Financial markets are still digesting the fallout from German Chancellor Merz’s sudden policy U-turn last week. Investors have revised their inflation expectations for Germany and the eurozone upwards. Expected GDP growth in the eurozone is now around 1.5%, more than double previous forecasts.
“We too see higher inflation with the consumer price index (CPI) forecast around 2.5%, up from below 2% previously. Now that the ECB is also revising its inflation forecasts, the likelihood of further rate cuts in the current monetary easing cycle seems to be diminishing. Markets are still pricing in too much additional easing,” says Mark Dowding, CIO of RBC BlueBay Asset Management fixed income.
If the deposit rate remains at 2.5%, the current 10-year government bond yields of 3.25% in the eurozone seem reasonably valued. However, Bund yields could rise further, as they become less scarce due to increased bond issuance.
On the corporate bond market, it is noticeable that European corporate bonds outperformed their US counterparts in March. European spreads remain stable, while US spreads are increasing. This is mainly due to favourable market conditions in Europe, which outweigh concerns about import duties and a negative stock market sentiment.
According to the ICE BofA indices, the spread on European corporate bonds remains at 90 basis points, while US spreads have increased to 97 basis points. This is the first time since the invasion of Ukraine (first quarter of 2022) that European spreads are lower than those in the US.
For the bond market, there is currently little reason for the Federal Reserve to cut interest rates in the short term. Despite better-than-expected US inflation figures, risks remain, especially due to the impact of new import tariffs in the coming months. "We see these tariffs as a supply shock to the US economy. Central banks can influence demand, but have less control over supply problems, as they did earlier during the corona crisis," says Dowding.
Nevertheless, investors still expect an additional 75 basis points of interest rate cuts by the Fed in 2025, which Dowding believes is too much. "That is why we reduced our duration in US bonds last week."
At this point, it cannot even be ruled out that the Fed will raise interest rates as a next step, despite them already being above the estimated long-term average. In 2021, the Fed underestimated rising inflation, and the FOMC does not want to repeat that mistake. “If core inflation rises above 4.0% (or 3.5% for core PCE), pressure to raise rates again could increase,” warns Dowding.
