"In real life, it is the hare who wins. Every time…it is my contention that Aesop was writing for the tortoise market. Hares have no time to read. They are too busy winning the game."
- Anita Brookner
Over recent weeks we have reviewed and opined on the monetary policy narratives of the European Central Bank (ECB) and the Federal Reserve (Fed). While we have argued that the narrative from the ECB Chair did not communicate the extent of the dovish persuasion of the ECB as effectively as she may have wished, the pledge of ‘favourable financing conditions’ is aimed at maintaining (or even increasing) the level of monetary accommodation. The Fed Chair, on the other hand, has used the forward looking if undefined target of ‘substantial further progress’ to reign in expectations of monetary normalisation – “patiently accommodative”.
However, there are clearly different pressures from the market upon the policy guidance from the respective central banks. Markets have been keen to price higher yields in the US as a function of sharply higher inflation breakevens over recent months (exacerbated by a bigger than expected fiscal stimulus) prompting the Fed to push back against the prospect of normalisation… in the very near term at least. The ECB have been more focussed on drawing attention to the possibility of further easing measures (across “all tools”) should US yield curve repricing unduly steepen the European curves. You could say that the ECB’s message is still more carrot-like, while the Fed’s more stick-like.
From our perspective, the dominant theme for currency and asset markets over coming months is differentiation – the key proponent of which is growth.
The US fiscal stimulus package is truly unprecedented – the latest Covid Relief Bill adding almost 10% of GDP (to total almost 25% since the onset of the pandemic). While the size and temporal concentration of this huge stimulus means that there will likely be large spillover effects to the rest of the world (as surging US demand outpaces domestic supply – a factor than in itself may also limit the direct inflationary impact), we believe the growth outperformance in the US over the rest of the world over the next few quarters is likely to be significant. In this regard, for EURUSD it is less carrot and stick, and more Tortoise and the Hare.
We have been quite vocal for a while now about our preference for USD outperformance relative to the EUR as differentials have widened. It is not just growth differentials that have formulated this core view, but vaccine procurement and delivery differentials have been clear, and fiscal stimulus differentials are substantial (and are widened further if we focus on just the grants of the Next Generation EU funds, which themselves are spread over a number of years – admittedly there has been some essential and significant, if non-uniform, fiscal easing at the national level). Lastly, while there has been much focus recently on the implications of rising US bond yields, there is also significant differentiation in the monetary stimulus provided by the Fed relative to the ECB during the Covid crisis where the Fed cut rates by around 200bps – the ECB has left rates unchanged at -0.50%, choosing instead to target the sovereign spreads and curves.
From our perspective, as growth differentials become more apparent, extended currency moves are more likely and, while the dominant driver of this move is likely to be the USD, the focus of differentiation is likely to become more engrained and thus by extension we would expect to see greater non-USD cross price movement (in this respect cross currency volatility is likely still under-priced).
Not only does the US have the most significant fiscal (and as discussed arguably deferred monetary) impetus, it also likely has the most dynamic, flexible economy, with the fewest pre-existing conditions. Thus, the increase in nominal US growth expectations / outperformance, driven by all of the factors we have outlined, is likely significantly bigger than any increase in the cost of capital as a function of recent moves in the US yield curve. In short, we continue to expect the acceleration in US growth to feed through into earnings growth outperformance and higher US equities – in this regard Q1 earnings season (and notably Q2 guidance) will be keenly watched.
On the theme of differentiation there are also likely some key focal points for the prospects of monetary and fiscal normalisation. Some fiscal support measures in Australia expire at the end of March (labour market support measures similar to the UK’s furlough scheme) and the subsequent impact on the labour market, sentiment and aggregate demand will be watched closely. Similarly, other DM countries such as Canada (and maybe even the UK) may be ahead of the US in tapering their asset purchases and thus will also become financial market ‘canaries in the coal mine’ – without the global stability connotations!
Ultimately though, we continue to see the USD outperforming over coming months as the peak of the US stimulus starts to feed through to the real economy. Just as importantly we feel that this will trigger a financial market backdrop that is more driven by growth differentials and less by risk-on / risk-off (especially if vaccine distribution can improve the health situation for all).
At some point market focus may return to the US twin deficits and, if and when growth fades, debasement arguments may once again weigh on the USD. However, from our point of view that is a discussion for later in the fable – perhaps if the overconfident Hare (the US) decides to take a nap during the race. For now though, markets should focus on the widening differential between the dynamic Hare, and the laden but purposeful (rules based?) Tortoise!
Sources
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