The American electorate has been wise enough over the past three decades to, more often than not, split its ticket. This hasn't reflected radical moderation so much as a form of risk management, an extension of the checks and balances so wisely written into the Constitution by the Founding Fathers.

The same principle of policy diversification extends globally among the various finance ministers and central banks. Sometimes their policies have been disparate -- the Federal Reserve's manic rate-cutting of 2001-03 was not matched by the other major central banks, nor was the Bank of Japan's similar charge toward 0% in the 1990s.

At other times, policies have been coordinated with little success. The 1987 stock market crash was preceded by two years of central-bank coordination to drive the dollar lower, and the final leg of the global equity boom in the late 1990s was preceded by choreographed rate cuts.

None of this argues for gratuitous noncoordination, however. We only need to recall how the Federal Reserve's rate cuts of the early 1990s were matched by rate increases by the Bundesbank to forestall inflation in the newly unified Germany; their clashing policies helped precipitate both a weak dollar and the September 1992 collapse of the British pound. I warned back in June 2000 of the risks posed then by diverging monetary policies.

United We Stand, or Fall

The statement made by European Central Bank President Jean-Claude Trichet last week that the ECB stood ready to raise interest rates to prevent an acceleration of inflation brings the ECB on board with the Federal Reserve and the Bank of Japan. Just as the Federal Reserve was more aggressive in cutting rates until recent years, it has been more aggressive in raising them since mid-2004.

Let's compare the relative movements of six-month London Interbank Offered Rate for the dollar, the euro and the yen. These rates incorporate current base lending rates set by central banks plus short-term policy perceptions. The chart below compares these rates on a logarithmic scale with their January 1999 levels at the euro's introduction.

One of the interesting aspects of this comparison is how none of the major six-month Libors are at January 1999 levels; this has been true since November 2002. Both euro-Libor and yen-Libor are substantially below those levels, and despite recent turns higher, they have yet to move in parallel with dollar-Libor.

There is room to rise for all of these interest rates and, more importantly, there is room for the dollar's rate advantage to narrow. Should this have an effect on the currency and equity markets?

On a relative basis, not necessarily. As discussed here in May 2004, there is much more to analyzing currency movements than a simple rate comparison. We have to look at the comparative asset returns and inflation expectations between the two currency zones. Otherwise, we can get a distorted picture of how markets operate.

The examples below will be limited to the euro; the yen is affected by too many extraneous factors to produce a clean comparison.

Room to Rise for Short-Term Rates
Source: Bloomberg

A glance at the chart below might tempt us to believe the euro-dollar exchange rate moves nine months or more in advance of the six-month Libor differentials between the two zones. In practice, whatever long lead and lag times we may wish to tease from the data are irrelevant. The currency markets instantly capitalize to the extreme any and all information that may affect the expected rate gap. That certainly was the case with the euro and its 1.7% rally last week following Trichet's statement.

Exchange Rates More Than Rate Gaps
Source: Bloomberg

Relative Performance

Now let's look at the relative performance of the euro-zone stock market (as measured by the Morgan Stanley Euro Index), the American market (as measured by the Russell 3000) and the six-month Libor gap. The relative performance of the two stock indices can be depicted on both a nominal and a currency-adjusted basis; the latter represents the gains and losses an unhedged American investor would see.

Short-Term Rates And Relative Stock Performance
Source: Bloomberg

The relative returns to American investors in European markets have advanced in recent months on both an adjusted and an unadjusted basis even as the rate gap between the dollar and the euro grew. We could argue that rates were rising faster in the U.S. by virtue of a stronger economic performance and higher asset returns in the U.S. In addition, the Federal Reserve's increasingly apparent resolution to fight inflation, something the ECB signed on to only last week, does indeed create a better investment climate.

Absolute and Relative

We only have one episode in the euro's short history of a prolonged period of euro rates rising faster than dollar rates: the two-year period between mid-2000 and mid-2002. This rate gap occurred within the context of a global bear market in equities, and it was driven more by the Federal Reserve's rate-cutting than by anything the ECB did.

American investors fared better -- if we wish to include losing less money in Europe than in the U.S. as "faring better" -- by holding European stocks during this period. This is a relative measure; the absolute returns were negative in both markets.

Now that the world's central banks are in apparent agreement on the need to raise rates and fight inflation, should we expect the European markets to start outperforming their American counterparts on the basis of a narrowing rate gap alone? And even more important than this relative basis, can we state in advance whether rising global short-term rates will be sufficient to stall all equity markets?

The answers to both questions are maddeningly indeterminate. The inflation now being combated is the culmination of several years of monetary ease. The Federal Reserve eased more and has been tightening more, and these actions produced both the 2002-04 rally in the euro and its weakness relative to the dollar in 2005. If the market senses the ECB is further behind the curve on inflation and will either stay that way or start raising rates too fast, the European markets will suffer on both an absolute and a relative basis.

If we go through the various policy combinations, we start to conclude the best course of action for the Federal Reserve is to stay on its measured pace and for the ECB to start talking this talk in its various languages. That is the only form of policy coordination that will benefit all markets. Is this asking a lot of the central banks? Yes, but as Benjamin Franklin noted, they had best hang together or else they surely will hang separately.

As originally published, this column contained an error. Please see Corrections and Clarifications.

Howard L. Simons is president of Simons Research, a strategist for Bianco Research, a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

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