Euro Zone’s Surprising Calm Amidst Global Market Turmoil
As investors fret over growing debt and sticky inflation in Britain and the United States, the euro zone appears to be weathering the storm relatively unscathed. But what’s behind this unexpected calm?
A Tale of Two Economies
The UK and US governments have seen their 10-year bond yields surge by 100 basis points since September, driven by concerns over fiscal plans and rising inflation. In contrast, Germany, the euro zone’s largest economy, has experienced a much more modest increase in borrowing costs, despite an impending general election that could see significant gains for the far-right.
Debt Burden: A Key Differentiator
Investors are taking comfort in Germany’s relatively low government debt-servicing burden, which provides room for further borrowing to finance public spending. “Germany is the only major economy that can afford to issue more debt to finance public spending if they decide to,” notes Francesco Castelli, head of fixed income at Banor.
Fiscal Restraint in Italy and France
Even debt-laden Italy and France have seen smaller increases in bond yields compared to Britain and the US. This may be attributed to signs of fiscal restraint in Rome and Paris, where the new government has pledged to get public finances in order.
Economic Growth: A Mixed Bag
However, the euro zone’s economic growth remains sluggish, particularly in Germany, due to higher energy costs and a lack of competitiveness in key sectors. This could lead to lower inflation, stagnant economic growth, and prompt the European Central Bank to cut interest rates in the coming months.
US Economy: A Different Story
In contrast, the US economy continues to defy expectations with its robust growth, leading economists to believe it may be headed for a structurally higher neutral rate of interest. Protectionist policies from the Trump administration could even add to US inflation, forcing the Federal Reserve to keep interest rates high for longer.
Interest Rate Divergence
The European Central Bank is expected to reduce its policy rate four times over the next year, easing it to 2.0%, while the Federal Reserve is seen cutting its key rate just once or twice, leaving it at around 4.0%. This divergence in interest rates could have significant implications for the global economy.
Uncertainty Ahead
While the euro zone’s calm may be a welcome respite, uncertainty still looms large, particularly given policy uncertainty from the Trump administration. High US yields could strengthen the dollar and boost imported inflation in Europe, limiting interest rate divergence.
A Silver Lining for Germany
On a positive note, Germany could potentially climb out of its economic rut if the next government decides to utilize its fiscal space to invest, boosting growth and inflation expectations. This would likely result in higher long-term rates, a sign of success rather than a concern.
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