[Reuters Analysis] Berlin's historic shift redraws euro rate horizon: McGeever

By Jamie McGeever

ORLANDO, Florida, March 6 (Reuters) - Germany's plans to go on its biggest public spending spree in 35 years will likely lead to higher borrowing costs across the euro zone – and that's a good thing.

While the European Central Bank may have proceeded with its widely flagged 25 basis point cut on Thursday, lowering the policy rate to 2.5%, the real story in Europe this week is the sudden and spectacular jump in euro bond yields and massive shift in expectations for the ECB's terminal rate.

Up until now, Europe's economy was widely viewed as stagnant and unproductive, reflected in the low yields on German bonds versus U.S. Treasuries, dovish expectations for the ECB's policy path, and estimates of an ultra-low or even negative long-term neutral interest rate.

But this all changed in an instant this week.

On Wednesday, news of Berlin's fiscal plans sent Germany's 10-year Bund yield rocketing the most since the euro was launched in 1999, and, by some estimates, since 1990.

Money markets are moving too. Implied pricing now suggests the ECB will not cut interest rates much more from here – a notable shift from market expectations only 48 hours ago.

While talk of 'European exceptionalism' may still be a stretch, the gap between the euro zone and the U.S. is narrowing on many fronts, including growth expectations, equity prices, and, now, interest rates.

This is a good reminder that while bond yields can rise for bad reasons – worries about widening deficits, burdensome debt loads, or plain old inflation – they can rise for good reasons, too.

For Germany this should be stronger growth, greater investment, increased productivity, and deeper fiscal coordination across the continent. It's a set of goals analysts have been urging the bloc to pursue for years. If the euro zone is successful in achieving them, it will need to get used to higher borrowing costs – but that's not a bad exchange.

POSITIVE R-STAR?

Policymakers are less nimble than market traders, so the ECB can be forgiven for cutting rates on Thursday, even as bond yields across the bloc were spiking.

The central bank noted that policy is becoming "meaningfully less restrictive," and President Christine Lagarde said policymakers must be "attentive and vigilant" to the new fiscal landscape.

This all suggests that the ECB's 'terminal rate' - the lowest point of the easing cycle still in play - will now be higher than previously thought. The question is how much higher.

Economists at Nomura have already removed two quarter-point rate cuts from their ECB outlook and are now forecasting a terminal rate of 2.25%. They had previously speculated that the ECB could go as low as 1.50%.

JP Morgan economists reckon a terminal rate below 2.00% is now unlikely, and that's where euro money markets appear to be settling as well. This all suggests the ECB is probably close to the end of its easing cycle, which chimes with a speech by ECB board member Isabel Schnabel, who argued even before this week's news that a "pause or halt" to rate cuts may be approaching.

Importantly, it's not just the outlook for nominal ECB rates that is changing. Estimates of "R-star" – the inflation-adjusted neutral rate of interest that neither slows nor accelerates economic activity – will likely rise also. And there's plenty of scope for that.

Several leading models have long indicated that the euro zone's R-Star is ultra-low or even negative, meaning the region's economy requires a real interest rate below zero over the long run.

In light of this week's news, it's safe to say those models – and many investors' priors – will need to be updated.

(The opinions expressed here are those of the author, a columnist for Reuters.)

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