Financial markets were shaped by considerably higher long-term interest rates, a progressing disinflation process in the euro area and dwindling expectations of policy rate cuts, especially in the United States. Market participants revised their expectations regarding policy rates in the euro area for 2025 slightly upwards. However, they continue to expect money market rates to fall noticeably and the degree of monetary policy restriction to ease as the year goes on. Surveys as well as market data point to the inflation target being reached in the medium term. Expectations of interest rate cuts in connection with US monetary policy fell much more sharply. The disinflation process has proven to be comparatively slow, especially in the United States. More recently, market participants expected for 2025 that the Fed would make only one further interest rate cut. 

Yields on ten-year US Treasuries rose sharply on balance – as did yields worldwide. Factors contributing to this included growing expectations of inflation in the United States, unexpectedly robust growth signals from the US economy, and expected fiscal pressures. Concerns as to whether tariffs or the more restrictive immigration policy could hamper US growth have thus far receded. Investors also expect, at least in the short term, growth stimuli from US fiscal policy, which is likely to result in a sharp increase in its debt levels in relation to GDP. The rise was ultimately caused by an unusually high increase in term premia. This not only reflected greater optimism regarding the US economy, but also renewed uncertainty surrounding inflation developments in the United States and the future path of key interest rates. The rise in term premia also spread to the yields of ten-year federal bonds (Bunds) and European government bonds overall. However, given that expectations regarding monetary policy interest rates were revised upwards more significantly for the United States than for the euro area, the interest rate differential between the euro area and the United States widened noticeably. This was the decisive factor in the euro depreciating significantly against the US dollar. Overall, the euro was also effectively down on the currencies of 18 trading partners in the reporting period; this is likely to be more a reflection of a subdued economic picture in Germany. 

With increased investors’ risk appetite and the US economy posting unexpectedly positive figures, prices in the international equity markets rose noticeably. On balance, this helped drive up valuations, in particular for US equities. Particularly in anticipation of the new US administration’s relaxation of regulations for the financial industry, investors expected banks’ high interest margins to persist for some time. The value of bank equities rose significantly as a result.

The euro depreciated significantly against the US dollar from the end of the third quarter of 2024. For a time it fell to its lowest level since November 2022, trading at US$1.02. A variety of factors contributed to the depreciation of the euro: first, the economic policy plans of the newly elected US President Trump boosted the US dollar. Mr Trump pledged to pursue a more expansionary fiscal policy and a more restrictive immigration policy. Furthermore, alongside the additional tariffs on the EU, which were announced for aluminium and steel at the start of February, he also threatened imposing broad-based tariff increases. All of these measures have the tendency to drive up inflation in the United States. Accordingly, market-based inflation expectations, and thus also interest rate expectations, rose after the election result became public. The resulting widening of the interest rate differential with the euro area caused the euro to depreciate. A second key reason for the weakness of the euro against the US dollar was the continuing surprisingly robust economic developments in the United States. For example, an unexpected increase in demand for labour was reported at the start of December. The Federal Reserve responded to these events by cutting interest rates by 25 basis points at its December meeting, while also signalling a slower pace of monetary policy easing for the course of 2025. This exerted additional appreciation pressure on the US dollar. A third factor that intensified this appreciation pressure relative to the euro came in the form of expected signs of an upturn in the euro area which failed to materialise. This fuelled the view among market participants that the Eurosystem’s monetary policy could prove to be more expansionary than previously thought, thus putting pressure on the euro. As this report went to press, the euro was trading at US$1.04, down 6.7 % on its level at the end of the third quarter of 2024.

The euro depreciated against the pound sterling from the end of the third quarter of 2024. In October, the euro temporarily gained ground against the pound sterling after the UK government announced higher levels of new borrowing for 2025. The euro appreciated more significantly at the start of the new year, but this also proved to be just a temporary development after it was reported that international investors were selling UK government bonds on a net basis amid renewed concerns about the UK’s fiscal situation and growth prospects. More recently, both the UK and the euro area have seen interest rates decline across all maturities. As the fall in interest rates was somewhat more pronounced in the euro area, the interest rate differential widened at the euro area’s expense. This caused the euro to depreciate, leading it stand at £0.83 most recently, which was 0.9 % lower than at the end of September 2024.

