Traders stick with rate-hike bets as markets set sights on new-look ECB

Traders held onto ‌bets ​for a year-end European Central Bank rate hike on Thursday, as the central bank left rates steady and markets looked ahead to how a new leadership will navigate elevated energy costs and volatility in French markets. ECB President Christine Lagarde said she would step down in February, a decision, she ‌told reporters, that would allow her to weigh in on issues, such as French politics, in a way she was unable to in her current role.

The ECB will also next year replace Vice President Isabel Schnabel and Chief Economist Philip Lane in a game of political chess among the bloc's 21 nations that will reshape how its most powerful financial institution functions. Lagarde's resignation has been anticipated by ‌markets. And while bond yields and the euro briefly dipped as traders digested the latest rate decision, they rebounded as Lagarde hinted at another hike at the post-meeting press conference.

Policymakers expect to ‌increase rates in December to fight high, energy-led inflation and then pause as a rise in bond yields is set to weigh on growth and inflation, three sources told Reuters. Germany's 10-year bond yield was last down 3 basis points at 3.35%, while the yield on the rate-sensitive Schatz was down 5 bps at 3.06%.

The euro was a fraction higher at around $1.116, having been down 0.2% before the ECB's decision. European shares remained broadly higher.

"On balance the path is still clear ⁠for further policy tightening," ​Martin Wolburg, Senior Economist at Generali Investments, said. "She (Lagarde) was ⁠very clear about that."

A TOUGH BACKDROP The ECB has raised rates twice this year so far, and Lagarde said the increased magnitude and duration of the energy shock were likely to drive up inflation and undermine growth.

Markets price around ⁠a 75% chance the ECB raises rates by 25 bps in December, and at least one further move next year. But how aggressive to be with next year's tightening will be a matter for the next ECB ​president.

"(Lagarde's) successor is going to step into an environment where rate hikes are expected throughout next year, although they (the ECB) note that energy prices pose an upside risk to inflation ⁠as well as a downside risk to growth," said Neil Birrell, CIO, Premier Miton. "That’s a tough backdrop to walk into."

The recent sharp selloff in government bonds around the world, which in Europe has been centred on France, will also be top ⁠of ​mind for the central bank's new leadership. Investors have become increasingly uneasy about France's growing debt burden and uncertain fiscal outlook following next year's elections. Concerns have been amplified by suggestions from parts of the political left that debt held by the ECB could be written off.

France's 10-year yield on Thursday was down around 1 bp at 4.9%, below recent 24-year peaks. The gap between ⁠French and German borrowing costs widened to around 155 basis points. Borrowing costs of other indebted countries, such as Belgium and Italy, have also risen, leaving markets wondering whether the ECB might step ⁠into markets if it feels the selloff is limiting ⁠its ability to shape monetary policy across the euro zone.

"We don’t expect the change at the top to alter the near-term rate outlook, but markets will be watching the succession closely as pressure on French government debt persists," said Aberdeen Investments economist Felix Feather. "Different candidates have different attitudes ‌to non-standard policy tools such as ‌the transmission protection instrument.”