Bond market turmoil complicates ECB rate decision

The European Central Bank (ECB) has raised interest rates twice in the last four months and another hike is expected in December as the bank combats the surge in inflation from energy prices.

That was the holding narrative we’ve been working from for the past number of weeks, but there’s a new weave in the tapestry that is complicating matters.

Turmoil in bond markets is lifting borrowing costs independently of the ECB’s rate hikes, which is also cooling the economy. The bond sell-off and commensurate surge in yields is reducing the need for further rate hikes, placing a question over whether the ECB will opt for a December rate hike.

Carsten Brzeski, global head of macro at ING, says the context has changed since September. “The surge in German bond yields since the September meeting has already had roughly the same impact on growth and inflation as an additional 25bp [basis points] rate hike,” he said.

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“For France, it’s closer to a 50bp hike. With bond markets doing the ECB’s job, some central bank officials might be less keen to continue hiking than they were at the September meeting.”

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ECB chief Christine Lagarde said pretty much the same thing on Saturday, noting that the current bond sell-off was making borrowing more expensive ‌in the euro zone, curbing economic growth and ultimately inflation.

“While growth has been resilient, financing conditions have tightened, with long-term interest rates rising notably since our last meeting,” Lagarde told fellow central bankers and finance ministers gathering in Bangkok.

“This will slow growth and reduce pass-through by more than projected in our September exercise.”

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If the ECB opts for a further quarter-point bump in December, that would take the bank’s policy rate to 2.75 per cent, a level financial officials define as restrictive or curtailing of economic activity.

The inflation outlook, and the second-round impacts on food and other items (which have yet to materialise) is being closely monitored.