Up until last Friday, both the ECB and the Fed were expected to hike by 50bps. In the case of the ECB, President Lagarde has all but confirmed that a half-point was planned. Where there were doubts was around potential tweaks to the QT program.
With the collapse of three regional banks in the US, the Fed is universally expected to not hike by that much. There is even a growing consensus that the Fed won’t hike at all. But, what about the ECB? EU leaders have repeatedly gone to the media to assure the market that no European bank is exposed to SVB, and the financial sector is on solid footing.
How sure can we be?
The thing is, the phenomenon that pushed the three banks into a position where they had to be seized by the FDIC to protect client deposits is also present in Europe. At this point, probably not to the same degree, given that the ECB has been slower than the Fed to hike. It is also a similar dynamic that led to the “flash crash” back in September with the UK’s disastrous “mini-budget.”
Interest rates in the EU had been very low for an extended period of time, which means that European banks have built up portfolios of large amounts of low- to negative-interest debt. As the ECB keeps hiking, that debt loses value, building unrealized losses among EU banks. Banks that have been struggling to maintain profitability because of the low interest rate environment, and were already facing challenges.
There are rumors
Italian banks have portfolios burdened with non-performing assets. Not directly under ECB supervision, but still doing a lot of business in Europe is Credit Suisse. The mega bank admitted just yesterday that it had discovered accounting problems in its books, and shares plunged to record lows for two days in a row.
Reportedly, sources within the ECB have told the financial press that the shared central bank plans to go ahead with the 50bps hike as planned. Inflation in the EU hit a record high last month even as the economy avoided a recession by the bare minimum. The shift towards safe havens helped push down yields around the globe, meaning the ECB has more room to tighten.
The case for the doves
But the group of ECB officials who would like a smaller hike to have some convincing arguments as well. Inflation is expected to trend lower already, and the economy is sputtering. The main cause of inflation is non-monetary; the high energy prices are from the war in Ukraine, not an excess of capital in the markets. And the more the ECB hikes, the more the already delicate European banks will lose on their bond holdings.
Europe has an inverted yield curve like the US, but the spread is under 40bps. In the US, the spread was well over 100bps before SVB collapsed. The ECB does have more room to maneuver, but a 50bps hike could generate some additional consternation in the markets. On the other hand, if the ECB fails to deliver, it could be interpreted by the market as a lack of confidence in the banking sector, and end up hurting the Euro as well.
