WILL THE FED DIVERGE?

Disparity in monetary policy creates risks

After five long years of extremely accommodative central bank policies, a cycle of rate hikes is close at hand. The era of collaborative monetary policy is over and the unprecedented convergence of interest rates is also coming to an end. The new environment is likely to have a profound effect on currencies and on investors’ portfolios.

Central bank rates in the Western world have been at zero – or close to zero – for so long that investors could be forgiven for taking little notice of the monthly monetary policy meetings held by the Fed and the ECB. But after five long years of extremely accommodative central bank policies, a cycle of rate hikes is close at hand. The big questions for investors in general, and fixed income investors in particular, are when the cycle will start, how long it will last and what the impact will be on their portfolios.

Convergence coming to an end

The convergence of interest rates since 2009 has been remarkable. In order to safeguard the global banking system, the world has witnessed a rare display of collaboration between central banks in the wake of the financial crisis, resulting in a near-perfect correlation among interest rates in the major economies.

However, the economic environment has evolved rapidly in the last two years. US growth has outstripped that of other countries in the West and its unemployment rate has dropped sharply. At the same time, there are no clear inflationary pressures, with inflation hovering at around 2%.

Given that the dual mandate of the Fed is to sustain employment while keeping inflation at around 2%, there appear to be no constraints on raising its main funding rate. The Fed has indicated a possible rise during 2015, and the market has certainly priced this in.

However, the same conditions are not evident in Europe, where growth is stagnant. ECB rates may not rise at all in 2015 and could conceivably fall further. So after years of central bank convergence, there is the possibility of a period of divergence.

The risks of divergence

Sometimes taking the lead provides first-mover advantage, but in the case of monetary policy this is rarely true. So while the Fed may act first, it must be aware that raising interest rates unilaterally creates risks.

The first risk is that a rise in interest rates increases costs to US companies and leads to a sharp reduction in economic activity. This mistake was made by a number of countries in the recent past. These countries were forced to recognise their mistake and reverse their policies, reducing interest rates again to stimulate growth and prevent deflation.

So while US growth is currently relatively strong, US policymakers will need to be sure that growth is firmly entrenched before acting.

Another risk is that Fed action could reintroduce volatility into markets. For the last three years, ultra-low rates and market expectations of continued low rates have “anaesthetised” volatility.

However, rate rises risk increasing volatility through a sell-off in Treasuries and high-yield bonds and through rising yields in emerging market local currency bonds. The Fed had a taste of this in June 2013 when it first signalled tapering. The sudden spike in volatility represented a market shock the Fed will have required 18 months to fully digest.

The next risk for the US of raising rates is the potential for a strong appreciation of the US dollar versus other major currencies. This would make US goods and services less competitive. If Chinese and European interest rates fall even lower, the US could see a sharp decline in its exports. Dollar appreciation is already evident, in fact, with a 12% rise on a trade-weighted basis in the second half of 2014.

Divergence not sustainable

Although early Fed raising poses risks, these risks are mitigated by the likelihood that divergence will be shortlived. In the past, the Bank of England has reacted to a Fed move within about two months, while the ECB tends to respond within six months.

Will such rapid convergence be the case in 2015-2016? It is possible that the ECB may not respond to a Fed move for longer than the six-month historical average, owing to the poor outlook for growth in the European Union. But the correlation between important indicators in the US and Europe suggests divergence in monetary policy would soon give way to convergence, as it has in the past.

It is clear from the graphs that inflation expectations in Germany and the US are strongly correlated. In addition, deflation risks from falling commodity prices will impact monetary policy in the US and EU equally.

Fed likely to err on side of caution

So how will the Fed respond to these risks and to the evolving macro environment? While it is probable that it will raise rates in 2015, the Fed will err on the side of caution. The risks of tightening early are too high to ignore. The Fed would expect the ECB and the BoE to follow suit but it cannot be sure of this.

So rate rises are likely to be small and implemented slowly. Fed governors will remain dovish through the tightening cycle, watching carefully for signs of economic weakness and halting rises for periods if necessary. It would wish to avoid providing a catalyst for a widespread bond sell-off which could destabilise markets, stifle growth and provoke a political backlash.

This pragmatic approach will provide comfort to investors. While worries about the sustainability of yields are understandable after a long bull market for bonds, investors have no reason to abandon the asset class. That said, they have good reason to watch central bank pronouncements carefully in 2015.