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One of the conclusions of our structural work, highlighted in my 2023 global economic outlook, is that macro-economic cycles are likely to be more extreme, frequent and compressed, as central banks become an additional source, rather than a compressor, of volatility. A key macro implication of that finding is the likely greater cyclical divergence between countries and the need for different central bank responses.
The market, however, appears to disagree and is currently priced for continued cyclical convergence (Figure 1), which assumes that the historical pattern that has formed since the late 1990s will remain in place.
Despite the current market pricing, we think that many of the factors that contributed to the central bank convergence over the past three decades have now ended or started to shift into reverse. As a result, we expect the interlinkages between countries, central bank policies and market pricing to change, creating potentially attractive opportunities for active portfolio management and security selection.
Our view challenges many of the inherent assumptions that held true over the last decades, notably:
Figure 2 highlights an example of this growing divergence. It shows that the recent acceleration in global money supply —defined as cash and redeemable shorter-term deposits (M2) — across China, Europe and Japan has more than offset the contraction in the US.
Global activity indicators for developed markets suggest near-term resilience but we expect signs of divergence to emerge, with the US no longer setting the pace. Following the global financial crisis, monetary authorities across several countries effectively mimicked the Fed and, to a lesser extent, the ECB, even though the source of their problems was different. As a result, those countries — typically small, open economies — ended up with higher inflation relative to the US and the euro area. In a low global inflation world, these price pressures pushed up housing costs and household leverage. These adverse effects of monetary policy convergence mattered less on a global level, as these were small economies.
As long as the US banking crisis doesn’t morph into a global banking problem, other countries quickly following the Fed’s response to the current problem will once again face consequences: to name one, they will be more likely to embed high medium-term inflation. That is why I think something is wrong in the current pricing on a cross-market basis. Either the current symmetrical front-end pricing across markets, which assumes that central banks will automatically follow a potential Fed cut, is wrong or, if it is right and central banks once again take the lead from the Fed’s policy actions, this unwarranted policy convergence could result in higher risk premia in the long end of yield curves in various countries. The current pricing for the long end of their curves is out of kilter given the scale of the implications, with the potential for significant underperformance versus the US across a range of assets. Something has to give.
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