Welcome back to European Markets. My name's Peter Schaffrik and today is the 26th of June 2025.
We here at RBC had a long-standing call that despite interest rate cuts from global central banks, term yields would not necessarily fall much. But differently, we've recommended not to be long duration or not necessarily be long rates markets, so it's fixed income markets. And so far, this has borne out.
Now, one of the key reasons behind that call is that we thought our term structures, our yield curves were too flat and we suspected that the so-called term premium would increase. This is exactly what has happened. We also think that this process has not run its course yet, particularly not in the Euro market. And today I would like to unpack that a bit. So let's get started.
The first chart that you're looking at simply shows interest rates or yields, the 30 year of the bond curve. And as you can see, we have risen lately but are still significantly below where we were in the early 2000s.
The second chart that you're looking at shows the so-called yield curve or the difference between 30 year yields and five-year yields. And as you can see, we have steepened lately, but we're still not as steep as we used to be.
Now the third chart takes them all together. And what you can see is that shorter term five-year yields have full of the ECB's interest rate much closer than 30 years have. And what you can also see is that the very strong flattening has occurred during the zero-interest rate period that we had following the European debt crisis. And while that has normalized to some degree, we're not quite two levels where we came from.
Another way of looking at this relationship between interest rates on the one hand and the level of the yield curve on the other is shown in the next set of charts. I'll explain first what you see.
The left-hand chart shows us the relationship over time between interest rates depicted here on the X-axis and the so-called yield curve slope, the difference between five years and 30 years on the Y-axis. The difference scatterplot represents different periods of time. And as you can see, the most recent one, which is at the bottom, is significantly lower than the oldest one, which is at the top, even though interest rate levels were comparable.
Put differently, for every level of interest rates that we're seeing at the shorter end of the curve, the yield curve is now flatter. Term rates are lower. This has recently changed. And over the last six months we have moved between the two red dots shown in the left-hand chart, essentially steepening the curve without a meaningful change in the level of rates. We call this a structural steepening of the yield curve or rise in the so-called term premium, embedded in long-term yields. A proxy for this term premium can be seen in the right-hand chart.
Now, why did this happen? We think there's three main developments. One is our trade growth levels have come down. And as a consequence, the so-called neutral rate of interest rate or R-star has come down. Secondly, we had, over that period of time, significantly lower inflation and inflation expectations. And in fact, there was a story in the market at the time about a Japanification of Europe or whether inflation would ever pick up again. Taking these two together, that also meant that there was an expectation in the market of lower for longer. So interest rates would stay essentially low for long period of time, and the expectation of these low interest rates over a long period of time has flattened the yield curve.
Thirdly, the ECB and other central banks conducted QE policies, quantitative easing. They essentially board bonds in the open market with the aim of compressing risk and term premium. And this is exactly what has happened. Now, the crux of the matter is that there is evidence that all three of these factors are reversing.
There's quite a bit of evidence that the so-called R-star rate is rising. We certainly had inflation, and inflation expectations have increased. And we certainly have turned around from QE to a QT, quantitative tightening policy. And when you look at all of these developments, it becomes quite apparent that this is not unique to the Euro area.
Now, the chart that you're currently seeing shows exactly the same chart I presented earlier just for the UK market. And what you're seeing is that we have moved in this scatterplot already to levels that we've last seen in the early 2000s. Put differently, we have seen a significant stronger steepening of the yield curve, a significantly stronger increase in term premium. And that can be seen as an approximation on the right-hand chart.
Where does this leave us? First of all, I would argue that even if we compare with the early 2000s, there are good arguments to be made why the term premium should be even higher than it was back then. After all, we are now having much higher debt GDP levels than we used to have and investors might reasonably say, "As a consequence, I demand a higher premium for buying a certain government's debt." You can see that in the chart that's on the screen.
However, looking particularly at the Euro market, and here you see the same chart again that we had before. We have not reached the levels that are comparable, let's say, with the UK market. We have further ground to cover. One of the reasons for that, for instance, is that the ECB is much slower in its QT program and is not proactive, i.e., not selling bonds in the market as the Bank of England is for instance. We think the ECB will probably be in the QT business for years to come.
Furthermore, we have long argued in our notes that the European economies, including the UK but also the Euro area, are much more inflation prone now than they used to be. As a consequence, we think the risk for actual inflation expectations is to the upside. And if you take this all together, we think there is a very strong argument, particularly for the Euro market that has not seen the same amount of steepening than before for that term premium to continue rising. And this as a consequence leads us to continuously recommend not chasing yields further up the curve. We think the risk is simply too high even if central banks are cutting interest rates. And in fact, for the ECB, we've probably reach the end of the cutting cycle already.
With that, I thank you for watching. I hope you found it informative. And I hope you're going to join us again next time.
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