Rates Spark: Fed holds, but ECB to keep cutting

It’s clear that inflation is still an issue at the Fed. Not as severe as it was, but let’s say, not a fully resolved issue. Treasuries have had the same view over recent months. This is a 3% inflation economy, and therein lies the genesis of the funds rate not getting back down to neutral (3%) and the 10yr Treasury yield remaining above 4.5%. The impulse reaction for Treasuries is negative due to this. We’re not fully convinced this is the beginning of resumed bear market just yet, as we have the PCE inflation report this week. The worry will be that the Fed has seen it, and maybe is not thrilled by it. If so, that’s not great for Treasuries.

On the likely end to QT by mid year (our view), the short FOMC statement chose not to mention it. Maybe not big for them now. But they certainly must have talked about it. The issue here is excess liquidity (which we define as bank reserves plus reverse repo balances). It is likely to hit levels that the Fed would prefer not to go below from the middle of 2025 onwards, partly depending on how the debt ceiling saga evolves. The key number here is US$3tn for bank reserves, representing about 10% of GDP. We are currently at US$3.3tn. However, with QT running at US$60bn per month, ongoing QT would bring reserves down in net terms. The Fed will want to end QT before things get overly tight.

But clearly the Fed did not want to make a big deal on the end of QT, as it will end. Rather the "no change" outcome is smothered by inflation stubbornness, although in the end smoothed over by another ever-calm Chair Powell performance.

Markets are fully pricing in a 25bp cut this meeting and also the next one in March is practically priced in. Thereafter the easing path is less clear and much hangs on the discussion of where the neutral rate sits and whether the ECB has to cut rates into accommodative territory. A survey conducted by Bloomberg shows a median expectation for the ECB to settle at 2%, which is broadly what markets are currently positioned for. In our view the ECB will cut to 1.75%, allowing for a slightly accommodative stance in the context of lingering growth risks.

When looking at the survey outcomes for 2026, around 25% of economists see the ECB cut to 1.5% or below, which signifies the downside risks to the rates outlook. We also take a more bullish view than current market pricing and think that any negative growth surprises can quickly push markets on a more dovish ECB rate trajectory. And whilst inflation may still cause some bumps on the road, we think growth will remain the key driver in the ECB’s reaction function.

We don’t expect the ECB to deviate from its broadly dovish message, but we will be listening for nuances in the balance of risks. If the risk of undershooting inflation is emphasised, then that would be a clear bullish signal for euro rates, with the 2Y swap rate potentially moving back lower towards 2.3%. Whilst instead a focus on near-term inflation risks, including higher energy prices, could move the 2Y rate in the opposite direction by some 10bp. Given the latest PMIs did not disappoint, we don’t expect the growth narrative will have much market impact.