FED and ECB’s monetary policy has shifted a lot

>> Monetary easing cycle is slowly kicking into gear

On the surface this seems strange; surely the US dollar deserves to be much higher. But scratch below the surface and it all seems to make sense.

The reason it makes sense is that although the narrative surrounding euro/US dollar has been squarely focussed on this policy-rate ‘divergence’, market pricing of central bank policy and even bond yields have not really diverged at all. For instance, the number of Fed rate cuts priced into the curve this year has fallen from five or six to barely one. But over the same period the number of ECB rate cuts priced into the curve has fallen sharply as well; from around five to two.

So, although the Fed rate-cut curve has moved by more than the implied ECB curve, the difference has hardly been huge; certainly not enough to cause any ructions in euro/US dollar. It is the same when it comes to the bond market. US 10-year yields have risen by around 70-bps since the start of the year, but the rise in 10-year bund yields is not far behind at all at around 65-bps.

Again, this seems insufficient to cause a big slide in euro/dollar, and we can say the same about other currencies, such as sterling/US dollar where the implied number of base rate cuts this year has fallen from around six to around one, and where 10-year gilt yields have increased by more than 80-bps. All told, it does not look as if the rather alarmist narrative surrounding the possible absence of rate cuts in the US this year, relative to Europe, is matched by what we’ve seen in market pricing.

The key here is that the US tends to ‘drag’ other countries with it. So, if US rate-cut expectations are unwinding at a fast pace it tends to lead to unwinding in rate-cut expectations elsewhere even if, as we’re likely to see in the case of the ECB next month, these rate cuts are still very much on the table. The position is very much the same with bonds as surging US yields tend to drag other yields higher.

Clearly, the exchange rate has some role to play here with ECB members admitting that, while the bank might be able to cut rates in the near-term, its ability to do this over the long haul could be more difficult if the Fed resists, not least because a weaker euro against the dollar could lift inflation. This constraint on the room for policy easing is not just a reason why rate expectations – and yields – follow those in the US, but also why the dollar is not stronger than many might have envisaged at this stage.

>> Outlook for central banks’ monetary policy

All this leads to the accusation that other G10 central banks should not pander to the Fed in this way. That EGB yields, for instance, should be able to fall much further below treasuries at the long end of the curve, and the euro should be under much greater pressure against the dollar. But the story is a bit more complicated than this, in the Standard Bank’s view. For one thing, the perceived narrative about the Fed being super cautious about rate cuts while the ECB is prepared to push ahead with rate reductions rather ignores the fact that the difference in inflation performance is actually pretty small.

In fact, if you compare US and euro zone inflation on a like-for-like basis, using the so-called harmonised CPI you will find that the US inflation rate is 2.4% against 2.9% for the euro zone. What’s more, the US HICP inflation rate has been below that of the euro zone since February 2023. Now clearly the HICP is not the Fed’s targeted measure and hence we are not suggesting that the bank should be cutting rates right now.

Nonetheless, in pricing bond yields, for instance there is a case to be made for the fact that a like-for-like inflation comparison is preferable and, if that’s the case then we could argue that it is actually appropriate that longer-term euro zone yields have not diverged too far from those in the US and, perhaps by implication, also appropriate that euro/dollar has been rock steady.