The big shift

Western economies are entering a new phase of increasing interest rates

The last few weeks have been characterized by a general increase in the yield of European government bonds, with a sharp rise in the ten-year French, Spanish and Italian government bond spreads over German bonds.

A first reason can be found in a growing political risk. In France Marine Le Pen is benefiting from a scandal affecting François Fillon; in Italy the political scenario is ever more uncertain; populist movements are increasing their popularity in different countries. All this is creating uncertainty around the Eurozone economies that makes bond markets nervous.

However, the main driver behind the recent drop in European government bonds seems to be the ECB, notably the market expectations about its next steps. The quantitative easing is going to slow down starting from March (60 billion a month instead of the current 80 billion) and is supposed to cease in December. True, Mr. Draghi has repeatedly said that the QE will be extended if necessary. However, two main factors could force the ECB to reduce its monetary stimulus.

The first one is that inflation is accelerating and will probably rise further in the next months as the last year low oil prices exit from the annual rate. Given the objective of an inflation "below but close to 2%", the monetary stimulus could no more be justifiable as inflation approaches its target.

The second factor is the limit on the ECB's purchases, which cannot hold more than a third of the total outstanding debt of each Eurozone country. Under the QE rules, the ECB must buy the different government bonds proportionally to the economic size of each country. As a consequence, given the relative shortage of some government bonds (notably German's ones), extending the QE beyond December might be impossible for the lack of eligible assets to buy.

At the same time, on the other side of the Atlantic, the Federal Reserve is moving toward a rate hike, in response to the strengthening American economy and to the inflationary policies announced by Mr. Trump.

Western economies are thus entering a cycle of increasing interest rates, not just for the risk premium component of the bond yields, but mainly for the risk-free component affected by the current macroeconomic fundamentals.

The beneficiaries will be all the subjects that suffered most from the period of ultra low interest rates: banks can finally broaden their margins again; insurers and pensions funds can restart to invest their liquidity in more lucrative long term bonds; private savers looking for safe returns will have plausible opportunities.

The economy as whole should not suffer for the simple reason that the rate rise is actually a consequence of the economic situation itself and thus not big enough to offset the beneficial effects of the reviving inflation on the economic growth.

South Europe governments appear to be the real losers, as higher yields put pressure on their budgets. However, as said, the increasing rates are a response to the return of inflation, which lower the real cost of borrowing (offsetting, at least partially, the increasing nominal cost). But most of all, the end of monetary stimulus can represent the right incentive for governments to focus on fiscal policies. For a (too) long period the monetary policies have been the only ones to effectively support the economic growth. Governments should now step in and reaffirm the importance of fiscal policies. The big shift from monetary to fiscal policies must certainly be carefully managed. Nonetheless, it can no more be postponed.

2017.02.16