Since November 2024, the relationship between US and European interest rates has notably weakened, signaling not only the nuanced shifts in financial market dynamics across the Atlantic, but also potentially foreshadowing significant ramifications for the global economic landscapeAnalysts have astutely emphasized that this trend is likely to further widen the spread between US Treasury yields and Eurozone ratesThe intricacies behind this phenomenon encompass a myriad of factors ranging from policy decisions to economic data and market expectations, all interwoven in a complex narrative that is reshaping transatlantic financial ties.

An insightful report from ING highlights the crucial role of US tariff policies in this evolving rate landscapeThe imposition of tariffs by the United States has triggered diverging inflation expectations globally, profoundly influencing interest rate trends on both sides of the AtlanticFor the US, tariffs have inflated the costs of imported goods, prompting domestic businesses to pass on these costs to consumers, thereby exerting upward pressure on inflation

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Conversely, countries hit by such tariff measures experience diminished export capacities, reduced economic momentum, and waning market demand, which could usher in deflationary risksThis bifurcation in inflation expectations is giving rise to an increasingly independent European interest rate landscape, contributing to the widening gap between US and Eurozone rates.

Statistical data highlights a dramatic shift in rate correlations as wellSince November, the daily fluctuations in the two-year Euro swap rates have become uncorrelated with the two-year Treasury yields, suggesting a severance of the previously tight coupling between these two metricsLooking at longer maturities, the influence of US Treasury yields on the ten-year Euro swap rates has likewise diminished significantlyBefore November 2024, over 50% of the variations in ten-year Euro swap rates could be explained by changes in Treasury yields; this percentage has plummeted to just 14%. This stark contrast underscores the reality of diverging paths for US and European interest rates.

The divergence grows more pronounced in light of the contrasting monetary policies of the Federal Reserve and the European Central Bank (ECB). Market sentiments suggest that short-term rates in the Eurozone are likely to decrease further in the near termWith weak European economic data, the ECB is under immense pressure to stimulate the economyThis has led to widespread expectations that the ECB may proceed with further rate cuts, potentially exerting downward pressure on short-term rates and consequently boosting long-term ratesMeanwhile, the Fed, buoyed by robust economic data, maintains a hawkish stance, sticking with current interest rate policies and even considering future rate hikesThis divergence in monetary policy - one tightening while the other loosens - exacerbates the growing schism between US and European interest rates

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As of now, the spread between the ten-year Euro swap rates and the ten-year SOFR (Secured Overnight Financing Rate) swap rates has reached 175 basis points, nearing the high of 185 basis points recorded in 2018, indicating a clear trend of widening spreads.

In addition, the anticipated policy direction of the ECB has also drawn market focusGiven the weak economic indicators, such as the manufacturing PMI consistently hovering below the neutral mark and rising unemployment rates, speculation regarding imminent rate cuts from the ECB has intensifiedInvestors are closely monitoring ECB actions, hoping to extract signals regarding potential rate cuts from policy announcements and public statements by officialsOn the flip side, the Fed's stability, propounded by favorable economic data and a resilient job market - combined with manageable inflation levels - grants the Fed an air of confidence to maintain a hawkish approach, thereby further complicating the interest rate divergence between the two regions.

This week’s market developments have also added another layer of complexity to the shifts in US and European interest ratesWith relatively few major economic data points on the horizon, the spotlight is set on the NFIB Small Business Optimism Index in the USThe latest report revealed a decline of 2.3 points to 102.8, signaling a waning confidence among small business owners regarding future economic prospectsThis drop could impede investment and hiring plans, potentially exerting a negative impact on the overall US economyAdditionally, investors will be keenly awaiting Chair Jerome Powell’s testimony in Congress, seeking further insights into future monetary policy directionsPowell's comments will heavily influence market expectations of the Fed's policy trajectory, directly impacting Treasury yield movements.

Simultaneously, this week presents significant supply pressures in government bonds within the Eurozone and the UK

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