Is the Market Too Hawkish on the ECB? What to Expect for the Terminal Rate and Bond Yields

Markets are pricing in a terminal rate of 1.75% for the European Central Bank (ECB) by year-end, but that level could be reached earlier and remain low for longer — especially if, as we believe, the current pricing is too hawkish given the cooling inflation outlook. This terminal rate would likely correspond to slightly lower short-term yields. Meanwhile, a 2s10s yield curve of around 50 basis points suggests that 10-year Bund yields still appear cheap despite recent increases.

1. Terminal Rate at 1.75%, 2s10s Curve at 50 bps Keeps 10-Year Bunds Undervalued

As policy rates approach their terminal level — likely close to neutral — the debate is expected to shift toward the appropriate shape and level of the yield curve under those conditions. As seen in other regions, lower policy rates are typically associated with a steeper 2s10s curve. However, a return to 100–200 basis points, as was common during the QE era, seems unlikely. In the slower-growth euro area, a 50-basis-point curve appears more realistic.

An ECB terminal rate of 1.75% by September could imply 10-year Bund yields trading in a range centered around 2.4% — well below current levels.

2. We Believe Market Expectations Are Slightly Too Hawkish

Bloomberg Economics believes that current market pricing leans too hawkish, given inflation is expected to remain close to the ECB’s 2% target throughout the summer. This is driven primarily by gradually easing wage pressures and moderating services inflation. Weak economic growth — further strained by U.S. tariffs — and disinflation in goods (due to Chinese exporters seeking new markets) are also likely to support continued monetary easing. Bloomberg Economics expects a 25-basis-point ECB rate cut in September.

If this forecast proves accurate, policy rates may average around 1.75% in 2026 and 2027, with a possible downward bias if growth concerns intensify. That scenario could also support renewed short-term rate cut pricing, potentially bringing the 2-year Schatz yield closer to 1.7% by late 2025.

3. Front-End Euro Yields Align With Market Expectations

Markets currently expect just one more 25-basis-point cut in the ECB’s deposit facility rate, bringing it to 1.75%. However, this cut is not fully priced in until the December 18 ECB meeting. After that, markets anticipate rates will remain steady until early 2027, when a gradual rise is expected.

This implies average policy rates of around 1.8% over the next two years and just under 1.9% in 2026 and 2027 — both levels broadly consistent with the current 2-year Schatz yield of approximately 1.85%.

4. Bund Yields Temporarily Decoupled From Treasuries

Ten-year German Bund yields have risen by 16 basis points in recent weeks, reaching levels last seen in May, after U.S. tariff concerns pushed Treasury yields higher.

Interestingly, U.S. 10-year Treasury yields have since declined again, while the Bund market has decoupled from that move. However, if the usual correlation between Bunds and Treasuries reasserts itself, longer-term Bund yields could soon follow suit and trend downward.

5. Front-End Yields Less Closely Correlated

Short-term U.S. Treasury yields have also retreated following their April–May tariff-driven surge. German front-end yields, meanwhile, have moved more conventionally, remaining in a range of 1.75–2.00%.

While softer U.S. front-end yields could exert some downward pressure on German equivalents, longer-dated Bund yields currently appear more misaligned with underlying market fundamentals.