Whatever it takes 2.0

Volker Schmidt, Senior Portfolio Manager, Ethenea 

The bond markets have already priced in most of the expected interest rate rises. The European Central Bank will have to raise interest rates considerably in the coming weeks and months if they don’t want to jeopardise their credibility.

Around ten years ago, on 26 July 2012, the then President of the ECB and now President of Italy Mario Draghi spoke the famous words “Whatever it takes” that were to turn the tide in the euro crisis. Since then, the phrase “whatever it takes” has become a mantra and refers to being prepared to do anything and everything required to contain a crisis and restore the trust of the people and of businesses.

Current inflation rates show that “whatever it takes” is now urgently needed once again: 7.9% inflation in Germany in June; for full year 2022 economists expect inflation to average 6.8% in the eurozone and, in 2023, subsiding, but still high, inflation due to base effects.

Of course, it is difficult to make predictions in the current economic environment. The combination of Ukraine crisis, coronavirus measures and supply chain issues make for a hard-to-predict mix of constantly changing variables and the desire not to straightaway snuff out the tentative economic recovery in the eurozone in the wake of the coronavirus crisis is very understandable. Nevertheless, key rates of -0.5% no longer wash with broad swathes of the population given current inflation figures and, at worst, will lead to substantial loss of trust and societal divides.

ECB should raise rates towards 2%

The turnaround in monetary policy has well and truly arrived. The U.S. Federal Reserve recently increased the Fed Funds Rate target range by 0.75% to between 1.50% and 1.75%. Despite growing recession concerns, the Bank of England (BoE) has raised the key rate for the fifth time in succession by 0.25% to 1.25%, and even the Swiss central bank in a surprise move raised interest rates by 0.5% despite inflation being a low single-digit figure. Only the European Central Bank seems to be paralysed and is sticking to its low interest rate policy. However, the ECB will have no option but to embark on a new course as the central bank across the water is too dominant for the ECB to go against its monetary policy, risk the euro losing value and, at worst, further fan the flames of inflation.

As is well known, stocks trade on the future, but that goes for bonds as well. 2-year sovereign bond yields have proved to be a useful gauge of where investors expect interest rates to go. A look back reveals that these have in the past been a reliable indicator of the European Central Bank’s deposit rate. At the same time, there has been a strong decoupling between sovereign bond yields and the key rate since March of this year (German bill 0.86%, ECB deposit rate -0.5%). So the market is anticipating at least five interest rate hikes of a good 1.25% in total. We even believe that this will not be enough and the European Central Bank will have to raise the key rate over the course of the coming year well above the 1.5% mark, towards 2%, to prevent the euro losing further value. We therefore see potential here for short-term yields to rise further (falling bond prices) and have positioned our portfolios accordingly by purchasing euro interest rate futures.

It is time for the ECB to call a halt to the monetary policy of the past ten years and start to take consistent and credible measures to curb inflation. The most important instruments in a central bank’s toolbox are, in fact, not bond purchases or key rates, but integrity and credibility. The ECB has lost a great deal of both in recent years but it is not too late to regain the trust of the citizens of Europe. That will take a consistent change of monetary policy, or “whatever it takes”.

Press contact