Policy rate outlook: US Fed to cut, European Central Bank on hold

Improving industrial dynamics in the Eurozone

The latest Purchasing Managers’ Index survey, which covers business sentiment in August, revealed a notable improvement in industrial dynamics in the eurozone, which has been under pressure for the past three years. New orders and output are expected to increase in the coming months. The decline in export orders, due to eurozone goods being subject to 15% tariffs when entering the US, has been offset by stronger domestic demand. This improving backdrop for industrial activity will most likely encourage the European Central Bank (ECB) to keep interest rates on hold after lowering them by 100 basis points in the first half of 2025. Softer economic momentum in eurozone service sectors and reports of underlying inflation dynamics drifting lower justify expectations that policy rates could fall further, but conviction is fading.

US rate cut prospects increase

In the US, the door to a resumption of rate cuts opened further last week when Fed Chair Jerome Powell acknowledged that an adjustment to the Fed’s policy stance was warranted in light of the downside risks to the labour market. Powell’s remarks suggest that the Fed is becoming more willing to view the impending rise in inflation due to US tariffs as transitory, given softening economic activity. This shift in focus by the Fed, from the risk of sustained increases in inflation to the risk of weaker growth, increases our confidence that the Fed will resume rate cuts at its next FOMC meeting in September.

Confirmation of a softening US labour market through economic data would further increase the probability of rate cuts, while even stronger inflation reports would have limited impact on US policy rate expectations.

Geopolitics: The complex art of the deal

You can’t discuss geopolitics without looking at the war in Ukraine, and the recent meeting in Alaska between US President Donald Trump and Russian Kremlin Vladimir Putin was a prime example of the current state of geopolitics. The meeting did not shift the diplomacy around the Ukraine war and was more show than anything else. However, given the link-up to the energy markets via sanctions or even to Europe’s growth prospects via eventual reconstruction, the conflict and its geopolitical influence deserve closer scrutiny. Below is a simplified outline of each parties’ stakes shaping the conflict’s balance:

Ukraine’s defence capabilities grow by the day. According to the latest estimates, the country meets more than 40% of its military equipment needs domestically. Its know-how, especially related to drones and their use in combat, has become the asset that attracts Western funding and, thus, reinforces its military strength longer term. Manpower and dependencies for long-range missiles remain weaknesses.
Russia’s war economy runs hot. The financial breadth to keep military supplies running will eventually be stressed, which is the key uncertainty. Irrespective of Western sanctions, Russia finds buyers for its oil on the so-called grey market. More importantly, geopolitics and this conflict are the Russian regime’s raison d’être.
The US administration seems keen to score a diplomatic quick win, but progress stalls as it is unwilling to use sticks, and has only a few carrots to offer. A case in point: any lifting of liquefied natural gas sanctions against Russia only raises competition for US suppliers.
Europe continues to slowly increase its support to Ukraine, which offsets perceived US fickleness. The pendulum has swung towards defence spending. Fiscal leeway is just sufficient for credibility. Europe delivers security guarantees and will thus be part of any negotiations.

Against the optimism apparent earlier this year, the peace talks promoted by the US administration largely stalled. Fundamentally, the common ground for negotiations builds as the power balance between Ukraine and Russia evens out over time. Ukraine’s military autonomy is growing thanks to its know-how, while Russia’s war economy looks financially fragile longer term. Diplomacy will unlikely advance or overcome these trends in the near term. In the meantime, the political show brings uncertainties, especially the US flip-flopping around tighter Russia sanctions. However, with the established grey market and the Middle East’s surplus, the oil market looks fundamentally more immune to such risks. Of course, geopolitics is always good for sentiment-driven, temporary price spikes. Rebuilding Ukraine remains a long-term topic with negligible economic impact for Europe overall.

What does this mean for investors?

First, there is a case for longer dated US bonds, since the Fed will likely end their rate-cut pause. Second, in the current US market environment, look to structural growth themes - AI adoption, cloud infrastructure, and scalable digital platforms — as they continue to lead the market. We have upgraded our Cloud Computing & AI theme back up to Constructive as a result. And third, the idea that the investment opportunity set is broadening has also been confirmed. Last week, we witnessed a major buying thrust across the board. Global investors who are wary of losing in the USD what they earn in US assets should look out for further ways to spread their wealth across the world. We continue to highlight Europe with its strong growth prospects as well as emerging markets, particularly Singaporean equities, which are one of the few operating in a hard-currency environment similar to the CHF.