Tariffs: Terminal levels for the United States and the euro area
Rate hikes galore, but what about the US and the eurozone
It has been a remarkable few months as markets collectively recalibrated expectations for higher rates, driven primarily by persistent inflation. Central banks from Norway to New Zealand have already raised rates, as have a series of Latam banks. In central Europe, countries like Hungary and Poland, which have seen a downward trend in official rates over the past decade, have succumbed to the need for a hike. And there are plenty more, including Czech, while the UK remains on the verge of pulling the trigger.
But what about the United States and the euro zone? There have certainly been built-in rate hike expectations. But the “when do we start?” “And the” how many in total? Are key issues. We have perspectives on both questions, but there is also a market discount that can provide answers as well. A place to start is what futures contracts discount. Forwards are pulled back from the shape of the current curve in the form of breakeven points. These then represent unbiased predictions of how the high rates should go.
The terminal market rate in the United States is 2%, and 70bp in the euro zone
The focus is on the United States, given how critical the Federal Reserve is. Here we see that the 5-10 year part of the curve stabilizes around the 2% area in the front space (chart below). The 5 year old tends to get there 5 years ahead and the 10 year old gets there about 3 years ahead. There is then a flatlining around 2%, almost anywhere you advance. It’s as good a measure as any, from the terminal rate to the federal funds rate.
Performing the same analysis on the EUR curve shows that we need to go further in the futures space to reach a flat line, and the implied end rate for this plateau is in the range of 60bp to 75bp in space. futures (chart below). In fact, the 10-year never goes far above 60 bp, and the 5-year reaches just north of 70 bp when it is advanced 10 years. Without getting too bogged down in detail, it seems that the euro curve tells us that 70bp is a terminal rate discount for the ECB’s refi rate.
This is not far from our own forecast, where we see the Fed settling in the 1.75% to 2.0% area, while the ECB hits 75bp (both slightly above the implied haircut). of the market).
Current curves versus certain forward curves
The United States and the euro area compared
Why the 2-year rate is a good guide to what is really reduced
And what about the timing? Here we are looking at the 2 year rate. Why the 2-year rate? It’s long enough to incorporate a robust view of where rates are heading, without being too long where things can get quite blurry (the further into the future). In the euro zone, the 2-year swap rate is -30 bps. Even the 2-year rate set at 5 years is only 30bp. If rates really go up in the next few years, these valuations should be higher.
In the United States, the discount for rate hikes is more pronounced, but still not dramatic. The 2-year USD swap rate is 65 bps. The 2-year forward rate is up 100bp to 1.65%. And we have to go 5 years ahead to reach the 2% zone. If there is a non-linear relationship between the level of tariffs and the shape of the curve, it seems to us that the absolute level of entry tariffs remains low compared to what it could be, given the orientation terminal tariffs.
Ultimately, the market haircut is where terminal rates of 2% and 70bp are applicable for the United States and the euro area respectively. But the front-end casts doubt on this, because the front-ends do not anticipate an imminent increase in tariffs, and the longer it takes, the more blurred the outlook in terms of reaching these terminal tariffs.