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Article | 4 March 2025
Rates: A volatile world warrants EUR
steepeners
The euro swap curve is still exceptionally flat by historical standards
and forwards don’t price any moves from here. With growth holding
up, underpriced structural inflation risks and EU spending plan
discussions, we see potential for more bear steepening of the 5s10s
curve. If recession risks intensify, then we'd see a bull steepening
We don’t believe the
current yield curve can
be an equilibrium
outcome – although
curves can remain flat
if risks keep lurking but
never materialise
The euro curve in forwards is still exceptionally flat
When we look at the steepness of the euro swap curve in forwards, we see exceptionally flat
curves compared to historical norms. The 5s10s in spot rates is strongly influenced by rate cut
expectations, which are for a large part expressed by rate expectations in the immediate two
years. By charting the 5s10s curve in two-year forwards, we implicitly filter for any near-term
monetary policy expectations.
The last time the 5s10s in forwards space was this flat was around 2007, which was when the
European Central Bank was hiking rates to address rising inflation. Policy rates were deemed
restrictive at this time, flattening the curve. With the ECB currently moving towards a neutral or
even supportive monetary policy stance, we would expect more steepening to materialise than so
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far has occurred.
Curves are still as flat as during the ECB’s previous hiking cycle
Source: ING, Macrobond
Markets are preventing steepening on structural fears
Curves remain exceptionally flat because markets take a very pessimistic view on the structural
outlook of the eurozone. A potential trade war, an actual war, and political uncertainty in France
and Germany are all preventing markets from normalising. The 5Y5Y forward inflation swap
reflects this pessimism with the risk premium now close to zero, weighing down the 10y swap rate.
Inflation swaps in line with expectations suggests little risk
premium
Source: ING, Refinitiv, Macrobond
We see two potential scenarios for where the yield curve will steepen from here: 1) a gradual
economic recovery with a rebuild of the term risk premium, or 2) through a sharp rise in recession
risk triggering a bull steepening. Our baseline is for a gradual recovery and recent data supports
this direction. Talks about defence spending and broader EU reforms can help markets grow more
convinced of this as the likely path forward. In contrast, if we do see an escalation of geopolitical
risks, then the ECB could be quick to resort to more cuts. Inflation is sticky, but below 3%, and any
severe risks to growth can therefore trigger a steepening from the front end.
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We don’t believe the current yield curve can be an equilibrium outcome, although curves can
remain flat if risks keep lurking but never materialise. The uncertainty would prevent the term
premium from rebuilding while the front end of the curve would remain where it is. It’s hard to
imagine a flattening move from here given the already stretched positioning. One would have to
see inflation risks pick up while the longer-term growth outlook gets challenged at the same time.
As such, the balance of risks favours a steepening of the 5s10s from here.
Reading forwards for future predictions
To understand current market positioning we look at forwards, which are simply a
mathematical transformation of spot rates but can nevertheless provide insights about the
future. Using US Treasury yield data going back to 1961, we show that since 2000, forwards
can help predict changes over short horizons and tenors. The correlation of implied and
realised changes of the 1Y rate over short horizons was above 0.3. Over time, the
predictability of rates using forwards at shorter tenors improved, which can ironically be
explained by the increased focus of central banks on “forward” guidance.
Our results suggest that the value of forwards in predicting the path of tenors beyond three
years is limited. The first reason relates to the term risk premium, which becomes
increasingly important for longer maturities. This risk premium should be added to the
forwards implied path for a purer measure of expected rates.
But perhaps a more important reason as to why longer-dated forwards fail to capture
future rate moves is due to systematic forecasting errors. The negative correlation in the
heatmap can be explained by the secular decline in rates over the past decades. An upward
sloping yield implied rising rates (and positive term premium), but instead the neutral rate
was consistently lowered by markets, leading to declines in rates instead.
In our analysis above, we think that markets are too pessimistic on the long-term outlook of
expected rates and we foresee a building of the term premium.
Special thanks to Manas Sadasivuni for contributing to the data analysis.
Forwards help predict rate moves for shorter tenors and terms
Source: ING Calculations
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Forwards have improved as a predictor of shorter tenors
Source: ING Calculations
Author
Michiel Tukker
Senior European Rates Strategist
michiel.tukker@ing.com
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