Bond markets’ attention is likely to shift from the Federal Reserve to the European Central Bank. Two important data releases, the ECB banking survey and the Eurozone manufacturing purchasing managers’ index, underscore the likelihood of a significant tightening of ECB monetary policy during the months ahead. European bond yields rose by about 4 bps and the Euro broke its week-long decline against the dollar in response.

eurozone PMI
Source: Bloomberg

The debate at the US central bank focuses on minor tweaks in monetary policy: inflation remains stubbornly below Federal Reserve expectations, and the question is whether the hoary Phillips Curve model linking employment to inflation is partly or completely broken. The difference between “hawks” and “doves” is a matter of a quarter-point tightening or two. Europe, on the other hand, clearly is broken: The continent cannot live with negative short-term deposit rates and short-term bond yields for long without bankrupting its pension system.

Negative interest rates are a transfer from savers to borrowers, dictated politically by the European Central Bank at the peak of the Euro crisis in the first part of this decade. That political agreement is coming unstuck. The two major German parties, the Christian Democrats and Social Democrats, lost ground to small parties opposed to the present policy. One of these, the Alternative for Germany, remains outside the mainstream, orbiting the Christian Democrats like a remote moon whose gravitational pull gradually shifts the orbit to the right. The other, the Free Democrats, almost certainly will gain the Finance Ministry in the new governing coalition, and will press for higher ECB interest rates and less accommodation for the deadbeats of the southern tier.

Germany’s new coalition won’t be in office until year-end, and the first public intimations of a change in German policy won’t appear until early in 2018. With the Eurozone showing a remarkable degree of economic strength, though, investors may anticipate a tightening and sell European bonds. European bond yields led US yields upward this morning, and we are likely to see more days like this over the next several months.