Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the European Yield Curve
Transcript
- Lucas: Luna, the ten-year Treasury yield is at 4.44 today — down a bit over the past week. But I want to talk about a number that has nothing to do with the U.S. Treasury market directly, and everything to do with it indirectly. Luna: You're going to take us to Europe, aren't you? Lucas: I am. Specifically, the spread between German bunds and Italian BTPs. That spread has been widening for weeks, and it hit a level this morning that people at the Fed are definitely paying attention to. Luna: Okay, so remind me — when investors get nervous about Italian debt, they sell BTPs and buy bunds, the spread blows out, and the ECB has to decide whether to step in. Is that the dynamic? Lucas: Exactly. And the ECB has a tool for this — the Transmission Protection Instrument, TPI — which it created back in 2022 to buy bonds of countries whose borrowing costs spike for reasons that aren't justified by fundamentals. The problem is, TPI has never actually been used. Luna: So it's a backstop that's never been tested. And now we have the Bank of France governor telling CNBC this week that the ECB 'will do what is necessary.' That sounds like a warning. Lucas: It does. And the reason this matters for the Fed is simple: if the ECB has to activate TPI — or if it signals it's considering it — that's a major policy event. It would likely push the euro lower, which could strengthen the dollar and tighten U.S. financial conditions without the Fed doing anything. Luna: That's the spillover channel. A stronger dollar acts like a rate hike for the U.S. economy — it suppresses import prices but also squeezes multinational earnings. Lucas: Right. And the Fed's job just got harder if they have to factor in a tool that doesn't exist in their own toolkit. Chair Warsh is already dealing with sticky core inflation — the April PCE came in at 3.3 percent annualized, exactly as expected, but still above target. Luna: Meanwhile, the ten-year breakeven inflation rate is at 2.39 percent, essentially flat. That suggests bond markets believe the Fed has inflation somewhat anchored, even if the actual data isn't cooperating. Lucas: So you've got a situation where U.S. inflation is moderately sticky, the Fed is on hold at 3.64 percent, and the biggest risk to the path might come from a European sovereign debt scare that nobody in Washington controls. Luna: Let's dig into that spread. How wide are we talking? Lucas: The Italian-German ten-year spread is hovering around 190 basis points. That's not crisis-level — it was over 250 in 2022 — but the trajectory matters. It's been widening steadily for about six weeks. Luna: And the trigger? Is it purely inflation and ECB rate expectations, or is there a political angle? Lucas: Both. Italy's fiscal situation is under renewed scrutiny — their debt to gdp ratio is over 140 percent, and the government's budget plans for next year are raising eyebrows in Brussels. Meanwhile, the ECB is still hiking or at least signaling it might, which puts pressure on the most indebted members. Luna: So the classic 'good cop, bad cop' problem: the ECB wants to tighten to fight inflation, but tightening risks breaking something in the periphery. Lucas: Precisely. And the TPI is designed to be the safety valve — buy Italian bonds if the spread blows out without cause. But the 'without cause' part is where it gets subjective. Luna: If the spread is widening because markets are correctly pricing in higher Italian risk, then TPI shouldn't be used. But if it's contagion from something unrelated — say, a repricing of global risk premia — then the ECB might argue it's justified. Lucas: And that judgment call falls to the ECB Governing Council. Which, by the way, includes some hawks who are skeptical of TPI altogether. They see it as monetary financing by another name. Luna: Meanwhile, Fed officials are watching. Kashkari said this week that inflation fight takes priority because the labor market is 'in decent shape.' He didn't mention Europe, but you know it's on their radar. Lucas: Yeah, and Goolsbee said energy inflation has been more persistent than expected. So the domestic picture is already complicated. The last thing the FOMC needs is an external financial shock that tightens conditions unpredictably. Luna: Let's talk about what a TPI activation would actually look like. How would it work operationally? Lucas: The ECB would announce that it's activating the instrument, then it would buy Italian government bonds — probably in the secondary market — in amounts sufficient to cap the spread. They've said purchases would be 'targeted and proportionate,' but they haven't defined a specific spread threshold. Luna: So it's essentially a conditional QE program for a single country. That's politically explosive in Germany and the Netherlands. Lucas: Hugely explosive. The Bundestag has already signaled it would challenge any TPI use in court. So the ECB might hesitate to pull the trigger unless the situation is really dire. Luna: Which brings us back to the Fed. If the ECB hesitates and the spread keeps widening, you could see a flight to safety that pushes the dollar even higher. That would hurt U.S. exports and put downward pressure on inflation — potentially enough to give the Fed cover to cut. Lucas: But it could also destabilize European banks that hold a lot of Italian debt, which would have direct impacts on U.S. money market funds and derivative exposures. The interconnectedness is real. Luna: So the bottom line is: the Fed's next move might be decided not by CPI or payrolls, but by the spread between two European bond yields. Lucas: I think that's a fair reading of the moment. And honestly, it's one reason we spend so much time looking at cross-market data. Speaking of which — if you find this kind of analysis useful, a small group of listeners helps us keep making it. There's no ads, no sponsors — it's listener-supported through Buy Me a Coffee dot com slash fexingo. That's what keeps these daily episodes going. Luna: Yeah, and we really appreciate those who chip in. It makes a difference. Lucas: So going back to the spread — we'll be watching the ECB's June meeting closely. That's when we might get more clarity on whether they see the current widening as justified or not. Luna: And if they hint that TPI is on the table, expect the dollar to react in real time. Lucas: Exactly. So for now, the Fed is on hold, watching. But the action might be in Frankfurt, not Washington.