Get ready for America and Europe to drift apart.

By Alex Weber

When the governing council of the European Central Bank meets in Frankfurt on Thursday, it is widely expected to announce a loosening in policy – most likely a cut in both the refinancing and deposit rates. Two weeks later, the US Federal Reserve will probably respond to strengthening economic data by moving in the opposite direction, tapering the pace of quantitative easing for the fifth consecutive meeting. This is another sign of how monetary policy is diverging in the two largest economies, a trend that is set to shape funding markets for years to come.

In the US, output is set to rebound in the second quarter after having been disrupted by dismal weather in the first. And while price rises have been subdued so far, employment surveys suggest an emerging skills shortage and thus the potential for wage cost growth that could help lift inflation close to the Fed’s 2 per cent target. By any measure the labor market is tighter in America than in Europe, where the recovery remains weak and uneven despite buoyant financial markets. The gap between actual and potential output will barely shrink in the Eurozone this year, and unemployment will remain close to a record high.

Before long, these divergent fortunes are bound to lead to large differences in policy. In the US, interest rates could begin to rise in 2015. In Europe, they are likely to stay low for much longer.

One might expect that movements in financial markets would reflect these expectations. However, so far, by and large, they have not. The dollar has been ailing for months, defying analysts’ expectations that the currency would strengthen in anticipation of higher US interest rates. What is going on?
The answer is that market expectations seem to count less than current conditions, which still support the euro. First, the high yields on government debt in countries such as Italy and Spain have made them an attractive investment for believers in the ECB’s pledge to do “whatever it takes” to save the euro. Second, America’s shrinking pension deficits may have stoked appetite among pension-fund managers to lock in profits and match liabilities, helping suppress long-term bond yields. And then there are the central banks. The Euro system's balance sheet has been shrinking for more than a year, as banks that borrowed from the central bank under the longer-term refinancing operation (LTRO) have repaid their debts early. Meanwhile, the Fed’s balance sheet is still growing, albeit at a reduced rate.
However, these factors are temporary. LTRO repayments are coming to an end, US quantitative easing will be completed by the end of the year, five-year government bond yields in Spain are already similar to those in America and long-dated US government bond yields are pricing in unrealistically low expectations of future economic growth. Diverging monetary policy will soon begin to have more impact.
To my mind, investors should prepare for more volatility this year. The degree of easing of US monetary policy has been exceptional. The tightening, when it begins, will also be unprecedented. The tightening has not yet begun – the Fed’s balance sheet is still expanding. I see significant potential for volatility and setbacks on financial markets over the next few quarters.
In particular, the story is not over for emerging-market countries that rely on cheap dollar funding. The recovery of their stock markets and currencies in the past months does not reflect improved economic fundamentals, but a better mood among investors. These countries are still vulnerable. When US interest rates begin to rise, these borrowers may be able to turn to euro-denominated debt as an alternative source of cheap financing. However, this at best delays adjustment; improving fundamentals remains urgent.
The Fed’s balance sheet, which was about half the size of the Euro system's going into the crisis, has now overtaken its European counterpart as a proportion of output. Emerging markets will not be the only ones to suffer when this trend goes into reverse. A tightening in US monetary policy always causes fallout. This time will be no different. In fact, it may be worse, since the tightening starts from extremely expansionary territory.

Ty Laffoon
Prime Mortgage Loans
San Diego , Ca.