Europe | Monetary policy normalization pushes up risk premia

The European Central Bank (ECB) has taken a further step in its process of normalizing monetary policy by announcing at its latest meeting that it will end its asset purchase program in July, and that it is prepared to pick up the pace of its rate hikes to contain inflation, in line with other central banks.

Key points

• Key points:
• The market reaction has been significant. Futures prices now suggest that the ECB will raise interest rates by 180–190 basis points (bp) this year, and by a further 100 bp in 2023, to 2.6%–2.7%.
• In addition, long-term bond yields have risen following these early indications of the central bank’s plans to hike interest rates and end its asset purchase program.
• However, the rapid rise in peripheral risk premia has raised fears of a repeat of the 2011–2012 European debt crisis, when doubts surrounding the solvency of certain member states led many investors to believe that some would leave the euro.
• The market’s performance over the last few days has been steered by the higher levels of government debt stemming from the necessary response to COVID-19, coupled with the end of the ECB’s net bond purchases and a somewhat more hawkish rate hike outlook following the central bank’s latest meeting.
• The ECB remains unflinchingly committed to protecting the euro. At an emergency meeting, it reiterated that the reinvestment flexibility of the pandemic asset purchase programme (PEPP) could be used to avoid euro zone fragmentation and that measures would be devised to contain this risk. This time, however, they will be shackled by the need to bring down inflation.

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