RPT-ROI-Transatlantic rate convergence may be a mirage: Mike Dolan

Interest rate differentials tell a tale ​right now - and it's a complicated one. The transatlantic policy rate gap is closing fast but look further out ​and a very different picture emerges. The euro/dollar exchange rate - the conduit for more than $2 ‌trillion ​in daily currency market turnover and more than a fifth of global flows - remains the world's pivotal currency pair. The U.S. short-rate premium over the euro zone could well evaporate by year-end.

On the face of it at least, that's likely a pretty powerful headwind against the dollar, which may struggle to sustain any of the renewed safety flows it enjoyed over the past two months. Both ‌the Federal Reserve and the European Central Bank are expected to hold rates steady when they meet this week. But the Iran war and its related oil shock havebamboozled inflation and rate expectations and horizons on both sides of the pond.

Setting aside the pandemic, when all major central banks cut to near zero, Fed policy rates have been consistently above ECB equivalents for more than a decade - driven largely by superior U.S. growth and equity market performance. The ECB was quicker to return post-pandemic, post-Ukraine inflation to target. It has been in ‌its happy place at a 2% official deposit rate and roughly zero real short-term rates since June of last year.

The Fed continued easing late last year but has been on hold since, with inflation stuck above its 2% goal - first aggravated by ‌tariffs and now by fuel prices over the past eight weeks. Both banks are now frozen by the uncertainties of the Gulf conflict and the resulting oil market hiatus. But the regional energy impact - and the inflation and policy fallout - differ sharply.

Money markets are pricing at least two ECB rate rises this year, with many bets hovering about 2.6% by year-end - coincidentally where the March euro zone inflation rate landed. That pricing touched 2.80% last month as the war and crude shock unfolded, and some forecasters still expect a more aggressive ECB response than markets price. HAWKISH TILTS

Citadel strategist Frank Flight points to the surge in one-year euro zone consumer inflation ⁠expectations to 4% ​in March as evidence that a hawkish surprise is on the ⁠cards. "Hawks will absolutely push hard to move towards an April rate hike on this print, and they have a reasonable justification for it," he said. "I wouldn't rule out a 50-basis-point catch-up hike in June if they leave rates unchanged this week and the conflict persists."

At the Fed, May 15 marks the final day ⁠of Jerome Powell's term as Fed chair, making this week's meeting his last. The futures market basically sees less than a 20% chance of another cut in the 3.625% Fed mid-rate for at least the next year.

But there is a significant drop in the rate horizon by the end of ​next year - presumably as the oil shock dissipates, President Donald Trump's appointee Kevin Warsh's chairmanship takes shape and Powell nears the end of his board term. The upshot is an outside chance that policy rates converge toward 3%.

Two-year transatlantic government ⁠bond yield differentials tell part of that story, squeezing to their tightest in almost five years earlier this month. Indeed, the real two-year rate gap fell below 50 bps for the first time in four years.

But there's a different picture when you spin out to 10-year maturities - the gap remains heftier for nominal yields and is actually ⁠widening ​when you compare real, inflation-adjusted 10-year yields either side of the ocean. The 10-year real rate gap between Treasuries and euro zone debt has actually risen since the Iran war started.

The runes of that are underlined by this week's euro zone numbers that show sharply higher inflation expectations, combined with tightening bank credit. That reinforces the stagflationary fallout longer-term and biases the region toward slower growth and higher inflation over the longer term. By contrast, key drivers of U.S. growth for a decade or more - most obviously the tech ⁠and artificial intelligence booms, but also elements of deregulation - are expected to run the U.S. hotter over the longer horizon.

That helps explain why tech-led Wall Street stocks surged on regardless of the Iran-related energy crunch. Goldman Sachs strategists note that most profits ⁠expected more than 10 years into the future - often called terminal value - ⁠now account for about 75% of the S&P 500's equity value, near a 25-year high. When it comes to the North Atlantic comparison, the more things change, the more they somehow seem to stay the same.

(The opinions expressed here are those of Mike Dolan, a columnist for Reuters.) Enjoying this column? Check out Reuters Open Interest (ROI), your essential new source for global financial commentary. Follow ROI on ‌LinkedIn, and X. And listen to the Morning ‌Bid daily podcast on Apple, Spotify, or the Reuters app. Subscribe to hear Reuters journalists discuss the biggest news in markets and ​finance seven days a week. (by Mike Dolan; Editing by Marguerita Choy)

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