Euro about to be caught in the ECB and Fed’s crossfire

Over the next fortnight, global markets have a major battle on their hands, dealing with the consequences of two of the world’s leading central banks moving policy in opposite directions.

This Thursday, the European Central Bank should put monetary stimulus into overdrive. While in a fortnight’s time, US Federal Reserve policy will hit the brakes for the first time in a decade.

There will be casualties along the way. Whenever any policy backdrop looks muddled, markets feel unsettled. Global equities, bonds and currency markets are all likely to feel greater fall-out from conflicting policy crosswinds. 

The biggest changes will be felt in relative asset shifts. The effect of the ECB stepping into super-stimulus mode will favour European equity markets over the US. The Fed launching off into tighter policy will also spell the end of the road for the 35-year bull market for US bonds and sharpen the market’s appetite for safe haven German government debt.

With US interest rates heading higher, at the same time that euro zone rates are turning increasingly negative, sentiment towards the euro will be hit hard. And if the ECB hits the panic button on easing, it will quickly tip the euro below parity against the US dollar. The last time this happened the euro sank to a post-EMU low of 0.8230. There is a lot at stake.

The ECB have already hinted at more aggressive easing this week to bolster recovery prospects and stop the economy slipping into a worse deflation crisis. Talk has centred on the chances of another rate cut, plus staggered penalty charges on banks hoarding cash rather than lending. Meanwhile, more accelerated bond buying is expected under the ECB’s quantitative easing programme.

Markets can hardly be blamed for thinking there is more than a hint of desperation in the air – never a good omen for currency stability. If the ECB is intent on opening up the monetary accelerator to full throttle then the euro is in deep trouble.

With the Fed set to move US monetary policy onto a less accommodative footing in two week’s time, the euro has even more to worry about. The market is not only threatened by short term rate tightening risks, but also what happens longer term when the Fed begins to unwind its huge cache of QE assets, stockpiled over the last seven years. Now worth around $4.5 trillion, it is a huge load for the markets to re-absorb.

The Fed is desperately trying to get its message across about a ‘gentle’ process of policy normalisation ahead. But there is no safeguard for a market fretting about a future Fed funds rate possibly heading back over 1-2 per cent, with all the negative connotations for higher US Treasury yields, especially once the Fed’s ‘great unwind’ of QE assets begins in earnest.

The Fed believes it can soothe market expectations, but once perceptions for higher rates and yields are out of the bag, the bullish mood for bonds will quickly evaporate and the bear market will be back. Ten year US Treasury yields have already touched 3 per cent in the last two years, within easy reach of the current 2.25 per cent once market optimism breaks down.

Longer term, 10-year US bond yields returning back to pre-crisis levels over 5 per cent cannot be ruled out, especially if the Fed has its eye on hitting interest rate neutrality closer to 3-4 per cent, with a dramatically slimmed down balance sheet in its quest for monetary ‘normality’.

Rising US bond yields are great news for the dollar, but bad for the euro, especially with so much of the benchmark euro zone government curve already steeped in negative territory. With the 10-year German-US bond spread looking deeply unfavourable at minus 175 basis points right now, the euro looks set to suffer the consequences as investors switch to higher yielding markets.

The close market correlation between the two-year US-German bond spread and the euro suggests the euro/dollar exchange rate is positioned for a dive through parity very soon. Once parity breaks, the bears will swoop and the feeding frenzy will intensify.

Nothing is standing in the way. The Fed looks determined to hike rates and the ECB seems committed to raising the super-stimulus stakes. Official benign neglect towards the euro appears to be taking over.

It is a risky strategy, but the ECB is pinning its hopes on a much weaker euro to resurrect the recovery and rekindle inflation.

Britain’s boom is running on empty and ready to stall

Conspicuous success can sometimes be very superficial and fail close scrutiny. Outside observers could easily envy the UK’s economic record over recent years, boasting a blistering growth rate, plunging unemployment and a booming housing market. Britain was the fastest growing of the biggest developed economies last year, so it is hard to imagine much of a problem.

But Britain is sitting on a time-bomb. The economy looks in poor shape to deal with the onset of slower global growth. Recession risks are rising, deflation remains deeply embedded and Britain’s yawning trade and budget gaps leave little scope for possible policy antidotes.

Longer term, the picture looks unsettling. Two potential structural shocks lie in wait. The UK government is set on a collision course with Brussels over its EU membership, which could eventually lead to a damaging exit from Europe. Meanwhile, independence pressures are still bubbling up in Scotland. Both events could inflict cataclysmic future blows on the economy.

Credit rating agencies are watching from the sidelines and are not impressed. Britain’s highly-regarded international reputation and top-notch credit ratings are at stake. UK financial markets and the British pound have a lot to lose.

Having been the pin-up poster economy in recent years, the UK now looks vulnerable. The UK economy lost momentum in the third quarter with quarterly growth slowing to 0.5 per cent in the past three months, compared with 0.7 per cent in the previous quarter.

A sharp fall in Britain’s bellwether construction industry was the main culprit for the slowdown. But another tell-tale sign of trouble ahead was a 7.1 per cent slump in steel production in the third quarter. Even before the recent round of closures in the British steel industry, the slump in global steel demand has been a worrying trend.

It is a precursor to troubling times ahead for UK manufacturers. As a major trading nation Britain is already feeling the pinch of slower global growth, with the strong pound compounding the problem as dwindling export competitiveness continues to hit demand for UK goods and services.

Early signs of slowdown are starting to show up in the domestic economy. Despite the boom in UK house prices, British mortgage approvals fell in September for the first time in four months and retail sales growth is starting to soften with consumer confidence dampened by deepening uncertainty about the domestic and international outlook.

The trouble is that UK policy is firing on blanks right now. UK interest rates are already at zero per cent, while the government remains intent on balancing its budget books in the next few years. UK policymakers would be powerless to act in the event of a sudden downturn in the economy, without a major policy U-turn.

In the last two years, sterling’s value against a range of currencies has risen as much as 15 per cent, buoyed up by strong capital inflows, nearly the monetary equivalent of a 5 per cent rise in short term interest rates. The Bank of England has already achieved its wished-for monetary tightening by default. Its aim to hike rates soon simply piles extra pressure on the economy

Bigger risks lie ahead. If British Prime Minister David Cameron fails in his quest to secure a better EU membership deal for the UK, the country could be heading into a dangerous referendum on a possible exit from the single market. With recent opinion polls showing the nation split right down the middle on the matter, it could have devastating results.

It could spark a major flight of banks, businesses and foreign capital out of the country, losing a huge chunk of productive capacity from the British economy. It would also precipitate another independence push by Scotland, risking an extra 10 per cent lost from UK output. Britain could end up in deep depression, so it is no surprise the rating agencies are taking a downbeat view.

Market reports suggest currency traders are still extremely upbeat on the pound based on views that the BOE will stage an early rate hike next year. But markets have short memories and forget too easily that sterling is ‘banana-skin’ currency that is prone to major slip-ups.

Sterling bulls may be on the warpath right now, but a delay in the BOE’s plans to tighten policy in 2016 could trigger a dramatic reversal in sentiment.

Longer term, if Britain is heading into an economic backwater, confidence in the pound would be a major casualty.