Mr. Balls, there has been a sell-off in bonds recently, and yields have risen significantly since the beginning of October. How do you explain this?

Next week’s US elections could have an impact on the monetary policy of central banks, including those outside the US. Especially if Donald Trump wins and continues his well-known trade policy as president. However, more importantly, market participants have revised their expectations for interest rate cuts in the US. They now expect 3.5% by the end of 2025, whereas they were anticipating 3% at the beginning of October. This aligns with the outlook that the US economy will have a soft landing, thus avoiding a recession.

So the main reason for the rising interest rates is the positive US data?

Yes, the yield curve is moving up fairly parallel across all maturities and is not really dominated by the long end. Some pressure is coming from US fiscal policy, as the annual budget deficits of the US government are very high. However, the uniform shift in yields can best be explained by the better US data. Just in August, there were strong fluctuations in the markets as concerns about the labor market increased significantly. Since then, however, the data has improved again.

How would Trump’s trade policy affect inflation and growth?

The stock markets are likely to react positively at first to the expected deregulation. However, high tariffs on imports from China, and generally from all other countries, will have significant effects on the US economy. This could slow growth by one percentage point and drive inflation up by one percentage point. This is a very serious risk.

After a data revision, the investment cycle in the US looks much better than previously assumed. Could this explain why the recession signal from the inverted yield curve in recent years was wrong: when the ten-year rates were below the two-year rates?

With the normalization of the yield curve, the gap between long-term and short-term interest rates is likely to widen further, making the yield curve steeper. The fact that the recession signals from the inverted curve did not materialize is partly due to the fiscal policy of the US government. Additionally, the US economy has, overall, coped well with the rise in benchmark interest rates, aside from the regional banking crisis last year. The US is also less dependent on Chinese demand than Europe, and productivity has improved. Investments in artificial intelligence, which play a larger role in the US, have clearly provided a boost.

Does US fiscal policy also have negative downsides?

One negative aspect is the US government’s budget deficit, which is at 6 to 7% this year. It will remain at this level, regardless of who wins the election. However, it will have less of an impact on growth, because a constant deficit does not have the same effect. The positive aspect is that the transition from Biden to Harris has reduced the likelihood of a one-party rule in the White House and in both houses of Congress. Therefore, an expansion of fiscal policy, as seen in the first terms of Trump and Biden, is less likely. However, since no improvement is expected, it seems plausible that the market will demand more risk premia from the US government over time, just to maintain the current deficit.

What risks does China pose?

The economic measures that have now been announced could halt the deterioration of the situation. However, it is unclear whether this will significantly improve the situation, which is a source of uncertainty.

The inflation premiums that investors are demanding in the Eurozone and the US are currently diverging. Are the downside risks for inflation and growth greater than the European Central Bank (ECB) currently recognizes?

What is important for the markets is what interest rate the ECB ultimately aims for. Currently, they expect 2% for the next year, which seems quite reasonable. But the ECB has only one mandate, and that is price stability. Therefore, it must also consider the inflation outlook. The growth outlook in Germany is a cause for concern. This was a key reason for the interest rate cut in October, which no one had anticipated just a few weeks ago.

How can Germany emerge from its three-year stagnation?

The debt rules in Germany make active fiscal policy difficult. The German economy is still suffering from the Russian war of aggression against Ukraine and the energy crisis, and weak demand from China is also slowing growth. The ECB’s declining key interest rates will positively impact the German economy due to the importance of the manufacturing sector. Nevertheless, it is difficult to provide an optimistic outlook.

Is there no glimmer of hope?

A better external economic environment would be important, as the German growth model is still heavily dependent on foreign demand. Over time, the economy could rebalance, but this is difficult and requires a long period for reforms. So far, there are no signs that politics will contribute to a significant improvement.

Another weak point in the Eurozone is France, where the government wants to appease investors in the bond markets with a savings program. How great is the danger of a new Euro crisis?

The yield level for ten-year bonds in France is currently slightly higher than in Spain. This makes sense, as it will take a very long time to reduce the budget deficit over time. But there are also positive aspects: compared to the sovereign debt crisis ten years ago, the Eurozone has now passed a series of extreme stress tests and remained stable: recession, pandemic, and war at the EU’s border. Since then, uncertainty about the role of the ECB has also disappeared. The collective issuance of debt securities since the Covid shock has been positive.

So the Eurozone has become much more stable?

In peripheral countries that had such a hard time ten years ago, the economy is now growing stronger. There will always be some residual risk in the currency union. But overall, there is potential for lasting stability in Europe. Because every time it overcomes one of these stress tests, stability also increases.

How convincing are the new EU debt rules for you as an investor?

Compared to ten years ago, there are not the same weaknesses and imbalances today that led to the extreme outcomes back then. Today, there is weaker growth and higher debt, but at the same time, there is greater stability. The fiscal rules themselves will not lead to much better outcomes.

What still makes you optimistic?

In the case of France, market discipline is clearly present. The government has clearly committed to improving the budget situation. Even though there are political risks, I am therefore confident that this will succeed. This also applies to Italy. Compared to the last ten years, populist politicians in Europe seem to be shying away from the discussion about leaving the Euro. This has led to instability in the past.

Does the EU need a fiscal capacity, as former ECB President Mario Draghi proposed for infrastructure investments, so that Euro countries can continue to borrow together?

For me as a bond investor, a joint issuance of European debt securities would contribute to greater stability. After managing the Covid crisis, the energy transition is another example where a joint bond issuance would make a lot of sense. Since there is still no fiscal union, it is very helpful for us investors to know that there is a precedent for a joint issuance.

Some observers are already talking about the risk that the Swiss National Bank (SNB) will return to negative interest rates in 2025. How do you assess this?

Our forecast is that the SNB will likely lower its key interest rate to 0.5%. The probability of interest rates becoming negative again is not very high. In our assessment, this will not be necessary. Moreover, it is more likely that the SNB will intervene in the foreign exchange market in the event of too low inflation rather than pushing the key interest rate into negative territory.

What do you recommend to bond investors?

Compared to the past ten or twenty years, yields on high-quality government bonds look attractive today. In dollar terms, we are talking about 5, 6, or 7%. This also applies to US agency mortgage bonds and structured securities tied to the residential real estate market. Additionally, investment grade corporate bonds are interesting, especially financials. We are more cautious about lower-quality corporate paper, such as high-yield bonds. It makes sense to minimize exposure in the most economically vulnerable parts of the market.

Aside from the US, which other regions do you prefer?

We like the United Kingdom and Australia. The trend towards a steeper curve will also be observed in Europe. The environment is likely to be good for emerging markets as well, especially for dollar-denominated securities. We also view countries like South Africa and Peru positively, as they raised interest rates earlier than the central banks of the major industrialized countries.