Tag Archive for: interest rates

Davos, interest rates and secular stagnation

| 08-02-2018 | Lionel Pavey |

 

Two weeks ago there was the annual meeting of more than 2,000 politicians, business people, economists etc. at the World Economic Forum. For 4 days the most pressing and urgent topics facing the world were discussed. Sifting through all the speeches and press statements, I saw a lot of articles relating to a rather old theme of secular stagnation.

What is it?

It is a theory dating back to the 1930s stating that developed countries can suffer from a period of too small investment and too large savings. This can be the result not only of an economic recession but, more importantly, as the result of changes in the underlying demographics within a country. This would in turn imply that growth would be low to negligible within the economy. As growth slows down, so demand for investment would also slow down, leading to more savings etc.

Normal theory would demand a reduction in interest rates (the cost of money) leading to an increase in long term investments by companies, a comparative feeling of wealth amongst the people and a kick start to the economy.

Since the crisis of 2008, we have experienced an extended period of low interest rates and low inflation. The expected increase in investment, leading to improved production processes and new goods does not appear to have materialised. Furthermore, the effect that the crisis has had on individual people – job losses, house repossessions, insecurity – has made them reticent to indulge in large bouts of consumer spending.

Even with negative interest rates there has been no rush to invest in productivity. Instead funds are invested in financial assets – shares, bonds etc. Whilst offering goods returns, such investments do not add to potential economic productivity and growth in the industries that provide it.

Furthermore, when consumers tighten their belts – restricting spending and increasing savings – they are not actually directly providing funds for investment. Banks operate as intermediaries and extend credit – individual investors do not in the present system.

The economy is growing – GDP forecasts are all up among the major developed countries and inflation appears to be restrained. So have we broken the long existing chain of recognised monetary theory – could we see a prolonged period of steady growth, backed by low interest rates and low inflation?

At this stage of the proceedings an added element was thrown into the debates – demographics.

Europe is experiencing a period of shifting demographics. The long term replacement fertility rate is 2.1 children per woman. There has been a steep decline of this rate within Europe, with the rate in Germany being as low as 1.4 children. At the same time people are living longer, which means they are retired for longer. In 2006 there were 4 active workers for every retiree – by 2050 this could be down to only 2. The median age in Europe is expected to rise from 37 to 52 by 2050. EU studies have forecast that by 2050 there will be a reduction of 48 million in the working age population and an increase of 58 million in the retirees.

At the same time other studies suggest there will be a 14% decrease in working population against a 7% decrease in total population. All these projections are based on the current situation and that the trend continues.

If this was to continue, then there would be significant challenges for Europe. The expectation of governments to be able to finance the existing outstanding debt by increases in national GDP will stall. Increased burdens will be placed on the state to provide the necessary facilities to an ageing population whilst the pool of available workers is shrinking, leading to lower productivity per capita. Within the last 10 years the distribution of wealth has been skewed – there is more inequality with the super rich having proportionally even more of the total wealth than before the crisis.

New technology has the ability to change the existing concept of productivity. However, if this could be more than enough to offset the expected developments caused by an ageing population is unclear. It could mean that we are entering a prolonged period of low interest rates, low inflation and low growth. If so, all the economic models – even within companies – will need to be reappraised and a new long term policy initiated.

Lionel Pavey

 

 

Lionel Pavey

Cash Management and Treasury Specialist

 

 

 

 

 

 

 

 

 

 

The strength of the EUR or the weakness of the USD

| 07-02-2018 | treasuryXL |

There has been a significant rise in the value of the EUR in the last year compared to the USD. From a low of USD 1.05 around the end of February 2017, the EUR has climbed up to USD 1.25 – representing an increase of around 20 per cent. Analysts are talking about the price rising above USD 1.30 later this year. All very good from the EUR side, but what is causing the EUR to appear so strong and the USD so weak?

