The European Central Bank hiked interest rates for the ninth consecutive month in July – lifting borrowing costs by a combined 425bps over the previous 12 months – as it sought to dampen a historic surge in consumer prices1.
Inflation in the eurozone rose 5.3% in August compared with a year earlier, down from more than 10% at the end of 20222.
At the time of writing, the ECB’s deposit rate stood at 3.75% – its highest level for more than two decades. Prior to July 2022, the ECB’s benchmark rate had stood at -0.50% for more than two years. It had been below zero since 20143.
As consumer price rises ease, the ECB has hinted a pause in hikes at its September meeting may be on the cards, but officials have also not ruled out another rise as the central bank seeks to bring inflation down to its 2% target by the end of 2025.
All the evidence suggests the ECB is either near the end of its historic monetary tightening cycle, or possibly, already there. Meanwhile, underlying weakness in the European economy – as evidenced by recent weak Purchasing Managers’ Index (PMI) data4 – points to a further squeeze on GDP growth in the bloc. As a result, the path for further cumulative rates hikes by the ECB has become extremely narrow.
The ECB holds eight rate-setting meetings per year. At every meeting, the governing council faces a choice: hold, raise or cut rates. In this article, we look at implications of this choice for euro-denominated short duration money market funds from this point onwards.
Figure 1: ECB deposit facility interest rate
Scenario 1: Rates hold
After almost a decade of negative interest rates, higher positive bond yields now allow investors to earn attractive income at a dramatically improved risk-adjusted basis. Moreover, further normalisation of eurozone rates anytime soon is likely limited, offering great risk-to-reward dynamics.
If, as expected, the ECB decides to hold the deposit rate at 3.75% and yields remain at current levels for a long time then an investor gets more than compensated for any risk they hold. As previously mentioned, the deposit rate has already risen 425bps – the best income/yield proposition in more than two decades. Under this scenario, investors earn roughly 4.0% with extremely limited duration and credit risk – an attractive long-term proposition in our view.
Scenario 2: Further hikes
But if inflation were to continue to remain stubbornly high, the ECB could opt for further hikes in the coming months taking the deposit rate from 3.75 to 4.25% (beyond 50bps is unlikely).
In this ‘higher rate’ scenario, the potential is still that the investor wins. The ECB deposit rate would have gone from negative to more than 4%. At this point, any capital losses generated by further ECB hikes can be easily absorbed by the additional yield/income in a short period of time. For instance, should the ECB hike another 0.50%, the breakeven point for a short duration fund with a one-year average duration is approximately one-and-half-months. In addition, investors would earn higher income with improved return dynamics.
Scenario 3: Rates decline
There are fears that Europe may fall into recession in 2024, with the possibility that the ECB will cut rates in the coming months should there be a dramatic slowdown in growth. Most risk assets will, of course, likely generate negative total returns in this environment. Under this scenario, an investor will have less carry – but they will get capital appreciation (every 100bps of rates decline translate to 1% performance for a 1-year short duration fund). At the same time, most other asset classes are likely to be going down in price, not up. In this scenario our view is that an investor should still make money.
Conclusion
Whatever the ECB does in the foreseeable future, our view is that the outlook for short duration is positive. The central bank is at or near the end of its tightening cycle and the key risks appear to have passed. From this point onwards, we believe only upside is likely.
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