Inflation readings between the major nations are increasingly disparate. Will bond market recognise the gap?
- Inflation appears more persistent in the US, while coming in behind expectations in the UK and Europe
- The UK and Eurozone have seen greater economic weakness than the US, with growth near or at zero
- In the US election both sides seem determined to juice an already thriving economy
The latest round of inflation data revealed an increasing divergence between the major economies. Inflation appears more persistent in the US, while coming in behind expectations in the UK and Europe. This seems rational given the strength of the US economy, and relative weakness in the UK and Europe. Will bond markets start to reflect this divergence?
US headline inflation dropped less than expected to 3.1%, as the cost of housing proved stubbornly high. The strength of US GDP growth and continued buoyancy in the labour market were always likely to be incompatible with significant falls in inflation. Yet the US central bank has been the most optimistic on interest rate cuts.
The UK and Eurozone have seen greater economic weakness, with growth at or near zero. Their labour markets have not been as strong and they have not seen the same level of fiscal stimulus as the US. In the UK, inflation was 4% year on year, lower than expected. Energy costs are likely to push inflation towards the 2% target by the middle of the year.
In the Eurozone, the most recent flash GDP data for the fourth quarter of 2023 showed that the region’s economy was flat. Employment markets are neutral, industrial production continues to fall, let by real weakness from Germany. Perhaps unsurprisingly against this backdrop, after a brief blip in December, Eurozone inflation appears to be heading lower.
Yet UK and Eurozone policymakers have been much more cautious on the prospects for rate cuts. And bond markets have believed them. The 10 year US treasury and 10 year UK gilt have largely tracked each other since the start of the year, even though inflation appears less persistent in the UK and rate cuts more likely.
Equally, whichever side wins in the UK election, there seems little danger of significant spending or tax cuts, and it is a similar pattern across Europe. By contrast, in the US election both sides seem determined to juice an already thriving economy – one side through spending, and the other through tax cuts. Higher inflation is surely a risk?
Against this backdrop, it seems likely that there will be an increasing divergence between bond markets, with US bond markets assuming too great a level of cuts, and Eurozone and UK bond markets assuming too few. This also may provide some much-needed good news for the relative strength of UK and Eurozone equity markets
