A decade ago, then-European Central Bank President Mario Draghi said the institution would do "whatever it takes" from a policy standpoint to preserve the region's currency amid Europe's sovereign debt crisis.
Now, money managers are warning that the ECB's new policies coupled with geopolitical stresses — including Mr. Draghi's resignation from his latest role as Italian prime minister — could force the bloc into recession.
Last month, the ECB took a surprisingly hawkish stance with its monetary policy update. While forward guidance had indicated a 25-basis-point rate hike — the first since 2011 for the eurozone — the ECB's governing council doubled that increase to 50 basis points in an effort to combat spiraling inflation, which hit 8.6% in June. The increases took the deposit facility out of negative territory to zero; the rate on refinancing operations to 0.5%; and the marginal lending facility rate to 0.75%.
Markets appeared to take notice of the changes immediately after the announcement — eurozone yields increased across the board, as did 10-year peripheral bonds and Italian bonds — before all falling back.
However, sources warned that hiking rates as the region continues to battle rising inflation, the spillover from the war in Ukraine, Russia's continued threat to turn off the gas taps and political turmoil in Italy due to Mr. Draghi's resignation could push Europe into recession and force the ECB to halt or even reverse its decision.
The pressures Europe is facing are already expected to factor into growth this year and next. The war in Ukraine and monetary tightening were cited by the International Monetary Fund's latest World Economic Forum, published in July, as key to its downgrades in its eurozone growth forecasts. It now expects 2.6% growth this year, down from a 2.8% forecast made in April and a 3.9% expectation made in January; and 1.2% growth in 2023, down from forecasts of 2.3% and 2.5% made in April and January, respectively.
"Europe is in a tough spot, and (ECB President Christine) Lagarde has got the hardest job out there right now," said Megan Greene, Kroll Institute's global chief economist and senior fellow at the Watson Institute for International and Public Affairs at Brown University, Providence, R.I.
Amid Russia's threat to turn off the gas taps, European member states have committed to cut natural gas demand by 15% this winter. Even if countries were to reduce gas demand by 10%, "that's a fancy way of saying you're going to have to forgo demand. I don't see how you cut demand for energy by 10% without there being a contraction," Ms. Greene said. Countries will do what they have to do, "but I think we should all stop kidding ourselves that (EU member states) can do that without there being a contraction," she said.
And when that happens, sources said the ECB will have to at least pause — if not cut — interest rates.
Prior to the ECB's announcement of its first hike in more than a decade, market consensus had been that the ECB would raise interest rates to 2% or 2.5% by year-end. Pricing now indicates it will instead only reach 1%, said David Riley, chief investment strategist in London at BlueBay Asset Management LLP. "That's what's underpinned this rally in bunds and government bonds across Europe. I think it's probably contributed to some of the rally we've seen in global bond yields. And I think the market has done that not because it is more optimistic on inflation, but it is much more pessimistic on the growth outlook," he said. "It's hard to believe the ECB can continue raising rates … to the end of the year" — even though inflation is undoubtedly above its target of 2% — if the eurozone were to fall into recession, he said.
The Bloomberg Global Aggregate Bond index was up 0.8% for the period July 21 to 27, while the FTSE European Monetary Union Government Bond index (euros) was up 1.8% for the same period.
That the eurozone will move into recession is the view taken by Columbia Threadneedle Investments, said Joshua Kutin, Boston-based head of asset allocation, North America. "The prevailing view firmwide, among the various asset allocation groups both in the U.S. and EMEA, is a relative concern for Europe. We would not be surprised at recessions anywhere in the world at this point, but the view is that a recession is likely to be deep for Europe in contrast to the U.S. and U.K., where we would characterize the expectation as mild," he said in an email. He said the ECB moves and the conflict in Ukraine, plus the implications that carries for energy supply, are important.
Ms. Greene added that the situation in Italy, where the outgoing Mr. Draghi and his government will remain as caretakers until an election takes place in September, also adds risk. "Italy was where the European project was always going to live or die. Italian politics is blowing up at an incredibly inopportune time for the ECB," she said.
As well as a rate hike on July 21, the ECB introduced its Transmission Protection Instrument — an unspecified amount of bond-buying it is willing to put into action if the transmission of its monetary policy is threatened by "disorderly market dynamics," the central bank said.
Its introduction is designed to provide investors with comfort, since "the ECB is aware that a slowdown in growth, coupled with tighter monetary policy is likely to lead investors to question the debt sustainability of some peripheral nations," said Iain Cunningham, London-based portfolio manager at Ninety One. The firm managed £134.9 billion ($164 billion) in assets as of June 30.
But while the TPI, as it's known, was broadly welcomed by industry sources for appearing to provide the central bank with a tool to deal with fragmentation risks, "further details are still needed and the TPI could yet disappoint market expectations," Ann-Katrin Petersen, a senior investment strategist at the BlackRock Investment Institute in Frankfurt, said in an email. "The caveat for the ECB: The fewer guardrails in the instrument's design, the more likely it is that the ECB will run into legal challenges over its use."
The lack of clarity around just what would trigger the TPI "makes it likely that the market will continue to test what it might be," said Orla Garvey, London-based senior fixed-income portfolio manager at Federated Hermes Ltd. "This is potentially very bad news for Italian/European risk given the political uncertainty because, although the TPI is unlimited in size, the criteria is very focused on compliance with the EU fiscal framework, which the right leaning members of the current coalition are vocally against," she said in an email.
Mr. Cunningham agreed that, "with growth slowing sharply, ECB monetary policy tightening underway and increasing political uncertainty in Italy, it is relatively likely that the market will test the ECB's resolve." As such, the firm is waiting for the ECB to show it is "willing to act upon its rhetoric before taking on any additional risk in the eurozone," he said.
But if the TPI is met with a positive response from markets, it could backfire for the region's economy. BlackRock's Ms. Petersen warned that a positive response "might embolden the ECB to hike rates more aggressively. We think that means there could be even greater recession risks ahead for the euro area."
Despite the threats Europe faces, the situation will not get as bad as the eurozone debt crisis of 2011 and 2012, sources said — the very situation that saw then-ECB President Mr. Draghi coin the "whatever it takes" phrase.
"I think the TPI, despite its drawbacks, is nonetheless a pretty unambiguous statement by the ECB that it is not going to allow" things to get as bad as they did in 2011, Mr. Riley said. Furthermore, a big part of the eurozone debt crisis could be linked to European bank behavior — something that has been addressed.
And there are pockets of opportunity. European debt markets "look relatively attractive to me when compared to U.S. and other markets," Columbia Threadneedle's Mr. Kutin said, although European equities are poised to underperform. "But I would say this is a consistent view. It's not uncommon, in general, to see government bond markets take a different direction than risky assets when linking expectations for economic growth and asset markets in general."
Ultimately, Europe will adjust to reducing its dependence on Russian gas, prices will stabilize and inflation will come down, "so I don't think this is going to be an existential threat to the euro — but it's going to be painful for citizens and for investors," BlueBay's Mr. Riley warned.
He thinks much is priced into credit and equity markets, but not quite enough right now. "I'd be pretty bearish European risk assets right now," he said. The $112 billion money management firm's preference is for higher-rated credit for Europe, which has already repriced and taken account of a lot of bad news, he said.
Hazel Bradford contributed to this story.
