US and European interest rate trends may diverge! Citadel Securities: Energy shocks and high interest rates may increase downward pressure on the European economy

According to Zhitong Finance APP, Citadel Securities believes that while energy price shocks and the European Central Bank’s tightening of monetary policy have continuously driven up European bond yields, these two forces may eventually also become factors limiting further yield increases. The reason is that high energy costs and high interest rates will place greater pressure on Europe’s economic growth, and as investors become increasingly concerned about economic slowdown or even stagflation risks, the potential for a continued sharp rise in European interest rates may be limited.

Last week, during a global bond market sell-off, bonds in Europe and the UK were particularly hard hit. The European Central Bank, citing rising inflation risks, raised interest rates again, further lifting expectations for subsequent tightening. Meanwhile, due to Europe’s heavy reliance on imported energy, the surge in energy prices caused by the Iran war led investors to bet that the ECB may need to hike rates further to curb inflation.

However, Nohshad Shah, Head of Fixed Income Sales for Europe, the Middle East, and Africa at Citadel Securities, believes the market may be underestimating the negative impact that the energy shock and tightening monetary policy will have on Europe’s economic growth, and that this growth pressure could ultimately serve to cap the rise in rates.

Shah stated: "As the consequences of tightening policy and energy shocks for economic growth become a growing focus for investors, I am increasingly skeptical about whether forward rates in the midsection of the European yield curve can continue to rise."

Differentiated Economic Resilience Between Europe and the US; More Upside Potential for US Treasury Yields

Compared with Europe, Citadel Securities believes the US economy has a stronger capacity to withstand high energy prices and high interest rates, and therefore there remains more upside room for US rates.

Although rising energy costs and inflation fears have also driven up US Treasury yields, the US, with its large oil and gas industry, is less sensitive to the increase in imported energy prices than Europe. At the same time, the ongoing wave of artificial intelligence investments is providing additional support to the US economy, enabling it to withstand higher interest rates for a longer period.

Shah noted that the US has “greater capacity than Europe to absorb high interest rates,” while Europe is facing a more prominent risk of stagflation.

This divergence in economic fundamentals is likely to be reflected in the trends of US and European rate markets. Shah believes that as growth pressures become more evident, Europe’s medium-term forward rates may fall relative to the US. In other words, even though both European and US bonds have recently been affected by energy shocks and inflation concerns, future yield trends in the two regions may gradually diverge.

For Europe, rising energy prices will not only fuel inflation, but also increase costs for businesses and households, weaken real purchasing power, and drag down economic activity. Meanwhile, further rate hikes from the European Central Bank to control inflation will push financing costs higher, exerting additional downward pressure on demand. This means the ECB faces a more pronounced policy dilemma: continued tightening helps curb inflation but risks further undermining economic growth.

Therefore, factors that have recently driven up European bond yields may in the future also become forces that constrain yields. Once market focus shifts from “inflation forcing central banks to raise rates” to “high interest rates and energy shocks dragging on the economy,” expectations for further ECB rate hikes may cool.

The Iran War Remains the Biggest Wildcard; US Inflation Risks Cannot Be Ignored

However, Shah also warned that the US is not immune to energy shocks. The risks arising from oil price shocks remain high as the Iran war persists.

He believes that with US midterm elections approaching, Tehran may have more motivation to escalate the conflict, including targeting commercial shipping and energy infrastructure in the Middle East. If the conflict further escalates, the global supply of oil and gas may face more severe disruptions, and energy prices could keep rising, further intensifying US inflationary pressure. Citadel Securities’ view on the US and European bond markets is not that European inflation risks have faded, but rather that Europe’s economy is less able to withstand an environment of both energy shocks and high interest rates. The US, by contrast, has greater policy and growth buffer thanks to its domestic energy sector and the economic support provided by the AI investment boom.

This also means that after the recent round of global bond sell-offs, US and European rate trends may gradually diverge: European yields may be further constrained by weak economic growth and stagflation risks, while, if the US economy continues to show resilience and energy prices remain high, US Treasury yields could face more sustained upward pressure.