Here Comes the New Divergence as Central Banks Amend Hike Plans

  • Fed, BOE seen less likely to increase rates this year
  • Asia slowdown may spur faster easing in Europe and Japan

Zentner: Fed Will Have to Lower Growth Forecast

The divergence among global central banks that was supposed to drive financial markets in 2016 barely lasted a month.

Coming into the year, investors were figuring out how they would trade between two paths set on one side by monetary tightening from the Federal Reserve and, eventually, the Bank of England, and on the other by Bank of Japan and European Central Bank easing.

Now, those investors are rethinking that divide as the U.S. and U.K. economies succumb to signs of a worsening global slowdown, forcing their central banks to rethink the interest-rate outlook. Any split now will be led by how much euro-area and Japanese authorities press ahead with looser policy.

The reassessment following a volatile start to the year suggests a world economy still in need of synchronous and easy monetary policy if it is to escape the threats of low inflation and slowing Chinese demand. It also means a review of the trade that propelled the U.S. dollar higher.

“We’re having peak divergence,” said Torsten Slok, chief international economist at Deutsche Bank AG in New York.

Disinflationary Pressures

Behind the switch is the turmoil in equity and bond markets triggered by uncertainty over the direction of China’s economy at a time when sliding commodity prices are compounding the disinflationary pressures dogging all key economies. With the Fed last week saying it was “closely monitoring global economic and financial developments,” BOE Governor Mark Carney joined the chorus on Thursday by bemoaning an “unforgiving world” for derailing his inflation forecasts.

“Something has got to give,” said Michael Gapen, chief U.S. economist at Barclays Plc in New York. “You can’t have the combination of steady if unspectacular fundamentals and volatile markets for too long.”

In the U.S., Fed Chair Janet Yellen and her colleagues on the FOMC voted to raise the benchmark federal funds rate in December for the first time since 2006, leading the charge out of an unprecedented period of low interest rates and unconventional stimulus worldwide.

Shifting Positions

Markets have since shifted their view, rejecting the Fed’s December suggestion of four rate hikes this year and sending the dollar toward its worst week since 2009.

As for the Bank of England, a Morgan Stanley index based on market prices suggests no rate hike for 30 months. Societe Generale SA said yesterday it was no longer predicting any increase at all in the 0.5 percent benchmark in the current growth cycle, having previously predicted Carney would lift it to 2.5 percent.

For the Fed, traders have also pared bets that it will be able to increase rates even once in 2016, partly fueled by the central bank’s signalling that financial and economic volatility may be shifting the risks to their forecast. Fed Chair Janet Yellen can validate or temper those views when she testifies before Congress next week.

The January employment report, which showed payroll gains of 151,000 and a decline in the unemployment rate to 4.9 percent, almost an eight-year low, was supportive of the Fed’s forecast for continued labor market strength this year.

Yellen “has to recognize the troublesome markets and that it’s difficult to quantify their impact,” said Slok. “If inflation and employment deteriorate then she won’t hike.”

As the anchor of the global monetary system, a more hesitant Fed also throws the plans of others into disarray. Carney is signaling he won’t be moving toward an increase in the cost of borrowing quite as quickly as first thought. Colleague Ian McCafferty also shelved his call for higher rates this week to leave the bank’s Monetary Policy Committee unanimous for the first time since July.

As Carney pushed out his estimate of when U.K. inflation would return to target to 2018, investors dialed back bets on when the first rate hike will come. Market pricing even suggests a cut is more likely than a rise in 2016.

While Carney slows down on the path to higher rates, his counterpart at the ECB, Mario Draghi, is ready to pick up the pace of monetary easing. The 19-nation euro area’s jobless rate still languishes above 10 percent, while the U.K. and the U.S. edge closer to full employment. The European Commission cut its growth and inflation forecasts for the region this week and now sees 2016 price growth averaging just 0.5 percent.

With a review of current policy due in March, Draghi spoke on Thursday of “forces” in the global economy “conspiring to hold inflation down.” The ECB could push its deposit rate, currently at minus 0.30 percent, even lower, and add to the pace of asset purchases, now at 60 billion euros ($67 billion) a month. The Governing Council is set to decide on policy on March 10.

The Bank of Japan’s shock foray into negative rates on Jan. 29 sets the scene for further cuts this year, particularly after currency traders rebuffed the stimulus move, leaving the yen poised to make its biggest weekly advance in more than six years. BOJ chief Haruhiko Kuroda said on Feb. 3 that he may cut interest rates again.

Indeed, with the early movers in the tightening process taking a pause, accelerating stimulus plans elsewhere create a fresh set of impulses, according to Nariman Behravesh, Chief Economist at IHS Inc. in Lexington, Massachusetts.

“Say the Fed and the BOE do nothing, but you have the Bank of Japan in negative territory now and the ECB maybe even deeper into negative territory,” he said. “You have greater divergence there, but just not the type we thought we were going to have.”

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