Central Banks Diverge Against Backdrop of Trade Tensions

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Eurozone Market Update

In January, the ECB cut rates by 25 bps, reducing the deposit rate to 2.75%. The Governing Council expressed greater confidence that the disinflation process remains “well on track”, although it acknowledged that domestic inflation remains elevated. Post-meeting market reactions were relatively muted. Short-term yields edged lower, leading to a slight steepening of the yield curve (see Chart of the Month), while risk assets remained largely unaffected. Peripheral spreads tightened only marginally relative to core markets. We believe the ECB is on a steady path toward an estimated neutral rate of around 2%, with 25 bps cuts expected at each meeting until mid-2025. However, risks remain skewed toward a faster pace of cuts and a lower terminal rate for this cycle. U.S. tariff risks could worsen growth pressures, accelerating policy easing. February’s ECB neutral rate of interest (r-star) report may provide critical guidance for the long-term rate trajectory.

_{Source: Bloomberg, data as of 31 January 2025}

UK Market Update

UK gilt yields surged in January, with the 30-year hitting 5.42% and the 10-year at 4.86%. Drivers included strong US jobs data that boosted global bond yields. At the same time, fiscal concerns over Chancellor Rachel Reeves’ £70bn spending and borrowing budget increase fueled scepticism about the UK’s debt sustainability. Persistent inflation and a weaker pound (down 1.74% to $1.2207) added further pressure. However, inflation unexpectedly eased in December, with CPI at 2.5% and core inflation at 3.2%. Services inflation dropped to 4.4%, its lowest level since March 2022, prompting gilt yields to dip. While January’s flash composite Purchasing Managers’ Index (PMI) rose to 50.9, the report highlighted a sharp decline in business confidence, reinforcing expectations for a 25 bps cut from the BoE in February.

_{Source: Bloomberg, data as of 31 January 2025}

US Market Update

The Federal Reserve held rates at 4.25% to 4.5% in January, with the Fed emphasising that the economy and current monetary policy are well positioned. This allows them to keep policy unchanged while assessing incoming economic data relative to their dual mandate. Chair Jerome Powell characterised current policy rates as “not highly restrictive but meaningfully restrictive” and noted that further easing would require “additional progress” on inflation. Meanwhile, US President Donald Trump signed an executive order imposing 25% tariffs on Canada and Mexico and an additional 10% on Chinese exports, citing the trafficking of fentanyl and illegal immigration. Trump also vowed new tariffs on the European Union. The announced tariffs could hit gross domestic product by 80 bps, likely resulting in Fed rate cuts rather than hikes.

_{Source: Bloomberg, data as of 31 January 2025}

Looking Ahead

2025 began with heightened uncertainty as fiscal concerns and strong data pushed global yields higher, forcing markets to recalibrate central bank expectations before yields retraced. Our long-standing view of policy divergence gained traction with the Fed pausing its easing cycle. The ECB remains on course for sequential cuts to a neutral rate near 2%, while the BoE is expected to adjust policy quarterly. Rate cuts will likely vary across regions due to differing economic conditions. Uncertainty over the new US administration’s policies adds complexity, prompting cautious, data-driven central bank responses. The ECB expects Europe’s disinflationary path to hold despite sluggish growth and downside risks. Tariffs could exacerbate these risks, possibly forcing rates below neutral. The BoE faces stagflationary pressures, with high services inflation and weak growth. The BoE’s dovish stance means we anticipate its most likely course will be four rate cuts, aligned with the quarterly monetary policy reports.

Chart of the Month

_{Source: Bloomberg as of 4 February 2025}

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