At a time when the market generally predicts that the European Central Bank will cut interest rates three more times this year, the giant with trillion-dollar Assets has made a stunning contrary prediction...
According to Franklin Templeton, the European Central Bank is expected to consider raising interest rates by the end of this year due to potential economic boosts from defense spending in the region.
David Zahn, head of European fixed income at the asset management company managing $1.5 trillion in Assets, stated in an interview: "If you look ahead to 2026, it will be very clear that Europe performs well. Inflation will be low, and growth will be very good. If you are a central bank, why not consider how to start raising interest rates?"
This is a contrarian view that goes against market pricing. Traders currently tend to believe that the European Central Bank will cut rates three more times this year, each by 25 basis points, before maintaining the deposit rate at 1.5% until the middle of next year.
The head of the Dutch Central Bank, Knot, in a speech, believed that the neutral interest rate "is roughly still at the current level." Despite inflation possibly slowing down more quickly than previously expected, he believes that the long-term impact of trade disruptions and increased spending on defense and infrastructure in Europe is "far from clear."
His comments suggest that the European Central Bank will be forced to revise down the forecast for consumer price growth next year at the meeting on June 5—his last meeting before the end of his term—previously predicted at 1.9% in March. However, assessing whether future prices are stable will depend on data from 2027.
Knot stated: "I believe the European Central Bank's meeting in June will be very complicated."
Zahn believes that the European Central Bank's deposit rate will bottom out between 1.75% and 1.5% by September, and expects investors to subsequently become more optimistic about the economic outlook. He is keeping a short duration in the bond market, anticipating that the yield curve will steepen as bonds are issued to fund spending.
He believes that although the tariffs imposed by USA President Trump may have slightly deflationary effects, the market's focus will soon return to the boost brought by Europe's defense plans. Germany has begun initiating hundreds of billions of euros in debt financing for defense and infrastructure spending.
This outlook has dominated Zahn's Asset Management decision-making. Given that Spain is one of the countries with the least defense spending, he decreased his significant overweight on Spain. He continues to underweight France and Italy, predicting that the 10-year Government bond yield spreads of these two countries may widen to 100 and 150 basis points compared to Germany.
He said, "We tend to favor core markets because they are the most defensive. So we are investing in countries like Spain, Germany, the Netherlands, and Belgium."
Franklin Templeton’s Europe total return Fund has had an ROI of about 3.6% over the past year, while the benchmark's ROI has been 6.5%.
Zahn is not bullish on the United Kingdom; he sold all his positions in United Kingdom Government Bonds in March this year, considering its grim fiscal situation, stating that this market is most vulnerable to any increase in spending. This outlook has pushed the country’s long-term borrowing costs to their highest level in more than two decades earlier this month, with the 30-year Government bond yield currently around 5.24%.
He added, "The United Kingdom needs to invest more in defense, but it has no money, and I think the 30-year UK bond yield could absolutely rise to close to 6%."
