Investment bank Goldman Sachs has revised its outlook for European Central Bank policy, citing the recent positive developments in the banking sector and comments from board members.
Analysts from Goldman Sachs stated on Monday that the firm expects the ECB to reach a terminal rate of 3.75%, a notable increase from its current level. The ECB's primary rate has remained at 3% since March, and recent remarks from ECB member Olli Rehn suggested that inflation remains a key concern for the bank.
Despite this, Goldman Sachs sees the potential for further hawkish action from the ECB in the near future, citing recent data, board members' comments, and the improving state of the banking sector. It pointed to solid inflation data as further justification for additional rate hikes.
According to preliminary data, headline inflation across the eurozone fell to 6.9% in March from 8.5% in February. However, core inflation, which excludes volatile prices of energy, food, alcohol, and tobacco, increased slightly from the previous month. These figures suggest that high costs remain a persistent issue in the region's economy.
The investment bank considers a rate hike of either 25 or 50 basis points in May to be a close decision, given reduced banking risks, continuous growth, and inflation. However, the bank expects the ECB to raise rates by 25 basis points at each of its May, June, and July meetings.
"Reasons for a more gradual speed of tightening from here include that the recent banking stresses are likely to leave some mark on bank lending, we expect some cooling in sequential core inflation in coming months, and the uncertainty around the global outlook has risen," the analysts said in their report.
Investors remain concerned
The Wall Street investment bank previously lowered its expectation of the ECB's terminal rate to 3.5% following the collapse of Silicon Valley Bank earlier this year.
The analysts noted that concerns over the banking sector have since subsided due to the decreased risk of a banking crisis in the US and the retracement of European bank stock and wholesale funding measures.
Despite ECB officials' persistent emphasis on the need for higher interest rates to tackle inflation, concerns over banks and a potential policy misstep hinder their efforts to persuade the markets.
As the ECB approaches its May 4 meeting, investors remain cautious about interest rates, with pricing for peak rates still below March levels due to concerns over the banking sector and the impact of rate hikes on the eurozone economy.
After reducing rate expectations in response to last month's market upheaval, investors are now hesitant to price in a deposit rate above 4%. They no longer anticipate borrowing costs to remain elevated for an extended period.
"What happened (with the market turmoil) is a reminder that hiking cycles usually get stopped out abruptly because of unforeseen fragilities," told BofA strategist Erjon Satko to Reuters.
After less than two weeks of banking stress, traders began to anticipate rates peaking at 3%, where they stood in mid-December. Analysts interpreted the ECB's March statement as suggesting the possibility of altering policy if financial stress could impact the effect of ECB decisions on money markets.
According to JPMorgan analysts, a surge in bond futures trading volumes, nearing levels seen in early 2020 for German Bund and Italian BTP futures, reflects the conviction that rates will peak lower. This suggests a significant adjustment of positioning at a critical juncture for monetary policy expectations. However, Bund futures volumes declined after March 15 as markets once again revised their rate expectations.
Investors are pricing in rate cuts in the first half of 2024, which further indicates their concerns that the ECB may raise rates too rapidly and need to reduce them swiftly. It is estimated by analysts that any modifications to monetary policy would take about six months to affect inflation and growth.