"...'Obvious' is the most dangerous word in mathematics"
- E. T. Bell
Over the past couple of weeks, there has been a lot of noise in financial markets - virus variants, employment disappointments and inflation concern. We have even seen the Chinese authorities effectively outlaw an asset class (cryptocurrency). Yet, outside of the dramatic reversal of Bitcoin et al., given the volatility of the backdrop, markets have been remarkably stable. We have some thoughts on proceedings.
The USD has been under pressure again in May. However, it appears to us that there is perhaps something akin to machine learning or Artificial Intelligence (AI) bias to the narrative, where we would question the base assumptions that lead to the current, admittedly widely held views of EUR strength, USD weakness. Indeed, we believe there appear to be a number of inconsistencies to this view.
Tapering Asset Purchases
The consensus market view is that the upward revisions to the staff projections of the European Central Bank (ECB) at the June meeting will be sufficient to warrant a reduction in the pace of asset purchases under the ECB’s current PEPP programme. Indeed, there is every reason to expect the growth backdrop across Europe to improve from the middle of Q2, as economies reopen from their 3rd wave lockdowns. However, the ECB’s PEPP programme is essentially a fixed amount QE programme (with some potentially modest variation at the margin as to whether the ECB purchases the full envelope). If, as we expect, the ECB reduces the pace of purchases but retains the commitment to complete the pre-announced envelope, then this process does not amount to a ‘taper’ but merely a technical adjustment to the process of purchasing a pre-announced amount of bonds.
This is the same for the Bank of England (BoE), who have been very clear that the slowing of the pace of asset purchases in May did not amount to ‘tapering’.
On the other hand, the US QE programme is an open-ended QE programme, and therefore announcing a reduction in the pace of QE assets has material implications for the ultimate stock of assets purchased under the programme’s full duration. In short, we disagree with the view of some commentators that an ECB taper is good for the EUR, but a Federal Reserve (Fed) taper is bad for the USD. From my perspective, a Fed taper likely drives a higher US yield curve (real and nominal) and a higher USD. An ECB taper likely leaves the ultimate stock of assets purchased under the programme unchanged and thus should have minimal monetary implications. There is of course a flow argument, but given that this likely has the greatest impact in the periphery, the reduced pace likely widens spreads rather than core yields - this is unlikely to be seen as positive for the EUR.
The second anomalous expectation from our perspective is that Europe is about to enter a period of faster growth than the US. Mathematically this may be correct, but for us, the economic differentiation that is likely the key driver of capital flow in the years after the pandemic is not about the mechanical or technical base effects of an economy going from closed to open - an economy transitioning from 100% closed to 100% open would have infinite instantaneous growth, but this tells us very little else.
We remain of the view that the US economy will widen its growth differential to the rest of the developed markets nations following the pandemic (and China to the rest of emerging markets), for reasons that we have discussed on many previous occasions - essentially a significantly faster sustainable or equilibrium level of growth as a function of greater dynamism, innovation, total factor productivity, lower reliance on external demand and fewer pre-existing conditions. Sustainable growth dynamics are likely a far bigger determinant of capital flows. Furthermore, while it has become popular to see US growth as positive for the world but European growth as positive only for Europe, in our view of a differentiated global recovery, these assumptions are not convincing.
In many respects, inflation is much more complicated. In the lockdowns of 2020, some sectors of the economy saw demand severely curtailed (or even totally disappear) by the restrictions imposed on individuals. In 2021, while we are seeing a resurgence in aggregate demand, there are many areas where there are bottlenecks or other supply constraints that may take some time to balance out. There is no wonder that the annual comparison of prices between these two periods is uncertain, volatile and, from a policy perspective, of little value.
Inflation will likely be volatile for some time to come, but we remain of the view that the current (albeit in some cases quite acute) price pressures are more a case of a timing mismatch between factors of demand and factors of supply. However, we are also clearly of the view that the level of stimulus and demand growth in the US will ultimately result in inflation stabilising at, or even marginally above, target, and thus policy normalisation, albeit very careful and very gradual, can begin (while 5Y5Y forward inflation remains below 5Y breakevens, the Fed will likely remain more confident in US inflation being transitory). However, as the ECB Chief Economist suggested this week, the ECB “have a lot of work to do to raise inflation”, as demand and output gaps remain significant over the forecast horizon - this backdrop is much less synonymous with policy tightening.
While at times it could be argued that I am at risk of portraying an anti EUR AI bias of my own, I would like to be very clear that my analysis of the current situation is by no means a slight on Europe. Europe is indeed in the process of a well-deserved, if overdue, rebound alongside a vastly invigorated vaccine rollout programme. My observations are simply that the current nascent recovery neither warrants or needs a further tightening of financial conditions from higher (German led) yields, nor from the second order implications of wider intra eurozone spreads.
Indeed, unemployment in the eurozone is expected to return to its pre-pandemic levels by the end of 2024, yet we already have bund yields above pre-pandemic levels. With EUR some 10% higher than before Covid, my personal view is that markets are a little ahead of themselves, and while the Fed is clearly erring on the side of caution, the ECB is perhaps not cautious enough. The suggestion that the ECB is considering policy normalisation (even at the most marginal margin), could lead to further damaging tightening of financial conditions and snuff out the recovery (sustainable not mathematical), before it has really begun.
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