Improved US inflation data and unexpectedly weaker economic signals reinforced expectations in the international financial markets of rapid interest rate cuts. The situation was different in the spring, when – in light of stalling disinflation and a robust economic environment, at least in the United States – market participants had successively shifted their expectations of when a phase of interest rate cuts would begin in the United States and the euro area into the future. Since the beginning of the third quarter, there have been increasing changes in the financial market environment. Backed by the Federal Reserve’s assessment that progress had now been made in tackling US inflation, market participants adjusted their outlook for key interest rates, in some cases significantly downward. As a result, unexpectedly weaker labour market data from the United States reinforced this market dynamic. Due to their interlinkages with US interest rates, key interest rate expectations in the euro area fell, too. Overall, developments in long-term yields were mixed. For instance, yields in the United States fell, while yields in the euro area barely changed on balance. These developments caused the euro to appreciate against the US dollar. By contrast, the euro depreciated against the yen on balance in an environment of rising yields in Japan.

Risky assets – including shares, in particular – came under pressure due to the more pessimistic economic outlook and a decline in investors’ risk appetite. As a result, international equity markets had to contend with substantial price losses in some cases for a time amid heightened financial market volatility. As risk appetite amongst investors declined, the yield spreads on long-term government bonds and corporate bonds widened slightly overall. Against this backdrop, investors demanded somewhat greater risk compensation for bonds with low credit quality. However, the surge in financial market volatility at the beginning of August caused by poorer US labour market data quickly abated. Developments in international equity markets since the beginning of the second quarter exhibit marked regional differences. Whereas price gains were recorded in the United States and the United Kingdom on balance, losses were registered in the euro area and Japan. 

On balance, the euro has appreciated against the US dollar since the start of the second quarter of 2024. The impact of impetus arising from monetary policy in the two currency areas on the euro/US dollar exchange rate overshadowed the effects of increasing risk aversion on the part of market participants. The dissolution of France's National Assembly by the French president in the aftermath of the European elections alone led to a marked decline in risk appetite for European assets. The level of uncertainty later also spread globally in the wake of increasing tensions in the Middle East, which, all else being equal, supported net capital flows to the United States and, hence, the US dollar. The euro was buoyed by increased expectations of interest rate cuts in the United States from the end of March, the effects of which only spilled over to the euro area to a lesser extent. A decisive factor behind the changing monetary policy outlook in the United States was the fact that there have been growing indications of a slowdown in the US economy since June. For instance, consumer price inflation in the United States turned out lower than originally expected on multiple occasions, and US labour market data published in August were surprisingly weak. By contrast, until recently, inflationary pressure in the euro area proved to be more persistent than expected by market participants. As this report went to press, the euro was trading at US $1.10, up by 1.9% compared with the end of the first quarter of 2024.

The euro exchange rate against the pound sterling remained almost unchanged on balance. Surprisingly high inflation figures in the United Kingdom, which, in the eyes of market participants, lowered the probability of monetary policy being eased soon in that country, contributed to the euro losing ground against the British pound until mid-June. For one-and-a-half months, the exchange rate then predominantly moved sideways within a narrow band of between £0.84 and £0.85. Early in August, however, a tight decision led the Bank of England to cut its key interest rate by 25 basis points, after UK inflation figures had previously turned out surprisingly low. The euro subsequently appreciated again against the pound sterling. It was most recently trading at £0.86, resulting in an almost unchanged rate compared to the end of the first quarter of 2024 (+0.1%).

The euro depreciated against the yen on balance, even though it had reached an all-time high against the currency in July. In view of the significant interest advantage of the euro area over Japan, the euro still managed to register fairly continual value gains during the second quarter. This trend was interrupted only temporarily, partly due to foreign exchange interventions by the Japanese authorities, which in May – as officially confirmed at the end of the month – purchased ¥9.8 trillion to prop up the currency. On 11 July, the euro reached a new all-time high of ¥175. This was subsequently followed by a robust countermovement, however. Renewed foreign exchange interventions by the Japanese authorities, officially reported to have purchased a further ¥5.5 trillion in July, were a probable trigger for the yen’s rapid gains. Shortly afterwards, the Japanese central bank decided to increase its key interest rate to 0.25%, which served to slightly tighten the interest differential between the two currency areas. The central bank also announced plans to lower the purchase volume of Japanese government bonds. Finally, it announced its intention to raise interest rates further if the economy developed as expected. This likewise helped strengthen the yen. In principle, the substantial gains by the yen impair the profitability of currency carry trades, in the course of which funds are borrowed in yen and invested abroad. If the relevant positions are closed for this reason, this causes additional upward pressure on the yen. Most recently, the euro was up against the yen again, partly in view of the statements made by the Bank of Japan that it will not raise key interest rates when financial and capital markets are unstable. As this report went to press, the euro was trading at ¥162, thus bringing it back to 7.6% below its previous peak. Since end-March 2024, the euro has depreciated against the yen by 0.8% on balance.