On balance, the euro lost value against the yen due to the narrowing interest rate differential between the two currency areas. The euro was buoyed against the yen by concerns regarding Japan’s economic outlook. This was fuelled by political uncertainty in Japan in the wake of the country’s parliamentary elections, and by international uncertainties stemming, for example, from the new administration in the United States. In light of this, the Bank of Japan did not raise key interest rates in December. Market participants interpreted this decision as a sign that the Bank of Japan might not further scale back its exceptionally expansionary monetary policy any time soon. This briefly put pressure on the yen. However, the publication of unexpectedly high inflation figures brought this trend to an end. The yen has once again been experiencing a period of appreciation since the Bank of Japan raised key interest rates further at the end of January in response to higher wage agreements. With the ECB Governing Council lowering key interest rates in the euro area over the same period, the interest rate differential on one-year monetary policy-driven interest rates between the euro area and Japan narrowed by around 15 basis points. This put pressure on the euro. On balance, it depreciated by 2.0 % against the yen and recently stood at 157¥.

The effective depreciation of the euro against 18 currencies has boosted Germany’s price competitiveness. In a weighted average against 18 trading partners, the euro’s effective exchange rate declined by 2.7 % compared with the end of the third quarter of 2024. This was largely due to the marked depreciation against the US dollar mentioned above. A further major factor in the effective weakness of the euro was its noticeable depreciation vis-à-vis the renminbi (-3.4 %). Therefore, the price competitiveness of Germany and the euro area has improved since the end of September 2024. At present, the euro area’s relative price level is significantly below the level that would be expected based on its relative productivity level. Thus, based on the productivity approach and compared to a broad group of countries, the price competitiveness of the euro area is deemed favourable. This tends to apply to Germany again now, too. Compared with much of 2024, when Germany’s price competitiveness as measured using this approach fell to a neutral level at times, this constitutes a recovery. By contrast, a longer-term comparison with the period from 2015 to 2022 indicates a moderate deterioration in Germany's price competitiveness. The supplementary information below demonstrates that the development of non-price factors relating to Germany’s competitiveness is much more serious, however.

US government bond yields rose sharply on the back of a surprisingly positive economic outlook and dwindling expectations of policy rate cuts. Since the end of September 2024, a number of indicators have been published that paint a surprisingly positive picture of the US economy. Market participants also assessed the new US administration’s economic agenda as being generally conducive to US growth (see also the "Financial market environment" and "Exchange rates" sections above). Taken together, these assessments resulted in higher real interest rates. Concerns were also observed among market participants that the disinflation process could slow down significantly. This was reflected in the sharp increase in ten-year market-based inflation expectations for the United States. Against this backdrop, market participants also revised their expectations for the future interest rate path of the Fed upwards. This was also largely driven by the Fed’s decisions. The Federal Reserve lowered its policy rates again in December 2024, while simultaneously making it clear that it would be slowing down the monetary policy normalisation process, and left policy rates unchanged in January. Most recently, the yield on ten-year US Treasuries stood 74 basis points higher than the level recorded at the beginning of the fourth quarter. 

The increase in US yields was largely due to a higher term premium, but also to diminishing expectations of interest rate cuts. Term premia constitute the premium that investors receive when they hold longer-dated bonds instead of short-dated money market paper, which they invest in on a revolving basis. These premia reflect the uncertainty and risk inherent in future interest rates and future economic conditions that are unknown at present. Depending on the economic situation, term premia may be positive or negative. 1 The sharp rise in the premium to its current level was due primarily to two factors. First, market participants saw a renewed risk of increased inflation in the United States. Higher-than-expected inflation erodes the purchasing power – i.e. the real value – of a ten-year bond at maturity. Investors demand compensation for taking on this inflation risk. The inflation risk premium and uncertainty surrounding the future development of key interest rates increased. Second, market participants are taking a more optimistic view of real US economic growth. Lower downside risks imply that short-term real interest rates are more likely to move upwards. This decreases the real insurance value of long-dated bonds against real income losses. It is more favourable for investors to increase their real consumption over the term of the bond. This declining real insurance value of ten-year bonds in itself also results in rising interest rates. It is this real component of the term premium, in particular, that has been rising in recent months. Revised expectations with regard to key interest rates also played a part in the rise in ten-year yields. At the end of the reporting period, the majority of market participants were only expecting one interest rate cut for the current year, thus 100 basis points lower than at the end of the third quarter of 2024. 

