The ECB has set course: we must stop inflation as it is. Consequently, last week it decided to raise the three official ECB interest rates at 50 basis points and approved the Instrument for the Protection of Transmission to support countries that suffer higher differentials in borrowing costs.
This movement is the first rise in interest rates in 11 years. and represents the final step to reverse unconventional policy applied to combat a series of crises.
The ECB has turned and wants to follow in the footsteps of the FED. A movement that was already taking shape in December, when it was said that the bond purchase program should be stopped during the pandemic, which helped the Eurozone to face the economic consequences of the COVID-19 crisis.
Also, last month stopped another bond purchase program dating from 2015when the Eurozone faced the risk of deflation.
Market reaction after rate hike
With this movement of the ECB, a timid rise was seen in the stock markets. For example, the European stock market represented by the Stoxx 600 ended the session with a timid rise of 0.44% on Thursday and 0.31% on Friday. However, if we take perspective, the European selective has lost 13.12% since the year began.
The winner of this immediate decision should be the bank because when interest rates rise, the return on bank assets increases.
But this is the theory… Let’s go to the facts.
European bank selective Stoxx 600 Banks rose 0.23% on Thursday, meaning that did not lead the rise after the monetary policy decision and fell 1.23% on Friday. So far this year, it has lost 15.37% and is close to the minimum recorded after the start of the war between Russia and Ukraine.
This is possible because the increase in margins by the rise in interest rates is overshadowed by the discount of cash flows of a possible recession that would damage the accounts of the entities.
In fact, the ECB is already informing the banking system that it must take into account a possible recession in its business plans and will use this new calculation to approve proposals for payment of dividends. A rate hike can trigger an increase in delinquency, a risk to be taken into account by clients with high leverage.
Y How are utilities evolving? In principle, these companies are the great beneficiaries of price increases, which allows them, in a marginal system, to sell hydroelectric, solar, wind or nuclear power at gas prices. We can also consider the same on the part of the refineries owned by the energy companies.
Interest rates, for now, have had no impact on the European utilities sector, fell 1.28% on Thursday but rose 1.43% on Friday, leading the rise in the last session. And it is one of the sectors that fell the least this year, 10.36%.
The same happens with the European energy sector (oil and gas) the great beneficiary of the inflationary stage.
It suffered after the rise in rates with a fall of 1.87% but in Friday’s session it recovered part of what was transferred with a rise of 1.24%. Also, continues to be the leading sector par excellence this year, adding an advance of 10.88%.
At the same time, it is interesting to analyze the impact of the rise in interest rates on the European debt market and whether the announcement of the Transmission Protection Instrument is giving its results in the spreads shown in the risk premiums.
The truth is that, for now, there has not been a severe impact on the debt market. Risk premiums have not moved since the ECB announced, although it is true that we have previously seen significant increases.
The bond that investors have their eyes on is the ten-year Italian bond, since it is trading at 238 basis points, even above the Greek (223 basis points). And it is that the economic structural problems mentioned on previous occasions (debt, competitiveness, growth) are joined by political instability with the resignation of Mario Draghi as Prime Minister.
What does the ECB gain by raising interest rates?
The ECB has decided to make a move against inflation. That is, stop hiding and face the great economic problem that currently exists in the Eurozone. And it is that the escalation of prices has continued in its peak, if in the month of May the annual inflation of the Eurozone was 8.1%, at the close of June it has risen to 8.6%.
In the first instance, combating inflation generates a message of confidence to economic agentssince the high rates of inflation have sunk real returns on investments and send a message of certainty in the environment.
On the other hand, central banks do not usually talk about the currency since it is not officially among their objectives, but rather they focus on economic growth, job creation and price level control. The ECB’s priority objective is price stability in the medium term close to 2%.
But on this occasion, the ECB has mentioned that this decision is also given for support the euro which had recently reached parity with the dollar.
In the words of the President of the ECB, Christine Lagarde, she underlined the stability of the European currency: “The euro unites 340 million people. It has been, and will continue to be, a stable coin. To that we commit. It’s our job, and we’ll do it.”
A much-needed stability at a time when your devaluation is a catalyst for a higher dose of inflation. This is due to the fact that products in dollars, such as oil, become more expensive to acquire in the event of the devaluation of the euro.
And it is that if the Federal Reserve takes the course of combating inflation with rate hikes, capital will buy dollars and sell euros -devaluing the single currency-. In this way, they position themselves in the risk-free asset that is the ten-year US bond, due to its higher remuneration. Raising interest rates stops this process and moves the euro away from the parity seen days ago.
One thing to keep in mind about what the problem of prices and a low euro means is that an exporting power, Germany fell into a trade deficit for the first time since 1991 in May when imports exceeded sales abroad.
Risks to be aware of
It is a complex decision because, yes, the main economic problem that this inflation is combating, but other far-reaching problems may arise in a medium-term time horizon.
The first problem that we can find on the table is to revive a euro crisis linked to sovereign debt. The widening differentials between the interest paid on bonds between countries that are considered safe and those that are considered risky not only create economic problems, they also create political and social problems as it already happened in 2011.
But this time we came to the notice with a significantly higher debt relative to GDP. At the end of the fourth quarter of 2022, the ratio between public debt and GDP in the Eurozone stood at 95.6%. And many countries have crossed the threshold of a public debt of 100% of GDP after the COVID-19 crisis: Greece (193.3%), Italy (150.8%), Portugal (127.4%), Spain (118.4%), France (112.9%), Belgium (108.2%) and Cyprus (103.6%).
Recession is another of the most obvious risks and seems to be one of the most feasible because the objective of the rise in interest rates is none other than to hit the demand that has triggered raw materials that recovered very quickly after the covid crisis while the offer was delayed.
In the United States, an increase in prices of more than 5% has been the prelude to a recession. It happened in the early 1970s, 1980s and 1990s when oil skyrocketed.
To this, let’s add a scenario of a possible cut in the gas supply that leads to restrictions on its use. The recent drop in Russian gas flows to Europe has raised concerns that Russia is poised to use gas exports as a political tool, with Germany recently activating phase two of its national gas emergency plan.
The rationing would affect the production of industries that use gas as a key input, with a knock-on effect on companies throughout the supply chain. Russian imports have accounted for about 30% of the eurozone and 60% of German gas consumption in recent years
It is estimated that in the most complex scenario and taking into account the impact on the supply chain, GDP could be reduced by 3% in the EU and 3.5% in Germany in 2023.