With the eurozone economy growing by 0.6% quarter-on-quarter in the first quarter and by 0.1% QoQ in the second for a year-over-year rate of 1.5%, and the risks to growth now ‘more balanced’, we believe the European Central Bank’s rate cutting cycle is done. Further cuts cannot however be completely excluded should disinflationary pressures intensify.
While some of the economic strength can be attributed to export front-loading ahead of anticipated US tariffs as well as GDP volatility in Ireland, survey data has pointed to a recovery in sentiment over the past few months, indicating growth resilience in the face of trade uncertainty.
Looking ahead, Europe’s fiscal policy shift is likely to offset the drag from higher US trade tariffs. Beyond an initial sentiment boost, the combination of the EU’s ReArm Europe plan and Germany’s infrastructure investment fund and increase in defence spending will likely boost growth in the medium term.
Germany has been running below its potential growth due to both structural and cyclical issues, but the government’s new fiscal plans could boost demand and help the economy to close the gap. The strong investment component of the financial package can also lift Germany’s potential growth.
Inflation has successfully returned to the ECB’s 2% inflation target, with headline Harmonised Index of Consumer Prices moving sideways between 1.9% to 2.2% since March.
Headline HICP is projected to print at levels around the ECB’s 2% target in 2026 as recent euro strength continues to pass through and suppress core goods inflation, and moderation in wage growth continues to contain services inflation.
Rate cuts over in the eurozone?
Against this backdrop, the ECB held its deposit rate at 2% in July and September. President Lagarde subsequently said the central bank ‘continues to be in a good place’ and downplayed the undershoot in the ECB’s inflation forecasts.
Despite the preliminary trade deal with the US setting tariffs higher than the ECB’s baseline assumption, the ECB described risks to growth as ‘more balanced.’ We largely agree with the market consensus that the ECB’s rate cutting cycle is over, with a chance of one more ‘insurance’ cut in the near term if downward pressures on inflation intensify.
We believe the prospects for steady monetary policy outcomes are largely reflected in market pricing and have taken a more tactical approach to our euro duration strategies. We expect the 10-year German Bund yield to remain in a tight trading range and will look for opportunities to trade the range tactically.
Towards a steeper yield curve
In terms of the yield curve, we believe the weight of rising issuance in Germany, fiscal concerns in France, and the broader narrative regarding debt sustainability could lead to further steepening in the medium term.
In the near term, the implementation of the Dutch pension system transitioning from a defined benefit (DB) to a collective defined contribution (CDC) model will likely put pressure on the longer end of the yield curve as pension funds look to unwind their duration hedges.
As such, we have started to reduce our overweight in the 30-year sector of the Italian real yield curve and establish positions anticipating a steeper yield curve.
Inflationary pressures in the eurozone and US to diverge
In breakeven inflation, we maintain a modest underweight bias in euro and French breakeven inflation against US BEIs as the recent euro appreciation and moderating wage growth will likely contain inflation in the eurozone, while higher tariffs will likely be passed on to US consumers.
Specifically for French CPI, in addition to the political turmoil which looks set to continue to weigh on France’s growth and inflation outlook, the Livret A (government-regulated savings account) remuneration rate has fallen to an unattractive level, which will continue to dampen demand for these inflation-hedging deposits, and therefore hedging demand in the French CPI market.
Overweight the ‘peripherals’ versus the core
In sovereign bond spreads, we maintain an overweight in Italy and Spain against France and Germany in the portfolio. The ReArm EU proposal represents an encouraging first step to fostering deeper integration. Italy’s fiscal outlook has also improved as the government is running a primary surplus this year and looking to exit the EU deficit procedure in 2026.
In contrast, the task of reducing fiscal deficits remains challenging in France, and there is also persistent political risk given the fragmentation in Parliament. French government bonds have already underperformed their peers, and we believe this is unlikely to reverse in the near term, given the lack of realistic fiscal consolidation in sight.
We anticipate little change in policy direction in the short term, as the political landscape remains highly fragmented and parties struggle to form a coherent platform for a stable government coalition. In this scenario, the spread between French and German government bonds will likely continue to hover around current levels and therefore provide limited upside for owning French debt. In contrast, recent events suggest that the risks of a snap election are increasing. The associated political uncertainty could push the spread in yields between France and Germany wider still.
Overall, we believe the asymmetry in risks justifies holding on to the underweight in France in the portfolio. At the same time, ‘peripheral’ spreads will likely remain supported as Germany increases its debt issuance to fund the government’s spending plans.
