[Reuters Analysis] Investors bet on sharpest U.S.-Europe inflation divergence since 2022

• U.S. inflation expected to outpace euro zone on higher growth, tariffs
• European energy prices drop on potential Ukraine peace deal
• U.S. bond yields fall despite inflation concerns as investors eye tepid data

By Harry Robertson

LONDON, Feb 27 (Reuters) - Traders who bet on the future course of inflation foresee the sharpest divergence for three years between the U.S. and euro zone, driven by different growth paths, tariff threats and cheaper European energy after a potential Ukraine peace deal.

That gap is not fully reflected in U.S. and euro zone bond yields, however, as investors are eyeing other factors including recent tepid U.S. economic data and expectations that European countries might need to spend more on defence.

Inflation swap markets late last week pointed to U.S. consumer price index (CPI) inflation running at about 2.8% over the next two years, with euro zone inflation swaps at around 1.9%. That would mark a small fall from a current U.S. CPI rate of 3% and a sharper one from euro zone inflation of 2.5%.

Pricing for both has fallen slightly since, but the gap between the two remains at its widest since early 2022.

Yields on U.S. Treasury bonds have nevertheless fallen compared to those in Europe in recent weeks as some weaker-than-expected data releases have sown doubts about growth, even as sticky inflation remains a concern.

"I think it's really, really hard to trade cross-markets when you have different drivers affecting the different markets," said Guillermo Felices, principal and global investment strategist at PGIM Fixed Income.

STARK DIVIDE

Inflation swaps are derivatives that allow parties to increase or reduce their exposure to inflation.

Many in the market - from speculative traders to companies needing to hedge - expect U.S. President Donald Trump's planned trade tariffs to push up prices in the United States but hit European growth, dampening inflation pressures there.

"Tariffs... are a one-off shock to the price level," said Blerina Uruci, chief U.S. economist in the fixed income division at T. Rowe Price.

"What's different now is we have lived in a high-inflation environment, and businesses have discovered they have pricing power (so) what could be a one-off shock to the price level could have more room to run."

Growth differentials are another factor. The U.S. economy has expanded about 12% since just before the pandemic, while the 20-country euro zone has grown 5%.

Trump's other major transatlantic policy focus, negotiating with Russia an end to the war in Ukraine, has startled European capitals but caused energy prices to drop. European natural gas prices - a key driver of euro zone inflation - have fallen 30% since mid-February TRNLTTFMc1.

"That is definitely pushing down on front-end inflation swaps," said PGIM's Felices. "So you're getting this unusual divergence between the U.S. and Europe."

VOLATILE MARKETS

Differences in inflation pricing would usually be expected to lead U.S. bond yields higher compared to Europe.

But the focus of investors recently has been on slowing U.S. growth even amid sticky inflation, highlighted by this week's slump in a key consumer confidence gauge.

The likelihood that European governments will need to borrow more - perhaps jointly - to fund higher defence spending demanded by Trump is another new factor to consider.

The gap between U.S. and German 10-year bond yields US10DE10YT=RR fell to its lowest since November on Tuesday at 182 basis points (bps) - down from a five-year high of 231 bps in December.

Traders now expect about 55 bps of Federal Reserve rate cuts this year, after previously expecting just one 25 bp reduction. Pricing for the European Central Bank has changed less, with 85 bps of cuts anticipated.

Some investors are sticking with the view that U.S. economic strength will keep borrowing costs there high.

"The Fed has been very clear in saying they are still in restrictive territory, but they are happy to stay here if growth still remains," said Ales Koutny, head of international rates at Vanguard. "That limits how much bonds can rally."

Lower returns have reduced the attractiveness of U.S. bonds and weighed on the dollar, helping the euro EUR=EBS rise to $1.05 from a more than two-year low of $1.01 last month.

Samuel Zief, head of global FX strategy at JPMorgan Private Bank, said he's wary of betting on a sustained rally in the common currency, however.

"We think the uncertainty from trade and those headwinds are the real thing that need to be cleared before you can turn more cyclically bullish on the euro zone," he said.

Felices at PGIM takes solace from the fact inflation expectations are not too far away from 2%, especially given the Fed targets the personal consumption expenditures index, which tends to be lower than CPI.

"That these numbers are still pretty consistent with inflation targets is very reassuring," he said.

Markets see much more U.S. than European inflation https://reut.rs/4i8HgK2

The U.S. economy has far outstripped the euro zone and Germany https://reut.rs/4bjVEgh