Decoupling time may be near
The US economy is still surprising us with its resilience to bad news, and its redoubtable capacity to grow. At the start of the year a reasonably consensus forecast for US economic GDP growth in the first quarter was less than half a percentage point. This has been now revised up to around 4.5 to 5%. At the March FOMC meeting the Federal Reserve moved the monetary stance to neutral, changing its 15-month old view that weak growth is the biggest threat to the US economy.
And the rest of the world – where the US leads so they follow? As far as Europe is concerned, there is still debate about how far behind the European economies are compared to the US and consequently how long it will be before the ECB raises rates. Some suggest that conditions may be ripe to allow a decoupling of the close trading relationship seen between US and Euroland government bonds.
Metzler Asset Management’s Nader Purschaker in Frankfurt thinks that there is relatively little scope for the ECB to be too far behind the Fed when it comes to tightening monetary policy: “The signs of a cyclical recovery in Euroland are becoming stronger with leading indicators and sentiment pointing to improving growth dynamics. We still see scope for positive growth surprises because the rate cuts of last summer are slowly having a positive impact on the economy and also because exports will gain strongly from the synchronised global recovery.”
For others, the recent rise in the oil price could be another reason to believe that the two central banks will not be acting too differently. “Paradoxically, the rise in the oil price is more likely to be interpreted by the Fed as a recessionary factor rather than an inflationary one,” argues Roland Lescure of CDC Ixis Asset Management in Paris. “We were expecting the Fed’s first hike to come in May, but this might be delayed until June if the current situation (high oil price, weak stock market) prevails. To the ECB, on the other hand, the rise in the oil price is first and foremost, inflationary.”
Lescure agrees that as European interest rates are already higher than those of the US, the ECB will probably refrain from raising rates until after the summer, but believes that this will not be enough to significantly widen the US-euro long-term yield spread. “It might (widen) a bit,” he suggests, and adds: “But despite better growth prospects, that differential has been difficult to widen because of the bad inflation figures in Europe. We have a 40-50 basis points US-Bund spread in mind, against today’s 10-20 basis point difference.”
“Decoupling is certainly an issue we are debating at the moment,” comments Ronan O’Donoghue director of Fixed Income at Bank of Ireland Asset Management in Dublin. “But we think it will be quite hard for that to happen. We are overweight in Europe, but only neutral in the US in terms of duration. The European economy is not nearly as strong as the US and the ECB has much less to do. The back up in yields so far this year has been less in Europe than in the US, and we think this has been appropriate.”
Year-to-date there has been significant flattening of yield curves on both sides of the Atlantic as growth forecasts have been upgraded and interest rate hikes discounted. “Of late, some of this flattening has been unwound as investors have re-appraised the degree of interest rate hikes,” states O’Donoghue. “We think that the flattening trend will be restored. As to whether this is a bullish trend with the longer yields falling depends on us getting more evidence that the momentum of the economic rebound is running out of steam. We would also need to see more positive data on the CPI in Europe.”
The managers at both Metzler and CDC Ixis Asset Management view the oil price as a significant risk to the otherwise reasonably benign scenarios. “Headline inflation will be on a downtrend until summer, at least as indicated by producer prices. However, recent developments in oil and commodities are both risk factors that we will be watching,” cautions Purschaker. And CDC’s Lescure agrees, “If the oil price remains high, inflation will remain stubbornly above the ECB’s 2% ceiling, continuing its pattern of the last two years of course.”