Interest rates are going up again.
Not in Britain – at least, not right now. Yesterday the Bank of England kept the bank rate at its 0.5% record low.
We’re talking about Europe here. The European Central Bank (ECB) has just lifted its official interest rate – for the first time since 2008 – from 1% to 1.25%.
Yet meanwhile, on the edge of the eurozone, Portugal has raised the white flag. It’s just asked for a mega-EU bail-out. The country could need up to ÂŁ80bn to keep going.
So what’s going on – and what does it mean for investors?
Why the European rate hike is a big deal
One quarter of a percent doesn’t sound very much. If we could all keep borrowing money at just 1.25%, I’m sure we’d all be quite happy.
But if it’s no big deal, then why is everyone talking about the ECB rate hike?
Because, of course, it is a big deal. When the Great Recession began in 2008, official eurozone interest rates were slashed from 4.25% to 1%. They’ve been there – at by far their lowest point since the euro was launched – for two years.
The fact that the ECB has raised rates now demonstrates a number of important things. Firstly, the ECB is stating that ’emergency’ interest rates are no longer required.
Secondly, the ECB is showing that, even if other central banks are sanguine about rising prices, it’s not. Inflation in the eurozone hit 2.6% last month, compared with the medium-term target of just below 2%. As the ECB seems to be pretty much the only major central bank in the world that worries about the value of its currency, a rate rise – the classic response – makes good sense.
Thirdly, the ECB’s move makes it clear that conditions in Germany, rather than anywhere else, matter most in Europe. German inflation is at 2.1%, a two-year high. And the economy is scooting along very nicely. February’s industrial production (IP) grew an impressive 1.6% compared with January’s figure, which in turn had been revised up. Both were much better than expected. In fact the annual IP growth rate has reached a new, stunning, 14.8% record high.
Germany’s fine – but what about Portugal?
But as Ben May at Capital Economics notes, “so far a strong Germany has done little to help the euro zone’s periphery”. And for Portugal it’s a very different story.
The country’s call for help from the European Union is no great surprise. For example, two weeks ago we said Portugal was “rapidly looking like the next eurozone bail-out candidate”: Another eurozone crisis is coming – this time it’s Portugal.
The problem is that Portugal has been running out of cash. So the yields on its bonds have been steadily rising as investors have demanded ever-higher returns to compensate for the risk of buying the country’s debt. With the government needing to repay €4.23bn of borrowings this month but having only €4bn in cash reserves, a bail-out became an absolute necessity.
So has the ECB thrown Portugal to the wolves with its rate rise? Along with Ireland and Greece, which have been bailed out once already?
Sure, that 0.25% won’t make any difference to countries that are currently paying between 9% and 12% to borrow money in the bond markets – as you can see from the bond page.
But it’s a clear sign the ECB is no longer prepared to set eurozone monetary policy to suit the peripheral countries. Some of these are already in such a deep financial hole, there’s no way out. And ECB rate hikes could be the last straw.
The euro could be heading for carnage
For now the ECB is hedging its bets about how much higher – and how fast – it will lift interest rates. Morgan Stanley reckons official rates will be up by 2% by next spring. But even a gradual series of hikes would be likely to push up the value of the euro in the short-to-medium term.
For peripheral countries already having problems boosting their exports, this would be very bad news. That’s because without growth from this source, they’ll find it yet harder to grow their economies quickly enough to service their debt repayments. In turn, that could force up the interest rates they’ll have to pay on their bonds as default risks grow.
What’s more, this isn’t just about state borrowing. The eurozone’s peripheral countries have plenty of debt-laden households who are struggling to pay their interest bills. Higher official rates are likely to be more than passed on by banks whose own finances are in a mess. This could push many of these households over the financial edge.
In short, it could all develop into a vicious downward spiral. Which could eventually push some of these peripheral countries out of the euro altogether. That could lead to financial carnage. It would almost certainly cause a lot of volatility in the euro’s value.
What does this mean for UK investors?
We’ve said it before, but that would play straight into the hands of traders. It’s risky, but if you want to play sharp shifts in the currency markets, see what our spread-betting blogger John Burford has to say in his free email MoneyWeek Trader.
Will this ECB move herald a near-term rise in UK interest rates? That’s a topic for another day. But don’t bet against it over the next few months. And that could mean stock markets – which generally don’t like rising rates – getting very choppy.
So it’s sensible to stick to defensive stocks that are less likely to be buffeted by market volatility. And in this week’s issue of MoneyWeek magazine, my colleague James McKeigue spotlights a sector that’s been out of favour for years. That means it now contains some very cheap shares, which are likely to do well in the long-term however the overall market fares.
Subscribers can read the story here: Biotech will ride to the rescue of Big Pharma – here’s how to profit – If you’re not already a subscriber, subscribe to MoneyWeek magazine.
Category: Market updates