Central Banks Take Back Global Market Spotlight -- Heard On The Street

By Richard Barley 

        Financial eruptions in Greece and China have been occupying markets' attention. But under the surface, the tectonic forces of global monetary policy are still moving slowly but inexorably. For many investors, it is time to think about the big picture again.
        Central bankers around the world set out their stalls this week and reaffirmed that monetary policy divergence is still the biggest single theme for later this year. U.S. Federal Reserve Chairwoman Janet Yellen and Bank of England Governor Mark Carney both signaled that their institutions were heading toward raising rates after more than six years of ultra-loose policy.
        Meanwhile, European Central Bank President Mario Draghi pledged to push on with his EUR1 trillion ($1.09 trillion) quantitative easing program. While U.S. and U.K. policy looks to be in sync, Europe is set to follow a different road, with the ECB expanding its balance sheet.
        That will hold challenges for markets. Some financial assets have clearly anticipated this, and by a long way: just look at the euro's exchange rate against the dollar, which started falling early in 2014. With Greece receding and monetary policy moving back into focus, further declines could lie ahead, although they are unlikely to be as precipitous. But if risk appetite continues to recover, the euro could serve as a funding currency in which investors borrow to buy higher-yielding assets elsewhere.
        Bond markets have yet to feel the full force of this potential divergence. True, 10-year yields in Europe appear now to have bottomed out after a bout of market madness in April that saw German yields fall close to zero, but the move higher has been modest, albeit volatile.
        The divergence is clearer at the short end of the curve, and should extend as markets begin to price in tighter U.S. policy in earnest. That would be another force that would tend to weigh on the euro.
        The challenge for Mr. Draghi will be to keep eurozone yields low even as the U.S. raises rates. A change in stance from the Fed would affect markets globally. Very short-dated yields should be anchored by the ECB's ultralow policy, and quantitative easing will help at the longer end of the curve, but probably won't offset all of a potential move higher in U.S. Treasury yields. J.P. Morgan Asset Management notes that while the correlation of moves in two-year German and U.S. yields has turned negative, for 10-year yields it has remained positive and relatively stable.
        Divergence shouldn't surprise markets: central bankers have been sending this message loud and clear. But risks remain. The route to looser policy was a straightforward one, but there is no clear road map for attempting to remove the enormous amount of monetary stimulus that has been pumped into the global economy since the financial crisis. Monetary policy divergence may be expected, but its effects are still unknown.
        Write to Richard Barley at richard.barley@wsj.com
        (END) Dow Jones Newswires

        July 17, 2015 07:28 ET (11:28 GMT)

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