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ECB facing a choice of frying pan, or fire

ECB sign in Frankfurt

After three days of gains, European markets slipped back yesterday, as concern over Russian gas supplies, and political turmoil in Italy, and the threat of collapse of the government prompted some profit taking.

US markets on the other hand, closed at their highest level in over a month, led by the Nasdaq 100 after the US Senate voted to push forward $50bn in subsidies to boost domestic chip manufacturing in the US. 

It doesn’t look like last night’s momentum will be carried forward into today’s European session with a slightly lower open expected, with Italian Prime Minister Mario Draghi expected to resign later today, in a huge blow to the ECB as they meet today where they are expected to raise rates for the first time in 11 years.

Not to put too fine a point on it the choice facing the European Central Bank today is akin to frying pan, or fire.

With inflation already at record highs across the euro area, at a record 21.9% in Estonia, at 19.3% in Lithuania and at a much lower 6.5% in France it’s clear that headline interest rates need to go up from their current -0.5%, but by how much, as the region heads towards a bigger energy crisis in the autumn.

ECB President Christine Lagarde has already indicated that rates will go up by 0.25% today, and that remains the most likely outcome, however in recent comments it has been made clear that the ECB will be discussing a move of 0.5%, with the potential of more to come in September. 

The fact is a rate rise of 25bps or even 50bps is merely tinkering around the edges when it comes to inflationary pressures of this magnitude when headline rates are in negative territory, and the euro is down over 14% over the last 12 months having moved below parity against the US dollar. In reality its like bringing a knife to a gun fight. 

The ECB’s biggest problem is not so much that it is powerless to mitigate current levels of inflation it’s that there are increasing splits on the governing council over how much rates need to rise without causing instability in Eurozone bond markets and widening spreads, particularly between Italian and German bond yields. 

Political instability in Italy isn’t helping the ECB manage Italian borrowing costs, where the spread between German and Italian 10-year yields is over 200bps. To deal with this Lagarde has been at pains to promise that the ECB is looking to unveil a special anti-fragmentation tool later today, with the markets increasingly looking for a lot more than mere details about such a tool. 

It’s not as if this isn’t a new problem, we saw similar fragmentation concerns in 2012, so there was always the likelihood that this problem would return. The ECB has had years to design something for just this sort of scenario, so it’s a mystery why it’s taken so long to furnish the markets with any clues as to how it might work. 

There has been growing pessimism that the ECB will be able to deliver on anything on bond buying that would keep it within the boundaries of what is legal under the ECB capital key, as it starts to raise rates. When Draghi was in charge at the ECB there was talk of OMT, but that requires conditionality being applied, which in Italy’s case will be politically very difficult to sell. It has also never been used or tested. 

The ECB is likely to limit itself to tough talk about an anti-fragmentation tool in the hope that another fudge sandwich will do the trick, but we’re rapidly moving into the realms of the ECB having to do more than talk, especially with an upcoming gas crisis heading into winter likely to test the resilience of the entire region, and Italian politics looking more and more uncertain. 

Before the ECB meeting, we’ve got the latest UK public sector borrowing numbers for June, which are expected to rise sharply from £13.2bn, to £21.2bn with a lot of the rise expected to come in the form of higher debt interest payments, due to higher inflation. 

EUR/USD – slipped back from the 1.0275 area with the main resistance still up near the 1.0340/50 area. Bias remains for a move below 0 9950, towards 0.9660, while below 1.0350.  

GBP/USD – encountering resistance at the 1.2040/50 area for now. We need to push through the 1.2040/50 area to stabilise and target the 50-day SMA. Support remains at the 1.1870 area, with the bias remaining towards the downside while below the 50-day SMA. 

EUR/GBP – the 50-day SMA at 0.8540 continues to cap advances. Only a move above the 50-day MA argues for a move towards 0.8600. While below the bias remains for a drift back towards the recent lows. 

USD/JPY – bias remains for further gains on a break above 139.40. A break of 140.00 targets the 145.00 area. Support comes in at the 135.80 level, as well as the more solid support at the 134.80 area.


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