Traders are increasingly betting on a growing divergence in inflation rates between the United States and the euro zone. This expectation is driven by different economic growth paths, potential tariff impacts, and the possibility of reduced European energy costs following a prospective peace deal in Ukraine. Despite these predictions, the resulting gap is yet to be fully reflected in bond yields from both regions.
Last week, inflation swap markets projected U.S. Consumer Price Index (CPI) inflation to hover around 2.8% over the next two years, while euro zone inflation swaps were at approximately 1.9%. This marks a slight decrease from the current U.S. CPI rate of 3% and a more pronounced decline from the euro zone’s 2.5%. Although pricing for both has decreased slightly, the disparity has reached its widest point since early 2022.
U.S. Treasury bonds have seen a decline in yields compared to European bonds. Recent economic data from the U.S., which has been underwhelming, has led to doubts about economic growth, even though inflation remains a concern. “I think it’s really, really hard to trade cross-markets when you have different drivers affecting the different markets,” stated Guillermo Felices, a global investment strategist at PGIM Fixed Income.
Inflation swaps, used by market participants to manage inflation exposure, reveal a stark divide. In the U.S., upcoming tariffs proposed by President Donald Trump are expected to increase domestic prices, potentially slowing European economic growth and lowering inflationary pressures there. “Tariffs… are a one-off shock to the price level,” noted Blerina Uruci, chief U.S. economist at T. Rowe Price, emphasizing that businesses, accustomed to a high-inflation environment, might maintain higher pricing power.
Growth discrepancies also play a role. The U.S. economy has expanded approximately 12% since before the pandemic, compared to a 5% growth in the euro zone. Concurrently, Trump’s negotiations with Russia to end the Ukraine conflict have pressured energy prices downwards. European natural gas prices, a significant factor in euro zone inflation, have dropped 30% since mid-February, according to PGIM’s Felices, contributing to the inflation differential between the regions.
Interestingly, while inflation differences might typically lead to higher U.S. bond yields compared to Europe, the focus remains on the slowing U.S. growth, despite persistent inflation. Increased defense spending in Europe, potentially funded through increased borrowing, adds another layer of complexity.
The current gap between U.S. and German 10-year bond yields has narrowed to 182 basis points from 231 bps in December, marking the lowest point since November. The market currently anticipates about 55 basis points of Federal Reserve rate cuts this year, contrasting with 85 bps expected from the European Central Bank.
Some investors continue to believe that U.S. economic resilience will keep borrowing costs high. The Federal Reserve’s stance remains firm, as indicated by Ales Koutny from Vanguard, highlighting that they are comfortable with current rates as long as growth persists. Lower returns have also made U.S. bonds less attractive, slightly boosting the euro against the dollar.
While inflation projections maintain alignment with targets, the intricate balance of factors such as tariffs, growth rates, and geopolitical developments leaves investors navigating a complex landscape.
