The European Central Bank insists that it will independently decide on the course of its monetary policy compared to the Fed. In this case, this would mean beginning to lower interest rates before the American central bank.

Trends driving the world’s largest economy usually spread to other regions, affecting financing conditions and exchange rates. Policymakers in different countries, therefore, cannot truly escape the Fed’s gravitational pull when assessing the fate of their own economies.

For ECB officials who will meet this week to discuss the timing, pace, and extent of their aggressive monetary tightening, this means keeping a close eye on the United States, even as they emphasize that they will chart their course.

If it remains a matter of timing differences, it should be manageable in bond markets. However, if the risk of monetary policy divergence were to set in, it could seriously affect global asset allocation, and bond spreads between the two economies.

The ECB has begun preparing markets for an initial rate cut on June 6 as price pressures quickly ease.
Based on recent economic data, investors bet the ECB will likely carry out four cuts this year. They are divided on whether the Fed will cut rates two or three times after Powell reiterated that he was not in a hurry to start reducing borrowing costs.
More than two years after Powell began raising rates, the US economy has shown remarkable resilience, with employers continuing to hire workers briskly. In Europe, the situation is different. While unemployment remains low, growth is sluggish.

It is too early to say if recent figures regarding inflation in the United States represent a new upward trend, but the data were largely above expectations. At the same time, inflation in the eurozone slowed more than expected in March and, at 2.4%, is approaching the ECB’s target.
In the past, the ECB has proven that it can diverge from the Fed: when it lowered rates in December 2015 and again in March 2016, while the US central bank embarked on a three-year rate hike cycle. The Swiss National Bank has already paved the way in the current cycle with an unexpected rate cut in March to prevent the Swiss franc from rising.

The ECB is divided with contested leadership and finds itself in an uncomfortable position. Given the latest figures, it has no choice but to lower its rates, risking losing all credibility. But if the Fed remains at a standstill, it puts itself in danger. Because the overall effect of a divergence between the ECB and the Fed could prove more damaging than the impact of rate cuts. A more aggressive easing in the eurozone could lead to more substantial inflationary pressures: lower borrowing costs than the United States could weaken the single currency and pose an additional risk through higher import prices.

There is a real risk that expectations of Fed rate cuts will be disappointed, resulting in a tightening of global financial conditions. Investors have already positioned themselves for losses in the European currency. In the options market, there are twice as many negative contracts on the euro as positive ones, according to data from the Depository Trust & Clearing Corporation. Such a scenario could bring the prospect of euro-dollar parity for the first time since 2022.

The impact would not only be on exchange rates, and in the euro area.
After spending all of 2023 and much of this year making much more accommodative bets than those of the Fed officials, investors have now taken the opposite direction. They anticipate around 65 basis points of rate cuts in 2024, compared to the 75 basis points signalled by the median estimate of projections released after the Fed’s March 19-20 meeting.

This reassessment is pushing investors to demand higher yields on US government bonds. Yields on Treasuries maturing in five to thirty years have reached their highest levels of the year. The 30-year yield surpassed 4.5%, and the benchmark 10-year bond rose by 20 basis points.

Investors have come to terms with new economic data confirming the strength of the US economy, potentially reducing the need for rate cuts. The initial data on February incomes and spending showed continued strong consumption. Then, a gauge of US manufacturing activity exceeded all economists’ estimates to return to positive territory for the first time since 2022.

If future data confirms such a situation, we could assist in a massive shift in asset allocation and an increase in volatility.