Peter Schaffrik:
Welcome back to European Markets. My name is Peter Schaffrik, and we're recording on the 31st of July 2024. Bond yields have fallen quite a bit. One of the key questions is, why? As a reminder, we at RBC have long been of the opinion that the cutting cycles from central banks is going to be a relatively shallow one.
We see four 25 basis point rate cuts from the Fed, ECB, and Bank of England respectively and so far, as we record, only the ECB has delivered one, albeit quite reluctantly. The question before us is, has something fundamentally changed that led bond markets to rally, and do we have to change our view potentially? Let's dig a bit deeper. The first two charts that you're currently looking at shows a dissection of bond yields. The left-hand chart shows you real yields in the five year part of the Euro curve, as well as the so-called break-even inflation or inflation swap, which is a form of inflation expectation. What you can see is the blue line, which represents the real yield, has essentially gone sideways, it has come down a little bit but essentially gone sideways.
The real drop lower came through the inflation component, the inflation expectation. Where did that come from? That's shown on the right-hand chart, which shows you exactly the same inflation expectation sub-component alongside a commodity index. That commodity index has sharply dropped. That comes from everything, oil, base metals such as copper or iron ore, and some others. That's clearly a downside pressure on inflation or inflation expectations going forward.
However, what hasn't really happened is that the underlying picture or question marks about where the economy is going have changed so fundamentally. Now, a second impact, and here is actually slightly different to what's happening in Europe, comes out of the US. The next chart that you're seeing shows exactly the same breakdown just for the US market. What you're seeing here is that both sub-components, the blue line and the orange line, the inflation component, as well as the real yield, has been going down and has been going down quite sharply. There is currently a very fierce debate in the market about the strength of the US, particularly the strength or the impending weakness of the labour market. That has driven real yields in the US lower, and by extension has impacted our markets to some degree as well.
We at RBC, or rather my colleagues in the US, have put extensive research out suggesting that the labour market in the US is much firmer than some people might have believed. We therefore think there's no need to worry about the US. Yes, the Fed will cut, but as I was saying earlier, we think it's going to be a shallow cutting cycle starting in September and ending after about 100 basis points of rate cuts. Where does that leave us here in Europe? For the time being, as long as there's downward pressure on these commodity markets, it could well be that these inflation expectations exert further slight downward pressure on bond yields as well.
However, we have priced in quite a lot of rate cut expectations already. The last chart that you're seeing shows the implied path in forward markets for the ECB alongside our own forecast. As you can see, we've once again, particularly next year, exceeded our own forecast quite substantially. We've been here before. At the end of last year, the beginning of this year, we were in a very similar position. We argued back then that the ECB is probably not going to deliver as much as was priced. We once again reiterate that. We think it's rather unlikely, particularly against the backdrop of a still relatively tight labour market here, and again, what I have argued before, unrealistic expectations that the ECB has implied in their own forecasts about where the labour market is going, where productivity is going and ultimately wages are going.
Therefore, we think also here in Europe, we'll get a much shallower cutting cycle. We still think it's not the time to embrace long duration positions in the bond market. With that, I thank you for watching. I wish you a great summer and hope you're going to join me again towards the end of the summer.