February has so far proved to be a major turning point in the European interest rate cycle. Much of the world has been on notice that interest rates are now heading upwards as inflation rates spike and economic activity remains relatively robust.  Until now, however, Christine Lagarde, the president of the European Central Bank, has always indicated that any movements will be measured and certainly not in 2022.

This is no longer the case with the markets now indicating a relatively strong chance of a first move taking place before the end of the year.  What has changed and what happens now?

Significantly, the ECB is now indicating that a number of the prerequisites for opening a discussion to increasing interest rates have been met.  Additionally, the indication that inflation expectations is starting to fuel spot inflation prices is also driving the thinking at the ECB.  Previously, the central inflation forecast at the ECB indicated that the supply shocks and high energy prices would only contribute to short-term inflation, with these one-off factors abating throughout the year. 

While this may be the case, longer-term inflation expectations are now pointing upwards.  This has led to much more hawkish comments from Lagarde, as well as some of the main European central bankers who have begun to indicate that the asset-purchase programme will end sometime towards the later part of Q3, paving the way for a first rate hike in Q4 2022. 

As can be expected, bond prices have generally reacted negatively, with prices falling, thereby pushing their yields up.  A move upwards in rates is seen very much as a step towards the normalisation of interest rates.  After all, it is rather unusual for interest rates to be negative i.e. the equivalent of banks charging for each deposit that you place with them, rather than rewarding you for ‘lending’ them your money.

In some ways, therefore, this is a welcome step.  Banks will certainly breath a sigh of relief at this prospect as they can look forward with greater visibility to the day when they are not charged a negative rate on the balances they deposit with central banks.  But for many savers, this is also an important step towards returning to the concept that you are rewarded for saving rather than penalised for it. 

Much of the world has been on notice that interest rates are now heading upwards- David Curmi

While it will mean that the value of current bond investments will fall, it will also mean that new bonds that come to the market will be issued at more attractive coupon rates. This will be great news for pensioners who have been through a torrid time in trying to maximise their income without taking on too much risk.

There are important considerations for businesses though.  The cost of money will rise.  In other words, businesses, and the government for that matter, will have to pay higher rates of interest on their future borrowings.  For Malta, this is not good news as the government needs to finance a deficit, forecast to be in the region of 5.6 per cent of GDP (or approximately €750 million) in 2022 at higher rates. This is in addition to the €469 million of government stocks that are redeeming this year.

For investment portfolios that are exposed to these types of investments, a thorough strategic review is important at this stage.  It has long been said that the bond market is going through the greatest bubble of all time.  While this may be an exaggeration, there is some truth in it as the move to negative interest rates has pushed prices to levels which makes it challenging to earn any sort of decent return. 

Additionally, prices of riskier bond investment have also been pushed to what are possibly extreme levels, even if the premium you get for these bonds versus an equivalent government bond is not at a historic low.

While we are still at the very early stages of a move higher in European interest rates, the process to normalisation of such rates could be a fairly lengthy one that will lead to significant changes in yields on bonds and higher volatility in the prices of such bonds, be they long or short. 

This is already playing out in the market. The key driver here will be the extent to which inflation remains sticky at these higher levels.  It may be worth watching this space this year. 

David Curmi is chief executive officer of Curmi & Partners Ltd.

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi & Partners Ltd is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.