Sharp Divergence in Inflation Forecasts: U.S. and Euro Zone on Different Paths LONDON (Reuters) - Traders who bet on the future course of inflation foresee a significant divergence for three years between the U.S. and euro zone, driven by different growth paths, tariff threats, and cheaper European energy after a potential Ukraine peace deal. This gap is not fully reflected in U.S. and euro zone bond yields, however, as investors are eyeing other factors including recent tepid U.S. economic data and expectations that European countries might need to spend more on defense.
Inflation Swap Markets Indicate Widening Gap Inflation swap markets late last week pointed to U.S. consumer price index (CPI) inflation running at about 2.8% over the next two years, with euro zone inflation swaps at around 1.9%. This would mark a small fall from a current U.S. CPI rate of 3% and a sharper one from euro zone inflation of 2.5%. Pricing for both has fallen slightly since, but the gap between the two remains at its widest since early 2022.
Why the Gap Persists Despite Falling Yields Yields on U.S. Treasury bonds have nevertheless fallen compared to those in Europe in recent weeks as some weaker-than-expected data releases have sown doubts about growth, even as sticky inflation remains a concern. Some investors are sticking with the view that U.S. economic strength will keep borrowing costs there high, limiting how much bonds can rally.
Factors Contributing to Diverging Inflation Forecasts Growth differentials are another factor. The U.S. economy has expanded about 12% since just before the pandemic, while the 20-country euro zone has grown only 5%. Trump's other major transatlantic policy focus, negotiating with Russia an end to the war in Ukraine, has startled European capitals but caused energy prices to drop. European natural gas prices - a key driver of euro zone inflation - have fallen 30% since mid-February.
Investor Sentiment: Uncertainty and Volatility The likelihood that European governments will need to borrow more - perhaps jointly - to fund higher defense spending demanded by Trump is another new factor to consider. Some investors are wary of betting on a sustained rally in the common currency, citing uncertainty from trade and headwinds.
What It Means for Investors and Markets The divergence in inflation forecasts has significant implications for investors and markets. Traders now expect about 55 bps of Federal Reserve rate cuts this year, after previously expecting just one 25 bp reduction. Pricing for the European Central Bank has changed less, with 85 bps of cuts anticipated.
Expert Insights: Reassurance from Consistent Inflation Expectations Felices at PGIM takes solace from the fact inflation expectations are not too far away from 2%, especially given 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.
Conclusion: A Complex and Volatile Market Environment The sharp divergence in inflation forecasts between the U.S. and euro zone reflects a complex and volatile market environment. Investors must carefully consider multiple factors, including growth differentials, tariff threats, and energy prices, when making investment decisions.
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