European government borrowing costs rose sharply Thursday as investors dumped bonds amid a robust outlook for the region's economy and subsequently snuffed out a record-setting global stock rally.
The moves are a reminder to U.S equity investors that one of the most important drivers for near-term market sentiment likely won't come from the Federal Reserve or U.S. tax reform, but rather the pace of economic growth in the eurozone and the subsequent reaction from the European Central Bank.
Thursday's five basis point increase in German government bond yields lifted the benchmark for European risk-free rates to around 0.38% and set of a cascade of rate increases around the currency area. It also trimmed 1.53% from the DAX performance index, its second-largest decline of the year and the biggest since late June, and dragged Wall Street into notable losses.
Curiously, the moves came amid a ringing endorsement for the eurozone economy from the European Commission, which said collective GDP growth for the 19 countries that use the single currency should expand at a 2.2% clip this year -- well ahead of its Spring estimate of 1.7% -- and 2.1% in 2018. The region's executive branch also said it expects to see France and Spain to cut budgets deficits deeply enough to align with EU rules and sees Italy's debt-to-GDP ratio peaking at 132.1% this year.
The market reaction in bunds, however, may be more linked to how the ECB is likely to reaction to improving economic conditions, especially -- actually, almost exclusively -- if they translate into faster inflation.
The Commission was largely sanguine on the latter, suggesting currency area prices will only rise by 1.6% in 2019, a figure that sits well shy of the ECB's "just below 2%" definition for price stability.
"Core inflation, which excludes energy and unprocessed food prices, by contrast, has been rising but remains subdued, reflecting the impact of a prolonged period of low inflation, weak wage growth as well as remaining labour market slack," the Commission said.
This reading, however, and the ECB's single inflation mandate, will likely dictate its broader reaction function next year, even with higher energy prices, and hold down yields for eurozone government bonds as the Bank continues to purchase E30 billion each month as part of its quantitative easing program and reinvest maturing debt in order to maintain market stability.
The Bank also has myriad lending and liquidity schemes in place that virtually lock it in to near-zero rates until at least the end of 2019. That offers a powerful support mechanism for European equities.
In fact, short of saying "buy stocks," ECB President Mario Draghi's insistence earlier this week that the Bank's efforts to stoke currency area inflation through quantitative easing, near-zero interest rates and ample financial sector liquidity are working as intended suggests no early pullback on the stimulus from Frankfurt.
That, coupled with solid quarterly earnings growth and a robust, low-inflation recovery should paint a compelling picture for European stocks in the final months of the year.
"At euro area level, we currently see no signs of credit-fuelled housing bubbles, which are at the root of most serious financial crises," Draghi told an audience of bankers and financial professionals in Frankfurt Monday.
"We have also seen little evidence that negative interest rates are undermining bank profitability, an issue which has caused a lot of concern," he added. "This would pose a financial stability risk to the extent that it hinders banks from building up capital through retained earnings and makes raising market equity too expensive. It would also affect monetary transmission for the same reasons."
Earnings from companies listed on the Stoxx 600, the region's broadest benchmark, are likely to rise 3.5% from the same period last year, according to data from Thomson Reuters I/B/E/S, while revenues will advance by a collective 3.6%.
Interestingly, while financial sector earnings will have the weakest sector growth rate (-6.9%) compared to the third quarter of 2016, the full-year figure is expected to rise 28.7% to around €138.8 billion as the comparable impact of negative interest rates and flat government bond curves rolls off the sector's bottom line.
In short, Thursday's "head fake" of softer equities set against rising bond yields isn't likely to last. The larger and more permanent move, when it comes, will instead be linked to a sustainable acceleration in currency area inflation and the corresponding ECB stimulus pullback. And that may take some time.
