Macro: The Bottom Line (9/15/14)

The ECB and the Fed: the transatlantic tug-of-war

 

Just a week after the ECB pulled out the Big Bertha (see last week's post), market attention shifted abruptly back to the Fed. If Draghi's big guns were enough to push bond yields to absurdly low levels, the past week's recoil was no less powerful. In fact, the 10-year U.S. Treasury yield, which just last month was testing the 2.30 pct level, closed north of 2.60 pct on Friday.

 

The main cause of the abrupt about-face was - believe it or not - an academic study. That's right, researchers at the San Francisco Fed released a study suggesting that market participants were underestimating the speed at which the Fed would raise rates. The recent market calm - so the researchers - was deceptive and symptomatic of complacency about how long easy-money would last.

 

Coming directly after the ECB's announcement, the SF Fed report had the effect (intentional or not) of placing the Fed in direct opposition to its counterpart in Frankfurt. On the one hand, there's Draghi and his Governing Council, preparing to blast open the liquidity floodgates and take on unprecedented risk onto the ECB balance sheet (remember, Draghi and company are planning to buy asset-backed securities, some without government guarantees). On the other hand, you have a Fed ending its buying spree and readying itself for its first rate hike since 2006. A transatlantic tug-of-war, between two powerful central banks, is shaping up.

 

So who will "win" this tug-of-war. Or to frame the question more accurately, who will end up ultimately influencing markets more? Will the ECB prevail, leading to a cross-asset rally, with bond yields setting new record lows and equity prices setting new record highs? Or will it be the Fed, touching off another cross-asset selloff similar to the taper madness of summer 2013? It's hard to argue entirely for one or the other. At the very least, both sides will create noise, periodically pulling the markets one way or another. But our inclination is that renewed 2013-style mayhem is unlikely. For all the flashiness of the SF Fed's study, the "conclusions" reflect the findings of its researchers, not necessarily the views of Janet Yellen or of other FOMC members. Not to mention that a 2nd half 2015 rate hike has already been largely priced in. And for all the rosiness in the U.S. labor market, the issues that we have repeated over and over again - weak wage growth and lackluster productivity increases - will not disappear overnight. 

 

Bottom line: don't expect a violent price correction across financial-market assets. But do fasten your seat belt for bouts of volatility ahead, as Mr. Draghi and Ms. Yellen dig in for an extended round of tug-of-war.