After being left reeling by the unexpected money-market crisis during its first round of quantitative tightening (QT1), the US Federal Reserve (Fed) intends to manage the second (QT2) with the utmost caution. This means reducing its securities portfolio without creating a shortage in central bank money, in view of the liquidity requirements imposed on banks under the Basel 3 framework. As it is unable to estimate the optimum amount of central bank reserves needed to ensure that its monetary policy is properly implemented, the Fed aims to reduce the stock of reserves to a sufficiently "ample" level.If QT2 is ended too early, it would have to activate its liquidity draining tools in order to limit the downwards pressure on short-term market rates
They say the Davos consensus is always wrong, but it usually takes longer than a couple of months to be apparent. Not so in 2025.
Equity indices, Currencies & commodities, and Bond markets.
Government bond yields in advanced economies are highly correlated, much more than the correlation of real GDP growth. Governments should be cognizant that a lack of fiscal discipline can create negative externalities, by pushing up bond yields abroad. Given the prospect of huge financing needs in the public and private sector, every issuer of debt should prepare for the possibility of structurally higher interest rates and stress test his balance sheet in order to test its resilience.
Inflation is no longer the No. 1 economic problem that it has been for the past three years, but it remains a major challenge. While it has not reached its 2% target yet, and the last pockets are slowly deflating, new inflationary pressures are mounting. At this stage, those pressures are limited but not negligible and new inflationary risks, linked to the economic and geopolitical context, are taking shape. The Fed's task is becoming more complicated by the risk of a US stagflation, and the ECB's one happens to be slightly trickier when balancing between downside and upside risks on growth.
The two most recent shocks to emerging countries (the 2022-2023 tightening of US monetary policy, and the election of Donald Trump at the end of 2024) have not affected their financing conditions. However, supporting factors have weakened since the second half of last year. In the coming months, financing conditions could tighten as a result of rising geopolitical risk in particular. However, the adverse impact on emerging economies should be viewed in perspective, given the low transmission of the two recent external shocks to interest rates. Although exchange rates have continued to depreciate against the dollar, the vulnerability of debt to foreign exchange risk is moderate or low for households and non-financial companies
While the Fed lowered its target rate by 100 bps from 18 September 2024, bond yields rose by around 80 bps (as at 7/2/2025). This rare divergence is reminiscent of an inverse version of the ‘Greenspan conundrum’ (2004–2005): during this episode, which spread to Europe, the rise in short-term rates had little effect on long-term rates. What are the reasons for these contrary movements between short- and long-term rates, and what might the implications be?
The consensus view currently holds that the great divergence between the US and EU economies observed since the pandemic is bound to continue. As a snapshot of current conditions, it is certainly true that the US economy has a strong growth momentum and bullish animal spirits, while Europe has neither. But extrapolating from a snapshot, as instinct tempts us to do, is often wrong. In fact, there are solid reasons to expect the gap between US and Europe growth to shrink in 2025—as envisioned in BNPP’s central scenario, with the US economy slowing down and the Eurozone’s accelerating (albeit modestly so). Beyond the year-ahead outlook, there are at least 5 reasons to challenge the view that Donald Trump’s economic policies will make Europe even weaker. Let’s consider them in turn.
Energy policy was at the top of the agenda during the election campaign and in the first few weeks of the Trump presidency. Its objectives are to reaffirm America's domination of the global hydrocarbon market (the United States has been the world's leading oil producer since 2019) and to ensure low prices for US consumers. In practice, this is manifesting in a desire to increase US oil and gas production by three million barrels of oil equivalent per day, for an average crude oil production of over 13 million b/d in 2024. But is this goal realistic?
On 20 January 2025, Donald Trump once again became President of the United States. With a ‘clear mandate’, the Republican intends to harness his victory by addressing his favourite issues. His return to the Oval Office comes at a time when the dollar is witnessing one of the biggest rallies in history. The real effective exchange rate of the greenback is now at a comparable level to the one which led to the Plaza Accord of 1985, and its appreciation has a high likelihood of continuing. This trend is likely to frustrate the new President, who is keen to denounce weak currencies as penalising US industry
The global economy faces a long list of uncertainties -growth, inflation, interest rates, political, geopolitical, tariffs, etc. When uncertainty is exceptionally high, as is the case today, the economic environment becomes intrinsically unstable and may evolve suddenly and drastically. This acts as an economic headwind because companies that are highly exposed to these sources of uncertainty may postpone investment and hiring decisions. This may weigh on household confidence, triggering a reduction in discretionary spending. Financial markets may also become more volatile because investors shorten their investment horizon. There is a clear urgency of creating a predictable policy environment.
The latest Employment Situation report prior to the next FOMC meeting (28-29 January) points to the surprising strength of the US labour market, illustrated by job creation at its highest level since March 2024. Publication concluded a week marked by a significant rise in bond yields against a backdrop of expectations of rates "higher for longer", leading to sharp movements on the financial markets.
The ECB is still keeping control of things. This was the general message from Christine Lagarde at her press conference on Thursday 12 December. As expected, the ECB cut its key rates by 25 basis points for the fourth time since monetary easing began in June, taking the refinancing rate down to 3.5% and the deposit facility rate down to 3.0%. Inflation forecasts have been lowered slightly, with the forecast brought down to 2.1% for headline inflation and 2.3% for core inflation, before the two measures converge at 1.9% in 2026.
