ECB raises rates by 0.5% and market forecasts another 1.0% before Christmas
ECB surprises with 0.5% move but more on the way
The European Central Bank (ECB) raised interest rates by a larger than expected 0.50% at last Thursday’s policy meeting and also flagged that more rate hikes are also on the way. President Lagarde said after the meeting that rates will keep moving higher as long as necessary to take inflation back to its 2% target. By close of business Friday, forward expectations for Euribor had priced in an additional 1.0% of rate hikes across the final 3 ECB meetings of 2022.
Cost to hedge falls as borrowing costs rise
Although the ECB raised rates by 0.5% and is forecast to lift rates by another 1.0% before the year end, the cost to hedge actually fell sharply on Friday. Largely reversing a 0.25% rise over the week leading into the meeting, 3-year fixed rates fell by a massive 0.22% on Friday alone as the market responded negatively to the release on Friday morning of the S&P Eurozone Purchasing Manager Index for June. Seen as a good gauge of economic health, the index broke below 50 which indicates a contraction in future economic activity in the Eurozone.
Volatility in rates market is increasing
To put Friday’s 0.22% move into context, over the past 10 years there have been only 6 days where we have had a single day move (up or down) in excess of 0.20% in 3-year swap rates. All of these single day moves over 0.20% have occurred since the middle of June. We can expect this type of volatility to persist over the coming months while rampant inflation wrestles with slowing economic activity to be the dominant narrative shaping equity, currency and rates markets. Without using a hedging advisor, this type of volatility makes it very difficult for businesses to monitor markets and borrowers looking to hedge can experience unexpected large swings in the cost of Caps and swaps over relatively short periods of time.
The volatility in rates also increases the interest rate risk for borrowers looking to arrange new debt facilities. As can be seen in the table above, in the 15 months leading up to September 2021, the range for 3-year swaps over a 3 month period was relatively stable around 0.10%. We are now seeing moves double this size in a day and the 3 month range has increased to just under 1.0%- almost 10 times the size of the range that this benchmark interest rate previously traded in. The impact on borrowers can be material as a large rise in term rates while a loan is being arranged can have an impact on debt serviceability, resulting in less favourable terms being offered. With the ECB at the beginning of its rate tightening cycle and 3-year euro term rates still 1.4% below their equivalent UK rates and 1.7% below US rates, this funding risk is something that borrowers need to be mindful of.
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