Different paths: the effects of ECB/Fed policy divergence

The start of 2016 has produced extreme volatility in capital markets. While the finger has been pointed at many culprits, from oil prices to China and European banks, one plausible driver has surely been the divergence of monetary policy between the Federal Reserve (Fed) and the European Central Bank (ECB). In this article we examine why the US and eurozone central banks are embarking on different paths, how sustainable this is in a world of growing headwinds to global and US growth and what the implications for capital markets might be for the remainder of 2016.

In December the Fed tightened and the ECB loosened within the space of a fortnight, a contrast not seen since 1994. Both central banks are talking up further action, with the Fed interest rate chart, the ‘dot plot’, indicating three further rate rises by year-end and the ECB promising an expansion of its quantitative easing programme.

These divergent policy paths largely reflect different stages in the business cycle, in particular the lower slack evident in US labour markets, but also heightened ECB anxiety over deflation. Fed chair Janet Yellen is watching headline unemployment fall to 4.9 percent, whereas ECB president Mario Draghi has to contend with a stubbornly high 10.3 percent. Fixed income markets have listened, with the yield curve for US Treasuries sitting well above that of German bunds (see Figure 1).