Amid all the uncertainty swirling around financial markets, one clear picture is emerging for investors: U.S. and UK interest rates will soon rise, while most of the rest of the world is easing monetary policy.
Federal Reserve chair Janet Yellen and Bank of England governor Mark Carney this week gave their strongest indications to date that they are getting ready to raise rates.
The most visible impact of this divergence with the rest of the world — policy in the euro zone, Japan, China and elsewhere is firmly headed in the opposite direction — has been in currencies, where the dollar and sterling have jumped in value.
The trade-weighted value of the U.S. dollar had its biggest weekly gain in two months, while the trade-weighted value of sterling rose to its highest since March 2008.
"The only game in town is how far the dollar goes from here," said Alan Wilde, head of fixed income and currency at Baring Asset Management in London.
The dollar has risen more than 20 percent in value over the past year alone, so some investors think it may not have much more upside left.
HSBC's currency strategy team went as far to say in March that the dollar's bull run is now over, and a Bank of America Merrill Lynch survey of global fund managers this week showed that being "long" dollars was the most crowded trade of all.
So the consensus view is still for a weaker euro as the European central Bank presses ahead with its 1 trillion euro bond-buying program, and a fall below parity versus the dollar is a bet being made by big players such as Deutsche Bank and Goldman Sachs.
On Wednesday, Yellen told Congress that rates will probably rise "at some point this year." Her comments helped drive the euro to a seven-week low of $1.0850 and the trade-weighted dollar to within a whisker of a fresh three-month peak.
AGAINST THE TIDE
The rise in sterling over recent months has been even more dramatic, with the trade-weighted pound now at its highest level in over seven years.
Carney gave that rally extra impetus on Thursday when he said that the decision to raise rates from record lows will come into sharper focus "around the turn of this year."
"The pound has done well and will continue to do well," said Mark Haefele, global chief investment officer at UBS's flagship private bank in Zurich. Haefele said he has an overweight sterling position.
One paradox of a strong currency, however, is it makes other assets in that country more expensive, exports less competitive and dents the overseas earnings power of its companies.
That's why Haefele, who has over $250 billion of assets in discretionary mandates, has an underweight position in UK stocks, which are particularly sensitive to the income earned from operations overseas.
The Bank of America Merrill Lynch survey this week showed that a net 13 percent of those polled were underweight UK stocks in July, and have been underweight UK equities for two years.
Haefele is also wary of the impact a stronger dollar and any tightening in U.S. monetary policy will have on emerging markets.
"If capital is coming out of emerging markets and going into the developed world, then we would remain underweight emerging markets," he said.
Globally, however, equities could remain attractive because monetary policy remains extremely loose and liquidity is still being provided by central banks other than the Fed and BoE.
"Any upturn in the U.S. rate cycle is not something we take lightly. However, equity markets should be able to take this in their stride. It usually takes more than one rate hike to stop a bull market," Citi strategists said in a note on Friday.
The prospect of higher rates makes the yields on U.S. government bonds more attractive, certainly relative to the much riskier assets in emerging markets.
Baring Asset Management's Wilde, with $12 billion global fixed income assets under management, said U.S. government bonds offer a "significant" yield premium over European bonds. He will continue to buy 10-year Treasuries over Bunds for now, but expects Bunds to become more attractive once Fed liftoff actually happens.
The yield spread is currently around 155 basis points , which Wild reckons will narrow to 135 basis points before he reassess his position.
Some investors and traders with a shorter-term horizon will look to take bets on whether the Fed or BoE moves first, although most analysts think the Fed will lead the choreography and raise rates first.
But no matter who moves first, the United States and Britain will be swimming against the global tide. No fewer than 37 central banks around the world have eased monetary policy so far this year to boost growth, fight deflation or both.
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