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The European Central Bank (ECB) settled on a 50bps increase today, bringing the main refinancing rate to 3.00%. This increase follows a 50bps hike in December, and the ECB indicated that it intends to increase rates by another 50bps in March.

Inflation in the Euro Area was 8.5% in January, down from 9.2% in December and 10.1% in November. Inflation appears to have passed its autumn peak (10.6%) and is now on a gradual downward slope. Although inflation is now falling, it is nowhere near the ECB’s 2% target. The economic situation in the Eurozone has improved, and we now forecast that it will avoid a recession, growing by 0.1% in 2023. Further, core inflation (which excludes food, energy and tobacco) has not been falling and at 5.2%, remains at its highest level since the Eurostat data began in 1997. President Lagarde repeated her assurances from December that the Bank would continue increasing rates for as long as it deems necessary to put inflation on a sustained downward trajectory. The ECB’s main refinancing rate was last at 3.00% in 2008, although it is still below the rates that prevailed before the Global Financial Crisis. The ECB also increased its deposit rate by 50bps to 2.50%.

The ECB confirmed that the reduction of its €5 trillion bond portfolio (termed Quantitative Tightening, or QT) will start in March 2023, initially at a pace of €15 billion per month, as was announced at the December meeting. Board members explained how the selling of debt will be proportioned between the different kinds of bonds that the ECB currently holds. To avoid widening the spread between German bunds and other government bonds in the Eurozone, the ECB has been using its anti-fragmentation policy tool, known as the Transmission Protection Instrument (TPI). The tool allows the ECB to purchase the bonds of Euro Area countries in order to prevent large spreads between the bond yields of different members. This tool has managed to keep Italian bond yields from rising significantly so far and protect bond market stability across the Euro Area.

The firm message about the planned 50bps increase in March comes because of the persistent high core inflation and the fact that the ECB’s main refinancing rate, currently at 3.00%, is still well below the comparable rates at the Bank of England (BoE) (4.00%) and the US Federal Reserve (4.5% to 4.75%). This week, the Federal Reserve raised rates by 25bps, whilst the BoE raised rates by 50bps. After March, the ECB will evaluate whether to raise rates further based on how much progress it has made in fighting inflation.

Eurozone government bond yields had already moved out in 2022 in anticipation of the ECB’s rate hike cycle. Since December 2022, however, the 10-year German bund yield and other Euro Area government bond yields have fallen back by around 30bps, reflecting market expectations of a lower peak on the refinancing rate than previously thought, as well as optimism that inflation would be brought under control faster than might be the case.

Following positive economic data, lower gas prices, and China’s reopening (the Euro Area’s third largest export partner), the Euro Area’s growth prospects have improved since December. Inflation is likely to decline over 2023, as commodity prices continue to fall and demand cools under pressure from interest rates. CBRE expects that inflation will decline to 2.5% by Q4 2023. Wholesale gas prices have already fallen considerably, as winter storage has been largely refilled and the European winter has been mild so far. However, stockpiling gas for next winter (2023-24) will pose a challenge, as the loss of Russian supply is unlikely to be compensated completely by other countries. Moreover, as China opens up its economy, the Euro Area will have to compete with it for liquefied natural gas (LNG) deliveries.

Since sovereign bond yields started drifting up in early 2022 and the ECB began raising rates, property yields have started to rise, with substantial moves in the second half of 2022. With interest rates expected to increase further in the first half of 2023, we anticipate property yields to continue moving out in H1 2023.