This week, there were two market indicators that highlight some new trends in international finance. First, oil prices have risen to over $60 per barrel, after hovering around $45 as recently as mid-March. Other commodity prices like copper and iron ore also have rebounded strongly. Second, German 10-year bond yields rose back above 60 basis points after having been near 5 basis points just three weeks ago. The rise in German bond yields almost exactly mirrors the gain in the euro.
The economic indicator that most tightly connects these data points is inflation. Higher commodity prices feed into inflation, which also shows up in investor appetite for bonds and their yields. Back in January and February, global central banks were in unison about the need to fight deflation and spur their economies toward more growth. Almost 25 central banks cut interest rates in those two months, with many pushing their domestic interest rates deep into negative territory.
It seems to have had the desired effect, as inflation numbers have improved lately. Many of us who have been around for a while still have a tough time seeing more inflation as an “improvement,” but it really is positive when the alternative is deflation, which tends to stop economies from any real growth at all. A moderate amount of inflation is necessary for growth expectations for any economy. Such inflation expectations have made their way into the higher interest rates across most of Europe.
While Europe has seen strong underlying improvement in some of its economic indices, the reverse has been true in the U.S. Weak first quarter GDP and a ballooning trade deficit, combined with other weakening economic data, have caused U.S. interest rates to sharply lag those of many of its competitors. This is part of the reason that the U.S. dollar has declined almost 6.0% from its March high.
My View: I view this change in the interest rate differential between the U.S. and its G7 counterparts as temporary. Q1 U.S. GDP was heavily influenced by the port strike and unseasonably bad weather, and economists are looking for a bounce back in growth in the quarters ahead. This should lead the Fed to begin normalizing interest rates later this year, thus paving the way for a stronger U.S. dollar.
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