The monetary policies of the world’s three largest central banks have been diverging for more than two years.
After leaving its fed funds rate unchanged at 25 bps for seven years, the Fed made its first rate hike in 2016. That same year, the European Central Bank (ECB) and Bank of Japan (BoJ) cut their rates further.
Since then, the Fed has made six more rate hikes with another one coming later this month, while the other two banks have left their rates unchanged.
In October 2017 the Fed formally began its balance sheet normalization process, wherein they began to let bonds mature without reinvesting the principle. Since then, its balance sheet has shrunk by about 5% (dotted line).
Meanwhile, as the Fed has been shedding assets from its balance sheet, the ECB and BoJ have been adding assets to theirs. Since October 2017, both their balance sheets have grown by about 6%.
Conventional wisdom says that tighter monetary policy generally causes the currency to strengthen. And yet, in spite of the policy divergence in both rates and balance sheets, the dollar is flat against the euro and down 2% against the yen.
What are investors to make of this?
If there’s anything to be gleaned from this, it may be that such massive central bank intervention can distort the economic and financial environment in ways that are hard to comprehend. If that’s true, it has implications for investors’ perceptions of uncertainty and risk.
Unless otherwise noted, data is sourced from Bloomberg.
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