Miroir aux alouettes

Despite Jay Powell’s cautious words last week, US long-term yields were at the end of last week still close to 5%. Even if the Fed Chairman’s words triggered a downward revision of market pricing for Fed Funds for the remainder of this year, the long end of the curve seems to be increasingly detached from the expected short-term trajectory for monetary policy. The market may have taken on board the notion that the US neutral rate is now higher. This would reduce the capacity of the Fed to influence long-term yields.

The resilience of the US economy now extends to how it reacts to international energy shocks. Of course, higher oil prices affect US consumers, but since the US has turned into a net exporter of fossil fuel, contrary to the Euro area this does not result in a deterioration in the terms of trade. This has contributed to the reversal of the correlation between oil prices and the dollar exchange rate. It used to be negative – rising oil prices coincided with a weaker dollar. It is now positive: the US dollar thrives despite elevated oil prices. This adds to the constraints weighing on Europe: a stronger dollar adds to the inflationary pressure triggered by energy costs.

The risk of another push in oil prices would affect the Euro area at a moment when its energy-intensive sectors have not yet recovered, their output still below the level seen before the pandemic, unlike in the US. This highlights the need to provide consumers with more visibility on energy costs. The deal on the reform of the EU electricity market last week brings some progress on this front.

We do not expect much from the ECB Governing Council meeting this week. A pause had been clearly telegraphed after the 25-bps hike in September and given heightened uncertainty the ECB is unlikely to want to “rock the boat”, including on balance sheet issues, even if we don’t exclude a small move on mandatory reserves.