Fiscal Divergence, Monetary Convergence?

“Tell me why everything turned around” ? ??????? Fleetwood Mac, Go Your own way

Written by Neil Staines, 7th March 2025.

Last week, we discussed the increasing debate about the existence or extent of the US growth slowdown. Essentially, the questioning of the extrapolation of US exceptionalism. We argued that the growth concern comes both in terms of momentum or delta as recent forward-looking high-frequency data have suggested a more conservative forward guidance - similar to many of the Q4 earnings releases - and also from the continued debate around a more conservative fiscal stance from the Trump Administration and whether this may mean a lower growth trajectory via lower fiscal. Ultimately, we restated our long-held views ‘on continued US disinflation and growth moderation and further, that we have for some time now questioned the (consensus) extrapolation of growth divergence as having gone too far in terms of pricing US exceptionalism and too far in pricing a European deterioration. We have also been very clear that while markets have continued to expect fiscal profligacy under Trump 2.0, we have disagreed.

We also argued that we continue to believe that the fiscal consolidation efforts of the Trump Administration are clear and resilient. In many respects, we would agree with the argument that we have transitioned from a backdrop of a Powell ‘put’ for equities to a Trump ‘put’ for the bond market. We argued that this had important connotations. This week, the global bond market dynamic had a different focus, a different driver!

New Government, new way?

The second point that we discussed last week was in relation to the German election and the implications for economic policy, fiscal expansion and for Europe, more broadly, the concept of increased defence spending in the post-Russia / Ukraine war narrative - likely, as it seems, without US security guarantees. Last week, we argued that the current geopolitical backdrop in Germany likely garnered sufficient political capital for fiscal expansion. (and by extension, that if we added in the potential for Ukrainian rebuilding contracts and a more positive backdrop for China consumption stimulus, property stabilisation and tech excitement, the growth backdrop outside of the US may well be turning more positive - notably in Europe)

Finally, last week, we argued that this combination would likely be a negative for US equity flows but that, essentially, it did not change our dominant macro views - continued disinflation and growth moderation in the US, but not a move towards recession. We argued that it was not clear to us, even against a backdrop of a further equity sell-off, that the USD would go up (‘we see the move as more of a rotation, and acceptance that globally, the concentration of US (and US tech in particular) relative to global equities is perhaps too high’). Indeed, we continue to see a weaker USD, even after the significant moves we have seen over the past week.

“You can go your own way”

This week marked a very significant series of events in Germany with a surprise fiscal expansion proposal. The incoming Chancellor, Friedrich Merz, outlined a planned infrastructure SPV worth around EUR 500B (or almost 12% GDP) over 10 years alongside a carve-out for defence spending from the debt brake (above 1% GDP) and a new ability for local governments to borrow (up to 0.35% GDP). While, as we pointed out last week, there was some expectation that the incoming coalition would likely try to amend the debt brake, the size and speed at which the CDU/CSU proposal was announced caused a substantial rally in the German stock market, German yields (sell-off in bonds) and the EUR.

In practice, there are some complications to this plan. Not least because parliamentary maths means that the best chance of attaining the two-thirds majority needed for constitutional reform (which all three measures would require) is more likely under the current members (i.e. before the new government comes in!). This is awkward (morally and practically, as it sets a precedent for future ‘outgoing governments’), but it appears the political will for this to happen is there. Indeed, Germany, for a long time the voice of fiscal conservatism within the region, has also called for a more long-term carve out for defence spending from the Maastricht Criteria at the EU level than the proposed 4 years waiver suggested at this weeks EU leaders meeting. A seismic change in Germany?

ECB - A Change in Direction?

Not only did this cause a headache for the market, but it also caused a headache for the ECB, with the significant fiscal announcement just hours before the ECB meeting and likely well after the data collection that formed the basis of updated projections. In essence, therefore, the ECB meeting was something of a halfway house between the pre-fiscal ECB path (likely expecting rates to be cut into expansionary territory) and the post-German fiscal world where growth and inflation forecast likely warrant a much shallower path of rate cuts. The ECB changed the description of rates from “restrictive” to “meaningfully less restrictive”?

Our argument has long been that a more fiscally conservative progression in the US (a smaller deficit) should lead to a more asymmetrically dovish Fed reaction function. Therefore, it should not be surprising that the proposed German fiscal expansion will lead to a less dovish monetary response from the ECB. By extension, relative monetary policy trajectories should have clear implications for currencies. We continue to see a weaker USD.???

The Long & Short of it…?

If we try to put this all together, the global macro backdrop will start to become very interesting. The uncertainties and complexities of the global trade and tariff negotiations continue, but some interesting divergences have emerged. We continue to see US disinflation and growth moderation driven by fiscal conservatism supply-side normalisation, and, by extension, we see a weaker USD as disinflation and monetary easing support growth. However, on the flip side, the recent proposed fiscal expansion and stimulus in Germany and China have moved the monetary dial in the opposite direction. Forward rate convergence (not the divergence that was consensus view over past months). To paraphrase Fleetwood Mac, global fiscal policies, monetary policies and likely, as a result, currencies ‘can go their own way’.

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