In a marathon day, the US Federal Reserve and the European Central Bank conspired yesterday to try to curb inflation, on the one hand, and in Europe, to end the speculation that haunts peripheral bonds, especially from Spain and Italy. Two movements of great depth in the two main monetary areas of the world happened for 12 hours. First thing in the morning, the ECB announced an urgent meeting to take action, ahead of the scheduled appointment of the Fed in which a rate hike of 75 basis points was expected, as it actually happened.
The main monetary authorities are facing the same problem, a rise in prices unknown in several decades, but with its nuances: on the one hand, a market that runs at various speeds, as is the case in the euro zone, and on the other, the firm threat of recession in 2023, in the US case. The complex puzzle that yesterday forced the monetary authorities on both sides of the Atlantic to make a move.
For the first time, Fed Chairman Jerome Powell openly backed raising interest rates to a very restrictive level despite the risk of cooling the labor market and increasing unemployment, a strategy that in the past has often led to an economic recession. Powell. In this sense, the rate forecasts have risen even more than the 75 basis points: if in March those responsible for the Fed expected, on average, rates at 2.75% in 2023, now the average forecast is one more point, 3.75%.
“It is very clear that the Fed will do whatever it takes to aggressively reduce inflation and that the rate is going to end up close to 4% or even higher,” Peter Yi, director of fixed income at Northern Trust, told Bloomberg. Asset Management. “Although Powell tried to play down another 75 basis point hike next month, he said rates remain extremely low.”
The change in position carries dangers not only for the economy, but for the financial markets, also in Europe, to the extent that US interest rates are the reference for the whole world. When the Fed raises rates, risk assets around the world suffer, as they have been doing this year. And the more they go up, the more pressure. This helps explain the haste with which the ECB convened its governing council yesterday to discuss the rise in risk premiums on the periphery of the euro.
The start of the withdrawal of stimuli from the ECB and the announcement last week by Christine Lagarde of interest rate hikes, together with the role of the Fed, has caused an increase in peripheral risk premiums, a situation reminiscent of the worst years of the euro crisis of 2011 and 2012, which almost wiped out the European currency. Debt rates have risen vertically throughout the world, but the spread between German and Spanish or Italian debt has gone from 70 to 130 points (Spanish) and from 130 to 240 (Italian).
The ECB has repeatedly warned that it wants to avoid the financial fragmentation resulting from this phenomenon: as the market extrapolates the risk premiums of each country to the assets of companies or entities located there, these differentials erode the unity of the eurozone. The words of European officials have not served to paralyze the market’s punishment of the periphery, which is why yesterday the ECB officially activated plans to set a mechanism to hold spreads. While that is happening, it will use the maturities of debt purchased during the pandemic on a discretionary basis. “If the spread widening is limited it will give the ECB the opportunity to raise rates more quickly, if the widening,” explains Ulrike Kastens of DWS, according to Bloomberg.
The situation is a dilemma for the bank. As Alberto Matellán, chief economist at Mapfre Inversión, points out, the ECB has three different enemies to combat: the rise in spreads, the lack of growth in some countries and inflation. “Each of the three needs different, and often contradictory, measures,” he explains. “The asset purchase mechanism to support spreads could compromise the reduction in liquidity needed to fight inflation. Letting inflation run would aggravate growth problems, although it could dilute debt somewhat. Reducing liquidity to fight inflation Inflation would tighten financial conditions much faster in Italy than in Germany,” he summarizes.
The turn in the US monetary policy, which does not come from now, has already caused weakness in the markets, particularly in very hot assets such as technology, low-quality debt or crypto assets. The S&P 500 is in correction territory (a fall of more than 20% from its maximum and in Europe, the stock markets have registered falls of 15% in the year (the Ibex has fallen less, around 7% since January). Italian and Spanish bonds have risen to levels not seen since 2014. And while markets took the US rate hike in stride yesterday, they remain fragile.