21 June 2019
Markets move on anticipation. As investors, business owners and even consumers begin to expect the FED, ECB or other Central Bank to cut interest rates, they begin to act now.
Source: US Federal Reserve, FRED. Series DSGS10. 10-Year Treasury Constant Maturity Rate, Percent, Daily, Not Seasonally Adjusted.
Central Banks generally lower rates to stimulate the economy, so everyone expecting interest rate cuts means slightly higher GDP growth, or an end to any GDP slowdown that might be occurring in Europe and the US. That’s the good news and leads in part to a rally in stock markets as investors see the Central Bank “saving the economy”.
The US stock market is hitting new highs, likely due to these expectations. Also, if investors expect interest rates to be lower in the future, then they’ll trade US Treasuries until the market rate adjusts to match the lower level they expect. The 10-year yield fell about 0.14 percent in recent days.
The Challenge for Central Europe: Exchange Rates and Keeping Interest Parity
While the US FED acts based on what’s best for the US economy, it doesn’t act in a vacuum. When interest rates in the US dip below the (risk-adjusted) returns in other countries, the global investors try to invest in those other economies to get a better return on their money.
That act alone has two effects. First, to invest in a foreign country you need to buy its currency, so this increases demand for foreign currencies, pushing up their value. If you follow InvestCEE’s Exchange Rate Reports, you’ll notice that this has been happening to Central European currencies in recent weeks as anticipation of a US FED rate cut built momentum. See the graph below, from our latest report, the CEE currencies (Euro per local currency, so an increase means an appreciation of the currency) relative to their historical averages.
Source: Eurostat and own calculations. Exchange rates are inverted to be EURO per local currency. The center line is a rolling three-month average. The upper and lower boundaries are the average plus and average minus one standard deviation, respectively, for the same three-month period.
The second effect is that investors move into buy into the local bond and other markets in these CEE countries. As they increase demand for local bonds, it pushes up the price of the bond, but pushes down the yield which is the interest rate in the local economy. This too has been coming out loud and clear in our recent InvestCEE Interest Rate Reports. See below, from our most recent report.
Source: Eurostat and own calculations. Daily EMU convergence criterion bond yields (i.e., central government 10-year bond yields). The center line is a rolling three-month average. The upper and lower boundaries are the average plus and average minus one standard deviation, respectively, for the same three-month period.
Over the coming weeks, we’ll continue to watch interest and exchange rates in the region. But seeing them all move together suggests a common cause. In this case, it seems that the growing likelihood of a US FED interest rate cut at their next meeting at the end of July is driving both US markets and markets in CEE to some degree.
The CEE Policy Response
The eventual policy response of the local CEE central banks and the ECB will be that they’ll likely have to match the US FED interest rate cut. If they don’t, they’ll find their appreciating currencies slowly becoming a drag on the local economy.
The reason for the economic drag is that an appreciating currency makes your country’s exports more expensive in world markets. This makes it harder for your local businesses to sell internationally and hence lowers your domestic GDP growth. And secondly, foreign goods become cheaper, so imports rise. Higher imports are fine, but in this case they also reflect domestic consumers switching away from some domestically produced goods and buying them instead from foreign countries, which again hurts domestic GDP.
So the US FED cut might help prop up the US economy. It will help the US economy and help maintain exports for everyone else, including CEE economies. But it will also mean CEE interest rates will likely come down over the coming month(s) as well.