"Some will win. Some will lose. Some were born to sing the blues."
This week witnessed the release of the Fed minutes from the 26th/27th January Federal Open Market Committee meeting and the European Central Bank (ECB) minutes from the Governing Council meeting culminating on the 21st January.
The Fed noted that, at the time of the meeting, they saw clear improvements in the medium-term outlook, describing the economic outlook as “considerably stronger”. The dominant factor in this analysis was the inclusion of the (4th) fiscal stimulus package passed in December (and clearly evident in the January retail sales data released this week) and the assumption that there will be a further package (the USD 1.9 trillion proposal from the Biden Administration – likely to be passed under the reconciliation process in the Senate, thus not requiring bipartisan support) over coming months.
Furthermore, while the market frets about the proximity of a Fed taper, the policy narrative remains that the pace of asset purchases will continue at the current pace until substantial further progress towards its employment and inflation goals has been achieved. Against this currently unquantifiable hurdle from the Fed, markets have also marked their expectations for a US recovery “considerably stronger” – which has also been translated into higher expectations for inflation. Indeed, the US inflation dynamic and the interaction between nominal yields and inflation breakevens is likely the dominant theme in markets at the moment: is a credible threat of inflation good or bad for the recovery and risk assets?
While we believe that rising nominal yields are unlikely to derail the rally in equities or broader risk assets (as growth momentum dominates), we are increasingly of the view that against a very strong nominal growth backdrop, rising US yields (both nominal, and more recently real) should be supportive for the USD.
In the Eurozone, the situation is a little different. The fiscal stimulus is not nearly as large, and the output gap is significantly larger. The less dynamic economy is yet to produce any demand-driven inflation through the first stage of the recovery process, and the heightened restrictions that remain in place suggest a further extension of this demand weakness. Furthermore, when the recovery in Europe does finally come, it is not clear how much the headwinds from the removal of labour market and corporate fiscal support mechanisms will drag on the reopening momentum – especially as the boost from the Recovery and Resilience Fund (RRF) is spread over many years.
While the Fed minutes urge caution towards the temporary or “one-time” factors driving near term inflation (likely above target “for a brief period”), they also acknowledge a gradual rising trend. The ECB minutes, however, highlight the concern that the “inflation outlook was falling significantly short of the Governing Council’s aim” and that developments in the exchange rate might have negative implications for euro area financial conditions and, ultimately, consequences for this inflation outlook.
The ECB continues to stress the importance of maintaining (the as yet unquantified term) favourable financing conditions to support the flow of credit to all sectors of the economy, with some members noting that the “fast rebound in growth seen in the December staff projections might be too optimistic”.
Ultimately, we continue to see the growth and yield differentials in favour of the US driving a lower EURUSD exchange rate – which ironically, if it does prove persistent, may provide the most effective policy fillip for helping the ECB attain its inflation mandate. The ECB minutes note “expectations of substantial US fiscal support had led to a steepening of the US Treasury yield curve, which had only affected yields in the euro area to a limited extent, as a significant “decoupling” of yields could be observed”. This is important – rising US yields dragging Eurozone yields higher (and curves steeper) is also a risk to the more nascent Eurozone demand recovery and one that is difficult for the ECB to address, even to a ‘limited extent’.
We expect this to be further reinforced by the second order differential of the Fed/ECB narrative. The ECB wants to achieve ‘favourable financing conditions’ by retaining the credible threat that it can provide further accommodation through the use of ‘all’ tools. The Fed, however, is trying to reign in market expectations of near-term tapering by leaving the phrase ‘substantial further progress’ undefined – but are in no doubt that the next policy move is tightening.
More broadly, the recent rally in oil prices – driven at least in part by extreme weather induced supply shortages (and demand increase) has complicated the real/nominal rate rise debate. Ultimately, however, we continue to view the US (and China) growth narrative as the dominant factor, and that the steepening of the US yield curve (provided it remains orderly) is unlikely to derail either the US economic recovery or indeed the (tech-driven, in our view) US equity outperformance – especially in the near term, as the fiscal impulse in the US is likely at its highest.
... Don’t stop believin’!
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