Great rotation unlikely symptom of central bank policy differences
We don’t see a so-called ‘great rotation’ being a direct symptom of diverging central bank policy. In our views, there are really three key implications: a stronger US dollar, continued weakness in global commodity prices and looser monetary conditions globally.
The contrasting outlook for growth and policy on different sides of the Atlantic is well demonstrated by the 1.5 percentage point gap that has opened up between the 10-year US Treasury yield and the equivalent German Bund yield. Both the real and nominal yield differential is greater than it has been since 2009. But it is by no means the largest gap we have seen in modern times.
What is different about this bout of transatlantic divergence is that, for once, it is the US that is tightening faster than the Europeans, and it is US real yields that are higher. The more common pattern in the past was for US policy to remain loose at a time when Europe, in those days, the German Bundesbank, was tightening. At various points, for example, the mid-1980s, this dynamic has been a source of diplomatic tension and market volatility, largely because of fears that it would lead to a collapse in the value of the dollar. Obviously the dynamic today is rather different.
We don’t know what the market implications of this period of divergence will be, exactly. However, as stated above, we would expect a stronger dollar and continued weak commodity prices. Another likely implication is that US interest rates are likely to be lower than they would otherwise be—for even longer than previously thought.
Traditionally we have questioned whether European monetary policy can truly de-couple from the US, given the dominance of US markets. This time, it seems at least possible that we will also see the opposite dynamic, with US long rates being pushed down too far by continued global demand for safe assets and the divergent policies of the ECB and the BoJ.
In response, either the Fed would be forced to make sharper, possibly destabilising increases in short-term rates, or the US would have inappropriately loose monetary conditions at a mature stage of its recovery. Neither possibility is very desirable. But if growth and inflationary pressures in the rest of the world continue to fall short, such a scenario cannot be ruled out.
Stephanie Flanders is chief market strategist for Europe, JP Morgan Asset Management