In November 2021 I wrote: “If inflation lingers at high levels longer than expected (which we will find out in the first half of next year), euro interest rates may rise faster than currently anticipated. There is still some time before the popular Euribor 3-month and 6-month rates reach zero after the first European Central Bank (ECB) rate hike, which could begin to impact euro borrowers directly.”
We learnt about that in the first half of 2022. Unfortunately, inflation not only remained at high levels for longer than expected but also reached new records, against the background of which we would most likely want to experience the return to the “high” levels of 2021 in the near future. The popular 3- and 6-month Euribor rates not only quickly approached zero but also shot well into positive territory (well into positive territory is a relative term), resulting in doubled interest payments for many borrowers.
What had happened? The war in Ukraine – an event that as recently as January 2022 was probably only predicted by conspiracy theorists or played out by the military in secret bunkers in “worst case” low probability scenarios. How I assess the impact of the war on the financial markets was described in the first quarterly report of 2022, “兀ilnīgs 兀...“. Hence the use of the symbol 兀 in last year’s assessment. The war in Ukraine, which has led to a surge in commodity prices and inflation, has ruined all plans for 2022. For this reason, the central banks had to act more aggressively than they were expected to.
Below are my thoughts on what happened in 2022 and what we can expect in 2023.
Central banks
Ensuring price stability is the main task of central banks. The medium-term inflation target has been set at 2%. Unlike in the US, where it is a single target for a single economy, in the Eurozone it is a target for 20 different economies (Croatia joined the Eurozone on 1 January 2023), which is why the ECB is struggling to keep the average indicator at 2%. At the end of 2022, the average was approaching 10% (data for December are still pending)!
Eurozone inflation data for the year
We will look at inflation later in this article. For now, let us look at the behaviour of central banks. Interest rate hikes were already expected in 2021. One of the first central banks to go down the rate hike route was the Norwegian central bank with a 25 basis point hike in October 2021. The Norwegians were followed by the Bank of England in December 2021 with a 15 basis point hike. All eyes were on the United States and the Eurozone.
In March, the US Federal Reserve (Fed) was the first to move: it raised rates by 25 points. The European Central Bank (ECB) only followed it in July with an immediate 50 basis point rate hike. After experiencing deeply negative interest rates last year, we are now at levels of central bank rates last seen in 2008. At the end of December, the Bank of Japan remains the only central bank that has not raised rates (annual inflation in November +3.8%), however, one could feel the chill of change approaching.
Changes in the base interest rates of central banks as of July 2021
The rise in central bank interest rates has not stopped. I would like to remind you what Christine Lagarde, the Governor of the ECB, said at the December ECB meeting, commenting on the 50 bps change in rates (down from 75 bps): “Anybody who thinks that this is a pivot for the ECB is wrong. We are not pivoting; we are not wavering. We are showing determination and resilience in continuing a journey where we have if you compare – comparisons are odious, but if you were to compare with the Fed – we have more ground to cover. We have longer to go, and that is the reason we have very specifically added messages in our monetary policy statement to reflect that fact. This is not a pivot. We are not slowing down. We are in for the long game.” The interpretation of these warnings is left to each person’s own discretion.
What does history say? Base interest rates on the US dollar reached 19% in 1981, being the consequence of having been cut too quickly from 16.5% in 1980. Fed reacted too quickly to changes in inflation data and the 16.5% rate in April 1980, lowered the rate to 11% in August of the same year, and then had to raise rates sharply again. This is precisely the scenario the central bank is willing to avoid (a premature release of the brake pedal followed by even faster rate hikes) and has therefore committed to maintaining its current course as long as inflation data show a convincing and sustained change.
