Back at the beginning of 1971, U.S. Treasury Secretary John Bowden Connally passed a message to European finance ministers: “The dollar is our currency, but your problem.” This statement is just as true today as it was then. At the time, the U.S. government was turning its back on the gold standard that set the value of the U.S. dollar, a decision that weakened the currency. As a result, a large number of countries that had hoarded U.S. dollars saw the value of their currency reserves drop.
The U.S. dollar is strengthening this time around. But the root cause of this shift could still cause problems, if rather different ones. The Fed ended QE in October 2014 and the markets’ focus is now on future U.S. interest-rate trends. Because the U.S. economy is growing robustly and the unemployment rate is falling, we expect the Fed to implement its first interest rate increase in the second half of 2015.
Borrowers both inside and outside the United States, after enjoying a low-interest-rate environment for the last few years, must therefore prepare for a rise in their interest burden. Initially, the rate hike may not have much of a negative impact because the nominal federal funds rate is very low and the real federal funds rate is negative. But if the Fed continues to raise rates in subsequent years, the risk of credit defaults will rise, and credit risks in general will climb with them (see upper chart).
The ECB is carefully monitoring the end of QE and the upcoming rate hikes in the United States. The dollar’s increased strength is being welcomed by the ECB’s economists because it should support Eurozone exports. They also know that, in the past, the yields of U.S. Treasuries and Bunds—the benchmark for interest rates across the Eurozone—have been positively and closely correlated.
Increases in the benchmark interest rate and the end of QE may also cause U.S. short- and long-term rates to rise next year. By contrast, the ECB is expected to keep interest rates low in the Eurozone. Growing interest-rate differences between the two major economic regions may trigger capital outflows from the Eurozone to the United States. Higher U.S. interest rates should also cause the dollar to rise.
Rising U.S. yields will also affect Europe: Because short-term interest rates will probably be kept low, the yield curve is likely to steepen. Steep yield curves are typically an indication of strong future economic growth. This interpretation—with certain reservations—should hold true for the Eurozone as well.
Growth momentum in the Eurozone remains very weak. For this reason, the ECB and individual Eurozone member governments will look unfavorably on a rise in bond yields. As a result, political leaders in the Eurozone are likely to direct their attention to public QE—that is, the purchase of sovereign bonds—as a way of keeping bond yields low.
The discussions are just now beginning. The IMF recently urged the ECB to consider a sweeping bond-purchasing program. But the German government has objected to such an idea, saying it would generate excessive liquidity. If bond yields did increase, the number of political supporters for such a move would be likely to rise. The ECB would then come under pressure to deploy public QE from its bag of tricks. In this case, the euro could continue to weaken against the U.S. dollar.
Investors should take this possible scenario into consideration when they make their investment decisions. Rising U.S. interest rates serve as an argument against U.S. Treasuries. On the other hand, Eurozone bonds may become very volatile. But there is one piece of good news for investors: Equities frequently continue to rise at the beginning of a cycle of rate increases.
Interest rates and crises: In the past, crises have frequently occurred when the real U.S. benchmark interest rate reached a level of about 3% or higher. During periods of low U.S. interest rates, economic crises and equity drawdowns are less likely. At the moment, the real benchmark rate is negative. This is one reason to remain invested in equities.
U.S. and German interest rates: Over the past 25 years, interest rates in the United States and Germany have moved almost in lockstep. This suggests that a rise in bond yields in the United States would lift yields in the Eurozone as well. This would likely be countered by ECB activity to mitigate related threats to Eurozone growth.
Deutsche AWM forecast as of 9/18/2014
IMF Managing Director Christine Lagarde in an interview with CNBC on June 19, 2014
Eurozone (year-on-year inflation in %) Inflation should be low in 2015 as a result of moderate economic growth and modest wage increases.
Deutsche AWM forecast as of 9/18/2014