Key Takeaways
- The Federal Reserve and European Central Bank are adopting very different interest rate policies.
- Europe and the US have diverged on inflation, economic growth too.
- Fed’s task more complicated than the ECB as tariff data starts to show in official statistics.
With interest rates in the US more than double those in the eurozone, this monetary policy divide between the Federal Reserve and European Central Bank is likely to have significant implications for European stocks and bonds.
The divergence started last year: since June 2024 the ECB has cut rates eight times and halved rates to 2%, while the Fed has reduced the federal-funds rate three times to a target rate of 4.25%-4.5%,from a target rate of 5.25%-5.5%.
This divergence could be a positive for European stocks and bonds, analysts say. Historically, an environment of low European rates and higher US rates attracts foreign investors into US stocks and bonds in search of higher yield, pushing the dollar higher. But with confidence weakening in the US’ status as a safe haven, the dollar could continue to fall, economists say, giving European investors a reason to invest their money closer to home.
“The interest rate differential between the US and Europe is now material, with the federal-funds rate more than twice the level of that of the deposit rate in Europe. This, combined with low inflation and a slowly improving economic growth rate [in the eurozone] are painting a supportive picture for European equities,” says Michael Field, chief European markets strategist at Morningstar.
Why Are the ECB and Fed on Different Paths?
The source of the divergence is the starkly different economic pictures in Europe and the United States, with the euro area contending with both lower inflation and slower growth.
“The job for the ECB this year has been straightforward. Ongoing disinflation coupled with a deterioration in the growth outlook mainly due to the US trade tariffs and the uncertainty around them, created the space for the ECB to ease policy,” says Michael Diamantopoulos, associate director of fixed income and currency at Morningstar.
“The rather unexpected strength of the euro following the tariff announcements removed any hesitations among the members of the ECB governing council,” he adds.
In the eurozone, preliminary inflation for July remained at a stable 2%, in line with the ECB’s target. This was enough to rule out the possibility of an interest rate cut in September. Meanwhile in the US, disinflation has stalled: In July, the Consumer Price Index rose by 2.7% year over year, above the Fed’s target.
The task of the Fed is far more complicated, Diamantopoulos says, because disinflation momentum has stalled recently, and both labor demand and supply have been slowing. Moreover, the inflationary impact of the trade tariffs on domestic prices has only started to become visible in the most recent price data.
“The message from Fed Chair Jerome Powell is that it is the Fed’s job to ensure that the impact on prices will be a one-off phenomenon,” he adds. “This implies that the Fed will not rush into easing policy; it will rather ‘buy time’ for more data. And more clarity.”
What the US-EU Rate Divergence Means for Bond Investors
In the bond market, the divergence between the ECB and the Federal Reserve means that US government bond yields are higher than those of German government bonds, or bunds, which are the benchmark for the eurozone.
The 10-year bund yields around 2.70% and US Treasuries around 4.26%. Outside the eurozone, UK 10-year gilts offer relatively high yields of 4.63%, with UK interest rates now at 4%.
Historically, government bonds with higher yields have attracted investor inflows, pushing up bond prices and boosting returns. The US dollar’s status as the world’s “reserve currency” has also pushed global investors into Treasuries.
As well as carrying inflation risk, some portfolio managers say that US debt has started to carry political risk too, making euro-denominated bonds more attractive to investors.
Italy’s Eurizon Asset Management, in its end of July investment report, voiced a preference for the eurozone over the US in fixed income. The multi-asset team of fund manager Schroders, in a note on Aug. 4, maintained a neutral view on US government bonds and continued to favor German bunds over US Treasuries: “We are seeking opportunities outside the US, where inflationary pressures are more contained.”
Morningstar’s Diamantopoulos still favors UK gilts and to a lesser extent, US Treasuries. “In our view, they offer the highest expected returns over our long investment horizon.”
US Treasuries and UK gilts offer higher returns to compensate for the increased level of economic and geopolitical risk they carry, he says. UK inflation, for example, is expected to hit 4% next month, double the official target.
Why Interest Rate Divergence Is Supportive for European Stocks
While attractive yields and a lower risk profile push investors toward European fixed income, the divergence between ECB and Fed rate policy could also be supportive of European stocks.
Consumer stocks in particular are ones to watch, according to Morningstar’s Field, as borrowing becomes cheaper. “Consumers have been struggling with high levels of inflation for some time, combined with high levels of interest rates pushing up the costs of home ownership.”
“Interest rates have fallen heavily in Europe over the last year or so, the relief of which should be slowly filtering down to consumers’ wallets, allowing them to increase spending in 2025 and beyond.” he says.
The downturn in consumer spending over the past few years has hit stocks like Gucci owner Kering KER, drinks giant Diageo DGE and household goods group Reckitt Benckiser RKT hard. “So, a pickup here would most certainly boost stock prices,” Field adds.
A Weakening Dollar, Interest Rates and Returns
Investors also need to be aware of the link between relative interest rates and exchange rates, which can have an impact on investment returns. Usually higher interest rates and a stronger currency go hand in hand, but that link has been broken this year for the US dollar.
Despite higher US interest rates in the period, since President Donald Trump’s inauguration, the US dollar index measuring its value against a basket of US trade partner currencies fell by around 10%.
In a recent article, How Low Can the Dollar Go?, we looked at the recent declines in a historical context and what that means for the US’s safe-haven status and asset class returns.
Hong Cheng, Morningstar’s head of fixed income and currency research, forecast further declines in the value of the US dollar against other major currencies. “In the near term, we believe the dollar may face continued headwinds due to a moderation in US economic growth and the relative shift toward more growth-supportive fiscal and monetary policies abroad,” she says.
If the dollar continues to weaken, European investors owning US Treasuries and stocks will be negatively impacted because a rise in the euro will erode the value of overseas investment gains when converted back.
