ECB Tightening Hikes Stagflation Fears Amid Eurozone Growth

The European Central Bank (ECB) is facing a challenging backdrop of renewed energy market stress and surprisingly resilient economic growth, as reflected in the latest flash PMIs. This mix has pushed short-end rates to price in a tightening cycle that sees three to four more hikes over the next year.

We think this outlook is too pessimistic and expect only one more hike from the ECB, taking the deposit facility rate to 2.75%. This assumption largely hinges on the expectation of geopolitical tensions easing after the US mid-term elections.

Liquidity conditions are tightening as the ECB continues to shrink its balance sheet and transitions to a new operational framework for implementing monetary policy. The new framework aims to nudge banks into a more active role, using liquidity operations as part of the ECB's day-to-day liquidity management.