(Bloomberg) -- Pacific Investment Management Co. and Fidelity International are among investors who say the darkening economic outlook in Europe may force policymakers to cut interest rates more than the market expects.
The latest pricing suggests the European Central Bank will lower the key rate to 1.75% next year after officials on Thursday delivered a third consecutive cut to 3%. But Fidelity says borrowing costs could drop further to 1.5%, while Pimco also sees risks of steeper declines.
A further repricing could supercharge a rally in European debt, which has already outperformed US and UK bond markets in 2024. A Bloomberg index tracking the returns of euro government debt is up over 3% this year, compared to a 2% gain for US Treasuries and a 2% loss for gilts.
The market “remains somewhat more hawkish than our expectations,” said Salman Ahmed, global head of macro & strategic asset allocation at Fidelity. There are “risks that the ECB cuts even more if downside risks materialize.”
European bonds fell on Thursday after ECB President Christine Lagarde struck a less dovish tone in a press conference than markets were expecting. Italian bonds, which tend to be more sensitive to monetary policy changes, fell sharply.
Still, the broader outlook for the region’s activity remains bleak. Manufacturing and services sectors are struggling and economic powerhouse Germany already faces a second straight year of contraction. At the same time, the bloc is enduring political upheaval in its two biggest economies, plus a potential jolt to global trade from Donald Trump’s return to the US presidency.
That supports the case for more aggressive rate cuts than its peers. The ECB is expected to lower rates by roughly 125 basis points through the end of next year — on top of the quarter-point cut delivered Thursday — while the Federal Reserve and Bank of England are seen lowering borrowing costs by around 80 basis points.
“The monetary policy divergence between the US and Europe is expected to continue to widen further in 2025 and we maintain a preference for European rates vs US ones in terms of duration,” said Nicolas Forest, chief investment officer at Candriam. “The outlook for Europe is darkening.”
The statement accompanying the ECB decision opened the door to more rate cuts. Officials dropped wording saying policy will remain “sufficiently restrictive” for as long as necessary. That foreshadows a potential shift to stimulative monetary policy where the focus is on perking up prices than restraining them.
“If you want rates in Europe to get really easy, you’re talking about 0.5% to 1% and that’s not priced,” said Tim Graf, head of EMEA macro strategy at State Street Global Markets. “If Europe really does fall out of bed next year, that’s where rates are going to go.”
New quarterly projections also reflect the need for more support, with forecasts for economic expansion and inflation next year being revised down. Even so, Fidelity’s Ahmed said the estimates appear “somewhat optimistic” and not reflective of the risk of Trump’s trade policies.
“We believe growth will continue to turn out weaker than what the ECB expects, and see potential for markets to price lower terminal rates,” said Konstantin Veit, portfolio manager at Pimco. “The data flow over the coming months will decide the speed and scale of monetary easing from here.”
--With assistance from Alice Gledhill and Sujata Rao.
(Adds State Street comment in third to last paragraph.)
