ECB meets this week and is tipped to raise interest rates by 0.75%
Financial market volatility expected to remain high
Financial markets remain extremely volatile of late. Having fallen from 2.16% in June to a low of 1.12% in July, the 3 year swap (fixed) rate ended August back up at 2.11%. Over these 3 months, the daily trading range breached 0.10% on 22 of the 66 trading days. To provide context to how significant this level of volatility is, over the 3 years from 2019 through to the end of 2021, there was not one occasion when a daily move of this magnitude occurred.
The prognosis for trading conditions in September is for volatility to remain high. Yesterday, European gas prices spiked 35% on the open in response to Russia’s decision over the weekend to close the Nordstream gas pipeline. 3 year swap rates jumped 0.05% this morning and this rise in term rates may have been more pronounced were it not for this morning’s release of the closely watched Purchasing Manager Index which showed that economic activity in Germany has fallen to a 27 month low and that across the whole of the Eurozone, activity contracted for the second month in a row.
ECB to raise interest rates by at least 0.50% this week
This combination of rising inflation and declining economic activity places the European Central Bank in an invidious position but won’t deter them from raising rates by at least 0.50% at their policy meeting this Thursday. In fact, with consumer inflation up at 9.1% and producer price inflation at 37.9%, the market is anticipating that an even larger 0.75% rate hike will be delivered.
How high will euribor go?
Borrowing costs are rising quickly. Having set at 0.0% as recently as July, 3 month euribor is already at 0.76%. And with 3-year rates above 2%, it’s evident that the market expects the ECB will continue to tighten at upcoming policy meetings and that euribor will rise sharply into the year end. Recent comments from ECB board members indicate that there is a willingness to tighten interest rates even into an economic slowdown. The Governor of the French central bank recently warned that the ECB is prepared to raise interest rates beyond the neutral rate of interest which implies a willingness to take interest rates above 2%. The question is, how far above?
Currently, the forward curve for euribor implies a terminal peak of 2.26% in 2023 while the forward curves for the equivalent rates in both the US and UK imply terminal peaks in their rates cycles above 4%. In light of hawkish comments from ECB officials, the ongoing energy crisis as well as the market’s projections for interest rates in other major economies, euro borrowers need to ensure that they can cope with interest rates well in excess of 2%.
How are borrowers reacting to rising interest rates?
Having enjoyed a low interest rate environment for over a decade, borrowers (and lenders) are now having to quickly adjust to a very different operating environment. Understandably, we’re seeing some gaps in the level of knowledge about how interest rate hedges are priced and structured and are working closely with clients to ensure that hedging costs are minimised and hedge structures are optimised. Examples of the types of conversations we’re having include:
- – Benchmarking the price on hedging trade calls between a borrower and their bank to ensure that bank pricing is as tight as possible. This is especially important now given that we are regularly seeing moves over 0.10% in a single day. The earlier we are engaged, the more leverage we have to deliver a better outcome
- – Structuring Cap profiles to minimise the premium cost
- – Monitoring market levels for clients to take advantage of favourable price moves
- – Pre-hedging the future interest rate risk on loans to be drawn or refinanced in the future/ expiring fixed rate loans. This is most relevant for borrowers who have fixed income and risk breaches of interest rate covenants or margin erosion
If any of this resonates with you, or for more information on how Vuca Treasury helps borrowers manage interest rate risk, please contact the team by mailing hedging@vucatreasury.com
Martin Mulligan
Martin Mulligan is the founder of Vuca Treasury. Since 1994, Martin has structured and sold foreign currency, interest rate and commodity hedges for corporate and financial institutional clients at a number of major banks in Ireland, Australia and the UK.
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