Yield outlook: Is inflation set to flare up again?

The lack of direction in growth and inflation indicators continues to create significant volatility in bond markets, where yields have moved lower over the past month. The decline in European rates can largely be attributed to developments in the US, where key figures have now started to disappoint after more than a year of consistently positive surprises.

Sluggish domestic inflation leads to fewer cuts from the ECB

In the eurozone, the ECB continues to signal a clear intention to deliver a rate cut of 25bp at the meeting on 6 June, but what follows remains uncertain. European growth has clearly rebounded in 2024, and even in the hard-hit manufacturing sector, headwinds now appear to be easing. Some improvement was expected after last year's stagnation, but if the growth bloom over the summer becomes too strong, it could complicate the path to lower rates as inflation is not yet under control. Total inflation in April remained unchanged at 2.4% (close to the target), but domestic inflation measures continue to regain strength, and wage growth remains significantly elevated. The June cut from the ECB is nearly a given, but considering recent key figures, we have moved the timing of the subsequent cut from September to December (a total of 2x25bp this year). At the same time, we now think that the ECB will only cut by 3x25bp in 2025 (down from the previous 4x25bp).

US rate cuts to be kicked off later than previously assumed

US data surprises have lately been on the downside, but overall, the cracks in the economic/inflationary narrative for the US remain marginal. The strong inflation and labour market figures for the first part of 2024 led us earlier this month to postpone the timing of the first rate cut from June to September, although we also see July as a realistic possibility. A slightly later start to interest rate cuts seems well in line with signals from the members of the Federal Open Market Committee (FOMC), who predominantly signal patience while waiting for clearer indications that inflationary pressures are subsiding. The first faint sign of this was (perhaps) visible in the April CPI release, where the underlying inflation measures saw some softening. Simultaneously, job creation fell back slightly, although the level of +175,000 in April is still too high to genuinely alleviate pressure on the economy's capacity. However, the economy is no longer exceeding expectations, and for the bond market, this has given a tailwind recently. We believe in a slightly softer data development from here, but not to an extent that seriously forces a swift easing of policy.

We now expect long-end rates to remain at current levels

As a consequence of our less ‘optimistic’ view on the prospects for monetary policy in the eurozone, we raise our long-held 12M forecast for the 10Y German government bond yield from 2.35% to 2.50%. It's not a massive change, but it does reflect that the path for the monetary policy rate in the eurozone now lies slightly higher. The forecast for the 2Y EUR swap rate is approximately 20bp higher than previously due to the change in our expected policy path. In the US, the forecast for short-end swap rates is adjusted slightly upwards following our decision to postpone the timing of the first Fed cut from June to September, but in principle, the impact of the revision on long-end rates will be marginal, as we continue to foresee quarterly cuts of 25bp in September, December and all through 2025. We still see the 10Y US government bond yield trading at 4.35% in 12 months, thus nearly at today's level. However, the uncertainty band is still significant, as there is considerable uncertainty around where short-end rates will end up in the long run. And that uncertainty will persist, even after the cutting cycle has been commenced.

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