Citigroup sees euro rates at 4.25%, SNB likely to hike 25bp

In its statement and press conference this week, the ECB retained a tightening bias but suggested that the policy outlook is more uncertain. The tightening bias appears to reflect the assessment that risks to prices are on the upside even if GDP growth is projected around trend. Reflecting this rhetoric, Citigroup analysts now expect rates to rise to 4.25% later this year (not necessarily in 3Q), elevating the previous risk case to baseline.

Although it did not fully reflect the changes envisaged, the ECB statement introduced enough adjustments to suggest that policy is entering a new phase, Citigroup analysts note in a research note dated June 8, 2007. The ECB abandoned the qualification that interest rates are moderate, but added that “given the positive economic environment, policy still is on the accommodative side.” That combination probably implies that, although rates are back to neutral, strong GDP growth will require some further tightening. At the same time, by emphasizing that the ECB will monitor the situation “closely” rather than “very closely” and by refusing to endorse probabilities of a September hike, president Trichet seem to veer away from the previous predictable schedule of rate hikes.

The staff’s macro-economic projections also failed to produce an obvious path for policy. The ECB raised its central projection for GDP growth to 2.6% for 2007 (from 2.5%) and lowered it by the same amount to 2.3% for 2008. These projections imply quarterly growth rates in line with the ECB’s latest estimate of potential (“about 2¼%”). Moreover, the statement claimed that risks to growth are balanced in the short term and on the downside in the long term. While these projections assume that three-month interest rates will rise by 50 bps from mid-May levels (which probably would imply another 25-bps policy rate increase), ten-year bond yields are assumed to stabilize around 4.2%, but they now are at 4.50%

 

SNB: Another hike

It is virtually certain that the Swiss National Bank (SNB) will hike rates 25bp at the upcoming policy meeting (14 June), note Citigroup analysts. Any other outcome (zero or 50) would be a real shocker. The more interesting issue is the extent to which, via its inflation forecast, the SNB signals further tightening ahead. A few weeks ago, Citigroup economists argued that markets understated how far rates will need to rise medium term. With 2-year rates now up by about 40bp since early April, that previous complacency has been shattered. Nevertheless, unless clear signs emerge that global financial conditions or growth are suffering, risks are that the SNB policy rate will still have to rise more than markets price in over time.

When the SNB hiked in March, the central bank forecast that growth would edge down from 2.7% in 2006 to “roughly 2%” in 2007, with inflation very low near-term but gradually rising over the next 2-3 years towards the top end of the “below 2%” inflation target. The SNB’s forecast — that inflation would be close to 2% and still rising 2-3 years ahead — already implied that further tightening lay ahead. Data since then suggest that medium-term inflation risks are greater than the SNB expected, with strong domestic growth and rising capacity strains, as well as external pressures from gains in import prices and global commodity prices.

Based on data for April and May, 2Q inflation is likely to be about 0.5% YoY, clearly above the SNB’s forecast in March (0.2% YoY). To be sure, higher oil prices account for part of the overshoot, but not all. By contrast, inflation undershot the SNB’s forecasts sharply in 4Q-2006 and 1Q-2007, as external factors repeatedly proved more disinflationary than expected.

The SNB does not need to quickly get interest rates to a level that will cap growth at trend. Indeed, a very rapid tightening path could produce a double whammy, by also unwinding carry trades and prompting a sharp CHF appreciation that would hit exports, produce renewed weakness in import prices and extend the recent period of very low inflation. Citigroup analysts expect continued hikes of a quarter per quarter, with rates rising to 3.25% in early 2008. From there, risks lie on both sides depending on the evolution of global growth and financial conditions — especially the CHF.