"A thousand miles and poles apart"
Last week, we discussed the economic narrative and carefully crafted forward guidance lexicon of both the European Central Bank (ECB) and the Federal Reserve (the Fed) (following their respective policy meeting minutes) and how the subtle differences in the monetary stance may ultimately lead to USD outperformance, as yield and growth differentials widen. Over the last couple of weeks, there has been a further intensification of the debate over the implications of the broadening of the global bond sell-off, which in many respects has highlighted these subtle differences further.
From the outset, it is perhaps worth stating that we maintain a more sanguine view about the medium-term implications of the recent move higher in yields, particularly in the US, despite the current high volatility. Ultimately, we are more of the view that the recent rise in yields (both nominal and real) is essentially a catch up to the repricing of growth and inflation that has been apparent in equity and commodity markets (in varying degrees) since the vaccine breakthroughs in early November.
It is perhaps worth stressing this point. If we take the US in isolation, the sell-off in Treasuries has seen yields at the 10y part of the curve rise to 1.60% (albeit briefly) from below 1.10% at the start of the month. While this is a relatively fast move (and we concede that fast changes in market pricing tend to be associated with higher volatility and lower risk appetite, or risk-off), it is important to put the move into the context of the rapid acceleration of fiscal stimulus in the US – likely to be extended further at the end of this week, as the Senate is set to vote on the Biden Administration’s additional USD 1.9trillion Covid Relief Bill. Against this further fiscal expansion, which is generally accepted to be likely to drive nominal growth in the US of over 6% in 2021 (and maybe close to 10% in Q2), the move in long term US yields appears manageable… at least for now.
From an equity and broader market risk perspective, we are of the view that if rates are rising much more slowly than the expected economic growth, then risk can remain positive.
(Indeed, as an aside, there are some interesting arguments as to why growth (tech) stocks should underperform cyclicals and value stocks in the reflation due to the duration argument (that in an environment of rising long end yields the net present value of future demonstrable positive cash flows is reduced). However, that was not the case during the US hiking cycle of 2016-2018, where the Nasdaq outperformed the S&P by 2X, as not only deposit rates rose, but long yields also rose sharply. Furthermore, it is also likely that the nature of the pandemic has accelerated adoption, development, necessity and innovation in the tech space.)
Much market emphasis has been placed on the distinction between the impact of the specific components of the rise in yields, placing a more risk-friendly link to higher yields driven by future inflation expectations, than by rising real yields. Ultimately, this may well be true (and we admit that this distinction is far more complicated in emerging markets, where Taper Tantrum memories, and sensitivity, runs deeper), but given the complicated aggregate demand and supply constraints across various areas of the economy, due to restrictions or reduced confidence, it is likely difficult to distinguish between the drivers of medium term inflation and/or their contribution to nominal yields...at least in the near term.
However, there is perhaps one area of the global bond sell-off that we can potentially draw inference from – differentiation. It is true to say that the bond sell-off has been global. Indeed, Australia, New Zealand and the UK have all seen bigger nominal yield rises than the US this year (though it is likely that positioning and liquidity have also played a part here). However, recent commentary has highlighted a key differential between the Fed and the ECB.
Fed Chair Powell, in recent testimony, has delivered a more sanguine view of the recent rise in US yields – stating that “developments point to improved outlook later this year” and that “vaccines should help speed the return to normal”, while continuing to emphasise that progress towards monetary normalisation remains a way off. Indeed, the Fed Vice Chair appeared to go a step further on Wednesday evening, stating that he is “bullish on the recovery in the US” and that markets are effectively just “pricing a better outlook for the US economy”.
From the ECB, the narrative has become more urgent throughout this week. On Monday the ECB President suggested that the ECB are “watching long end rates carefully”. By Wednesday, an ECB Executive Board Member had upgraded the rhetoric to “we will ensure no unwarranted tightening of monetary conditions”; and by Thursday, and the ECB Chief Economist had stated that the “ECB will buy bonds flexibly to prevent undue tightening”!
Herein we see the differentiation going forwards. The US has a more clearly defined policy reaction function. If by year-end inflation is at 2% and full employment has been reached, then the Fed will have surpassed its ‘significant further progress’ towards its (defined) objectives and will thus likely be talking about policy normalisation (talking about tapering if not thinking about raising rates!). The ECB, on the other hand, is focussed on maintaining ‘favourable financing conditions’, and as such is likely to try and lean into the rising yields (as the ECB Chief Economist suggests they already intend) to prevent a tightening of monetary conditions driven by the US’ (fiscally turbocharged) economic growth outperformance (both chronologically and in magnitude).
Ultimately, and consistent with our thoughts last week, this progression likely sees a widening of yield and growth differentials and will increasingly weigh on the EUR. More broadly, while market tensions are rising with the sell-off in bonds we maintain an optimistic growth outlook … more Quantum of Solace than Skyfall!
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