It is fairly well known that the Fed could be looking to increase interest rates in 2018 – consensus is for 3 small rises throughout 2018. As EUR interest rates are negative, initially one would expect a large movement out of EUR and into USD. But it looks as if the economies are aligned in the same way and any rise in USD rates could later be followed by a rise in EUR rates.

A lot will depend on the announcements by the ECB to taper off its QE programme. Long term EUR yields are rising in possible anticipation, but are still far behind USD yields. There is a 2 per cent yield pickup in 10 year USD treasuries over Germany who act as the benchmark for the EUR.

The posturing of the US administration and the words of President Trump appear to be having a negative impact on the value of the USD. Statements from Washington about a weaker USD being good for the US trade have impacted on the market. Trump has been very critical about trade relationships with other countries. The words being uttered by the administration are certainly having a reaction on the markets.

The Dow Jones saw a sell off on Friday – it lost more than 650 points. The job report that was published showed that the US had added 200,000 jobs in January but, despite this good news, fear is growing that this will put upward pressure on inflation, leading to further rises in treasury bond yields.

However, there are potential hazards in the future for the EUR. General elections in Italy are due to take place on the 4th March 2018. Current sentiment within Italy shows a growing negative appreciation of the EU. The trials and tribulations concerning Brexit could also seriously undermine the strength of the EUR.

Whilst it appears that the USD is weak at present, any adverse news from with the EU could lead to a swift reversal in fortunes. The underlying sentiment would imply a weaker dollar, but fundamental changes in economic policy on both sides of the Atlantic could lead to rapid changes in sentiment.

 

If you want more information please feel free to contact us via email [email protected]

What will be the new “normal” for interest rates?

| 23-01-2018 | Lionel Pavey |

Despite interest rate being very low for the last few years, general consensus is that rates will eventually rise – rates will become more normal. Rates are being held down by the actions of central banks with their quantitative easing. As QE is scaled backed and stopped this should allow rates to rise from their current low levels. The big question is – how high will rates rise? The Euro is not yet 20 years old and that means that whilst there is a lot of data, it does not require looking through 50 or 60 years of data to try and find the norm.

From a high of just over 5% in the summer of 2008, 10 year swap rates have fallen to a low of around 0.25% in the autumn of 2016 and are currently just under 1%. Historically, it has been usual to describe prices as moving back to around the average. However, having just under 20 years of data, it is possible to analyse the average fairly quickly.

The average rate for 10 year swaps for the last year is about 0.80%
The average rate for 10 year swaps for the last 2 years is about 0.70%
The average rate for 10 years swaps for the last 5 years is about 1.15%
The average rate for 10 year swap for the last 10 years is about 2.20%
And the average since 1999 when the Euro started is about 3.40%

The lowest rate was about 0.25% in 2016
The highest rate was about 6% in 2000

What is normal? From a personal point of view when I took out my first mortgage (back in the previous millennium) the advice I was given was that if long term fixed rates (10 years) were lower than 6.5% I should look to lock into that rate as the long term average was 7%. With every other property that I subsequently bought the long term fixed rates were lower than with my first mortgage. Currently mortgage rates for 10 year fixed are around 1.75%. Long term interest rates have been steadily falling for the last 30 – 35 years.

So, when we talk about rates eventually rising, we are still left with the problem that previous benchmarks – which were normal then – may not be applicable anymore.

A rate raise is absolute – the magnitude and its impact will be relative to our perception of the new “normal” benchmark.

Lionel Pavey

 

 

Lionel Pavey

Cash Management and Treasury Specialist

 

Eurozone economic prospect – Goldilocks meets the bears?

| 12-12-2017 | treasuryXL |

The markets and the ECB feel that the economy is doing very well. It can be compared to Goldilocks – not too hot and not too cold. Is it possible that the Eurozone could be entering a period of continued growth with little or no immediate prospect for rising inflation? A quick scan of the relevant markets would appear to suggest that it is possible. Let us examine where the markets are now.

