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Reflation frenzy drives historic wedge between U.S. and Europe

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(Bloomberg) – Europe is being left in the dust like never before by the frenzy of reflation across the Atlantic.

Rising energy costs are pushing up yields on German Treasuries and Bunds, but market indicators of inflation expectations in the United States have exceeded those in the euro zone the most in more than a decade.

As the White House prepares a $ 1.9 trillion stimulus package to spur growth, it’s another story in the single currency bloc where a stumbling vaccine rollout threatens to intensify a likely double-dip recession .

All of this offers a historic divergence trade between the US and Europe, for fund managers like BlueBay Asset Management and Aberdeen Standard Investments.

We are looking for a reflation theme in 2021, but we are seeing it more pronounced in the United States due to expansive fiscal policy, said portfolio manager Mark Dowding at BlueBay Asset. I’m more inclined to see eurozone inflation come down after a temporary rise, even as US inflation pushes up this year.

A debt gauge for future inflation in Germany collapses to an all-time low compared to its US counterpart. The Treasury and Bund curves are deviating to levels not seen in about a decade. The continent’s small-cap companies linked to the economic cycle are lagging behind a big rally in US benchmarks.

Yet while the investment strategies linked to the economic expansion of the eurozone seriously underperform their US counterparts, they saw big swings last week.

German 30-year yields turned positive for the first time in five months, with US counterparts hitting a one-year high. European five-year and five-year inflation swaps – a key indicator of long-term price expectations – hit their early 2019 levels.

Read more: Global markets see inflation hitting multi-year highs

Even after a moderate report on consumer prices, bond indicators of inflation expectations in the United States reached their highest level since 2014 last week. The yield curve, a barometer of economic health, tested the steepest levels in five years.

The story continues

The spark was twofold: Treasury Secretary Janet Yellens called for stimulus measures to pull the United States out of the coronavirus crisis, and efforts to install former European Central Bank president Mario Draghi in as prime minister in Italy.

Still, strict lockdowns, vaccination delays and deflationary pressures are expected to weigh on the notoriously lifeless European bond markets, raging divergence trade.

Last week, the European Commission lowered its growth forecast for 2021 to 3.8% from 4.2%, while projecting price growth of 1.3% on average in 2022. The International Monetary Fund, as for he sees the region lagging behind its international peers.

The eurozone will recover somewhat with the rollout of vaccines, but structural problems facing the eurozone persist, said Charles Diebel of Mediolanum International Funds Ltd. The portfolio manager is betting that the 10-year Treasury spread will reach 200 basis points from around 164 currently.

Reflation skeptics like Steven Major, meanwhile, are telling clients to bet against the recent advance in market-derived price expectations.

It seems odd that the market has reassessed in order for the ECB to meet its inflation target, at a time when the level of economic downturn argues for continued policy adjustment, the global head of securities research wrote. fixed income at HSBC in a note. We suggest positioning the opposite.

Made in america

In one view, the nascent reflation trade in Europe is simply a fallout of the US rally, the latter being guided by recent Federal Reserve statements that it would tolerate a temporary overrun in inflation.

If the US and Eurozone markets were completely isolated from each other, we bet no reflation swaps would occur on this side of the Atlantic, ING Groep NV strategists wrote.

The result? Price pressures in the US still appear to be contained for now, but there is a belief that the US business cycle will improve as Europe has a familiar story of stagnation to tell.

The United States is undergoing massive creative destruction right now – but we know it will rebound hard, said portfolio manager Luke Hickmore at Aberdeen Standard Investments. I would love to see that in Europe, but I don’t see much evidence of it.

(Updates US-Germany performance bonus to 13th paragraph, adds all)

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