It May Be Too Late Already for the Fed-ECB Divergence Tradeby
Reluctant hawks vs reluctant doves makes for narrower divide
Strategists at UBS, Deutsche Bank questioning the split theme
The days of the divergence trade may be numbered.
With Janet Yellen and her Federal Reserve cohorts set to push the lift-off button in two days, financial markets may have already overshot in betting on a split in U.S. and euro-area monetary policies even as the European Central Bank extends stimulus, according to Deutsche Bank AG and UBS Group AG.
“What we have been highlighting is the pricing is very extreme,” Themos Fiotakis, co-head of rates and foreign-exchange research at UBS’s investment bank, said in a telephone interview. “The market is pricing a remarkable confidence in a full Fed tightening cycle and on the other hand recessional conditions in the euro-area.”
If UBS is right then the euro has found its bottom against the dollar after falling to as cheap as $1.0524 on Dec. 3, the lowest since April. Deutsche recommends investors sell 30-year German bunds and buy their U.S. equivalents, narrowing the spread in yields between the two assets.
The Fed’s ability to keep raising its benchmark is limited by weak inflation and the likelihood that the so-called neutral rate is lower than it once was. The ECB also can’t cut its deposit rate much deeper and some of its officials are already against buying bonds.
Meantime, both economies are improving at similar rates, albeit with the euro-area lagging. Deutsche predicts U.S. growth will slow next year to 2.1 percent from 2.4 percent while that the euro-area will accelerate to 1.6 percent from 1.5 percent, narrowing the gap between the jobless rates of the two economies.
Deutsche Bank strategist Francis Yared said although weaker oil and the ECB’s reluctance to stimulate more this month could lead the market to anticipate even easier policy in the euro area, the focus could turn next year to it withdrawing support.
If joblessness keeps falling at its current clip then it will be around 10 percent a year from now, about 3 percentage point over its pre-crisis level which was the same environment in which the Fed began pulling back stimulus, according to Yared. He also expects inflation outside of food and energy to be around 1.3 percent by the end of next year, not far from its pre-2008 average of 1.55 percent.
Meantime, the Fed’s pace of rate hikes could be limited if core inflation also stays tame because of past strength in the dollar and the slide in commodities, he said. Investors are already questioning the ability of the Fed to lift its benchmark above 3 percent and Yellen has pledged to act gradually.
“It’s not obvious to me you can have a lot more divergence from here,” said Yared. “I feel a little less comfortable saying that as the ECB did less and oil prices have gone down.”
Others are still wagering on division. Bank of America Corp. economist Michael Hanson has told clients that “policy divergence will remain a major theme for the upcoming year” and his colleague, Michael Hartnett, has highlighted how similar splits in 1937, 1987 and 1994 all presaged market crashes.
Still, Hanson said even if rates do head on different paths, policy makers are are still likely to keep their balance sheets at historically high levels. “Larger for longer is one place central banks will not diverge very much over the next few years,” he said.
The divergence trade may have sown the seeds of its own demise. As Fiortaki’s UBS colleague Daniel Waldman noted, anticipation of a Fed increase pushed up U.S. bond yields and the dollar, squeezing U.S. financial conditions. On the flip side, the euro area got a fillip from a decline in the euro and bund yields.
“To the extent that dollar strength against the euro is predicated on an aggressive Fed, strength eventually becomes self-defeating,” said Waldman. “The same thing holds in the other direction for the ECB.”