What would it take for the EUR yield curve to recouple with the US yield curve?

Everyone wonders how the ECB might react to the rise of US yields. At the same time, financial conditions barely tightened on this side of the Atlantic, and the urgency to step up QE is not obvious. German 10Y yields are still negative in both real and nominal terms. Government and corporate bonds - even high-yield bonds - are jammed at tiny spreads, and the EUR exchange rate has stopped appreciating.

The question is therefore why the US and the EUR yield curves have decoupled and whether this decoupling will last.

There are some good reasons to believe that the decoupling of the yield curves on both sides of the Atlantic relies on fundamental factors, which might last for a while.

First, the gap in long-term real interest rates between the USA and the Eurozone is unlikely to tighten soon. The fiscal expansion in the Eurozone last year was only one third that of the US, while monetary expansion by the ECB and the Fed were of similar size (15 to 20 points of GDP in both cases). This year, fiscal expansion will probably be of the same magnitude as last year in the US and outpace by a factor 3 to 4 fiscal expansion in the Eurozone.

The source of fiscal expansion in the EU will change, but it will not increase: the EU recovery plan is expected to add 2% to GDP in 2021 and in 2022, but it will take over from the fiscal expansion from national governments during 2020, with the latter supposed to revert to a neutral or even slightly restrictive fiscal stance this year. At the same time, the ECB has 10% of GDP to go on QE until March next year to fulfill its PEPP program.

Second, inflation is not returning the Eurozone as quickly as it seems – unfortunately for its central bank. Headline inflation will continue rising until the end of Q2 2021, principally because of past developments in oil price. And then? Inflation in 2022 is most likely to be lower than in 2021, on base effects and the fact that unit labor costs will have to mirror the productivity shock caused by Covid-19, which has been strongly negative in Europe due to the furlough schemes. It would be probably fairer to say that in Europe, deflation risks have diminished over the past few months, rather than to flag a risk of stagflation.

So, what would it take for European yields to rise and converge toward US yields? Certainly, more fiscal stimulus in 2021 and beyond. Is it likely to happen? The announcement of the UK budget went in that direction. On the continent, the EU said recently that it might consider postponing the normalization of budget rules and the discussion over new rules by one year to the end of 2022.

The fiscal stance assumed so far in Europe might indeed evolve, but it’s unlikely to take on the proportions of what is currently happening in the U.S.