Euro Rates to 4% & Beyond?

The European Central Bank (ECB) confirmed on Thursday (as largely expected) that it was leaving its key interest rate unchanged at 3.75%. The statement made by ECB President Jean-Claude Trichet was by and large the same as the one he made in March and as ever the bond market listened intently for certain ‘key’ words that either were or were not present. The rhetoric continues to suggest that the Council has a hiking bias remaining in ‘very close monitoring’ mode, describing the key interest rate as ‘moderate’ and monetary policy as continuing to be on the ‘accommodative side’. The bond market is now pricing in a further hike to 4% in June. As you would expect Trichet was unwilling to be drawn on predicting if or when the ECB would choose to raise rates but he did little to suggest the markets expectations of a June hike were flawed.

Growth in the Eurozone led by Germany remains strong. Real GDP grew at 3.3% in 2006 and the indications are that this strong growth has continued into 2007 despite concerns around the US economy faltering. Corporate profitability as a share of GDP remains high and money expansion remains at levels that appear above the ECB’s level of comfort. German exports remain strong and I believe the consumer could potentially surprise to the upside in 2007. Whilst inflation remains anchored below 2%, we remain worried that wage developments threaten to the upside. The ECB unsurprisingly continue to talk tough; ‘the medium-term outlook for price stability remains subject to upside risk’ and that it remains ‘essential to ensure that risks to price stability over the medium term do not materialise.’ Just as Richard believes the Bank of England will continue to hike in the face of inflationary pressures I believe that the ECB could be forced to go beyond the 4% that the bond market is currently expecting as its peak.

So what does this mean for my fund (the M&G European Corporate Bond Fund)? I have taken the fund shorter duration expecting yields to rise further. Ten year Bund yields have moved from 3.95% at the start of March to 4.23% as I write. This week is likely to be an important one with the US Q1 reporting season getting into full swing. For now I intend to continue to run a short duration position though just like the ECB I’ll be watching the data closely!