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Investor hedges drive ECB rate hike bets beyond forecasts

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By Stefano Rebaudo

LONDON (Reuters) – Although economists have warmed to the idea of the euro zone’s deposit rate hitting 0% in 2022, most dismiss interest rate hikes of more the 100 basis points by year-end as excessive.

However, interest rate futures suggest the European Central Bank’s (ECB) first rate hike since 2011 will likely come in July, with 110 basis points (bps) priced in by December.

And policymaker Klaas Knot on Tuesday raised the possibility of a 50 bps hike in July, further fuelling speculation of a rise in a market already adjusting to a new era of high inflation.

With the euro zone deposit rate still at -0.5%, analysts agree a July move now appears likely, but their expectations for how much monetary tightening the ECB will deliver differs widely from markets.

Morgan Stanley expects the ECB to exit negative rates in September with two more hikes in 2023, Generali Investment and Janus Henderson sees rates rising to 0%.

Analyst and market expectations differ widely because money market futures are being used as an insurance policy against inflation risks and that has exacerbated what is being priced in by investors, analysts say.

The strength of long-dormant euro area inflation, now at a record high 7.5%, has caught investors and the ECB by surprise.

For HSBC European rates strategist Chris Attfield current money market pricing is akin to “a sort of an insurance policy against the worst-case scenario… in case inflation keeps surprising on the upside.”

He expects the ECB terminal rate, where this hiking cycle ends, to reach 1.5% in 2023.

A rush to hedge loan portfolios in March and April, just as the ECB turned more hawkish, also accelerated what was priced in by money market futures.

JP Morgan said a rush to ditch the Japanification theme – an idea prevailing before the COVID-19 pandemic that the euro area was stuck in a low inflation environment – forced investors holding interest rate risk to shed exposure to longer-dated bonds.

The U.S. bank said an “abrupt repricing” of two-year euro swap rates, where investors exchange one form of interest rate exposure for another, triggered one of the largest quarterly changes in two-year swap rate forwards.

Lastly, because the United States drives global rate expectations, an increasingly hawkish tone by the Federal Reserve and aggressive market pricing for Fed moves, dragged euro area rate expectations higher.

“If you think 10 rate hikes for the year as a whole for the Fed is priced in, I can see the logic that you think, well the ECB simply has to follow suit,” said Wouter Sturkenboom, chief investment strategist for EMEA and APAC at Northern Trust Asset Management.

He expects two 25 bps rate hikes from the ECB this year and a further six-to-seven moves from the Fed.

(Reporting by Stefano Rebaudo; Editing by Dhara Ranasinghe and Alexander Smith)

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