Opinions

On 4th March, the recent German election winner parties CDU/CSU and SPD agreed on a massive fiscal expansion, breaking the brakes of the constitutional debt brake. In our view, the proposed fiscal package amounts to the most significant fiscal regime shift since German reunification.Germany's own proposed measures are EUR 500bn special purpose vehicle for public infrastructure investment & reform of the debt brake rule to exempt any defence spending over and above 1% of GDP, effectively permitting open-ended borrowing for defence. EU too has responded by proposing €150 billion in loans to boost defense spending as well as allowing countries to use their national budgets to spend an additional €650 billion on defense over four years without triggering budgetary penalties. Assuming the EU & German plans are spread over a four-year horizon that implies a total of up to €250bn per year of new fiscal support across the EU for a combination of infrastructure (Germany) and defence (pan-EU and Germany) – i.e., almost 1.5% of EU GDP per year. We now expect 1.4% growth in EU in 2026 vs our previous forecast of 1% y-o-y. For Germany, we now expect 1% growth in 2026, double our previous forecast of 0.5% y-o-y. The new plans imply higher fiscal spending leading to 2026 HICP inflation and core HICP inflation being on an average 20bp higher than previously; we now forecast both to average 2%. To us, it seems like Trump has decided that one way to reduce US fiscal spending is to push it’s allies to take responsibility of their security needs. This bodes well for the UST yields but not so much for USD. As US gives up it’s security umbrella, other nation’s spending will push their growth higher and their FX too against USD. But this is what Trump wanted in the 1st place. Lower rates & weaker USD. Hence, he has killed two birds with one stone. Above assumptions imply a less dovish ECB with our terminal rate expectation to be now at 2-2.25% (current policy rate at 2.5%) than the previous 1.5-1.75%. Hence, we expect only 1-2 more 25 bps cut in REMCY25. We see 10year German Bunds at 3.25% (CMP at 2.83%) by end CY25 and EURO at 1.15 (CMP 1.0830) by end CY25

At the National People’s Congress (NPC) starting on March 5, Chinese policymakers will likely keep the growth target unchanged at “around 5%”. But we believe a realistic no is around 4.5% which is more an outcome of export reduction due to tariffs than any adverse impact from domestic demand. They might raise the budget deficit from 3% of GDP last year to 4%. But we believe that the increase in fiscal deficit might be driven more by reduction in revenues than the increase in spending. Also as President Xi heads into this meeting, he will be emboldened by the recent Deep Seek success as well as the blistering equity rally, he will also be concerned by the recent tariff measures by US new administration as well as proposed new tariffs from Mexico & Canada. The key focus area of NPC announcements might be funding for a trade in program for equipment renewal and consumer goods as well as spending on the property sector via the buying back of land or helping developers finish pre-sold homes. A moderately loose monetary policy stance is also likely to be reaffirmed at the NPC, though we expect limited policy rate cuts this year, given policy-makers’ recent focus on currency stability. We believe that the NPC most critical outcome will be focusing on stimulating domestic demand because unlike last year, there’s little chance Beijing can bank on a boom in exports. We expect exports to remain flat in CY25 against 6% growth in CY24. Hence clocking the same growth rate this year while grappling with tariff challenges will require greater fiscal expenditure, given US tariffs could stall China’s export engine.

The exceptional mix of factors that led to US exceptionalism for last 15 years are slowly disappearing. No further welfare checks, high real rates, expensive US equities compared to cheap European & Japanese equities, the onset of DeepSeek questioning large capex in US IT were all present before. But what has accelerated the beginning of the end of US exceptionalism is the new Trump administration. The threats of tariff has caused major uncertainty in business and consumer sentiment.Results can be seen in latest core control retail sales, nominal consumer spending, Atlanta Fed's Q1 GDP projection of -2.8%, out performance of European equities vs US equities & a 60 bps fall in 10yr USTs. Trump administration's stated objective of regaining the manufacturing theme to US goes through lower dollar & higher tariffs/tariff threats. We see two distinct possibilities of the US administration response to achieve above objectives: 1) the new US treasury revaluing Gold to current market prices to make a treasury gain of 800 BN USD which helps in reducing US fiscal deficit 2) US treasury issuing long term bonds (100years maturity) to be subscribed by sovereigns as a concession against tariff threats or as a payment for providing security umbrella. While we agree with the new administration goal of returning manufacturing back to US, there will be a cost attached to this theme. The cost will be born by US equity investors and US service exports. We believe we are starting a multi year DXY down trend going to sub 98 levels. The new US administration's transactional nature has induced a high level of uncertainty in the investor class & we don't see this confidence returning any time soon. We like European equities and Japanese equities over US equities due to both earning's growth and valuation basis.

