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U.S. and Europe are taking completely different paths



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It’s been a week in which there have been some mixed and undecided signals from the U.S. about the direction the Fed wants to take on interest rates. Does it stay put, cut, or, unexpectedly, raise?

First came the price index data on personal consumption expenditures (+2.7 percent and +2.8 percent was the “core” figure, against slightly lower expectations); then the day on Wednesday when Fed Chairman Jerome Powell, in keeping rates unchanged, reiterated that he was in no hurry to cut rates; and finally, on Friday, labor market data showed a marked slowdown in new job creation, hand in hand with a relative moderation in the upward momentum of wages.

On the occasion of each of these events, the markets—as is moreover logical to do—have changed their attitude each time. I was first convinced that the US rate cut was receding over time, if not actually disappearing. Then, especially on Friday, be more confident in a cut by July.

On Friday, Christine Lagarde and her entire executive board at the ECB also breathed a sigh of relief. Prospects for a U.S. rate cut make the journey toward the reduction less adventurous, which instead should have been started at least a month ago in Europe. In short, divergences between U.S. and eurozone monetary policies are softening. The euro/dollar exchange rate is rising from lows around 1.0650 precisely as a result of this changed outlook for U.S. rates.

But for those who do not need to look at events with a microscope, as those who operate in the markets are forced to do and must catch every single trend, little has changed.

Putting events in perspective, it is reasonable to predict that the U.S. economy will continue to show signs of decent vitality, supported by an impressive federal deficit of around 6 percent of GDP. So not “higher for longer” but just “high for longer” (high, not higher for longer, referring to rates).

On this side of the pond, one can expect only asphyxiating growth with area code numbers (in which Germany is at the tail end) and inflationary tensions that, past the shock wave of energy prices, will not abate. This is because the Green Deal and the related mindless rush for commodities will always keep price tensions high. The energy transition is, by definition, inflationary because it leads to huge imbalances between (high) demand and (low and rigid) supply. Not to mention the “ambitious” defense-related spending targets, about which everything is known except who will fund them and where they will get the money.

The result is a structural divergence of the paths on which the U.S. and Eurozone economies are set. Of course, there may be fluctuations in the short term around these directions, but that is the direction.

The outcome will be a necessary rate cut in the eurozone, but probably no more than 100 points over the next 12 months. Not surprisingly, long-term bonds seem to have reached a floor that they cannot break through, precisely because of inflation expectations related to structural factors. On the other hand, there may be only a modest reduction by year-end, but nothing more.

The paths have split, and small bumps in the ground will not be enough to change direction. And Lagarde will have to prove she can run on her own without taking advantage of the U.S. runner’s “wheel.”

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