The economic momentum is in favor of the U.S. as the Eurozone is heading for a double dip. The prevailing view among market participants seems to be that this divergence in nominal yields reflects a divergence in economic momentum. Indeed, with the increasing pandemic risk and the subsequent containment measures, the Eurozone should fall back into recession in Q4 2020. We expect real GDP to decline again in France (-1.1% q/q) and Spain (-1.3% q/q), among others. This weakness in the Eurozone could even continue into Q1 2021 as we see a rising risk of a stimulus gap. Political tensions in some member states (fragile majorities, fragmented political system) may make it difficult to maintain adequate fiscal measures. In addition, there is uncertainty about the timing and extent of the payments from the EU recovery fund. Its disbursements could be strongly politicized, given the degree of Eurosceptic views in some countries. In the U.S., on the contrary, expectations are for a new stimulus as market participants seem to be positioning themselves for a Democratic victory in the presidential election.

We find that the recent widening of the transatlantic spread is due to inflation expectations, more precisely to a repricing of the inflation risk premium in view of the Fed’s average inflation target (AIT). If economic momentum really was the main driver of the recent transatlantic yield divergence, one would expect rising real yields in the U.S. and somehow stagnating real yields in the Eurozone. However, by decomposing the nominal yields into the real yield and the market-based inflation expectation (inflation swap), we observe that for the 10y maturity real yields in the Eurozone have indeed stagnated since mid-September, but declined by 10bp in the U.S. This is due to a significant increase in market-based inflation expectations, which nominal yields only partially followed. Thus, the recent widening of the transatlantic spread is not explained by the real yield component but the inflation expectation component.