Didier Le Menestrel

What next?

The recent US interest rate hike was a little bit like the long-awaited combat of Lieutenant Drogo who spent his life guarding the remote border fortress in the novel, The Tartar Steppe: spoken of constantly, expected constantly, but slow in coming. This wait finally ended on 16 December when Federal Reserve Board Chair Janet Yellen initiated the first rise in the US central bank’s benchmark rate since 2006.

At the same time, Mario Draghi continued to step on the accelerator of quantitative easing. Thus began an unprecedented period during which US and European monetary policies have entered upon radically different paths. This parting of the ways has already produced, as expected, its first results: since rebounding in October to 1.15, the euro then lost 8% against the dollar before stabilising around 1.09.

More difficult in contrast will be anticipating the impact of this divergence on bond markets. The price of a country’s government bonds (within the universe of long-term rates) largely depends on two factors: the level of short-term rates (with maturities from 0 to 2 years for this country) and the behaviour of other bond markets. We consider it a given that US long-term rates will rise. Will this trend be carried over to Europe or, to the contrary, will the effects of QE prevail, keeping long-term rates in Europe very low?

However, raising this question implies a relation of causality from the United States to Europe. A traditional dynamic, whether in the case of financial markets or the consumption of Coca-Cola or hamburgers, whereby as a rule it is the Americans who influence Europeans rather than the contrary.

Nevertheless, a recent study by the IMF has provided evidence of a curious reversal in this dynamic. The Granger causality test2, showed that while from 2010 to 2014, the US bond market influenced bond markets in Europe, since 2014, this relationship of causality has reversed: the dynamic of European QE is sufficiently powerful to push US interest rates down and thus become the primary independent variable for this market.

Today, strategists remain fixated on pursuing their 2016 roadmap. Like elephants, while not necessarily blessed with a very good vision, they do have an excellent memory: they remember how during the last thirty years, spreads between US and German 10-year rates never exceeded two points. Today, at 1.65%, this gap is closer to its upper limit.

While this observation of Europe’s leadership at a given point in time with respect to the behaviour of the markets for government bonds may be only theoretical, the fact that European rates may (even partially) resist the upward pressure from US rates constitutes a very reassuring development.

An encouraging point of view that is not however sufficient to incite us to adopt a more positive bias in favour of bonds as an asset class still offering returns that are much too small while presenting a very asymmetrical risk profile. However, the bond market’s behaviour has a strong influence on other asset classes and in particular equities. The resilience of European bonds by “wisely” becoming decorrelated from US bonds is accordingly a good sign for stock markets in 2016.

Didier Le Menestrel

1 Dino Buzzati, 1940.
2 The Granger causality test: a statistical measure for determining whether one time series has explanatory power in forecasting another.