(The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own)
LONDON, Feb 24 (Reuters) – When U.S. interest rates sneeze, Europe catches a cold.
Market anxiety about the inflationary impact of the U.S. government’s massive planned spending boost is driving up U.S. Treasury yields and undermining the dollar.
That risks stifling Europe’s recovery with a stronger euro and relatively higher real borrowing rates, even though Europe’s fiscal stimulus is dwarfed by Washington’s $1.9 trillion plan.
Absent another government spending push in Europe to match the “go big” drive of new U.S. President Joe Biden, markets suspect the European Central Bank (ECB) may be forced to push back with even more bond buying to calm the waters.
ECB chief Christine Lagarde sent the first shot across the bows on Monday saying the central bank was “closely monitoring the evolution of longer-term nominal bond yields”.
But her verbal protest had only a fleeting impact on nominal yields and didn’t stop inflation-adjusted, or real, German yields hitting a four-month high on Tuesday.
It’s the contrast in inflation expectations and the resulting relative real rates either side of the Atlantic that are storing up trouble for Frankfurt and, unhelpfully for the euro zone at least, lifting the euro/dollar exchange rate again.
“The rise in real yields in the euro area is more problematic,” Gilles Moec, group chief economist at Axa Investment Managers, wrote this week.
“This calls for action, and a decisive acceleration in PEPP purchases could do the trick,” he said, referring to the ECB’s latest asset purchase scheme – the 1.85 trillion euro ($2.25 trillion) pandemic emergency purchase programme.
For a start, ECB researchers only last month outlined how bouts of U.S. interest rate volatility hit economies around the world, including the euro area, via trade and financial channels – the latter largely via debt and exchange rate markets.
Unexpected changes in U.S. rate volatility spill over to other economies in a “highly synchronous manner”, they said.
With the main index of Treasury bond market volatility, the MOVE index, jumping almost 50% over the past month, shockwaves are already being felt.
But it’s the dynamics of real rates that are potentially pernicious.
U.S. bond yields surged this month as investors rushed to price in the potential inflationary impulse from the Biden stimulus, which is due to arrive just as vaccines accelerate the underlying recovery from pandemic lockdowns, with money supply growth soaring and household savings still brimming.
With short-run Treasury bill rates still near zero amid the flood of Federal Reserve and Treasury cash, 10-year yields have surged 40 basis points this month to almost 1.4% – sending inflation expectations implied by inflation-proof Treasury securities above 2.2% for the first time since 2014.
But as markets now start to fret the Fed may be forced to mop up some of the money flow at the short end, and even consider drawing in its tightening trajectory, real long-term U.S. yields have started to climb as well.
Even the hint of that credit tightening on the horizon has seeped around world markets instantly and also popped sky high U.S. equity prices most reliant on low interest rates – such as technology and internet stocks.
What’s more, rising U.S. real yields on their own should lift the dollar and provide a partial offset for Europe – even if not for the more dollar-dependent emerging world.
But the twist is that European real borrowing rates have risen even faster than U.S. equivalents this time around and the dollar’s real-yield premium has eroded further. And that’s led the euro to start climbing again against the dollar instead.
The 10-year U.S. real-rate premium over Germany has dropped 10 basis points from this year’s high to just 52 basis points, for example.
And as Credit Suisse points out, it’s more dramatic for short-term maturities which are more sensitive for currency markets.
U.S. two-year rates adjusted for long-run inflation assumptions are almost 40 basis points below Germany’s – and the gap is at its most negative since 2014.
In other words, while the U.S. bond yield tightening has transmitted to Europe, inflation expectations there have not.
Few see euro zone inflation topping 2% on the horizon and expectations captured by the five-year/five-year forward inflation swaps market are, at 2.3% for the United States, some 100 basis points higher than for the euro zone.
“If eurozone sovereign yields continue to move higher in coming weeks, it’ll leave the ECB no choice but to step up their purchases with the PEPP to counter this undesirable tightening of monetary conditions,” wrote UniCredit chief economist Erik Nielsen.
He recently outlined the stark Transatlantic fiscal policy contrast, where stimulus in the United States this year is more than twice the country’s output gap, while the euro zone’s spending boost doesn’t even cover its.
With rising long rates and a strengthening euro delivering a double whammy for the bloc, it may be more than just policy nudges that are required.
For some, it ups pressure on the ECB to keep pace with the greater tolerance of inflation now encoded at the Fed after its recent strategic review moved it to an average inflation target over time from a fixed-point goal.
“The danger for the ECB is it will be seen as a congenitally hawkish if it doesn’t revise its inflation targeting framework sufficiently to rise to the challenge the Fed has put on the table,” said Morgan Stanley economic adviser Reza Moghadam. ($1 = 0.8232 euros)
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