Long term Interest rates

Long term interest rates have been in a downward channel since the summer of 2008. 10-year EUR interest rate swaps (an acceptable benchmark) peaked just above 5% in 2008 before falling and steadying around 2% towards the autumn of 2013. After a period of relative calm, the rates continued their descent to a bottom of 0.25% around 15 months ago. Over the last 3 years, 10-year EUR interest rate swaps have averaged a yield of just 0.75% – now the yield is 0.80%.

Short term interest rates

3-month Euribor turned negative in April 2015 and has remained negative. Over the last 3 years, the yield has averaged -/- 0.20% – now the yield is -/- 0.33%. 3-month Euribor futures imply that the rate will remain negative until March 2020 and, will rise to just 0.75% by September 2022.

Economic indicators

Unemployment falling to 9.6% in 2017; 9.1% in 2018
GDP growing by 1.6% in 2017; 1.8% in 2018
Government debt to GDP ratio falling to 90.4% in 2017, 89.2% in 2018
Average maturity for new government debt extending to 13 years in 2017; 9 years in 2007

So, what could happen to trigger a reversal in this sentiment?

Share prices are rising – AEX index is up almost 15% since the start of the year
House prices are rising – in the Netherlands prices have increased by 8% over the last year. Turnover is greater with 14% more homes sold than last year.
Global debt is rising – about EUR 190 trillion. This amounts to more than 300% of the world’s annual economic output. (source IIF report)
Interest coverage ratios (ICR) are deteriorating worldwide – in Europe specifically in Germany and France. (source IIF report) This, even though interest rates are low.
Balance sheet of central banks are dangerously expanded – result of Quantitative Easing.
Historical low interest rates – leading to underestimation of risks.
Political change – a rise in “populist” parties in many countries reflecting disenchanted voters

So, what about Goldilocks?

The dilemma for the ECB is that the Eurozone has, essentially, become 2 blocs – the North and the South. In the North, with increases in house prices and stock markets, and drops in unemployment; a rise in interest rates would not be deemed to be negative. However, in the South, the recovery is far behind and they welcome every form of stimulus to aid their economies.

And the moral of story – how your actions/inactions may affect others.

And remember who chased Goldilocks away – the bears (markets!)

 

If you want more information please feel free to contact us via email [email protected]

Saving on FX deals? Often neglected but potentially a “pot of gold”

| 21-8-2017 | Patrick Kunz |

 

Doing business internationally often means dealing with foreign currency (FX). This poses a risk as the exchange rate changes daily, basically every second. To mitigate this risk a company can hedge the position via FX deals (discussed in a previous article). But what are the costs of those deals to companies?

 

FX deals

FX is traded on exchanges where only authorized parties have access to. This can be brokers or banks, the so called market makers. They can take your fx position for a give rate and they try to find a counterparty for the deal who is willing to take the opposite trade. For this effort (and risk as they might not be able to directly match the position) they ask a provision. This is the bid-ask spread; the spread between rate for buying and rate for selling the currency. The fx (mid) rate is determined by supply and demand.

The spread depends on several things:

  • Market liquidity; how many people are buying and selling and with what volume
  • Market timing; is the market open for that currency
  • Restrictions: some currencies have restrictions

For a company to trade FX they need an account with a party that has access to fx market makers. This is often a bank. This bank will take another bite out of the spread for their profit (and maybe risk as they might take the position on their books). The spread the bank will charge depends on how many deals and how much volume you will be doing. Sometimes it is an obligation to trade with the bank from a financing arrangement. For the big currencies for big clients the spread can be as low as 2-3 pips (0,0002/0,0003).

Trading FX seems to be without costs as the bank charges no fees. However, those fees are put into the fx rate. When doing spot deals it is easy to calculate them, it’s the difference between the traded rate and the then actual market spot mid rate. When doing forward deals or trading illiquid currencies it is harder to determine the spread. Always try to get to know the spread you are paying. The spread is basically the costs of the fx deal (for forward deals there is an interest component).

