Upward pressure on long-term interest rates persists
The eurozone economy's growth remains low, at around 1%. Low growth is also expected for next year, despite fairly loose fiscal policy. The problem, however, is that this loose fiscal policy is mainly driven by higher defense spending.
A large share of defense contracts, in fact, go abroad, giving them a very low, and often even negative, multiplier. Furthermore, monetary policy is neutral, and Europe is investing relatively less in everything related to AI.
An important negative factor is also the eurozone's fairly weak competitive position, which leaves little room for real wage increases.
Viewed from this angle, one would therefore be more inclined to think of a rate cut than a rate hike.
The problem, however, is inflation. At the current oil price, it will likely remain at 3 to 3.5% for the time being, especially if food prices rise as expected. This means it is quite possible that the ECB will raise interest rates once more, if not twice more, by 0.25% over the coming quarters.
In itself, this would form a positive backdrop for the euro, although it remains questionable whether that is enough to outweigh:
- low growth;
- the less dynamic AI sector and lower investment in it;
- the limited implementation of the recommendations from the Draghi report of two years ago, aimed at improving Europe's competitiveness and boosting productivity growth;
- the shrinking workforce, which is still growing somewhat in the US, as a result of an aging population and restricted immigration;
- uncertainty surrounding the future of French government finances. It remains to be seen whether sufficient action will be taken there before a crisis emerges.
On the other hand, just as in the US, European long-term interest rates are under considerable upward pressure due to fears of government finances spiraling out of control, concerns about higher inflation resulting from rising oil and food prices, as well as deteriorating supply-demand dynamics in the bond market.
Weighing all this against conditions in the US, the American currency also faces a number of negative factors:
- somewhat weakening economic growth;
- recently also softer-than-expected inflation;
- deficits in government finances and the current account. This means large amounts of foreign capital need to flow into the US if the dollar is not to decline in value. Washington's policies certainly pose a problem here, as more and more foreign capital holders are becoming reluctant to hold as much in dollars.
This would naturally look different should the oil price rise sharply further. We do not expect this, however, as Trump will do everything he can until the elections to prevent a sharp rise in the oil price.
Iran, on the other hand, does have an interest in rising oil prices, as this increasingly "backs Trump into a corner." However, the oil price also cannot rise so sharply that it triggers a global crisis. Many countries would then turn against Iran, and Iran's export revenues would also decline sharply as a result.
An oil price of roughly between $80 and $90 therefore appears, for now, to be the best achievable outcome for both parties under current circumstances. The price currently sits above this range, but not by enough to make much difference. This would mean that upward pressure on inflation remains present, but does not become significant. (This also fits with growing evidence that more oil is passing through the Strait of Hormuz than originally thought. Iran apparently allows this, since otherwise the oil price would rise too much.)
The final conclusion therefore remains that, from the standpoint of economic growth and inflation, at least for the period ahead, there is no need to fear significantly higher interest rates.
- On the other hand:
- the US economy is growing considerably faster than that of the eurozone;
- the investment boom surrounding AI is also attracting a great deal of capital from abroad;
- interest rates in the US are higher.
Only this last point also has a downside. For the same reasons as in Europe, long-term interest rates in the US are also under upward pressure, though more so than in Europe given the higher growth. This is putting the fear of God into the US administration. There is deep concern that higher long-term interest rates will push down equity prices and drive up the government deficit through much higher interest payments. Lower equity prices would then slow down the economy, leading to lower tax revenues and an even larger deficit, and so on. In other words, rising long-term interest rates could easily lead to an economic crisis.
It is therefore understandable that Washington has begun buying back more long-term government bonds, financing this through the issuance of more short-term paper. The problem, however, is that this kind of artificial intervention only ever works temporarily, much like currency interventions. If one wants to push long-term interest rates down for longer, the fundamentals need to be improved first: sharply reducing the government deficit and restoring foreign capital holders' confidence in US policy.
