Update Bonds: Eyes on inflation data
Last week, the European Central Bank (ECB) cut its key interest rate for the eighth time since June of last year. Following the decision, ECB President Christine Lagarde indicated that the central bank has "nearly concluded" its current monetary policy cycle.
Markets expect one more rate cut by the end of the year. Now, the focus is on the upcoming tariff negotiations and their potential impact on growth and inflation on both sides of the Atlantic.
The interest rate cut came as no surprise, given the pressures on European economic growth and the expectation that inflation will remain subdued for an extended period. Two key factors contributing to the disinflationary trend are lower energy prices and the strength of the euro. The euro/USD exchange rate is approaching its highest level since 2022, driving down import prices. In May, eurozone inflation was at 1.9% year-on-year, raising concerns about potential under-inflation. ECB Chief Economist Philip Lane emphasized this week that the rate cut was crucial to prevent inflation from staying below the 2% target.
The ECB's rate policy has exerted pressure on shorter-maturity European bond yields, with the German 2-year bond yield declining by 120 basis points over the past year, while the 10-year yield has remained relatively stable year-on-year.
In the US, markets were also closely monitoring inflation data this week. May's inflation increase was less than anticipated, suggesting that companies have yet to pass the higher tariff costs onto consumers. Following the release of these inflation figures, the likelihood of a Federal Reserve interest rate cut by September rose to 80%. The two-year Treasury yield, which is sensitive to central bank policy, fell below 4%, while longer-term yields have climbed since April, due to concerns about expanding government deficits.
The impact of US import tariffs remains uncertain for both Europe and the US. While the Federal Reserve is expected to hold rates steady next week, the ECB is approaching the conclusion of its easing cycle. European investment-grade bonds with longer durations are still favoured and offer a potential buffer in uncertain times.