It therefore makes sense to always compare your FX rates and get quotes from several banks. Trading with a broker sometimes can be cheaper as one party in the process is eliminated. Savings can be up to 5% per deal (for exotic currencies), for the bigger currencies an average saving of 1% is possible. If you do several million worth on FX deals a year this is a big money saver.

Pecunia Treasury & Finance b.v. has an online fx trading platform backed by one of the biggest worldwide fx broker.

Patrick Kunz

Treasury, Finance & Risk Consultant/ Owner Pecunia Treasury & Finance BV

 

 

2 most common financial risks faced by a company

| 16-6-2017 | Victor Macrae | treasuryXL |

You might visit this site, being a treasury professional with years of experience in the field. However you could also be a student or a businessman wanting to know more details on the subject, or a reader in general, eager to learn something new. The ‘Treasury for non-treasurers’ series is for readers who want to understand what treasury is all about. From our expert Victor Macrae we received another article on risk management, of which we thought that it adds some extra aspects to the earlier article on riskmanagement. 

An important task of a treasurer is to fully understand the financial risks that impact the firm. Two risks faced by most companies are interest rate risk and foreign exchange risk. Both risks can negatively impact the firm’s financial statements and can ultimately even lead to bankruptcy!

Interest rate risk

Interest rate risk originates from interest bearing liabilities. Most firms have loans. In the case the interest rate is variable, the interest paid varies according to an agreed market rate, such as Euribor or Libor. The risk is that the market rate will increase to a level where the firm is not able to pay its interest payments any more. In that case the firm is in default and theoretically the loan provider can request full loan redemption. In practice the loan provider is now in charge and will increase the margins on the loan as a result of the higher counterparty risk and also other charges such as fees of lawyers will be due. In order to mitigate interest rate risk a firm can use fixed rate loans or use variable rate loans in combination with interest rate derivatives such as interest rate swaps or options.

Foreign exchange risk

Foreign exchange risk occurs when a firm has subsidiaries abroad or when it transacts in a foreign currency. Suppose a firm with the euro as home currency sells products in Japanese Yen (JPY). Payment is due in three months’ time. If the JPY has weakened against the euro with 20% when the payment is due after three months, the revenues in euro are 20% lower. If the margin on the sales was 15%, then the negative foreign exchange rate change has led to a loss of 5%. Foreign exchange rate risk can be mitigated by various means, such a moving production to countries where the firm sell its products in order to match the currency of cash in- and outflows. Furthermore, derivatives such as forwards or options can be used to mitigate foreign exchange risk.

3 steps

The first step in managing interest rate risk and foreign exchange risk is to examine how the firm is exposed to these risks. The second step is to measure the impact of the volatility of interest and currency rates to which the firm is exposed on its financial statements. In the third step, if the effects are serious, the treasurer should consider which of the available options for risk mitigation best suits the firm.

Victor Macrae

 

 

Victor Macrae

Owner of Macrae Finance

 

 

 

Managing treasury risk: Interest rate risk (Part II)

|31-1-2017 | Lionel Pavey |

 

There are lots of discussions concerning risk, but let us start by trying to define what we mean by risk. In my first article of this series I wrote about risk managment and what the core criteria are for a solid risk management policy. Today I want to focus on interest rate risk. There are 4 types of interest rate risk.

 

Absolute Interest Rate Risk

Absolute interest rate risk occurs when we are exposed to directional changes in rates – either up or down. This is the main area of rate risk that gets monitored and analysed within a company as it is immediately visible and has a potential effect on profit.

