Interest rates: Europe is vulnerable
Interest rates have risen sharply in recent quarters. In the past few days, interest rates have fallen somewhat, but we view this as part of a downward correction within an uptrend. So far, the impact of the sharp rise in interest rates on the currency markets has been limited, as interest rates rose across most major currencies. But we are seeing that change.
The consequences of higher long-term yields vary significantly from one economy to another. Japan stands to benefit from higher yields. While this does increase the government's interest expenses, this effect is more than offset by the fact that it is now more attractive for Japanese investors to invest more domestically. Increased capital inflows are positive for growth, leading to higher tax revenues.
For the U.S., higher long-term yields are primarily a factor that slows strong growth. Consumer spending by affluent households is not adversely affected by higher yields (higher yields may even have a positive effect, as this group receives more interest income). Investments in AI are not being curbed by this trend for the time being, as the expected return on such investments is significantly higher than the increased financing costs. In addition, nominal economic growth exceeds long-term yields, allowing the economy to cope well with the high rates.
Europe is being hit much harder by the higher interest rates. As European interest rates rise, we are entering dangerous territory. First, growth in the eurozone is lower than in the U.S., meaning interest rates are more likely to exceed nominal growth. If that happens, countries will have to cut spending to prevent debt from rising as a percentage of the economy. In addition, the rapid rise in the sovereign spread between German and French interest rates brings back memories of the euro crisis of 2010-2012.
France under pressure
This exacerbates the situation for France in particular. Higher interest rates are heightening concerns about French public finances, putting even more upward pressure on French long-term yields, which now exceed the nominal growth of the French economy. At the same time, shares of French banks are under relatively strong downward pressure. As a result, French banks may become more cautious about extending credit, particularly if depositors view falling bank stock prices as a sign that it is less safe to deposit money with these banks. All of this is detrimental to the French economy, which in turn is detrimental to public finances and the stability of the French banking system.
The turmoil is also beginning to spread to other eurozone countries with concerning public finances (Belgium and Italy). If this trend continues, concerns about the eurozone's survival will intensify once again. In that scenario, the ECB will have no choice but to significantly ease monetary policy by using newly created money to purchase government bonds from the weaker countries on a large scale.
However, the situation will likely have to deteriorate much further before the ECB steps in to help. In 2022, the yield spread between 10-year Italian and German government bonds rose toward 250 basis points, and the ECB did not take action to counter it. The current yield spread between French and German 10-year government bonds, at 140 basis points, is still well below that level.
In addition, political division is deep and growing in many European countries, with parties on the political right and left gaining popularity at the expense of traditional centrist parties. This makes it increasingly difficult to reach political compromises to cut spending on programs that cost a lot of money and that many voters regard as entitlements. Consequently, there is little prospect that (future) governments will take the necessary painful measures of their own accord. This will require an external factor in the form of a revolt by bond investors, who will keep ramping up the pressure on governments through higher interest rates until governments finally get their act together. If the ECB intervenes at an early stage, it will remain too tempting for governments to further postpone these measures. The more this happens, the worse public finances will ultimately become.
Against this backdrop, bond investors will err on the side of caution and avoid the weaker eurozone countries until the governments of these countries take the necessary measures and/or until the ECB intervenes. Since we do not expect either of these to happen for the time being (especially not in France), we expect the spreads of these countries to widen further. This is negative for the euro and also has implications for interest rates and exchange rates, which we have discussed in this weeks Interest Rate & Currencies Outlook reports.
