Big ECB hike adds fuel to the banking sector fire

A shopper pays with a ten Euro bank note at a local market in Nice
A shopper pays with a ten Euro bank note at a local market in Nice, France, June 7, 2022. REUTERS/Eric Gaillard

LONDON, March 16 (Reuters) - Euro zone bank shares hit a ten-week low on Thursday after the European Central Bank (ECB) raised rates by half a point, even though some investors had thought the turmoil in financial markets would deter it from delivering another hefty hike.

The rising cost of borrowing added pressure on banks, already in turmoil following the collapse last week of Silicon Valley Bank (SVB) and a crisis at Credit Suisse (CSGN.S), which sent its shares to record lows on Wednesday.

As forecast by a Reuters poll, the ECB raised its benchmark interest rate by 50 basis point (bps) to 3%, its highest level since late 2008.

But over the past few days, money markets had started to price in the possibility of a 25 bps move amid concerns over the banking sector.

"The ECB hike has come as somewhat of a surprise, especially given the events of the last few days. The problem being that European banks were forced to load up on bonds in order to meet capital requirements, and the higher interest rates go, the less these bonds are worth, so hence the negative reaction here," said Michael Field, European Equity Strategist at Morningstar.

An index of euro zone banks (.SX7E) fell by as much as 1.2% to its lowest since Jan. 2 in the minutes after the decision. After five consecutive monthly gains, the index is now set for its biggest monthly drop since the first COVID-19 lockdowns in 2020.

Underscoring the febrile state of markets, however, euro zone banks later recovered ground, with the index closing up 1.35%. The ECB lifted its growth outlook for the euro area and said the region's banks were in a much stronger position than they were during the 2008 financial crisis.

"Central banks have a real dilemma that they have a core mandate, which is inflation. But there's also a challenge now post-SVB and given banking volatility," said Justin Onuekwusi, Head Of Emea Retail Investments at Legal & General Investment Management in London. "We have seen volatility and likely to see greater volatility".

Ratings agency Moody's said on Thursday Europe's banking systems remained in fundamentally good health. Having a lower proportion of their assets in bonds means Europe's lenders are less exposed to fluctuating interest rates than their U.S. counterparts, Nick Hill, a managing director at Moody's, told investors and reporters.

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The ECB has raised interest rates since July at its fastest pace on record to curb inflation. It had effectively promised another 50 bps increase for Thursday and signalled further moves in the months ahead.

"The rising systemic risk investors have endured over the past five days does not make the ECB flinch," said Florian Ielpo, head of macro and multi asset at Lombard Odier Asset Management in Geneva.

"Inflation remains too high to be ignored and the risk to unwind what the ECB has started is worth the resulting financial instability for now," he added.

The euro's reaction to the decision was fairly muted. It was last trading 0.35% higher on the day at $1.0616. On Wednesday, the currency hit its lowest against the U.S. dollar since early January, at $1.0516.

Germany's 2-year bond yield initially fell after the central bank decision. It was last up 22 bps on the day to 2.5820%.

Euro zone government bond yields and the single currency had already rebounded earlier on Thursday after Credit Suisse said it would borrow up to $54 billion from the Swiss central bank to shore up liquidity and restore investor confidence.

Reporting by Joice Alves; Editing by Amanda Cooper and Mark Potter

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