(The opinions expressed here are those of the author, a columnist for Reuters.)
By Jamie McGeever
LONDON, April 25 (Reuters) - As the global shift towards higher interest rates moves up a gear, attention is turning to Europe’s two major central banks.
Current market pricing strongly suggests the Bank of England will tighten further and faster than European Central Bank. But the reality may turn out to be quite different.
Having hiked rates once last year to counter a slump in the pound and the resulting rise in inflation, the BoE is further down the road of policy “normalization” than the ECB, albeit only slightly.
Money markets show investors expect the ECB will raise its deposit rate, currently -0.4 percent and below zero for four years, by only 30 basis points over the next three years. Meanwhile, they expect the BoE to raise its 0.5 pct Bank rate by 50 bps over the same timeframe.
The implied UK-euro zone rate gap is expected to remain wide at, or around, current levels for several years. The implied gap in four years is around 100 bps. It will narrow, but slowly: the implied gap in 10 years time is still around 50 bps.
Two-year bond yield spreads, another indicator of where investors see relative policy rates going over the near term, also point to UK rates rising more than euro zone rates.
Last month, the two-year UK-euro zone yield spread reached 150 basis points, the widest gap since 2007 and double what it was only a year ago.
This market pricing dovetails with a perception in markets that the nimble, flexible BoE will tighten policy more than the consensus-led, cautious ECB - a supposedly clumsier operation beholden to the views of 19 national policymakers and facing far less acute inflationary pressures.
Unsurprisingly, sterling is doing pretty well right now. It’s up more than 2 percent on a trade-weighted basis this year, supported by the BoE’s rate hike last November and expectations it will raise again this year.
The trade-weighted euro is up only 0.4 pct year-to-date.
But what if markets are wrong, or at least too aggressive in their view?
Once the ECB delivers its first rate hike, there’s every chance it will continue to raise more steadily and consistently than the BoE. This is not in the current script, so currency, rates and bond markets could be vulnerable.
A detectable shift is underway in both camps.
Firstly, the ECB. Policymakers are increasingly coalescing around the view that, a decade on from the onslaught of the crisis, policy normalization should begin sooner rather than later, even if inflation is still well below target.
According to one euro zone central banking official, the ripple effects of QE and negative interest rates on the economy and banking system are much harder to gauge than simply raising rates by x basis points.
“When you are doing something experimental, a small step approach is natural. But when you move away from that there’s not necessarily the same softly-softly approach,” he said.
“Once we move, we could be moving on a regular basis.”
Meanwhile, UK inflation is slowing more than expected and the likelihood of a rate hike next month is no more than 50-50 now compared with around 90 pct only a week ago.
BoE governor Mark Carney himself played a role in the market reversal, saying recently there are “other meetings” this year where the Bank could raise rates.
The next increase is not fully priced into UK money markets until November, and doubt over the path of UK rates is being sowed in traders’ minds.
Not for the first time. Carney and his colleagues have form for teeing up rate hikes then failing to deliver, so much so that in 2014 one UK lawmaker likened the Bank to an “unreliable boyfriend”, a label that has stuck.
Shortly after taking over as governor in 2013 Carney unveiled his “forward guidance” policy, which paved the way for higher interest rates once unemployment went below 7 pct. At the time, this wasn’t expected until 2016.
Unemployment fell below 7 pct only a few months later, but the Bank didn’t raise rates.
In July 2015 Carney said the decision to raise rates would come into “sharper relief” around the turn of that year. It didn’t, and indeed rates were cut in August 2016 following the Brexit referendum.
With the cloud of Brexit-related uncertainty still hanging over UK economy, traders could be forgiven for treating further pledges to raise rates with a degree of skepticism, even if inflation is still above the Bank’s 2 pct target.
Consumption has been virtually been the sole engine of GDP growth in recent years but recent data suggests it may be sputtering. And if the UK consumer flags, you can kiss higher UK interest rates goodbye.
Reporting by Jamie McGeever; Editing by Toby Chopra