Yield Curve Risk

Yield curve risk occurs from changes between short term rates and long term rates, together with changes in the spreads between the underlying periods. Under normal circumstances a yield curve would be upward sloping if viewed as a graph. The implication is that longer term rates are higher than short term rates because of the higher risk to the lender and less liquidity in the market for long dated transactions. Changes to the yield curve (steepening or flattening) can have an impact on decisions for investment and borrowings, leading to changes in profit.

Refunding or Reinvestment Risk

Refunding or reinvestment risk occurs when borrowings or investments mature at a time when interest rates are not favourable. Borrowings or investments are rolled over at rates that had not been forecast leading to a potential loss on projects or investments.

Embedded Options Risk

Embedded options are provisions in securities that cannot be traded separately from the security and grant rights to either the issuer or the holder that can introduce additional risk. Benefits for the issuer can include a call option, a right to repay before maturity without incurring a penalty, an interest rate cap. Benefits for the holder can include a put option, a conversion right via convertible bonds, an interest rate floor.

 

An attempt can be made to calculate the interest rate risk on either a complete portfolio or on individual borrowings or investment. This is done by comparing the stated interest rate to the actual or projected interest rate. Methods include:

  1. Mark to market
  2. Parallel shift in the whole yield curve
  3. Tailor-made shift in the whole yield curve
  4. Duration, DV01, Convexity
  5. Value at Risk (VaR)

These are all forms of quantitative analysis and well recognized. Personally I am of the opinion that VaR is not a very good method for interest rates. Interest rates do not display normal Gaussian distribution – they do not resemble a normal bell curve. Interest rate distribution curves display fat tails compared to normal statistical models.

Financial products that are commonly used to manage interest rate risk include FRAs, Futures, Caps, Floors, Collars, Options, Interest Rate Swaps and Swaptions.

Lionel Pavey

 

Lionel Pavey

Cash Management and Treasury Specialist

 

 

 

More articles from this author:

Safety of Payments

The treasurer and data

The impact of negative interest rates

How long can interest rates stay so low?

 

Beleggen in obligaties met een hoge rente – een bespiegeling

| 15-12-2016 | Douwe Dijkstra – Fastned- Het Financieele Dagblad |

pile-of-money

 

 

Hoe interessant is beleggen in bedrijfsobligaties met een hoge rente? Hoe aantrekkelijk is deze financieringsoptie voor ondernemingen? Wij  hebben onze experts Douwe Dijkstra en Pieter de Kiewit om een kort commentaar gevraagd naar aanleiding van de obligatie uitgifte van Fastned.

 

Op de site van Fastned was begin december 2016 te lezen:
‘U kunt nu investeren in Obligaties Fastned met 6% rente’. Later in de maand ging de tekst verder: ‘We zijn verheugd u te kunnen mededelen dat Fastned de inschrijving is gestart voor de uitgifte van obligaties. De obligaties hebben een looptijd van 5 jaar en keren per jaar 6% rente uit. Dit is een mooie kans om (verder) te investeren in de groei van Fastned en een duurzame wereld.’
Vervolgens werden de belangrijkste kenmerken van Obligaties Fastned genoemd.
Dat de obligaties zeer gewild waren blijkt vandaag. Op de site van Fastned verschijnt nu een tekst dat alle obligaties geplaatst zijn. En Fastned vervolgt:
‘Gezien de grote interesse in obligaties Fastned zijn er zeker voornemens om binnenkort nog een uitgifte te doen.’

