The trade war between the US and China also threatens to turn into a currency war. In the meantime, there are growing doubts about the effectiveness of monetary policy. The bond markets are already factoring in this gloomy scenario. Will the other markets follow suit?
Financial markets signal that the most important and urgent problems besetting the global economy are reasonably under control, for now, whereas the underlying forces are not being addressed. The result is very sluggish growth. Are the political trends in line with this outlook? And, will the relative lull soon be over?
The interest rate spread between de dollar and the euro is experiencing downward-pressure, but this is overshadowed by amongst other things a dollar squeeze and higher returns in the US. This causes EUR/USD to depreciate.
EUR/GBP has already discounted a lot of the negative consequences of Brexit. Still, a no-deal Brexit will cause additional strengthening of EUR/GBP to around 1,00. On the other hand, EUR/GBP will depreciate a lot in case of a soft Brexit, postponement or the UK even deciding to cancel leaving the EU..
The ECB has few levers to pull left to stimulate growth in case the trade war will result in lower business and consumer confidence and an economic recession. This could lead to a further decline in long-term rates, although we think a near-term upward correction of the 10-year German interest rate is likely. In the long-term, more fiscal easing is necessary to start a more structural uptrend in European long-term rates.
A growing number of investors believe the trade war will cause a US recession and this means increasing pressure on the Fed to do more to stimulate the economy. However, the US economy is less exposed to foreign trade and enjoys a robust inflow of capital. Hence, more Fed easing might actually boost growth more than expected and will result in higher rates and a steeper yield curve in the coming quarters.