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.