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      Borrowers should prepare for tougher funding conditions
      TUESDAY, 28/02/2023 - Scope Ratings GmbH
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      Borrowers should prepare for tougher funding conditions

      The bond market has enjoyed favourable conditions since the start of the year but Scope’s European Financial Conditions Index has started to tighten in response to sticky inflation, meaning borrowers are likely to face more difficult funding conditions.

      The Financial Conditions Index measures the long-term deviation from the average of 10 financial market variables across rates, foreign exchange, credit, equity and commodity markets. While higher rates have been a key driver of tighter financial conditions, risk premiums for credit and equity markets have started to rise as well, despite etter-than-expected economic data.

      European credit initially benefited from the normalisation of energy costs but with spreads close to their historical average, they are now likely to move wider in view of the global inflation trend and prospects of weak overall economic growth.

      Figure 1: Financial conditions set to tighter further in March

      Source: Scope, financial data providers

      Headline inflation has started to decline across major economies but core inflation was revised upwards for the euro area, reaching a record 5.3% in January year-over-year. In the US, annual price increases for personal consumption rebounded to 4.7%, interrupting four months of steady decline in annual core inflation.

      Even in Japan, core inflation hit a new high of 3.2% after almost two years price declines. The UK bucked this trend in January but core inflation has already been running well above that of other major economies for months. The worse-than-expected inflation numbers coincide with stronger economic activity and survey data that suggests that final demand across major economies is holding up better than expected, especially in the services sector.

      Figure 2: Core price inflation remains sticky

      Source: National statistical agencies

      Core inflation has pushed short-term German and US government bond yields to 3% and 4.8% respectively, their highest since the Global Financial Crisis. But while nominal bond prices have fallen, real yields have remained surprisingly stable ,with the yield on 10-year German inflation-linked bonds hovering around 0%.

      This means that market-implied long-term inflation expectations have increased in the euro area, which can be observed both in break-even rates for German Bunds and in inflation swaps. Low or zero real yields are positive for indebted corporates and households as they imply the burden of higher financing costs can be inflated away over time. However, in this environment they are above all a sign that financial conditions remain too loose relative to the current inflation trajectory, suggesting that investors will demand higher returns ahead.

      Figure 3: Inflation expectations in the euro area

      Source: Macrobond, Bloomberg

       

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