The Rise of Front-End Rates: ECB's Hawkish Stance and Market Impact

Rates Spark: Keeping upward pressure on the front end

After the Fed, the ECB has managed to more than live up to the market's hawkish expectations. The central banks have had some success in giving the high-for-longer narrative more traction and providing especially front-end rates more room to rise. Whether the narrative sticks will ultimately depend on the data.

 

The ECB more than lives up to hawkish expectations

The ECB has lived up to the hawkish expectations, especially on the back of having revised up its own inflation forecasts. In the press conference, President Christine Lagarde used the words we have become accustomed to, that “more ground needs to be covered”. And she heavily hinted at another hike in July.

The initial reaction to the ECB decision saw a strong bear flattening of the curve. Note that it mainly comes from pricing out 2024 cuts than pricing in a higher terminal rate. That move later faded somewhat, but 2Y Bund yield still ended 10bp higher on the day, while the 10Y yield was up by 5bp and thus stayed shy of its recent highs at 2.55%. The 2s10s curve now stands at close to -63bp, its most inverted since the banking turmoil in March when the curve briefly hit -73bp.

 

The inversion is reflective of the ECB having to straddle persistently high inflation on the one hand, but also already weakening economic data on the other. The way the ECB deals with it is to focus on the former while being quite optimistic about the latter. That optimistic view on the economy also gives it more room to keep tightening, keeping front-end yields elevated. But the market will have to account for the increasing probability that this narrow focus on current inflation to determine the ECB's success results in a policy error further down the road. Hence the reluctance in longer rates to follow the front end higher.

As a final note, the ECB confirmed that APP reinvestments will end in July. Lagarde signalled that ECB was not worried about the declines in excess reserves in the banking system also with the €477bn TLTRO redemption coming up at the end of this month. Today the ECB will also announce any further voluntary TLTRO repayments from banks.

 

ECB and Fed were successful in curbing rate cut expectations

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