The euro base interest rate record is 4.75% (last seen so high in May 2001), against the background of which the current rate of 2.50% is nothing out of the ordinary. In fact, interest rates are now close to what they would be in the Eurozone had ECB succeeded in bringing inflation towards the 2% mark. Last year, the situation became “dramatic” because interest rates previously had lingered at unreasonably low levels (below zero), which “lulled” the attention of credit markets. For about seven years, most borrowers were not affected by the Euribor figures, as zero was used for negative interest rates instead of Euribor. And unfortunately, this trend was planned years in advance. Moreover, a number of loan calculators offered this feature (which used the most recent interest rate as an example in calculations, as it is impossible to predict future interest rate changes).
Now, after the sharp rise in Euribor, the disclaimers next to the loan calculators about a possible change in interest rates look quite different. I believe that when planning interest payments for long-term transactions (we are speaking of several years in advance), it is best to aim for a Euribor of 0%. In the base scenario, Euribor should be in the vicinity of two per cent (more likely with a plus sign), but in the worst case, it will historically be in the ballpoint of five per cent (hopefully we will not end up there). On top of Euribor rates, there are other figures (look at your contracts, but according to data from 2021, mortgage loans in Latvia average between +2.5 and +2.7%).
The US and euro base interest rates over the last 50 years (the euro was introduced in 1999)
This time, the rapid pace of the rise in interest rates has surprised everyone (even the financial market experts with decades of experience). If not considering the “crazy” 1970s and 1980s in the US, this is a period of record rate hikes. US interest rates rose by 425 basis points in 9 months, in Eurozone, interest rates rose by 250 basis points in 5 months. Below is a visual comparison with other periods of interest rate increases in the US and the Eurozone.
Interest rate hikes by the US Fed and ECB
This interest rate hike was, of course, done in leaps and bounds. The US Fed has a history of raising interest rates substantially. In the few charts above, note the green line from 1977 to 1987. At a single central bank meeting in May 1981, the US dollar base rate was raised by 350 basis points (bp). There have been two increases of 300 basis points (both in 1980). In 1973, the Fed raised rates three times by 75 basis points, and this year, this record was broken with four consecutive increases of 75 basis points. By the end of the year, the increase slowed to a 50 basis point hike in December (see this year’s hikes in the Figure below).
On the other hand, ECB already raised rates by 50 basis points in 1999 and 2000. Two consecutive increases of 75 basis points (in September and October) have set a new record this year. In December, ECB also slowed down the pace. However, I have already quoted the warning of the Governor of the ECB that there is no reason to celebrate the possible end of interest rate hikes.
US Fed, ECB and Bank of England rate hike range in 2022
Moreover, the capital market operations of central banks have changed. QE has changed to QT, i.e., central banks have moved from Quantitative Easing (market support) to Quantitative Tightening (market braking) mode. As a result, the bond market, already under pressure from rising interest rates, is likely to face even tougher times. It is likely that borrowing will become both more expensive and more difficult in 2023 as the “last buyer in line” exits the bond market. It used to be possible to sell bonds that met the central bank’s quantitative easing criteria to the central bank. However, this has become less likely, which would most likely reduce the demand for new bonds (but this depends on the rating, the interest rate and the availability of “free” money). The lines in charts showing changes in central bank assets will tend to the x-axis.
Central bank assets in the US, Eurozone and Japan
The US Fed was the first to launch QT last year. Between April and the end of the year, its assets fell by more than USD 400 billion. The significance of this figure is somewhat diminished by the fact that the central bank had almost USD 9 trillion in assets in April 2022. Currently, the process of asset impairment is underway, but we need to be cautious about the consequences for the market, as in the past, QT programme was interrupted in 2019 by problems that were not caused by the Covid-19 pandemic (we still had to wait some 4 months for them). The US Fed was forced to resume QE as early as September 2019 in response to deteriorating economic data and liquidity concerns on the stock market.
US Fed assets
In addition to the impact of QT on the Eurozone market, interest rate hikes associated with QT are expected to continue to create tensions in the bond market in the near future. A number of governments will be required to refinance significant amounts in a market with much higher interest rates and lower investor appetite.
