The European Central Bank is sealing Greece’s fate

Interest rates have gone up again.

Not in Britain, of course. Yesterday the Bank of England kept the bank rate at its 0.5% record low.

But across the Channel, the European Central Bank (ECB) has just lifted its official rate – for the second time this year – from 1.25% to 1.5%.

Neither decision was a surprise. In fact, anything different would have been a shock. But this move by the ECB matters for investors.

Here’s why.

The ECB is sealing Greece’s fate

Even allowing for the ECB’s other rate lift this year – the 0.25% increase in April that was the first since 2008 – 2011’s rate rises don’t look a big deal.

If we could all borrow money at just 1.5%, we’d probably all be very happy. Compared with what’s going on in eurozone bond markets (where the likes of Greece and Portugal are seeing their cost of borrowing soar) it seems small fry.

So why is the move so important?

First, it shows that the ECB is worried about inflation, even if other central banks aren’t. EU-wide consumer prices are climbing at 2.7% a year, some way above the official medium-term target of just below 2%. By sticking to its guns and hiking rates, the ECB is just doing its job by looking after the value of its currency.

Second, the ECB is making it clear it won’t be blown off course by the growing problems on the eurozone’s edge. It will set monetary policy to account for what’s happening at the ‘zone’s core: in Germany.

German industrial production is expanding at 7.6% a year. That’s slowed down a bit recently, but it’s still very healthy: in Britain, overall production output is actually shrinking. Meanwhile, German inflation is at 2.3%. That’s still uncomfortably close to its three-year high.

But, what’s right for Germany isn’t so great for holders of peripheral eurozone sovereign debt.

How Europe could see a wave of defaults

The levels of overspending and overborrowing in the likes of Greece, Portugal and Ireland have long been headline news, so we don’t need to repeat the details here. But although it’s bending its own rules on collateral to keep these countries going for the moment, the ECB’s latest action is sealing these countries’ fate.

For one thing, higher ECB rates will mean more expensive home loans. Mortgages in most of these countries are linked to the ECB rate. For overstretched borrowers, that could be very bad news.

More to the point, it won’t make it any easier for these countries to grow their economies and repay their debts. The bigger picture is that yields on government bonds issued by Greece, Portugal and Ireland have been surging for months. In other words, the price of these bonds has plunged as investors get ever more concerned about their chances of being repaid.

But what’s happened this week has been extraordinary.

Irish two-year bond yields have jumped from sub-13% on Tuesday evening to 16% yesterday. Portuguese two-year debt yields have soared from 13% to 18%. Greek two-year bonds now yield a staggering 29%.

That simply can’t continue. Such dramatic moves imply the market is saying the game is nearly over. Default in some form by one or more peripheral countries is fast becoming more likely, whatever the politicians are pretending. And as John Stepek recently pointed out, we don’t know where it will end: The next big worry for the eurozone – Italy.

What would this mean for investors?

“In the short run, a default is usually very costly and leads to, or exacerbates, a sharp fall in output”, says Andrew Kenningham at Capital Economics.

“This is usually accompanied by a banking and/or currency crisis and can lead to capital flight, which can force a government to impose capital controls or freeze bank accounts” My colleague Merryn Somerset Webb – ahead of the game as usual – blogged about this last month: How Greece could bring capital controls back to Europe.

And the fallout could spread far and wide.

“Once one country defaults, the costs and benefits of servicing sovereign debt can change dramatically for other [similar] countries”, meaning “defaults tend to come in groups rather than individually”, says Kenningham. It could “take many years to resolve the eurozone crisis”: and facing “years of stagnation, some governments are likely to think seriously about exiting the currency union”.

It’s impossible to predict exactly how this will all play out. But it’s bound to cause lots of volatility in the euro’s value. That would play straight into the hands of traders. It’s risky, but if you want to play sharp currency market shifts, see what our spread betting blogger John C Burford has to say in his free email MoneyWeek Trader.

And stock markets could get very choppy indeed. We’ve said it many times before, but this makes it sensible to stick to defensive shares that are less likely to be buffeted by market volatility.

But there may be a beneficiary. The US dollar is a traditional safe haven in troubled times, even if it hasn’t been showing those qualities much recently. And in this week’s issue of MoneyWeek magazine, I take a look at some stocks that would benefit if the buck gets a boost from euro woes. Subscribers can read the story here: The dollar: will it rise from the dead?

Category: Economics