A tour of Europe — an update on interest rates

There have been many common features across the European and UK markets in recent months – an increase in bond yields creating an unintended tightening of financial conditions, upward revisions to GDP projections, and emerging concerns about inflationary forces.

Despite these similarities, there remain large differences in each domestic market with respect to the direction of, and the forward curves for, interest rates, thereby influencing the hedging decisions for those with borrowings in these currencies.

We will provide a brief update on the EUR, SEK, and GBP interest rate conditions, putting the recent year-to-date movements into the context of the last 12 months.

GBP

The first chart above shows the increase in market swap rates (5-year) in the UK since the beginning of 2021 compared to the floating variable reference rate (3-month LIBOR). In this short timeframe, these interest rate rises look material; and even in the context of the last 18 months, the extent and speed of the increase is significant.

We wrote earlier in the year about the increase in rates, and a broader economic comment on inflationary concerns. Growth forecasts for the UK continue to be revised upwards with some 2021 estimates getting close to 8%. Together, these have provided the tailwind for the market to start to price in higher interest rates. The Bank of England meets this week, and while there is zero expectation of a change to base rate, the markets will pay close attention to signals on whether the MPC will begin tapering the bond buying programme. We know the BoE have also upped their growth forecasts, and that their measure of anticipated Bank Rate (OIS forward curve) has risen sharply since their last meeting. Any signal that tapering is coming will further steepen the yield curve, dragging swap rates up with them.

EURO

The markets have become used to negative rates in the Eurozone, so much so that little attention is paid to short-term movements. It was way back in June 2014 when the ECB became the first major central bank to take one of its key interest rates into negative territory – in what was communicated, at the time, as an emergency measure.

The Eurozone economy is expected to grow at 4.2% this year. While substantially below UK forecasts, the upward revisions to growth have fed through to the interest rate market. The increase in market rates (5-year swap rate) is shown above as well as the divergence between floating 3-month EURIBOR and the 5-year fixed rate. It is the widest it has been in the last 15 months.

In response to rising bond yields, the ECB announced that it expects to ramp up its bond buying for the rest of 2021. While denying this was yield curve control, the ECB re-emphasised their policy of maintaining economically favourable financing conditions and effectively disregarding any temporary jumps in inflation or nominal interest rates. There is zero expectation of an altered stance from the ECB, and any change is more likely to be further loosening rather than a tightening of monetary policy.

SEK

The Swedish central bank (Riksbank) made their move away from negative interest rates back in December 2019, taking the main policy rate from -0.25% to 0% after a few years of decent economic conditions and inflation reaching its target. It is now evident that this was a one-off move, and there are no indications that monetary policy will be anything other than expansionary for the foreseeable future. Growth in 2021 is estimated to be 3.6%, but there remains pessimism on the labour market. Banking economists are adopting a slightly more bullish outlook than Riksbank but agree that the repo rate will remain unchanged at 0%. Riksbank are focused on inflation, and it is not expected to reach a level which will convince them to ease off on very easy monetary policy.

Of the core European markets, it seems most likely that the UK will diverge and tighten monetary policy first, through bond buying tapering initially, before any hike in interest rates. But the swap market will still move on the former; look out for higher hedging costs even when central bank rates remain low.

The negative interest rate environment in Eurozone looks set to be here for a while longer – and might even reach its tenth birthday. Fixed rates in the market have moved up and the ECB might need to provide more guidance on the volumes of their bond purchases to prevent an inadvertent tightening of monetary conditions.

While the Swedish interest rate market looked to be following the Eurozone in the later stages of the great financial crisis, a move away from a negative rate policy highlighted the differences. Inflation is the key metric for Sweden’s central bank, and they are concerned about choking off recovery if they tighten too early. They seem most likely to stick with the status quo for now.