Katherine Buso (*)
Financial markets are witnessing one of the largest inflation divergences between the United States and the Eurozone since 2022.
While inflation in the US is expected to remain elevated, driven by trade tariffs and robust economic growth, Europe faces deflationary pressures due to falling energy prices and slower economic growth.
This disparity is prompting investors to adjust their strategies, although not all market moves fully reflect this trend.
The Inflation Divergence in Numbers
According to inflation swap markets, US inflation, as measured by the Consumer Price Index (CPI), is expected to hover around 2.8% over the next two years. In contrast, inflation in the Eurozone is projected to fall to 1.9% over the same period. This nearly 1 percentage point difference is the largest since early 2022 and reflects distinct economic paths between the two regions.
In the US, current inflation stands at 3%, while in the Eurozone it’s at 2.5%. Despite both regions seeing a slowdown in prices, the decline is more pronounced in Europe. This divergence is driven by factors such as trade policies, uneven economic growth, and fluctuations in energy prices.
Factors Driving Inflation in the US
US inflation is expected to remain higher than in Europe due to a combination of robust economic growth and protectionist trade policies. President Donald Trump announced plans to impose tariffs on imports, which tends to raise domestic prices. Additionally, the US economy has grown by about 12% since the start of the pandemic, compared to just 5% in the Eurozone.
"Tariffs are a one-off shock to the price level, but in a high inflation environment, companies have found they have pricing power," explained Blerina Uruci, Chief Economist at T. Rowe Price. This means that price hikes caused by tariffs could have a prolonged effect, keeping inflation elevated for a longer time.
The Decline of Inflation in Europe
In Europe, inflation is falling faster, driven by lower energy prices. Trump’s negotiations with Russia for a potential peace deal in Ukraine eased geopolitical tensions, leading to a 30% drop in natural gas prices since mid-February. As natural gas is a major driver of inflation in the Eurozone, this reduction has a significant impact on consumer prices.
Furthermore, slower economic growth in Europe, compared to the US, contributes to lower inflationary pressures. The European economy has not fully recovered from the impacts of the pandemic and the energy crisis, which limits price increases.
Impact on Bond Markets
Despite the inflation divergence, US Treasury yields have fallen relative to European bonds in recent weeks. This is due to investor concerns about signs of economic slowdown in the US, such as the recent decline in consumer confidence indicators.
Additionally, the expectation that European governments will need to increase defense spending, possibly through joint borrowing, is also influencing bond markets. The spread between 10-year US and German bond yields has narrowed to 182 basis points (bps), the lowest level since November.
Outlook for the Dollar and the Euro
The inflation divergence and shifts in monetary policy expectations are impacting currencies. The dollar has weakened recently, with the euro rising to US$1.05, up from US$1.01 last month. However, some analysts are cautious about a sustained recovery for the euro.
"We need to see a resolution of trade uncertainties and headwinds before we can be more optimistic about the Eurozone," said Samuel Zief, Chief Currency Strategist at JPMorgan Private Bank.
Conclusion
The inflation divergence between the US and Europe is one of the most important themes in financial markets right now. While the US faces persistent inflationary pressures, Europe is dealing with falling energy prices and slower economic growth. This disparity is shaping investor expectations and influencing bond and currency markets.
However, investors should stay alert to other factors, such as trade policies, defense spending, and recent economic data, which could quickly alter the landscape. Meanwhile, moderate inflation and expectations aligned with central bank targets offer some comfort amid market volatility.
Katherine Buso is an expert in Economics and International Affairs, graduating with academic honors from the Armando Álvares Penteado University (FAAP-SP) in 2014. She holds a postgraduate degree in Statistics from the Pontifical Catholic University (PUC-Chile). She is an Editorial Consultant at Ciência Capital, an International Columnist at Rádio Alta Potência, and an International Columnist at Rádio Agro Hoje. She is also the CEO of Business Intelligence at BlueBI Solution in São Paulo.
Instagram: @bluebisolution
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