b-school, Business, Economy, Macroeconomy, MBA

Rates keep raising: is this the end of cheap money?

Yes, interest rates are soaring. The ECB raised rates two days ago 25 basic points to 4% as expected. That was the highest rate in six years. You know how I like using images, here is the picture of the last year:

Why has the ECB risen the rates again? Fear of inflation as usual. Europe has been growing faster than the US and that means that industries will approach production peaks and probably companies will face more pressure to drive salaries up. But only probably, because that hasn’t happened yet. The European Central Bank bets to put pressure down even before it’s needed. Or is it?

We’ve seen so much liquidity lately, so many money. The quantity of money has been growing steady, more than ever. You can see it in this graph I made with data from the US Federal Reserve, 1959 to 2006:

M2 and M3 are common metrics or measures for money. While M2 represents physical currency, bank reserves, current accounts, saving accounts and small deposits, that is the money that is available to domestic economies, M3 also includes bigger certificates of deposits (above $100,000), Eurodollars and repos.

You might ask, where has that liquidity gone? That’s why I chose to draw the red curve: M3 without M2, that is the money that is not in the hands of domestic economies. As you can see it has been growing at a hectic pace. This is the money that has been refuelling the economy, making stocks soar, gone into funds, hedge funds, private equity or debt.

So maybe, after all, central banks were not thinking of us when raising taxes, but in those huge quantities of money that are not in the hands of domestic economies.

And with money being more expensive, we’ll probably see trouble in junk bonds, too-risky capital and excessive leverages, subprime mortgages, the riskiest places where the bulk of the money has gone to.

Rising taxes mean that the most vulnerable parts of the economy may suffer. We’ll see the definitive end of many bubbles, maybe mortgages, junk bonds, overpriced shares or excessive debt can be the match that lightens the next crisis. And that can mean trouble for our pockets too.

One thing for sure: rates will keep soaring, I have no doubt. One way to know what the market thinks about it is using the Euro Interbank Offered Rate, Euribor. If you follow that link you can get the daily Euribor rates in a range from one week to twelve months, that is the rates that first class Euro banks offer each other. Euribor is representative enough of the Euro money market.

The red curve was in January, the blue curve is now. So far the market has been predicting well the increases for the last six months. The arrow marks the value for borrowing Euros for six months six months ago and compares it to the actual value. As you can see, it’s rather close to the current value.

Well, in fact it’s higher because there is a smoothing effect: when you are paying to borrow for six months you are paying higher (or lower) for the last months, but closer to the current rate for the first months, so you get an average of both.

So, looking at the blue curve, the market predicts additional increases for the next months. And the slope is even steeper slope, that means no sign of stopping to be seen in the next year. The rates will keep rising on the long run.

It’s been ten years from the last monetary crisis. Maybe the next one is getting closer. That would have central banks change their mind about rates.


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