The Ugly Truth

Underlining the worsening outlook for the eurozone economy, the International Monetary Fund this month lowered its growth forecast for the currency area's economy in 2024 to 0.8% from 0.9%, even as it raised its forecast for the United States, which it expects to grow by 2.8% this year.

Moreover, private-sector activity in the euro area retreated for a second-straight month in October, compared with a month earlier, purchasing managers indices (PMI) showed. The October PMIs are likely to increase the pressure on the European Central Bank (ECB) to cut interest rates by 50bps in December.

Signalling that a 50 bps ECB cut is on the table at its next meeting, in December, ECB President Christine Lagarde said this week (22 October): "The direction of travel: clear. Pace: to be determined." This contrasts with officials at the US Federal Reserve calling for more caution on the pace of their cuts after a 50 bps reduction in September.

If the ECB fails to engineer the so-called “soft landing” it is aiming for, whereby the economy slows without tipping into recession, or if it even feels there is a risk of that happening – then interest rates in the euro area could head sharply lower. In Switzerland, where the central bank must also deal with the additional brake that the strong franc puts on growth, getting to 0% rates is not unthinkable.

In the euro area, our central scenario is for the ECB to cut rates by 25 bps at every meeting through to June 2025, which would take its deposit rate to 2.0%. But the ECB could end up going well below the so-called neutral rate – the estimated level at which monetary policy is neither contractionary nor expansionary.

This is because The Ugly Truth is that Europe faces an asymmetry of risks: the best case scenario is that a stack of downside risks to our scenario simply don’t materialise.

Investment implications

After the big 50 bps Fed rate cut in September and more dovish comments from the Swiss National Bank (SNB), the ECB and the Bank of England (BoE), we believe that the risk asymmetry is skewed towards lower 10-year European sovereign bond yields.

But while all short-term market rates have room to fall at least as far as central banks’ terminal rates – their long-term target rates – the room for further compression of US long-term sovereign bond yields could be more limited given uncertainties around the fiscal and political direction after the presidential election. For this reason, we have moved back to neutral on US Treasuries in favour of long-term euro government bonds, where we are now overweight, along with UK gilts. Given the strength of the Swiss franc we now expect the SNB to become stimulative in the coming months, so we have moved from underweight to neutral on Swiss government bonds.