By Padhraic Garvey, CFA, Regional Head of Research, Americas
The US market rates are exerting upward pressure on eurozone rates
Over the past few months, one noticeable trend has been the widening gap between US and eurozone market rates. We typically analyze the 10-year differential as it is less influenced by direct central bank intervention. The spread between Treasury and Bund rates, a commonly used reference, has now increased to 165 basis points (bp), up from below 100bp in April. Another reference, the spread between the Secured Overnight Financing Rate (SOFR) and the Euro Short-Term Rate (ESTR), has also expanded to 100bp from around 25bp in April. The main driver of this development has been the strength of the US economy, which has put upward pressure on US market rates and subsequently pulled up eurozone rates as well. So, what does the future hold?
The limited rate cut discount constrains the decline of eurozone market rates
In the eurozone, the European Central Bank (ECB) seems determined to continue raising rates, even as economic activity is negatively impacted, in order to combat inflation. European inflation has proven to be more persistent than that of the US. Higher ECB rates increase carry costs and naturally lead to upward pressure on rates across the curve. However, there are also factors that can cause longer-term market rates to decline, such as the end of the rate hiking cycle, as longer-term rates begin to focus on the ECB’s expected stance 18 months from now. Currently, this expectation implies cumulative cuts of approximately 100bp. While not a significant amount, it leaves little room for lower long-term rates.
The impact of the US rate cut discount on higher longer-term rates
The US is experiencing a similar situation. The expected rate cuts are larger, around 125bp, but still provide little room for longer-term rates to fall. For instance, the 1-year SOFR stands at 5.5%, while the 10-year SOFR is just below 4%. Even if the 1-year SOFR were to decrease by 125bp, it would still be higher than the current 10-year SOFR of just under 4%.
Also, keep in mind that at the end of the next rate-cutting cycle, we should see an upward-sloping yield curve of at least 50bp. Based on this projection, longer-term rates need to be higher than their current levels in both the US and the eurozone. Furthermore, there are concerns about an elevated supply projection in the US, which would justify higher rates and steeper yield curves, all else being equal.
Continued upward pressure on market rates
Considering all these factors, if something significant were to occur in the US causing a substantial repricing of expected rate cuts, it could lead to lower longer-term rates. However, until such an event occurs, the path of least resistance is for longer-term rates, especially 10-year rates, to face upward pressure in both the US and the eurozone. This also implies that yield curves will remain under steepening pressure rather than experiencing inversion.
In conclusion, we maintain a bearish stance on bonds and anticipate further upward pressure on market rates from a tactical perspective.