Today we have the crucial German elections. Current polls point to a two-way coalition led by the Conservatives. A CDU/CSU-SPD "grand coalition" would be a well-known option (3 grand coalitions in past 20 years), while a CDU/CSUGreen coalition would be a novelty at the federal level. We expect the new government to quickly embark on finding a cross-party consensus on topping up the EUR 100 bn off budget defence fund or introducing a golden rule for defence. US pressure to increase defence spending/securing the Ukraine peace deal to act as an additional catalyst. We believe it is plausible to assume a net fiscal easing of around 0.5% of GDP by 2026. Much of this is likely to come from greater defence spending, where the short-term growth impact may be limited. Beyond defence, we see an easing of the debt brake at the state level as likely and potentially meaningful, as it could unlock substantial public investment and consumption with high multipliers. With chances of a large defence spending increasing along with fiscal purse loosening in German economy, DAX (German stock index) has outperformed S&P500 recently. Even the 10yr German bond yield spread with 10yr UST has narrowed recently. A large defence spending along with higher German govt spending on federal level does not augur well for future inflation. Hence while growth might pick up, inflation too might start consolidating at higher levels. This implies lower probability for ECB to cut rates to below neutral level by end CY25. We expect neutral at 1.75-2% for ECB. Current deposit rate is 2.75. So, we reduce the number of cuts to maximum 3 in REMCY25 for ECB and hence now reverse our call on EUR. EUR now becomes a buy on dips and the parity view is not feasible any more considering the new political discourse in Eurozone with US asking EU to spend more on defence. We now see EUR at 1.08 by end CY25.

The minutes to the January FOMC meeting included a surprising discussion on an early end to balance-sheet rundown (QT). A shift to a proactive risk-management approach raises the risk that the FOMC could pause or end QT at the 19th March meeting. The FOMC tends to move relatively quickly on balance sheet policy once a potential change has been socialized through the minutes. Last year, slowing the pace of QT was discussed in the January meeting minutes, followed by an announcement making this adjustment on 1 May. Given our debt limit baseline (end July or early Aug), we project QT technically can resume in October. But if there are weakening economic indicators along with US equities severely falling by that time, QT might never resume again for the sake of macro -economic stability. We also believe that the level of “ample reserves” has risen significantly in the last 6 years since the Sep’2019 episode of repo pressure. The economy and financial system have grown over the past five years and reserve demand likely increased following the bank stress in March 2023. The Fed also conceives of ample more conservatively than it did during the 2017-2019 QT episode in the sense that it is now not inclined to plumb the very minimum levels of reserves consistent with operating its floor system. The whole point of acting soon is to avoid the roughly $250bn in balance sheet reduction that would occur over the following six months under current QT caps. Once overall QT ends, we expect MBS prepayments to be invested into USTs to facilitate further reduction in the share of MBS in the SOMA portfolio. Along with the likely possibility of SLR relief for UST holdings for G-SIBs, the pause of 6 months in QT implies lower term premium for long end USTs. We maintain that 4.65 is the short-term resistance for 10yr USTs and medium-term range is 4.35-4.65 till economic data or Trump’s tariff events swing it out of the above range. We also believe that QT might not resume in Sep after the pause because by that time, macro-economic stability won’t allow QT to start.

Steve Bannon (Trump’s former guru) said in 2019 a famous line “All we have to do is flood the zone”. Trump on a daily basis throws so many stones up in the air that media, democrats, judiciary, sovereigns cant keep up with him. But there is a method behind his chaos. He does not intend to achieve all what he says, rather most of it is to deflect attention so that his core principles of returning manfacturing to US, equal tariff structures, low energy prices, tax cuts, lower long end yields are always in play. On domestic front he has almost achieved what he promised in elections whether be it immigration control, DEI initiatives. On global front, we believe the Russia Ukraine ceasefire is very near brokered by US & Saudi Prince MBS. We also believe tariffs use will be kept as last resort even for China. Asset monetisation is going to happen mostly via the revaluation of gold reserves. Details are shared in the report. With US CPI running hot in Jan’25 at 0.5% MoM, Trump knows fully well tariffs can only add fuel to fire. He wants lower rates and weaker dollar so as to bring manufacturing back to US. He wants lower oil prices to help him reduce inflation so Russia Ukraine ceasefire is a given with OPEC too returning with output increase in Q2CY25. In return Trump might ensure that US SPR starts getting refilled so as to stabilise oil prices near 65-70 odd levels. Details of how this plays out are there in the report. Europe is likely to spend far more on defense than present implying Eurozone long end bond yields to move significantly higher from here in medium term as EU borrowings increase. We also expect DXY to have peaked out. Not only from rate differentials perspective but also from tariff noise rationalise, DXY fair value is around 105-108 for us in medium term. On the rates front, we believe that asset monetisation plan of Scott Bessent, Trump’s statements on defence spending as well as Musk’s DOGE activities might cap any medium term uptick in US long end bond yields. For us, we see a range of 4.35-4.65 for next 1 month on 10year UST yields. Our recent receive call (25th Jan) on 5yr US SOFR has played out well and we are almost near the profit target. Our 17th Nov’24 trade recommendation of Long 10yr UST and Paid 10yr US SOFR has also reached it’s profit target this week.