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"...climb a mountain and you turn around"

- Landslide, Stevie Nicks

Last week (and indeed last year) we raised our concerns about the remarkable consensus in financial market forecasts. However, much like the start to the year, it is not as simple as that. In a world where numerous highly effective vaccines enable consumers, businesses and forecasters to imagine the world beyond the restrictions and lockdowns of a global pandemic, it is hardly a surprise that there has been unanimity in a positive medium-term outlook. And so, as the global economy reopens, it follows that growth should rebound alongside rising confidence, spending (pent up demand), valuations and further that inputs or factors of production should also rebound. We have no problem with this natural rebound narrative. Next, as demand returns, we can expect markets to look for future inflation and or monetary (and eventually fiscal) policy normalisation. The natural representations of these two processes is likely higher equities (and commodities) and higher, and steeper rate curves.

This is where it becomes a little more contestable. The consensus view was clear that the huge monetary stimulus in the US, in conjunction with the huge fiscal stimulus (which now seems set to become even more huge under the Democrat controlled Senate) will lead to higher forward inflation expectations and thus persistent low US real yields, driving flows not only into risk assets such as equities but also out of the USD. From our perspective, however, this is not clear. Aside from the deficit connotations and the prospects of a move potentially a little too close to MMT, I find the argument that higher US equities and a higher US yield curve should be a negative for the USD difficult to square. Especially when the growth and yield (risk adjusted of course) outside the US remains debatable.

Last week we warned of differentiation returning in FX. I have a couple of further thoughts. As the global economy battles a resurgent coronavirus with varied procurement and now delivery of vaccines, the prospects for reopening are likely a core driver of near-term currency sentiment - and differentiation. In this regard, the UK, despite (or likely because of) highly publicised criticisms, has the potential to lead the reopening in earnest. In conjunction with (in my view) a weak case for negative rates (the prospect of which holds significant sensitivity to both yield curves and GBP) and a cheap valuation, GBP may continue to outperform.

EUR on the other hand has greater potential to struggle from here, despite the fact that consensus remains positive. Yesterday brought perhaps the most explicit reference to the currency from ECB President Lagarde since she took over the role. The narrative that the ECB are monitoring the exchange rate “very carefully” and that they are “extremely attentive” to the FX rate impact on inflation is a marked change from the standard line “the ECB do not target FX rates” - taken through last year as a green light to buy. Furthermore, the minutes of the ECB policy meeting in December highlighted “concerns” about exchange rate moves. While ‘concern’ and ‘careful attention’ do not drive currency markets in their own right, for us this highlights a differential. The ECB bias towards monetary policy, as a function of their primary mandate - price stability - remains to the downside, valuations are on the high side after a substantial move in the EUR trade weighted index through 2020 and vaccine rollouts continue to lag.

At this point it is worth touching on the recent Fedspeak. Rhetoric has most recently been reined in a little, but nevertheless has likely already changed the dynamic for the USD - at least against some counter currencies. Talk of tapering (or more precisely perhaps talk of when tapering may be discussed) has seen an extension of the US yield curve rally, exacerbated by a Democrat control of the Senate that has brought reinvigorated fiscal policy (and inflation) expectations - just as the ECB rhetoric pledges maintained accommodation - asset purchases to keep long rates subdued.

Ultimately, I feel that the turn of the year may retrospectively be viewed as the time at which Fed policy - or to be more precise, expectations of the Fed policy’s incremental bias - flipped from an, albeit modest, stance of easier policy (where around the time of the December meeting there were expectations that the Fed were actively contemplating increasing the average weighted maturity of its asset purchases - even to the point of pre-empting a yield curve control or YCC approach) to one of trying to ascertain the proximity of the Fed to tapering its asset purchases - the first step on the path to normalisation.

It is of course a very subtle shift but potentially a very significant one - particularly for FX. A shift that could be characterised (again to paraphrase FOMC Chairman Powell) as going from not even thinking about thinking about raising rates, to talking about talking about tapering!


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