Yield outlook: Between facts and noise

The increasing political uncertainty across the West has been taken calmly in the rates markets over the past month. Following the significant rises in Q4 24, long-term US rates have eased, while developments in EUR and DKK rates have been somewhat flatter. The rather subdued development throughout February stands in stark contrast to the news landscape, which, since the Trump administration's inauguration at the end of January, has been filled with reports of punitive tariffs, security policy upheavals, and a shift in domestic policy priorities. However, overall, the actual political changes have had very little impact on economic prospects so far.

US: Fed moves cautiously amid uncertainty

The cautious approach from the US Federal Reserve (Fed) continued at the January meeting, where, for the first time since July 2024, the central bank refrained from cutting interest rates. There are several reasons for this. The US labour market remains solid by most measures, inflation has recently shown less softening across underlying measures, and there is enormous uncertainty about economic policy. President Trump has already issued a record number of executive orders targeting everything from government payments to more value-driven issues. Threats of punitive tariffs have become part of the daily news, and attempts to slim down the public sector (via DOGE) have already led to a significant number of resignations. However, overall, the actual change in economic policy has been close to what was expected and insufficient to alter the short-term Fed outlook. This is not to say that concerns about the political shift's impact on inflation prospects have disappeared, and greater clarity regarding the new administration's priorities in several crucial areas such as tax, trade, and immigration policy are yet to show. In light of this uncertainty, it is natural for the Fed to take advantage of the opportunity to wait and see. We expect the next rate cut of 25bp to occur in June, followed by quarterly cuts until the summer of 2026. Thus, our expectation for the 'endpoint' of the Fed Funds at 3.00-3.25% remains well below the market-implied 3.50-3.75%.

Europe: Increased defence spending does not halt ECB cuts

In Europe, the economic indicators at the start of 2025 have supported our expectation that the ECB's rate cuts will continue at upcoming meetings. Core inflation in January was again roughly consistent with the ECB's 2% target, while the wage agreements now clearly indicate that wage pressure will ease over the next year. This seems to pave the way for lowering interest rates towards a more neutral stance. However, there are differing opinions within the ECB about what a 'neutral stance' specifically means in terms of rates, and already some of the Governing Council's 'hawks' are eager to bring the discussion about halting rate cuts to the table. This discussion is also fuelled by recent months' signs of growth, particularly in the manufacturing sector, which has shown clear improvement. However, in our view, this is not to an extent that will hinder the ECB's rate cuts in the short term.

In Germany, the conservative CDU/CSU, as expected, became the largest party in the February election. The likely coalition partner appears to be the Social Democratic SPD, although this will result in a slim majority and thus limited manoeuvrability for the new government. This could particularly pose a challenge regarding any potential change to the country's strict budget rules, which will likely dampen the military build-up that seems necessary in both Germany and the rest of Europe following signs of reduced US involvement in Europe's security. In general, the period after the isolationist American messages at the Munich Security Conference has seen a wave of declarations of intent from European governments to increase defence spending. For many countries, this will mean increased borrowing, an even larger supply of bonds, and potentially higher term premiums on European bonds. So far, the impact on the bond market has been limited—perhaps because the scope and timeline are still unknown. However, the theme is clearly among several risk factors related to our expectation of lower interest rates across the European curve. Our baseline is that a lower endpoint for the ECB deposit rate (1.5% versus the market-implied 2%) will be the decisive catalyst for rate developments over the next year.

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