ROI-ECB can cool rate bets, but may not want to yet: Mike Dolan

The European Central Bank could make a decent case for markets to dial back expectations of another interest ​rate rise this week. Whether it wants to do so is another matter. It may be happier with the status quo for another ​couple of months. Of the big three central bank decisions over the next couple of days, the ‌ECB meeting ​on Thursday is arguably the most interesting, as it grapples with the wildcard of the outsize French debt turmoil and global inflation aggravated by energy prices.

None of the three banks is expected to shift policy rates, but if you were seeking a nod or a wink in the attendant communications, the Federal Reserve and Bank of Japan are likely to implicitly endorse market pricing for further hikes by year-end. But having lifted its official rates twice already this year into ‌the Iran war-related energy squeeze, the ECB now has a messier picture than its counterparts, thanks mainly to France's bond blowup.

Since the ECB last hiked rates in September, government bond yields in the euro zone, the US and around the world have surged as energy prices climbed anew. But a near-doubling of the French 10-year bond risk premium over the German benchmark over those six weeks - on a toxic mix of high government deficits, a budget impasse, street protests and a divisive election next year - has complicated things further for an ECB always wary of fragmentation among euro zone members.

A key question is whether the higher borrowing costs the ECB may ‌have welcomed to tamp down on aggravated inflation are now being amplified excessively by French debt stress and the risk of spillover to other euro sovereigns. Or, in market parlance, overall financial conditions may have tightened excessively, warranting some response from the ECB that might cool money market pricing for ‌another hike on December 17. If, as some in the ECB suggest, markets are doing some of the ECB's tightening for it, that may mean less is needed from Frankfurt.

The evidence is equivocal, however. Looking at euro zone financial conditions indexes (FCIs), the picture is more mixed than you might think.

The ECB's own Macro Finance FCI for September tightened sharply to its highest level of the year, but then levelled off at the end of the month despite the brewing problems in France. Models from Goldman Sachs and others then show further easing of FCIs early this month, even as the French problem mounted. While higher sovereign debt costs registered, they were offset in overall conditions by a softer euro and more buoyant stock markets.

Ironically, the euro has lost about 4.5% since ⁠the ECB last raised rates, ​in part because markets feel the French jolt has lowered and brought forward the "terminal ⁠rate" of the ECB tightening cycle. Yet the Goldman index is rising again and tightened three times as much as the US index in the latest weekly update.

As for readings from lenders themselves, the ECB's bank lending survey for September showed demand for mortgages had fallen sharply, while lending terms and standards for business and consumers were becoming stricter. Perhaps unsurprisingly, the biggest mortgage drop-off ⁠was in France, where weeks of restive politics have sent consumer confidence to a 13-year low.

All of which could theoretically give the ECB some ammo to signal that another rate rise this year is not a done deal. CAN DO, WON'T DO

But the ECB may not want to be that explicit, mainly because the uncertainties surrounding the French budget ​may cut both ways before it meets again on December 17, not to mention wildcards surrounding energy prices, the Iran war and US midterm elections. The central bank itself has so far been remarkably deft at not addressing the French debt problem head-on, indicating that it's not dominating thinking ⁠in Frankfurt and publicly insisting the issue lies with the authorities in Paris.

ECB President Christine Lagarde has talked of a more "measured" approach to further tightening, but that was less about France than about what she saw as the lack of "second round" effects from this headline inflation surge so far. ECB chief economist Philip Lane did say this month that surging bond yields did constitute "a material tightening ⁠of financial ​conditions" and were "a relevant factor" for the bank in determining policy. But again, the context of his comments was the overspill to government bond markets from corporate borrowing to fund the AI boom, not France.

As long as the French debt situation doesn't hamper other countries' fundraising unduly, many on the ECB Governing Council may quietly feel that market pressure is a useful way to focus minds in Paris on resolving the problem. Altering policy horizons, or suggesting the use of extraordinary ECB intervention tools to calm debt spreads or even halt its balance sheet rundown, may just backfire on that score.

"Right now we would expect President ⁠Lagarde to say as little as possible" about France, wrote Deutsche Bank's Mark Wall and team. They see a very high bar for the ECB to deploy its emergency bond-buying tool, the Transmission Protection Instrument (TPI), to calm euro debt spreads.

But the Deutsche team also insisted: "There's no inconsistency in the ECB hiking ⁠policy rates to address inflation and deploying TPI to stabilise France at the same time." The euro, ⁠for its part, has slipped in anticipation of this week's meeting, suggesting some investors might think the ECB may blink.

But that reasoning is circular. By weakening the currency further, the market may help ease the financial-conditions crunch that might otherwise tempt the ECB to react. Neither nods nor winks may be the wisest course of action.

(The opinions expressed here are those of Mike Dolan, a columnist for Reuters.) Enjoying this column? Check out Reuters Open Interest (ROI), your essential new ‌source for global financial commentary.

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(By Mike Dolan; Editing by Marguerita Choy)