Euro Short-Term Rate (ESTR) and Secured Overnight Financing Rate (SOFR) futures are pricing interest rate cuts of roughly similar magnitude and timing by the European Central Bank (ECB) and the Federal Reserve (Fed), respectively. Traders in both markets center their expectations on cuts beginning in Q2 2024, and totaling over 150 basis points (bps) by late 2025 (Figure 1).
Figure 1: Both SOFR and Euro ESTR futures pricing 150+ bps of cuts by ECB and Fed
In the U.S., expectations for lower rates are being fueled by a sharp decline in inflation, especially when excluding owners’ equivalent rent (Figure 2). European inflation has also been declining, but at a slower pace (Figure 3). When measured in a harmonized fashion, excluding owners’ equivalent rent, U.S. core inflation peaked in early 2022 and has since dropped from 7.3% to 2.1% year on year (YoY). This is a much steeper drop than in Europe, where inflation has been falling, but more gradually.
Figure 2: Outside of owners’ equivalent rent, U.S. CPI has already dropped to 2% YoY
Figure 3: Measured in a consistent fashion, inflation in U.S. has fallen faster than in Europe
While the inflation data would argue for more rapid Fed cuts to interest rates than ECB rate cuts, consumer spending data points in the opposite direction. In the U.S., inflation-adjusted retail sales continue to grow slowly. In Europe, inflation-adjusted retails sales peaked in 2021 and have been sliding since (Figure 4), which is emblematic of weakness throughout Europe’s economy, which is also reflected in manufacturing and other data.
Figure 4: Consumer spending is growing in the U.S. and shrinking in Europe in real terms
In addition to weaker economic data, ESTR futures traders may also be kept awake at night by memories of the eurozone debt crisis, which eventually prompted the ECB to lower rates below zero. In 2022 and 2023, the ECB undertook the biggest tightening cycle in its history, dwarfing rate hikes cycles in 1999-2000 and in 2005-2008. Moreover, it now has rates at their highest level since 2001, 25 bps higher than they were at their peak in 2008, which helped to trigger the 2009-2012 eurozone debt crisis (Figure 5).
Figure 5: The ECB has conducted its biggest tightening cycle ever and has rates at 2001 levels
Since 2008, neither the eurozone nor the U.S. has deleveraged their economies: total private and public sector debt remains close to 250% of GDP (Figure 6). However, there are key differences between the eurozone and U.S. debt markets. The U.S. Treasury is the sole sovereign issuer emitting debt into the U.S. dollar and the U.S. ultimately controls its central bank. The European Economic and Monetary Union, over which the ECB governs, has 20 national governments issuing debt into the same currency. As such, the eurozone debt market acts more like a municipal bond market, with individual issuers having their own credit rating and their own market-determined cost of credit.
Figure 6: Neither Europe nor the U.S. deleveraged after the global financial crisis
Thus far, spreads between eurozone sovereign bonds have been quite stable. But that doesn’t mean that they might stay that way in the face of durably higher financing costs. Since the 2009-2012 eurozone debt crisis, several countries including Ireland, Portugal, Spain and the Netherlands have deleveraged dramatically (Figure 7). The same is true for Greece, which defaulted in its debt in 2010 and has since staged an impressive economic recovery. Meanwhile, Italy, with high public sector and low private sector debt, has been close to the eurozone average (Figure 8). Finally, Germany and Austria maintain debt ratios that are far below the eurozone average (Figure 9).
Figure 7: Some countries within the eurozone has deleveraged
Figure 8: Greece is also deleveraging while Italy is close to the eurozone average
Figure 9: Austrian and German debt remains at lower than eurozone average levels
However, if some countries have deleveraged dramatically while the eurozone’s overall debt-to-GDP ratios have remained stable, it follows that someone must have leveraged up. So, who are they? The answer is Belgium, Finland and especially France (Figure 10). France’s debt ratios have soared over the past decade and are now among the highest in the world outside of Japan. Curiously, this has not weighed on French government debt, which is trading at typical spreads with respect to peer nations. As such, if ESTR investors are pricing nearly 200 bps of ECB rate cuts because they are concerned about the potential for a second round of debt-financing trouble in the eurozone, that message has not been passed on to investors in French OATs, or Treasury bonds (Figure 11).
Figure 10: Belgian, Finnish and especially French debt levels have soared.
Figure 11: French OATs still trade at yields 45-50bps lower than Spanish Bonos
French OATs have yields around 45-50 bps lower than Spanish Bonos at the 10Y point on the curve. One argument in favor of this pricing is that Spain may have greater sensitivity to the ECB’s hikes than France given the preponderance of floating rate mortgages in Spain versus fixed rate mortgages in France. That said, the fact that French debt totals 329% of GDP compared to 246% in Spain might make France more susceptible to financial problems, along with Spain and its other eurozone neighbors.
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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
