Rates: downside limits for yields, versus bigger room to the upside

We’ve moved into calmer waters for market rates. The 10-year Treasury yield has recently tended not to stray too far from 4.5%. In the eurozone, the 10yr Euribor rate has trended around the 2.5% area, and the 10yr Bund yield is broadly flat to this.

If we were to map out a case for these rates to fall, we’d point to the rate-cutting tendency ahead as a key component. Here’s how that would go for the eurozone and the US:

• In the eurozone, we anticipate that the European Central Bank will get to 1.75% (now 2.0%). The current 10yr rate is only 75bp above that future low. Perhaps we could squeeze a 25bp move lower. Realistically, the ECB would have to dip to 1.5% to make some room for a structurally lower 10yr rate. That, in fact, is the market discount. If that were to be realised, we could talk of 10yr rates dipping to the 2-2.25% area.
• In the US, the Federal Reserve is expected to cut to the 3.25-3.5% range (now 4.25-4.5%). That would imply a curve of some 115bp to the current 10yr yield at 4.5%. That appears to present value in the 10yr yield. However, we need to account for the swap spread to 10yr SOFR, which cuts the "true curve" down to roughly 65bp (10yr SOFR now at around 4%). Maybe we could squeeze a 25bp move to the downside. To see a proper manoeuvre to the downside for the 10yr yield, the Fed would need to cut much more than is currently discounted.

The bottom line is that when we look at yields' capacity to fall, we find there are constraints. Yes, there is macro angst to consider, and a rate-cutting backdrop. But we'd need more than is currently discounted to rationalise meaningful falls in longer-tenor yields.

In contrast, when we consider the potential for yields to rise, things begin to open up. The key ingredient on both sides of the Atlantic is the fiscal balance.

In the US, if the tax-cutting package currently going through Congress ultimately gets passed (and it looks like it will), it will leave the bond market with no plan in place to reduce the fiscal deficit. This piles the issuance pressure on as a theme. In the eurozone, plans for more spending (on defence "plus"; Germany in particular) won’t push average fiscal deficits to US-style extremes, but it will add to issuance pressures in a meaningful way, albeit likely more from 2026 onwards.

This has implications for how we see longer tenor market rates evolving through 2025/2026.

• For the US, we see the passage of the tax-cutting bill plus a tariff-induced rise in inflation as themes for the third quarter, manifesting in upward pressure on the 10yr yield. We pitch 4.75% as a target, but would not be surprised to see this extend to 5%. Subsequently, we have a calming process as the Fed cuts, starting in the fourth quarter. And the 10yr yield eventually eases its way back down towards 4.25% (mostly through 2026).
• For the eurozone, the bigger independent upside pressure for the 10yr Bund yield is through 2026 as the ECB finishes with cuts, and the aforementioned fiscal pressure builds. That coaxes the 10yr yield to the 2.75% area (and likely above).