On a weighted average against the currencies of 18 major trading partners, the euro has gained slightly on balance since the beginning of April 2024 (+0.4%). The euro not only recorded gains against the US dollar, but also against the Canadian dollar (+2.9%), for instance. By contrast, alongside depreciating against the yen, the euro was also down markedly against the Swiss franc in particular (-2.3%). While the Swiss National Bank’s surprising 25 basis point reduction of its key interest rate in June led to the euro recording temporary gains, the latter nevertheless depreciated against the Swiss franc on balance during the reporting period. This reflected the role of the Swiss franc as a safe-haven currency in times of heightened uncertainty. 1 Overall, however, the gains mentioned previously predominated, meaning that the euro appreciated slightly on balance in effective terms.

Government bond yields in the United States declined amidst increasing expectations of interest rate cuts and the weakening economic outlook. Persistently high key interest rates dominated the US government bond markets leading into spring, as the disinflation process initially ground to a halt. Market expectations of key interest rate cuts for 2024 subsequently rose again significantly amid declining inflationary pressure and a cooling labour market. Contributory factors included the communication from the July meeting of the Federal Open Market Committee (FOMC), which emphasised the progress made in combatting inflation. The futures markets recently signalled key interest rate cuts of 95 basis points for the United States by the end of 2024. As a result, the nominal yields of ten-year US Treasuries declined by 29 basis points to 4% on balance.

In the context of the ECB Governing Council’s monetary policy communication, market participants adjusted their expectations of interest rate cuts in the euro area less significantly than was the case in the United States. At its June meeting, the Governing Council lowered its key interest rates by 25 basis points in view of the decline in the inflation rate observed since 2023. At the same time, the Governing Council referred to the persistent domestic price pressures and the data dependance of its approach going forward. Moreover, several members stressed that the June interest rate decision was not to be considered a signal of a transition to a phase of successive key interest rate cuts. According to model-based analyses, the confirmation of this communication at the Governing Council’s meeting in July and the latest unexpected upside developments in inflation data for the euro area in July contributed to the expansionary monetary policy impetus from the United States being transferred to the euro area only to a weak extent. Overall, the expected deposit facility rate derived from money market rates remained virtually unchanged at a level of 3.1% for the end of 2024; however, expectations of interest rate cuts increased up to the end of the first quarter of 2025. The GDP-weighted yield on ten-year euro area bonds remained unchanged at 2.8%, meaning the US yield advantage tightened.

Yields on ten-year Federal bonds (Bunds) declined slightly by 4 basis points to 2.3%. A decomposition of the yield curve of Federal securities shows that the contribution to yield movements made by the rise in term premia curbed that of lower interest rate expectations, as investors demanded a higher interest rate premium in return for taking on interest rate risk. Overall, the yield curve of Federal securities flattened during the reporting period as yields fell, particularly at the short end.

Yield spreads on European government bonds widened slightly as market participants’ risk appetite declined. Accordingly, the average yield spread as measured by the GDP-weighted euro area bond yield on matched-maturity Federal securities was up by 5 basis points. By contrast, ten-year French government bonds registered stronger increases of 22 basis points, reflecting the ongoing political uncertainty regarding the majority in the French parliament as well as concerns about future French fiscal policy. Following the announcement of early parliamentary elections, yield spreads had temporarily widened somewhat more strongly – investors' increased demand for Federal securities also played a role in this (safe-haven effect). Overall, however, the impact remained limited, and there were no signs of market functioning being impaired.

Government bond yields in the United Kingdom flatlined in accordance with developments in the euro area and the United States, whereas, in Japan, they rose as a result of the Bank of Japan’s continued monetary tightening process. In view of progress made in combatting inflation, at its August meeting, the Bank of England lowered key interest rates for the first time since 2020 by a total of 25 basis points. At the same time, it noted that a number of indicators continued to suggest a persistent inflation process. Accordingly, market participants revised their interest rate expectations downward only slightly. The yields of ten-year gilts were unperturbed by these developments and remained at 4%. By contrast, the Bank of Japan raised its key interest rate by 15 basis points in July, continuing its monetary policy tightening to combat inflation. In addition, the Bank of Japan decided to reduce its government bond purchases by half. As a result, yields of ten-year Japanese government bonds climbed by 12 basis points to 0.8%.

Market-based inflation indicators in the euro area declined substantially, particularly towards the end of the reporting period, indicating a speedy return to the 2% definition of price stability. Inflation compensation for the euro area, which is calculated from inflation swaps, fell significantly at the end of July and the beginning of August, dropping to 2.3% for the current year. It was recently projected at 1.9% for 2025. Accordingly, market-based inflation indicators are below the Eurosystem's projections – unlike the situation at the end of March. This was probably due to the economic outlook recently deteriorating and declining oil prices.

