The near-term growth outlook is proving more challenging. A rate cut is supported by the drop in energy prices and tariffs.
Rates have ceased to be a constraint on economic activity. The European Central Bank’s key indicators are moving in a desirable direction.
Fragmented World Economy
A more fragmented world economy has the potential to increase prices.
We’re seeing that the previous constraints on economic growth, particularly from higher borrowing costs, are beginning to ease. As energy prices and trade tariffs both fall, pressures that were once pushing inflation upward are now beginning to reverse. This sets the stage for easier monetary policy, which the European Central Bank has started leaning toward. It reflects in the movements of their headline inflation readings and core metrics, both of which are drifting closer to their intended targets.
Lagarde’s group has pointed out that the disinflation process is continuing at pace. Domestic demand, however, hasn’t picked up in a way that would normally support rising prices. There’s an apparent disconnection between services strength and the weakness elsewhere, especially in manufacturing. Private consumption isn’t bouncing back with any vigour, particularly not in Germany or the southern economies where wage growth has failed to translate into any meaningful spending momentum. That’s one reason real GDP forecasts have been lowered.
We’ve taken particular note of how trade frictions—driven by new export rules, cross-border inspections, and retaliatory tariff risks—are beginning to create inefficiencies. They aren’t widespread just yet, but they are enough to alter import patterns and distort short-term price signals. That’s got us watching core goods more than usual because cost pass-through effects may return if supply chains tighten again, even in isolated sectors such as advanced components and agriculture inputs.
Central Bank Strategy
Schnabel’s team has flagged upside risks here. Mainly, it’s the possibility that attempts to shift supply dependency away from certain countries come with short-term inflation bumps. These may not be long-lasting, but they could confuse pricing trends just as expectations are beginning to lock into place. Our models adjust for that, but markets tend not to.
For traders in rate-sensitive products, what this all means is relatively clear. The central bank is not pursuing a fast or sharp easing path, but they have begun one, and unless external shocks materialise, we expect it to stick. However, it’s a gradualist approach. The first cut has landed, and another one looks likely for the following quarter, but any moves beyond that will need confirmation from wage metrics and services inflation.
We’re keeping an eye on swaps and forwards, where we see market pricing still slightly ahead of what we believe the bank is ready to deliver. That suggests room for correction. Bull steepening in the front end has already run; adding to that position might carry downside rather than upside in the coming sessions. Neutral carry strategies or relative curve positioning may perform better, particularly across peripheral spreads.
The likelihood of inflation volatility returning from fragmentation is low near-term, but it’s not zero. That matters for hedging profiles in options, where implied volatilities remain well above realised. If those premiums persist, short gamma positions may continue to underperform. So we’re not adding to those, not yet.
There’s also the matter of US divergence. Powell’s stance has firmed up once more, and with domestic consumption holding there, rate differentials may widen again after narrowing. That strengthens the dollar against the euro, which can subtly import disinflation into the common bloc. That direction of travel helps Draghi’s old office, but complicates things for inflation-linked strategies in cash instruments that aren’t currency-hedged.
So, for now, our stance is to avoid large directional exposure until the next set of wage data. It’s the one variable the ECB has consistently cited as central to further cuts. That means watching national breakdowns, especially in places where collective bargaining has recently been revised.
Any unanticipated strength in those numbers could stall easing, and in that case, we’d shift tilt more defensively, both in rates and spread exposures.
