Euribor above 2% by Christmas?
The European Central Bank (ECB) raised their key reference rates by 0.75% at their regular policy meeting in September and Bank officials reaffirmed their commitment to take benchmark interest rates to at least a neutral rate of interest to tame inflation which Eurostat estimates has now hit 10% in September. While not defined, a neutral rate of interest is widely considered to be around 2%.
Financial markets are now forecasting another rate hike of 0.75% at the next ECB policy meeting on the 27th of October and a further 0.50% at the following meeting on the 15th of December, which would leave the benchmark ECB deposit rate at 2% by the end of the year. Unless inflation peaks and starts to fall rapidly towards the 2% medium term inflation target, it is highly probable that the ECB will continue to tighten beyond this neutral rate. As 3-month euribor is currently at 1.10%, 0.35% above the ECB Depo Rate of 0.75%, it’s likely that a ECB Depo Rate of 2% in early December would also see the benchmark 3-month euribor rate set above 2% by Christmas.
UK crisis is affecting EUR interest rate markets
For the second month in a row, EUR term rates moved sharply higher over September. 3-year euribor swap rates started the month at 2% and traded through 3% in late September before closing the month at 2.78%. Part of the volatility in EUR term rates in late September was collateral damage from the poorly received fiscal update provided by the latest UK Chancellor on the 23rd of September. Following intervention in the UK government gilt market by the Bank of England, UK term rates have fallen in recent days, allowing EUR term rates lower to move lower also.
3-year rates are currently trading around 2.6%, a 0.40% drop from the September high which is the biggest correction lower in term rates since the middle of July. Cap costs have also fallen. The Bank of England is expected to continue to intervene in the UK gilt market until the middle of October so underhedged EUR borrowers may see further welcome falls in swap rates and cap premia over the coming days.
Underlying trend for rates is still up
However, with inflation in double figures and still rising, the most likely outcome is that this correction lower in hedging costs is a temporary respite. The peak for euribor in this cycle is currently forecast to be below 3%. In comparison, the equivalent peaks for US Libor and UK SONIA are 4.90% and 5.30% respectively, despite the fact that inflation in Europe is higher. A lower expected path for euribor compared to their US and UK peers is inconsistent with the Eurozone also having a higher rate of inflation especially now that the ECB appears set to tighten aggressively over the upcoming policy meetings. It’s important that borrowers take the time to identify their euribor tipping point beyond which they cannot meet covenant or return hurdles. If capacity is tight, the recent move lower in the cost to hedge could be a great opportunity to mitigate this risk.
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