Hi guys, glad to be back.
In this piece we uncover:
The ECB meeting & Interest Rate Hike
Why the ECB is cautious about raising rates at an accelerated pace
As always, lend me your attention from here on out!
The ECB Hike & Potential Pivot?
For the longest amount of time the Eurozone had been notorious for having their interest rates in negative territory; that was until inflation came in the picture.
Ok, so let me break down firstly why a central bank would implement NIRP (Negative Interest Rate Policy) as well as the cause and affect relationship this has on markets.
Negative Interest Rate:
For the past decade, the Euro Area has utilised a NIRP; the main driving factor behind any central bank doing so is to provide monetary accommodation through the easing of financial conditions. What does that mean? Here’s the answer laid out.
Loose financial conditions tend to boost credit demand for investments also portfolio rebalancing towards riskier assets and also consumption (i.e buying a house, a new car, or other discretionary goods). Low/negative interest rates also provide some fiscal space for governments to move budgets/payments around, therefore having a direct impact and increasing demand along with inflation. If you’re scratching your head trying to understand how lower interest rates affect/helps public sector finances aka the government’s budget here’s an explanation. Lower short-term and long-term interest rates make it cheaper for Governments to roll over their existing debt and issue new debt; interesting isn’t it? So when rates are low managing public sector finances is smoother with less friction; in contrary when rates are rising/high it becomes increasingly difficult for governments to roll over and issue new debt, which is exactly why we had a sell-off/run in the Uk markets particularly the pound and gilts. Investors put two and two together; rising rates in the Uk + further government spending (expansion of government debt) = unsustainable interest payments, risk of something breaking within the financial model of the Uk.
That’s how negative rates in ‘theory’ should work, of course, this is financial markets we are talking about, meaning nothing works in theory. Cases such as the Japanese economy represents the effect of an economy that has utilised both NIRP and YCC (Yield Curve Control) but failed to stimulate growth & inflation. But back to the point.
The ECB was forced to move out of negative rate territory earlier this year as inflation surpassed all expectations, currently sitting at 10%. We first saw a hawkish committee that convinced markets they were in line with their mandate to return inflation to 2%, but as of yesterday, we saw what could be the beginning of the end when it comes to aggressive tightening with the ECB.
We can see from this distribution of CPI within the Eurozone the biggest drivers have been energy (+40%) and food (+10%), both driven by commodity shortages as well as ongoing feuds with Russia to supply gas.
ECB Pivot & Euro Rates
“We will base the future policy rate path on the evolving outlook for inflation and the economy, following our meeting-by-meeting approach.”
— ECB President Lagarde, 27th Oct
The only way one can judge whether we’re about to experience/see a pivot in central bank action can only come from the language of those who are in control. This statement above should send your thoughts back to Jay Powell’s press conferences where he removed forward guidance reverting to a “meeting by meeting” approach.
This speech delivered a message lacking clarity on:
The specifics of when we will see further rate hikes
The size of future rate hikes
But, instead sent the message that the ECB is already making “substantial progress” with their tightening of monetary policy.
If you’re now asking; why would the ECB want to pivot? Here’s my view
Fragmentation Risk
I touched upon this in a previous article, but for emphasis on the current Euro Area, I’ll detail exactly what risk lies ahead, starting off with what fragmentation risk is.
Within the Eurozone, fragmentation risk is the widening of sovereign spreads in some countries within the EU as the monetary policy system leads to interest rates higher. The risk here is that as rates across the Eurozone increase, so do the refinancing costs involved with each and every country, even the vulnerable ones like Italy particularly. To factor for this risk investors require a ‘risk premia’ and as this process happens the spreads on such vulnerable countries widen to a point where the goal of progressing monetary policy across the grouped economies within the Eurozone becomes delayed due to uncertainty surrounding the weaker economy’s ability to maintain financial stability.
As the spread between German & Italian debt deepens the risk of a screw coming loose in the Eurozone economy magnifies exponentially; politically speaking the new Italian Prime Minister Georgia Meloni openly criticised the ECB’s decision in regard to monetary policy saying:
The decision to raise borrowing costs “is considered by many to be a rash choice, which runs the risk of impacting banking credit to families and businesses,”
— Italian Prime Minister, Georgia Meloni
Apart from fragmentation risk; the euro exchange rate has felt the short end of the stick this year already hitting parity. Figure 4 shows the spread (difference) between the Federal Funds Effective Rate and the ECB Deposit Facility Rate (Left Hand Side) and the dollar to Euro exchange rate (RHS).
From the figure below, the trend is that as the spread between the Fed funds rate and ECB deposit rates widen, meaning the Federal Reserve is hiking rates at a faster rate than the ECB, the dollar appreciates against the euro as shown in the highlighted regions. Vice versa, as the spread between the two economies tightens as shown in 2008, when the ECB maintained rates at 2.5% and the U.S dropped to just above 0%, the euro experiences an uplift against the dollar.
That’s the end of today’s piece, hopefully, you picked something up along this read!
It’s been a hectic week but glad to be back, I was also a guest on a good friend of mine’s podcast so be sure to check it out here if you want to know a bit more of my back story!
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Until next time
Joe