The ECB governing council will meet this week, and we expect them to cut policy rates by 25bps for the fourth time this year. This will bring the deposit rate to 2%. Inflation is actually receding fast to the ECB target, at 1.9% in May according to the preliminary estimate. Looking forward to 2026, we see inflation risks skewed to the downside on the back of low oil prices and the sharp EURUSD appreciation (+10% so far this year). We show in the report that inflation expectations, as measured by 2-year inflation swaps, have significantly diverged from US inflation expectations, currently trading at 1.6% (vs 2.9% in the US). This is significantly below the 2% ECB target. As a result, the EUR OIS curve suggests that markets expect policy rates in the range of 1.5-1.75% in twelve months. In Switzerland, markets expect the SNB to cut rates to 0% on June 19. Back to the future of low interest rates in Europe…
How to play it?
#1: Curve steepeners in EUR. The ECB has been one of the most aggressive central bank in this easing cycle among the G7, causing a bull steepening of the curve. The spread between 30-year and 2-year swap rates currently trades at 70bp, versus -100bps a year ago. We expect the spread to converge towards the long-term average of 115-120 bp in the coming months and quarters.
#2: European small and mid caps are set to benefit from lower rates and lower energy prices. Small caps have dramatically underperformed large caps during the monetary tightening cycle associated with rising energy prices following Russia's invasion of Ukraine. Between 2022 and 2024, they underperformed by 25 percentage points. Our report shows that in the past two months, small caps have started to significantly outperform large caps. We see huge upside potential. Small cap benchmarks in Europe have a bias towards energy-intensive sectors such as industrials and materials, which will clearly benefit from the recent OPEC+ decisions to increase supply. Additionally, the relative valuation versus large caps remains near multi-decade lows. Small caps are also more domestic than large caps and are thus somewhat sheltered from trade wars. European small and mid-sized companies generate more than 60% of their revenues in Europe. However, their cost base could be negatively impacted by European tariffs on US goods if the trade war escalates further.
#3: European telcos. Admittedly, our strong Overweight stance on the Telecommunications sector is somewhat independent from the view on the ECB and energy prices discussed above. Yet, one commonality with small caps is the domestic nature of Telcos, and the fact that they are largely sheltered from trade wars. The sector has turned a corner last year, after years of massive underperformance, as the capex inflection point brings greater visibility on margins and cash flows. Meanwhile, with Telecoms now seen as crucial to the EU’s digital ambitions, pressure is building to relax the regulatory grip on consolidation. The change in the EU regulatory stance on consolidation could support a further re-rating of the sector in our view.
Week ahead: ECB monetary policy meeting on Thursday, US job market report on Friday.
