Events and economic data over the past couple of weeks reinforce the divergence between U.S. and Eurozone monetary policy.
In terms of the ECB, the rollover of long-term inflation expectations is undoubtedly quite uncomfortable. The last thing the central bank needs is another deflation shock. Lower inflation expectations would push up real short-term interest rates, threatening to tip the Eurozone economy into a Japan-style liquidity trap.
Moreover, upward momentum in credit growth is losing steam, suggesting that growth disappointments will arrive this autumn in Europe. The combination of depressed inflation expectations and slowing growth momentum would send Bund yields sharply lower as investors discount “QE-forever” from the ECB.
In sharp contrast, the FOMC appears determined to hike rates this year. Whether one agrees with the FOMC or not, policymakers are anxious to lift rates off of the zero bound, now that the labor market is in the vicinity of full employment.
The market is still pricing in about a 50% chance of a September rate hike, implying that the short-end of the Treasury curve remains at risk.
Bottom Line: The “policy divergence” theme is still in play; favor Bunds to Gilts and Treasurys.