Historical high for Euribor- but for how long?
Summary
- The ECB has raised its official Depo rate to a historical high of 4.0%
- This is expected to be the terminal rate but is data dependent
- The focus has now shifted to how long rates will remain at this level
- At this stage of the rates cycle, a more nuanced approach to hedging is required
Historical high for Euribor- but for how long?
The European Central Bank (ECB) made history yesterday by raising its official interest rates to a historical high of 4.0%, surpassing the previous peak of 3.75% set in 2001.
However, the ECB now finds itself in a predicament. The ECB’s sole mandate is to maintain price stability in the Eurozone, but with inflation at 5.3% (well above the 2% target), meeting this mandate is a challenge not least because the central bank has just increased its inflation forecast for 2024 to 3.2%, indicating that rates will need to stay higher for longer. At the same time, the ECB has revised down its growth outlook for 2024 to 1.0%, from 1.5% reflecting at least in part the impact of the cumulative 4.50% in hikes delivered over the last year or so.
Curve inversion makes hedging attractive
Looking ahead, while the forward market for interest rates suggests a possibility of another rate hike in 2023 (28% probability), the consensus view is that the ECB will reverse course in July 2024 with three rate cuts anticipated before the end of next year. Due to these forecast cuts, the interest rate curve is now inverted with 3 year fixed rates now ~0.50% below 3-month euribor.
However, fixing may not be the best approach
This inversion presents an immediate and tempting incentive for borrowers to switch from floating to fixed rates. Nevertheless, borrowers must be cautious, as the forward curve is a very poor predictor of future interest rate movements. Historical data shows that previous rate cutting cycles by the ECB occurred earlier and were more aggressive than what the forward curve is currently predicting. This suggests that fixing rates now may not be the most cost-effective decision in the long run.
To illustrate this risk, we examine past rate cutting cycles of the ECB in the chart above. There have been three such cycles since the establishment of the ECB in 1998. In all three instances, the ECB delivered its first rate cut earlier than predicted by the current forward curve. Moreover, in 2001 and 2008, the ECB implemented more aggressive rate cuts. The only time the extent of the cuts was similar to the current forward curve was in 2011. However, the peak Depo rate back in 2011 was only 0.75%, leaving less room for aggressive cuts, at least until negative interest rates were introduced in 2014.
It’s important to note that this analysis has limitations, such as a small sample size and the assumption that the current rate is in fact the terminal interest rate. Nevertheless, it is reasonable to anticipate that a future rate cutting cycle could be deeper than what is currently priced into fixed rates. While the initial discount from floating to fixed rates may be enticing, there is a material risk that fixing at this point could ultimately be more expensive over the long term.
A more nuanced approach to hedging is required at this stage of the rates cycle
As the focus shifts from the peak rate to the duration that rates will remain at this level, it should be evident that a more nuanced approach to hedging is necessary and a binary decision between fixing or floating rates for the term of a loan may be suboptimal during this stage of the interest rate cycle. Asset hold periods, banking covenants, risk tolerance, and other factors need to be considered before committing to any hedging strategies
Although future rates are uncertain, careful consideration of the potential risks and rewards will help guide informed decisions. History may not repeat itself exactly, but learning from past patterns can help avoid costly mistakes in hedging strategies. Contact the team at hedging@vucatreasury.com to find out more about how we are currently working with clients to deliver hedging strategies that are appropriate for this stage of the rates cycle
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