ECB and BoE: Donning a more hawkish mantle

February 3, 2022

Guillaume Menuet

EMEA Head of Investment Strategy & Economics

Judiyah Amirthanathar

EMEA Investment Strategist

SUMMARY

European Central Bank (ECB) may hike interest rates before the end of 2022 while the Bank of England (BoE) has already done so in step with an active policy tapering strategy. We see upside potential in financial sector stocks amid a rising interest rate environment.

At its meeting on Thursday, February 4, 2022, the BoE increased interest rates by 25 basis points to 0.5% as widely. The British central bank’s Monetary Policy Committee (MPC) voted 5-4 in favour of a 25bps hike. The four MPC members voted in favour of a 50bps hike. Regarding assets held on the BoE’s balance sheet, the MPC voted unanimously to start reducing the stock of UK government bonds by ceasing to reinvest maturing assets.

The same decision was taken for the stock of sterling non-financial investment grade corporate bonds. However, rather than the passive approach that applies to UK gilts, the MPC opted for an active tapering strategy, planning to unwind fully the stock of corporate bond purchases that it holds no earlier than towards the end of 2023. This was a hawkish surprise.

Meanwhile, the ECB. left all its key interest rates unchanged. There were no changes to any of the guidance, either with respect to interest rates, or asset purchases (including reinvestments). However, ECB President Christine Lagarde acknowledged discomfort about the size and length of the inflation overshoot.

While the full ECB guidance also includes a reference to the fact that this may also imply a transitory period in which inflation is moderately above target, the central bank’s tone suggests that not only is the likely size of the overshoot, but also perhaps its duration, could lead to an intense debate during the spring about how best to wind down the net asset purchase programme to respect the sequencing which stipulates that rate hikes can only happen after the net asset purchases.

BoE & UK Market Outlook: We now expect the BoE to lift interest rates again by 25bps at the 17 March meeting and at the 5 May meeting, extending the series of back-to-back rate hikes to four. At 1%, we think that the BoE will likely pause or at least slowdown the pace of 25bps rate hikes to one per quarter up to a maximum Bank Rate of 1.5% by Nov-22 to see how the economy unfolds. We continue to see upside potential from the UK financial sector amid a rising interest rate environment. The UK financial sector remains cheap, and earnings momentum positive while upward pressure on rates should contribute to higher net interest margins and profitability. We remain underweight UK government bonds amid strong evidence that the BoE will engage in balance sheet reduction which will require the private sector to shoulder a greater share government borrowing, most likely at higher nominal yields.

ECB Outlook: There is no rush for the ECB to hike interest rates before the end of 2022. For too many years inflation has undershot its target and there are some risks associated with the suspension of the pandemic emergency purchase programme (PEPP) in March, particularly for some sovereign spreads which could impede the transmission of the monetary policy stance in some jurisdictions. Risks of stronger-than-expected GDP growth and higher-than-expected inflation would offer the ECB a golden opportunity to take a step towards ending the policy of negative interest rates which has been in place since June 2014. Our baseline is that a shift in communication will start in March and will likely be reinforced in June, allowing for a first hike of 25bps in the deposit facility rate at the 15 December meeting, to be followed by similar moves every six months until it reaches 0.75% in Dec-24. This would likely imply a main refinancing rate of 1.25% and a marginal lending rate of 1.75%