European fixed income: 2025 outlook

Investors are facing uncertainty going into 2025, with significant political changes likely both within the euro area and across the Atlantic. Meanwhile, we anticipate sub-trend economic growth and accommodative monetary policy in Europe, which should be largely supportive for European bond markets over the medium term. Nevertheless, the potential for elevated volatility means that active investment management will become even more important, in our view.

European economic growth remains subdued, with potential downside risks arising from a Republican-controlled US government

The election of Donald Trump as US president and Republican control of both chambers of Congress are likely top of mind for investors as we wait to see how the new administration’s policies unfold. While significant uncertainty remains, we don’t foresee any outcomes in the United States that would be particularly positive for European economic growth.

The United States is the largest export market for the euro area, and so Trump’s promised tariffs could spell trouble. Since the euro area economy has seen domestic demand contract (as savings significantly outpace private consumption), its recovery hinges on expanding foreign demand. However, we estimate only a modest direct drag on gross domestic product from any tariffs that are likely to be introduced. Indirectly, though, trade tensions create uncertainty  which we believe will, in turn, weigh on economic activity and act as a disincentive to investment and consumption.

Another aspect that bears watching is Trump’s apparent reluctance to maintain the same level of military aid to US allies, which likely means that European governments will need to step up their defense spending. It is important to note that the multiplier effect on defense spending is usually lower compared with many other alternatives due to the high import content. Therefore, both of the aforementioned developments could weigh on the European economic growth outlook, though the extent remains unclear, and there will certainly be mitigating factors (for example, a strong US economy generates positive spillovers for trade partners).

The European Central Bank (ECB) will need to act decisively

In response to a struggling economic recovery and inflation that is close to returning to target, the ECB will likely cut interest rates further than many expect. In fact, despite financial market participants pricing in a deposit rate of around 1.8%–1.9% by end-2025 (at the time of writing), we believe that the ECB might need to be more accommodative and take the deposit rate to 1.5%, or even lower. This, in turn, means to us that shorter maturity European bonds could outperform longer tenors. Meanwhile, longer maturity bonds will be more dependent on US Treasuries, where we expect yields to remain higher in light of expansionary fiscal policy and a resilient US economy.

While we aren’t currently too worried about the evolution of the interest rate differential with the United States, higher rates across the Atlantic could put pressure on the euro. The ECB will have to keep an eye on the euro’s exchange value, as it could result in upside risks to inflation. Generally, though, subdued economic activity and moderating wage growth should support a sustained disinflationary trend, in our view.

Despite some tailwinds, careful portfolio construction will be crucial in 2025

Overall, looser monetary policy and declining yields contribute to a more constructive backdrop for European bond investors going forward. Nevertheless, we are seeing significant divergence between European countries in terms of economic growth and political stability—with notable elections coming up in Germany and France—which is keeping us vigilant. We believe that an active and deliberate approach to security selection will be important in 2025, in order to try and benefit from positive tailwinds while ensuring that any risks taken are intentional and measured.