The Factory Daily Letter

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ECB preview - June 2022

While the Fed has already started its policy normalization in last March with a 25-bps hike for the first time since 2018, the ECB is likely to announce at today’s meeting the end of its net asset purchase programme and to commit to start hiking rates in July. Such a move would mark the end of more than a decade without any rate hikes in the Eurozone. In May, inflation figures rose to record-highs, putting further pressure on the ECB to fight inflation. As ECB’s President Lagarde highlighted in her blog in late May (click here to read it), the central bank had already started its journey towards policy normalization by announcing the end of the pandemic emergency purchase programme (PEPP) in Q1 2022. The end of the asset purchase program (APP) and the announcement of a first rate-hike later this year are the next steps.

Latest flash inflation data put the ECB under pressure

The key question ahead of today's meeting currently sits around what the latest flash inflation data means for the ECB's monetary policy. As ECB’s Muller said recently there is “no reason to assume energy, food costs will fall“ and “inflation will slow but remain elevated“. Therefore, a July rate hike is now ‘baked in’ and the debate remains whether it will raise the deposit rate by 25 bps or 50 bps at that meeting (recent upside surprises in inflation prints and the broadening of price pressures have bolstered the hawks’ determination to push through a 50-bps increase, while several central banks around the world – the Fed, the Reserve Bank of Australia, the Bank of Canada and the Reserve Bank of India – have already hike rates by 50 bps).

Source: FactSet; Pictet Trading Strategy; as of 8/6/2022.

Market participants are expecting a first 25-bp rate hike in July while the likelihood of a 50-bp hike has been rising over the past weeks.

Our economists’ baseline scenario is a 25-bp hike in July, September and December (potentially bringing the deposit rate to +0.25% by year-end). Interestingly, while market participants now price in a first rate hike of 25 bps in July, the likelihood of a 50 bps hike in September has been rising over the past days – especially following the Eurozone’s HICP print for May –, as shown by the implied rate of 0.13% in September.

Source: FactSet; Pictet Trading Strategy; as of 8/6/2022.

The ECB will have to navigate in an environment characterized by strong and persistent inflation as well as lower growth

Following a strong recovery in 2021 (where the Eurozone real GDP grew 5.4% y-o-y), brokers have been much more conservative in their economic growth estimates. As shown on the graph below, expectations for Q2 and Q3 2022 were continuously revised higher over the final months of 2021. However, the beginning of the war in Ukraine in February sparked concerned over the impacts of the conflict and forced brokers to strongly revise lower their expectations. The median Q2 2022 GDP growth estimate fell from 1.2% in February to 0.2% in May. The same trend – albeit less extreme – was seen on the median estimate for Q3 2022 (falling from 0.9% in February 2022 to 0.6% as we write). Other estimates still evolve in a range between 0.55% and 0.4%, with risk probably tilted to the downside.

Against a backdrop marked by strong uncertainties, our economists have decided to revise lower their growth forecast for the euro area to 2.5% this year (down from 2.8%) and 1.8% (down from 2.0%) in 2023. On a quarterly basis, they expect growth to be close to 0.2% q-o-q, in line with the median consensus.

Source: FactSet; Pictet Trading Strategy; as of 8/6/2022.

Inflation forecasts for the coming quarters have all been revised upward

The reopening phase following the Covid-related restrictions, massive monetary and fiscal stimulus associated with supply chain issues have contributed to higher realized and expected inflation across both developed and emerging markets. Indeed, as shown on the graph below, brokers’ quarterly median estimates of HICP inflation in the Eurozone (annual growth) have been continuously revised upward since December 2021 and the beginning of 2022. Moreover, Russia’s invasion of Ukraine has exacerbated that trend, leading brokers to expect further inflationary pressures in the quarters to come. Energy and food price hikes have significantly weighed on inflation estimates. For instance, brokers expect Q2 2022 headline inflation in the Eurozone to reach a median 7.7% y-o-y and see still-high but declining inflation rates over the rest of 2022 and 2023.

