Lower EUR rates despite French debt woes

Over the past month, rates have been particularly affected by political unrest in France in connection with negotiations regarding the budget for next year. The prospect of persistently large deficits and a perceived lack of political willingness to address the large deficits have weighed on French government bonds. The spread between 10-year French and German government bond yields has widened by around 0.40 percentage points to the highest level since the European debt crisis in 2011. The unrest has also dampened expectations for the number of rate hikes from the ECB, and rate developments have become more decoupled from energy price developments. The market now expects the ECB to deliver a further three rate hikes over the next year. In the US, there is also a prospect of further rate hikes, with upward pressure on the long end of the yield curve continuing.

Fed: More rate hikes in sight, but uncertainty about the pace

US economic indicators continue to show signs of underlying inflation pressure, although some readings have been slightly softer than expected. Wage and employment growth slowed in September, while the unemployment rate rose slightly. Combined with the latest tightening of financial conditions since the rate hike in September, this, in our view, postpones the need to deliver the next rate hike later in October. Inflation was higher than expected in September, but the increase was not alarming and was driven mostly by higher energy prices and rent, which is not the best reflection of the underlying inflationary pressure. We expect the strong underlying nominal growth to create inflation pressure that the Fed eventually will need to respond to. However, we believe the Fed will proceed more gradually and deliver two further rate hikes, in December 2026 and March 2027, which would bring the policy rate to 4.25-4.50%.

ECB: Focused on underlying inflation

Comments from members of the ECB Governing Council have been on the soft side over the past month. The ECB's pronounced focus on higher energy prices has moved into the background. Instead, focus has shifted to the lack of signs of an increase in core inflation and the risk of a growth slowdown. We therefore now expect the ECB to deliver only one further rate hike over the next year, in December 2026, which will bring the policy rate to 2.75% by year-end and throughout 2027. There is a non-negligible risk that the ECB delivers another rate hike in the new year, but this is not our base case and depends largely on developments in core inflation. The risk picture remains two-sided, in our view. If growth in Europe remains strong, supported by increased private consumption and rising pressure in core inflation, we could see more rate hikes. Conversely, a sharp decline in energy prices and continued low core inflation would reduce the need for further rate hikes.

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