Key inflection point for the ECB at this week's meeting

This Thursday brings a significant meeting for the ECB with the market expecting an announcement for APP to come to an end very early in Q3 (potentially July 1) and a clear signal for a rate hike. This would be the ECB’s first since 2011. We’ll also receive an updated set of economic projections with growth being downgraded and inflation receiving an upgrade. I’ll be paying particular attention to where the late 2024 inflation forecast sits in relation to their 2% target. This will send a signal to the market about the accuracy of their current rate pricing. As of writing, 34bps is priced for the July meeting (indicating a non-trivial probability attached for a 50bps move) and 121bps through to December. If they don’t provide a shock unexpected hike at the June meeting, then with 4 meetings left including December’s the market is seeing at least one 50bps hike at some point until then.

A shock hike for Thursday is currently priced at 1.7bps (market practically sees it as a certainty that no hike will occur). This small probability is due to Lagarde’s recent guidance as well as the self-imposed policy sequencing (rate hike only after QE ends). I think the balance of risks are tilted hawkishly going into this meeting as a hawkish interpretation of ECB rhetoric combined with above target inflation forecasts for late 2024 could see a higher chance of 50bps hikes priced in (euro bullish). 50bps does seem more unlikely in July though as market based inflation expectations have rolled over and wage growth although increasing is not showing a spiral. Additionally, moving by 50bps in July would hit Lagarde's credibility and her signalling capacity. Lastly, liquidity is shallower in the summer months and aggressive normalization could shock markets and prevent further desired tightening. However, risks are tilted to a larger hike given the red hot upside surprises in realized inflation. September could be favoured more for the 50bps move.

Fragmentation risks are creeping back in. The BTP Bund spread hit 214bps late last week (highest since 2010). Will this topic be touched on during the press conference? Their options range from utilising PEPP reinvestments or the deployment of a completely new targeted instrument. Sources this morning told the FT that most of the ECB governing council members are expected to back proposals to create a programme which would buy stressed sovereign debt such as Italy’s.