Interest rate swaps indicate growing volatility in Luxembourg economy

Interest rate swaps serve as a crucial risk hedging tool, especially during periods of economic uncertainty, and the recent trend of more aggressive swap rates in Luxembourg reflects investors’ perception of elevated risk levels in the business economy compared to households, as well as relative to neighbouring economies.

The widening spread between loan interest rates and the swap rates indicates that investors are concerned about Luxembourg’s economic outlook, leading them to price swaps more aggressively.

In an effort to bring down runaway inflation, the European Central Bank has implemented a series of eight consecutive key banking rate increases, resulting in a cumulative rise of 375 basis points. Consequently, interest rates on loans for businesses and households across the eurozone have been raised to varying degrees.

These increases have also had a notable impact on swap rates, which serve as a mechanism for investors and traders to manage their exposure to interest rate risks.

Additionally, swap rates are influenced by a range of economic indicators, including market conditions, central bank policies, inflation expectations, credit risks and other factors that shape expectations about future interest rates. These expectations are reflected in the pricing of swap contracts, ultimately determining the levels of swap rates.

Geopolitics

Even before the ECB commenced its monetary policy tightening in July 2022, the EU economy had already been under pressure due to escalating geopolitical tensions, notably including the military invasion of Ukraine by Russia in February 2023.

This development resulted in an initial increase in swap rates.

However, as loan rates remained relatively stable until May 2022, the spreads between interest rates for loans to the business economy (encompassing sectors such as manufacturing, construction, retail, services and others, but excluding households and non-profit institutions serving households) and the swap rates with a corresponding maturity began to shrink.

Inflation

As the war in Ukraine persisted and supply-chain bottlenecks continued, inflation experienced a surge throughout 2022, lasting longer than initially anticipated. In response, the ECB started tightening monetary policies, resulting in a further reduction in spreads.

This decrease in spreads signaled an increased perception of economic uncertainty and interest rate risks associated with business lending.

However, it is possible that the market’s expectations of future interest rate hikes, as reflected in the swap rates, outpaced the actual increase in bank loan rates.

Between July and October 2022, the spreads diminished even further, approaching zero, indicating considerable market uncertainty and perceived interest risks.

Diverging expectations

However, what is particularly intriguing is that since October, the spreads have started to rise but have diverged among the euro area member states.

For instance, the spreads in Belgium, Germany, France and Luxembourg, which previously moved closely together, have now shown significant divergence.

This suggests that either investors’ appetite for interest rate risk has fundamentally shifted between member states due to varying perceptions of future economic growth, or there has been a change in business sentiment regarding taking out new loans across different economies. As a result, the recovery of spreads has diverged among the member states.

Negative spread

The occurrence of a negative spread, as observed in Luxembourg at present, serves as an important indicator of substantial market volatility and uncertainty.

This situation typically indicates that investors and traders are increasingly seeking higher compensation to account for the risks associated with lending or borrowing funds in the market.

It may be worth mentioning that leading up to the 2008 financial crisis, spreads also experienced a contraction and briefly dipped into negative territory in October 2008. However, the current negative spread is broader in comparison.

It is though essential to recognise that the pricing of loans and the corresponding spreads are influenced by various factors, such as creditworthiness, risk perception, supply and demand dynamics and regulatory expectations. These factors contribute to the volatility observed in the spreads to differing extents.

Households

When examining comparable spreads between interest rates for new loans to households, including loans for house purchase, and the corresponding swap rates in terms of maturity and loan category, a slightly distinct situation emerges.

Germany demonstrates considerable resilience, whereas Belgium, France and Luxembourg show a close alignment, with spreads reaching their lowest point in October 2022 but subsequently widening once more.

This suggests that investors are having different perceptions of risks associated with Luxembourg households compared to those associated with the business economy.

A spokesperson for the ministry of finance clarified to Delano that the ministry “does not comment on current market conditions for private companies.” However added, “against a difficult macroeconomic backdrop, Luxembourg’s economy counts among the most resilient in the EU.”