Europe's Yield Curve May Hold Key to Markets in 2018

A narrowing gap between short- and long-term rates should provide a boost to risk assets and the economy.

Europe's bonds to get less curvy.

Photographer: Daniel Roland

There's a lot of discussion these days about the U.S. bond market's yield curve, or more specifically how it has shrunk to the narrowest levels since 2007 -- a movement that has historically presaged an economic slowdown. What hasn't been talked about as much is how Europe's yield curve has failed to follow the same path. And while there are strong signs that may soon change, the result could end up being positive for Europe's economy and financial markets.

In the past, the slopes of the U.S. and European curves, as measured by the difference between five- and 30-year bond yields, often moved in tandem because central bank policies tended to be closely linked. But in the aftermath of the financial and euro-zone debt crises, the link was broken and the yield curves diverged. Now, it seems more likely that Europe's curve may start narrowing as the European Central Bank reduces its asset purchase program and moves closer to raising interest rates for the first time in more than five years. 

U.S. and European Yield Curve Comparison

Source: Bloomberg

One byproduct of a flatter yield curve in the U.S. has been a weaker dollar and a loosening of financial conditions, which have provided a supportive backdrop to both local and worldwide risk assets. There's no reason to suspect that also won't happen in the euro zone if the yield curve there narrows in 2018 and the euro weakens, benefiting the region's $11.9 trillion economy.

Euro-zone financial conditions, however, have tightened despite gains in European equities. One reason is related to the rise in short-term interest rates, specifically the “repo” rate at which the ECB purchases government securities from the commercial banks. The rate rose because the bonds were in demand for use as collateral, and there were increasingly fewer of them available given the ECB had bought so many under its QE program.

This situation, though, has begun to ease since the ECB decided to allow cash to be used as collateral in its securities lending program. And with the central bank scaling back its QE program, the drag on financial conditions from higher repo rates should ease even further. What should also happen is that yields on the almost $2 trillion of shorter-maturity debt begin to rise, which would help cause the yield curve to narrow.

Global Financial Conditions and Equity Returns

Source: Bloomberg

The strengthening European economy has changed the perception that the ECB wouldn't be able to start pulling back from super-loose monetary policy without causing frictions in the markets. To that effect, Europe has a lot of room to normalize short-term rates if only for fundamental reasons alone. Once the ECB begins to move that way, expect to see the euro zone yield curve to begin flattening and become a boon to markets in 2018.

U.S. and European Interest Rate Expectations

Source: Bloomberg

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