Investors bet on sharpest US-Europe inflation divergence since 2022
Published: 03:02 PM,Feb 27,2025 | EDITED : 07:02 PM,Feb 27,2025
LONDON:Traders betting on future inflation trends foresee the sharpest divergence in three years between the US and the eurozone, driven by different growth paths, tariff threats, and cheaper European energy following a potential Ukraine peace deal.
That gap is not fully reflected in US and eurozone bond yields, as investors are also considering recent weak US economic data and the possibility of increased European defense spending.
Inflation swap markets late last week pointed to US consumer price index (CPI) inflation running at about 2.8% over the next two years, with eurozone inflation swaps at around 1.9%. That would mark a small decline from the current US CPI rate of 3% and a sharper drop from eurozone inflation of 2.5%.
Pricing for both has fallen slightly since, but the gap remains at its widest since early 2022.
Yields on US Treasury bonds have nevertheless fallen compared to those in Europe in recent weeks, as weaker-than-expected data has raised concerns about growth, even as inflation remains a concern.
Inflation swaps are derivatives that allow parties to adjust their exposure to inflation.
Many in the market—from speculative traders to companies hedging risks—expect US President Donald Trump's planned trade tariffs to push up prices in the US while dampening inflation in Europe by slowing growth.
'Tariffs... are a one-off shock to the price level,' said Blerina Uruci, chief US economist in the fixed income division at T. Rowe Price.
'What's different now is we have lived in a high-inflation environment, and businesses have discovered they have pricing power, so what could be a one-off shock to the price level could have more room to run.' Growth differences are another factor. The US economy has expanded about 12% since just before the pandemic, while the 20-country eurozone has grown only 5%.
Trump’s negotiations with Russia to end the war in Ukraine have startled European capitals but led to a sharp drop in energy prices. European natural gas prices—a key driver of eurozone inflation—have fallen 30% since mid-February.
'That is definitely pushing down on front-end inflation swaps,' said Guillermo Felices, principal and global investment strategist at PGIM Fixed Income. 'So you’re getting this unusual divergence between the US and Europe.' Differences in inflation expectations would typically push US bond yields higher compared to Europe.
However, investors have focused on slowing US growth despite persistent inflation, highlighted by this week’s slump in a key consumer confidence measure.
The likelihood that European governments will need to borrow more—possibly through joint debt issuance—to fund increased defense spending demanded by Trump is another factor at play.
The gap between US and German 10-year bond yields fell to its lowest since November on Tuesday at 182 basis points (bps), down from a five-year high of 231 bps in December.
Traders now expect about 55 bps of Federal Reserve rate cuts this year, after previously anticipating just one 25 bp reduction. Expectations for European Central Bank cuts have shifted less, with 85 bps of reductions priced in.
Some investors still believe the strength of the US economy will keep borrowing costs high.
'The Fed has been very clear in saying they are still in restrictive territory, but they are happy to stay here if growth remains,' said Ales Koutny, head of international rates at Vanguard. 'That limits how much bonds can rally.' Lower returns have reduced the attractiveness of US bonds and weighed on the dollar, helping the euro rise to $1.05 from a more than two-year low of $1.01 last month.
Samuel Zief, head of global FX strategy at JPMorgan Private Bank, remains cautious about betting on a sustained euro rally.
'We think the uncertainty from trade and those headwinds are the real thing that need to be cleared before you can turn more cyclically bullish on the eurozone,' he said.
Felices at PGIM finds reassurance in the fact that inflation expectations are not far from 2%, especially given that the Fed targets the personal consumption expenditures index, which tends to be lower than CPI.
'That these numbers are still pretty consistent with inflation targets is very reassuring,' he said. — Reuters
That gap is not fully reflected in US and eurozone bond yields, as investors are also considering recent weak US economic data and the possibility of increased European defense spending.
Inflation swap markets late last week pointed to US consumer price index (CPI) inflation running at about 2.8% over the next two years, with eurozone inflation swaps at around 1.9%. That would mark a small decline from the current US CPI rate of 3% and a sharper drop from eurozone inflation of 2.5%.
Pricing for both has fallen slightly since, but the gap remains at its widest since early 2022.
Yields on US Treasury bonds have nevertheless fallen compared to those in Europe in recent weeks, as weaker-than-expected data has raised concerns about growth, even as inflation remains a concern.
Inflation swaps are derivatives that allow parties to adjust their exposure to inflation.
Many in the market—from speculative traders to companies hedging risks—expect US President Donald Trump's planned trade tariffs to push up prices in the US while dampening inflation in Europe by slowing growth.
'Tariffs... are a one-off shock to the price level,' said Blerina Uruci, chief US economist in the fixed income division at T. Rowe Price.
'What's different now is we have lived in a high-inflation environment, and businesses have discovered they have pricing power, so what could be a one-off shock to the price level could have more room to run.' Growth differences are another factor. The US economy has expanded about 12% since just before the pandemic, while the 20-country eurozone has grown only 5%.
Trump’s negotiations with Russia to end the war in Ukraine have startled European capitals but led to a sharp drop in energy prices. European natural gas prices—a key driver of eurozone inflation—have fallen 30% since mid-February.
'That is definitely pushing down on front-end inflation swaps,' said Guillermo Felices, principal and global investment strategist at PGIM Fixed Income. 'So you’re getting this unusual divergence between the US and Europe.' Differences in inflation expectations would typically push US bond yields higher compared to Europe.
However, investors have focused on slowing US growth despite persistent inflation, highlighted by this week’s slump in a key consumer confidence measure.
The likelihood that European governments will need to borrow more—possibly through joint debt issuance—to fund increased defense spending demanded by Trump is another factor at play.
The gap between US and German 10-year bond yields fell to its lowest since November on Tuesday at 182 basis points (bps), down from a five-year high of 231 bps in December.
Traders now expect about 55 bps of Federal Reserve rate cuts this year, after previously anticipating just one 25 bp reduction. Expectations for European Central Bank cuts have shifted less, with 85 bps of reductions priced in.
Some investors still believe the strength of the US economy will keep borrowing costs high.
'The Fed has been very clear in saying they are still in restrictive territory, but they are happy to stay here if growth remains,' said Ales Koutny, head of international rates at Vanguard. 'That limits how much bonds can rally.' Lower returns have reduced the attractiveness of US bonds and weighed on the dollar, helping the euro rise to $1.05 from a more than two-year low of $1.01 last month.
Samuel Zief, head of global FX strategy at JPMorgan Private Bank, remains cautious about betting on a sustained euro rally.
'We think the uncertainty from trade and those headwinds are the real thing that need to be cleared before you can turn more cyclically bullish on the eurozone,' he said.
Felices at PGIM finds reassurance in the fact that inflation expectations are not far from 2%, especially given that the Fed targets the personal consumption expenditures index, which tends to be lower than CPI.
'That these numbers are still pretty consistent with inflation targets is very reassuring,' he said. — Reuters