While rate cuts are now in motion across the developed market economies, Europe, the US and UK are certainly not loosening from an equal base. Each central bank is at a different stage of its own perception of the path of interest rate cuts, with their different mandates also playing a part.
In the US, despite the volume of will they/won’t they chatter ahead of every Federal Reserve (Fed) meeting, the market had taken the view that we would see a fairly aggressive schedule of three further cuts through the remainder of the year. Bond markets were pricing in a more difficult picture for US growth, in contrast to a flying equity market and the Goldilocks outcome. Notably, GDP is ahead of expectations at 3%, job creation is surging and the consumer, who remains employed, continues to spend.
In fact, the latest employment data was strong and the market is now more or less in line with the Fed’s own dot plots, albeit with the caveat that the market is slightly more hawkish than the Fed at this point. Bonds have thus had to revise their bleak outlook for now.
In Europe, the macro landscape is trending the other way. Now we have clarity on the 25bps October trim, the market is only pricing in one more cut by the end of 2024, yet it is an easy argument to declare Europe the weaker economy versus the US (with its expected three cuts).
Germany, Europe’s historic powerhouse, is stuck in a low-growth recession. Its struggles are perhaps most acutely visible in the auto sector, where weak demand has been exacerbated by the collapse of the Chinese export market. There is a tit-for-tat tariff war going on with China on autos, which is exacerbating the sector’s malaise.
Europe’s number-two economy, France, has rising idiosyncratic risks, with Prime Minister Barnier urgently needing to cut the deficit and stimulate the economy, but without much of a toolkit to work with. Tax rises and spending cuts do not paint a favourable growth picture for the future.
In the UK, the market is pricing cuts out, with the odds on a November trim jumping around with each data release. While the September CPI figure has come in under target, services inflation remains high. We also have the huge uncertainty of the Budget at the end of October, which is likely to result in more fiscal tightening.
In summary, we’re seeing a contradiction – the market is anticipating different reaction functions for the three economies that largely ignore their underlying conditions. The US is still pricing more rate cuts than the other large central banks, but it doesn’t need to. Europe is much more neutral on rates when they really need to cut. And the UK seems to be flip-flopping on Bank of England rhetoric.
This dichotomy is made more intriguing by the continued high correlation between US Treasuries and European government bonds – we have not seen the divergence that you’d expect; the curve has steepened in the US, with European government bonds largely following suit. It has been the exchange rate where the real action is being played out, with the euro weakening vis-à-vis the US dollar in anticipation of an acceleration in cuts.
What might it take for that correlation to break down?
Given financial loosening takes at least 6-8 weeks to affect the underlying economic environment, the US could start to develop a clear lead as November rolls into December, creating more divergence between the two markets and perhaps with stronger growth and stickier inflation. The ultimate winner of the US Presidential election should also provide market direction, given the clear policy water between the two candidates.
Equally, we could see more cuts being priced into the curve in Europe, as the pressure to act grows. The argument against this scenario is that as interest rates are lower in Europe, they are less restrictive, and the central bank doesn’t need to move as fast or as aggressively. But this does not really bear close scrutiny given the underlying economy requires lower rates now and in a quantum that the European Central Bank has so far failed to address.
Either way, the high correlation remains intact between the various government bond markets. Where we have seen divergence, and with it, potential investment opportunity, is between French and German government bond spreads, and even in some of the peripheral European economies. Despite Germany’s economic weakness, Bunds remain closely correlated to the US.
In contrast, French spreads are currently wider than Greece – suggesting there’s a confidence crisis in its sovereign bond market which could continue until its fiscal issues are resolved. While France clearly has a deficit problem, it does feel that the reaction and thus re-pricing is overdone, and therefore could present an opportunity. The likelihood of a crisis of confidence and even default are extremely unlikely at this point.
