Investors bet on ‘great divergence’ between Fed and ECB

The Federal Reserve and the European Central Bank delivered interest rate rises this week, but investors now expect rate setters in the US and the eurozone to move in opposite directions.

Following 10 consecutive rate rises, markets predict the Fed has finished its tightening cycle and could start cutting rates as soon as July, as it shifts its focus from curbing high inflation to soothing a slowing economy.

The ECB, which started increasing rates four months later, is expected to lift borrowing costs at least one, and probably two more times this year, according to the overnight index swap market, which sets prices based on investors’ expectations of future official interest rates.

“We are in for a great divergence in monetary policy on both sides of the Atlantic which is something quite new,” said Christian Kopf, head of fixed income at Union Investment.

“People in the markets have always said it’s pointless to forecast the ECB because it will always do Fed minus 200 basis points, but we are now in a situation where the ECB is really following its own path and will continue to hike.”

Investors’ nerved about the US banking sector have led them to bet on rate cuts from the current benchmark rate of 5 to 5.25 per cent, despite annual wage inflation of 4.4 per cent and a labour market which remains “extraordinarily tight” according to Fed chair Jay Powell.

However, he also warned the recent banking turmoil appeared to be “resulting in even tighter credit conditions for households and businesses”, which was likely to weigh on economic activity and the labour market.

Meanwhile Christine Lagarde, ECB president, signalled more rate rises to come in a speech on Thursday. “We have more ground to cover and we are not pausing, that is extremely clear,” she said, after announcing an increase of the benchmark eurozone interest rate to 3.25 per cent.

Investors say the Fed will either hold rates until inflation falls closer to target and the labour market cools, or will be forced to cut quickly to support bank balance sheets and curb deposit outflows if a crisis unfolds.

“If they had to cut for that reason they would not do 25 basis points, they would have to do 50 or 75 basis points,” said Thanos Papasavvas, chief investment officer at ABP Invest.

Papasavvas and others think that if the US embarks on crisis-induced rate cutting, the ECB would be forced to follow suit.

“Lagarde tried to push the view that the ECB can keep tightening independent of what the Fed does [on Thursday] but it is only credible if the US escapes a hard landing,” said Antoine Bouvet, head of European rates strategy at ING.

Others, including Kopf, are not convinced. “I think the European banks are in much better shape than their US counterparts,” he said, noting that unlike in the US, all European banks have to comply with the Basel rules on capital and liquidity.

He added that there was no equivalent of the Federal Deposit Insurance Corporation in Europe so banks and regulators “really make sure they don’t have problems precisely because they know they cannot pass on the risk to a Federal entity”.

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