Interest rate differentials continue to widen as Fed set to hike


This week, the focus shifts to Wednesday’s FOMC rate announcement where the Fed are widely expected to raise rates by 25bps, taking the target range to 1.50 – 1.75%. The futures market is suggesting that a hike is a foregone conclusion, so what’s most interesting is any indications about their intention for additional hikes in the months ahead.

 

When delivering his first testimony to Congress at the end of last month, new Fed Chair, Jerome Powell, hinted that the Fed are likely to be more upbeat about the US economy than they were in December. As such, the market is expecting a higher growth forecast, a slightly lower path for unemployment and a higher rate of inflation. That being said, it seems likely that Powell will retain an element of caution given a greater level of uncertainty around the Globe and thus we aren’t expecting a dramatic change in stance.

 

While the US economy appears to be powering ahead, the same cannot be said this side of the Atlantic. The latest Eurozone inflation data showed prices rising just 1.1% year on year – well below the ECB’s 2% target rate and consequently, it’s hard to envisage the ECB hiking rates anytime soon. Likewise, economic growth in the UK remains fragile and consumer confidence is on the decline so while we continue to expect a rate hike later this year, the MPC is likely to continue to lag behind the Fed.

Over the past two years, we’ve had many conversations with clients about EURUSD interest rate differentials being at historical highs (meaning that it is an excellent opportunity for USD denominated funds to be hedging EUR exposures). Looking at the chart below, history tells us that these differentials have been relatively cyclical and a growing trend of globalization has meant that over the long term, the world’s central banks have all tended to move in a similar direction (albeit at different paces). However, with US rates consistently higher than EU rates over the past six years and the gap continuing to widen, the current environment looks set to continue for the foreseeable future.

 

CHART 1 – EURUSD 3 Year Forward Points (pips)

Source: Bloomberg

 

The story is similar, albeit slightly less extreme when looking a GBPUSD differentials. For a USD fund hedging GBP assets, there is a 160bp pick-up available when hedging using a 3 year forward. Likewise, many UK corporates importing goods from USD based economies will have noticed the significant change.

 

CHART 2 – GBPUSD 3 Year Forward Points (pips)

Source: Bloomberg

 

The converse of this, is that it is becoming increasingly expensive for EUR (and GBP) funds to hedge USD assets. While there are undoubtedly a huge number of opportunities for European credit funds lending in USD, increased hedging costs make it difficult for the EUR denominated funds to be competitive. Likewise, for European corporates exporting to the US, hedging USD revenue is becoming increasingly prohibitive.

 

Outlook

Although history suggests that interest rate differentials tend to be relatively cyclical, there appears little scope for the gap narrowing at this stage. For the time being, there is a good chance of differentials widening further. Longer term, we need one of three outcomes to facilitate a narrowing:

 

  1. The ECB and BoE to significantly raise rates and outpace the Fed.
  2. The US economy to run out of steam and for the Fed to cut.
  3. A combination of 1 & 2 – this would result in differentials narrowing quickly.

Clearly the most likely outcomes are either 1 or 2, but in the current environment, both look unlikely. Given that we have long been skeptical about central banks’ ability / willingness to dramatically tighten policy, we see a significant risk of the Fed being forced to scale back plans for monetary tightening in the months ahead if recent economic growth begins to slow.

Author: Marc Cogliatti

 

 

 

 

 

 

 



 

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