In the eurozone, while price pressures seem well behaved, we identify inflation undershooting as a key tail risk to our rates outlook. Friday’s inflation numbers are unlikely to swing markets, but a series of lower-than-expected figures could reverse some of the recent upward pressure on rates. The short end of the curve is especially vulnerable to a shift lower as markets are now pricing in just 18bp of European Central Bank easing by mid-2026, which is not even a full cut. Having said that, inflation fixtures already account for a period of inflation well below the 2% target.
As fiscal impulses start ramping up, the medium-to-longer term inflation outlook should remain firm, keeping upward pressure on the back end of the curve. This also seems the consensus from the ECB’s June meeting minutes, although the inflation outlook is a topic of debate. In our baseline we think the curve should turn towards hiking mode by the end of 2026 or beginning of 2027 as inflation reverts above target again. As a result, the 10Y swap rate should find itself moving higher from here, steepening the curve.
The question is whether markets can maintain a bearish view on longer rates against a backdrop of falling inflation numbers. European investors are still traumatised by the secular stagnation environment from pre-Covid, one in which inflation was well below target. As such, markets may extrapolate downside inflation surprises too far out in the future, which would then pull down the entire curve. Again, this is not our baseline but is a tail risk we should be aware of.