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Europe braces for an ECB tightening

Short-term interest rates in Europe are rising, in anticipation of a decision by the ECB to start raising interest rates. ECB President Trichet today surprised the world by suggesting the ECB may raise rates at its next meeting, in response to evidence of rising inflation pressures. German 2-yr yields, priced to the market's expectation for the average of the ECB's target policy rate over the next two years, jumped over 20 bps today and have risen almost 100 bps so far this year; they are now 100 bps above 2-yr Treasury yields. As the chart below shows, the ECB already has the distinction of being the "tightest" major central bank in the world, with its target rate of 1%. (It would be perhaps better to say that the ECB is the "least easy" of the major central banks.) If they are the first to tighten, and it would appear likely, this will be a very important development.

The world's major central banks—with the notable exception of the Bank of Japan—tend to move together, as the chart above suggests. An early move by the ECB to raise rates will thus put pressure on the Fed to follow suit. Is this something to worry about? No. The prospect of higher rates has not deterred European stocks from rising, and it has given a substantial boost to the Euro, as indeed it should. Currency markets love tight-fisted central banks. The dollar, in contrast, is at its weakest level ever, thanks in large part to the Fed's repeated promises to keep rates close to zero for a very long time.

European yield curves are still very steep, and the real ECB target rate is approximately zero. This means that the ECB could (and is likely to) raise rates by hundreds of basis points over the next several years before policy becomes tight enough to threaten growth. In the meantime, it bolsters confidence in the Euro, and strengthens the outlook for the Eurozone economies. I note also that 2-yr Euro swap spreads fell today on the ECB news, and are now at a 10-month low—another sign that this is a welcome development.

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