NatWest Says Bet Against Over-Aggressive ECB Rate-Hike Pricing

(Bloomberg) -- Traders are expecting the European Central Bank to start raising interest rates in the third quarter of 2023. That’s too soon, according to NatWest Markets.

Analysts at the London-based bank don’t see how policy makers can possibly move fast enough to keep to that timeline. Firstly, they would have to scale back current bond purchases by around 600 billion euros ($734 billion) a year starting in early 2022, strategists Giles Gale and Imogen Bachra wrote in a research note.

Secondly, the ECB would need to feel extremely confident that inflation will be persistently higher in 12-months’ time for them to take this step, they added.

Investors should therefore bet on a pull back in future rate expectations by placing a trade such as receiving two-year forward one-year overnight index swaps at minus 0.35%, according to the pair. The swaps traded Tuesday around minus 0.38% and began the year at minus 0.54%, according to data compiled by Bloomberg.

Markets also appear to be mistaken in betting on a steady rise in bank borrowing rates, via the widely-watched FRA/OIS spread, the NatWest strategists suggested. A gradual widening is being priced in between Euribor -- the rate at which banks can theoretically borrow -- and overnight rates over the next 18 months.

But excess liquidity in the financial system exceeded 4 trillion euros in April, a new record, and it’s unlikely to fall significantly in the near future, according to NatWest. Growth has been driven by the ECB buying about 1 trillion euros in assets from banks, while lending them close to 2 trillion euros as part of low-cost loans, they noted.

With conditions so accommodative and banks awash with deposits, there will be little incentive for them to borrow in short-term paper markets, which should keep Euribor rates depressed. The strategists suggested investors position for a tightening of the spread between September 2022 Euribor and overnight index swap rates.

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