Precedent of U.S.-Europe policy divide serves as warning to stretched markets

Wed Dec 2, 2015 11:30am EST
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By Jamie McGeever

LONDON (Reuters) - If the last "Great Divide" in Transatlantic monetary policy 21 years ago is a reliable guide, stretched currency and debt markets could well be wrongfooted this month.

With the U.S. Federal Reserve and European Central Bank preparing to go their separate ways, respectively tightening and easing policy, the dollar is close to its highest since 2003 while the euro is on course for its biggest annual fall since its launch in 1999. The gap between yields on 2-year U.S. and euro zone government bonds is the widest in nine years.

The central bankers' decisions are expected to mirror those of February 1994, when the Fed began a series of interest rate increases that lasted a year just as Germany's Bundesbank - the dominant force in European monetary policy before the euro - was in the midst of a six-year rate-slashing cycle.

U.S. economic growth and the dollar slumped during the Fed's tightening campaign. At the same time the yield curve on U.S. government debt, measuring the gap between traditionally lower short-term and higher long-term borrowing rates, flattened almost to the point of inversion - a development long seen as a harbinger of recession.

Now, before the ECB meets on Thursday and the Fed later in the month, the U.S. yield curve has already started to flatten.

At the same time there has been an extreme build-up of bets that the dollar will appreciate further to parity with the euro and beyond - bets that some fear may be the one of the most crowded trades in the world despite the 1994 precedent. The euro was trading at around $1.0570 on Wednesday EUR=.

The ECB is set to decide on Thursday to flood financial markets with even more cash in the hope of reviving the euro zone economy and pushing inflation back up towards its target.

Then, with the U.S. economy in a more robust state, the Fed is widely expected to raise interest rates at its Dec. 15-16 meeting for the first time since June 2006.   Continued...

The Federal Reserve headquarters in Washington September 16 2015.     REUTERS/Kevin Lamarque