If growth is the answer to Europe’s debt crisis, then oil is the question.
European Central Bank President Mario Draghi, who lowered interest rates at his first two monthly meetings as head of the ECB since November, may struggle to keep borrowing costs down as oil reaches a record when calculated in euros. Crude is up more than 30 percent in the past six months in the single currency, reaching a record 81.85 euros ($110) a barrel this week.
“Rising oil prices will present another challenge to the ECB and it may make it less likely for it to cut rates at a pace the market is pricing,” said Mohit Kumar, the head of European fixed income strategy at Deutsche Bank AG in London. “I’m not saying the ECB will raise rates anytime soon. It tends to be more sensitive to inflation than the Federal Reserve or the Bank of England.”
European Commission President Jose Barroso said this week that “growth is the answer” to the economic woes that have driven Greece, Italy, Spain, and Portugal into recession. Inflation-linked debt suggests investors are starting to anticipate faster inflation, demanding the highest premium since August to own regular 10-year German securities rather than bunds with interest payments tied to consumer prices.
The yield on 10-year index-linked bunds has declined from minus 0.11 percent at the start of the year to minus 0.20 percent, while Germany’s 10-year borrowing cost is little changed at 1.82 percent. The 10-year breakeven rate, a gauge of inflation expectations derived from the gap between index-linked and regular bonds, climbed to 1.85 percentage points last month, the most since August. It was at 1.65 percentage points today, compared with an average of 1.58 points in the past six months.
The region’s inflation rate was at 2.7 percent in January, while the ECB aims to keep it just below 2 percent. On Jan. 12, Draghi cited energy costs for stoking inflation. The central bank forecasts that the consumer price growth rate will average 2 percent this year, compared with 2.7 percent in 2011.
France’s two-year breakeven rate rose to 2.0 percentage points from 1.79 percentage points at the start of the year. Yields on non-index linked bonds of the same maturity have dropped 21 basis points to 0.60 percent.
Oil priced in dollars has advanced 9.9 percent this year on concern that escalating tensions in the Middle East will disrupt supply, after the European Union agreed Jan. 23 to ban crude imports from Iran. West Texas Intermediate crude futures touched $109.95 in New York trading on Feb. 25, before trading at $108.30 yesterday.
Commerzbank AG raised its 2012 oil price forecast for West Texas Intermediate crude to $107 a barrel from $101 and North Sea Brent to $117 from $108, the Frankfurt-based company said in an e-mailed report on Feb. 22. The euro region will shrink 0.3 percent this year, down from a November estimate for growth of 0.5 percent, according to the European Commission’s forecasts.
Rising oil prices are “a double-edged sword” for central banks, said Carsten Fritsch, an analyst at Commerzbank. “It may boost inflation in the short term, but it damps the growth outlook,” he said.
The ECB, whose primary job is to fight inflation, left its benchmark interest rate at a record low of 1 percent this month and last. It reduced borrowing costs in November and December by a quarter-point each time, reversing increases made last April and July. Former President Jean-Claude Trichet applauded the bank’s willingness to raise rates in July 2008, two months before Lehman Brothers Holdings Inc. filed for bankruptcy protection, as evidence of its determination to fight inflation.
Greece to Germany
“The ECB’s tightening in 2008 and 2011 testifies to its willingness to react to higher commodity prices,” said Kumar at Deutsche Bank. He sees less risk of energy costs leading to rising prices in countries such as Greece or Spain, where unemployment has surged, than in Germany. “The risk of a pass- through of higher energy prices into inflation is higher in core countries given the tighter labor market conditions,” he said.
Social unrest against a backdrop of spending cuts and tax increases makes it harder for the ECB to raise interest rates, said Robert Farago, the London-based head of asset allocation at Schroders Private Banking which has 15.6 billion pounds ($25 billion) in assets. Tens of thousands of protesters rallied across Spain on Feb. 19 against a decree that lowers firing costs and makes it easier for employers to reduce wages. Rioters in Athens set fire to as many as 45 buildings during street protests that began on Feb. 12.
“Raising interest rates at the same time as imposing severe austerity measures could trigger a political crisis,” Farago said. “Expect the European Central Bank to talk tough but sit on its hands.”
The five-year, five-year forward breakeven rate in euros, which gauges inflation expectations for the five-year period beginning in 2017, rose to 2.63 percent on Feb. 8, the most since March 2010. That’s higher than in April and July of last year, when the ECB raised interest rates. It was at 2.47 percent yesterday. The gauge is among the inflation indicators that the ECB watches.
“Energy prices are a real struggle for the central bank,” said Thina Saltvedt, an analyst at Nordea Bank AB in Oslo. “It makes it more complicated for the ECB while they’re trying to stimulate growth.”
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