Rising term premia in the United States had a significant impact on yields in the euro area in the reporting period. International capital markets are linked via a more or less close interest rate relationship. A real increase in the burden on the capital markets by the world’s largest economy will inevitably have a real impact on the rest of the world. This relationship can be understood by observing the current situation with the term premium. The term premium on ten-year Bunds also rose significantly by 24 basis points, albeit not as sharply as the term premium for matched-maturity US Treasuries. Since the ten-year Bund is the benchmark bond for the euro area, and thus a key reference for the prices of other euro area government bonds, yields on these bonds also rose above the term premium. 

The expected development of policy rates in the euro area decoupled from that in the United States. At its meetings in October, December and January, the ECB Governing Council cut its policy rates by 25 basis points on each occasion, thus reducing the degree of its monetary policy tightening further and more sharply than the Fed. By contrast, the future path of key interest rates for the euro area expected by the market shifted upwards only slightly. Market participants continue to anticipate a marked decline in money market rates over the course of 2025. For example, calculated on the basis of money market rates (€STR), the expected deposit facility rate for mid-2025 most recently stood at approximately 2.2 %, which is around 55 basis points lower than its current level. This reflects the view of market participants that the disinflation process in the euro area is progressing. Concurrently, this also reflected the fact that the expected signs of an upturn in the euro area failed to materialise and the indicators as a whole pointed to surprisingly weak economic growth in the euro area. 

Against this backdrop, yields on ten-year Bunds did not rise as sharply as those in the United States. However, due to the comparatively strong contraction in scarcity premia, they increased more than yields in other euro area countries. The spread of the GDP-weighted average of ten-year government bond yields of other euro area countries narrowed by 13 basis points against Bunds with the same maturities. The marked increase in Bund yields of 41 basis points on balance compared with the rest of the euro area also reflected the discontinuation of the monetary policy asset purchase programmes. The Eurosystem no longer reinvests the principal payments from maturing Bunds. This is gradually changing the investor structure: the volume of federal securities in free float is growing, thus reducing the scarcity of these securities. These structural shifts are reflected in diminishing scarcity premia, particularly those paid on safe Bunds. This effect is amplified by the fact that investors' risk appetite has grown, which has curbed demand for default-free federal securities. On balance, the rise in yields on ten-year Bunds was influenced above all by the developments in the United States described above. However, the latest rise in yields following the Munich Security Conference is also likely to be linked to the expectation of higher levels of defence spending in the EU, which, from the market’s perspective, will increase the fiscal burden.

Ten-year UK and Japanese government bonds mirrored movements in US Treasuries during the period under review. On balance, yields on UK gilts were up 62 basis points on their level from the start of October, while yields on Japanese government bonds were 59 basis points higher. After the first interest rate cut in August, the Bank of England lowered its key interest rate by a further 25 basis points in November and in February, respectively. By contrast, the Bank of Japan raised its key interest rate again by 25 basis points in January after having tightened its monetary policy in July (see the “Exchange rates” section). This was in response to the continued rise in domestic inflationary pressure. Thus, key interest rates in Japan are now the highest they have been in the past 17 years. 

Market-based inflation indicators continued to move towards the Eurosystem’s projection for 2025, while virtually showing no change for 2026 and 2027. Market-based inflation expectations calculated on the basis of euro area inflation swaps rose steeply by 56 basis points for 2025. The main reason for this was the publication of higher-than-expected inflation data at the end of October. In addition, higher oil and gas prices around the turn of the year fuelled rising inflation expectations for the year ahead. Market-based inflation expectations for 2026 fell slightly by 7 basis points, while they rose by 3 basis points for 2027. From the market perspective, downside inflation risks were increasingly dominant factors for the years 2026 and 2027. By contrast, the experts participating in the Survey of Professional Forecasters conducted by the ECB expect inflation risks to be tilted slightly to the upside due to mounting geopolitical tensions. 2 These differences in the risk assessments of the impact of a more restrictive US trade policy on inflation reflect the high level of uncertainty that market participants are faced with. The impact of a potential hike in import prices due to the expected tariff increases combined with a weak euro exchange rate needs to be weighed against a deteriorating growth outlook. Overall, however, both market participants and survey respondents expect euro area inflation to return close to the Eurosystem’s inflation target. 

