ECB Central Bank Euribor
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ECB expected to raise Euribor by 0.25% again next week

Summary

  • – Inflation has fallen to 6.1% year/year but still well above ECB’s 2% target
  • – ECB meets next week with 0.25% rate hike expected
  • – Swaps curve is inverted making hedging more attractive but borrowers need to ensure complacency doesn’t seep in as volatility could return if inflation remains sticky 
EUR Rates June 1

Euro rates curve is now inverted

For the first time in a number of years, the euro swap curve is inverted. Fixed rates are cheaper than 3 month euribor, providing an immediate reduction in borrowing costs when switching from a floating to a fixed rate basis.

Euribor EUR 2 Year Swap 1

For most of 2022, the cost to switch from floating to fixed had been prohibitive (chart 1), peaking with fixed rates around 1.90% above floating last June as the market began to price a series of rate hikes from the ECB into fixed rates ahead of the central bank’s first rate hike in July. Anyone brave enough to fix last June would have traded sub-zero euribor for a fixed rate around 1.6% but would now be reaping the benefits of that decision with floating rates at 3.46% and still increasing.

A year on and the picture is quite different. Switching to a fixed rate provides an immediate cost saving as 2 year fixed rates are 0.11% lower than floating rates. The discount is even greater the further out the curve you move, with 5 year fixed rates 0.44% lower than euribor. However, while borrowing costs are initially reduced with a fixed rate, they may ultimately be more expensive if euribor is close to a peak and starts to fall sharply from here. We get a timely update from the ECB next week on their current thoughts as to the appropriate level for interest rates for the Eurozone as the central bank is scheduled to hold its regular monetary policy meeting on the 15th of June. 

Markets expects another 0.25% rate hike from the ECB next week

At the policy meeting, any outcome other than a 0.25% rate hike would be a massive surprise from the ECB. Looking further out, the forward curve has also priced in one final 0.25% rate hike at either the July or September meeting, indicating that the market view is that we are very close to the end of the tightening cycle.

Underpinning this rates view is the improving inflationary outlook. Figures released last week showed that y/y headline inflation in the Eurozone fell from 7% in April to 6.1% in May. However, with Eurozone wage inflation in the 5-6% range and unemployment at a record low, inflation may prove to be quite sticky at these levels and progress back towards the ECB’s 2% inflation target from here may be more difficult than currently anticipated. Highlighting the risk that the actual path for euribor may be quite different from the market’s current view is the stance taken by some central bank officials, most notably the German Bundesbank President, who are calling for “several more” rate hikes to ensure that inflation to the ECB’s 2% target.

Recent price action in the UK rates market shows that the market reaction can be violent if the return to target is slower than expected and market consensus shifts. Although there was a welcome drop in UK inflation to 8.7% in April from March’s 10.1%, a larger fall to 8.2% was anticipated and the market responded negatively to this news. Prior to the release, the market view was that the Base Rate had already reached its terminal rate at 4.50% but after the disappointing inflation update, the market recalibrated its expectation for the Base Rate to peak from 4.50%, up to 5.25%. Swap rates moved up by 0.70% over 2 days on this development-an increase of over £0.2m on the expected cost of a 3 year £10m loan.
While the inflation picture is better in the Eurozone, disappointing data still has the potential to drive an increase in volatility and cost to hedge euro debt. Hedging costs have been relatively stable over the past 2 months, with fixed rates trading in a 0.40% range between 2.90% and 3.40% since the middle of March. However, as the UK experience shows, it only takes one poor inflation report to reset the expected path for euribor and increase hedging costs
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Euribor & SONIA

The forecast path for euribor is constantly changing but its role is significant as the curve is the primary input used by financial markets to price hedging products like Caps and Swaps. Currently, the inversion in the curve and range trading have provided a stable environment for borrowers to make informed hedging decisions. But borrowers must be wary of complacency.

The recent UK market experience has shown us the crucial role that early engagement plays in managing interest rate risk. Companies that act early and engage with lenders, debt advisors and hedge advisors can avoid the potential loss of flexibility, make more informed decisions, and mitigate risk more effectively than those who wait until the last minute and are overcome by events. Interest rate risk is a significant challenge for businesses of all sizes, but by taking proactive steps and seeking professional advice, companies can better prepare themselves and protect their bottom line from harm. Don’t wait until it’s too late, engage early, and stay ahead of the curve.

Martin Mulligan

Martin Mulligan

Founder

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