U.S. and European bond markets have become unusually highly correlated this year, despite big differences in GDP growth rates, inflation trends and interest rate policy expectations. Does this lay the groundwork for attractive relative-value and dispersion trades over the rest of 2024?
Lockstep
The past nine months have offered the clearest picture of two different economies that one could ask for.
The eurozone barely grew at all during the first quarter of 2024, after ending 2023 in recession; the U.S. grew at around the same rate of 0.3% in the first quarter, but that consolidated growth of 1.2% and 0.9% in the third and fourth quarters of 2023, respectively.
Eurozone year-over-year inflation has been below 2.6% since February and the month-over-month rate has fallen rapidly from 0.8% in March to just 0.2% in May; U.S. year-over-year inflation bounced from 3.1% in January to 3.5% in March and its month-over-month rate has been stuck between 0.3% and 0.4% so far this year.
Markets had been pricing for the European Central Bank’s (ECB) first rate cut of the cycle for weeks; the same markets have gone from pricing for six U.S. Federal Reserve (Fed) rate cuts in 2024 at the start of this year to pricing for just one or two today.
Despite all this, U.S. and European fixed income markets—and even near-term rates markets—have been trading in lockstep this year. Trailing 20-day correlation of interest-rate futures prices and long-term bond yields, which is usually modest, has been high and persistent since October 2023 (figure 1).
The trend was perhaps exemplified on May 29 when, after two days of weak U.S. Treasury auctions, European government bond yields spiked by around 10 – 12 basis points in apparent sympathy with the U.S. market; in the U.K., unlike in the Eurozone, there wasn’t even any new inflation data to help explain the move.
FIGURE 1. UNUSUALLY HIGH CORRELATION BETWEEN U.S. AND EUROPEAN RATES AND BOND MARKETS
10-year yields, and trailing 20-day correlation between daily changes in yield
Euribor and SOFR December 2025 futures prices, and trailing 20-day correlation between daily changes in price
Source: FactSet, Neuberger Berman. Data as of June 3, 2024.
This is not entirely unexpected to us. The leading fixed income theme in our Solving for 2024 outlook was “Supply and Demand Outweighs Fundamentals,” after all: “Marginal changes in spreads and yields will continue to owe more to supply-and-demand technicals than fundamentals, much like they have in 2023.”1 And some correlation is to be expected, at any time.
But greater than 60% for weeks on end? When the eurozone runs a 3.6% budget deficit against the U.S.’s 6.3%? Not in our opinion. Longer term, in our view it cannot be right that trading German Bunds requires one merely to parse the U.S. fiscal and inflation environment.
Imminent Convergence Rather Than Recent Divergence
What might explain this phenomenon?
One theory is that perceptions of Europe got so bad during 2023 that they now cannot get any worse, whereas perceptions of the U.S. got so good that they now cannot get any better. We see this in the Economic Surprise Indices for the two regions in figure 2: Europe kept outperforming the increasingly gloomy forecasts through 2023 but, since March, performance and outlooks have aligned; the U.S., by contrast, couldn’t keep up with increasingly upbeat forecasts through 2023 and, since March, performance has worsened while the outlooks have remained positive.
One could take the economic data outlined in the paragraph above and tell a story of imminent convergence rather than recent divergence: Europe is growing out of its recession just as the U.S. is slowing from its deficit-financed mini boom; Europe’s very high month-over-month inflation has moderated and is now in line with the 0.3% level that has become a sticking point in the U.S. The latest inflation data had the eurozone surprising on the upside and the U.S., to some market relief, coming in aligned with expectations.
FIGURE 2. ECONOMIC SURPRISES: STABLE IN EUROPE, NEGATIVE IN THE U.S.
Citi Economic Surprise Indices
Source: Bloomberg. Data as of June 3, 2024.
Another theory suggests that ballooning supply of U.S. Treasury bonds and notes is sucking demand out of other government bond markets worldwide. That supply is required to finance the U.S. deficit, and over recent months the Treasury has tilted back toward issuing bonds rather than bills, after a period favoring bills through 2023.
The higher yields demanded by U.S. bond buyers look attractive to overseas investors, even after the costs of hedging back to euros. This crowding-out effect may be forcing European bonds to trace the yield movements of U.S. Treasuries.
Excessively High and Persistent
We think these theories may explain some of the correlation we are currently seeing, but it still appears excessively high and persistent to us.
Trading relative value and increased dispersion between European and U.S. yield curves could become attractive through the second half of the year—especially if, as my colleagues Brad Tank, Ashok Bhatia and Patrick Barbe recently suggested, markets begin to price for a normalization of ECB policy rates over the coming months.2
Maybe bond investors should continue to analyze the European economy, after all.
