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European Macro Outlook - Decisive Policy Action Reduces Downside Risks

Policymakers in Europe have been jolted in action after being confronted with the realities of Trump 2.0. The blockbuster German fiscal package is a hugely significant development from a domestic perspective and could spur a solid growth resurgence in 2026. There are already signs of a positive confidence effect in the survey data.
That said, the near-term balance of risks remains firmly tilted to the downside. Next week’s US announcement on ‘reciprocal’ tariffs looms large over the global economy. We continue to expect significant measures on the EU with a clear risk of tit-for-tat escalation. However, the sea change in German fiscal policy both reduces the associated downside risks from a trade war and bodes well for longer-term competitiveness.

US Fixed Income: Uncertainty rules supreme…

Macro View: We have had a long-standing view that underlying labour market dynamics are weaker than they appear on the surface (as seen in the monthly NFP reports). Following a soft report in January, February saw a modest (and lower than expected) 151K gain in non-farm payrolls, while January’s print was revised down to 125K. Employment growth slowed in government, and was negative in leisure and hospitality. Meanwhile, the unemployment rate ticked up to 4.1% as unemployment increased while the labour force shrunk. Notably, while most of the full impact of Trump’s federal workforce retooling should appear moreso in later months, there was also an increase in unemployment of self-employed workers, consistent with some initial DOGE contract cancellations. Given the federal hiring freeze and accompanying layoffs, as well as less immigration ahead due to stricter border control, we expect higher unemployment and slower jobs growth to surface in the coming months.
On the inflation front, after January’s upside surprise, headline, core, and supercore CPI all increased a more subdued 0.2%. Several main categories (used autos, auto insurance, and drug prices) all came down closer to December growth rates after larger gains in January. Shelter prices, which have been especially sticky compared to market-based measures, notched a 0.3% gain. Food prices at home were little changed even with egg prices rising by another 10% in February. Energy prices also improved during the month, leading to a softer headline to match the core rate.

Fed view: : As expected, FOMC kept rates unchanged (at a range of 4.25-4.50%) at its March meeting. Powell’s indicated that conditions in the labour market remain broadly in balance, but uncertainty surrounding trade policy is high. He repeated that the Fed is not in a hurry to adjust and is well positioned to wait for greater clarity. Given that the lower growth and higher inflation forecasts essentially cancel out, the dots still project two cuts in ‘25. The major announcement was regarding QT: Starting in April, the Fed will slow the pace of decline of its securities holdings by reducing the monthly redemption cap on Treasury securities from $25B to $5B, while maintaining the monthly redemption cap on agency debt and agency MBS at $35 billion. The Fed views this as a slowing down to elongate the QT process versus calling for a pause. We disagree that there wasn’t a signal in this latest QT tweak. They stopped short of ending the UST part of QT by keeping the cap at $5bn versus going to zero and MBS pre-pays are relatively non-existent to matter at these levels of rates. In order for the balance-sheet to shrink further rates really have to rally here. So, QT is largely over.
Overall the Fed largely delivered on what we expected, with a neutral to slightly-dovish leaning update to SEP forecasts, reduced QT and signalled that greater uncertainty will impact growth ahead. Further afield, with QT tweak behind us, rate cuts can start as early as June. We maintain our view the Fed will deliver at least 2 cuts in 2025.

DC Views: Updates from the Trump administration are still the major market mover. Trump’s 25% tariffs on steel and aluminium came into effect, leading to retaliation from Canada and the European Union. Looking ahead, April 2 appears to be the next date to watch. This is when reciprocal tariffs are expected to be enacted, in which the goal is to negotiate lower trade barriers between foreign counterparts. In addition, Trump paused tariffs on goods falling under the USMCA for Canada and Mexico until April 2. Policy and growth uncertainties surrounding trade policy and potential downside risks to economic growth have led to a risk-off tone. In addition, a bumpy congressional budget process remains a notable risk factor in the coming weeks/months.