Market interest rates
The central bank’s interest rates and hints about their future are the reference point that everyone pays attention to. The central bank sets overnight interest rates, while the market trades maturities ranging from one day to several decades. The key to securing interest rates for several months or even years is to “guess” what the central banks will do during that period. Accordingly, market interest rates sometimes run ahead of central banks’ actions and sometimes lag behind.
In spring 2021, I tried to model by how much interest payments on mortgages might potentially rise in 2023. I took the maximum 3-month Euribor rate at 1.5% (which at the time the market was pricing a year ahead). I cannot believe how wrong these calculations turned out! At the end of 2022, the 3-month Euribor rate was already 2.13%!
I am now updating the Excel file with the current forward prices (approximation). You can still download it to your device. Modelling interest payments for different scenarios is possible, but in reality, all will be different, therefore, factor in a cushion.
It is useful to examine the relationship between the blue line (1-month Euribor) and the red line (ECB deposit rate) in the graph below to understand how the market prices in one month’s interest rate while anticipating possible ECB action in the next month. On the other hand, the difference between the 1-month and 1-year Euribor rates usually indicates how much the market expects interest rates to rise in the future.
As the one-year Euribor rate of -0.50% at the beginning of 2022 shows, no rate hikes were expected, but after the outbreak of war in Ukraine, the market started to price in rate hikes in late March and early April. When ECB unexpectedly decided to raise rates by 50 basis points (originally a 25 basis point increase had been hinted at), the first sharp rise in longer-term interest rates occurred in June.
Changes in Euribor and ECB deposit interest rates in 2022
For the coming year, I use the Euro FRA (Forward Rate Agreement) rates in my interest cost forecasting calculator. Although this is not a reliable benchmark, it does give an indication of the direction in which interest rates are likely to move in the near future. Estimates have varied widely over the past year, and they have always been wrong - not in direction, but in the range. Of course, this is not a forecast, but an indication of what the market can expect in terms of futures prices. The interest payment on a mortgage, lease or other loan is also a futures transaction, so you should understand what the market expects.
Here is why the prices of forward contracts, futures, swaps and other instruments are not a good indicator of expected interest payments. Look below at the figure with the 3 coloured lines.
The green line on the chart represents the prices of 3-month euro interest rate transactions on 3 January 2022 one year ahead. After six months, the market offered a price of -0.47% for the deal. After six months, on 1 July, the 3-month interest rate in the market was -0.176%. Interest rates climbed faster, with a spread of about 29 basis points. The price the market offered for a deal after 12 months on 3 January was -0.28%. After 12 months, the 3-month rate was above 2.13%, a spread of 241 basis points. The further we look into the future, the greater the divergence will be in the real market. Futures buyers were the winners (i.e., saved money through lower interest payments).
Now the blue line. These are the prices on 1 July 2022 for 3-month euro interest rate transactions one year ahead. After six months the market was offering 1.044% for the transaction. On 1 January 2023, the 3-month rate in the market was 2.132% - rates rose faster again, a spread of 109 basis points. As you can see from the blue line, the price on 1 July 2023 was 1.519%, which is already lower than the current 3-month Euribor rate on 1 January 2023 (2.132%). Again, futures buyers were the winners (i.e., saved money by paying less interest).
The red line (usually the current curve – this time updated on 1 January, which is actually the figures for the last working day in December 2022) is the one I used to calculate the expected interest payments on 1 January in the Excel file above, but it is already clear that things most likely will look different in reality. It is currently unclear whether the 3-month rate will reach 4% this year (if inflation does not pick up and the ECB continues to fight it aggressively) or whether it will fall to 3% (if inflation falls sharply, the ECB will be forced to prop up the market). Either way, the red line represents the baseline scenario at the time the calculations were made as it has already moved or will move differently 5 minutes before and 5 minutes after making the calculations.
