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US & Europe: monetary divergence or convergence?


It comes as the eurozone is growing at its fastest pace since 2011, finally picking up the slack left by the financial crisis. This has prompted many investors to predict a period of convergence, not divergence between the US and Europe. This has been reflected in the appreciation of the euro versus the dollar this year.

David Zahn, head of European fixed income at Franklin Templeton, urged the European Central Bank (ECB) last month to “reconsider its approach to QE, not least because of the increasing similarities between the trajectories of the eurozone and the US.” Inflation, growth and even employment trends are “strikingly similar” in both economies, he contended.

In recent weeks, the dollar has gained ground again on the back of above-trend expansion of the US economy, a hawkish Fed and renewed expectations of US tax reform. But is this enough to turn the tide?

Turnill thinks so. “Markets are pricing in less than two 0.25% rate increases by the U.S. Fed through the end of 2018, and a modest rise in European Central Bank (ECB) rates during the same period (see graph below). We believe the former is too low and the latter not likely,” he says.

“Our new BlackRock Inflation GPS suggests U.S. core inflation will rise back toward 2%, giving the Fed comfort in raising rates up to four times by the end of 2018. Inflation in the eurozone, however, is likely to remain well below the ECB’s target over the next 12 months, making an ECB rate increase unlikely,” he adds. “We do see the central bank trimming its bond purchases, as it reaches the self-imposed limits of its bond-buying program, but the adjustment may happen at a slower clip than market participants currently expect.”

Divergence implications

A renewed divergence in monetary policy divergence between the US and Europe would push US Treasury yields up further, says Turnill, “with any U.S. tax cuts fueling further rises.” It would also bring the period of dollar weakness to a premature end.

This is not, however, the base case scenario of most investors. Aviva Investors, for example, continues to believe the ECB will follow through with monetary tightening.

“Above-trend growth should continue [in the eurozone] in the rest of this year and next, although a slight moderation is to be expected. We expect tapering of asset purchases soon, and modest rate hikes to follow in the second half of next year,” the asset manager says in its outlook for Q4 2017 which was published this Thursday.

Irrational exuberance?

If Turnill turns out to be right, this may present investors with short-term opportunities. But the Fed will only hike rates faster if the economy and inflation continue to accelerate. And this will increase the odds for a policy mistake to happen, and for a boom-bust scenario to materialise.

The previous time an episode of exuberant, above-trend economic growth coincided with a hawkish Fed, a recession followed. Add the incompetence and capriciousness of the Trump administration to the mix, and there is little reason to think it would be different this time.

Part of the Mark Allen Group.