Rens Borsje: To hedge or not to hedge, a playbook for the next crisis

11 maart 2025

Let’s start with a quick overview of what is happening now, and then make some predictions on how this could play out for the EU, the ECB and financial markets. Two fundamental changes at the moment are both driven by the US, or more specifically by Trump.

• US withdrawal of support for Ukraine
  Europe and the UK are now compelled to step up their involvement, both in supporting Ukraine and in increasing defense spending. European Commission President Ursula von der Leyen has presented the ReArm Europe plan. € 800 billion will have to be raised and spent over the next four years. Notably, € 150 billion will be raised through some form of Eurobonds, with von der Leyen stating that 'nothing is off the table'.
• Trade war and economic uncertainty
  Aggressive tariff discussions and a looming trade war could significantly disrupt supply chains, international trade and (corporate) investments as uncertainty grows. The volatility of US trade policies, with frequent changes and pauses, is making the US an increasingly unreliable trade partner, further reducing economic stability.

Additionally, we must consider the impact of the ECB's prolonged stimulus efforts. The ECB has maintained historically low interest rates, from 2011 to 2021, using a combination of low benchmark rates, aggressive forward guidance, and quantitative easing through asset purchase programs (APP). The COVID-19 pandemic extended this period of monetary easing, arguably exacerbating the supply-driven inflation spike of the past two years. The ECB balance sheet as of 31 December 2024 has about € 377 billion of QE assets.

 

^{Source: ECB annual account 2024}

The build up

Now for part two. How could the current state of Europe lead to a crisis? First let’s look at the swap curve and forward interest rates. The ECB has so far successfully defeated inflation by the fastest rate increase we have ever seen: ten rate hikes in the timespan of just over a year. The market was expecting quick rate decreases, leading to one of the more uglier interest rate curves I have ever seen. Below I present an example of a forward curve from the beginning of last week:

 

^{Source: Chatham Financial}

However, following the ECB’s rate cut last week, market expectations have shifted, with investors now predicting only one more rate reduction at most. I expect we will have a normal upward sloping yield curve soon if not already the case by the time you are reading this.

Inflation

I am afraid we are going to see EU inflation rise again. A trade war on the horizon, or at least a decrease in efficiency of internation trade and supply chains, will increase the cost of goods and imported materials for the EU. Furthermore the spending package announced by Von der Leyen and the German proposed easing of fiscal policy has already increased costs of capital for Germany. As more member states follow, I expect this to push the euro down further, adding to the cost of imported goods and materials. Note that the expectation is that the majority of this package will not directly flow into the EU economy despite the 'EU first' language used, thereby reducing the positive impact of the stimulus package on the EU economy.

The ECB’s dilemma

The ECB might become stuck between a rock and a hard place. The dual directives of 2% target inflation and financial stability will come at odds with each other. As inflation rises and uncertainty increases, the interest rates will have to go up to battle inflation, however the economy and politicians may prefer to keep stimulating through low benchmark rates. This tension could lead to policy missteps, causing further instability in the financial markets. I expect the interest rates to go up as a hawkish ECB will try to reduce inflation and protect the strength of the euro.

A recipe for disaster

The combination of rising interest rates, credit spreads widening and an artificially inflated economy as a result of ten years of cheap money is to me, a recipe for disaster.

• This credit risk cycle, of higher costs of capital and increased defaults, can strengthen itself, leading to extremely high costs of capital and/or a complete drought in liquidity akin to the 2008 crisis.
• The so-called 'zombie' companies that have been kept alive for too long by easy credit will finally collapse.
• Equities have ample room for correction, and as funding costs rise, defaults will increase and future expectations are recalibrated down.
• Market volatility is already on the rise, reflecting investor concerns.
• Lastly, private equity firms now control an unprecedented share of private debt and equity holdings. It is unclear to me how this reduced transparency in combination with historically quick and ruthless acting agents will influence the course of a developing crisis, however I doubt it will be a stabilizing factor.

What now?

The dire picture I have painted is, of course, just one possible outcome. A swift resolution to the Ukraine war and a de-escalation of Trump’s tariff threats under US domestic pressure could restore market stability and allow for a gradual return to normality.

However, I am not convinced that investors and risk managers fully appreciate the risks of a potential crisis, nor do I believe these risks are currently priced into financial markets completely.

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