Rates Spark: Can everything align for the euro hawks?

The sudden hawkish positioning by euro rate markets this week will likely face scrutiny. To justify the current position, growth numbers should continue to improve whilst inflation data may not start drifting below the European Central Bank’s projections. Meanwhile, (geo)political risks should remain contained and Trump should not surprise Europe with new policy actions. That’s a long list. And even though these are all part of our baseline forecasts, we doubt the ride will be perfectly smooth from here.

Interestingly enough, inflation swaps have not moved much in the broader repricing of rates. The 2Y inflation swap is still just below 1.8%, which captures the CPI undershoot anticipated by the ECB. The fact that real rates did most of the heavy lifting suggests that markets have changed their assessment of the ECB’s reaction function. Whilst near-term disinflation is still anticipated, the ECB may simply see less need for further easing. We'll be interested to see if Schnabel's hawkish view is shared more broadly during next week’s ECB meeting.

Reflecting on all this, markets may have turned a bit too hawkish too soon, and if sentiment faces even minor headwinds, we may well see part of the move fade. Keep in mind that broader market sentiment is particularly strong at the moment. The implied volatility of the euro STOXX equities index is at the lowest level this year, while the S&P 500 index in the US is eyeing new records. The question is whether investors are happy to stay risk-on going into the Christmas season. After a turbulent year, we can imagine sitting on the sidelines during Christmas gives us more peace of mind.

In the US, the 3mth SOFR rate is finally at or about the same level as the 10yr SOFR rate (just this week) and going forward the 3mth SOFR rate should drift lower, resulting in structural positive impact carry for fixed-rate receivers. It’s the first time since the second half of 2022 (and briefly in January 2025) that the 10yr SOFR rate has been above most floating rates. For players who have baulked at the idea of swapping to floating on account of negative impact carry, that is going away (at least for as long as 10yr SOFR remains elevated). On the other side of the coin, one advantage of setting a fixed rate payer in the 10yr is the positive mark-to-market we anticipate as the 10yr SOFR rate heads towards 4%.