ECB hits pause again, Fed caught between labor and money market and vigilantes coming for credit

The ECB is expected to keep policy rates unchanged for the third consecutive meeting on 30 October, with the deposit rate remaining at 2.0%. The Governing Council seems comfortable holding rates at neutral level, given inflation is still slightly above target, despite growth stagnating – a backdrop that would usually call for more stimulus. We maintain our outlook of no policy rate changes going forward, though risks remain skewed to the downside. Weak oil prices, a strong euro and imported deflation from China pose downward pressure on inflation. Geopolitical uncertainty is curbing consumer demand, reflected in rising savings rates, and Germany’s planned fiscal stimulus to boost the region’s economy in 2026 hinges on reforms. Meanwhile, bond markets remain under pressure, given rapid quantitative tightening (QT), which releases bonds equivalent to 3.5% of GDP annually into the market, compounding elevated fiscal deficits.

We expect another 25bps rate cut at next week’s meeting as persistent labor-market weakness remains the Fed’s top concern. The government shutdown entering its fourth week has already reduced Q4 annualized GDP growth by 0.45pp. In this context, policymakers are prioritizing employment risks as opposed to persistently above target inflation. However, after this cut, the Federal Funds rate will stand 50-70bps below a Taylor rule-implied level, a gap last seen in 2022 when the Fed underestimated inflation. We still expect a pause in December, followed by another 50bps of cumulative rate cuts in H1 2026, less than what markets are pricing. Chair Powell’s recent hint at an early end to QT underscores that the Fed also faces intensifying funding stress on repo markets. The SOFR–IOR spread recently peaked at 15bps, reflecting tighter liquidity conditions after the USD2trn buffer in the ON RRP facility was depleted. Meanwhile, the Treasury General Account has been refilled from USD260bn to USD800bn (mainly by T-Bills issuance), draining reserves from the banking system. We view the recent repo rate spikes as signs of late-cycle tightening rather than a crisis but expect QT to stop by the end of the year, with limited effects on the US yield curve.