Interest rates are the master lever central banks use to steer the economy. We track the frontline of monetary policy through three lenses: Market Expectations - forward-looking interest rate paths priced in by investors via Fed Funds and EURIBOR futures; Official Policy Rates - the current benchmark rates set by the Fed and the ECB; The Policy Spread - the shifting gap between US and European interest rates.
CURRENT READINGS
Focusing on the next 6 months, investors are pricing-in STABLE interest rates in the US with no rate change, and TIGHTER interest rates in Europe (up by 50bps). Looking further ahead, up to one year from now, US rates are then expected to move by 25bps up, while European rates are then expected to float around those levels.
Looking at the current US-EU rate policy divergence, the actual spread (1.71%) is high and is changing direction, moving lower after earlier gains.Interest rate levels between the two regions are quite different at this point. In theory, such divergence should push US bond yields to be clearly higher than EU ones, and should also support the USD (ignoring other factors).
MARKET IMPLICATIONS
The ECB’s tightening path is a clear headwind for European fixed income. For European equities, the higher rates will not hurt as long as corporate earnings and economic growth keep pace. Otherwise, expect valuations to cool. Meanwhile, stable expected rates in the US do not suggest any meaningful impact on bond or equity performance.
Interest rate hikes act as a brake on the economy—they crush inflation by making borrowing pricier, which eventually chills spending and growth. Conversely, rate cuts act as an accelerator, cheapening money to spark hiring and investment.