FRANKFURT, Germany. September 8th, 2022. The European Central Bank raised its benchmark interest rate by 75 basis points up to 1.25% for the first time since 2011 in a bid to contain runaway inflation.

The ECB felt that a rate raise of anything less than the higher end of expectations was not enough to “dampen demand”.

“Over the next several meetings the Governing Council expects to raise interest rates further to dampen demand and guard against the risk of a persistent upward shift in inflation expectations,” the ECB said in a statement.

Market activity during the Thursday, Friday, and Monday trading days seemed to show that European markets had already priced in a higher-than-expected rate increase, with the FTSE 100, the CAC 40, and DAX Index all closing positive on all three days.

Unlike the U.S. Federal Reserve, the ECB has just the single central bank mandate of controlling inflation, which they see as greatly driven by consumer and investors’ expectations, alongside market conditions.

Current expectations are for an average inflation rate of “8.1% in 2022, 5.5% in 2023 and 2.3% in 2024,” the ECB said.

While the markets looked up, even in the face of a now nearly-formed cap on the price of Russian oil to enter into force on December 5th, the “spread” is still far higher than the ECB usually tolerates.

Spreading further

The ECB necessitates that government bonds of all major economies of the Eurozone remain as close as possible, i.e. that the return on a ten year bond from Italy is as-near-as-makes-no-difference to a ten year bond from Germany. These are known as the “spreads” — the range of yield of government bonds between nations.

During 2011, in the midst of the sovereign debt crisis in the Eurozone, spreads between the troubled economies of Portugal, Ireland, and Greece and the more stable nations of Italy, France, and Belgium were often double in favor of the riskier investments, i.e. the troubled nations.

Today, the spreads are doubled, or nearly doubled, between even the stronger economies.

A German 10-year bond closed Monday at 1.654, and a French 10-year at 2.224. Italy’s by contrast closed at 3.896, and Greece’s at 4.192

Spreads influence inflation expectations, and are a signal to investors that certain economies in the Eurozone are becoming riskier haunts for investment. Given the penchant for bailing out troubled Eurozone economies, the spreads also influence investor expectations in the stronger economies of central Europe.

“Investors are understandably nervous about buying more bonds after a hawkish ECB meeting and more generally due to elevated rates volatility,” Antoine Bouvet, senior rates strategist at ING in London told Reuters after Monday’s close.

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