Federal Reserve and ECB: the great divide

Market Update, Multi Asset 6/15/2018
Reading time: 3 minute(s)
image

(1)    As widely expected, the U.S. Federal Reserve’s rate-setting body FOMC has hiked the federal funds rate by another 25 basis points and emphasized its confidence regarding the strength of the U.S. economy.

(2)    Also as expected, the European Central Bank will stop its liquidity injections by year-end, but its pledge to keep rates unchanged (at extremely low levels) until the end of summer 2019 – a consequence of downside risks for the European Monetary Union – surprised markets.

(3)    This divide between the Fed and the ECB should support the U.S. dollar.

Fed will normalize monetary policy faster on stronger economy

The FOMC’s recent assessment of the economic is more upbeat than in May. Economic growth is both solid and sustained (instead of moderate) and unemployment has declined further. Its forecasts for GDP growth, unemployment and inflation for the entire year of 2018, however, are only marginally above those from March. After the two rate hikes in March and June, the FOMC members (on average) now consider two further rate increases in 2018 appropriate, bringing the total number of rate hikes in 2018 to four instead of three. For 2019, the FOMC sees two more rate hike and for 2020 just one (see chart 1).

Chart 1: U.S. central bank increases its own interest rate forecasts for 2018

 

Source: U.S. Federal Reserve, Vontobel

We also change our forecast and now see a total of four instead of only three rate hikes in the current year. The U.S. economy continues to be strong (May retail sales grew by 5.9 percent year-on-year) and the FOMC is confident that this economic momentum will be maintained going forward. The ongoing trade conflicts hurt the U.S. considerably less than the rest of the world. Moreover, an expansive fiscal policy on top of an economy running at capacity should provide an additional boost.

ECB: One step ahead but two steps back

The ECB’s announcement to stop its “quantitative easing” (QE) program at the end of the year was in line with expectations. To get there, the central bank will cut monthly bond purchases from 30 billion to 15 billion euros over the fourth quarter of 2018. However, Mario Draghi’s clear forward guidance that rates will not be hiked before the end of summer 2019 came as a surprise. For now, we see the ECB’s move as a clever way to stop QE while simultaneously maintaining a very accommodative monetary policy for longer than markets expected. Yet Draghi’s commitment to very low rates for longer may backfire if risks such as trade tensions and subdued inflation don’t materialize in the euro zone. In such a case, the ECB might find itself behind the curve.

What impact on markets?

The divergence between a self-confident Fed and a cautious ECB reflects a divergence in economic performance between the U.S. and, broadly speaking, the rest of the world. On the one hand, the U.S. economy is boosted by a massive fiscal stimulus while the euro zone is slowing down somewhat. This is due to the lagged impact of a stronger euro and higher oil prices. In addition, any worsening of trade relations would clearly hurt the euro zone more than the U.S. Likewise, Europe faces political risks such as Brexit in the UK, a populist government in Italy or the migration crisis. The ECB’s action will continue to put a cap on Bund yields, which is supportive for equity and corporate bond markets, everything else being equal. As the yield difference between the yield of U.S. Treasuries and German Bunds has already reached record levels (250 basis points for 10 year maturities), long-dated Treasury yields should remain anchored. This removes the risk of an unorderly upward move, at least for now. However, the increased pressure resulting from this great divide between the Fed and the ECB should result in further U.S. dollar strength.