European Rates Mid-Year Outlook: Forwards Well Above Neutral Warrant Longs

Research evidence excerpt

European Rates Mid-Year Outlook: Forwards Well Above Neutral Warrant Longs

Europe InsightMExhibit 2: US economic developments and Middle East conflict, more than domestic

developments, drive forecasts variability

End 2026 End 2027 End 2026 10y End 2026 10y Italy-

Scenario Macro

ECB ECB Bund Germany

Further pressure on energy prices in the near

Economists' baseline term, before reduction; modest impact on 2.50% 2.00% 2.90% 80bp

growth

US capex and consumer spending prove

Alternative scenario 1: US stronger than expected, and faster growth, lower

2.50% 2.50% 3.15% 75bp

demand unemployment, and rising inflation push the Fed

to raise interest rates

AI disrupts the labor market, causing a wave of

layoffs, though growth holds up. With falling

Alternative scenario 2: AI

inflation and rising unemployment, the Fed cuts 2.50% 2.00% 2.90% 75bp

boost

rates aggressively to stimulate the economy to

take up the newly developed slack.

Oil and gas prices move into "demand

Alternative scenario 3: Global

destruction territory", hit to growth (and 2.00% 1.50% 2.35% 120bp

oil-led recession

significant market dislocations)

Alternative scenario 4: De- Drop in energy prices, core inflation below 2%

2.00% 1.50% 2.45% 75bp

escalation already in July 2027

Probability-weighted 2.70% 85bp

Source: Morgan Stanley Research

In addition last year, domestic and international technical factors such as the anticipation

of the Dutch pension fund reform had a strong impact on the long end of the curve. Going

forward, we assume that those factors will be less of a driver in the coming quarters, with

macro/geopolitical developments taking center stage and only modest increase in term

premia.

Looking at German yields, under our European economists' baseline scenario we envisage