It was interest rate turnaround week. Only last Wednesday did the US Federal Reserve make the largest rate hike in over a quarter of a century. Then, on Thursday, the Swiss National Bank and Great Britain both raised key interest rates for the first time in fifteen years. And how is the European Central Bank (ECB) reacting to the radical change in monetary policy elsewhere?
She keeps accelerating instead of finally stepping on the brakes. At a crisis meeting on Wednesday, she decided to buy more government bonds from highly indebted member states of the monetary union. In doing so, she wants to prevent the refinancing costs of some euro countries from rising again to such an extent that the next sovereign debt crisis threatens.
The ECB is also firmly – some would say stubbornly – sticking to the zero interest rate, even though consumer prices in the euro area in May 2022 were more than eight percent higher than a year earlier. The ECB does not intend to tighten interest rates until July – that is probably too late and too hesitant. By then, inflation will have eaten up the purchasing power of wages, savings and pensions for far too long.
Why is the ECB finding it so difficult to make the statutory contribution to the fight against inflation? “Leverage effects” provide the explanation. Because the math of investment returns is relentless. Emerging from the underworld of negative and zero interest rates comes with extreme risks. An increase in interest rates by one percentage point from two to three percent means something completely different than from zero to one percent.
In the first case, an absolute increase of one percentage point is a relative increase of half, but in the second case it is a multiple (1.0 is a hundred times 0.01 and a thousand times 0.001). The relative rise in interest rates is forcing a corresponding relative correction in government bond book values. Why this is so can be illustrated with a simple example.
It is about an investor who would like to earn one euro per year in interest income. If he owns an old 1,000 euro government bond with a fixed interest rate of 0.1 percent, he has reached his goal exactly. For this he receives one euro per year in interest income.
However, if new euro government bonds are offered with a fixed interest rate of one percent, the investor could achieve his desired interest income much more cheaply. Even the use of a hundred euros would lead to interest income of one euro interest.
What the old government bond with a value of 1000 euros and an interest rate of 0.1 percent yields in interest income, the new government bond with an interest rate of one percent already creates at a value of one hundred euros.
That is why the old 1000 euro government bond only has a market value of one tenth compared to the new government bonds. No one would pay a thousand dollars to earn one dollar of interest when they could have a dollar of interest for a hundred dollars!
Thankfully, the brutal leverage rates in the example only apply if the interest-bearing securities have an indefinite term. In practice, it’s not nearly as dramatic. Government bonds are usually repaid at the full nominal value after ten years at the latest and in exceptional cases after thirty years. But the rule of thumb is what the example shows: if interest rates rise sharply, the book values of government bonds collapse. And all the more dramatically, the lower the interest rates are before the increase.
If the ECB increases its key interest rate by a quarter or even half a percent from today’s zero percent – which corresponds to a huge jump in relative terms – it provokes a crash in prices for government bonds in the euro countries.
As a result, there is an immense need for value adjustments – especially for banks and insurance companies that hold government bonds as safe interest securities. This, however, threatens the collapse of those financial institutions that own many government bonds from highly indebted euro countries – often as supposedly safe investments.
It is immensely uncertain how the ECB will get out of the dilemma of “leverage effects” and raise interest rates in the fight against inflation without triggering the collapse of financial institutions and the next sovereign debt crisis. Never in its history has the ECB faced the challenge of emerging from an underworld of zero interest rates and returning to positive interest rates. It therefore lacks any historical experience of what kind of shocks such an emergence process triggers in practice.
It is precisely for this reason that the ECB will only hesitantly and weakly participate in the general turnaround in interest rates in the coming months. It does not want to make interest costs more expensive by raising interest rates and risk a recession or even worse as a result of leverage effects.
Rather, it will – once again – gamble with low interest rates and lots of cheap money for time, hoping that more growth will mean more supply and thus less inflation. But that is and will remain a high-risk strategy in view of the many structural deficits within the euro area.
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