Market brief
French Bond Sell-Off Complicates ECB's Rate Call as Gas Prices Add to Inflation
MUFG expects the ECB to leave rates on hold later today despite a September inflation surprise at 3.8%, arguing that rising French bond yields are already tightening conditions — and it still sees a December hike.
Key points
- MUFG expects the ECB to hold rates at today's meeting, with a further hike still projected for December.
- September inflation surprised at 3.8% and European natural gas prices have hit fresh year-to-date highs this month, rising around 40% — the case for tightening further.
- Higher French government bond yields are tightening financial conditions before the ECB acts; the 2-year German yield has fallen roughly 25 basis points from last month's highs as hike expectations were scaled back.
The European Central Bank sets policy later today with a French government bond sell-off already doing part of the tightening for it, a bind that MUFG said should keep policymakers on hold even as the bank sticks to its call for another rate increase in December.
The argument for moving again has not disappeared. MUFG pointed to another upside inflation surprise in September, at 3.8%, and said European natural gas prices have hit fresh year-to-date highs this month, rising by around 40% and adding to upside inflation risks in the euro area. That combination had previously led the bank to see another back-to-back increase as possible.
What has shifted is the cost of borrowing across the bloc. The sharp sell-off in French government bonds has pushed yields higher and tightened financial conditions without any decision from the central bank — an unwanted tightening that MUFG expects to make policymakers relatively more cautious about further hikes. The 2-year German government bond yield has already fallen by about 25 basis points from last month's highs as investors scaled back bets on more increases, a repricing MUFG identified as one reason the euro has underperformed recently. A basis point is one hundredth of a percentage point.
ECB President Christine Lagarde is likely to be asked how the central bank could respond to the loss of confidence in French debt. MUFG lists two options beyond rate policy: slowing or pausing quantitative tightening — the running down of the ECB's bond holdings — to ease upward pressure on euro-area yields, or turning to the Transmission Protection Instrument as a last resort. That instrument is the ECB's facility for buying government bonds when rising yields threaten the even pass-through of monetary policy across the currency bloc. MUFG judged it probably premature for the ECB to send a strong signal that it is preparing to use either tool.
MUFG's expectation still includes another hike by the end of this year, in December, but that call rests on the inflation impulse outweighing the drag from higher yields. The condition that would change it is spelled out in the same analysis: it becomes a bigger problem for the ECB if there are increasing spillovers to other euro-area members that could threaten the smooth transmission of monetary policy. In that case the debate would move from price stability toward protecting transmission, weakening the case for a December increase. Absent such contagion, MUFG keeps its December call while saying the risks for the euro remain tilted to the downside.
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