At the start of 2015, the market’s view was that central bank divergence would be driven by a hawkish leaning from the US Federal Reserve and looser monetary policies from other central banks.
Instead, as we approach the close of the year, divergence has been largely driven by central banks erring on the dovish side.
In fact, in spite of expectations that the Fed will lift rates this week, there is widespread belief that the central bank will accompany the first rate hike with dovish language that signals future rate hikes will remain conditional and gradual.
Having said that, it finally looks like the last few weeks of the year should usher in a period of active policy divergence.
Just as the European Central Bank (ECB) has taken its policy rate further into negative territory, the Fed is setting the stage to raise its policy rate at the December meeting. Markets have responded to such divergence with two-year US Treasury yields rising 20 basis points in November, while two-year Bund yields fell to a record low of -0.45 per cent intra-month.
This shows that a large degree of central bank divergence is already priced into markets. But with only two rate hikes from the Fed priced in next year, the market could be too pessimistic. As the market adjusts to a higher terminal policy rate in the US, this policy divergence theme is expected to continue.
The Fed’s cautious approach to tightening is symptomatic of the potency of the currency channel in tightening financial conditions in a low, uneven global growth environment.
The US dollar index has risen 10 per cent year to date, effectively tightening financial conditions and forcing the Fed to adopt a gradualist stance to raising rates. The strength of the US dollar is reflecting the US’s economic advantage to its main trading partners.
While this is unlikely to stay the hand of a Fed rate hike in December, the strength of the US dollar is expected to affect the path and pace of Fed rate rises in 2016. Moreover, persistent negative rates in Europe are putting additional appreciation pressure on the US dollar, again depressing expectations for a faster pace of policy tightening in 2016.
Active policy divergence should be – and has been – felt most potently in front-end yield spreads and currency.
It is estimated that the US dollar will strengthen less next year, but until the Fed actually starts tightening, this divergence theme is expected to continue to play out among currencies. A key determinant of the extent and persistence of US dollar strength next year will be driven largely by the risks of a US recession.
As of now, there is a low risk of a US recession over the next 12 months. The country is seen as firmly within the middle stage of the current business cycle. A higher terminal policy rate than the market has priced in is also distinctly possible. Both of these factors suggests the US dollar will strengthen more – at least while other central banks are moving in the other direction.