Central bank policy divergence has become a … errr… “central” theme over the past two weeks.
Maybe you noticed.
The “problem” started to emerge when a “dovish” Fed hike clashed with an ECB that, thanks to a less-bad outlook for the eurozone economy and dissipating political risk, looked increasingly prone to starting tentatively down the policy normalization path.
In short, we were witnessing policy convergence (dovish Fed, hawkish ECB) and that caused rate differentials to narrow, putting pressure on the dollar. What we needed was a healthy dose of ECB dovishness and/or some hawkish rhetoric from the Fed to get things back on the “right” track and that’s exactly what we got (Friday’s “tentative” Dudley notwithstanding).
Indeed, it wouldn’t be a stretch to attribute Thursday’s strength in US stocks to the return of the policy divergence narrative.
Well, since we’re on the subject, consider the following useful bit from Deutsche Bank whose analysts decided to ask themselves some questions and subsequently give themselves some answers with regard to the outlook for Fed policy.
Via Deutsche Bank
Q: Is the Fed more hawkish than the market assumes? A: Yes, the median FOMC forecast sees more rate hikes this year than the market currently seems to be expecting. It is important to note, though, that the Fed dots and market pricing are not directly comparable – market pricing is an aggregation of many potential paths for the fed funds rate in the future under various economic scenarios; the Fed’s dots on the other hand provide their assessment of a most likely baseline scenario.
Q: How do the recent setbacks to the Republican legislative agenda affect prospects for Fed policy? A: Probably not much. The Fed had not raised its forecast in anticipation of legislative changes that had not yet passed. The rise in animal spirits may have shifted the risks a bit in the direction of more rate hikes, but Fed language after the March meeting was balanced, even cautious in that regard. Some recent Fedspeak (Evans, Lockhart) has sounded a bit more dovish in reaction to events on Capitol Hill.
Q: Will the Fed signal a rate hike in June the way it did in March? A: Yes, we would expect so if data remain on track and the market is no higher than 50/50 on a June rate hike.
Q: Emerging market economies may be hit hard when the Fed raises rates significantly further. How sensitive is the Fed to the negative repercussions of its policy abroad? A: The Fed bases its policy decisions first on what it judges to be in the best interests of achieving its domestic US economic objectives of full employment and 2% inflation. In doing so, it considers the implications of potential repercussions abroad for US growth prospects. With interest rates near zero for much of the past several years, the Fed seemed to be more reactive to risks from abroad than in the past. But as interest rates rise and domestic risks become more symmetric, the Fed will likely become somewhat less sensitive to international factors.
Q: Could the Fed move in 50 bp increments, and what would cause it to do so? A: Seems quite unlikely any time soon, but yes, the Fed could shift to 50 bp hikes if growth and inflation pressures said policy was well behind the curve.
Q: Could the Fed taper reinvestment and raise policy rates at the same time? A: We expect a tapering announcement to come later this year or early next after a couple more rate hikes, and we assume it will take the place of a rate hike. But if the economy were performing well and inflation beginning to show signs of overshooting, we could well see a tapering announcement combined with a fourth rate hike this year