The fixed income market is resolutely positioned for a “soft landing” on both sides of the Atlantic and, when controlling for the difference in potential GDP growth between the US and the Euro area, it is also AXA IM’s baseline, writes Group Chief Economist and Head of AXA IM Research Gilles Moëc. However, when it comes to risks around such baseline, Moëc feels there is too little thought given by the market on the possibility of some significant transatlantic divergence this year.

The most obvious alternative scenarios revolve around the two classical policy mistakes:

A. Central banks may already have gone too far and engineered a “proper recession” which would ultimately take inflation below target.
B. Central banks may have stopped their tightening too early making it impossible to bring inflation fully back to 2%.

In Moëc’s view, the Euro area is more at risk of falling in the first scenario, and the US in the second. Beyond the fact that the economy has recently been much more resilient in the US, a fundamental difference between the US and the euro zone is that in the latter the maximum effect of the tightening of monetary conditions, given the usual transmission lags, will coincide with the start of budgetary restriction. The asymmetric materialization of these alternative scenarios would be quite damaging to the euro exchange rate and make the policymakers’ choices even more delicate.

“It seems to us that respective posture of the ECB and the Fed does not seem necessarily aligned to the most plausible risk in their region,” Moëc states. “Jay Powell was explicitly worried about the risk of falling into scenario A in its latest press conference, with some insistence on the FOMC’s awareness of the risks of having gone too far, while the ECB's rhetoric rather reflects a concern to avoid scenario B. This could bode well for a lot of volatility at the start of the year. If market participants begin to anticipate the materialization of risk A in the euro zone – which would then justify their expectation of swift rate cuts, but also weigh on equity prices as profits would be dampened - and risk B in the United States, which would force a significant upward repricing of the Fed’s trajectory, then strong downward pressure on the euro exchange rate would ensue.”

If the real economy and the Euro exchange rate plunge at the same time, the ECB could choose to proceed cautiously on rate cuts for fear of fueling imported inflation, while public finances would not benefit from much relief on their funding side, given the usual contagion effects from the United States to the euro zone bond market. This in turn could prolong the pain in the real economy