The European Central Bank (ECB) is committed to a massive bond-buying programme, which will probably continue till December. The ECB also has a negative rate. The US Federal Reserve has started hiking its policy rate, and is expected to continue tightening. Europe has seen some sort of gradual revival of corporate activity but this activity is still weak. Although EU inflation has risen to an average of 1.5 per cent, the ECB is still holding its negative policy rate. The ECB is targeting an inflation rate of two per cent in major economies like Germany and France. As a result, German Treasuries are consistently trading at negative yields, being bought at premium to face-value.
The ECB is also braced to keep policy accommodative because of fears of devastating political change. France goes into the second round of its presidential election next week. If Emmanuel Macron wins, as the opinions polls suggest, that could mean a second relief rally. If Marine Le Pen wins, it could mean a steep fall.
The US Fed hiked the policy rate, the so-called “Fed Funds rate” in the past two policy reviews. However, US gross domestic product (GDP) growth has slowed in the first quarter (January-March 2017). Both consumption and job creation seems to be slowing. On the other hand, wages have increased, and unemployment is down. These factors could cause inflationary pressures which may increase if the US becomes more protectionist. The Fed is expected to hold rates in this meet but traders expect a rate hike in June.
The other big sword of Damocles for financial markets
is the massive balance-sheet of the Fed. Multiple rounds of QE (quantitative easing) over a long period of seven years have led to the Fed holding huge quantities of bonds. It bought those in order to release money into the system.
If the Fed thinks US growth recovery is solid, it could start selling those bonds, reversing the process of QE. By pushing bonds into the market, it would reduce its bloated balance sheet. It would also suck money out of the system, cutting down inflationary pressure. Any sign that the Fed intends to shrink its balance sheet would lead to corrections.
Apart from protectionism, the Fed must make a call on President Trump's tax policies. The Fed had admitted earlier that it had little idea of the new President's policy direction and the likely impact. Not much detail is available about Trump’s tax plans yet. But he does seem to intend very deep corporate cuts, coupled to a massive spending hike on infrastructure. It’s anyone guess if these proposals will actually pass the US Congress, since even Republicans are dubious about some of them.
Assuming both ECB and Fed hold rates, the statements will still be read with great attention. Any signs of future tightening, or pessimism from Draghi could lead to a pullback. Any signs of dovishness from the Fed could lead to another surge in equity values. The statements in themselves could also cause swings in the dollar-euro rates. The euro was down to $1.04 in December. It has recovered since, to 1.09 dollar/euro. It could go either way, depending on traders' interpretations of the banks' statements.