If we look across the English Channel or perhaps La Manche there is a lot going on. Last week we saw a shift in interest-rate policy which has been backed up this morning. This is from Vice Presidebt de Guindos in Le Monde.
First, increases of 50 basis points may become the new norm in the near term. Second, we should expect to raise interest rates at this pace for a period of time. And third, our interest rates will then enter into restrictive territory. The steps we have taken so far are going to have an impact on inflation, but we still need to do more.
As you can see this is a continuation of the rhetoric which suggests the Deposit Rate will rise from the present 2% to 3% over the next couple of meetings, and led some to think it could go as high as 4%.
Today I want to look at a consequence he himself mentions.
Admittedly, raising interest rates means an increase in funding costs for governments.
It is a little tucked away in his interview probably because there was another big shift announced last Thursday. But let us now look at that colliding with the problems created by the energy crisis.
Borrowing for energy needs
Bloomberg has taken a look at what the energy crisis has cost so far and the numbers are not pretty.
Europe got hit by roughly $1 trillion from surging energy costs in the fallout of Russia’s war in Ukraine, and the deepest crisis in decades is only getting started.
The International Monetary Fund has looked at it another way.
European governments have up to now used a wide range of policies to lessen the effects of high energy prices, including various forms of price suppression. In some countries the fiscal cost of the energy crisis response is set to exceed 1.5 percent of GDP in the first year alone—with more than half of that in costly non-targeted measures
In the IMF piece I note something which is rather familiar from the inflation issue.
Most measures were meant to be temporary, but they have already been extended, expanded, or both in many places.
That does of course fit with the definition of temporary in my financial lexicon for these times.
Actually European government’s have spent this so far.
Europe’s massive tab for securing energy supplies and cushioning consumers from price spikes soared past €700 billion by end-November
This includes the UK which does not count for Euro borrowing purposes but 600 billion Euros is still a lot and there is more to come according to Bloomberg.
After this winter, the region will have to refill gas reserves with little to no deliveries from Russia, intensifying competition for tankers of the fuel. Even with more facilities to import liquefied natural gas coming online, the market is expected to remain tight until 2026, when additional production capacity from the US to Qatar becomes available. That means no respite from high prices.
So high levels of borrowing could be with us for a while. This would only be added to by this reported by Politico last month.
The EU is in emergency mode and is readying a big subsidy push to prevent European industry from being wiped out by American rivals, two senior EU officials told POLITICO…….The European Commission and countries including France and Germany have realized they need to act quickly if they want to prevent the Continent from turning into an industrial wasteland. According to the two senior officials, the EU is now working on an emergency scheme to funnel money into key high-tech industries.
We something familiar in this as we see perhaps another SPV or Special Purpose Vehicle being set up for it.
The tentative solution now being prepared in Brussels is to counter the U.S. subsidies with an EU fund of its own, the two senior officials said. This would be a “European Sovereignty Fund,”
So countries can simultaneously borrow and claim they are not doing so. Actually Eurostat has done a pretty good job over time of pegging them back. But in the year it may take it to do it politician’s attention has usually moved on.
Let us move on with Europe preferring the IMF version above as it has lower numbers although in another piece they too mention 1 trillion Euros as a worst case scenario. But before I do let me point out that Bloomberg have been cheerleading for a green revolution which has morphed into quite a crisis.
ECB Policy
Previously the ECB would have hoovered up the bond issuance implied by the changes above. After all it is the only central bank I can think of that ran two QE bond buying plans at once as it added the PEPP to its existing one. That is the road which saw its balance sheet head for 9 trillion Euros. This has led to an interesting comparison from Robin Brooks.
Relative to the outstanding issuance, the ECB is as big a holder of government debt as the BoJ…
As of the third quarter they had bought some 40% of bond issuance. But as David Bowie would put it we are about to see some ch-ch-changes.
From the beginning of March 2023 onwards, the asset purchase programme (APP) portfolio will decline at a measured and predictable pace, as the Eurosystem will not reinvest all of the principal payments from maturing securities. The decline will amount to €15 billion per month on average until the end of the second quarter of 2023 and its subsequent pace will be determined over time.
This is the beginning of Quantitative Tightening or if you prefer reverse QE for the Euro area. It is not going to be actively selling bonds like the US Federal Reserve or the Bank of England. But it will no longer be oiling the wheels of bond issuance by reinvesting maturities. So others will have to find an extra 15 billion Euros a month to replace it. They will still be oiling the bond issuance wheels just less so.
It represents roughly half the redemptions over that period of time. ( President Lagarde )
All this is happening whilst the economy is weak. Back to Vice-President de Guindos.
The indication for the fourth quarter of 2022 is that we are perhaps in negative territory, but not very deep, with GDP expected to contract by 0.2%. The lead indicators we have are not good. Our projections therefore expect the euro area to fall into a mild recession in the last quarter of this year and in the first quarter of 2023, when GDP is expected to contract by 0.1%.
Comment
There is something of a perfect storm on the way for government borrowing costs.
- The energy crisis means they will be borrowing more and probably a lot more.
- The economy is likely in a recession which does not help
- The major bond buyer in recent years which is the ECB is planning to reduce its purchases to a relative dribble.
- The ECB plans to push short-term interest-rates above 3% and maybe towards 4%
It is not my purpose to say bond yields will go higher. Well apart from shorter term ones as Germany will not have a two-year yield of 2.5% should the Deposit Rate go above 3%. But to point out this change which has already taken place. Over the pandemic borrowing period Italy was able to borrow for ten-years at a cost of less than 1% and ay times for around 0.5%. As I type this it is 4.4%
Such a move happens in slow motion as countries issue new bonds and refinance existing ones. But it is also happening with a quicker move as inflation linked bonds have been very expensive in 2022.