Rates Spark: Upside potential for euro rates should not be underestimated

This time, Germany managed to pull off a subtle upside data surprise, but markets remain sceptical about the long-term growth outlook. The IFO business survey on expectations increased to the highest level in over three years, suggesting some sparks of optimism amongst German businesses. On the other hand, we doubt this reading marks a turning point. GDP numbers on Thursday may well confirm a technical recession in Germany.

From a rates perspective, the upside potential of a more robust growth outlook would be significant. If we look at 5Y5Y forwards as a measure of market positioning for long-term growth, we have already seen a 50bp increase in real rates since the German spending announcement in March. But even after that jump, the real rate barely reaches 1%, still signalling a downbeat view of future growth. Before the euro sovereign crisis, the 5Y5Y real rate hovered mostly around 2%.

Markets won’t be convinced overnight of an improving structural growth picture for the eurozone. But we think the fiscal impulse over the medium term could help push rates higher. We don’t expect stellar growth numbers. Yet simply pricing in the probability of a return to secular stagnation—a world of low inflation and low policy rates—can be enough to push swap rates materially higher. We think markets should gradually gain confidence and see the 10Y swap rate drift close to 3% in 2026.

The US 10yr continues to mean revert at or around 4%, and the 2yr remains very attracted to the 3.5% area. Not much of a curve between the two. The downmove in the 10yr yield has been helped by an ongoing narrowing in the swap spread to SOFR. It's narrowed by over 10bp, from the mid-50's bp to the low 40's bp. The move began in the weeks leading up to the release of the 2025 fiscal deficit number, which came in below the 2024 reading. It's still too high, but squeezing in below the 2024 level is a (small) win. That win has been facilitated by tariff revenue, which came in at $120bn, higher than in 2024. Debt dynamics remain very poor, but the bond market seems to have no immediate intention of discounting a bad outcome.

At the same time, the heavy net issuance of bills is affecting money market conditions. The Treasury cash balance continues to grow, while reserves decline. Repo has tightened up, and the funds rate has risen, partly due to competition among the various buckets where players can place cash. In the end, it's a relative-value trade, where upside pressure on repo —and, by extension, SOFR— presents a tempting bucket for liquidity. The Federal Reserve may well have to consider buying bills to build reserves if this continues. That said, the reserves position looks broadly balanced (see more here). And the Fed is neither providing nor withdrawing liquidity from the system to any great extent. The USD basis premium on cross-currency is a tad up, but not to any material extent. The best solution to this whole set of circumstances is a loosening of US big bank supplementary liquidity requirements (see more here).