CONTRIBUTORS
David Zahn, CFA, FRM
Head of European Fixed Income,
Franklin Templeton Fixed Income
The European Central Bank (ECB) cut rates at its January meeting, in a continuing series of rate reductions to try to remedy a weakening economy. The policy is appropriate, we believe, as well as beneficial for bond investors. The January cut is the fifth reduction since the start of this cycle in June 2024. Policymakers still have a long way to go, in our view, and may, by the end of 2025, bring rates down to a level lower than the market currently expects.
The bank’s announcement came on the same day that Eurostat released data showing economic growth in Europe from October to December 2024 was 0%—in other words, no growth at all. By contrast, the United States released data showing growth of 2.3% in the same time period.
Europe’s rate cuts are clearly needed to help stimulate a sluggish economy, but it's important to remember that monetary policy operates with a lag: The January cut will likely have an impact 12 to 18 months from now. When the ECB began cutting rates more than half a year ago, Europe’s economy was relatively stronger. The effects of the cuts made so far have not prevented a slowdown, and inflation levels remain about the same. ECB President Christine Lagarde at her post-meeting press conference expressed confidence that inflation would come down this year to the bank’s target level of 2% from recent levels near 2.4%.
Amid these conditions, we believe the ECB should continue on this course. Its style is to be slow and gradual, and so we expect a series of 0.25% cuts during this year, bringing the policy rate to approximately 1.25%. Our views differ from what the market is currently pricing, which is closer to 1.75% or 2%.
The continued reduction in interest rates is supportive for European bonds generally, and especially for bonds near the short end of the yield curve, where rates are dropping most quickly. With both interest rates and inflation likely to ease in Europe this year, our outlook for European bonds remains favorable. We are closely watching a couple of areas of risk—politics and trade. Germany has a national election in February, and France is mired in a budget impasse triggered by a large fiscal deficit. France may have new parliamentary elections by the summer or fall. Meanwhile, trade is surrounded by uncertainty as the new Trump administration considers imposing tariffs on Europe and many other trading partners. It is too soon to anticipate the possible economic effects, given that US tariff policies are yet to unfold, and global trading relationships could change in a variety of ways.
The ECB’s decision, coming as it did a day after the US Federal Reserve chose to keep US policy rates the same, reinforces that Europe and the United States are on two very different paths. The ECB needs to be more accommodative because of the region’s economic weakness, while the Fed can afford to take its time and assess the impact of new policies coming from the Trump administration. We believe the growing differential is positive for European bond investors, despite above-average political risks in Germany and France. We are also going to pay close attention to an ECB staff paper with a fresh analysis of the neutral interest rate. ECB President Lagarde made multiple references to it in her press conference, and it may contain clues about how low rates will go. Lagarde also made multiple references to “looking out the window” as well as to monitoring data, which hints that the ECB will give more attention to the needs of the economy and political economy in the months ahead.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.