Faster route to ‘normality’

The global decline in rates continued in August, fuelled by a series of soft economic indicators at the beginning of the month that raised hopes for more aggressive rate cuts in the US. Contributing to the decline in rates was the uncertainty following the Bank of Japan's somewhat surprising rate hike at the end of July, which led to the unwinding of Japanese investors' 'carry trades' in foreign assets. Market uncertainty has decreased over the course of August, but the question remains whether central banks – and particularly the Federal Reserve (Fed) – can meet the increasingly aggressive expectations in the market. If not, we could face a turbulent market environment later this year.

Faster route to US ‘normality’

Over the summer, the focus of the Fed has shifted from a singular emphasis on curbing inflation to now discussing the risk of causing significant damage to the labour market. This shift is particularly supported by an increase in unemployment (4.3% compared with 3.7% at the beginning of the year) and a slower pace of job creation in recent NFP reports. Fed Chair Powell signalled at the Jackson Hole conference that the Fed might need to ease policy more aggressively if the cooling of the labour market continues to intensify. This opens the door for a potentially much shorter path to more 'normal' rate levels than previously assumed. The new signals from the Fed, along with softer growth and inflation indicators, have strengthened the arguments for a faster normalisation of policy than initially expected before the summer. As a result, in our latest Nordic Outlook (see link), we have advanced the profile for short-term rates, now anticipating rate cuts of 25bp at each of the next seven meetings through to June 2025. Furthermore, we expect rate cuts of 25bp at the subsequent meetings in September/December 2025, bringing the Fed Funds rate to 3.0-3.25% by the end of 2025 compared with 5.25-5.50% as of today.

The ECB is still restrained by inflation

In the Eurozone, the inflation picture remains more ambiguous than in the US, with domestically driven inflation in August remaining significantly above the ECB tolerance level. However, overall, data over the summer has supported another 25bp rate cut at the 12 September meeting. Excluding the one-time boost from the Olympics, growth has been on the softer side over the summer, broad inflation is still converging towards 2% (2.2% in the latest figures), and wage growth decreased quite noticeably in the preliminary figures for the second quarter. Consequently, we see the deposit rate cut to 3.25% by year-end, compared with 3.75% as of today. Next year, we expect rate cuts totalling 75bp, which by the end of 2025 will push the deposit rate down to 2.5%.

We expect slightly higher long-term interest over the next 12 months

The change to our Fed calls primarily affects our view on short-end US rates, while the impact is more limited at the longer end of the curve. However, our target for long-end rates has been lowered, which specifically means a 12M target for the 10Y US Treasury yield at 4.00% (previously 4.35%). This adjustment mainly reflects the recent months’ declines in long-term US rates, which have pushed market expectations for the terminal rate – the endpoint for the Fed Funds rate after the rate cuts are finalised – from about 3.5% in June to 3% today. Consequently, the market is increasingly aligning with the Fed’s (and our) view on where the Fed Funds rate should stabilise in the long-term. The drop in the market’s view on the terminal rate has occurred significantly faster than we had expected, and it is primarily for this reason that the forecast for the 10Y UST rate is being lowered.

We still expect that the term premium in the long end of the US curve should eventually increase due to the persistent budget deficit, but the impact from this will likely be gradual and probably not decisive in the short-term. In Europe, our 12M forecast for the 10Y German government bond yield is slightly reduced from 2.50% to 2.35% following the adjustment in the US. Therefore, we now see only marginally higher long-term interest rates in Europe over the next year, but our target is still above current forward pricing.

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