In the medium to long term, market participants perceive a slightly lower risk of the inflation target being overshot. This is indicated by the preference-weighted probabilities for future inflation rates derived from inflation options. Market participants recently assigned a probability of 41% to the scenario of the average inflation rate exceeding 2% over the next five years (-11 percentage points compared with end-March). Accordingly, the five-year inflation compensation based on inflation swaps fell to just under 2% (-0.2 percentage point). Longer-term market-based inflation compensation has likewise eased slightly since end-March. The five-year forward inflation rate five years ahead recently stood at 2.2%, 0.2 percentage point lower than at the end of March. Market-based longer-term inflation expectations thus approached the survey-based inflation expectations of Consensus Economics, which are close to the 2% target according to the quarterly survey from July. Consequently, the difference between market and survey-based inflation expectations (which can be interpreted as a measure of the inflation risk premium) narrowed; overall, however, it remains positive over these long horizons. Investors therefore remain willing to pay a premium to hedge against unexpectedly high inflation scenarios. As in the case of the euro area, market-based five-year forward inflation rates in five years also fell in the United States to 2.4% (-0.2 percentage point).

European corporate bond yields recorded slightly higher risk premia owing to diminishing risk appetite among market participants. Overall, yields on corporate bonds with a rating of up to BBB with residual maturities of between seven and ten years remained unchanged, whereas bonds from the high-yield segment with all maturities declined moderately. Spreads widened as yields on matched-maturity Federal securities declined somewhat more strongly. Yield spreads on corporate bonds with a rating of up to BBB increased slightly, while investors demanded a higher premium for high-yield bonds in the context of the decline in risk appetite outlined above. In the face of the higher financial market volatility triggered by the negative economic impulses in the United States, the yield spreads proved to be relatively robust. Overall, the financing costs of European enterprises, as measured by yield spreads, were recently close to or below their respective five-year averages for all rating classes.

The international equity markets registered losses in some cases given the weaker assessment of the economic situation and investors’ risk appetite declining. US equity prices continued their upward trend from the previous quarter in view of an initially robust economic outlook at the beginning of the second quarter. Amid rising earnings growth expectations, they reached a new peak in July, measured according to the S&P 500 index. A substantial contribution in this regard was made by firms in the technology sector, which account for a relatively high weighting in the S&P 500 Index. However, towards the end of the reporting period, weak US economic data along with a substantial decline in risk appetite and increased financial market volatility triggered a sharp correction, which had an effect on global equity markets. Moreover, subdued quarterly figures of some major technology firms exerted downward pressure on prices. Following a speedy recovery from this abrupt increase in volatility, the S&P 500 recorded a plus of 5.5%. In the euro area, notable equity price losses recorded by French companies weighed on the performance of the equity markets. This reflected the political uncertainly that had still not fully subsided at last report. Since the end of March, European and German equity prices, as measured by the EURO STOXX and CDAX, fell significantly by 4.8% and 4.0%, respectively. By contrast, UK equities, as measured by the FTSE 100 index, were up by 5.0%.

Japanese equities saw a particularly sharp price decline towards the end of the reporting period. While Japanese equity prices showed a marked increase until mid-July, they have since declined significantly. The expected slowdown in US economic activity, growing expectations of US interest rate cuts and the willingness signalled by the Bank of Japan to raise interest rates further are likely to have been contributory factors. The ensuing appreciation of the yen was a burden on Japanese export-oriented firms, in particular. At the beginning of August, the Nikkei index experienced the sharpest stock market slump since October 1987, with prices partially recovering in the aftermath. The Nikkei index was down by 9.0% over the entire reporting period.

European and US bank stocks performed similarly overall to equity indices for the markets as a whole. The fact that market participants continue to expect still elevated interest margins, due to the deterioration in expectations of interest rate cuts, is likely to have contributed to this. Overall, prices of US bank equities recorded a comparatively moderate increase of 2.4%. Although European bank equities fell by 2.0% on balance, the declines are smaller when compared with European equity markets as a whole.

European and US equity valuations have declined since the end of March. This is indicated by higher equity risk premia and the implied cost of equity in both currency areas. The implied cost of equity is derived from a dividend discount model that also takes into account enterprises’ medium-term earnings outlook and the path of risk-free interest rates. The medium-term earnings prospects measured on the basis of analysts' estimates and therefore only available with a time lag, rose in the reporting period, particularly for the S&P 500, but also for the EURO STOXX.

Hossfeld, O. and R. MacDonald (2015), Carry funding and safe haven currencies: A threshold regression approach, Journal of International Money and Finance, Vol. 59, pp. 185‑202.