Euribor 3-month rate set to increase further
Euribor 3 month and Euribor Swap Rates Continue to Climb
Central banks have continued to underestimate inflation. December 2021, the ECB was 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 guided that official interest rates would remain at or below -0.50% for the following two years. However, inflation has increased every single month since this statement, hitting a new all-time high of 10.7% in October 2022.
The ECB has reacted, raising rates 200 basis points over the past three meetings to 1.25%, the highest level since 2011. The 3-month rate which drives the pricing of variable rate loans is at 1.8%, the last time it was at this level was February 2009. However, forward curves are projecting Euribor will rise even higher throughout 2023. Euribor forecasts see rates hitting 2% in December 2022 and 3% in September 2023. For anyone looking at hedging (swaps or caps), euribor forecasts see 3-year euribor swap rates at 2.70%, a rise of 3% over the year to date. While the five-year Euribor swap rate (the typical floating rate on which banks add their margin for lending to real estate in Europe) increased from -0.099% to 2.985% in the 12 months to October 2022.
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 2.70% 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%, 2.70% looks decent value in this context.
Hedging costs are increasing but not hedging may ultimately be more expensive
With euribor at 1.25%, there is a carry cost for borrowers when switching to a fixed rate at 2.70%. 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.
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.
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
Martin Mulligan
Partner
Martin graduated from University College Dublin with a Bachelor of Commerce (Banking & Finance) and holds a Masters in Investment and Treasury from Dublin City University. He has been a member of the Association of Corporate Treasurers since 2013.