Public debt is the sword of Damocles hanging over the heads of governments, especially those whose debt levels are above those that are necessary for the desired levels of sustainable economic growth. While it is true that high inflation allows for debt reduction, not all Eurozone countries experience the same level of inflation. Debt to GDP calculations are affected by the expected recession. It is important to note that in December 2022 almost all Eurozone governments will be able to issue short-term bonds at a negative interest rate (or borrow money from investors). Currently, only Japan has a negative short-term interest rate in the world, and even there sentiment is changing.
Indicative yields on government bonds issued by Eurozone governments (what governments pay to borrow money)
Clearly, debts are not repaid, they are refinanced, and not all debts are refinanced at the same time. Debt should be smoothed over several years in advance to avoid very high-interest payments when interest rates rise. Nevertheless, several governments have to borrow tens of billions of euros every year, which last year alone, at this level of interest rates, led to the cost of servicing the debt increasing by several billion euros every year.
In 2023, Italy will have to cancel or refinance EUR 363.4 billion worth of bonds. In January 2022, the 10-year interest rate on Italian bonds was around 1.2%. Currently, it is around 4.6%. The spread is 340 basis points and 340 bp in interest payments for a debt level of EUR 363.4 billion means an annual increase of about EUR 12.5 billion. Compared to interest rates a year ago, this EUR 12.5 billion annual cost is a debt service cost that cannot be invested in economic growth but must be “put aside” for future interest payments.
Investors, however, can be happy about such interest rates. It is now possible to invest in safe bonds and get reasonably good interest rates after many years of negative interest rates. By the end of 2022, bond buyers were awakened.
In the table below you will find the interest rates for bonds outside the Eurozone. However, if you live in the Eurozone and invest in these bonds, there is a currency risk that can increase as well as decrease your return.
Borrowing costs for non-Eurozone governments
The news is good for investors but bad for corporate borrowers. Interest payments on loans in the Eurozone rose sharply, not only on the basis of the Euribor rate, but also on the basis of corporate bond rates. Now creditworthiness is playing an important role again. During the period of negative interest rates, the gap between “good” and “bad” rated securities was small. In contrast, interest rates on low-rated securities have almost doubled as market rates rise and risk premiums increase. In the middle and right graphs, you can see how the price of risk for the market (or for German bonds) has changed in recent years and how the spread between AAA and BBB-rated corporate bonds has changed. Moreover, the coming months are likely to hold further interest rate hikes (unless the ECB changes its tone).
A measure of the cost of money for companies in the Eurozone (average interest rates on AAA and BBB-rated Eurozone corporate bonds)
Stock markets
In 2022, the stock market was probably best described as a game of “Who wants to be a millionaire?” for billionaires, which has become an oft-used joke. Read an article published in CNBC: “America’s richest lost $660 billion collectively in 2022“.
Stock indices behaviour in 2022 (percentage change since the beginning of 2022)
In 2022, only the FTSE 100 Index (+0.9%) was in positive territory. All other indices fluctuated between -2% (Vilnius) and -33% (Nasdaq). A few figures below show the history of the S&P 500 index. The S&P 500 index is representative of the largest stock market in the world, the US, and is a useful indicator of investor sentiment, regardless of where they are located.
Despite the fact that December has historically been positive on average for the S&P500 index, December 2022 was disappointing (-5.9%). However, the last quarter (+7.1%) pulled the second half of the year (+1.4%) into positive territory. Nevertheless, the disastrously bad year was not averted.
S&P500 index monthly percentage change
I have summarised the index performance since 2000. December 2022 was the weakest December since 2018 and the third worst month since 1992. Likewise, January 2023 does not look promising as the last three Januarys have been in negative territory and economic sentiment is also more negative in January this year. Perhaps the market will follow the pattern observed since 2008 – three negative Januarys followed by three positive Januarys... But joking aside, that is not how markets work. Negative months are highlighted in red in the chart below.
