Whither growth, rates and spreads after decade in a week?
Crédit Agricole CIB’s Valentin Giust, global macro strategist, Louis Harreau, head of developed markets macro and strategy, and Valentin Marinov, head of G10 FX research and strategy, tackle the historic moves and their impact.
You can download a pdf version of this article in the full BIHC Briefing alongside further coverage.
Neil Day, Bank+Insurance Hybrid Capital: What impact are the German fiscal package and any other developments since the ECB cut rates 25bp on Thursday of last week likely to have on the development of its monetary policy?
Louis Harreau, Crédit Agricole CIB: Unfortunately, the press conference of the ECB was too early to take fully into account the announcement of the German fiscal package. However, you already had a lot of uncertainties — regarding the next moves from the US administration, and also regarding the outlook for the Eurozone economy, which has been disappointing over the last quarters — and at the same time, inflation is still too high. That’s why the ECB has been non-committal and why Christine Lagarde emphasised that the ECB will remain super data-dependent. So there was nothing new in the press conference. Maybe if it were now, there would be some change in the communication. In her speech a couple of days ago, Lagarde emphasised that we are in a time of great uncertainty and reiterated that the ECB has to be data-dependent, to react to negative developments, but also to upward pressures on inflation, wherever they come from.
Our official call remains the same, that the ECB will cut in April and then it will be done. But things are currently moving relatively quickly and we believe that the German fiscal package will have a significant impact on the Eurozone economic outlook, starting with Germany, naturally, but also for the Eurozone as a whole. Consequently, the ECB could perhaps be encouraged to be more hawkish than was expected a few weeks ago. It would have to include this new element, this positive external shock in its macroeconomic projections, with probably higher GDP growth for Germany and the Eurozone, and possibly higher inflation, not necessarily immediately, but in the medium to longer term. We are awaiting some direction from ECB members as they digest the new scenario, and can probably expect a more hawkish communication in the coming weeks — if I am right and the impact of the fiscal package is as important as our estimates imply.
We were already more hawkish than the market, which is pricing a more dovish view on the ECB, still expecting almost two rate cuts by the end of this year, rather than only one. But we are all taking some time to adapt to this new environment, with the worries regarding tariffs on the one hand, and the hopes regarding the German fiscal package on the other.
Day, BIHC: Indeed, there are a lot of moving parts. Valentin, what is your view on the aggregate implications for Eurozone growth of the US and European developments?
Valentin Giust, Crédit Agricole CIB (pictured below): This is a good point, to try to compare the relative significance of tariffs and the fiscal package, mainly the infrastructure element. I would highlight two aspects here.
Firstly, that tariffs are significantly more uncertain than the fiscal package right now. We are putting a significant probability on the German fiscal package passing, on the amounts being discussed getting done. Yes, there are some risks, but the probability of getting something significant is relatively high. Regarding tariffs, it is much more difficult to have a proper view on that. There may well be tariffs, but Trump has announced many things, only to go back on them, and it’s very difficult to follow what is happening. So in terms of certainties, tariffs are significantly more uncertain than the German fiscal package, and, most importantly, the infrastructure plan.
Secondly, even if you consider tariffs being implemented, in that case, the relative weight of the German infrastructure package is higher than tariffs. If 25% tariffs are implemented — if the US puts 25% on everything and the Eurozone applies equivalent counter-tariffs — we estimate that the negative growth effect for the Eurozone is likely to be 100bp, more or less. It may be slightly more for Germany and slightly less for France, for example, but overall, we are talking about one percentage point of growth that will probably be lost over the next one or two years. When it comes to the German fiscal package, we are talking about probably some additional GDP this year, not necessarily too much — perhaps 20bp, 30bp or 40bp — but we are easily talking about something like 100bp next year, and more for the years after. So if you take the medium term view, and if you look at what could be the situation in 2030, for instance, I think that the trade war has a significantly lower impact than the German fiscal package. The trade war is completely significant, absolutely, but the German fiscal package is so large, and especially the investment and infrastructure plan, that it is outweighing tariffs for the moment, based on what Trump has discussed. So, bottom line, the aggregate implications are positive.
Day, BIHC: You have stressed the importance of the infrastructure element in your answer, whereas headlines are being grabbed by the defence element. Are markets misjudging the relative importance of the two, or is defence perhaps just mentioned as a more sensationalist way to refer to the overall dynamic?
Giust, Crédit Agricole CIB: Currently, it’s very difficult to disentangle everything, to be honest. The defence side is extremely important, because we are talking about geopolitics, we are talking about Ukraine, and it has big implications, far beyond Germany’s domestic situation, the sluggishness of demand, and so on. But at the end of the day, what will mainly impact the European economy is not necessarily the war in Ukraine, is not necessarily defence. This will be something absolutely crucial for that industry, but we are talking about an industry that generates less than 1% of Eurozone GDP.
On the other side, we are talking about the infrastructure plan that Germany needs, that basically every EU economist, except some in Germany, have been advocating for the past 15 years or so, since the sovereign debt crisis, to invest in Germany and stimulate aggregate demand in the Eurozone. They did not decide to do so at that time, so they had a huge current account surplus. Currently, Germany — alongside China — is providing a huge amount of savings to the rest of the world. The German one is particularly invested into the US and this is not sustainable or satisfactory for Germany. There has been, I would say, a reawakening about this situation — probably linked to Trump, JD Vance in Munich, and the like. The Germans are in a very bad place, but they have huge financial firepower and are increasingly motivated and ready to use it. That is very good news.
