Inflation and 10-year rate: Surprises are all that matter - Natixis

Currently, European interest rate levels depend rather more on inflation than on growth indicators and since July of this year, the trajectory of the Eurozone 10-year rate (Data stream benchmark) has trended downwards, the spreads between the US and EZ 10-year rates widening since the start of September (from 173bp then to more than 200bp at the end of November), points out the research team at Natixis.

Key Quotes

“Divergences in monetary policies are one of the explanations for all this (Federal Reserve announced a balance sheet normalisation and is continuing to raise the Fed Funds rates, whereas the ECB has announced a QE extension), but not the only one. Of late, the trajectory of Eurozone interest rates (compared to average level on a 12-month rolling basis) is no longer correlated to the macroeconomic news flow.”

“This configuration is not a one-off. In particular, since 2012, there have been three periods when interest rate levels and the macroeconomic news flow were out of sync. In all three cases, the absence of a reaction on the part of interest rates to an improvement in the macroeconomic news flow was due to the inflation factor, with a temporary divergence in the inflation news flow (i.e. decrease in inflation surprise index vs. increase in economic surprise index). It is therefore inflation that has the greater influence over interest rate levels.”

“What the current configuration highlights is that concerns centre on inflation, whereas the growth outlook for the Eurozone is no longer perceived as a risk factor, which is not without recalling the situation of the US during 2014. The case of the US and previous episodes in the Eurozone suggest that this disconnection (between the economic and inflation surprises indices) will not last and that the growth enjoyed by the Eurozone makes for an improvement in the inflation surprise index.”

“There remains that inflation and, in particular, its behaviour compared with expectations have a decisive bearing on the Eurozone 10-year rate as well as its trajectory relative to its US counterpart. An upturn in Eurozone inflation surprises and/or downturn in US inflation surprises would be expected to lead to a narrowing of the US/EZ spread. This impact would be all the more significant in that the correlation between the TNote and Bund still has a very significant bearing. In short, inflation may well be leaden-footed on both sides of the Atlantic, but it remains the main macroeconomic variable on which you need to keep tabs.”