Yield outlook – Arguments for policy restrictiveness fade

Disappointing growth signals continued to put downward pressure on global rates through September. Throughout the month, the curve has steepened in most areas, aligning with the historical patterns we typically observe during monetary policy easing. We expect that the decline in short-end rates will persist as the ECB/Fed softens their policy stance, while we expect the long end to rise. This 'twist' steepening of the curve (lower short-term/higher long-term rates) was evident throughout September, where an aggressive start to the Fed's easing strengthened beliefs in a soft landing. We assess that this rate dynamic will be prevalent over the next year

US 'jumbo' cut bolsters belief in a soft landing

In mid-September, the Fed executed its first major policy easing, initiating a significant rate cut of 50bp. This move reinforced market confidence that US monetary policy is now being calibrated towards sustaining a robust economy and less towards curbing inflation pressures. The belief in a soft landing for the US economy has thus been strengthened, although it is still too early to determine whether this shift in monetary policy direction has come too late. Historically, the labour market softening we are currently witnessing often transitions into more severe weakening shortly thereafter. This risk remains, despite the recent rate reductions.

Arguments for policy restrictiveness weaken in the Eurozone

As anticipated, the ECB delivered its second rate cut in September. Today, the deposit rate stands at 3.5%, which is 50bp lower than the level at the first rate cut back in June. However, monetary policy in the eurozone remains quite restrictive, and with the current pace of rate cuts (25bp per quarter), it is likely to remain so for some time. Nonetheless, data since the start of the summer has challenged the notion that the ECB can continually pursue a gradual normalisation of monetary policy. Growth indicators (PMI) have significantly weakened since May, and the underlying inflation pressure now clearly appears to be diminishing. In particular, the drop in domestically generated inflation (mainly services) is crucial, as this has been where the ECB has previously justified its caution in easing policy. In light of the soft growth and inflation data from September, we have factored in another 25bp cut from the ECB in October. We expect the deposit rate to be lowered by a total of 1.5 percentage points by the end of 2025. Thus, the policy - as in the US - will by then be close to the central bank's assessment of the 'neutral' rate level. However, the question remains whether this will be sufficient.

A neutral policy stance may prove inadequate

The ongoing weakening of economic signals from the eurozone has initiated discussions on whether it is sufficient for the ECB simply to return policy to a neutral stance. Doubts have surfaced in the market, and as a result, the EUR forward curve factors in that the deposit rate will bottom out at 1.75% next year. This indicates, in our view, that the market has accounted for a significant probability that the policy will shift to being accommodative over the next year as growth continues to disappoint. Our baseline assumption remains that a soft landing can be achieved with a gradual normalisation of policy, and we expect growth indicators to improve soon. However, the risk has admittedly increased significantly that policy rates may need to be lowered more quickly and to a lower level than we currently pencil in our main scenario.

Download The Full Yield Outlook