Wide outcome space and time to consider scenarios

The fundamental shift in fiscal policy in Germany over the past month has caused significant upheaval, placing the European bond market on uncertain ground. What will happen to longend rates when the usual assumptions about German frugality may no longer apply? The market has offered its initial take on the implications, sending the 10-year German yield up by approximately 0.4 percentage points since the beginning of March. This is a rather dramatic reaction, in our view, reflecting several mechanisms within the bond market. With a more expansive fiscal policy, the likelihood increases that growth and, consequently, the 'neutral' interest rate level in the economy, should be higher. Added to this is an adjustment of the term premium that bond market investors require for holding long-term versus short-term bonds. The increased expenditure on defence and infrastructure will necessitate a substantial increase in borrowing across European countries over the next decade. For the market to absorb more debt, a more favourable premium is required.

In the coming period, the market's focus will likely rest on the actual implementation of Europe's military and infrastructure upgrade. How much will Europe be able to achieve independently, how will the financing be arranged, and will political support remain strong, even when the vision demands reallocation from other welfare areas? There are still many pitfalls for Europe's 'paradigm shift', presenting risks on both sides of the rate outlook.

ECB sees a greater risk of inflation flaring up again

As expected, the ECB delivered its sixth rate cut at the March meeting, reducing the key deposit rate to 2.5%. This means the level has been moved 1.5 percentage points lower over nine months, and it is clear that at least parts of the governing council are beginning to see an end to the need for further easing. Communication now suggests that policy has become 'meaningfully less restrictive', and at the same time, the upside risks to inflation seem to be gaining attention in the governing council. This has been supported over the past month by the prospect of more supportive fiscal policy and the trade policy threats from Washington.

Despite a continued downward trend for inflation, concerns about a return to low inflation do not appear to be in the spotlight among ECB members. This challenges our expectation of further rate cuts totalling 1 percentage point, largely based on the assumption that weakness in realised growth/inflation data will keep the focus on the downside inflation risks in the central bank. The shift in risk assessment by the ECB could mean the first pause in rate cuts at the April meeting. For us, this would signal that the ECB is nearing the end of its easing cycle.

The US economy has recently shown clear signs of weakness

Consumer confidence has deteriorated significantly in the first months of 2025, business confidence has been notably weaker in sectors such as services, and overall this has created greater uncertainty about growth prospects. We do not believe the US is on the brink of a major downturn, but a rising risk of that could alone influence how the Fed chooses to act in the coming months—especially if the gloomy signals from the consumer side of the economy are followed by signs of weakness in the labour market.

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