| Oil prices will trigger global rate rises |
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| Niall Dunne analyses the impact of recent trends in the oil markets, and warns of higher interest rates ahead. |
WWhen history looks back at 2004, in financial terms, it’s going to be remembered as the year of global monetary tightening. And if historians want to know why 2004 marked the turning point in the international interest rate cycle, they’ll find the trigger in the second quarter when oil prices soared.
Looking back at media coverage of oil prices in May, it’s clear that geopolitical unrest, the threat of terrorism, and speculative activity all combined to drive the cost of crude to a ‘record’ high. Yet it’s not immediately evident that the record high was only a record for the futures contract traded on the New York Mercantile Exchange, a contract which has only existed since the ‘80s. In current prices, oil traded comfortably above $80 during the crises of the ‘70s. This fact, combined with OPEC’s decision to increase its production quotas, explains why the cost of crude has now fallen off the front pages.
However, the recent oil price spike will have a long lasting effect on corporate treasury management.
For a start, oil has entered a new trading range. Increasing global demand, falling global supplies, and the threat of terror in the Middle East effectively render OPEC’s former target price of $25 per barrel obsolete a $30 dollar target is now more realistic. We’ve also entered a far more volatile market. Obviously this is of most relevance to treasurers with direct fuel exposures, but any company with significant transport or electricity costs might now also wish to consider possible hedging strategies. For example, through Ulster Bank you can now hedge your exposure to price fluctuations in various commodities, including oil, gas and coal. Beyond obvious customers for these strategies, such as airlines and haulage companies, heavy users of electricity might also consider hedging against a sharp rise in the price of commodities which would likely lead to higher energy costs. The other, more widespread, effect of rising oil prices can be seen in global inflation rates. In the second quarter of ’04, inflation rates in all major economies spiked, particularly in the Eurozone and the US. It’s especially important for treasurers to recognise this, because higher inflation rates are already leading to higher funding costs.
Take the Eurozone as an example. Across the dozen nations that share the euro, in the 12-months to the end of May 2004, consumer prices rose by 2.5 per cent. That’s the fastest rate of Eurozone consumer price inflation since March 2002. Meanwhile in America, prices paid by US consumers rose by 0.6 per cent in May, the fastest monthly increase recorded since January 2001. And as we move into the summer, central banks around the world are starting to worry about the ‘second round effects’ of rising oil prices. The European Central Bank (ECB) is not overly concerned by the short-term effect of rising oil prices; what troubles the governing council is the possibility that rising energy costs will result in higher wage demands, which would threaten future price stability across the continent.
That’s why the market has now come around to the view which we’ve long held that the next move in the Eurozone base interest rate will be a hike, not a cut. If prices continue to rise at a rate in excess of what the ECB consider stable (they define 2 per cent year-on-year inflation as stable), then that rise could come before year-end. And the pressure on the ECB is likely to mount on Wednesday June 30th, when the American Federal Reserve is expected to raise the US overnight interest rate.
With first quarter inflation in the US running at 2 per cent on an annualised basis, it’s hardly surprising that US rates have to rise.
The interest rate market has taken a similar view, because futures contracts have adjusted sharply to reflect a new expectation of rising rates. As we go to print, the LIFFE 3-month euribor contract for expiry in December 2004 implies that 3-month euro will cost 2.48 per cent by year-end. Given that 3-month euribor usually trades 10 - 15bps over the refi rate, the futures market is suggesting that the overnight rate will rise to at least 2.25 per cent by December ’04. By way of comparison, the same contract in March was suggesting a year-end refi rate of 1.80 per cent - the market was still looking for a rate cut at that stage. And the further ahead the market looks, the more hawkish its expectations become. By June ’05 the 3-month euribor contract implies a rate of 3.00 per cent; by year-end ’05 the market implies 3.48 per cent; and by mid-year ’06, the futures market expects 3-month euribor to cost 3.78 per cent. Meanwhile the forward curve has become similarly hawkish of late. In late March, the 5-year euro swap rate stood at 3.20 per cent; as we go to print, the forward curve implies a 5-year rate closer to 3.85 per cent.
So the interest rate cycle has turned, and it can only be a matter of time before the ECB follow the Fed and the Bank of England in tightening monetary policy. The futures market might be too eager in looking for an ECB rate rise by year-end after all, the ECB often fall behind the curve. Yet with US rates set to rise rapidly from their current 46-year low, the ECB may be left with no choice but to follow suit, if they wish to avert an inflationary euro collapse. This point is worth emphasising the Eurozone economic recovery is tentative, and if the price of oil stabilises, there might be no obvious need for a rate rise. Yet if the Fed double US rates by December 2004, and then push the overnight US rate to 4.00 per cent by end-2005 without any response from Frankfurt, then the dollar will probably rise sharply against the euro. A significantly weaker euro would restore pricing power to Eurozone producers and suppliers, and that itself would prove inflationary and force Eurozone interest rate hikes.
So what action should you take as a corporate treasurer, if you agree with the above analysis? It can be hard to take a long-term view and commit to fixed-term funding when current variable rates are so low, and that’s why we in Ulster Bank think that collar strategies with triggers look attractive at current prices. By way of illustration, we can offer 5-year strategies that allow you to benefit from current low rates while simultaneously offering peace of mind. For example, over 5-years, such strategies currently allow you to pay 3-month euribor on a quarterly basis (assuming the 3-month euribor rate remains within a range of 1.85 per cent and 6 per cent - only on a break out of this range do you convert to fixed rate funding at 6 per cent.) This strategy looks particularly attractive when you compare the current 3-month euribor rate (2.12 per cent) to the current 5-year fixed rate (3.85 per cent).
And finally by way of comparison, consider the following: in the 66 months since the ECB took control of Eurozone monetary policy, term swap rates have traded higher than current levels for 44 months or roughly two-thirds of the time. So while current fixing costs might look unattractive compared to those on offer 3-months ago, history warns that rates can move significantly higher. |
Niall Dunne is treasury economist at Ulster Bank.
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| Article appeared in the July 2004 issue.
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