Australia faces economic risks as US and Europe fight

One way or another the US Federal Reserve and the European Central Bank face the prospect of an intensifying policy conflict.

One way or another the US Federal Reserve and the European Central Bank face the prospect of an intensifying policy conflict. The key question for investors is the primary location of the battleground — foreign exchange or bond market? It’s the pitch where policy is fought over that will determine who’s going to come up trumps.

The backdrop so far looks a little like this: at face value the Fed is set to hike rates sometime this year. Fed funds futures suggest the market can expect maybe two hikes in 2015 — one in September and then another possibly by December.

Now if they do hike, it’s reasonable to assume that the Fed will want the whole yield curve to shift up — that is, for rates further out on the curve to lift — in tandem with the cash rate. There’d be no point otherwise and it’s how monetary policy works — especially in the US where mortgage rates are priced further out on the curve.

The problem for the Fed, however, is that their friends across the Atlantic are printing about €60 billion ($84bn) every month: the European Central Bank has got €1 trillion to create, and they’re not expected to finish until September 2016. The way global markets work, a lot of those euros are going to find their way over to America, bidding up US Treasuries, and putting a dampener on whatever tightening or policy normalisation the Fed was trying to achieve.

The implication is that with the ECB printing, not to mention the Bank of Japan, the Federal Reserve might have to hike much more aggressively than they otherwise would have, to get the desired effect. Tighten enough, and investors may just tire of receiving barely any return for holding European bonds, or, in many cases, having to pay governments for the privilege of lending them money (so called negative interest rates).

Clearly if the Fed sticks to the program and starts to normalise rates this year, then a battle for supremacy will be played out in the bond market with each central bank trying to target different outcomes. Given that it’s easier to print than tighten, the ECB’s policy goals are likely to hold sway. The Fed can then either retreat, or risk a recession.

That scenario assumes the Fed even wants to normalise policy: there are good reasons for doubt. First, the run of disappointing US economic data — GDP and the fall in durable goods orders, etc. Then there’s the elephant in the room — the strong US dollar. Few countries have any tolerance for a stronger currency at this point, and that’s no different either side of the Atlantic — although not necessarily for all the same reasons.

For the Europeans, a weaker euro is a critical element in the recovery plan and a safeguard against deflation. Consumer prices in the eurozone fell 0.3 per cent on the latest reading and have been below the target of 2 per cent for more than two years. Growth otherwise is barely positive and many are concerned that Europe will inevitably suffer a similar fate to Japan — the lost decades.

For the US, things are a little different. Growth is robust, notwithstanding recent disappointments, although as in Europe, inflation is also low — around zero on some measures.

Up to now, US policymakers don’t appear too concerned about US dollar strength — at least publicly. Nevertheless, historical precedent suggests we can’t be too far from that point. Recall the popular view in US policy circles that it was a wide current account deficit, caused by capital inflows from Asia, that ultimately caused the global financial crisis. According to the US view, these inflows lead to lower rates and stronger demand (in the US) than would otherwise have been the case: imbalances developed and a crisis ensued.

Noting this, a further widening in the current account deficit is obviously something US policymakers want to avoid — especially with debt-to-GDP at much higher levels than in the past. Two things won’t help the deficit: a strong dollar and relatively high interest rates.

Fought on this turf, the Fed clearly has the upper hand — the mere mention of being patient again, or downgrading long-term inflation forecasts, would probably be enough to see another 10-20 per cent off the US dollar — much to the chagrin of European policymakers, who may simply print more money.

The problem for the market is that no one knows the tolerance threshold of each central bank. There is guesswork involved either way. But two things are perhaps more certain. Volatility is likely to spike further in one or both markets, to the detriment of international trade and investment. And small open economies like Australia’s will get hit in the crossfire. Destabilising capital flows, a sharply appreciating exchange rate or plummeting interest rates are just some of the risks Australian policymakers face.