European bond markets are climbing a mountain of worry. Despite the risks, history suggests a positive outcome.
Europe faces adversity and uncertainty. The negatives are easy to list but hard to quantify: the financial and human costs of wars in Ukraine and the Middle East; increased military spending, potentially hiking at least 1% to a minimum 3% of GDP; higher US tariffs, at maybe 10%–20%, or more for certain industries like autos; and additional green transition costs estimated at 2.5% of GDP annually for two decades.
High deficits across much of Europe and political instability in France and Germany constrain policymakers’ freedom of action, while the return of President-elect Trump threatens to exacerbate Europe’s competitiveness problems and populist pressures.
Against that challenging background, we find the outlook for European bond markets surprisingly bright. High yields and falling interest rates have historically been powerful positives for bond investors and—barring worst-case outcomes like another war or pandemic—may be so again in 2025.
Stalling Growth and Falling Rates Mean Lower Bond Yields
European economies are already struggling to return to meaningful growth after the COVID pandemic, and an external shock could push the region into recession. The market expects the European Central Bank’s (ECB’s) policy rate to settle around the pre-pandemic norm of 2% over the next few years.
We think that level is too high and that rates will fall further, as Europe faces the same structural problems as before the pandemic. At its December 2024 meeting, the ECB Governing Council flagged an end to restrictive monetary policy, paving the way for rate cuts at each subsequent meeting until June 2025. Fresh challenges from Trump’s policies could mean even more ECB and Bank of England rate cuts. Meanwhile, these policies could result in higher US nominal growth and inflation, and fewer cuts from the US Federal Reserve.
The prospects of much lower rates in Europe and stronger growth in the US will likely be major positives for euro and sterling bond markets over the next two years. We expect a particularly favorable environment for bonds with 0–10 years to maturity; their yields would be pulled lower as central banks cut interest rates. We also expect some steepening of the yield curve, as longer-dated European Treasuries could be hurt by the fiscal deterioration we've seen across governments globally.
European Credit Is Still Robust
Investment-grade issuers with the strongest financials will be the most resilient to weakening economies and tariff pressures, and their bonds should benefit most from falling rates, in our view. High-yield issuers are more sensitive to changes in economic prospects and could be more affected by a growth slowdown. Even so, European high-yield corporates start from a position of strength. Current yields look attractive relative to history and have been a good indicator of future returns, irrespective of market conditions (Display).
