When Is It Gonna Be, ECB?

Euro zone’s benchmark interest rate has been sittin’ pretty at 1% since May this year and, with recovery underway, whether the ECB will hike rates or not isn’t really the question anymore. Rather, currency traders are starting to focus more on the “when” of things. To them, it is only a matter of time before the ECB begins tightening its monetary policy and starts raising rates.

Too presumptuous? Given the recent developments in the euro zone, I think it’s a pretty good assumption. Besides, I came across an interesting article suggesting that the ECB could raise rates as early as the first half of next year. From the looks of it, the ECB might be trying to be artsy with their monetary policies in considering a floating rate for its 1-year loans. Floating what? Allow me to break it down for you…

As of now, the ECB is offering banks bottomless funds in its effort to induce lending in the markets. The rate for the 1-year loans is pegged at 1%, which is the ECB’s current interest rate. If the rate is fixed, banks borrowing from the ECB will have to pay 1% in interest no matter what happens, even if the ECB decides to raise the benchmark interest rates before the 12 months are up.

Adopting a floating loan structure, on the other hand, enables the ECB to charge the “extra” interest in case they decide to raise rates. Of course, the opposite holds true. If the ECB cuts its rate further, then the interest incurred by borrowers is also reduced. Simply put, the borrowing costs would move in tandem with the ECB’s benchmark rate.

With the prospect of a floating rate on the table, many are starting to speculate that the ECB could hike rates within the next 12 months. In fact, lending at a fixed rate could somehow undermine the effect of a future rate hike. Consider this scenario: A bank borrows $1m at 1% per annum, compounded monthly. Given these, the bank will have to pay $83,785.41 in amortization per month for 12 months until the entire loan is paid off. But if the ECB, for example, hikes its rate to 1.25% at the end of the sixth month, the bank will have to pay now $ 83,846.42 per month until the twelfth month! You see, allowing the 12-month loan rate to float would encourage banks to lend more now in order to take advantage of today’s lower costs.

Remember, the ECB has been quite optimistic about the economy as of late, with some hints of possible exit strategies in their recent meetings. This could mean that the ECB will be holding a tighter leash in providing funds to banks. However, by offering these 12-month floating rate loans, they are still leaving some stimulus available to banks. At the same time, they are able to limit their risk through a floating rate – just in case they do hike rates in the future.

Adding fuel to the rate hike fire are the recent improvements in euro zone fundamentals. After all, the 16-member region did emerge from the recession in the third quarter as it printed a 0.4% economic expansion. Just last week, we saw a slew of strong PMI readings from Germany, France, and overall euro zone. In fact, both services and manufacturing industries for these economies have been advancing since June this year. Consumer activity has picked up pace while business conditions continue to improve. If euro zone continues to tread this path for the coming months then a rate hike should be in the works…

ECB President Trichet seems to have an upbeat outlook for the euro zone economy as well. Strong US dollar interests aside, he did mention that the central bank is already looking to mop up excess liquidity in their financial markets. According to him, not all their existing easing measures will be needed in the same extent as in the past.

Indeed, things are looking a lot better – at least according to the reports available to us! Ha! In any case, the effects of an improving economic landscape and a rate hike would undeniably benefit the euro. Increased risk tolerance, along with the prospect of higher interest rates, would satisfy the cravings of risk hungry investors who, in past months, have been gobbling up higher yielding assets like the euro, Aussie and the Loonie. Furthermore, if you take into account the unappetizing situation of the dollar, we may just see central banks diversify their reserve funds and stock up on the euro, which has been widely considered as the anti-dollar. Sounds pretty far-fetched, but given this environment, who knows what concoction will be stirred up!