Euribor 3-month rate set to increase further
Euribor 3 month and Euribor Swap Rates Continue to Climb
The European Central Bank (ECB) has raised interest rates by 425 basis points since last summer to 3.75%, the highest level since 2009. The 3-month rate, which influences the pricing of variable rate loans, is at 3.701% – the last time it was at this level was in February 2009. Despite this, Euribor forward curves are projecting rates to rise even higher throughout 2023, with rates expected to peak at 3.9% by December 2023. Those looking at hedging (swaps or caps) should note that the forward curve has been a very poor predictor of the actual path that euribor will take. For example, this time last year the forward curve estimated that 3 month euribor would be trading at 1.05% in April 2023 and would peak at 1.54%, well below the current 3.70% rate. For this reason, it is not recommended for borrowers to rely on the forecast curve for a hedge/ don’t hedge decision even though the curve is the basic building block used by the market to price all interest rate hedging products.
However, markets have been extremely volatile this year, with 3-year swap rates experiencing significant fluctuations. They fell by 0.40% in January, rose by 0.80% in February, fell by 0.60% in March following the collapse of Silicon Valley Bank, and are currently up by 0.30% since the start of April. An 80 basis point move on a €50m 3-year swap can add an additional €1m in costs, putting the viability of many projects at risk.
3 month Euribor breaches 3% for the first time since January 2009
Euribor 3m breached 3% in February 2023. While in a cash sense, the move from 2.99% to 3% is no different than the move from 2.98% to 2.99% the move is significant for a number of reasons- not least being that borrowers with Caps at 3% will expect to receive settlements from their hedges in 2023.
The move above 3% is also psychologically important for many credit-worthy borrowers as it now means Euribor is higher than their loan margin, reinforcing the point that interest rate risk is now a strategic risk item again.
Back to the future for Euribor?
We’re now at a crossroads for Eurozone interest rates. In the 10 years preceding the 2008 Global Financial Crisis, inflation didn’t deviate too far from the ECB’s 2% target, fluctuating between 1.6% and 3.1%. Consequently, euribor set in a range between 2% and 5.4%. The ECB’s latest forecast sees inflation averaging 5.5% in 2023 and 2.3% in 2024. If the ECB forecasts that inflation will stabilise at levels that persisted between 2000 and 2008, should euribor not also gravitate to the upper levels it traded at during this period? Recency bias suggests that a fixed rate at 3.5% looks expensive but in the context of an economic environment where inflation is stable at or above 2%, this may not be the case. The rolling 3-year average euribor rate for floating rate borrowers between 2000 and 2008 was between 2.2% and 4%, 2.70% looks decent value in this context.
Hedging costs are increasing but not hedging may ultimately be more expensive
With 3 month Euribor at 3.71%, there is a carry cost for borrowers when switching to a fixed rate at 3.80%. As a result, interest rate caps are proving to be a popular hedging alternative as borrowers stay floating until Euribor breaches the borrower’s chosen cap protection rate. However, there is no such thing as a free lunch. Like fixed rates, premium costs for Caps have been increasing too.
The cost of borrowing hasn’t been a concern for borrowers over the past 10 years, the sudden increase has caught many firms by surprise. However, at a time when there is so much uncertainty over revenues and costs, hedging interest rate risk can provide increased visibility over a significant cost line. At the very least, a review of hedging strategy should be a priority for all borrowers as we head into the summer months.
We are seeing companies starting to manage the cost of debt for the first time in over a decade. While hedging interest rates protects against higher rates, it can also increase the gearing on transactions. Lenders conduct interest rate stress tests (cashflows need to show an ability to service debt at higher levels) at multiples that can be 4/5 times where rates are today. We’ve arranged several Caps where lenders were happy to increase the gearing on transactions in scenarios where the borrower bought ‘in the money’ Caps. The lender was happy because there was visibility over the client’s ability to meet the higher interest expense and the borrower was happy because the increased gearing was 4-8x the premium cost on the Cap.