The following article was penned by MZ Investment Services Portfolio Manager Jesmar Halliday

After a prolonged period of low interest rates aimed at stimulating the Euro Area's disinflationary climate, the European Central Bank (ECB) has begun to raise interest rates to the benefit of savers and bankers.

The recent surge in prices for essential items has prompted the ECB to respond decisively by tightening financial conditions and increasing interest rates to levels not seen since 2006/08. The ECB's supervisory role, structural reforms and ongoing bank stress tests have fostered confidence in European banks, as they have demonstrated resilience and an ability to withstand financial uncertainty.

The inflationary challenges faced by developed economies can be primarily attributed to Russia's invasion of Ukraine, which disrupted commodity markets, and to a lesser extent, the pandemic-induced fiscal stimulus led by governments.

The initial phase of inflation observed in 2021 was a result of economic reopening and a reversal of the deflation seen in 2020. The ECB's target of two per cent inflation was breached in mid-2021, with the Harmonised Index of Consumer Prices (HICP) ending the year at five per cent. This meant that the purchasing power of the euro decreased, as every euro was worth only 95 cents.

Banks, as price takers, were compelled to keep deposit rates low while the ECB maintained low interest rates in 2021 to ensure a smooth economic recovery from the pandemic. However, Russia's timing of the invasion of Ukraine was strategically aimed to maximise economic disruption in developed economies, leading to a compounding effect on price levels in the Euro Area.

Inflation spiked to 9.2 per cent in 2022, resulting in a significant decrease in the value of money.

To counteract inflationary pressures and mitigate the risk of a return to high inflation levels, the ECB made the decision to raise borrowing costs and cool down the economy. The ECB's deposit rate for banks increased by four per cent, rising from -0.50 per cent to 3.5 per cent within eleven months.

Inflation not only erodes the value of money but also negatively impacts consumer confidence and hampers employment prospects, thereby affecting an economy's potential output.

The anticipation of interest rate hikes had knock-on effects on investments with fixed returns. Most of the Euro Area bond market consists of fixed-rate bonds, resulting in significant capital losses due to rising interest rates in 2022.

The ECB implemented measures such as the transmission protection instrument (TPI) to mitigate perceived credit risk premiums. However, any decline in economic activity may amplify expected credit losses.

Despite the challenges, higher interest rates have provided European banks with a renewed sense of purpose and flexibility to drive responsible earnings. The net interest margin for European banks has rebounded significantly in recent times. The longevity of the current interest rate environment relies on the Euro Area's ability to sustain its economic momentum in the face of a higher cost of capital. Additionally, the ECB must effectively manage emerging credit strains within the financial system.

This article was written by Jesmar Halliday, CFA, Portfolio Manager at MZ Investment Services Limited. The author has obtained the information contained in this article from sources believed to be reliable and has not verified independently the information contained herein. The contents of the article are the author’s views and may not reflect the other opinions in the organisation. The article is being published solely for information purposes and should not be construed as investment, legal or tax advice or as a recommendation to buy, sell or hold any security, investment strategy or market sector. Past performance is no guarantee of future results, and the value of investments may go down as well as up.

MZ Investment Services Limited is a private limited liability company licensed by the MFSA to conduct investment services business under the Investment Services Act. Registered Office: 63, MZ House, St Rita Street, Rabat RBT1523 Malta. Further information may be obtained upon request from MZ Investment. Emails can be addressed to [email protected]. Telephone number is +356 21 453739.