Last updated: 06:04 / Tuesday, 13 May 2014
By Henderson Global Investors

Atlantic Policy Divergence

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Atlantic Policy Divergence

Monetary policy in the US and in the eurozone is increasingly heading in different directions, with corresponding implications for fixed income markets. In truth, differences in monetary policy owe more to the stage in the economic cycle at which their respective economies are at – the eurozone arguably still in the recovery stage, some way behind the US which is in the mid-to-late cycle stage.

Divergence in eurozone and US 10-year yields

Source: Bloomberg, 10-year core government bond yields, US and eurozone, 02 May 2009 to 02 May 2014.

We expect that the US economy will continue to build momentum and that existing forward guidance will come under greater pressure this year.  The first quarter gross domestic product growth figure of 0.1% (annualised) was disappointing but needs to be put into context. Unseasonably bad weather clearly hurt consumption, net exports are a notoriously volatile figure whilst the inventory build slowdown that negatively impacted first quarter figures augurs well for a rebuild over coming months. The second quarter, therefore, is likely to see a resumption of stronger growth data.

We are employing a number of strategies to take advantage of this divergence. This includes having exposure to interest rate risk in Europe

What is more, the jobs market is buoyant. Unemployment is dropping and associated wage pressure may not be far off. Vacancy rates, which are at high levels, suggest growing labour market tightness. Whilst inflation pressures are still muted, wage push inflation could be a concern and this will allow the market to consider interest rate hikes earlier and quicker than are currently priced in.

The US Federal Reserve (Fed) also appears committed to tapering its asset purchases (quantitative easing – QE) by an additional $10 billion at each Federal Open Market Committee (FOMC) meeting.  If tapering is maintained at this pace, this would see additional QE end by the fourth quarter of this year.

In contrast, we have an outright short duration position in the US to mitigate the expected rise in yields

Assuming economic data remains robust, the Fed has suggested that rate hikes could come as early as six months after the current round of QE ends.  Absent very weak data or another crisis, we therefore expect the first rise in interest rates to take place in the first half of 2015.   

In contrast, eurozone growth is still anaemic and deflation remains a threat. The latest April flash Eurozone annual consumer price inflation rate came in at 0.7% versus 0.8% consensus. German inflation did not bounce back as strongly as expected and Spain is hovering close to outright deflation. This is helping to raise expectations of further policy easing measures such as negative deposit rates, revitalising the Asset Backed Securities market or QE.

We expect the euro to underperform the US dollar

Although the European Central Bank (ECB) has so far refrained from outright QE, Mario Draghi, the president of the ECB has been keen not to rule it out. Even Germany, which has been the most vocal opponent of QE, has softened its line somewhat. In late March, Bundesbank President Jens Weidmann stated that he could back QE under certain circumstances.

With this in mind we are employing a number of strategies to take advantage of this divergence. This includes having exposure to interest rate risk in Europe, which we believe will be rewarded given our view that eurozone monetary policy is unlikely to be tightened. In contrast, we have an outright short duration position in the US to mitigate the expected rise in yields, which would weigh on the prices of existing bonds.

In addition, we expect that shorter dated European government bonds will remain anchored, with the European yield curve remaining steeper than that of the US where we expect the yield curve to flatten as short dated yields rise faster than long dated yields.

Finally, we expect the euro to underperform the US dollar. This is because the euro has been relatively strong against the dollar recently but this relative strength is likely to be tested as US yields move higher and any rise in US interest rates draws closer.

Article by Kevin Adams, Director of Fixed Income at Henderson Global Investors

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