Summary

1. ECB: No more rate cuts. The ECB’s July meeting delivered a more hawkish communication than we had expected. The tariff deal with the US also allowed reducing the risk of a major slowdown. As a result, we no longer expect the ECB to cut rates in September. We think the cycle is over, and the next move is a hike, in Q4 2026.

2. Fed: Pressure to cut is rising. The last employment reports were very weak, and this points to a rebalancing of risks surrounding the dual mandate due to increased concerns about the ‘full employment’ component. We expect 25bp cuts in both September and December, and further easing in 2026, targeting a 3.50% terminal rate.

3. Bond yield targets: We keep our 10-year yield targets over the next 12 months at 2.75% in Germany, 4.20% in the UK, and 4.25% in the US. For now, we remain Positive on core EU, US and UK government bonds, favouring intermediate maturities for both resilience and income.

4. Topic in focus: Bond yield decomposition and inflation indexed bonds. Earlier this year, the German real yield increased by around 20 basis points to about 0.75% and has remained around this level over recent months. Real yields could push a bit higher but that would be temporary. We do not see the recent rise to be sufficient to come back to EU inflation linked bonds. We see opportunities in US inflation indexed bonds (TIPS) as long as real yields remain close 2% or higher.

5. Opportunities in Fixed Income: In addition to core eurozone, US and UK government bonds, we are Positive on US Agency Mortgage-Backed Securities, US TIPS, and eurozone and UK investment grade corporate bonds

Central Banks

The ECB is probably done while the Fed will be cutting

European Central Bank (ECB)

The ECB’s July meeting delivered a more hawkish message than we expected and suggests a more cautious stance. The new staff projections in September will probably show a visible and prolonged undershooting of the 2% inflation target. Resilient growth, fiscal developments and the recent US-EU trade deal limit any downside for economic activity.

As a result, we no longer expect the ECB to cut rates in September. The European defence and German infrastructure spending will lift growth and inflation over the medium term. With the negative effects of trade tensions starting to fade through 2026, we continue to see the ECB raising rates.

US Federal Reserve (Fed)

We look for a period of slower economic growth due to a transitory negative shock from tariffs and a temporary rise in inflation. Economic will slow but we expect no recession.

At the July meeting, Powell introduced a balanced approach based on unemployment and PCE inflation. The Fed committee has shifted its attention to the risks related to the labor market and seems confident that inflation pressures due to tariffs are a transitory phenomenon. The market pricing has gradually shifted towards pricing a rate cut in September. The inflation data for July surprised to the upside and cooled somewhat the expectations.

We expect 25bp cuts in both September and December, and two further easing in 2026, targeting a 3.50% terminal rate.

Bond Yields 

No major trend except for peripheral spreads

We saw no further steepening during the summer months. That was the case both US and German yields.

The US mortgage rate (30-year) peaked late October 2023 around 7.90%. It stabilized recently around 6.80% versus 4.85% for the 30-year government bond. The spread remains somewhat higher than on average over the last 35 years. In the eurozone, lending rates for house purchases have peaked late 2024 but the fall was quite moderate.

Peripheral spreads were generally down, continuing their remarkable downward trend after the peak early April. The biggest move was seen for Italy with a spread reduction from around 130 to almost 80 basis points. The announcement of the European defence and German infrastructure spending program certainly helped.

For now, we remain Positive on core EU, US and UK government bonds, favouring intermediate maturities for both resilience and income. 

Topic in Focus

Bond yield decomposition and inflation indexed bonds

The bond yield can be broken down to separate expected inflation and real yields (or ‘purchasing power’) economic growth compensation. At this stage, German long term inflation expectations measured on the basis of inflation linked bonds have stabilized at around 2%. This is not surprising because the European economy is not at full employment and an acceleration in growth will not necessarily generate inflation above the ECB's target. The European monetary authority has established a remarkable credibility especially in terms of inflation as expectations remained well anchored. This year’s rise in bond yields can therefore be explained primarily by a rise in real yields. The German real yield increased by around 20 basis points to about 0.75% and has remained around this level over recent months. Indeed, the German government's economic stimulus announcements and the potential for deregulation at the European level suggest higher real potential growth. This is the maximum growth compatible with stable inflation. It is estimated around 1%.

Looking at supply and demand, the additional supply of bonds is not expected to put a lot of upward pressure on yields as the demand for high rated government bonds is very large. Real yields could push a bit higher but that would be temporary. We do not see the recent rise to be sufficient to come back to EU inflation linked bonds.

In the US, the situation is somewhat different. Looking at inflation and inflation expectations, they moved somewhat higher, and we could see these levels sustained over the coming months. Real yields have become positive since 2022 and have broken 2% late 2023. This is quite remarkable as it exceeds our estimate of the real potential growth in the US. This level is estimated at around 2%.  We are concerned about the negative effects of the new immigration policy in the US on labor supply and potential growth. We do not share the optimism that AI would have a meaningful impact on that estimate. We see opportunities in inflation indexed bonds (TIPS) as long as real yields remain close 2% or higher.