Widening Interest Rate Gap: Eurozone and USA on Diverging Paths

A noticeable difference between the bond markets of the Eurozone and the USA is increasingly developing, driven by a weakening European economy that is putting pressure on the European Central Bank (ECB) to quickly lower interest rates. The gap between the yields on ten-year US Treasury bonds and German Bunds has reached the highest level since July at around 183 basis points (bp). While US yields have risen sharply in recent weeks, German yields have only moved slightly upwards. Yields move inversely to price. Simon Blundell, Co-Head of European Fixed Income at BlackRock, a $11.5 trillion asset manager, sees further potential in these market dynamics and favors European bonds over American ones. While strong US job market growth in September underscores the strength of the American economy, business activity in the Eurozone experienced unexpected declines last month. Traders expect the US Federal Reserve to pause after a 50 basis point rate cut in September, while the ECB is targeting its third rate cut since June this week. Goldman Sachs forecasts that the interest rate differential between US and German government bonds could rise to 200 bp, a level last seen at the beginning of the year. The bank's analysts emphasize that European interest rates could outperform US ones in light of weaker data and more cautious central bank policies. The increasing interest rate difference is already affecting other markets, with the euro falling to its lowest level in two months. Higher yields are attracting investors to US bonds, thus strengthening the dollar. Germany’s Finance Ministry announced last week that Europe's largest economy is likely to shrink for the second consecutive year in 2024. The once-strong industrial sector continues to struggle with the aftermath of the energy crisis following the Ukraine war. Meanwhile, France has promised to raise taxes and cut spending to reduce the budget deficit. Reinout De Bock from UBS forecasts that ECB rates could fall to 1% next year if growth does not pick up, warning that consolidation in France will weigh on growth. In contrast, strong US employment figures have dispelled fears of a sharp economic downturn. The OECD expects the US economy to grow by 2.6% this year, compared to 0.7% in the Eurozone. Traders expect the ECB to end its rate cuts late next year at around 2%, significantly above the negative values prior to the pandemic. Nevertheless, analysts, such as those from Bank of America, are skeptical that the Eurozone can cope with higher interest rates and forecast rising European bond prices. Not all investors are pessimistic about the Eurozone's prospects, as there are signs of robust growth in countries like Spain and Italy. Lloyd Harris from Premier Miton Investors views European data more favorably than expected and anticipates a slight increase in bond yields, albeit stronger in the US.