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(Bloomberg) — Investors, including Pacific Investment Management Co. and Fidelity International, are voicing concerns that the worsening economic conditions in Europe may compel policymakers to implement more substantial interest rate cuts than currently anticipated by the market.
Recent market pricing indicates that the European Central Bank (ECB) is likely to reduce the key interest rate to 1.75% in the upcoming year, following a series of cuts that have brought the rate down to 3%. Fidelity, however, suggests that rates could be lowered even further to around 1.5%, while Pimco expresses concern over the possibility of more drastic reductions.
Such adjustments in monetary policy could ignite a significant rally in European bonds, which have already shown stronger performance compared to their US and UK counterparts in 2024. According to a Bloomberg index, euro-denominated government debt has increased by more than 3% this year, in stark contrast to a 2% rise in US Treasuries and a 2% decline in UK gilts.
Salman Ahmed, Fidelity’s global head of macro & strategic asset allocation, noted, “The market remains somewhat more hawkish than our expectations. There are risks that the ECB cuts even more if downside risks materialize.”
On Thursday, European bonds experienced a decline following comments made by ECB President Christine Lagarde, who adopted a more restrained stance than anticipated. This was particularly evident in sharp drops in Italian bonds, which are often more reactive to changes in monetary policy.
The overall economic outlook for the region appears grim. Both the manufacturing and services sectors are facing difficulties, and Germany, a crucial driver of the European economy, is on track for its second consecutive year of economic contraction. Additionally, the region is grappling with political instability in its largest economies and potential disruptions to global trade linked to Donald Trump’s potential return to the presidency.
Such factors bolster the argument for more pronounced rate cuts compared to other regions. Analysts expect the ECB to lower rates by about 125 basis points by the end of next year, building on the recent quarter-point reduction, while the Federal Reserve and the Bank of England are anticipated to reduce their rates by approximately 80 basis points.
Nicolas Forest, chief investment officer at Candriam, stated, “The monetary policy divergence between the US and Europe is expected to widen further in 2025, and we maintain a preference for European rates versus US ones in terms of duration. The outlook for Europe is darkening.”
The ECB’s recent statement opened the possibility for additional rate cuts by removing previous language indicating that the policy would remain “sufficiently restrictive” indefinitely. This change suggests a potential pivot towards a more accommodative monetary policy framework aimed at stimulating economic growth rather than constraining it.
Tim Graf, head of EMEA macro strategy at State Street Global Markets, commented that for truly effective rate easing, rates might need to drop to the range of 0.5% to 1%, a scenario not currently reflected in market pricing. He warned that if Europe experiences significant economic challenges next year, such drastic cuts could become necessary.
With economic growth and inflation projections being downgraded, new quarterly forecasts reflect the need for enhanced support. Nevertheless, Ahmed from Fidelity believes that these estimates may be overly optimistic, failing to account for the risks associated with Trump’s trade policies.
Konstantin Veit, a portfolio manager at Pimco, echoed similar sentiments, asserting, “We believe growth will continue to turn out weaker than what the ECB expects and see the potential for markets to price lower terminal rates. The data flow over the coming months will determine the pace and extent of monetary easing going forward.”
Source
finance.yahoo.com