Update Bonds: US Fed is walking a tightrope
On Wednesday, Federal Reserve Chair Jerome Powell left the key US policy rate unchanged, as expected. However, investors were more focused on his comments afterward. Uncertainty surrounding the rate path for the remainder of the year has been growing in recent weeks.
Fed governors have now indicated that they may cut interest rates twice in both 2025 and 2026. Powell emphasized that uncertainty about the economic outlook remains unusually high.
Concerns over future interest rate cuts have intensified amid fears of a trade war and federal government layoffs, raising worries about an economic slowdown. For instance, consumer confidence took a sharp hit in March, according to preliminary data from the University of Michigan released last Friday. Lowering interest rates could help stimulate the economy. The
yield on the two-year Treasury note—closely tied to shifts in monetary policy expectations—fell to its lowest level of the year on 11 March. Around that time, President Donald Trump appeared willing to accept a temporary slowdown in growth during a transition period.
Paradoxically, an interest rate cut is expected to fuel inflation, which remains above the Federal Reserve's 2% target. The US consumer fears that Trump's tariff war could further drive up inflation. The US two-year breakeven inflation rate—which reflects market expectations for inflation over the next two years—has reached its highest level since March 2023, standing 1% above the central bank’s target. This limits the Fed’s flexibility to cut rates. However, Fed Chair Jerome Powell stressed on Wednesday that the inflationary impact of higher import tariffs may only be temporary.
On Monday, the German parliament approved Friedrich Merz’s proposals to invest billions of euros in defence and infrastructure. When the plans were first announced two weeks ago, German bund yields experienced their sharpest surge since reunification, with yields on longer-term bonds rising more than those of shorter maturities. As a result, the yield curve has taken on a more typical shape, with the spread between two- and ten-year yields reaching its highest level in over two years.
The Federal Reserve finds itself in a delicate balancing act between growth and inflation, which makes future rate cuts uncertain. We expect the European Central Bank to continue with rate cuts, as an escalating trade war could weigh on growth. We therefore continue to prefer investment-grade European bonds.