S&P500 index changes by month since 2000
2022 was a tough year for investors. Historically, in the last 90 years, only five years have been worse than the previous year. 2022 was the worst year for the S&P 500 index since 2008, yet it was a better year for investors than recent ones (with the exception of the pandemic “blowout” in March 2020). Is there anyone interested in buying stocks at record prices? See the next section for an overview of the “discounts” you get when you buy shares in various companies. The fastest way to become an owner of a well-established and well-performing company is to buy shares (those who have built their own companies know what it takes to reach this level). In the following chart, the years with a decline of more than 19.4 % are highlighted in red.
S&P 500 index percentage change since 1931
To bring the S&P500 index back into focus a little, I have compiled the percentage changes in the S&P500 and the Nasdaq100 over the last 40 years in the chart below. In the last 40 years, it has only happened a couple of times that the two indices have not been on the same side of zero. Only the Nasdaq100 index tends to have a higher volatility range. A look at the negative years also supports that only once in 40 years has a negative year not been followed by a positive year, and that was after the bursting of the internet bubble when we had three negative years in a row.
Comparison of year-on-year changes for the S&P500 and Nasdaq100 indices
Now - how much longer can the S&P 500 fall? There is still some room for it. However, no one can tell you how low or how long it will go. We are currently witnessing the 7th time in 50 years that the S&P 500 Index has fallen more than 20% since its last record level (4818.62 points on 4 January 2022). All seven times are shown as lines in the chart below. This week marks the first anniversary of the index’s decline. Even if we disregard the fact that the S&P 500 index fell 86% from 31.86 points to 4.4 points in 679 working days during the Great Depression, the longest decline in the index in the last 50 years occurred between March 2000 and October 2002. There is no bubble bursting in the market at the moment, but there is an unpleasant combination of war in Ukraine, record-high inflation, rising interest rates, central bank easing (withdrawing money out of the market) and an expected economic recession that will negatively affect the stock market. How much longer?
S&P500 indices’ 7 biggest declines over the past 50 years (weekday declines)
Commodities
Russia plays a significant role in the commodities market, especially in Europe, therefore the war in Ukraine had a significant impact on prices and inflation figures. Whereas China is the world’s biggest player in the commodities market (outdated 2018 article: China’s Staggering Demand for Commodities). Therefore, as well as keeping an eye on the war, we must also be aware of what is happening to the Chinese economy. China is changing, too (China’s commodities demand growth to slow; energy transition to uphold prices). Below is a figure of four commodities and their price changes over the last 5 years (each line represents one year). This gives a good idea of the impact of commodity prices on annual inflation. The percentages in the figure are the price change on the last day of December 2022 compared to the prices on the last working day of December 2021.
Seasonal timetables for commodities
Below are the price change charts of some metals (steel and aluminium) over the last five years. The price is given in Chinese yuan per tonne.
Steel and aluminium price changes over the last 5 years
The above charts are price charts. However, to get a more accurate measure of the impact of commodity prices on inflation, I have calculated the percentage change in prices over the year (the difference between today’s price and the price a year ago, expressed as a percentage change). The following charts show how commodity prices have changed over the year. When the shaded area is above zero, inflation goes up, but when the shaded area is below zero, this should drive the price level down.
Globally, log prices have risen sharply in 2021. Judging by lumber prices in Chicago, it reached 400%. However, at the end of 2022, the price was already more than 60% below the closing price in 2021. Consequently, there is already a deflationary trend in timber prices.
Log price in Chicago – price percentage change during the year on the relevant date
There is still no positive news on the fuel front. Although oil prices have fallen from last spring’s highs (they were over USD139 per barrel in March), they are still higher than they were at the end of 2021. At the end of 2022, oil prices were below EUR87 per barrel. The following chart illustrates the price change for the most commonly used diesel fuels. With fuel prices over 40% higher than a year ago, fuel continues to “feed” inflation.
