European bond yields have been rising since Dec. 10, 2024, reaching multi-year highs and narrowing the gap with their U.S. counterparts. German Bunds have led the rally on expectations of a growth revival in the Old Continent, which could reintroduce the bond market’s old villain—inflation.
The recent spike in European bond yields began in mid-December in anticipation of further interest rate cuts by the European Central Bank (ECB) to spur economic growth. This prospect materialized this week, with the ECB cutting its official interest rate again.
Adding to optimism about the revival of European growth is a radical shift in Germany’s fiscal policy following an agreement between the Christian Democratic Union, Christian Social Union, and Social Democratic Party to ease the country’s debt limit by exempting most military expenditures from the debt brake. In addition, the parties proposed creating a 500 billion euro off-budget fund to boost infrastructure spending, which could set the fiscal policy tone for the rest of Europe.
“Since Feb. 28, the German 10-year government bond yield has surged by 18 percent, rising from 2.38 percent to 2.82 percent by mid-Friday,” Alejandro Zambrano, ThinkMarket’s chief market analyst, told The Epoch Times.
“Germany looks set to approve a 500 billion euro infrastructure deal, equivalent to 5 percent of GDP. The EU also plans to spend approximately 1,777 euro per citizen to rearm its military, another shot in the arm for the European military complex.”
Higher government spending is typically inflationary unless it is accompanied by an expansion of the economy’s productive capacity, which drives long-term bond yields higher.
The divergence of moves in the growth prospects on the two sides of the Atlantic has narrowed the spread between European and U.S. bond yields, with the German 10-year and Italian 10-year bonds trading roughly 130 basis points and 50 basis points below their U.S. counterparts, respectively.
“Typically, European and U.S. government bond yields move in tandem, with higher yields usually slowing stock market gains, but we have not seen the same surge in US yields,” Zambrano said.
“As a result, the impact on Wall Street is minimal, if any. The lack of response and lower yields in the U.S. reflect the increased probability of a recession as Washington strains trade relationships with his ongoing trade war.”
Meanwhile, the narrowing of the spread between European and U.S. bond yields is beginning to show in the currency markets, where the dollar is losing ground against the euro.
“While U.S. yields have barely moved, EUR/USD has risen dramatically by 4.5 percent, meaning the dollar is weakening,” Zambrano added. “EUR/USD can sometimes be highly correlated with stock indices, but it does not impact Wall Street in the long term.”
“The only potential benefit I see is that a weaker USD might lead Washington to shift his focus away from the EU while also making U.S. exports more attractive,” he said.
