"Music creates order out of chaos: for rhythm imposes unanimity upon the divergent..."
- Yehudi Menuhin
Last week we discussed the likely imminent US economic boom – a reflection of the unprecedented US fiscal stimulus and represented in the high frequency growth data – a growth trajectory that will likely be exacerbated (if noisily) through the relative vaccination and reopening success in the US and ultimately the return of the US consumer. However, over recent weeks, we have been surprised at the continued focus the market appears to have on a near synchronous global expansion from the pandemic – only differentiated by the timing of reopening and/or vaccine progress. From our perspective, it is more complex than that. In other words, there is more than simply reopening dates to global growth differentiation going forwards.
This week, the focus shifts back to Europe and the European Central Bank (ECB), and I for one have been very surprised at just how bullish commentators have become about the European recovery over recent weeks, not necessarily in its own right, but certainly relative to the US. Analysts have also interjected with renewed topside projections for the EUR vs. USD. While there is always the possibility of currencies moving in either direction for a number of reasons, the popular narrative behind the view of a renewed push to 1.25 is from a removal of monetary support from the ECB – and thus a narrowing of yield differentials. This is more difficult to square.
It is difficult to envisage that the ECB would be happy with rising eurozone yields and steeper curves in expectation of a rebound that, as we have just noted, many thought we would currently be in the middle of, just a few weeks ago. The Fed have made it clear that they want to see the white of the eyes of both inflation and growth before they will take their collective feet off the monetary gas pedal. Whether or not the ECB expects real and nominal long-term rates to rise, in tandem with the real equilibrium rate, this approach seems to me to be out of line with the desire for ‘multi-faceted’ and ‘holistic’, favourable financing conditions. Especially as the ECB bank lending survey this week highlighted a further tightening of credit conditions for firms in Q1 (albeit at a slower pace than Q4 2020), which banks expect to continue into Q2 – against an already weakening loan demand growth.
We discussed last week a number of reasons why we expect an imminent growth boom in the US, as the fiscal stimulus, pent up demand, labour market recovery and improving confidence propel aggregate demand.
Indeed, Europe has many reasons to feel encouraged by the improved vaccination pace, signs of case stabilisation and prospects for a reopening bounce in activity later in the quarter. Some of this rising optimism on growth is expected to be driven by the ‘spillover’ or leakage of the US fiscal stimulus in terms of sucking in EU exports. We have little issue with this; indeed, this has been an argument of ours as to why inflation in the US may ultimately be less impressive ex post as it may seem ex ante. However, the argument that the spillover effects of the US stimulus package on European exports should be more material than the domestic impact of the package remains surprising.
That said, we acknowledge that there should be some pick-up in growth expectations for the eurozone in Q3 (even if many of the same commentators were calling for this to be predominantly a Q2 story, until very recently). However, the prevailing commentator view that this can be extrapolated to a reduction in the pace of PEPP purchases in Q3 – and some suggesting it may be signalled either at this week’s ECB (it wasn’t) or over coming weeks, seems premature.
Indeed, this week’s central bank focus was arguably the Bank of Canada (BoC), who delivered a tapering of its Asset Purchase Programme, and brought forward its estimated period over which it sees economic slack fully absorbed (along with inflation at target) to the second half of 2022 – ultimately reducing its forward guidance term or the period over which it commits to hold rates unchanged to the second half of 2022, from 2023.
Perhaps some had hoped that the ECB would be convinced by the relative hawkishness of the BoC. However, as the BoC Governor stated, the taper “reflects progress already made”. Growth has been significantly higher than expected in Q1 (and provisionally Q2), leading the BoC to revise up its growth forecast for the full year to 6.5% from 4% – while inflation is at or above target for the policy relevant forecast horizon. In Europe, growth is still expected to be (albeit modestly) in contractionary territory in Q1, and that is amid significant economic slack, still weak demand and a significant shortfall in inflation. The last thing the (comparatively nascent) eurozone recovery needs at this stage is a tightening of financial conditions (even through the signalling purchase pace expectations beyond the current quarter), or indeed a higher EUR.
Lastly, as economies begin to recover, there is another important differential between the US and Europe (including the UK) and that is in respect to the labour market. In the US, the lack of publicly funded job retention schemes meant that the unemployment rate shot up last year, whereas it remained relatively low in the eurozone and the UK. However, as the European economies reopen, the labour market support measures will end – this dynamic will be a drag on eurozone and UK growth, but likely a further boost to the US.
Ultimately, we continue to see a higher US yield curve, with 10y yields moving towards the 1.75-2.0% region and at the peak of the growth impetus it is not beyond the realms of possibility that the US 10y yield could breach pre-pandemic levels, given the continued level of monetary stimulus and unprecedented fiscal boost. At this point, a decision by the ECB to enable higher long rates – which would be dragged further higher by US rates – may seem, retrospectively, like a policy mistake. This is not to mention the fact that with inflation still faltering significantly below target in the eurozone (at the policy relevant horizon) that facilitating a higher EUR – as signalling comfort with higher term rates at such a nascent stage of the recovery would, in effect – would risk further de-anchoring inflation expectations.
Menuhin suggested that “rhythm imposes unanimity upon the divergent”, but for now, at least from my perspective, the US and the eurozone economies are aligning to very different rhythms...
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