State Street Global Advisors: U.S. tariffs may lead to significant interest rate cuts by the European Central Bank, European bonds are set to soar
State Street Global Advisors strategists indicate that European bonds are expected to perform well in 2023 due to the U.S. threat of tariffs, with the European Central Bank anticipated to lower interest rates from 2.75% to 1.5%. This rate cut will drive European bonds higher relative to U.S. Treasuries and may lead to the euro-to-dollar exchange rate returning to parity. Although Trump agreed to suspend tariffs on Canada and Mexico, State Street Global's research director believes that the threat of tariffs against the EU will persist
According to the Zhitong Finance APP, strategists at State Street Global Advisors believe that European bonds are expected to perform well this year, as the threat of tariffs from the United States will force the European Central Bank to significantly cut interest rates.
The strategists at State Street Global indicated that, given the sluggish growth and declining inflation in the EU economy, U.S. tariffs will put pressure on the region's export-oriented economy. They added that this will lead the European Central Bank to lower interest rates from 2.75% to 1.5%, below the market expectation of 1.9%.
The repricing of further rate cuts by the European Central Bank will drive European bonds higher relative to U.S. Treasuries, as inflation remains high and the Federal Reserve is expected to cut rates only one or two times this year, each by 25 basis points. State Street Global stated that this will also cause the euro to fall back to parity against the dollar.
Altaf Kassam, Head of Investment Strategy and Research for Europe, the Middle East, and Africa at State Street Global Advisors, stated: "This year could be the year of European government bonds. The pace of rate cuts in Europe will be more robust than in the U.S."
The yield spread between U.S. and German bonds remains high.
Earlier this week, U.S. President Donald Trump stated that tariffs on the Eurozone "will definitely happen," citing the significant trade deficit between the U.S. and the EU. Following this, Eurozone bonds surged. However, Trump agreed to suspend tariffs on goods from Canada and Mexico, easing concerns about a full-blown global trade war, and Eurozone bond prices quickly fell back.
However, Elliot Hentov, Head of Macro Policy Research at State Street Global Advisors, stated that this optimistic view is misguided. He believes that Trump is using tariffs as a negotiating tool in talks with Canada and Mexico, but intends to hold firm for economic reasons in negotiations with the EU.
Hentov stated that further rate cuts by the European Central Bank will push the euro to dollar exchange rate back to parity. On Friday, the euro to dollar exchange rate was around 1.04, above the more than two-year low of 1.0141 set on Monday.
Last year, Lori Heinel, Chief Investment Officer at State Street Global Advisors, correctly predicted that the Federal Reserve would significantly cut rates by 50 basis points before the U.S. elections, marking the beginning of a loosening cycle. Nevertheless, her expectation of a 150 basis point cut by the end of 2024 proved to be overly aggressive, as the Federal Reserve actually cut rates by 100 basis points during that period.
The market expects the Federal Reserve to make its next rate cut in July, with a 65% chance of another cut in December. A market-based long-term inflation indicator in the U.S. is currently above 2.50%, which is 50 basis points higher than its Eurozone counterpart.
Kassam stated: "Unfortunately, we believe that the inflation dragon, which we thought had been slain, has not disappeared. At least in the short term, bonds outside the U.S. have a greater opportunity."