ECB Rate Hike Bets Cut as Financial Stress Rises

Traders have recently reduced their expectations for European Central Bank (ECB) rate hikes, betting that financial stress, particularly a French debt selloff, will halt further increases. However, this strategy has failed twice before in 2022 and 2023, as the ECB continued raising rates despite financial turmoil, citing inflation above its 2% target. Euro-area inflation stood at 3.8% in September, while the ECB's deposit rate is currently at 2.50%. Germany's two-year bond yield, a key indicator of ECB expectations, reached 3.32% on September 28 before falling to 3.02%.

France's bond selloff has widened the gap between French and German 10-year borrowing costs to 1.54 percentage points, the widest since 2011. This spread has also affected Italian, Belgian, and Greek bonds, prompting Spain to call a snap election for November 29. The selloff has led traders to assume the ECB will do less, even though France's 2027 budget deficit remains above the EU cap. Money-market pricing now shows a reduced expectation of hikes, with 0.28 of a hike expected by the October 29 meeting and 0.89 by December 17.

ECB President Christine Lagarde and Chief Economist Philip Lane have argued that higher long-term rates could slow growth and spread energy costs. Historical data shows that similar financial stress in 2022 and 2023 did not deter the ECB from raising rates, as core inflation remained elevated. The ECB has tools like the Transmission Protection Instrument (TPI) to address financial stress without halting rate hikes. However, the current situation in France, which is under the EU's excessive deficit procedure, could complicate the use of these tools.

The case against this scenario is 2011, when the ECB raised rates amid financial stress but later cut them. The difference today is that the stress is more contained, with Italy's and Spain's borrowing costs far below their 2011 levels. The ECB's September forecasts predict inflation excluding energy and food at 2.6% in 2027 and 2.3% in 2028, above the target throughout. The lean is that the December hike is delivered, and the stress will eventually be priced out of ECB forecasts.