November 30, 2015 / 4:58 PM / 2 years ago

The Great Divide: How markets are shaping up ahead of Fed, ECB

Traders work at their screens in front of the German share price index, DAX board, at the stock exchange in Frankfurt, Germany, October 1, 2015. REUTERS/Staff/remote

LONDON (Reuters) - The U.S. Federal Reserve and European Central Bank are expected to deliver sharply contrasting policy decisions next month, reflecting how the world’s two largest economies have moved from the Great Recession to the Great Divide.

The U.S. and euro zone central banks have been on a similar path of monetary easing since the financial and economic crisis of 2007-09. But the Fed is now poised for “liftoff”, delivering its first rise in interest rates for almost a decade, while the ECB is expected to flood the market with more deflation-busting stimulus.

These expectations are clearly shown in financial markets. The dollar and short-term U.S. bond yields have soared, while the euro and short-term euro zone bond yields have plunged.

The gap between benchmark two-year U.S. and euro zone yields is its widest since 2006 - the two-year German yield is -0.42 percent while the U.S. yield is just under 1 percent - and the dollar’s value against a basket of currencies is within a whisker of a peak not seen since 2003.

The euro is on track for its biggest annual loss since the year of its launch in 1999. It is down 8.5 percent on a trade-weighted basis so far in 2015 and many analysts expect it to crash through parity with the dollar next year. Analysts at Goldman Sachs predict a new low of $0.80 in 2017.

It’s rarely been cheaper for companies to raise cash in euros but the cost of swapping those funds into dollars, the so-called basis swap rate, is the highest since mid-2012.

The policy divergence reflects the contrasting outlooks; the Fed appears to believe the U.S. economy has recovered sufficiently from the crisis and no longer warrants emergency-level interest rates of zero, while the ECB feels yet more stimulus is needed to battle deflation.

The ECB is one of 43 central banks to have eased policy this year when it launched its 1 trillion euro “quantitative easing” (QE) program of bond-buying in March.

Economists expect the ECB to extend and expand QE, and cut the deposit rate even further below zero on Thursday, as policymakers attempt to get inflation from around zero currently back up to target just under 2 percent.

Futures markets are pricing in a 77-percent probability the Fed will raise rates at a Dec. 15-16 meeting. When it comes to the Fed and market expectations, that’s pretty close to being a nailed-on certainty.

The one big unknown is how aggressively the Fed raise rates, a crucial factor in determining how far the U.S.-euro divergence will go.

It’s a similar story with the ECB. President Mario Draghi will have to pull off something spectacular next week to surprise investors who have high expectations for new policy measures to stimulate the euro zone economy.

One side effect of the dollar’s charge higher since the middle of last year has been the collapse of oil and metal prices. Platinum, for example, is at its lowest level in seven years.

These commodities are priced in dollars, so are often inversely correlated to the greenback’s performance.

As the dollar rises, so commodities fall, which puts downward pressure on inflation, which spurs more easing from the ECB and other central banks, which lifts the dollar ... and so on. It’s a tough cycle to break.

Reporting by Jamie McGeever; Editing by Pravin Char

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