Payden & Rygel: The Fed and The ECB
Jeffrey Cleveland, Chief Economist
In 2026, we expect the Fed to cut three times (25 bps each) in the latter half of the year, bringing the fed funds rate to a neutral of 3%. Our reasoning is twofold: First, we expect core inflation to moderate to 2.2% by year-end as tariff pass-throughs fade and service prices continue to cool. Second, we expect the labor market to remain weak and the unemployment rate to rise slowly throughout the year.
Paul Saint Pasteur, Global Fixed Income Portfolio Manager
The ECB left the deposit rate unchanged at 2.00%, highlighting a balanced risk outlook between inflation and growth and the need to monitor the conflict in the Middle East. Lagarde pointed to resilient domestic demand and inflation firmly anchored to the target, but reiterated the ECB's readiness to act in the event of energy shocks.
The new projections show inflation slightly higher and persistently above target in the medium term, while growth estimates were revised downward, reflecting the negative impact of rising energy prices on real income. The ECB's stance was less restrictive than the market had expected, maintaining a flexible approach and a meeting-by-meeting approach.
Following the announcement and press conference, the market reaction was fairly changed. The two-year swap rate, an indicator of short-term rate expectations, rose to around 2.60% (from 2.52% previously), while German government bond yields held onto the gains recorded during the day, with the two-year yield up by about 11 basis points to 2.56% and the 10-year yield near 3%.
Overall, the market continues to price in about two rate hikes by September 2026. On the currency front, the euro strengthened slightly against the dollar, settling in the 1.14–1.15 range, supported by relative rate expectations that only partially offset demand for the dollar during periods of heightened risk aversion.
In our view, however, these rate hike expectations appear aggressive: we do not believe the ECB will necessarily be forced to raise rates, and in the event of a relatively swift resolution of the conflict, such expectations could be quickly reabsorbed.
Much will depend on the dynamics of energy prices and second-round effects on inflation: only in a scenario where oil remains steadily above $100 for several months might the ECB find itself with no alternative. This is not, however, our base-case scenario. The outlook therefore remains highly uncertain and strongly tied to developments in the energy markets.
