Interest Rates to Rise?
Record rise inflation increases pressure on ECB to raise rates
Inflation hits 7.5% in March
Annual inflation in the Eurozone surged to 7.5% in March. Up from 5.9% in February, this is the 5th straight month in a row where Eurozone inflation has hit a record high. Yet, despite facing the biggest inflationary shock since the introduction of the euro almost 25 years ago, the European Central Bank (ECB) has kept official interest rates at record lows.
The ECB’s sole mandate is to maintain price stability at 2% over the medium term and it’s becoming increasingly difficult to square how having official interest rates half a percent below zero is consistent with this mandate. After persistently underestimated inflation over the past year, pressure is now building on the ECB to raise interest rates and prevent price rises from becoming entrenched.
3-year term rates rose by 0.54%- a record monthly move
Financial markets don’t believe that the ECB can hold out. The interest rate forward curve is a snapshot at a point in time of the future path the market expects Euribor to follow. A fixed rate is the average expected rate for Euribor over this term. The record rise of 0.54% in 3-year fixed rates last month demonstrates that the market has shifted suddenly to price in a much higher path for Euribor over the next 3 years. At the start of March, the expected high for Euribor over the next 3 years was only 0.5%. The market now expects this high to be 1.25% in Q1, 2024.
Can Interest Rates go higher
The key questions now are whether the correction in rates needs to be more aggressive than currently expected and whether a terminal rate of 1.25% is sufficient to take inflation back to the ECB’s medium-term target of 2%. Market based measures for inflation aren’t convinced. Medium term inflation projections are still around 2.4%- suggesting that the market believes that the actual path taken by Euribor will need to be even higher than currently projected to take inflation back down towards 2%.
Policy responses in the UK and US also suggest that the actual path for Euribor could be a lot higher. Even though inflation in the UK is lower than in the Eurozone, the Bank of England has already raised the Base Rate from 0.10% to 0.75% in recent months and the market further expects that UK interest rates will get to around 2% by the end of this year. An even more aggressive tightening path for US rates has been priced in over the rest of 2022. While the overnight US interest rate is only at 0.33% now, the market expects that the US Federal Reserve will hit 2.33% by the end of the year with a high probability that a rate increase of 0.50% will be delivered at the next meeting and potentially at the subsequent two meetings also, a lot more aggressive move than the standard 0.25% move we typically see from central banks.
The ECB house view is that inflation is largely due to short term shocks
Both the ECB President and Chief Economist (correctly) highlight that the dominant driver of inflation has been an energy shock, intensified by the war in Ukraine. And energy costs did rise 44.7% in March over a year earlier. However, core inflation that excludes volatile components like energy and food still rose to 3%, a full percentage point above the ECB target demonstrating that inflationary pressures are broad-based. Pressure from their colleagues within the rate-setting governing council at the ECB is mounting. Last week, the president of the German Bundesbank, said the inflation figures ‘speak for themselves’ and has called for interest rate increases as have other rate-setters on the governing council.
Hedging rates risk is now front and centre
For a large body of rate-setters, borrowers and lenders, interest rate risk management has been irrelevant for many years. However, at a time, where the risk of material forecast error for both revenues and costs is elevated, hedging interest rate risk is a relatively simple way to gain an element of control over a significant cost line. With inflation still yet to peak, and term rates rising rapidly, control of financial risks is increasingly important. 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 firstname.lastname@example.org or contact Martin Mulligan below: