Summary

1. Policy divergence: ECB holds, Fed cuts. With key data delayed and visibility clouded, we expect the Fed to stick to the median “dot plot” plan for this year, i.e. two rate cuts. We also anticipate two additional cuts in 2026, bringing the terminal rate to 3.25%. In our view, markets are too aggressive in pricing Fed cuts. In the eurozone, we expect the ECB to keep rates on hold for several quarters, with any rate hike occurring no earlier than December 2026.

2. Bond yield targets: We maintain our 12-month 10-year yield targets at 2.75% in Germany, 4.40% in the UK, and 4.25% in the US. We remain Positive on core EU, US, and UK government bonds, favouring short-dated maturities in the US and intermediate tenors elsewhere.

3. Emerging Markets local currency bonds: recommendation raised to Positive from Neutral, supported by improved macro fundamentals, attractive yields, and favourable currency and policy trends.

4. Fed independence under scrutiny: We continue monitoring fading Fed independence, as this may impact both macroeconomic outcomes (higher growth and inflation) and financial markets (higher term premium, steeper yield curve, weaker dollar, increased market volatility).

5. Credit market update: The recent default of First Brands underscores the importance of discipline and diversification. We remain Neutral on USD corporate High Yield bonds. Return drivers will predominantly come from carry, rather than spread tightening or gains from falling rates.

6. Opportunities in Fixed Income: In addition to the above-mentioned core eurozone, US, and UK government bonds, and EM local bonds, we are Positive on US Agency Mortgage-Backed Securities, US TIPS, and eurozone and UK investment grade corporate bonds. 

Central Banks

Policy divergence: ECB holds, Fed cuts

European Central Bank (ECB)

Easing cycle ends: The Governing Council appears increasingly comfortable with its current stance. Traders agree the ECB has ended its easing phase, even as downside growth risks persist. A stronger euro limits imported inflation but weighs on exports. 

Wait and see: The ECB is likely to tolerate inflation temporarily below the 2% target. Its own projections point to 1.7% in 2026 and 1.9% in 2027. 

Our view: While near term risks tilt toward cuts, we expect the ECB to keep rates on hold for several quarters. The fiscal impulse should be felt only by late 2026, hence, we see scope for a 25bp hike no earlier than December 2026. 

US Federal Reserve (Fed)

Foggy macroeconomic background: The US labour market is experiencing adjustments, with demand for workers easing and supply also constrained, notably due to tighter immigration policies. Inflation dynamics are shifting as well: core goods now contribute positively to CPI inflation, reflecting tariffs’ lingering effects.

Our view: With key data delayed and visibility clouded, we expect the Fed to stick to its median dot plot path of two rate cuts in 2025 (October and December). We expect two additional cuts in 2026, bringing the terminal rate to 3.25%. Inflation risks should prevent deeper easing, and we do not share market expectations for a policy rate just below 3% by early 2027. 

Bond Yields 

Structural shifts and yield curve dynamics

Recent moves: Since 1 October, long-term US yields have dropped in response to shutdown worries, renewed trade tensions, limited bond supply, and strong demand for Treasuries. German long-term yields have fallen amid weak economic data, and UK long-term yields followed a similar pattern driven primarily by softer labour market data.

Structural transformation: Before the pandemic, expectations of rate cuts usually resulted in bull steepening (short-term yields falling more than long-term yields). Currently, yield curves tend to twist (short-term yields dropping while long-term yields move higher), a reflection of a regime marked by fiscal dominance, where policy rate cuts are pro-cyclical and potentially inflationary, especially in a context of high fiscal deficits and elevated debt-to-GDP ratios.

Our view: We do not expect the US 10-year yield to drop significantly below 4%, supported by tariffs’ inflationary effects and fiscal concerns. We favour short-duration US Treasuries (2–5 years), German Bunds for carry, and UK gilts for elevated yields ahead of expected Bank of England cuts.

Topic in Focus

Emerging Markets local currency bonds: Compelling case

We have raised our recommendation on Emerging Markets Local Currency (EM LC) bonds from Neutral to Positive, reflecting improved macro fundamentals, attractive yields, and favourable currency and policy trends.

Policy rate tailwind: Many EM central banks have initiated easing cycles ahead of the Fed, responding proactively to cooling inflation and deploying credible policy frameworks. We expect more rate cuts than the market currently prices in for 2026, enhancing carry and roll-down opportunities.

Valuation and currency opportunities: EM currencies remain undervalued relative to economic fundamentals, supported by an expected weaker US dollar. We see EM FX as an attractive source of return against the dollar, but not relative to the euro, and recommend considering hedging currency exposure for EUR-based investors.

Yields and fundamentals: EM LC bonds yield around 6%, well above developed market counterparts, providing a substantial income cushion. Several EM countries demonstrate improved fiscal discipline and prudent budget management. We expect greater fiscal sustainability and investor confidence in EM markets overall, supported by relatively low debt-to-GDP ratios compared to many developed economies.

Technicals and positioning: Foreign investor participation in EM LC debt remains below historical averages in many markets, notably Thailand and Malaysia, following years of outflows. This suggests room for renewed inflows as conditions stabilize.

Diversification benefit: EM local bonds offer relatively low correlation to US Treasuries and developed market rates, providing portfolio diversification. In addition, EM rates exhibit lower volatility than developed market (DM) counterparts thanks to credible central bank policies and domestic investor stability.

Topic in Focus

Fed independence under scrutiny

Unprecedented overlap: For the first time in Fed history, a Fed governor (Stephen Miran, appointed by Trump in August) simultaneously holds seats at the FOMC and in Washington, as he has not resigned from his role as Chair of the Council of Economic Advisers, arguing the Fed role is temporary.

Implications for policy governance: This dual appointment raises concerns about the Fed’s institutional independence. Miran’s term ends in January 2026, and Trump may reappoint him or nominate a successor, pending Senate approval. Trump will also select the next Chair -Powell’s term ends in May 2026- and must choose from the Board of Governors, increasing political influence on Fed policy decisions.

Market perspective: The risk of reduced Fed independence is that monetary policy could become less countercyclical, leading to stronger growth, higher inflation, and a steeper yield curve. However, markets currently show little concern: the dollar has not collapsed, and term premiums have not surged.

First Brands fallout 

A wake-up call in credit markets: The recent default of First Brands, a US auto parts supplier, highlights the consequences of excessive risk-taking and insufficient due diligence. Investors have largely ignored risks in recent years, focusing mainly on yield in the relatively small and crowded high yield (HY) segment.

Is this a turning point ? Defaults remain largely confined to smaller issuers. The HY default rate stays low, below 2%, and well under historical averages. We do not expect a sharp rise in defaults given limited distressed exchanges, sound corporate fundamentals, decent economic growth, and strong corporate resilience.

Our view: Spreads have widened by over 30bp since mid-September lows despite light bond issuance, as risk sentiment is reassessed following the First Brands default and renewed tariff tensions. We anticipate greater dispersion in the HY market and maintain a Neutral stance on USD HY bonds, balancing tight valuations against strong technicals.