Central Banks Navigate Rising Inflation Expectations and Trade War Uncertainty!

Last week saw a surge in economic uncertainty and market volatility, as growing concerns over the impact of tariffs on U.S. growth and consumers led to sharp shifts in central bank rate expectations. In the U.S., consumer confidence fell for the third straight month, reaching its lowest level since 2022, while inflation expectations spiked. One-year inflation expectations jumped from 4.3% to 4.9%, while long-term (5-10 year) inflation expectations hit a 33-year high at 3.9%—a worrying development for the Federal Reserve. This combination of weaker growth sentiment and rising inflation risks caused wild swings in Fed rate cut expectations, which were further amplified by the Fed blackout period ahead of its March 19 meeting. Initially, markets priced in 90bps of Fed cuts by year-end, but after the inflation surge, expectations dropped back to just 66bps, signaling mounting fears of stagflation—the worst possible scenario for the Fed. For now, the Fed is expected to remain in "wait and see" mode, keeping rates unchanged next week while assessing the longer-term impact of tariffs. In Europe, market expectations for ECB rate cuts remained steady, as the economic outlook remains highly uncertain. While U.S. tariffs pose downside risks to growth, the German government’s newly approved fiscal stimulus package—the largest in decades—could offset some of the drag, potentially even sustaining inflationary pressures. As a result, markets continue to price in just two ECB cuts in 2025 (-50bps), with the first 25bp move expected in June and another in the second half of the year. Meanwhile, the improving growth outlook for the Eurozone and a weaker Swiss franc (-3% vs. EUR since February) have reduced pressure on the SNB to ease policy further. While a 25bp SNB rate cut this week is still the most likely outcome, markets now price only a 75% chance of the move, and if delivered, it is widely expected to mark the last cut of the cycle, leaving Swiss rates on hold for the remainder of 2025. In the UK, weak GDP data did little to shift BoE expectations, as the British economy continues to grapple with soft growth and persistent inflationary pressures. U.S. tariffs pose downside risks, but domestic resilience could keep inflation sticky, limiting the scope for BoE easing. Markets still expect just over two rate cuts this year (-55bps), with the first 25bp cut expected at either the May or June meeting. In Japan, the recent strengthening of the yen prompted traders to reduce their expectations for BoJ rate hikes, with market pricing for 2025 tightening from 40bps to 32bps. Lastly, in Canada, the Bank of Canada cut rates by 25bps as expected, lowering its key rate to 2.75%. With Canada particularly vulnerable to the escalating U.S. trade war, markets now expect two additional 25bp rate cuts by year-end. However, given the fluid political landscape and uncertain economic trajectory, the outlook for further BoC easing remains highly uncertain.

Credit Markets Struggle as Trade Tensions Escalate and Recession Risks Loom

It was a risk-off week in credit markets, as escalating trade tensions between the U.S. and EU weighed on sentiment. The EU retaliated against U.S. tariffs on steel and aluminum, and early April could see another wave of protectionist measures. Meanwhile, Trump threatened a 200% tariff on imported wine, champagne, and other alcoholic beverages from France and the EU, unless the bloc abandons its planned tariffs on U.S. whiskey. While these targeted products may not directly impact Eurozone GDP, France’s wine industry is deeply intertwined with national heritage, adding political complexity to the trade dispute. At the macro level, economists have flagged an above-average risk of a U.S. recession or stagflation, leading to a notable shift in global credit markets. For the first time since February 2022, European investment-grade (IG) spreads are now tighter than U.S. IG spreads, reflecting diverging fiscal, monetary, and political conditions between the two regions. The outlook for European credit remains relatively supported by Germany’s upcoming fiscal stimulus package and the EU’s ReArm Plan, both of which should help sustain growth and corporate fundamentals in the Eurozone. In corporate news, UniCredit received ECB approval for its 29.9% acquisition of Commerzbank, clearing the way for a potential full takeover. If completed, this would mark a rare cross-border European bank merger, signaling increased consolidation in the European banking sector. In terms of performance, EUR IG credit spreads widened by 7bps to 90bps, but still remain 4bps tighter than U.S. IG. Despite the widening, the iShares Core Euro IG Corporate Bond ETF declined only -0.3% (-0.7% YTD), outperforming its U.S. counterpart. U.S. IG spreads widened by 5bps to 94bps, leading to a -0.5% drop in the Vanguard USD Corporate Bond ETF, erasing its previous gains (+1.6% YTD). High yield (HY) credit markets faced steeper losses. EUR HY spreads widened by 25bps to 314bps, yet remain 11bps tighter than U.S. HY spreads, as U.S. credit sold off amid recession fears. The iShares Euro HY Corporate Bond ETF dropped -0.4% last week (+0.5% YTD) but still held up better than its U.S. counterpart. U.S. HY spreads widened another 28bps to 325bps, following a 10bps widening the previous week. The iShares Broad USD High Yield Corporate Bond ETF fell -0.8%, cutting its YTD gain to +1.0%. High-beta credit segments also suffered from the risk-off sentiment. The WisdomTree AT1 CoCo ETF slipped -0.3% for the week (+1.3% YTD), while European corporate hybrids declined -0.5% (flat YTD).