Central Bank Watch: BOE & ECB Interest Rate Expectations Update
Central Bank Watch Overview:
- Several rate hikes are priced in over the next few months for the Bank of England, though comments from their Chief Economist in recent days suggests that markets may be wrong.
- Rates markets are discounting the first rate hike from the European Central Bank in June, even though several policymakers continue to suggest that policy tightening will arrive in 4Q’22 at the earliest.
- Retail trader positioning suggests GBP/USD rates have a bullish bias while EUR/USD is on neutral footing.
Inflation or Slowing Growth in Focus?
In this edition of Central Bank Watch, we’ll cover the two major central banks in Europe: the Bank of England and the European Central Bank. The first few weeks of 2022 have brought a great deal of excitement for both central banks. The BOE delivered back-to-back rate hikes for the first time since 2004, while the ECB abruptly abandoned its ‘head in the sand’ approach towards downplaying inflationary pressures. Nevertheless, significant questions remain over the near-term rate path for both of these major central banks.
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BOE Chief Economist’s Warning
The 25-bps rate hike levied by the BOE in February followed the 15-bps rate hike in December, marking the first time since 2004 that interest rates were hiked in consecutive meetings. With UK inflation holding at its highest level in 30 years, there’s good reason to think that further tightening is on the horizon.
But not so fast! Over the past week, BOE Chief Economist Huw Pill has offered conflicting signals about the pace of rate hikes. On February 4, he said that “as long as things play out broadly as we expect, we would expect to see a further modest tightening of monetary policy which would embrace a rise in bank rate.” But then on February 9, he noted that he worried “that taking unusually large policy steps may validate a market narrative that Bank policy is either foot-to-the-floor on the accelerator or foot-to-the-floor with the brake.”
Bank of England Interest Rate Expectations (February 10, 2022) (Table 1)
For now, rates markets aren’t buying BOE Chief Economist Pill’s dovish turn. UK overnight index swaps (OIS) are discounting a 152% chance of a 25-bps rate hike in March (a 100% chance of a 25-bps hike and a 52% chance of a 50-bps hike). Overall, rate hikes are anticipated at each of the next four BOE meetings. If BOE Chief Economist Pill’s warning is to be taken seriously, then the British Pound may be getting setup for a November 2021-like disappointment.
IG Client Sentiment Index: GBP/USD Rate Forecast (February 10, 2022) (Chart 1)
GBP/USD: Retail trader data shows 50.36% of traders are net-long with the ratio of traders long to short at 1.01 to 1. The number of traders net-long is 12.77% lower than yesterday and 2.01% lower from last week, while the number of traders net-short is 6.13% higher than yesterday and 4.34% higher from last week.
We typically take a contrarian view to crowd sentiment, and the fact traders are net-long suggests GBP/USD prices may continue to fall.
Yet traders are less net-long than yesterday and compared with last week. Recent changes in sentiment warn that the current GBP/USD price trend may soon reverse higher despite the fact traders remain net-long.
Rates Markets Outpace ECB Officials
ECB President Christine Lagarde surprised financial markets in the first week of February when she abandoned the ECB’s recalcitrant view towards inflation and raising interest rates, bringing forth the possibility that hikes could arrive later this year once the ECB’s bond buying operations ceased.
But there still seems to be a disconnect between ECB policymakers and rates markets. Rates markets are expecting at least one rate hike in the first half of 2022, whereas several officials are still suggesting that the ECB will be slow to respond to excess inflationary pressures.
On Sunday, ECB Governing Council member Klaas Knot suggested that the first rate hike could come by the end of the year. The new head of Germany’s central bank, the Bundesbank, Joachim Nagel, noted that “interest rates could be raised before this year is over.” In a blog post today, ECB Chief Economist Philip Lane commented that “the logic underpinning a hold-steady approach to monetary policy is reinforced if the bottlenecks are primarily external in nature.”
EUROPEAN CENTRAL BANK INTEREST RATE EXPECTATIONS (February 10, 2022) (TABLE 2)
These mixed, if not dovish, signals from ECB policymakers continue to be ignored by rates markets, at least for now. Eurozone OIS are discounting a 10-bps rate hike in June (85% chance). €STR, which replaced EONIA, is priced for 50-bps of hikes through the end of 2022, and roughly 110-bps of hikes through the end of 2023. Only one thing can be true: ECB officials will yield to high inflation pressures; or rates markets are too aggressive with their current expectations.
IG Client Sentiment Index: EUR/USD Rate Forecast (February 10, 2022) (Chart 2)
EUR/USD: Retail trader data shows 40.68% of traders are net-long with the ratio of traders short to long at 1.46 to 1. The number of traders net-long is 9.50% lower than yesterday and 7.85% lower from last week, while the number of traders net-short is 9.76% lower than yesterday and 22.11% higher from last week.
We typically take a contrarian view to crowd sentiment, and the fact traders are net-short suggests EUR/USD prices may continue to rise.
Positioning is less net-short than yesterday but more net-short from last week. The combination of current sentiment and recent changes gives us a further mixed EUR/USD trading bias.
--- Written by Christopher Vecchio, CFA, Senior Strategist
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