By Lowie Debou,
Fixed Income Fund Manager


Over the last weeks, financial markets have been buzzing with expectations of a central bank pivot. It reminds us of the endless discussions about the transitory nature of inflation. However, the word ‘pivot’ is a loaded expression and should be used with caution, as the implications for portfolio positioning are severe. We believe discussing central bank pivots at this stage is inappropriate. As long as central banks do not completely switch from tightening to easing, it is not so much a pivot as a logical continuation of monetary policy tightening. In terms of the ECB’s interest policy rate, dividing monetary policy actions into separate stages gives us a more appropriate way to assess this evolution:

  1. The central bank starts with rapid rate rises, as inflation momentum has spiraled – or is likely to spiral – out of control. Aggressive hikes are meant to manage the tail risk of unanchored (or poorly-anchored) medium-term inflation expectations. This tail risk is illustrated by the survey of professional forecasters, which turns economists’ inflation expectations into a probability distribution. It is a slow-moving data series, but the right tail of the distribution clearly shows a continuous increase in inflation expectations, surpassing 4%. The mean of the distribution has also moved towards 3% (versus pre-COVID levels of 2% or lower).
  2. Once inflation reaches this cycle’s peak and the a-priori policy rate has been met (if it still exists), it is time to change the increments by which interest policy rate is increased. At this stage, the policy rate is not necessarily in line with the ex-posteriori terminal policy rate, which can only be observed when inflation starts trending towards the target. Regretfully, most developed market central banks no longer take on an academic approach to neutral and terminal rates in their communications, but instead refer to market pricing. This has clearly given the wrong signal over the last few years.
  3. As a final step, rates are kept at high levels to observe whether policy actions affect the real economy, as monetary policy acts with a lag. Typically, monetary policy actions start tightening financing/financial conditions, which is clearly happening now. These tighter financing conditions eventually impact the real economy through growth and inflation. If inflation does not sufficiently decrease, the ECB can reassess by re-adopting rate hikes. Note that the duration of high policy rates can be more restrictive than the initial rate increases. Over the last few years, the ECB has generally preferred to observe the effects of monetary policy actions through financing conditions rather than financial conditions. This is more appropriate for the Eurozone, given its reliance on a bank-based funding system instead of an equity market-funding system (like in the US). In general, the ECB assesses financing conditions through different channels: it looks at how much banks are currently lending to households and corporations, examines borrowing rates and spreads for both governments and firms, and uses surveys to reflect credit standards and expectations for new bank loans. Most channels have started to tighten lately, implying that the ECB’s actions will affect the real economy… but with a lag.


Based on this staged approach, the ECB will likely move rates between 2.5-3% by the end of 1Q23, roughly in line with market pricing. A subsequent pause will let the ECB observe effects on financing conditions and the effects on the real economy. Maintaining a balance between inflation and real growth over the coming quarters will be challenging, as real growth might decrease more rapidly than inflation.

The asset purchase programs are the second part of the monetary policy toolbox that has not been normalised. A staged approach is not needed, but let’s make a distinction between the different asset purchase tools to understand how they guide markets.

  1. In the current macroeconomic environment, it is appropriate to let the Asset Purchase Program (APP) peter out from 2Q23 onwards. This means that the ECB will no longer reinvest its maturing bonds or coupons because, at that point in time, it might have decided to pause rate increases. In addition, the demanding Q1 sovereign issuance schedule will be out of the way by then, giving governments a head starts to secure financing at higher, but stable, levels. There will be no active asset sales of the APP. The ECB is clearly worried about the cost of its monetary policy actions. Since national governments are the main shareholders of the ECB through their national banks, actively selling the ECB’s bond holdings that trade at a mark-to-market loss could mean that the governments might have to bear the costs of recapitalizing the ECB has it might overdraw it’s equity capital. This could be seen as monetary financing. For example, if the losses of the ECB’s Italian bond holdings are much higher than those of the German holdings, the German government will have to partly finance these losses. Indeed, the ECB’s equity capital applies to the losses across the whole APP portfolio instead of just the German holdings. The argument of monetary financing is key for the APP and PEPP portfolios, but less critical for Targeted Longer-Term Refinancing Operations (TLTRO) funding. As the loss argument seems to have been an important driver of the TLTRO decisions, it will be at least as important for the APP. Also, given the global synchronisation of easing and tightening by central banks as the Fed is still not actively selling securities, we don’t see why the ECB would act differently.
  2. Continued, flexible use of Pandemic Emergency Purchase Program (PEPP) reinvestments is the ECB’s first line of defence against unwarranted bond yield moves. The ECB’s commitment to this approach was confirmed by the overpurchase of peripheral countries and under-purchase of core countries this summer.
  3. The Transmission Protection Instrument (TPI) will continue. It has proven its worth as a communication tool in July ‘22 after the spike of certain spreads and yields. The TPI’s underlying conditions are not binding and can easily be expanded. More importantly, the program’s size is unlimited. This program remains the ECB’s last line of defence, a clear backstop to be used without hesitation, if necessary.


We believe the ECB’s current monetary policy actions continue to move in the right direction. However, its upcoming messages on terminal rate expectations and the roll-off of its balance sheet will be intensely scrutinised by financial markets. Since the start of the COVID crisis, the ECB’s communication has clearly improved, as has its willingness to do what is necessary to bring inflation within the limits of its mandate, be it above or below target.


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