Our economists still expect headline inflation to average 6.6% in 2022 and core inflation to hover around 4% at the end of the year, with risks tilted to the upside.

Source: FactSet; Pictet Trading Strategy; as of 8/6/2022.

The yield differential is one of the factors that have weighted on the Euro

The Euro has been suffering since mid 2021 as many factors weighed on its attractivity compared to the USD. First, hawkish comments from Fed’s officials in H2 2021 pushed US yields higher, increasing the attractivity of the greenback compared to the Euro. Then, the beginning of the tightening cycle in the US widened the monetary policy differential between the two regions as the ECB remained relatively accommodative at that time. In late February, Russia’s invasion of Ukraine sparked flights to safety as uncertainty and concerns over growth perspectives rose, further exacerbating the pressure on the single currency. Moreover, as a net importer of energy, the Eurozone is highly vulnerable to high energy prices, that continued to edge higher following the sanctions on oil and gas imports from Russia.

However, having dropped to 1.04 against the USD recently – its lowest level since  2017 – the single currency could gain in traction in the months to come. Indeed, a less aggressive Fed over the medium term may enhance investors’ risk appetite, who may start to favor again the single currency. Moreover, a potential first-rate hike by the ECB in July could provide support to the Euro, and the recent hawkish tone adopted by the ECB has already started to reduce the yield differential between the German and US 10y bonds (in grey in the chart below). Finally, the reopening of China, a potential improvement in the situation in Ukraine and supportive fiscal policies should provide support to the euro over the medium term.

As a result, our FX team expects the Euro to rise to 1.11 in 6 months and to 1.15 in 12 months.

Source: FactSet; Pictet Trading Strategy; as of 8/6/2022.

Traders’ sentiment may be shifting in favor of the single currency

As highlighted on the chart below, the historical relationship between the EUR/USD pair and open interest for futures contracts on the EUR/USD has significantly weaken since the beginning of the year.

While traders reduced their long exposures to EUR/USD future contracts over the course of 2021, the open interest even turned briefly negative before bouncing back in May. The gap between the two time-series is now significant and may indicate that traders’ sentiment could be shifting in favor of the Euro.

Source: FactSet; Pictet Trading Strategy; as of 8/6/2022.

The technical picture has improved for the Euro

Since breaking out of its uptrend in the summer of 2021, the EURUSD pair has broken all supports to return near its March 2020 level. In early March, the price appeared to bottom at around 1.08 before a relief rally from oversold conditions materialized. However, the price failed to return above its former local low at 1.1151 and a further decline pushed the pair below 1.10. Contrary to our expectations, the negative momentum gained further traction and the pair moved below another support at 1.05. Short-term, the RSI has formed a bullish divergence suggesting that the negative momentum may be losing steam and that a rebound from oversold may occur. A daily close above the 50-day SMA (currently holding at around 1.08) would trigger a rise towards the next resistance at around 1.10:

Source: FactSet; Pictet Trading Strategy; as of 8/6/2022. *Criteria are explained in the endnotes. The target price presented in the chart is based upon chart analysis. This is not the product of any Pictet financial research unit.

A monetary normalization: until something breaks

As highlighted by our economists, risks associated with the ECB’s monetary normalization amid lower growth, rising inflationary pressures and Russia’s invasion of Ukraine remain significant. The central bank’s ability to hike rates will depend on several factors, including the war in Ukraine, the volatility in the peripheral bond market and the ongoing Fed’s tightening. Moreover, how far can the ECB go in its monetary tightening remains a key question. As a result, our economists expect the ECB to hike rates by 25 bps until something “break”, either in the real economy or in the peripheral bond market.

Over the short-term, we remain positioned for a potential tactical rebound in equity markets as any small improvement in the news flow or the data (a slightly less-hawkish Fed, a potential ceasefire in Ukraine or more encouraging evidence of peaking/slowing inflation for instance) could allow equities a reprieve from the downward pressure, and European companies seem attractive should this scenario materialize.

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Please see criteria explanation in the endnotes

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