We expect the net effects from the US trade tariffs to be disinflationary. Downward price pressures from the direct hit to growth, weaker confidence, and a re-routing of Asian exports away from the US to the European markets will likely outweigh upward price pressures from potential EU retaliatory measures.
Headline inflation in the eurozone has already returned to the ECB’s 2% target. We expect progress in disinflation to be maintained in the near term given the recent rise in the euro and the dissipation of the threat of a renewed surge in energy prices.
The trend in underlying inflation has also been encouraging as services inflation nudged down further in the second quarter to 3.3% year-on-year in June. Forward-looking measures of wage pressures point to a further cooling in pay growth.
Europe’s fiscal policy shift is likely to offset some of the drag from higher US tariffs. Beyond an initial boost to sentiment, the combination of the EU’s ReArm Europe plan, Germany’s infrastructure investment fund, and an increase in defence spending will likely lift growth in the medium term.
Against this backdrop, ECB President Lagarde has described the central bank as ‘well positioned’ to navigate the uncertainty. Although the risk to growth is still viewed as being tilted to the downside due to trade policy uncertainty, this is offset by optimism about government investment in defence and infrastructure.
Expect a steeper yield curve
On the yield curve, we believe the weight of rising bond issuance in Germany and fiscal concerns in France could lead to a further steepening in the medium term.
Over a shorter time horizon, we are cognisant that the usual hiatus in issuance over the summer could benefit longer-dated bonds. German Bunds could benefit from their rising safe-haven status relative to US Treasuries in bouts of risk aversion.
On breakeven inflation (BEI), we are maintaining a modest underweight bias in long-dated euro BEI against a long bias in US BEI as the recent euro appreciation will likely contain inflation in the eurozone while the increase in tariffs will likely be passed on to US consumers.
On sovereign bond spreads, we are overweight Italy and Spain against France and Germany. The ReArm EU proposal is an encouraging first step to fostering deeper integration. Italy’s fiscal outlook has improved as the government is running a primary surplus this year and is looking to exit the EU deficit procedure in 2026.
In contrast, the task of reducing fiscal deficits remains challenging in France. There is also persistent political risk given the fragmentation of parliament. The government faces a potential no-confidence motion during the budget process, and another snap election cannot be ruled out as President Macron regains the ability to dissolve the National Assembly in July.
We anticipate ‘peripheral’ spreads to be well supported over the summer. Germany will be in the process of increasing its debt issuance to fund its spending plans, while investors continue to search for yield in a range-trading environment.
UK Gilts – Is fiscal credibility at risk again?
As we head into the summer, the UK’s public finances have returned to a familiar situation. Efforts to put finances on a more sustainable footing have met with only limited and temporary success, and the headroom against the government’s fiscal rules has once again been depleted after major policy U-turns.
Elevated Gilt yields, the uncertain growth outlook, and the overly optimistic productivity assumptions in the OBR’s forecasts mean that Chancellor Reeves’ fiscal challenges still lie ahead. Given the government’s commitment to its ‘non-negotiable’ fiscal rules, this means that further consolidation measures will likely be needed to ensure the rules are not broken.
Whether Rachel Reeves stays as chancellor or not, the fiscal fragilities will persist. Our baseline assumption remains that the government will look to shore up its fiscal credibility through tax increases in the autumn when the chancellor delivers her budget. Delivering on spending cuts will be challenging, particularly when other spending needs, including on defence, are rising.
That said, the Labour Party pledged in its 2024 election manifesto and recent statements not to increase VAT and not to increase taxes on ‘working people’, including income tax and National Insurance. A meaningful rise in tax revenue will likely involve backtracking on these promises.
Therefore, the risk scenario is that the government decides that it has no mandate to raise taxes and no appetite to push through more spending cuts, particularly when its popularity has been declining. In this scenario, the government might tweak or abandon its fiscal rules to justify more borrowing.
In the near term, our expectation is that Prime Minister Starmer will continue to reiterate his support for the chancellor, and she will continue to signal her commitment to the fiscal rules.
In the medium term, we believe the government will look to raise revenue and double its efforts to legislate growth-oriented policies to shore up its fiscal credibility.
In terms of monetary policy, the Bank of England (BoE) will remain focused on pay settlements as well as employment trends in judging whether it can lower interest rates despite the projected rise in headline CPI over the coming months. With services inflation at 4.7% and wage growth at 5.1%, the BoE’s caution is justified.
Deeper and faster BoE rate cuts ahead?
Although inflation expectations remain elevated, survey results point to their continued normalisation. The continued slowing in the labour market and normalisation of wage growth will eventually allow for faster and deeper cuts in policy rates later this year.
UK real yields remain attractive from a valuation perspective. After dipping briefly to 1.8% at the end of January, the yield of 30-year UK index-linked Gilts bounced back to its historical high in April and has been moving sideways since.
As the recent U-turns in government policies brought the country’s fiscal fragility back into the spotlight, we saw long-dated UK real yields moving back to the highs of the second quarter, with 10-year/10-year forward real yield revisiting levels above 3%, a level not seen since 1997 (and one that far exceeds the level of UK trend growth).
In the near term, the combination of a more dovish BoE policy stance (thanks to a deteriorating employment outlook) and attractive valuations should support UK Gilts.
We are nonetheless cognizant that concerns surrounding the UK’s debt sustainability could contribute to a selloff, which would provide better entry levels still. Furthermore, against a backdrop of rising interest rates and extremely tight fiscal headroom, weaker economic growth could exacerbate the debt sustainability issues as the associated decline in tax revenues weighs on the fiscal calculus.
With fiscal sustainability fears lingering in the background, we prefer to take a tactical approach when trading UK duration. In the longer term we believe continued slowing growth and a loosening in the labour market should help ease concerns over the UK’s inflation problem and allow for deeper and faster BoE rate cuts.
On the yield curve, we are maintaining a modest 2s10s nominal curve steepener. In our view, front-dated yields should be well anchored by market expectations for rate cuts. At longer maturities, the record level of net supply and concerns about debt sustainability could drive further underperformance as the term premium rises.
This is an extract from our Q3 2025 quarterly fixed income outlook – full document.