The infrastructure plan is absolutely critical and we expect it to have at least three to four times more impact on the German and the European economy than the defence spending plan. So when considering the outlook for growth, just look at the German infrastructure plan; the defence plan is absolutely critical, too, but we are talking about geopolitics and security, not about economics to the same extent.
Day, BIHC: What implications does all this have for the relative performance of euro and US assets, and what are financial markets indicating?
Valentin Marinov, Crédit Agricole CIB (pictured below): A big part of what we are seeing in the development of euro-dollar is, as FX investors would say, more euro buying than dollar selling. This is also evident from the fact that the euro trade-weighted index has rallied really quite strongly after hitting lows late last year. There is a lot of optimism on the FX investor side with respect to what the efforts on the fiscal side could do to the economic outlook in Germany and outside Germany. Quite a few people I’ve been speaking to are just fed up with the noise coming out of the White House, and certainly want to focus on the more tangible guidance coming out of Berlin, Brussels and elsewhere in Europe, and its impact.
That said, a key question is whether the rally in euro-dollar has captured most or all of the positive impact. And if not, then how much further can we go? On fundamentals, we expect any change to the growth or inflation outlook to be rather incremental. Tariffs would have a much more immediate impact, but the positive story that we’ve been discussing so far will take potentially years to play out. The yield on the 10 year Bund is currently at 2.88%, but 3% by the end of this year is now in sight, so you would argue that at least on the yield side, there is at least some scope for repricing on the back of that growth optimism. And Bunds yields could further close the gap with Treasury yields. So essentially, part of the positive news is priced in, but not all of it. And coming back to what Louis highlighted at the beginning, the market at the moment is still going for 2% as a terminal rate for the ECB, and our view is at least 25bp higher than that. The fiscal package and growth optimism could certainly push market expectations in that direction, so the current rate spread for euro-dollar may be a little insufficient, and could move again in favour of the euro as the markets converge to our view.
The initial euphoria, around the announcements out of Germany and Brussels, is certainly baked in the cake when it comes to euro-dollar. Some further upside may be likely, but maybe more on a six to 12 month horizon. $1.12 is the upside risk to our current $1.07 forecast. We’ve been consistently above consensus on euro-dollar throughout essentially the last two years — never as bearish as the market — and that call continues to serve us well, but we believe that the appreciation of euro-dollar we are expecting for 2026 will need to be frontloaded into this year. In the interim, the next three to six months, the picture is slightly more mixed. Again, upside risks to our current projections, but only modest, because alongside the need for markets to converge to our views, there are some certainly cross-currents, as just mentioned: we have tariffs, a trade war, developments that at least historically have been negative for euro-dollar, so we could be more rangebound.
Day, BIHC: After the ECB last week, we have the FOMC in the coming days — any update in your view on expectations for the Fed?
Harreau, Crédit Agricole CIB: Yes, we have recently been revising our view, based on the new political news we are seeing, but also on the fact that core inflation in the US is stickier than what we expected a few months ago, and consequently we now expect the Fed to continue gradually its cutting cycle but at a slower pace than expected. That’s also consistent with the ECB and Christine Lagarde saying that they are more data-dependent — we expect the US central bank to be more cautious in its cutting cycle, and also to adapt to the fact that you could have some upward inflationary pressures that the Fed itself did not expect a few months ago. So we expect the Fed to cut in June and again in September.
Day, BIHC: What are the implications of the European developments for asset swap spreads?
Harreau, Crédit Agricole CIB (pictured below): Even before the announcement of the German fiscal package, we saw the ECB’s monetary stance, and especially policy regarding its balance sheet, having a significant impact on the EGB market and on asset swap spreads. This phenomenon is by no means over. There is renewed talk in the market that the ECB could restart its quantitative easing, or at least to stop its quantitative tightening — we don’t believe it at all. The ECB will continue returning bonds to the market — never selling them, but stopping reinvestments, so more bonds being absorbed by the private sector in the market. Consequently, such assets have lower values, so higher yields, and hence tighter asset swap spreads. This German fiscal package could put even more weight on EGB curves, starting with Germany, of course. A continuation of the phenomenon is therefore to be expected, and possibly an acceleration due to this potentially huge issuance in the EGB market from Germany. The market has already priced in a lot, but the movement is not yet over — and that’s also true of the repo market, where we have seen an increase in short term rates due to the fact that market is pricing more collateral in the market and less liquidity because of the ECB’s balance sheet policy.
Day, BIHC: Taking a broader view, liquidity — together with the carry — has been one of the two strong supports of the credit market, but is set to become less relevant as you describe and as SSA supply picks up, leaving spreads vulnerable. How might that unfold?
Harreau, Crédit Agricole CIB: The ECB has been very clear about the process of reduction of its balance sheet — it has communicated well in advance and hence it’s extremely predictable. That’s the good news. The bad news is that, as we saw in the fourth quarter of last year, the market is sometimes non-linear in terms of reaction. Asset swap spreads were relatively steady, and suddenly there was an immediate tightening when the market seemed to acknowledge the ECB’s quantitative tightening. The story will probably be the same in the future: some underreaction to a certain extent over time, then suddenly an overreaction. And my view is that, although it is still some way off, we are getting closer and closer to liquidity scarcity, and as we do so, volatility in these assets could increase. However, the timing is, unfortunately, extremely uncertain.