Chart Of The Week   August 19 2022

On US-Europe Yield Curve Divergence

yield curve divergence

As of Thursday’s close, the 2-year/10-year US Treasury curve is inverted, with the 10-year yield trading -35bps below the 2-year yield.  In Europe, there is no inversion, with the 10-year German yield trading 37bps above the 2-year yield.

Why the divergence? The simple answer is that markets believe that the Fed is more likely than the ECB to raise interest rates to restrictive territory.  

The fed funds rate is expected to peak at 3.86% in July 2023 according to pricing in the US overnight index swap (OIS) curve.  Over in Europe, the euro OIS curve is pricing a peak in rates of 1.66% in August 2023.

The New York Fed’s survey of US bond market participants shows an estimate of the neutral fed funds rate between 2-2.5%, in line with the Fed’s own 2-3% estimate. Thus, the market-implied peak funds rate of 3.86% would be considered restrictive, consistent with expectations of slowing economic growth – and future interest rate cuts - that would lead to an inverted yield curve.

The ECB does not publish a formal estimate of a neutral European policy rate, but the ECB’s survey of financial market participants shows that investors believe that the neutral rate is in a range between 1.2-1.8%.  With the euro OIS curve priced for a peak ECB policy rate of 1.66%, that would be considered neutral and, therefore, consistent with a relatively flat but still positively sloped German yield curve.

Looking ahead,  the US Treasury curve is likely to stay inverted as the Fed is likely to hike rates by as much, if not more, than markets are discounting.  In Europe, our Global Fixed Income strategists see the ECB delivering fewer hikes than markets expect, which should maintain a mildly positive slope to the German curve.