Real interest rates are deeply negative in much of the Eurozone due to the combination of interest rate repression by the ECB’s bond buying program plus above-target inflation.
Take a look at the real 10y German bund yield below.
As I have pointed out, the further behind the curve a central bank gets, the harsher the snap back toward normalization is once the process to normalize is anticipated by market participants. No central bank is further behind the curve right now than the ECB.
Investors are pricing in two or three 25 basis point Fed rate hikes this year. No such expectations exist in the Eurozone due to Mario Draghi’s persistent, stubborn denials of even discussing normalization with the Governing Council—yet. We may be at a turning point in market expectations for the euro as the severity of political risk subsides.
The 2yr yield spread divergence in US-German government debt is at extreme levels of 221 basis points. You could cruise a row of mega tanker ocean liners through that spread. This suggests a higher EUR/USD if and when the spread narrows to historically normal levels, but most likely long before then. The 10y Bund real interest rate yield is so deeply negative during a period of increasing economic activity and inflation that probabilities suggest a brisk reversal higher in yields the moment markets start pricing in a post-QE Europe.
The exact timing of when the yield spread will close is not as critical as knowing what will happen when it does. Once the sea tide resides back from the beach, it will be apparent holders of European government debt were swimming without bathing suits. They will likely be standing along side short sellers of the euro who will also be… exposed.
In summary, now is probably as good of a time as any to make sure you aren’t holding long European bonds that look and sound an awful lot like time bombs. The same could be said for short euro positions. Long EUR/USD and EUR/GBP entries on political fear-based dips will provide favorable asymmetric risk/reward opportunities.