Trade War Drives 4-Year High in US-Eurozone Inflation Gap

The trade war initiated by former U.S. President Donald Trump has resulted in a significant divergence in short-term inflation expectations between the United States and the Eurozone, marking the largest gap seen in four years. This divergence is primarily driven by Trump's decision to raise import tariffs to levels not seen in over a century. The market indicator measuring one-year inflation expectations in the U.S. has surged, while the corresponding indicator in the Eurozone has declined sharply, highlighting the differing economic impacts of the trade war on the two regions.

This divergence has become a key factor in supporting investor preference for German government bonds over U.S. Treasury bonds. The persistent inflation in the U.S. has made the Federal Reserve cautious about lowering interest rates, which could limit further price increases for U.S. Treasuries. In contrast, the European Central Bank's path to lowering interest rates has become clearer as high tariffs begin to impact the Eurozone economy.

Investors are closely monitoring the upcoming release of the U.S. Consumer Price Index and Producer Price Index data this Thursday and Friday, looking for signs that new tariffs have already sparked inflation. The differing inflation expectations have led to a shift in investment strategies, with some global asset managers moving funds from equities to German and British government bonds, rather than U.S. Treasuries. This shift is driven by the perception that the Federal Reserve has limited room to maneuver compared to the European Central Bank.

Despite the current high inflation rate in the U.S., which exceeds official targets, and the potential for further price increases due to Trump's large-scale deportation of immigrants, the Federal Reserve has so far maintained its stance, refusing to ease policy prematurely. However, the long-term inflation expectations between the U.S. and Europe remain closely linked, suggesting that the market views this inflation as a one-time shock that will gradually dissipate as the economy slows down.