Fed on hold, ECB to maintain rate cutting cycle in January

Comments by Michael Krautzberger , Global CIO Fixed Income at AllianzGI, ahead of the Fed and ECB meeting on 29 and 30 January 2025

• At their respective meetings on the 29th and 30th January, we expect the US Federal Reserve to keep rates on hold, leaving the Fed funds target range unchanged at 4.25%-4.50%, while the European Central Bank cuts the deposit rate by 25bp to 2.75%.
• US economic data has remained relatively upbeat since the Fed began its rate cutting cycle in September 2024, while disappointing European growth data continues to put a spotlight on the cyclical and structural headwinds facing the region.
• The trade policy implications of the Trump Presidency are also re-enforcing expectations about the relative growth divergence between the US and Europe.
• In the first few months of 2025, we think the Fed will remain more cautious in its policy stance relative to the ECB.
• Market pricing has already shifted to reflect a less dovish Fed policy outlook ahead, with barely one Fed rate cut priced in H1 2025. The ECB is priced to cut rates at least three times over the same period. We think this market pricing seems reasonable at the current juncture given the relative growth and inflation expectations for both economies.
• However, if we see a further back up in US real rates and bond term premia, this could sufficiently tighten US financial conditions and temper some of the more lofty growth expectations for the US economy this year, bringing the Fed back into play. Similarly in the Euro area, any escalation of trade tensions could result in faster and deeper ECB rate cuts than currently priced.
• We think the current market environment favours curve steepening expressions in both the US and Germany. Duration exposure is favoured in countries that offer a better risk/reward, primarily in Europe. Against this, we favour a tactical short US duration stance, as well as owning US inflation protection given potential US inflation risks in 2025.

As the new US administration takes office, the US economy is in relatively good shape – the unemployment rate is at just 4.1%, with little to suggest that a sharp deterioration in the labour market is imminent. Meanwhile, the market consensus is relatively bullish on the US outlook for this year, with the economy forecast to grow by 2.2% in 2025 versus 2.8% in 2024, supported by a pro-growth Trump policy agenda. The inflation backdrop is more mixed, however; although inflationary pressures are fading, the Fed’s preferred core PCE measure of inflation is still sitting above target at 2.8% y/y. Consequently, we think the Fed is minded to maintain a more cautious policy stance, keeping rates on hold in the near-term, as it evaluates incoming growth and inflation data.

It is a different story in the Euro area, with the region forecast to grow by just 1% in 2025 versus 0.7% in 2024. Core Euro economies continue to face both cyclical and structural headwinds, with future trade uncertainty and tariff risks also presenting downside growth risks for the region. On the inflation front, the broad disinflation narrative remains intact, with Euro headline and core CPI inflation at 2.4% y/y and 2.7% y/y, respectively.

In the short term, the structural challenges, trade uncertainty and policy paralysis facing the region - as we await the outcome of the German federal elections in late February - present a rather downbeat picture for European prospects in 2025.

However, on a positive note, financial conditions in the region are easing, helped by expectations of a quick removal of the ECB’s restrictive policy stance, as well as a weak Euro. The prospect of German debt brake reform after the German elections could also help to reduce the downside risks facing the region. For ECB policy, the rate cutting path is clear in the near term, with rate cuts over the coming months well-priced in short term interest rate markets.

From a strategy perspective, we favour curve steepeners in the US and Germany as we think term premia are still too low in both markets.

Duration exposure is favoured in countries that offer a better risk/reward, in markets currently pricing a shallower interest rate cutting cycle and where real yields look relatively attractive. Against this, we favour a tactical short US duration stance. We also favour owning US inflation protection given the US monetary and fiscal policy stance and the potential upside inflation risks arising from US tariff and immigration policy.

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