December 2, 2015 / 4:33 PM / 2 years ago

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

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

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.

"We've not been here since 1994 and a lot of people are looking at this," said Kenneth Broux, head of corporate research, FX and rates, at Societe Generale.

"But it's difficult and dangerous to draw parallels because central banks are in a completely different world now," he said, referring to their response to the global financial crisis that has swollen their balance sheets by trillions of dollars.

The flattening yield curve is a warning that the economic recovery is mature. Rising interest rates and short-term debt yields could choke growth, while stable or falling long-term yields suggests investors see lower growth and looser monetary policy further ahead.

Ten-year U.S. yields are still about 123 basis points higher than two-year yields, so the curve is nowhere near the inversion that preceded the last five recessions over the past 40 years.

But that's still the smallest gap in 10 months and the trend is firmly downward. A fall below 120 basis points would mean the flattest curve in four years, and below 117 the flattest since the onset of the crisis in early 2008.

Rates strategists at Citi say the curve could invert, with 10-year yields below 2-year yields, more quickly than the market consensus expects. Previous economic cycles point to a 65 percent probability of U.S. recession next year, they add.

"The (inverted) curve always presages recessions," said Mark Zandi, chief economist at Moody's Analytics.

DOLLAR CONSENSUS

When the Fed raised rates in 1994, U.S. growth was running at an annual pace of over 5 percent. By the end of the tightening cycle a year later it had slowed to 1.4 percent.

In the last two Fed rate "liftoffs" in 1999 and 2004, European monetary policy largely followed suit but the market reactions were still broadly similar.

When the Fed raised rates in June 1999 the economy was growing at around 3.3 percent. Growth jumped when the hikes ended a year later but the economy fell into recession in 2001.

In mid-2004 growth was around 3 percent but had slowed to 1.2 percent by the time the Fed raised rates for the last time in June 2006. The Great Recession was soon to follow.

The last three Fed "liftoffs" of 1994, 1999 and 2004 were all followed by dollar weakness. The dollar index fell an average of 3.4 percent in the subsequent three months and by 5.6 percent over six months, according to Societe Generale.

Right now, according to Bank of America Merrill Lynch, the strongest consensus trade in any financial market is the bet that the dollar will rise.

Data from the Chicago Mercantile Exchange show that hedge funds and other speculators are close to their most bearish ever on the euro. The scope for that to increase further is limited, and the scope for a deep reversal is much greater.

The situation in the euro zone couldn't be more different. While the risks to U.S. growth are to the downside, they're to the upside in the euro zone, largely thanks to the ECB stimulus.

Economists at JP Morgan expect the euro zone economy to grow 2.0 percent next year, just 0.3 percentage points behind the United States. Yet with inflation virtually zero it will be years before the ECB tightens monetary policy, analysts say.

Yields across the spectrum are the lowest on record. All German yields on bonds out to six-year maturities are negative, with the two-year yield a remarkable -0.43 percent.

About 630 billion euros of euro zone government bonds, or 15 percent of the total 4.2 trillion euros outstanding, now trade below -20 basis points, a threshold that makes them ineligible for ECB purchases, according to JP Morgan.

More than a third of the 740 billion euros of outstanding German government bonds is trading with a yield below -20 basis points, they added.

Below are some links to charts showing the extent to which investors are pricing in the Fed-ECB policy divergence.

link.reuters.com/gab44s

(U.S. yield curve and recessions)

tmsnrt.rs/1MZkxdV

(U.S. 2-year yield)

tmsnrt.rs/1MZkfnB

(Euro zone 2y yield)

tmsnrt.rs/1MZkAXi

(U.S.-euro zone 2-year yield spread)

tmsnrt.rs/1MZkJtF

(Trade-weighted euro's annual performance)

editing by David Stamp

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