European Macro Recap and Outlook

Europe Recap

Last we spoke about the ECB's potential to raise rates by 50 bps. They proceeded with a half-point increase in interest rates, adhering to their plan to combat inflation. However, recent turmoil in financial markets has created uncertainty about the path forward.

In the past few days, the financial sector has been shaken by the collapse of three midsize banks in the United States. This has led to growing concerns among investors about the stability of other banks, including the prominent Swiss lender Credit Suisse, and the overall ability of the banking sector to endure higher interest rates. The European Central Bank's decision comes as the first major central bank to establish monetary policy since the volatility commenced late last week.

Christine Lagarde, the president of the ECB, addressed the current market tensions during a news conference. She assured policymakers were "monitoring current market tensions closely" and that the bank "stands ready to respond as necessary to preserve price stability and financial stability in the euro area."

Despite the increased uncertainty surrounding the financial markets, ECB policymakers did not deviate from the half-percentage-point rate increase they initially announced in early February. Consequently, the bank raised its deposit rate to 3 percent.

The decision to proceed with the rate increase highlights the ECB's commitment to fighting inflation, causing concerns about the impact on consumers and businesses across the eurozone. However, the ongoing market turbulence adds an element of uncertainty, prompting the central bank to closely monitor developments and maintain readiness to act accordingly to ensure price stability and financial security within the euro area.

In response to the turmoil affecting the banking sector, the Federal Reserve and five other leading central banks have taken new measures to enhance global access to dollar liquidity. The European Central Bank, Bank of England, Swiss National Bank, Bank of Canada, and Bank of Japan have joined the Fed in announcing a shift from weekly to daily auctions of dollars, aiming to ease strains in global funding markets. As stated by officials, these daily swap lines are set to run at least until the end of April.

This policy of conducting daily dollar auctions across time zones, last implemented during the 2020 Covid-19 crisis, was announced mere hours after the Swiss National Bank revealed the merger of Switzerland's two largest banks, UBS and Credit Suisse, following intensive negotiations over the weekend. European officials are apprehensive about the potential stress that the heavy losses from Credit Suisse's shareholders and bondholders holding its additional tier one (AT1) debt might inflict on bank funding markets this week.

Established in 2007, the Fed's swap line network has served as a vital funding safety net for global banks during severe market stress. These swap lines enable lenders outside the US to access dollars in exchange for their domestic currencies by pledging collateral at their central banks. The ECB's governing council convened a call on Sunday evening to approve the transition to a daily swap line with the Fed.

The ECB's governing council held a call on Sunday evening to approve the switch to a daily swap line with the Fed. "The network of swap lines among these central banks is a set of available standing facilities and serve as an important liquidity backstop to ease strains in global funding markets, thereby helping to mitigate the effects of such strains on the supply of credit to households and businesses," the central banks said.

Outlook

Due to recent banking issues, economies worldwide face many challenges that make things uncertain. Although some effects of these challenges are starting to fade, it could take a while for things to calm down and reach a stable point. We might see long-lasting changes to how economies are organized as supply chains are adjusted to be stronger against global problems and to match changing political strategies. Right now, managing monetary policy takes a lot of work. We must understand economic uncertainty and check how different policy tools work together and the effects of policies from other places.

ECB President Christine Lagarde said that inflation is expected to stay too high for too long. The recent increase in interest rates was needed to help bring inflation back to the bank's 2 percent goal. Inflation is predicted to be around 5.3 percent this year and over 2 percent in 2025. What will happen in the next few months is still being determined. If things go as the ECB predicts after the current market problems are over, there is still much more work to do to lower inflation. The current situation shows how hard it is to fight inflation while dealing with unpredictable market conditions. The ECB's actions in the future will depend on how the economy changes and how well they can keep prices and the financial system stable in the euro area.

The following steps for the ECB are to watch for further signs of stress from the banking sector. As an investor, you should ponder whether the ECB will be able to continue raising rates to fight inflation, given the turmoil in the banking sector that has seen U.S. lenders go under. ECB President Christine Lagarde said the ECB's interest rate hikes might be magnified if banks become more risk-averse and start demanding higher lending rates, likely implying the central bank would need to do less. The ECB has increased the rate it pays on bank deposits by a record-breaking 350 basis points to 3% since July, and financial markets expect a further increase to 3.5% later this year.

The ECB doesn't have much left in hiking rates. For the subsequent meetings, market conviction is growing that central banks will no longer be able, or need, to hike as much as previously thought. A hike could precipitate a fall in assets if market sentiment deteriorates. Inversely, some measures could go towards reassuring the market and so prevent a further fall. The more likely that we see a banking crisis, the more likely we are to see lower interest rates and higher prices for assets.