In het Financieele Dagblad kon men op 6 december een Bartjens commentaar lezen over de Fastned obligaties:  Het principe is simpel: een wankel bedrijf leent geld. Beleggers willen de relatief grote kans op wanbetaling gecompenseerd zien met een behoorlijke vergoeding: dus een hoge rente. In de VS zijn junkbonds populair, hier is het een kleine markt. Maar deze week is er weer een onvervalst speculatieve obligatie uitgegeven. Fastned. Het bedrijf dat een Europees netwerk van snellaadstations voor elektrische auto’s bouwt, leende € 2,5 mln. De lening heeft een looptijd van vijf jaar. De couponrente is 6%. Ter vergelijking: de Nederlandse Staat (superveilig) leent voor vijf jaar tegen 0%, Shell (behoorlijk veilig) leent voor vijf jaar tegen een coupon van 1,25% en Gazprom (Russisch, iets minder veilig) leent in Zwitserse frank voor vijf jaar tegen 2,75%. De 6% van Fastned impliceert dus behoorlijke risico’s. Het bedrijf is klein, jong en verlieslatend. Het heeft geen reserves en een negatief eigen vermogen, zo blijkt uit het prospectus. Maar goed, ‘de cost gaet voor de baet uyt’ en juist nu moet Fastned investeren.’

Expert Douwe Dijkstra vult hierop aan:
Voor beleggen in Fastned obligaties geldt hetzelfde als voor elke andere investering. Het rendement is omgekeerd evenredig aan het risico. Zolang niemand weet of de koers van aandelen Koninklijke Olie omhoog of naar beneden gaan, weet zeker niemand of beleggen in een 6% obligatie van Fastned achteraf wel of geen goede investering zal blijken te zijn geweest. Het lijkt mij enkel aantrekkelijk voor beleggers die wel een gokje durven te wagen met een te overziene inzet die ze wel kunnen missen. Of voor beleggers met een ideologische wereldvisie. Vorige week las ik in een ander artikel nog dat die investeerders met een loep gezocht moeten worden.

En Pieter de Kiewit zegt:
Investeren in start-ups gaat mijns inziens gepaard met een andere investeringsanalyse dan in volwassen ondernemingen. Daarbij is de ‘groene factor’ voor vele beleggers reden anders naar een onderneming te kijken. Dit is bijvoorbeeld heel zichtbaar bij Tesla. Persoonlijk vraag ik me af of een avontuurlijke investeerder in dit geval niet beter een equity investering kan doen.
Vanuit Fastned perspectief kan ik, met hun vertrouwen in hun business case, begrijpen dat ze liever obligaties uitgeven dan nieuwe aandelen..

douwedijkstra

 

Douwe Dijkstra

Owner of Albatros Beheer & Management

 

Fed Rates – Prospects of USD/INR Carry

| 09-09-2016 | Rahul Magan |

ir“Federal Reserve Rates and INR Reverse Carry”. As we understand that Federal Reserve Chairman Janet Yellen turning Hawkish and asking for 25 Bps increase in September 2016. If we look carefully then Fed vice Chair Fisher also suggested the same and at the same time most prominent Bond Trader – Bill Gross also suggested increase of 25 Bps in September and 25 Bps in December. If this would happen then Overnight Rates of USD would move to 1% and this would be closer to Australia which is 1.5% in $ terms.

We should also appreciate the fact that both Central Bank of Australia and Reserve Bank of India are moving towards Accommodative Monetary Policy. This way they would decrease the interest rates as to stimulate their economy. In that regards there are millions of thoughts but in my view Accommodative Monetary Policy is a big suicide as Japanese is a perfect example in that regards. They are doing QQE since last 2 decades but at the end need to depend upon Helicopter Money to stimulate their economy?? We all understand that Helicopter Money is nothing but Explicit Debt Monetization by BOJ for Govt of Japan.

There are multiple reports which suggest that Helicopter Money has already started in the form of Helicopter Drops by BOJ for Govt of Japan. This would surely create Reverse carry for USD/INR. We all understand that Indian Central Bank – Reserve Bank of India is now following Accommodative Monetary Policy henceforth there is a big pressure on RBI to cut present Repo Rates of 6.5% by at least 100 Bps to 5.5%. This would surely decrease the carry of INR for all Foreign Institutional Investors (FII), Foreign Portfolio Investors (FPI) to invest funds in India.

