In June, the ECB delivered its eighth consecutive rate hike; policy rates rose by a cumulative 4% in less than a year. However, Eurozone core inflation remained sticky at 5.3%, indicating that the unprecedented tightening cycle only had a limited economic impact.
The unemployment rate is at multi-decade lows and corporate earnings near record highs, not signalling an imminent recession, and therein lies the challenge. The ECB's primary objective is to maintain inflation around 2%, and it relies on rate hikes and quantitative tightening (QT) to achieve this. Both these tools, however, are quite blunt and have substantial lag effects on economic growth and inflation. This makes it difficult to engineer a soft landing. Further complicating the picture is the fact that inflation is a lagging economic indicator itself, often peaking in or just before a recession. Given these complexities, we perceive a high risk that central banks might overtighten monetary policy for an extended period, potentially missing the crucial signs of an economic downturn. Purchasing Managers’ Indices (PMI) and producer prices are already falling sharply, yet the ECB is likely to continue with its rate hikes and balance sheet reduction, possibly exacerbating the economic downturn down the line. Given this outlook, we remain cautious on credit risk and are moving to increase our duration, placing a bet on a decline in longer-term rates.