ECB Surprises With Big Rate Hike As Recession Fears Hit Europe And U.S.

• ECB defies own guidance by raising policy rate 0.5%
• Government bond yields decline as investors' recession fears grow
• Fed rate hike of 0.75% expected this week

The surprise last week came from the European Central Bank, which unexpectedly raised its policy rate by a half-percentage point, after insisting for weeks that the first hike would be just a quarter-point. The first increase in 11 years raised the deposit rate to 0 from its previous -0.5. 

ECB President Christine Lagarde effectively put an end to forward guidance, defying her own guidance of a quarter-point hike and then saying at her press conference last week that ECB policymakers will now decide on rates depending on data, without setting any targets.

“The frontloading today of the exit from negative interest rates allows us to make a transition to a meeting-by-meeting approach to our interest rate decisions,” she said.

“Our future policy rate path will continue to be data-dependent and will help us deliver on our two percent inflation target over the medium term.”

Yields on euro government bonds took an immediate hit following the surprise hike and the next day’s decline in the purchasing managers index, which dipped below 50 to 49.4 in July from June’s 52, marking a contraction of the economy for the first time since 2013.

Yield on Germany’s 10-year bond, which serves as a benchmark for the eurozone, fell below the 1% threshold briefly on Friday, before bouncing back to 1.0355% in late trading, still a good 20 basis points below Thursday’s level.

The ECB governing council also approved the so-called Transmission Protection Instrument, enabling it to buy bonds of any eurozone country in unlimited amounts if necessary to prevent spreads on the yields from growing too large.

The ECB policymakers believe it’s necessary to intervene on spreads to support the effective transmission of monetary policy. Italian government bond yields obligingly declined, with the 10-year bond yield falling to nearly 3.5% from its day’s high above 3.7%.

The Italian government collapsed last week as Prime Minister Mario Draghi, a central banker who headed the ECB for eight years, resigned and President Sergio Mattarella called a snap election for September 25. Giorgia Meloni, the founder of the neo-fascist Brothers of Italy, is surging in popularity and is tipped to become the next prime minister at the head of a right-wing alliance.

In the US, Federal Reserve policymakers are expected to raise the overnight Federal Funds rate by three-quarters of a percentage point at the meeting of the Federal Open Market Committee this week. The large hike follows a similar increase in June.

However, opinions are divided as to whether the Fed will continue at the pace in September, or whether a noticeable cooling of the economy will lead them to pull back some from tightening monetary policy.

The core personal consumption expenditure index for June, due out on Friday, is expected to remain unchanged on the year at 4.7%, although the headline consumer price index released earlier this month came in at a scorching 9.1%.

The GDP advance estimate for the second quarter is due out Thursday, and the Atlanta Fed GDP tracker is forecasting negative growth, which would technically mean a recession after the first quarter’s negative number. However, Treasury Secretary Janet Yellen said Sunday that the National Bureau of Economic Research is unlikely to call a recession amid strong gains in employment.

Yield on the 10-year Treasury note, which is a benchmark for that market, retreated below the 3% level on Friday. The yield had risen in recent weeks as the Fed raised interest rates, but fears of a recession induced by further rate increases are now outweighing other considerations for investors.

The US PMI index also fell, hitting its lowest level in more than two years at 47.5, and initial jobless claims rose for the first time in eight months. The bigger-than-expect hike in rates by the ECB also weighed on US investors.

Disclosure: The author currently does not own any of the securities mentioned in this article.