Market expectations shift on rate cuts as Goldman Sachs foresees divergence between US Fed, G10 central banks

There are compelling reasons for the Federal Reserve to uphold a hawkish stance in the coming months, citing the upcoming US election and its potential impact on fiscal policies and trade protectionism

The favourable US inflation data in April brought relief to capital markets. Coupled with robust US growth and a string of positive US inflation surprises earlier in the year, this has shifted market expectations regarding the Federal Reserve's interest rate decisions.

Unlike most G10 central banks, markets anticipate the Fed to reduce rates later and at a slower pace. While the European Central Bank (ECB), Bank of England (BoE), Bank of Canada (BoC), and other G10 banks are expected to initiate cuts this summer, the first complete Fed rate cut is not anticipated until November.

Meanwhile, Sweden’s Riksbank and Switzerland’s SNB have already started cutting rates. At the same time, many emerging markets (EMs) are well into their easing cycles. The Bank of Japan (BoJ), the usually dovish outlier among G10 central banks, recently became the hawkish outlier as it began hiking rates for the first time in nearly two decades.

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In a recent report, Goldman Sachs delved into the extent of central bank divergence and its potential implications for economies and markets.

The international brokerage spoke to three monetary policy watchers namely Peter Praet, Maurice Obstfeld, and Jan Hatzius, who anticipate a near-term divergence between the Federal Reserve and most G10 central banks due to the Fed's anticipated delay in initiating rate cuts.

This deviation from historical norms is deemed reasonable owing to the robustness of US growth and a slower-than-expected disinflation trend in the US.

G10 central banks to diverge from US Fed?

Their views, however, differ somewhat regarding the duration and extent of potential diversion in the future. Praet, the former Chief Economist and Executive Board member of the ECB, told GS that there are compelling reasons for the Federal Reserve to uphold a hawkish stance in the coming months, citing the upcoming US election and its potential impact on fiscal policies and trade protectionism, factors not applicable to the ECB.

Obstfeld, Professor Emeritus of Economics at UC Berkeley and former Chief Economist at the IMF, suggests the robustness of the US economy could prompt the Fed to deviate more than anticipated, potentially resulting in only one or no rate cuts this year.

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In contrast, GS Chief Economist and Head of Global Investment Research Hatzius anticipates a more modest level of divergence, citing synchronised growth relative to potential and inflation trajectories across major G10 economies.

How will the hawkish Fed impact other central banks' policy options?

While differences in economic conditions may justify some deviation from the Federal Reserve's policies, could a more hawkish stance from the Fed ultimately limit the policy options of other central banks?

The mentioned economists, along with GS Chief European Economist Jari Stehn and senior global economist Joseph Briggs, largely disagree. They stress that policy divergence's main impacts would be felt through FX markets, with sharp currency depreciations potentially raising domestic inflation.

They express minimal concern about inflationary repercussions on most G10 economies. Briggs notes modest impact on core inflation from policy divergence, while Stehn suggests any spill-over effects from a hawkish Fed are unlikely to constrain ECB policy. Praet argues that the primary ECB policy limitation stems from the Euro area's fiscal integration absence.

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Japan presents an exception, where unfavourable rate differentials with the US have depreciated the Yen significantly. This could prompt the BoJ to increase rates faster than justified by domestic conditions, although Obstfeld and Hatzius urge caution for BoJ, citing uncertainty about Japan's exit from lowflation.

Could too much divergence from the Fed prove problematic?

Hatzius acknowledges potential significant policy divergence if supported by economic data but remains optimistic about the global financial system's ability to manage it, citing previous periods of disparity.

Despite past EM debt crises, he told Goldman Sachs that EMs are now less susceptible to the impact of elevated US rates. Obstfeld shares this view but notes frontier and low-income countries still warrant attention.

Kamakshya Trivedi, Head of Global FX, Rates, and EM Strategy at GS, along with senior FX strategist Michael Cahill, note that policy divergence and resultant FX volatility have primarily impacted EM currencies, while G10 FX has priced in a relatively minor degree of divergence, aligning with our economists' policy projections.

Consequently, they anticipate limited potential for G10 FX volatility. However, significant unexpected divergence could alter this trajectory, potentially prolonging the strength of the Dollar.

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Obstfeld agrees but remains attentive to the US election's potential impact on the Dollar's strength. Meanwhile, Cole perceives limited capacity to factor in further divergence into US-EU rate spreads, particularly in long-end rates.

He highlights the disparity not yet factored into US traded inflation. Goldman Sachs credit strategists Karoui and Rogers anticipate that the outperformance of EUR IG compared to USD IG is unlikely to recur, citing factors such as risk sentiment alignment and the ECB's shift from buyer to seller of corporate bonds.