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A first step towards normalization

A first step towards normalization

11-11-2018 | Vision

The European Central Bank is ready to raise interest rates for the first time since Draghi took office. The question is whether it will happen before the end of his term.

  • Ruud van Suijdam
    Ruud
    van Suijdam
    Portfolio Manager

The only way is up

Source: Thomson Reuters Datastream, Robeco

Mario Draghi might go down in history as the only European Central Bank (ECB) president never to have raised interest rates. When he took office in November 2011, the lending rate stood at 1.5% and it gradually dropped to the current level of 0.0% during the course of his tenure. The ECB looks set to hike rates for the first time next year, but it will be a close call if it happens before Draghi steps down.

The ECB will, after all, be on automatic pilot until the fall of 2019: quantitative easing will end at the start of next year and interest rates will be kept at their current level at least until after the summer. As such, the ECB's meeting on 12 September 2019 could be the earliest opportunity to raise interest rates. After that, there will be one last chance for Draghi on 24 October, before his term ends a week later on 31 October.

Nonetheless, we think the ECB is likely to take a first modest step towards normalizing short-term interest rates in September, as the Eurozone economy continues to show strong growth. Over the last five years, unemployment showed an impressive drop from 12% to 8% and is continuing this downward trend. Additionally, more wage inflation is expected. This provides room to raise the abnormal and market-distorting negative deposit rate incrementally from minus 0.4% to 0.0% in December, with the lending rate moving back into positive territory.

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Deflationary shocks

A rise in Germany's capital market interest rates is also expected. At around 0.4%, it is unnaturally low, while the Eurozone's core inflation rate is about 1.0%. The low rates are partly due to the ECB's bond-buying policy, which will be discontinued at the end of the year. 

German Bunds are, after all, one of a select group of investments still considered to be a safe haven. This stability is particularly welcome in Europe, where political turmoil still abounds. A scarce commodity is simply more expensive and in the case of bonds, this equates not only to high prices but also to low yields. Their safe-haven status offers investors asymmetric protection against deflationary shocks. 

A ‘hard’ Brexit could trigger a deflationary impulse. This risk will probably be a thing of the past after March 2019, when the UK officially leaves the European Union and a transition deal takes effect. For all intents and purposes, this deal will keep the UK in the internal market for years to come and have no economic effect compared to the current situation.

Collapse of the Eurozone

The collapse of the Eurozone would also have a strong deflationary effect on the region's economy. That risk is not entirely unrealistic and, over the last few years, it has continued to rear its ugly head, albeit in different forms. This time Italy is taking its turn in violating earlier budget agreements − risking getting stuck in a downward spiral of rising interest expenses, higher budget deficits, costly recapitalization of its shaky banking sector and a downgrading of its credit rating. The ECB can only assist the country once it starts to comply with EU agreements again. 

But at the same time, that would obviate the need for assistance, as it would send the risk premium on Italian government bonds plummeting again. Under pressure from the bond market, we expect the Italian government to cut its losses at some point. This will give German capital market interest rates room to rise because the risk of collapse will be judged to be much lower.

Due to its flawed structure, the Eurozone is more vulnerable to deflation and default than inflation, unlike the United States, for instance. ECB policy must always take this into account. 

The new Draghi

Deciding who replaces Draghi will be the outcome of a complex diplomatic chess game. A number of top European positions have to be filled (presidents of the European Commission, European Council and European Parliament), and the regional balance must be maintained. The importance of the individual should not be overestimated, either, as the ECB is the only key European body that decides by simple majority vote. 

Furthermore, Italy's high debt burden is a factor that for the years to come will significantly limit the leeway of Draghi's successor. In an effort to support the weakest link, in this case Italy, with its relatively modest growth, the interest rate policy will retain a certain asymmetry.

This article is part of our investment outlook 2019: ‘Turbulence ahead’.

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