Euro rates started the week in an incredibly bearish mood, catching markets (and ourselves) quite by surprise. Suddenly the possibility of more European Central Bank easing seems gone with money market curves now almost perfectly flat one year out. To be fair, many of the risks we identified earlier as triggers for more cuts seem to have faded. For one, growth continues to pick up, with Monday’s data even providing hope for Germany given decent industrial production numbers. Secondly, service price pressures remain more stubborn than hoped, keeping core inflation well above target for now. Add hawkish comments from the ECB’s Schnabel to the mix, and markets are quick to jump on higher rates across the curve.
Whilst the move up in rates happened sooner than we anticipated, we do think higher rates are justified from a structural perspective. The growth outlook for 2026 looks decent, whilst from a supply perspective we should also get more upward pressure. Germany’s funding announcement is likely next week and in January we expect plenty of frontloading of funding plans, both placing supply in focus for the coming weeks. In between, around €600bn of Dutch pension fund assets will transition to a new system, drastically reducing the amount of longer-dated swaps and bonds needed.
That begs the question, where can the curve move from here? We would continue to argue that the front end has little room to go higher for now, given more inflation data is needed before seriously contemplating a rate hike. The 10Y swap rate, however, could still move higher as a term risk premium builds. The 2s10s is now at 60bp, which is still relatively flat compared to the average of 80bp since 2000. From an economics perspective, one could also look at long-term nominal growth expectations as an anchor for longer rates. In that case, having the 10Y swap rate settle around 3.0-3.5% would be considered fair value.