Tug of war
A great divergence is underway. Federal Reserve Chair Janet Yellen is pulling one way by preparing the ground for a tightening in U.S. monetary policy. Meanwhile her counterpart at the European Central Bank, Mario Draghi, is pulling in the opposite direction by paving the way for further easing in the euro zone. The result is eye-catching market moves. Investors may be taking their continuation for granted.
One of the trends is in the euro. It fell to seven-month lows near $1.0630 on Nov. 17. Meanwhile in the bond markets, U.S. two-year government yields offer the biggest premium since 2006 over German counterparts. More obscure prices have also moved sharply. The cost of swapping euro funding costs into dollar-denominated exposure, which is measured by so-called cross-currency basis swaps, has climbed to its highest levels since 2012.
Some of these moves are easy to rationalise. A currency backed by higher interest rates should be relatively more attractive to investors, according to textbook theory. Similarly, investors typically demand higher yields on shorter-dated bonds when they expect policy tightening but are perfectly content with lower yields when easing lies ahead. Shifts in the more opaque cross-currency basis swaps are a bit harder to explain. Perhaps a slew of U.S. companies trying to take advantage of cheaper euro borrowing costs want to swap their liabilities back into dollars.
In theory, there is little reason for such trends to stop. Yellen and Draghi will most likely move in opposite directions for a while. But market dynamics are rarely that simple. The risk is their policy divergence is so obvious that the trades associated with it become too crowded.
Even a subtle shift by Yellen, say to rein in expectations of how fast U.S. rates will rise, could then trigger a run for the exits. Or a small bout of profit-taking could spiral into heavy unwinding of positions. It happened earlier this year when the German 10-year bond yield rose 21-fold in less than two months, and when the euro leapt more than 5 percent against the dollar in two trading days. Once complacency sets in, the biggest divergence may be between investors’ expectations and their returns.