a year or two from now.  The Fed is priced to kick off its tightening cycle next week with a 25bps rate hike.

While European currencies are lower over the past 24 hours, it’s been a different story for the commodities currencies, with gains of 0.4%-0.5% for the CAD, NZD and AUD.  The NZD has pushed up towards 0.6865, nearing resistance around the 0.69 mark.

Commodity markets continue to be roiled by Russian sanctions and supply concerns.   Overnight, aluminum futures spiked as much as 6% after Rio Tinto said it would stop supplying raw materials to a Russian-owned refinery in Ireland, which is a key supplier of alumina in Europe.  Meanwhile, Brent crude oil futures reversed gains of as much as 5% to now trade slightly lower on the day while European natural gas futures continued their extreme volatility, falling 19% to €126.

Turning to local developments, after their recent strong run, NZ electronic card transactions slumped 7.6% in February amidst the surge in Omicron cases.  The fall was bigger than the 4% we had pencilled in and adds some downside risk to Q1 GDP.  The RBNZ won’t be deterred from its rate hike intentions though, with its focus on getting inflation back to 2%.

NZ rates were higher and the curve steeper yesterday, following global moves the previous night.  Swap rates were up by 2-3bps while government bond yields were 4-6bps higher.  Both the 10-year swap rate and government bond yield closed at fresh 3½-year highs of 3.17% and 2.94% respectively. Market expectations of OCR hikes remain elevated, with 81bps priced into the next two meetings and the cash rate priced to reach almost 3.25% next year.

Yesterday saw the return of NZ inflation-indexed bond issuance after a six-month hiatus (issuance was suspended last September after a run of poor tenders).  New Zealand Debt Management has changed the issuance process for inflation-indexed bonds, making it more flexible and demand-driven, and the early signs are encouraging.  Yesterday’s tender of $50m 2030 inflation bonds saw a bid-to-cover ratio over 3x with the tender clearing around 2bps below secondary market levels at the time.

The NZ 10-year breakeven inflation rate jumped 8bps yesterday, reaching a new all-time high (since 2012) of 2.48%.  NZ is no different from other countries, which have seen inflation expectations reach multi-year highs as markets react to strong underlying global inflation pressures and the recent spike in oil and commodity prices.  Some caution needs to be applied when looking at NZ ‘breakevens’ as a measure of inflation expectations as inflation-indexed bonds are much less liquid than their nominal counterparts.  But the direction of travel is consistent with most survey measures.

The NZ manufacturing PMI and food prices are released this morning while tonight sees the Canadian employment report and the University of Michigan consumer confidence index.