Diesel fuel on the financial market – price percentage change compared to the previous year on the respective reporting date
When it comes to price percentage change and economic impact, gas is the strongest accelerator of inflation. However, there is light at the end of the tunnel. Although the war in Ukraine might lead to an increase in the price of gas on the market, the price of gas is already below the price levels of a year ago. Hopefully, spring will be warm this year.
Gas on TTF stock exchange – price percentage change during the year on the relevant date
There has also been strong inflation in the food market, but the trend in recent months has been positive. While prices are still rising, the rate of increase is slowing.
Wheat on the stock exchange – price percentage change during the year on the relevant date
Steel prices fell significantly in the second half of 2022 after experiencing a price spike in 2021. Metals critical for the automotive and construction industries are already contributing to the deflationary trend.
Steel in China – price percentage change during the year on the corresponding date
It is similar with aluminium. It looks like the big price increases are behind us and we are already seeing a decline compared to last year.
Aluminium in China – price percentage change during the year on the corresponding date
The US dollar plays an important role when it comes to commodities, as commodity prices on the exchanges are usually quoted in dollars. The euro-dollar exchange rate has fallen by around 15% since September 2022. This is compounded by rising commodity prices quoted in dollars, which has contributed to a rise in inflation in the eurozone. However, things improved towards the end of the year, and the euro exchange rate ended the year 6% below its January 2022 level. Below you can see how the euro performed against various currencies in 2022. A line below zero is good for Latvian exports, while a line above zero is bad (and vice versa for imports).
Euro value percentage change in 2022 since the beginning of the year
Inflation
In recent years, it has proved pointless to make accurate predictions (who could have predicted the Covid-19 pandemic, or stucking of the Evergreen in the Suez Canal, or a war in Ukraine?). According to ECB management, forecasts need to be based more on binary search algorithms applied to rapidly evolving data sets. “The Council will continue to make its interest rate decisions based on the data available at each meeting.”
The figures below illustrate the thankless nature of forecasters’ work. The charts are the ECB estimates for Eurozone GDP and inflation. The range of forecast revisions is clearly visible and the difference between forecast estimates is 3 months. The commodity price charts you have seen above point to the expectation of falling inflation rates. A complete inflation outlook should also include data on wages, consumption and consumer sentiment. Sentiment, however, favours falling inflation. Remember that low inflation means that prices will continue to rise, but at a slower pace than today. Deflation (i.e., falling prices) is not expected. This does not rule out a fall in prices for certain products, as we have seen in the commodity price charts.
ECB Eurozone’s GDP and inflation forecasts
In December, the Bank of Latvia organised an expert panel: Inflation then and now. During the event, an overview of current inflation was provided from the perspective of a number of factors, including rising energy prices, food prices, the labour market situation, and fiscal and monetary policy. You can watch the video below.
The chart below shows that ECB strives to keep inflation at the 2% level, and given the relatively short history of the Eurozone, there was a reasonably normal situation between 2003 and 2006 (the green period below in the chart). Both inflation and interest rates were at “normal” levels. This chart also shows that euro interest rates in the Eurozone were above 5% at least a few times.
Eurozone’s annual inflation and Euribor 3M and 1Y interest rates since the introduction of the euro
In times of high inflation, people usually talk about ways to protect their money from losing value, and gold is considered one of these safe havens. Historically, gold has often risen in value faster than inflation, but unfortunately, in these times of high inflation, gold is no saviour.
Gold’s price per troy ounce in US dollars since 2010
Andris Lāriņš
Head of Financial Market Department at SEB
This article is for information only. It contains general information about the economy, financial products, investment services or ancillary services. The information provided is based on sources we believe to be dependable. However, SEB cannot accept liability for any inaccuracies or errors or for any losses arising from reliance on this information. Furthermore, exchange rates, interest rates, and commodity prices may rise or fall at any time and historical performance is no guarantee of a similar outcome in the future.
