Euro Rates Have Good Reason To Be Nervous

(MENAFN- ING)

Last year's outlook was all about a stabilisation of euro rates, and boy, were we wrong. For 2027, we have no illusions of a calm ride. Our 2027 euro rates view combines substantial near-term upside risk with a more constructive year-end outlook.

Ugly second-round inflation fears could push the 10-year euro swap rate above 4%, while faster disinflation could take it towards 2%. Our baseline is that inflation pressures ease and the ECB terminal rate anchors near 2.5% by the end of 2027, although heavy global bond supply should keep long-dated rates relatively elevated.

Inflation is one of many uncertainties that can trigger different rate paths Source: ING, Macrobond

"> For 2027, we shift our focus from oil to second-round inflation risks

Oil was the big story of 2026, but in 2027 we can no longer rely on the oil price to tell us where rates will go. Even if oil fell below $80/bbl, as assumed in our baseline, swap rates would not find much immediate relief. Instead, markets will watch each inflation reading anxiously for signs of second-round effects.

We take a relatively optimistic view in our baseline, but the upside risks to rates from inflation remain material. One bad reading could be enough to spook markets and risk a repeat of 2022-23, while it would take a series of benign inflation readings to convince markets of a more dovish tilt. We therefore see limited downside to rates in the first half of 2027. Only once there is sufficient evidence that second-round risks are limited do we turn more bullish on rates.

A tail risk for rates would be rising inflation combined with an inability of the ECB to stem the increase. Markets are pricing inflation in two years' time (the 1Y1Y forward) at just 2.2%, suggesting strong confidence in the ECB's ability to return inflation to target quickly. This is consistent with markets pricing in an aggressive further three ECB hikes. However, the effectiveness of monetary policy during supply shocks may be limited. Energy prices are still far from settled, and the global geopolitical landscape remains unstable.

Meanwhile, artificial intelligence investment is unlikely to respond to a few 25bp hikes when earnings growth is measured in double digits. A perceived weakening of monetary policy transmission, combined with upside inflation surprises, could push two-year euro swap rates another 100bp higher.

Markets remain very confident in the ECB's ability to keep inflation close to target Source: ING, Macrobond

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A related risk would be a dovish shift in the ECB reaction function, effectively tolerating higher inflation to support the eurozone economy. The 5yr5yr inflation swaps suggest that markets price very little risk to the ECB's commitment to the 2% target. At just 2.1%, the pricing is still well below the levels from before QE. France could, however, pose a challenge, as higher rates would trigger wider bond spreads, forcing the ECB to keep financial conditions supportive.

Quantitative tightening (QT) might be halted, and the ECB may simply have to accept higher inflation. Such a scenario does not appear to be priced by 5Y5Y inflation swaps. Brace for significantly steeper curves if this risk materialises.

An ECB forced to tolerate higher inflation looks like an unpriced risk Source: ING, Macrobond

"> The US is crowding out the rest, pushing euro curves steeper

Longer-dated real rates are not anchored to central bank policy rates and are being pushed higher globally. The US is in the lead here, but the forces at work should be viewed in a global context. Quantitative tightening at all major banks continues to add bond supply that markets must absorb, pushing up longer-dated yields. Meanwhile, government debt is rising, adding to the issuance.

Global forces are pushing longer-dated rates higher, with no end in sight Source: ING, Macrobond

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We do not expect government bond supply trends to change overnight. We therefore think 10yr euro swap rates will remain relatively sticky at elevated levels, despite our baseline view of a move lower in 2yr rates. If the private sector also starts borrowing more, we may face even higher global rates. Corporates and households have been deleveraging since Covid, but the latest data may point to increased borrowing. This is not our baseline, as higher rates should weigh on investment appetite. The wildcard is artificial intelligence, which has driven investment in the US. Outside technology, however, the investment boom is not yet convincing.

US government debt is leading the credit cycle, but keep an eye on corporates Source: ING, BIS, Macrobond

"> Fundamentals have not changed enough to warrant an entirely new normality

As economists, we want to see the economy return to a steady state, but such an equilibrium is now hard to pin down. We think markets in 2026 have gone too far in repricing the terminal ECB rate. An ECB rate settling above 3% is difficult to reconcile with the previous 1.75-2.25% range. Growth data have shown resilience, but the eurozone economy's structural challenges remain. Although we still see significant near-term upside risks to rates, we expect rates to begin anchoring around an ECB terminal rate of about 2.5% by the end of 2027.

The sharp rise in the terminal ECB rate cannot be justified by macro changes Source: ING, Macrobond

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We do, however, think longer-dated rates are close to their historical fair value, limiting the downside potential for 10yr swap rates. Before the global financial crisis, 10yr rates were anchored around economists' long-term nominal growth expectations. Fiscal austerity and quantitative easing pushed rates away from this equilibrium, but we are now close again to nominal growth expectations of 3.3%. Although artificial intelligence could boost productivity, in our baseline the increase is not material enough to produce a fundamentally different economic outlook.

The 10yr swap rate is close to fair value, limiting downside potential Source: ING, ECB, Macrobond

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