Monetary policy divergence set to widen further

06 Mar 2017

  • Fed: setting the scene for a move soon
  • ECB: a delicate balance between hawks and doves
  • China: is 6.5% really a new growth target?

How many signals can a central bank give the markets? The US Federal Reserve has continued to bring this month’s FOMC policy-setting meeting into play and it has worked. Fed funds futures are now discounting a 96% probability of an interest-rate rise. In this setting, bank stocks have done well, keeping US equity markets at close to record highs. Underlying economic growth data has not been stellar lately, but it has been good enough for the Fed to be able to continue to normalise interest rates gradually.

This week’s policy discussion at the ECB will be much more heated, with a still dovish and extremely simulative central bank confronted with strong growth data, but low core inflation. In China, the government at first sight lowered its growth target, but looking behind the headline number, not much may have changed in its outlook.


A barrage of Fed speakers has given off signals that interest rates will be raised at next week’s monetary policy meeting. New York Fed president William Dudley said that the case for raising interest rates has become a lot more compelling since the November presidential election. He mentioned rising confidence and expectations for fiscal stimulus. Fed chair Janet Yellen told the Executives’ Club of Chicago that “at our meeting later this month, the Committee will evaluate whether employment and inflation are continuing to evolve in line with our expectations, in which case a further adjustment of the federal funds rate would likely be appropriate”.

Remember that in policy meeting statements, the Fed had repeatedly said it expects the economy to move towards its goals of maximum employment and 2% inflation. The title of Yellen’s speech, “From Adding Accommodation to Scaling It Back”, also left little to the market’s imagination.

Low economic growth will not keep the Fed from raising rates soon. Higher inflation has put real disposable income and real consumption under pressure and with consumption accounting for around 70% of GDP in real terms, that sets a serious speed limit on first-quarter GDP growth. Orders and shipments of capital goods have slipped, so business investment cannot save the day for growth. A widening trade balance implies that trade may also hold back growth. No wonder that the Atlanta Fed’s GDPNow index, which tracks GDP growth based on contemporary economic indicators, has slipped to 1.8% QoQ annualised for the first quarter.

What can keep the Fed from raising rates is a weak labour market report on 10 March, but any number close to the consensus forecast for 190 000 new jobs should suffice. If the Fed wants to tighten policy, it obviously has recent leading indicators on its side. The ISM manufacturing and non-manufacturing indices have risen and a large majority of companies has reported higher prices.


The debate on the ECB council, which meets this week to decide on the course of monetary policy, will likely be even more heated than within the FOMC. The hawks will point to above-trend growth, a narrowing output gap, falling unemployment and a modestly positive credit cycle. The Economic Sentiment Index, an important leading indicator, notched up to its highest since September 2007. The unemployment rate is now 2.5 percentage points below its 2013 peak. Bank lending to the private sector has accelerated. The hawks would also point to the moral hazard of keeping interest rates too low. It could induce borrowers (both private and public) to postpone adjustments of any deficits and lead to excessive credit growth. This is a particular risk since private sector debt remains high across the eurozone.

The doves have some ammunition left, especially regarding inflation. Core inflation has held at just below 1% since last April. It could be that the output gap is still too wide to generate inflation. The doves could also point to the modest growth in bank lending. Government debt has increased, though. And this is where things become tricky. If the ECB starts tapering its asset purchases, a slight rise in ‘peripheral’ bond yields would make it hard for Italy to stabilise its government debt-to-GDP ratio. But should the ECB leave quantitative easing intact in the whole eurozone just for Italy? This is not very likely, in our view. Even though an announcement of tapering by the ECB is widely expected this year, bond yields have hardly reacted so far.

Given the more balanced risks and the recent modest declines in yields, we have taken some duration exposure out of our asset allocation, leaving us underweight duration (see below).

We do not expect ECB president Draghi to take any steps now, but he could shift the balance of risks from biased to the downside to neutral. But even this does not look likely, nor does raising the now negative deposit rate slightly or an announcement of tapering.


Chinese GDP growth of 6.7% in 2016 required quite some help, including accelerated credit growth and government spending. The authorities have now taken minor steps to curtail credit growth and last year’s fiscal impulse is unlikely to be seen again. Still, this year’s target is 6.5%, which looks like another notch slower. However, the authorities said that they would try to do better. This signals that anything below 6.5% would induce government spending to stabilise the economy. For now, China’s latest overall composite PMI, which averages official and private sector data on manufacturing and services, was unchanged.


Developed equity markets jumped after Dudley’s remarks. Higher policy rates are currently seen in the markets as confirmation of the reflation trade. While valuations usually fall during most of the Fed hiking cycle, this is often offset by higher profits. However, this time US profits have already recovered. Current valuations are rich when we look at our various scenarios for growth, inflation and interest rates. To us, equity markets are broadly priced for perfection.

Emerging markets have struggled lately. Leading indicators have lagged those for developed economies. The higher US dollar and geopolitical risks on the Korean peninsula, risk events in the US administration and the realistic threat of protectionism encourage us to be underweight.

Given our cautious asset allocation – underweights in equities, US high-yield corporate bonds, emerging market debt in US dollars and commodities – we have looked for hedges against a rise in risk assets. Next to our overweight in eurozone real estate versus eurozone government bonds, we have now shortened the duration exposure, making us effectively short duration.

This should protect portfolios in an environment of stronger growth and gradual normalisation of monetary policy. Alternatively, in a scenario where trend growth stays low and economies run into capacity constraints, inflation could rise and bonds would suffer more. In the case of a hard landing in China or global protectionism, our other strategies would clearly benefit.