Market Implications: After weeks of risk-off trading, the markets were joyful to see the Fed lean dovish and concerned about growth prospects. The basic elimination of QT was also viewed as supportive of risk assets given that more liquidity will remain in the system ahead. Rates had a clear reversal. The pre-FOMC setup was driven by fears the Fed would be more concerned about tariff induced inflation versus growth shocks. The issue with rates is that they are already low and pricing in multiple cuts. Thus, until we see proof of a greater slowdown, whenever expectations move towards 3 cuts or more, that will serve as resistance and whenever there are 2 cuts or less, that will become support. We also think that risk assets have discounted a fair bit of uncertainty.

FX Outlook

The US dollar has depreciated sharply since the last Global Markets Monthly fuelled by a decline in optimism over the sustainability of “US exceptionalism” given the underperformance of US equities relative to the rest of the world. Trump policy uncertainties have hit business and consumer confidence. In addition, Europe has responded to Trump’s return to the White House with Germany announcing a significant shift in fiscal policy that could amount to a EUR 1trn increase in spending on infrastructure and defence over a 10-year period. Our previous US dollar bearish forecasts by end-2025 have already been achieved and while we see scope for some dollar recovery, we see scope for further US dollar depreciation in the second half of the year. Very near-term, the scale of tariff action under President Trump’s reciprocal tariff plans to be announced on 2nd April will be key for FX and rates direction. Nonetheless, over the medium-term, we see signs of a US cyclical slowdown emerging that will ultimately weaken the US dollar.

USD/JPY - Bearish Bias - 145.00-154.00

EUR/USD - Neutral Bias- 1.0500-1.1000

USD/CNY - Bullish Bias- 7.1500–7.4000

KEY RISK FACTORS IN THE MONTH AHEAD

• The main upside risk for USD/JPY over the short-term is Trump trade tariff announcements fuelling a renewed rise in UST bond yields that translates into a broader rebound of the US dollar and a rebound in USD/JPY. A rebound in US growth and renewed optimism over “US exceptionalism” being sustained for longer would be US dollar positive and help fuel a renewed divergence between the US and Japan.
• The EUR faces more balanced risks in the month ahead. On the downside, the EUR could weaken more than expected if President Trump implements more disruptive tariffs on the EU and the euro-zone economic continues tor remains weak dampening expectations for a pick-p in growth in the near-term. On the upside, the euro would benefit from other European countries following Germany’s lead by announcing plans to step up defence spending, and/or if the ECB decides to skip cutting rates at the April policy meeting.
• The main upside risk for USD/CNY would still be largely on Tariff side. Trump may further escalate tariffs on China for any alleged unfair taxes and non-tariff barriers from China. Downside risk for USD/CNY would be the quicker-than-expected consumption recovery thanks to policy support and more technological breakthrough that would reshape China’s industries and consumption demand (e.g., AI-related products purchase).

European Credit

Credit has remained relatively stably positioned at a historically expensive level, despite the various headwinds facing the global economy, with the Main at c.58bp remaining sat around the middle of a relatively tight twelve month range of 51bp to 66bp

Brent crude recovered ground that had been lost at the start of the month on the back of a surprise decision by OPEC+ to restart some halted production to recover from a YTD low of $69/bbl  to a current level of $73/bbl, albeit concerns remain over the lacklustre global demand outlook and the risk of stagflation posed by current trade tensions.

As discussed latter in this section, while the Trump administration’s trade policy stance has lacked detail and been a disruptive factor for markets, we assume that the market will have the benefit of far more clarity in respect to this important matter over the coming weeks as we enter Q2, which should be helpful to markets, absent a global trade war breaking out.

The passing of the German defence and infrastructure this month represented a substantial boost for the European manufacturing sector, which has remained firmly in recessionary territory since H1 2022 and was the driver behind a surge in longer dated European sovereign yields this month, which we view as supportive of the attractions of longer dated credit in the near term from a total yield perspective, with the 10y bund rising by 33.5bp and the 2-10y curve steepening by c.25bp during March to date.

We continue to maintain a more cautious stance towards European IG corporate credit than European Banks, with the former more exposed to the risks posed by US tariffs and the latter supported by a steepening in Eurozone yield curves.