“The farther backward you look, the farther forward you are likely to see"
- Winston Churchill
Against the backdrop of Remembrance Day across the Commonwealth member states (the poppy that represents this day is a tradition started by Queen Elizabeth II’s grandfather, King George V, in 1919) it is perhaps a worthy time to take a step back and contemplate, reflect.
The past couple of years have been very tough for the global economy, but while many countries still have a long way to go, the medical progress, innovation and evolution has been incredible. What is not clear (nor will it likely become so in the very near future), is what the long-term implications of the pandemic are. What will the new normal look like?
There are many structural reasons why inflation may continue to stay low – from our perspective this is especially true in Europe. That said, no matter how far we step back, inflation is still the defining parameter for financial markets. In fact, the more we step back from the near-term dynamics, the more inflation stands out, and the risks are asymmetric.
Last week, we noted that “on the basis of many metrics we consider the Fed insufficiently hawkish. However, they are more hawkish than the market.” and that “for much of the developed markets, the situation is reversed”, arguing that the USD stands out as the developed market (DM) central bank that has the most hawkish work to do in terms of addressing the perception of its reaction function relative to the rising uncertainties around inflation – at the very least relative to the rest of DM.
This week, we have seen US inflation surging to 6.2% y/y, a level not seen since the early 90’s, hot on the heels of PPI print at 8.6% y/y, not to mention the Chinese PPI jump to an incredible 13.5% y/y. Much of this absolute strength is a function of base effects, relative to a Covid induced weakness in 2020; but the longer it goes on, the more persistent the upside inflation pressure, the more likely it is to spur second round effects – wage and price hikes. It will likely get worse before it gets better and the longer it does, the greater the uncertainty and thus the greater potential for risk premium at the front end of government curves (in most cases encouraged by the central banks).
Indeed, the specific point that we made last week in relation to the hawkish repricing of markets, given the invigorated global inflation impulse, was that the US curve (or Fed reaction function, or inflation risk premia) was underpriced relative to its DM peers. This week, we have not only seen a front-end repricing in the US but more realistic pricing in Australia (where we had a very disappointing employment report) and to a lesser the UK, where political risks add to the uncertainty, amid the Bank of England stutter-start. This has benefitted the USD in the DM space.
Into the year end, we continue to see this as a dominant theme. The US is still underpriced from my perspective in terms of inflation risk premia, and as the EU forecasters continue to ‘dig in’ on their transient narrative (EU updated forecasts this week show euro area inflation at 2.2% in 2022, but falling back sharply to 1.4% in 2023 – well short of satisfying the European Central Bank (ECB) criteria for rate rises any time soon)
Farther forward, the US long end (10y by reference) of the US yield curve still only prices at a level consistent with where rates were pre-pandemic – the equivalent level in Germany would be 10y bund yields at -0.50%. This week I have heard many prophecies of eurozone normalisation and sharply higher term rates, alongside positive ECB rates at some point in the mid 20’s. Of course, this is eminently possible, but from our perspective this comes only with the precedent of a significantly higher US yield curve.
So, as we take a step back to contemplate the evolving backdrop and the path to a post-pandemic new normal, we should be open to the prospect of an alternative inflation dynamic. In the near term however, we retain the view that economic dynamism, innovation, monetary and fiscal stimulus continue to state the case for a higher USD. Many may have been comforted by the recent reticence of EURUSD to break lower, by the familiar ranges over recent months or even by the sell side prophecies of EURUSD topside.
This week’s break below 1.1500 reminds us not to forget that pre Covid EURUSD was significantly lower and that recent ranges are not a reliable gauge of the future. Or perhaps, “the farther backward you look, the farther forward you are likely to see”.
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