EfTEN CapitalEfTEN Capital


To fix or not to fix – that is the question

In the 7 years of business of EfTEN, at various points in time, we have discussed the potential fixing of the floating interest rate by using the financial instrument of an interest rate swap. Opinions on this have varied. One position states that we are in the real estate and not interest business, meaning we are engaged in our principal job and leave interests for others to worry about. Also, it is important to add that even in this current environment of zero interest, financial expenses are the largest cost item in our monthly income statement. Another factor, a counterargument, maintains that if often, our income part is “locked” due to long-term fixed price lease contracts, it would be reasonable to fix the expenses part as well, via the interest rate swap.

At the end of 2007 and particularly at the beginning of 2008, when the 6-month Euribor kept crawling upwards, banks started strongly recommending, that is, demanding that interest rates be fixed for borrowers. So, there was a loan in EfTEN’s portfolio, taken in 2008, for which we fixed the Euribor at 5% for five years at the request of the bank. After the bankruptcy of Lehman Brothers on 15 September 2008, floating interest rates started falling sharply. Therefore, this fix was clearly unfavourable for us.

The attitude of banks at that time was understandable – at the beginning of 2006, the 6-month Euribor had only been at 2%, whereas by autumn 2008, right at the time of the bankruptcy of Lehman Brothers, this figure had been going up and reached 5%. The 3% increase in base rate started to have a significant impact on the loan servicing capabilities of companies. This was added to by the dark clouds of economic crisis lurking above the Baltic States economy at that time. When the Euribor started falling quickly, many borrowers cursed those interest rates fixed at high levels and promised never to do this again. And so did we.

However, we have just decided to fix the floating interest rate risk by using the financial instrument of a 7-year interest rate swap. If we look at the big picture for a moment, it is clear that everyone is expecting the US central bank, the Fed, to raise interests already this year. This decision is expected from as early as the September meeting of the Fed. Great Britain or the Bank of England, which is showing the fastest economic growth among the G7 countries is facing the same pressure. It is important to note that if in the USA in 2008, interest rates were taken down to zero where they have remained till today and the respective interest rate of the European Central Bank is downright negative today – at -0.2%, the effective interest rate of the Bank of England today is 0.5%.

Central bankers are notorious for being really slow to raise interest rates as the economy grows, but really quick to lower interest rates in a crisis. We remember the coordinated and simultaneous interventions by the world’s leading central banks to calm down money markets in the shock experienced after Lehman. In the situation where interest rates are raised, every man is out for himself.

In conditions of economic growth, a slow increase in interest rates creates bubbles on financial markets, mainly in the asset prices. The greatest applicable argument against an increase in interest rates is non-existent inflation. The European Central Bank is a central bank with one clear mandate – its purpose is to guarantee price stability in the Eurozone with inflation close to 2%, but preferably below it. In its first 10 years of operation, the European Central Bank managed to keep average annual inflation at an excellent 1.9%. The US Fed has two mandates – one is to keep inflation under control and the other is employment. If we look at the freshest news from the US labour market, interest rates should be raised immediately. Five years ago, the USA was struggling with an unemployment rate of 10%, but by today, this has dropped down to 5.5%. From the school lessons in macreconomic theory, we can recall that an unemployment rate of 3% basically means full employment because there are always people in every society who never wish to work.

The main counterargument for raising interest rates is non-existent inflation both on this and on the other side of the Atlantic. Or even deflation that slows down the economy. Against the backdrop of the zero interest rate policy and quantitive easing, in other words money printing, by central bankers, the inflation rate has not risen much above zero. That is, monetary policy decisions have not reached the real economy in the expected form. This is a phenomenon the exploration of which will permit the defence of quite a few doctoral theses in the future. At the same time, it is the current objective reality.

However, there is still reason to believe that the increase in inflation (of course, we are not talking about a high inflation rate, but only a return to an annual inflation of 1-2%) is not far off. If we look at the dynamics of the broad or M3 monetary aggregate of the European Central Bank (the term is explained in detail here), it is clear that the European Central Bank will do its best to increase the velocity of circulation of money and with that, stop deflationary pressure in the Eurozone. Recent statistics show that the efforts by the European Central Bank have started to pay off to some extent – in March deflation in the Eurozone was -0.1% but by June it was already inflation +0.2%. The change is small, but still there. In 2015, both the narrow monetary aggregate M1 and the broad aggregate M3 are experiencing a real growth over the years (read the newest report here). Everything seems to indicate that we can see an inflation increase in the Eurozone as well. As unbelievable as it may sound today.

From lessons in macroeconomics, we know the relationship between money supply, velocity of circulation of money and inflation (MV = PQ where M is the amount of money in circulation, V is velocity, P is price level and Q is quantity or the real GDP) – a significant increase in money supply will eventually lead to the formation of an inflationary environment. Even if we do not see it in the real economy just yet.

In reality, central bankers deserve much more attention than they have received so far. The indirect economic power of central bankers has significantly increased over the past decade. As persons, they are clearly more reserved with their academic background in economic theory than the “political pop stars” exercising executive power given by electoral mandate. As a group, they are far more boring for the media than Yanis Varoufakis, for example. Governments are struggling with their permanent four-year election cycles, endless desire to be popular and colossal public debts. According to the OECD, in the period 2007-2013, the debt level of the governments of the OECD member states has gone up by 34.7%. Higher inflation also means larger costs to governments for servicing public debt. So it is not said in vain that in the current environment, central bankers are the “actual masters of the universe” who prefer to remain inconspicuous. We must not forget that central banks as such are a relatively new phenomenon for us. The Fed came into this world a little more than a century ago – in 1913. The European Central Bank was conceived in the framework of the Maastricht Treaty in 1991, but the actual birth had to be awaited for another 8 years. The bank started operations on 1 January 1999 when the euro was adopted.

Coming back from the global level to EfTEN’s micro or rather nano-level, we are of the opinion that in the nearest future, a change in the movement trend of interest rates can be expected. It is a historical fact that of the four major central banks in the world (USA, UK, Japan and Europe), the USA is indisputably the pacemaker. So if the US Fed starts raising interest rates this autumn, the same lies ahead in a couple of years for Europe as well.

If the current zero interest rates feel like a fundamental human right for many and a “new standard” to remain forever, one should still look over one’s shoulder to the recent past. As a fund manager, it is my duty to stress that history is never a perfect guide for the future, but, citing Estonian former president Lennart Meri, history is an integral part of the present. In the period 1999-2009, the 6-month Euribor fluctuated between 2-5%. The current level is a non-existent 0.05%. The 7-year interest rate swap is expected to remain between 0.6-0.7%. So if we consider which risk is more likely – whether interest rates continue falling in the next seven years or start to rise, I would definitely bet on the latter. Why 7 years? We do not predict European interest rates to rise in the nearest few years. Especially if the European Central Bank continues with its QE programme. However, in the period of 3 to 5 years from now, significant changes may take place. If interest rates are fixed, it should rather be done for a longer period than a shorter one. For our taste the spread between the 10-year and the 7-seven year interest rate swap is too large, so we preferred 7 years over 10. Maybe one day we will regret this; we will see.

What is certain is that no-one can predict the future and we are not even trying to do that. The way we look at it is that we bought ourselves insurance for covering the increase in interest expenses. Like it often happens with car and home insurance – you pay the insurance but never really need it. However, if you do need it, it is good to know that you have the protection.


Viljar Arakas

CEO of EfTEN Capital AS

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