Inflation worries, the possibility of Eurozone sovereign defaults and a general move away from risky assets suggests continued rises in euro interest rates.
Since the start of the year the price investors are willing to pay for what are perceived to be risk assets in financial markets has decreased significantly while the desire for safe havens has increased. This is not simply a comment on the yields on Greek and Portuguese bonds, which are clearly driven by particular circumstances. Other examples are the gold price and the EUR/USD exchange rate. And three-month EURIBOR has risen sharply from early 2011 from around 1.0% to 1.43% where it stands now.
The rate has risen on the back of a number of factors. At the end of 2010 and the start of 2011, inflation started to rise in the euro area in the wake of developments in the emerging markets. Soon afterwards the ECB began signalling that it contemplated a series of rate hikes this year. As time went by it became increasingly clear that the central bank was not only talking the talk but that it was serious and ready to walk the walk as well.
Growth drives rates
In response, three-month EURIBOR rallied. The rise was also fuelled by the fact that simultaneously the European economy was seen to be doing very well. Economic growth picked up, particularly in strong Eurozone countries such as Germany. German economic growth has not been as high and unemployment as low since reunification back in 1991. In addition, the French and the Dutch economies have recorded sizeable growth since the beginning of this year. Those three countries together form a large part of the Eurozone economy. This high-speed growth in the northern part of the euro area boosted the demand for capital in those countries, another factor that pushed up the rate.
We at ECR Research think the rally in the three-month EURIBOR is far from over. In the coming months we anticipate a persistent climb that could take the rate to 1.75% or slightly higher levels by the New Year.
This may seem at odds to anyone familiar with our research, as we also expect world economic growth to slow in the months ahead and hence the euro area GDP engines to shift into a lower gear. It may also seem contrary to the usual pattern for three-month EURIBOR in that it falls as the economy cools (or appears to be cooling). In our view, the coming slow-down could indeed temporarily depress the rate to some degree but we do not think this will last long or that the rate will fall far.
The reason we do not foresee any significant drop of the three-month EURIBOR and see the rate even surging further up, despite the slower growth in the coming months, is because we expect another force to come to the fore, a force that will push up the three-month EURIBOR strongly.
In all likelihood sluggish growth in Europe will cause new problems for the struggling European Monetary Union (EMU) countries and lead to mounting tensions in the euro area as a whole (we already see clear signs of that, what with the increasingly tough and undiplomatically harsh exchanges between on the one side ministers and other officials from the strong Eurozone nations and on the other side the same figures from the countries that are kept afloat thanks to emergency lending from other European countries).
These tensions and new economic and financial problems in the weak euro area countries could create heavy weather for the European banks as they still have large amounts of what is now junk (for example, bonds of the Greek state and other weak euro area countries). In turn, this will make it harder for banks to assess which banks are still healthy and which have been mortally hit by these new troubles. This is crucial to the interbank money market as it affects whether or not the ‘stricken’ banks are still able to pay off their loans. Growing distrust on the interbank market that we foresee, will likely push up risk premiums (in this case, the rates that banks charge each other for short-dated loans) as banks opt for safe havens.
Why not higher?
One logical question at this time could be ‘why should three-month EURIBOR stop at 1.75% or slightly higher and not move ahead to much higher levels?’. After all, the last time banks ran aground it rose above 5%.
We feel those levels were reached in extraordinary circumstances and in completely different surroundings than we are now in. For starters, back then banks did not have the backstop facility the ECB has been providing for some time now. The ECB is honouring all requests for lending from banks, so liquidity is much less an issue as back then (but obviously an issue to a certain degree). Second, the first time around, the crisis came largely out of the blue, which is what caused widespread panic and the overwhelming rush to safe havens.
This time around, the ECB is acting very publicly as the lender of last resort and the possible new problems in the banking sector are something almost everyone is aware off, meaning the panic will not reach the levels that have been reached at the beginning of the financial crisis.
As our research reveals a strong positive correlation between three-month EURIBOR and the EUR swap spread (the gap between the ten-year swap rate and the yield on ten-year German government bonds), we by extension expect the EUR swap spread to widen significantly over the coming months and quarters.