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All is not well in the euro area

Another EU crisis summit has come and gone and the dire straits in which the euro area is stranded, have not been alleviated. With that in mind, what is the outlook for (long-term) interest rates in the euro area and the role of the European Central Bank?

At the beginning of December the world witnessed another EU summit, promising a comprehensive package to solve the euro crisis and save the common European currency. In the end, the only thing that was new coming from this summit, was a name: ‘comprehensive package’ has been replaced by something called a ‘fiscal compact’.

Financial markets have reacted in a lukewarm way – at the very best – to the fiscal compact. In essence, there was scarcely anything new in it. For the most part, earlier agreements were confirmed and plans were made to strictly enforce compliance with the fiscal rules. Unfortunately, Europe’s track record is abominable when it comes to compelling member states to comply with its ‘house rules’; not helped by the fact that this had been and will remain a political matter (sanctions are not automatically enforced and it is possible to stop them).

With details still to be worked out, including judicial ones like whether the agreement can be ratified by national parliaments only; whether in some countries a referendum is needed; and whether the institutions of the European Union are allowed to implement an agreement between 26 member states (ie an agreement that is not made by all EU member states), uncertainty about the near future has, if anything, increased. Moreover, the likelihood of ratings downgrades of all euro area member states, thus including the six AAA rated members, has increased. All in all, ECR Research expects the euro crisis to escalate in 2012.

Sticking together

With the fact that no euro area country is willing to pull the plug on the common currency, in practical terms this means that the relatively strong countries will have to put more money on the table to keep the euro area together.

Furthermore and despite the recent comments from the new President Mario Draghi, we expect that the European Central Bank (ECB) will have no other choice but to engage in wider scale buying of bonds of distressed euro area members. Moreover, the central bank will lower its key interest rate further, after cutting it in November and December by a total of 0.5 percentage points. The ECB key interest rate now stands at 1%, much higher than comparable rates of the Bank of England (0.5%) and the Fed (between 0 and 0.25%).

We expect the ECB to further cut its key interest rate because of the worsening economic outlook. At the very best, the euro area will record a very low rate of economic growth in 2012 with high chances of a recession in almost all member states. This low economic growth could lead to fear of deflation materialising. Deflation does not square with the ECB’s goal of price stability, defined as annual rate of inflation below but close to 2%.

Chart 1: House rules on budget deficits and debts might continue to be violated as sanctions are not automatically enforced
Chart 1: House rules on budget deficits and debts might continue to be violated as sanctions are not automatically enforced

Source: Thomson Reuters Datastream/ECR

All of this will have profound effects on long-term interest rates in the euro area. Low growth, if not an outright recession due to austerity measures, will darken the already gloomy outlook for government finances. Not only for the ‘usual suspects’, ie Italy, Spain, Portugal and Greece, but also in France, Germany and other euro area nations. Chances are that economic growth will be (much) lower than the growth rate governments have used to calculate their budgets for 2012. This in turn will lead to lower than expected revenues and higher than expected expenditures, thereby pouring cold water on any hopes of much lower budget deficits.

The deteriorating outlook with regard to public finances, against a backdrop of the escalating euro crisis and no signs of higher economic growth down the line, means that chances of a euro area wide rating cut will increase further. As a result the emergency facility may end up with a lower credit score as well, which will limit its scope of action even further.

Risks aplenty

This combination of increasing financial obligation of the relatively strong euro area member states for the preservation of the common currency and likely rating cuts in the entire euro area as a result, will carry more weight than any fear of deflation and hence will push long-term interest rates sharply upwards during 2012.

Chart 2: Economic activity indicators point to a severe downturn, making deflation and ECB loosening a distinct possibility
Chart 2: Economic activity indicators point to a severe downturn, making deflation and ECB loosening a distinct possibility

Source: Thomson Reuters Datastream/ECR

There are three additional reasons why long-term interest rates will find themselves under strong upward pressure. The first is that European banks are forced to increase their capital base. One way they are trying to do that is selling government bonds of the weak euro area member states.

The second factor at play is that investors who hold government debt of euro area nations have to consider the possibility that the euro area might disintegrate or at the very least that one or two countries could be forced to leave the monetary union in the years ahead. This introduces an exchange rate risk. For instance, if Greece were to leave the currency union, it is likely that the Greek national debt would be converted to the new currency. In any case there would be much uncertainty on this matter.

The third, often overlooked, factor that is important with regard to public finances in the coming years, is ageing. As the so-called baby-boom generation retires, a process that has started already in the euro area, it will put much pressure on public finances. Both the medical care and the retirement payments bill will increase. Almost all euro area member states fund their pension systems on a so-called ‘pay-as-you-go’ basis, meaning pensions are financed by current revenues. Most likely this will translate into even higher budget deficits, austerity measures and lower growth.

Finally, a fourth effect that might enter the equation in the medium to long term is that a more accommodative monetary policy by the ECB could lead to fears of higher inflation down the road.

As a side note, in recent months we feel another problem has started to emerge, a problem that in a few years time could present an even bigger challenge for the survival of the euro area and the future of the European Union as a whole even if the euro crisis were to be solved instantly.

Chart 3: Ageing society will weigh ever more heavily on health care costs, reducing growth, making default more likely
Chart 3: Ageing society will weigh ever more heavily on health care costs, reducing growth, making default more likely

Source: Thomson Reuters Datastream/ECR

ECR Research calls this the potential accountability problem. Since the beginning of the crisis, measures that have been taken to tackle the troubles have led to the formation of new institutions, arrangements and changes in the way Europe works. For example, there is now a permanent European Stability Mechanism, the role of the ECB goes much further than the Treaty on the European Union allows, the European Commission is set to get new powers especially in the area of fiscal policy, and in a number of fields more sovereignty has been handed to the European Union. All these changes have one thing in common: they have been or are being implemented without asking the people of Europe for their support.

In the years to come, this will have to happen, either directly via referendums in various countries or indirectly, at the regular elections. Already we are seeing the surge of various populist parties and movements across the euro area.

Keep alert

In short, there is not much reason for optimism in the short and medium term with regard to the euro crisis being solved.

Having said that, an occasional gentle, warm southern wind of optimism could breeze through the euro area, pushing long-term interest rates temporarily lower. When long-term interest rates decline or rise in the euro area, the degree of rise and fall will differ greatly between countries. As much as the aforementioned factors will affect short-term and long-term interest rates in the euro area, they will also influence the exchange rate of the euro vis-à-vis the US dollar and other currencies. But other forces, such as developments in the US, play a role as well in that area.

That is why it is important to remain on top of the latest events.

For more information on the political situation in Europe,read ECR Research’s Global Political Reports at

Weekly analysis of the outlook for European interest rates (including three month EURIBOR) and EUR swap spread, the exchange rate of the euro and by default implications for Swiss franc and the British pound, can be found at

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