The European Central Bank (ECB) increased interest rates to 4%, which I believe was a policy mistake.
European Central Bank President Christine Lagarde continues to exacerbate the situation as the European economy is already experiencing the tightening measures much more severely and quickly than the United States. But why?
European 10-Year BBB Corporate Borrowing Costs
This is a result of both the ECB’s tightening measures and the fact that the European private sector enjoyed remarkably low borrowing rates for an extended period. As a result, the change in policies is felt much more strongly.
Take a look at the chart below, which illustrates the European BBB 10-year corporate borrowing costs from 2013 to the present:
– Average from 2013 to 2023: 1.69% (blue line)
– Average from 2016 to 2019: 1.35% (green line)
– Current rate: 4.20% (!!!)
Between 2013 and now, European BBB-rated companies were able to borrow for 10 years at an average cost of 1.69%. This is represented by the blue line on the chart. During the pre-pandemic period of 2016 to 2019, the average borrowing cost was only 1.35% (green line).
However, the current situation is much more challenging, as borrowing costs have nearly tripled (!!!) to 4.20%, and more importantly, they have remained at this level for almost a year.
This significant tightening of borrowing conditions is having a significant negative impact on the European economy.
Despite these adverse conditions, the ECB continues to raise interest rates and overlooks another macroeconomic risk that poses a more serious threat to Europe than the United States: refinancing cliffs!
The chart above illustrates the percentage of corporate loans and bonds maturing each year in different jurisdictions.
Since corporates spread out their borrowing over time, refinancing needs are not concentrated in one period. On average, companies need to refinance about 10-15% of their entire borrowing needs each year (represented by the red line).
As shown in the chart, Europe (blue) faces a daunting task next year. European companies will need to refinance 25% (!) of their borrowing needs in 2024, and they will have to do so at much higher borrowing rates than they are accustomed to.
As the refinancing cliffs approach rapidly in Europe, companies are forced to make difficult decisions: either reduce leverage and shrink their businesses, or cut structural costs (such as jobs) in order to maintain a viable business despite the higher borrowing rates.
The ECB’s decision to raise interest rates in the midst of an already weak economy facing significant refinancing cliffs leads me to believe that Lagarde has made a policy mistake.
Japan’s Impact on Global Bond Markets
In a recent interview, Bank of Japan Governor Haruhiko Kuroda indicated that the era of negative interest rates in Japan may soon come to an end.
As a result, there have been movements in currencies and bond markets.
But why does Japan hold such importance for global bond markets?
Japanese investors are among the largest capital exporters in the world and have become significant buyers of US Treasuries, European fixed income, and other foreign bond markets.
Due to prolonged low domestic yields and Japan’s accumulation of savings and foreign reserves, Japanese investors have sought opportunities to invest abroad to generate higher returns.
For reference, Japanese investors alone own over $1 trillion in US Treasuries and approximately EUR 400 billion in various European bonds, mainly French and German bonds.
Now that domestic yields in Japan may rise, will they stop investing in foreign bonds?
Here’s the thing: they have already started doing so.
The Japanese support for global bond markets has been dwindling for several quarters now.
But if Japanese bond yields have only recently started to rise, why did this trend emerge several quarters ago?
You see, when Japanese investors buy foreign bonds, they must swap their existing currency for the currency in which the bonds are denominated.
This means they are exposed to foreign exchange (FX) risk, which they often want to avoid. From my previous experience speaking with Japanese investors, they typically hedge the FX risk for a period of 3 to 12 months. This is considered a sufficiently long period to assess the risk/return of their bond investment after hedging the FX risk.
The chart above shows what Japanese investors see when considering investing in US Treasuries after taking into account the costs of hedging USD/JPY for the next 12 months.
For Japanese investors, owning US Treasuries is currently extremely expensive due to the high costs of hedging the FX risk. Additionally, yield curves are inverted, which significantly reduces the yield benefit of investing in foreign 10-year bonds.
US Treasuries are the most expensive they have been for Japanese investors in decades, and this has been the case for several quarters now.
The next action taken by the Bank of Japan will be crucial in determining whether this trend continues.
Is Fed Chair Powell Done Raising Interest Rates?
US inflation unexpectedly accelerated in August. What does this mean for the Federal Reserve (Fed)?
The Fed breaks down core CPI (Consumer Price Index) into the following components:
1. Goods inflation
2. Housing inflation
3. Services inflation excluding housing
Disinflationary pressures are particularly evident in goods, with factors such as inventory overhang (e.g., in the car industry) and supply chain disruptions indicating a continued moderation in core goods prices.
This is mirrored in indices such as the Adobe Price Index, which measures online digital goods prices and has reached a 40-month low.
Housing inflation represents a significant portion of the core CPI basket, and the Fed received positive news in this regard.
The rate of rent growth continues to decelerate, as evidenced by the Zillow rent growth series, and housing inflation captured in the CPI statistics is following suit.
This deceleration is great news for the Fed, as the 3-month annualized housing inflation rate has dropped to 4.6% from a peak of nearly 10% at the beginning of the year.
Going forward, housing inflation is expected to continue slowing down, which is positive for Fed Chair Jerome Powell!
What about Powell’s preferred measure of sticky inflation, which excludes housing?
This component is supposed to be the stickiest part of the CPI basket, with a close correlation to output gap and labor market slack. Powell pays particular attention to this measure.
The monthly change in sticky inflation was 0.4%, which was stronger than expected. However, by looking at the chart above, we can see that the 6-month annualized rate of change reached a new low in this cycle, dropping to 2.7% from over 5% at the start of the year.
Sticky inflation appears to be coming under control as well.
All in all, it seems that the Fed has finished raising interest rates. However, the markets are beginning to question this assumption, with factors such as higher oil prices, pressure building in bond markets, and a solid monthly print in core services inflation excluding housing raising uncertainties.
Could this be the calm before the macroeconomic storm?
This article was originally published in The Macro Compass. Join the vibrant community of macro investors, asset allocators, and hedge funds – check out which subscription tier suits you best using this link.