If there is one big idea running markets around the world at the moment, it’s the ‘great policy divergence’. I’ve articulated the idea more than once: just last month I suggested it would take a “brave, brave soul to bet against the dollar”.
“Whenever you find yourself on the side of the majority, it is time to reform (or pause and reflect),” wrote Mark Twain. As it never hurts to take advice from Mark Twain, here is a moment of pause and reflection on the great policy divergence idea.
Let’s start by asking why people talk about policy ‘diverging’. They see the Federal Reserve floating the idea of ‘tapering’ QE in 2013 and following-through during 2014. By now, attention has turned to the timing of its first rate hikes. In short, people have associated the word ‘tightening’ with the Fed for a year and a half.
When they look at Japan they see a central bank expanding its balance sheet, desperate to generate inflation. From the ECB they see negative deposit rates and an asset-purchase programme increasingly likely to include government bonds. This, unambiguously, is ‘loosening’.
But hold on. If I see a shiny new car appear in my neighbour’s driveway, and then resolve to trade in my old banger for a similarly shiny new model, in what sense am I ‘diverging’ from my neighbour?
The size of the Fed’s balance sheet now stands at about 25% of US GDP, after years of expansion. Until recently, however, the ECB had allowed its balance sheet to shrink for three years, by 10 percentage points, to about 20% of GDP. If anything, these were the years of policy divergence, when Mario Draghi was content with his old jalopy and Ben Bernanke revved up his shiny new speedster in the drive next door.
Add the fiscal shifts in the euro-zone – the little revolutions happening in France and Italy, the rise of Podemos in Spain, the softer tone we might expect from Germany as its export engine starts to run on empty, the €315bn investment plan touted by Jean-Claude Juncker – not to mention the oil price collapse removing the inflationary pressure on the Fed to hike early next year, and the convergence story looks even more solid.
Then this becomes a question of how effective we think euro-zone loosening will be. The knee-jerk response of selling Eurodollar (and all of its analogue trades in other asset classes) makes sense only if we assume that Europe is about to trash its currency and its budgets in an effort doomed to fail. Should Europe’s economic performance converge on the US’s as its fiscal and monetary policies are doing, why shouldn’t the euro arrest its fall, European equities retrace their underperformance, and German Bunds close that record-breaking spread against US Treasuries?
Maybe it’s time to get brave, to overcome the gloom about all things European. Maybe it’s time to diverge a little?