Market-based inflation expectations and surveys point to firmly anchored expectations at the level of the stability objective. The five-year forward inflation rate five years ahead remained almost unchanged from the end of the third quarter, and was thus aligned with the target at around 2.1 %. Similarly, the longer-term survey-based inflation expectations for the euro area from Consensus Economics, collected on a quarterly basis, remained at the 2 % inflation target in January.

Yields on European corporate bonds in the non-speculative segment remained nearly unchanged in the context of increased risk appetite among market participants, while yields on high-yield bonds fell significantly. Yields on BBB-rated corporate bonds with residual maturities of between seven and ten years fell slightly for financial corporations, while they rose marginally for non-financial corporations. Since the yields of German federal securities with the same maturities rose sharply, the yield spreads narrowed considerably. Yields on high-yield bonds declined noticeably by 27 basis points in the period under review due to increased risk appetite, a development which also manifested in lower credit default premia for all relevant bond classes. Overall, the financing costs of European firms, as measured by yield spreads, were recently below their corresponding five-year averages irrespective of their credit quality ratings.

International equity indices recorded noticeable price gains in the period under review. The S&P 500 index rose by 6.2 % from the end of September, temporarily reaching a new peak. While the EURO STOXX had lost some ground up until the end of the year, it too rallied strongly, closing the year with total gains of 7.8 %. In the United States, the economic revival that many investors had been anticipating was the main factor fuelling the rise in prices. This was reflected not only in unexpectedly robust US economic data, but also in a positive start to the reporting season for US corporations and growing risk appetite. Prompted by favourable economic signals from the United States, interest rates rose sharply around the world, especially in the United States (see the “Bond market” section above). Taken in isolation, an increase in interest rates weighs on equities because it reduces the present value of future profits. Ultimately, the increase in interest rates had only a temporary effect on the upward trend of the S&P 500. However, some US technology stocks fell significantly for a time during the period under review when a Chinese company unveiled a surprisingly efficient AI-based language model. As a result, US technology sector stocks posted relatively small gains, thereby curbing the market’s overall performance. In the euro area, weak economic activity and uncertainty about future trade barriers initially weighed on equity prices, which was reflected in lower profit expectations. These developments had a particularly strong adverse effect on the chemicals and automotive sectors. At the turn of the year, prices picked up across virtually all sectors as risk appetite improved. One reason for this may be that, for a time, market participants began to hope that tariffs imposed by the United States would be lower than expected overall, and that the previously announced special tariffs on aluminium and steel would not escalate into a full-scale trade conflict. In addition, European and German indices also comprise equities of technology companies which, in contrast to the United States, recorded disproportionately large gains. European technology firms are likely to have benefited particularly strongly from interest rates rising less sharply in the euro area. Against this backdrop, German equity prices (CDAX) saw a strong increase (13.3 %), with prices temporarily reaching new record levels. Equity prices in the UK, as measured by the FTSE 100 index, gained 5.2 % in value. Japanese equities (Nikkei index) recorded a slight increase in prices of 2 % during the period under review. 

Stocks of banks and other financial services providers in Europe and the United States recorded larger price increases than their respective overall markets. Equity prices of US banks posted particularly strong gains following the US presidential election. This was helped, in part, by the new administration's pledge to roll back some of the regulations governing the financial industry and to cut corporate taxes. In mid-December, bank shares on both sides of the Atlantic were given an additional boost when the Federal Reserve tamped down investors’ expectations of further interest rate cuts. This nurtured the prospect of high interest margins persisting and was reflected in higher earnings expectations. In addition, positive quarterly results for a number of US banks buoyed investor optimism. In the euro area, bank equity prices also benefitted from expectations of high dividend pay-outs and share buy-backs, as well as signs that the mergers and acquisitions business could be recovering. European and US bank equity prices rose by 20.9 % and 21.6 %, respectively.

European and US equity valuations have continued to rise since the end of September. This is indicated by the decline in earnings yields over the next 12 months in both currency areas, as well as by the narrowing of the respective equity risk premia, which can be calculated using a dividend discount model and also take into account the medium-term earnings outlook. The lower equity risk premia offset the rise in risk-free interest rates, meaning that the implied cost of equity remained unchanged on balance. This suggests that valuations for European and US equities have increased and are also above their long-term averages and remain high, particularly in the United States.

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