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A closer look at what could be next for interest rates in Europe and what this could mean for the economy and stock markets.
This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.
In 2022 the world’s major central banks, bar Japan, were aligned in their fight against rising levels of inflation. Interest rates moved higher in the Eurozone, the US, and the UK in a bid to temper price growth with varying degrees of success.
However, as we progress through 2023, these central banks are starting to diverge.
The US is expected to deliver its final rate hike in May and then cut rates aggressively throughout the rest of this year. In contrast, the European Central Bank (ECB) is expected to keep hiking rates.
Will this divergence impact your portfolio, and do we need to be worried about rising interest rates in the currency bloc?
This article isn’t personal advice. If you’re not sure whether a course of action is right for you, ask for financial advice. All investments and any income they produce can fall as well as rise in value, so you could get back less than you invest.
The ECB continuing to hike rates after the Federal Reserve (Fed) has reached its terminal rate is to be expected. That’s because the ECB started hiking interest rates four months after the Fed, in July 2022.
However, what’s concerning about the future of interest rate policy in the Eurozone is just how committed some members of the bank are to higher interest rates.
In April, the President of the Bundesbank, Joachim Nagel, told journalists that “there’s still some way to go on monetary policy”. The head of the Austrian central bank said he would support a fourth straight 50 basis point rate hike when the ECB next meets.
The head of Estonia’s central bank also said that the banking turmoil in the US and Switzerland doesn’t, at this stage, change the outlook for the euro area. And the head of Slovenia’s central bank also said that receding concerns about financial market stability makes a 50-basis point rate hike a possibility.
You usually only expect statements that support further rate hikes to come from the most hawkish members of the ECB’s governing council, including German officials. However, in recent weeks and months there’s been an increase from neutral members of the ECB. This includes ECB President Christine Lagarde, who hiked interest rates in the middle of the recent banking turmoil.
Current market expectations suggest the ECB will hike interest rates by a further 56 basis points between May 2023 and January 2024. In contrast, the market expects 88 basis points of rate cuts from the Fed in the same time period. So, what are the implications of higher interest rates in the Eurozone?
Europe’s banking sector is likely to feel the force of the ECB’s rate hikes the most, however, the news isn’t all bad for the banks.
The ECB published research back in December 2022 looking at the impact of rising interest rates on the European banking sector. Their main conclusion was that banks are sound enough to handle the effect of rising interest rates on their balance sheets. However, the ECB also noted that banks need to prepare for longer-term effects related to normalising monetary policy, and they should pay attention to interest rate risk in their asset and liability management.
This is striking in two ways. First, interest rates are likely to be high for the long term, meaning banks need to be prudent. And second, it was interest rate risk that ultimately led to the collapse of Silicon Valley Bank and Signature Bank in the US in March.
On the positive side, the ECB found that Eurozone banks should remain resilient to an interest rate shock, and profitability would increase overall due to an increase in net interest income. But, on the downside, while banks could weather a shallow economic recession in 2023, banks would also need to increase their loan-loss provision rate to take account of how rising interest rates could hurt struggling borrowers.
Overall, the ECB seems happy that systemically important banks in the currency bloc can handle the ECB’s monetary policy tightening. However, they pointed out back in late 2022 that some banks could face trouble as rates continue to rise.
It points out that under a yield curve flattening scenario – where shorter-term rates are significantly higher than longer-term rates – this could cause problems.
If interest rates stay higher for longer, then some smaller banks might face a significant increase in their borrowing costs that wouldn’t be covered by their earning income. This is down to the fact that banks earn interest from long-term loans, but they fund themselves in the short-term lending markets.
This suggests that the Eurozone’s banking sector faces the same challenges as the US banking sector. Because of the market volatility and upheaval that the collapse of Silicon Valley Bank caused in March, you could assume the same might happen if there was a collapse of a European bank.
Sovereign debt risk is the other factor to think about.
Europe’s sovereign debt crisis between 2009 and 2012 caused several countries to require bailouts and threatened the survival of some European banks. Banks had significant holdings of government debt that exposed them to major losses.
Today, European banks have more robust capital positions and larger liquidity buffers, however, there are still risks.
During the pandemic, many countries in the Eurozone issued huge amounts of debt. Because of this, the euro-area debt-to-GDP ratio increased to 100% in 2020, which is higher than the 95% debt-to-GDP ratio reached in the aftermath of the euro-area sovereign debt crisis. This has led to some fears about debt sustainability.
The ECB’s analysis has found that an interest rate shock in the Eurozone, would be more detrimental for countries with higher debts, which is to be expected. As interest rates rise, countries with higher borrowing would see their debt burdens rise, which could heighten their vulnerabilities.
The risk is that this in turn could lead to the market reassessing the risk of these sovereigns, which could put them under more pressure, and lead to a situation like the sovereign debt crisis 10 years ago. The ECB think this could also be problematic for lower-debt countries in the bloc, presumably because they might need to bail out their debt-laden neighbours.
Bloomberg’s recession risk monitor shows that the Eurozone currently has a lower probability of a recession than the US, at 49% versus 65% for the US. This should help protect the most vulnerable banks, sovereigns, and borrowers in the Eurozone from rising interest rates. Remember though, these are just estimates and nothing is guaranteed.
Added to this, since the ECB has raised interest rates, the sovereign debt of some of the most indebted nations has remained stable, for example in Italy. There’s now part fiscal union in the currency bloc too with the Recovery and Resilience Facility. There are also other tools available to protect against another sovereign debt crisis, like the European Stability Mechanism.
Since the Russian invasion of Ukraine, there appears to be a greater willingness to tackle problems together at the European level. This could also help keep a lid on sovereign bond yields in the current environment.
There’s no doubt that interest rates at a 16-year high of 3.5% pose a challenge for the Eurozone. However, right now, it looks like the risks are manageable.
Kathleen Brooks is Founder of Minerva Analysis, a market analysis company. Hargreaves Lansdown may not share the views of the author.
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