1. ECB Raises Rates by 75 basis points and Why You Shouldn't Care
- The ECB raised rates by 75 basis points despite fears soaring energy prices will push the eurozone into recession.
- Surprisingly, eurozone economic data has remained resilient so far with growth rising by an unexpectedly strong 0.8% in the second quarter.
The European Central Bank (ECB) has lagged behind most major central banks in its response to high inflation with a 50 basis point hike, the first such move for more than a decade.
The latest rate rise to tackle record inflation was 75 basis points despite fears soaring energy prices will push the eurozone into recession a decision backed by all 25 members of the governing council and matches the ECB’s previous biggest increase in borrowing costs.
The ECB’s benchmark deposit rate has now lifted from zero to 0.75% the highest level since 2011.
According to the ECB’s president Christine Lagarde, there would be “several” rate rises in the coming months to bring inflation down from its latest “far too high” record of 9.1% back towards the bank’s target of 2 per cent.
The interest rate rise comes despite mounting fears that the currency area’s economy will shrink in the coming months because of surging energy prices with Russia’s throttling of critical European gas supplies hammering businesses and households throughout the region.
Surprisingly, eurozone economic data has remained resilient so far with growth rising by an unexpectedly strong 0.8% in the second quarter.
In July, the unemployment rate hit a record low of 6.6%, bolstering calls by hawkish ECB policymakers for more “forceful” action on rates.
But the real revelation wasn’t the rate hike, nor the ECB’s determination to fight inflation, instead it was the nod to excess liquidity in the European banking sector that is here to stay.
Between 2020-2021, European banks borrowed more than 2 trillion euros from the ECB via TLTRO operations under borrowing conditions extremely advantageous with interest rates as low as -1% for the period.
There are around 2 more years to go before these TLTRO loans mature but banks could in principle opt to repay early, reducing the ECB balance sheet, but the ECB just gave the banks the perfect incentive not to repay these loans.
Low funding costs were locked in between 2020 and 2021 at -1% for basically all banks, and going forward they will be equivalent to the average ECB depo rate between June 2020 and June 2022 and the maturity of the TLTRO loan.
Looking at market-implied forwards, that means roughly 0.25% to 0.50% borrowing costs ahead from the bank’s perspective.
On the investment side, banks will be making good money if they merely park the excess reserves they borrowed back at the ECB, according to the same market-implied forwards they will be making on average 1.25% to 1.50% because of the recent rate hikes.
With such warped incentives, it’s very likely European banks won’t be repaying these TLTRO loans and importantly, no mention of quantitative tightening was discussed at all by the ECB.
This means the ECB balance sheet won’t shrink, and euro excess liquidity won’t be coming down anytime soon.
And because European governments are making guarantees to shore up the private sector and households during the energy crisis, governments will be absorbing losses through their balance sheets, which means printing more euros via deficits.
While more real-economy euros being created and persistently high financial-economy euro balances could be net positive for the private sector through less defaults and a smaller decline in earnings, the euro is poised to act as a long-term release valve and the currency could be in for an emerging-market style shock.