The recent market turbulence has seen the US money market curve price no hikes this year, and a fair probability of a rate cut next year, whereas our expectation is that the Fed’s tightening cycle still has further to run.
Meanwhile, although European bond markets have also rallied, the ECB and the Bank of England are still priced to hike their policy rates over the next few years. This confluence of pricing cuts in the US and hikes in Europe is unusual, and has not happened since the run up to the 2008 crisis. We think it is unlikely to be delivered, because the importance of the US to the global economy, and to global financial conditions, means that it is difficult for other major economies to tighten policy, when conditions in the US are weak enough to warrant easing.
One way of seeing this is to look at how much tightening was priced for the Fed, when other major developed market central banks started their hiking cycles over the past few decades. This is seen in the chart below, which shows US monetary policy expectations at the start of hiking cycles by the ECB, Bank of England, Bank of Canada and Reserve Bank of Australia since 1994. Of the 24 hiking cycles shown below, there were only three instances when the central bank hiked without at least one hike priced for the Fed. Each of these episodes was in the lead into the financial crisis, which the US money market curve was by that time anticipating. The Bank of England and Reserve Bank of Australia, which started tightening in 2006, did manage a series of hikes before the crisis struck, whereas the Bank of Canada, which started tightening in 2007, had to reverse course quickly.
Another way of showing this is to look at US growth forecasts, at the start of these same developed market central bank hiking cycles. Again, there have only been two instances when other major DM central banks hiked, when US 1-year-ahead growth forecasts- currently around 2.5% – were below 2%. Of these two instances, the ECB in 2008 had to reverse course almost straight away, while the RBA in 2009 was the exception that proves the rule, and did manage a series of hikes.
The upward-sloping money market curve in the Eurozone is in some sense mechanical. The ECB’s current policy rate of -0.4% is perceived to be around the effective lower bound, and if further easing is off the table, the market is obliged to price a skew towards higher policy rates. Also, negative rates represent emergency policy in what are no longer emergency conditions, and the change in ECB leadership later this year could prompt a change in the policy stance.
Against that, very little in the current Eurozone data flow argues for tighter policy. Granted, the labour market has shown strength, with unemployment still falling to the lowest in a decade, and wages rising solidly. But Eurozone growth has been weakening steadily for a year, and underlying inflation is showing little or no upward momentum.
For the UK, Brexit remains the key swing factor for both the economy and monetary policy. If Brexit uncertainty abates materially in the next few months, then unemployment at the lowest rate since the 1970s and rising wages point to further rate hikes from the Bank of England. But this too would require a supportive global environment – if the Fed is knocked off course, other central banks will be too.