Fast reading
- On one hand, the central bank is faced with unprecedented fiscal expansion from the region’s largest economy, Germany.
- On the other hand, the euro area may have to contend with punishing US levies on European exports.
- These two contrasting dynamics are inherently in conflict with each other and present a formidable challenge for the future path of ECB monetary policy.
The rise in market volatility this year has led the European Central Bank to stick with its easing programme. The ECB’s 25bps cut on 17 April – the seventh consecutive reduction – took its benchmark rate to 2.25%.
The economic backdrop in Europe is brimming with competing dynamics that have made the ECB’s principal mandate for ‘price stability’ more challenging than ever.
On one hand, the central bank is faced with unprecedented fiscal expansion from the region’s largest economy, Germany. (In March, German lawmakers approved a €500bn spending package that could have a big impact on the bloc’s defence and infrastructure sectors.)
On the other hand, the euro area may have to contend with punishing US levies on European exports. The EU and the US have begun negations over their future trading relationship, but many potential sticking points remain.
These two contrasting dynamics are inherently in conflict with each other and present a formidable challenge for the future path of ECB monetary policy.
What is likely is that this economic maelstrom will generate more uncertainty, and as a result, more volatility will probably follow.
Figure 1: Where next for the ECB?
‘Wait and see’ mode
So, what is the ECB’s current roadmap? In response to this Venn diagram of outcomes, the ECB finds itself in a ‘wait and see’ mode.
The ECB recently removed ‘restrictive’ from its terminology, which would suggest that it is somewhere near the end of its easing cycle. However, the central bank has clearly been worried about the downside effects that US imposed tariffs could have on growth. In March, the ECB cut its 2025 growth forecast for the eurozone to 0.9%.
Despite removing ‘restrictive’, the ECB actually turned more dovish in its April meeting – suggesting that US trade policy is viewed as a greater risk to growth than the stimulative effects of German fiscal expansion.
Consequently, larger downside risks have emerged that are likely to sway the ECB to cut borrowing costs further than originally believed.
What should investors to do in the current environment? They can opt to weather the storm – but at the same time needlessly expose themselves to unknown risks.
They can move into cash – but subject themselves to the forces of inflation. Or investors can remove the guesswork and ally themselves with the ECB’s own objective by routing their capital towards short-dated euro-denominated credit.
Short-dated bond holdings offer greater immunisation from market volatility
Short-dated bond holdings offer greater immunisation from market volatility while generating income as the ECB navigates towards its ultimate goal of ‘price stability’.
Short-term investments are also shielded from long-term uncertainties. In the event of volatility – caused by geopolitical ructions or changes in monetary policy – then an investment in short duration credit can allow investors to navigate this volatility while at the same time potentially delivering a more attractive return than other ‘safe haven’ options.
In addition, a global approach, trading in multiple currencies, can also allow an element of arbitrage in terms of opportunities that may arise – between one country and another – to maximise the overall returns. Globally, monetary policies always diverge to some degree – as do asset classes based in different geographies – and over the short term this divergence is amplified.
A third way
Some investors may (just like the ECB) choose to adopt a ‘wait and see’ approach – while at the same time generating excess income.
Federated Hermes Euro Kurzlaufer Strategy is primarily invested in euro-denominated short-duration credit (as well as fully currency-hedged dollar and sterling) in more than a dozen countries, across investment grade, sovereigns and corporates, it offers a third way – one, we believe, that has the potential to allow investors to both weather the current volatility and get paid for it.
For more information on Euro Kurzlaufer, short duration and liquidity solutions.
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