The European Central Bank (ECB) settled on a 50bps increase today, bringing the main refinancing rate to 2.50%. This was a lower increase after two consecutive 75bps hikes in July and October, but the ECB indicated more increases are still to come.
Inflation in the Euro Area was 10.0% in November, down from 10.6% in October. Inflation across the Euro Area appears to be past its peak. This, together with increasing fear of recession in 2023, bolstered the case for the ECB to slow the pace of rate hikes. The 50bp hike was consistent with market expectations, as many board members recently voiced support for slowing the pace of increases. However, board members expect to raise interest rates further in 2023, but at a steadier pace. They stated that, even though inflation decreased in November, it remains far too high and is projected to decline only slowly to its medium-term target of 2%. The ECB’s main refinancing rate was last at 2.50% in December 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 2.00%. The deposit rate has now approached levels that might be regarded as “neutral” for the inflation outlook. This is in line with previous comments from President Christine Lagarde and from the governor of the Banque de France, who put these levels at around 2.00%.
The ECB signalled 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. Further details on QT will be confirmed at the next ECB monetary policy meeting in February. QT will be implemented alongside further interest rate increases to fight inflation in 2023 and beyond. Board members laid out the key principles that will guide the reduction of the ECB’s balance sheet. The speed at which the ECB will be selling bonds will depend on the inflation outlook and the time it takes for policy to typically affect the economy (the transmission lag). The ECB is likely to hike rates by another 50bps at its next meeting in February. This is expected because core inflation (i.e. excluding the effects of energy and food prices) is still stubbornly high and because the ECB’s main refinancing rate, currently at 2.50%, is still well below the comparable rates at the Bank of England (BoE) (3.50%) and the US Federal Reserve (4.25% to 4.50%). In similar moves to the ECB, both the Federal Reserve and the BoE raised rates by 50bps this week.
Eurozone government bond yields had already moved out earlier in the year in anticipation of the ECB’s rate hike cycle. Investors had priced in a 50bp rate increase, with more hikes to come. The 10-year German bund yield, for example, is now at 2.08%, up from -0.12% at the start of 2022. The 10-year bund yield, and other Euro Area government bond yields, however, have fallen back by over 30bps since late October, reflecting market expectations that rates might peak at lower levels than previously thought.
The spread between German bunds and other Eurozone bonds (the Germany-Italy spread has increased by around 70bps in the 12 months to December) is limiting the ECB’s scope to pursue higher rates. To avoid this limitation, 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 bond yields. This tool has managed to keep Italian bond yields in check so far and protect bond market stability across the Euro Area.
The Euro Area economy has remained more resilient than expected. GDP in Q3 2022 positively surprised by growing 0.2% on the previous quarter. However, economic difficulties driven by high energy prices are still likely to push the Euro Area economy into recession this winter. Even though inflation appears to have peaked, it is still high and is expected to only come down slowly. It will continue to be a drag on real household incomes, leading to lower consumer spending over the winter. However, governments have provided significant fiscal support, which is worth about 2.5% of the Euro Area’s GDP for 2022 and will likely be extended into 2023, to protect households from higher energy prices.
The CBRE House View is that the Euro Area will see a moderate recession in 2023, with GDP declining by an 0.7%. Inflation looks like it may have already peaked and will decline gradually over 2023, as commodity prices fall, supply chains reconfigure, and domestic demand cools. Due to the uncertainty over energy prices, which depend on an unstable geopolitical context, it is possible that the recession might be deeper and longer. Wholesale gas prices have already fallen considerably, as winter storage has been largely refilled. It takes time for this to be felt by most households due to the nature of agreements with energy providers, but it will eventually relieve some of the pressure on household finances. However, filling up storages for next winter (2023-24) will pose a challenge. The loss of Russian supply is unlikely to be offset fully by other providers, especially if China further relaxes its Covid lockdowns and the Euro Area has to compete with it for liquefied natural gas (LNG) deliveries. There is also a risk that Euro Area economies will suffer long-term consequences of the gas crisis, as many gas-dependent industrial enterprises may cease operations or move them away from Europe. Despite the recessionary environment, markets expect that the ECB will raise interest rates by another 50bps in the first quarter of next year.
Since 2021, inflation has been on an upward trend across the globe. This did not have a material impact on real estate yields in the first months of 2022, as spreads between real estate yields and risk-free rates remained wide. Since sovereign bond yields started drifting up and the ECB began raising rates, the property yield impact has been more pronounced. Even so, the yield shift has not been as large as it should have been based on market interest rate movements and deterioration in occupier market sentiment. Therefore, and with further interest rate increases expected in 2023, we anticipate further property yield increases in 2023.
