What does 2021 hold for European interest rates and foreign exchange?

Financial forecasting is a treacherous business. Almost by definition, markets receive their sharpest jolts from the events that are least expected. Periods of seismic change, when accurate forecasts would be most useful, are also the periods in which the consensus view is likely to be furthest from the mark. Few years have illustrated this as dramatically as 2020.

It is therefore an odd time to be making predictions for the year ahead. And yet the consensus expectations for interest rates and foreign exchange are still worth a look – if only to consider how they could be wrong.

Interest rates and inflation

Rates across the UK and the Eurozone started the year at the historic lows struck by central banks’ emergency responses to the pandemic. At the short end of the yield curve, the Bank of England’s (BoE) base rate stands at 0.1%, while the European Central Bank’s (ECB) headline deposit rate is -0.5%. More striking is the near-total absence of any expectation that these will rise in the foreseeable future. Market participants anticipate, at most, one rate hike from each central bank in the next five years, and nothing in the next two. In 2021 the BoE is viewed as more likely to push through a further cut.

Longer term borrowing costs have been kept in check by vastly expanded quantitative easing (QE) programmes. At £895 billion, the BoE’s announced purchases of government bonds are now double their pre-pandemic level, while the ECB’s Pandemic Emergency Purchase Programme for buying sovereign and corporate bonds totals €1.85 trillion. Such enormous increases have prompted concerns that central banks are effectively printing money to finance their governments’ deficits – calling into question both their independence, and the soundness of their monetary policy decisions. Earlier this month, a survey of the 18 largest players in the UK gilt market found that the majority believe the BoE’s QE programme is primarily aimed at financing new issuances of government debt, rather than achieving the Bank’s inflation target.

For now, these views have not developed much. But they do underline the degree to which the current low interest rate environment depends on inflation remaining subdued. Should an inflationary wave materialise, central banks would come under significant pressure to both raise rates and rein in QE. While the consensus view all but dismisses this possibility, there are reasons to keep a watchful eye on it.

First is the money supply, which expanded throughout 2020 due to increased bank lending. Both corporate treasurers and households now have relatively high levels of cash on balance – and, unlike in 2009, household debt is below average. As vaccine rollouts allow society to reopen, and pent up demand is released by people who have been kept in varying levels of lockdown for a year, prices could push up.

Any demand surge would not occur in isolation though; it would be exacerbated by a constriction in supply. The shutdowns of the last year caused severe hits to production around the world, and bottlenecks are already starting to emerge in freight and commodities. The price of copper is up 25% from the start of 2020, and iron ore by 60%. Meanwhile, the oil price has rebounded from a brief spell in negative territory in April 2020. All will feed through to higher consumer prices.

It is difficult to picture a recovery in which these inflationary pressures are anything more than transitory. Should they prove to be more persistent, however, the impact on financial markets would be significant. Inflation has a way of getting out of hand very rapidly – and of forcing a central bank’s hand on interest rate decisions.

Foreign exchange and financial services

Both GBP and EUR finished 2020 at their highest levels against USD for two and a half years, although this was primarily due to dollar weakness. With vaccine news returning a degree of confidence to the global economy, investors who had previously sought the safety of USD-denominated assets switched back to “risk on” mode. Analysts generally expect this trend to continue at a slower pace throughout 2021.

More interesting is the dynamic playing out between GBP and EUR. Having fallen from €1.20 to €1.06 in the early days of the pandemic, sterling finished the year at €1.11 – a level around which it had hovered for much of the prior six months. This relative stability was maintained despite a succession of “last ditch” attempts between the UK and the EU to come to a post-Brexit trade agreement; persisting after the agreement was reached on 24 December 2020.

This is unsurprising given that the discussions to date have barely touched on the services sector, which form the overwhelming bulk of the UK’s economy. 2021 will be the year (or, at least, the first year) in which the future of the trading relationship – and, therefore, of the pound – will be determined.

The negotiations around financial services, the UK’s biggest export, will be particularly important. As of 1 January 2021, UK-supervised firms lost the passporting rights that allowed them to carry out regulated activities in the EU without additional red tape. The replacement is “equivalence”, whereby each side can allow the other’s financial firms to provide specified services based on an assessment that their regulatory regimes are broadly equivalent. While the UK has granted equivalence to EU firms for a wide range of financial services, the EU has only reciprocated for a small number that it deems crucial for its own financial stability, such as clearing. Even in these areas, the designation is only temporary, and the expectation is that EU regulators will eventually require such systemically important services to be provided within its own jurisdiction.

Ultimately, it is in the interests of both sides to come to arrangements that avoid fragmenting markets and increasing the costs of virtually all financial activities. Some areas, such as asset management, rely on a delicate ecosystem of different professions that it would be nearly impossible to relocate in a rush. That said, the City of London is unlikely to retain its current 90% of the €735 trillion EU clearing market, its 84% of FX trading, or its 80% of over-the-counter derivatives trading. Already, €1.6 trillion of banking assets have been relocated to EU entities in order to support trading and liquidity. The first week of 2021 also saw a shift in the trading of EUR-denominated shares from London to Amsterdam.

The back end of 2020 saw the removal of two of financial markets’ biggest uncertainties: we now know that a “no deal” Brexit has been avoided, and that the end of the COVID-19 pandemic is in sight. Many might conclude that 2021 will be a less eventful year – for markets and for the world at large. It may be the factors that the consensus view is most complacent about that pose the greatest risks.