Update Bonds: More potential for lower rates in Europe than US
In the current economic dynamics, the European Central Bank (ECB) is continuing its path of rate cuts, while the US Federal Reserve (Fed) is delaying and letting it depend on economic developments.
Ten-year US Treasuries are yielding around 4.50% and German Bunds are at around 2.55%. The low-interest rate environment and period of quantitative easing (i.e., central banks buying huge amount of bonds) that we experienced after the 2008 financial crisis and related to the pandemic are behind us. These events led, direct or indirectly, to a surge of inflation. Central banks aggressively raised their official interest rates to slow runaway price increases. These actions have an impact on economic growth, which are felt differently in the US and Europe.
Federal Reserve Chair Jerome Powell expressed at this week’s meeting of Fed policymakers that further rate cuts are paused, depending on evidence of disinflation (which the Fed still expects) or a significant weakening of the US labour market. The Fed will continue with its financial tightening, as US bank reserves are still excessive. Powell said that it is too soon to adjust monetary policy in anticipation of possible future changes to trade or fiscal policies (such as due to Trump administration actions).
This outcome was not a surprise for investors, but it confirms, at least for now, that the Fed is no longer in an active easing mode. We expect two more cuts of 25 basis-points each at the Fed’s March and June meetings, although this may be seen as aggressive, given Powell’s remarks.
In Europe, we expect the European Central Bank (ECB) to remain in easing mode through the first quarter of 2025 and after having delivered a 25 basis-point cut this week. We expect that 2% inflation may be reached sustainably by April, against a background of a slight weakening of the euro-area labour market. Due to uncertainties over possible US tariffs, a pause in April, however, is likely. If the potential tariffs impact growth and inflation, the ECB could resume its easing cycle at its June meeting, cutting rates by more than markets currently are pricing-in and until the deposit rate reaches 1% in early 2026. For us, a lower rate trajectory in Europe is clear.
Despite attractive yields in emerging markets and high-yield bonds, we remain cautious, due to the potential impact of higher rates on risky assets and valuations that we believe remain expensive. We favour higher-quality bonds offering more attractive risk premiums, as they are likely to perform well even amid limited growth in Europe.
Roel Barnhoorn