ECB’s Lagarde signals 0.75% Euribor rate increase
ECB readies market for interest rate increase in July
What a difference a few months makes. Back in December, confident that inflation would fall back from November’s 4.9% to below 2% by September 2022, the ECB kept its official interest rate (euribor) at -0.50% and provided guidance that official interest rates would remain at or below -0.50% for the following two years. At the end of 2021, 3 year fixed rates were comfortably below zero.
At last Thursday’s policy meeting, by committing to a 0.25% rate increase in July and preparing the market for a larger 0.50% increase in September, the ECB reversed its stance and effectively brought the curtain down on the negative interest rate policy they have championed since June 2014. Forward curves are already projecting that euribor will rise above 1% in December and above 2% in July 2023, taking euribor back to levels last seen in early 2009. While official rates have still to change, 3 year fixed rates are already at 1.70%, a rise of 1.85% over the year to date.
Back to the future for Euribor?
We’re now at a crossroads for Eurozone interest rates. In the 8 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 3.5% in 2023 and 2.1% in 2024. If the ECB forecasts that inflation will stabilise at levels that persisted between 2000 and 2008, should euribor not also gravitate to levels it traded at during this period? Recency bias suggests that a fixed rate at 1.70% 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%, comfortably above the 1.70% that borrowers currently can currently fix at. 1.70% looks cheap in this context.
Hedging costs are increasing but not hedging may ultimately be more expensive
With euribor still-for the moment- at/below zero, there is a carry cost for borrowers when switching to a fixed rate at 1.70%. 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, up fourfold since the start of the year.
The cost of borrowing hasn’t been a concern for borrowers over the past 10 years but it looks like this will be a live issue as the ECB belatedly moves to tame inflation in the Eurozone. 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.
For more information on how Vuca Treasury helps borrowers manage interest rate risk, or for advice on how to manage your financial risks, please contact the team by mailing hedging@vucatreasury.com
