Author: Gary Skedge, Head of UK Liquidity Strategies, Federated Hermes
The eurozone is facing deepening economic woes from the conflict in the Middle East as surging energy prices choke growth.
The bloc’s economy expanded by only 0.1% in the first quarter, while inflation rose to 3% in April, its highest level since September 2023.
The labour market has held up better. Unemployment fell to 6.2% in March, helped by modest hiring in Spain and Italy across tourism and services. But other indicators are softer. Manufacturing is still expanding, though more slowly, while business confidence has weakened, particularly in services and construction.
At the start of the year, the EU was forecast to grow by 1.4% in 2026, with inflation a little above 2%. But in May, the European Commission slashed its forecasts to 1.1% GDP growth and raised its inflation expectations to 3.1% because of the energy shock. Unemployment is also expected to rise.
A harder policy trade-off
At its April meeting, the European Central Bank (ECB) kept its deposit rate unchanged at 2%, stressing that upside risks to inflation and downside risks to growth had both intensified. Markets have since pushed back expectations of near-term easing and, at the time of writing, were pricing in at least two rate increases in 2026, with a first 25bps move possible as early as June.
In bond markets, euro area spreads have remained stable, but the repricing of ECB expectations pushed the two-year German Bund yield to about 2.70% in mid-May1, underlining how little room investors now see for near-term easing.
The Italy-Germany 10-year spread has remained broadly steady at about 75-80bps, although Italian debt has come under slightly more pressure due to the country’s energy exposure and fiscal backdrop.
Such uncertainty has the potential to reshape investor behaviour. Euro-denominated money market funds (MMFs) have become more attractive as elevated short-term rates, daily liquidity and low duration offer a relatively defensive place to hold cash.
Assets in euro MMFs have risen sharply over the past two years and stood at €450bn at the end of April. Demand accelerated after the ECB began raising rates in June 2022, ending eight years of negative rates.
Shorter duration
Money market funds hold diversified pools of highly-rated, short-dated debt. That gives managers room to adjust quickly if the macro picture shifts. Since the outbreak of the Iran conflict, many euro-denominated funds have opted to shorten portfolio duration in response to rising uncertainty.
In that environment, conservative-approved lists matter. Portfolios focused on liquid bank and sovereign issuers in northern Europe are generally easier to trade and reposition. Funds that reach further into emerging markets or the Middle East may offer the potential for higher yields, but they can also be harder to adjust when conditions change quickly.
The near-term outlook still depends heavily on geopolitics. If the US and Iran move towards a resolution and the Strait of Hormuz reopens fully, the latest inflation spike may prove temporary, allowing the ECB to look through part of the shock. If not, and energy prices remain high, the drag on global growth will deepen, with Europe likely to be among the most exposed regions.
MMFs provide more than just a yield play against a short-dated cash position. They offer investors a rare combination of liquidity, income and relative insulation from a deteriorating macro outlook and, amid the economic fallout from the Middle East crisis, they are likely to play an increasingly significant role in portfolios everywhere.
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