One more fact which matters is the growing relevance of Indonesia where in 10 Y G Sec is trading at 7.7% and Singapore who would like to increase overnight rate to 1.35 %. If this would happen then all the funds which are scheduled to India would invest in United States who is offering 1% , Australia 1.5% , Indonesia 7.7% and upcoming Carry Currencies like Singapore offering 1.34%.

We also need to appreciate the fact that Carry Traders needs big return and specially at that time when Japanese , Swiss , Europe is in negative and also big banks like Royal Bank of Scotland , Bank of Ireland and Deutsche is asking big clients to pay negative collateral. Sitting today we are having “Quest for Yield Hunt”.

Reserve Bank of India should be well aware of the fact that if they would reduce Repo Rate by 100 Bps to 5.5% then probability of having INR moving towards Reverse Carry is 100%. This won’t appreciate INR rather would depreciate the same as less $ would park in India. We also understand that this would also increase the reliance of Indian Corporates on External Commercial Borrowings (ECB) and there would be very less funding covering Foreign Currency Non Resident Bonds (FCNR) in India which would have reciprocal impact on both USD/INR Interest Rate Swaps (IRS) and Overnight Index Swaps (OIS)

On the 5th of September 2016 Bank of Japan Governor Kuroda said there is still a big for Qualitative Quantitative Easing (QQE) in Japanese Economy however this time Negative Interest Rates would play a very important role in that regards. Keeping all the aforesaid factors, Currency Traders are advised to take care of the same while making trading bets involving INR. Currency Traders are advised to have Options Structures to hedge their exposures.

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Rahul Margan fotoRahul Magan – Chief Executive Officer Treasury Consulting LLP

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How long can interest rates stay so low?

| 08-09-2016 | Lionel Pavey |

rating

How long can interest rates stay so low? When we talk about interest rates, it is helpful if we know the basic theory of how the level of an interest rate is determined.Classical thinking states that there are 5 components in interest rates (x).

 

5 Components in interest rates:

  • Risk free rate – a constant rate with no inflation
  • Inflation – the future expectation for inflation is added to the risk free rate.
    These, together, are called the nominal interest rate
  • Default risk premium – the individual credit score of the borrow
  • Liquidity premium – compensation for offering a product that can be difficult to sell on
  • Maturity premium – in a normal positive yield curve, longer maturities have a higher interest rate

A review of various data providers show that the “indicative rate” for a bullet loan with a maturity of 5 years for a Dutch local authority would be 0.06% per annum. Let us look as this rate compared to the 5 components already mentioned.

C, D and E are all premia and would, therefore, have a positive value. Even if their collective value was zero, it would imply that “nominal” 5 year interest rate would be 0.06%. This nominal rate, as previously stated, comprises both the risk free rate and the expected inflation.This leads to the presumption that either risk free rates are zero or that future expectations of inflation are negative.

According to the ECB inflation (HICP) index in July 2016 prices rose by 0.2% as an annual percentage change. The target inflation rate for the ECB is below, but close to, 2% over the medium term. Central banks set interest rates whilst keeping a watchful eye on headline and expected future inflation (it is a lagging indicator). Many studies claim that inflation indices overstate the true inflation figure, which would imply that the true inflation change would be zero or slightly negative.

If we were to enter a recession now there would be no room to use monetary policy as done previously as there is no space to lower rates any further. This would then only leave fiscal policy, but there is no unity within the Euro zone on fiscal policy.

It would appear that the present policy of quantitive easing (QE) has lead us to very low interest rates coupled with minimal inflation and no significant growth in GDP. Therefore, it is not improbable to envisage the current period of very low interest rates being maintained for quite some time in the future.

Furthermore, when QE stops, the ECB will eventually have to sell the bonds they are holding. Such an action could, conceivably, lead to a large rise in interest rates causing disruptions in the economic cycle. In the current environment, monetary policy can not revive the economy.

Lionel Pavey

 

Lionel Pavey

Cash Management and Treasury Specialist – Flex Treasurer