ECB Rate Hikes Unlikely, Bond Yields Set for Decline

Capital Economics has released its latest forecast for the euro-zone economy, predicting modest growth across major member states over the next one to two years. The research firm expects Germany, France, and Italy to grow at a pace consistent with their trend rate of approximately 1%, while Spain is set to outperform due to continued immigration.

Headline inflation in the euro-zone is projected to rise to around 4% by year's end, driven primarily by indirect effects from higher energy costs. However, core inflation is expected to remain low, and Capital Economics believes second-round effects on wages will be negligible. As a result, headline inflation should fall sharply next year and return to levels consistent with the European Central Bank's 2% target by the end of 2027.

The ECB's interest rate hike in December is unlikely to be followed by further tightening, according to Capital Economics. In fact, the firm expects interest rate cuts to become a priority again in the second half of next year, with the deposit rate likely falling below its current level in 2028. This outlook suggests that bond yields will decline in 2027 and spreads will remain low across most countries.

France and Italy may be exceptions to this trend, however, as Capital Economics notes that their governments' unstable finances and upcoming elections could lead to widening spreads.