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“...You gotta roll with it"

- Roll with it, Oasis

Last week, we discussed what we see as widening differentiation of the macroeconomic backdrop in developed markets, as global supply chain and inflation dynamics interact with idiosyncratic demand factors and varied Covid incident trajectories. Furthermore, we argued that the recent appreciation of the USD had not yet closed the gap on widening differentiation from a valuation perspective. This week, we have seen further USD appreciation and for us the ‘repricing’ of inflation, growth and rate trajectories remains incomplete

This week, ahead of the Thanksgiving Holiday in the US, we had the minutes from the November Federal Open Market Committee (FOMC) meeting, and by way of comparison, we also had the minutes of the late October European Central Bank (ECB) meeting.

From our perspective, there were three main takeaways from the minutes:

Firstly, it was clear from the minutes that there has been an upward shift in both uncertainty and concern over the (in)transience of the inflation backdrop in the US. This is emphasised by the upgraded forecasts and risks to the inflation outlook - “The staff’s near-term outlook for inflation was revised up, as consumer food and energy prices had risen faster than expected and production bottlenecks and recent wage gains were seen as putting somewhat greater upward pressure on prices than had been anticipated.

Secondly, on growth there was also more uncertainty. Staff projections were marked slightly weaker than the September meeting, as data continued to suggest that the impact of the delta wave on Q3 GDP had been significant. While the minutes also indicated that the ”Incoming data suggested that the resolution of supply constraints was starting later and would be more gradual than previously assumed”, the period since the FOMC meeting in early November has been suggestive of rebounding consumer and broader economic activity, alongside a receding Covid wave.

Thirdly, and perhaps most importantly, was the narrative around the taper. The Minutes acknowledged that proposed pace of tapering was broadly accepted by participants, but also noted that “some participants preferred a somewhat faster pace of reductions that would result in an earlier conclusion to net purchases” - a modest hawkish upgrade from the September narrative.

In conjunction with the assertion that “Fed officials saw labour participation structurally lower”, the overall tone of the minutes erred towards the hawkish end of expectations. Furthermore, as we move further into Q4, we are increasingly of the view that both labour market and economic activity are picking up after the (likely Covid induced) moderation or caution of Q3 - this likely has important connotations for the risk premium at the front end of the US interest rate curve, particularly relative to other central banks, and can continue to support the USD.

In the eurozone, the minutes of the October 27/28 ECB meeting struck a more balanced, cautious tone. The minutes acknowledged an increase to the upside risks to inflation, but the acknowledgement came with the heavy emphasis that “it was deemed important for the Governing Council to avoid overreaction”. At the same time, Chief Economist continues to stress his view that inflation will remain below 2% in the medium term - thus removing the prospect of attaining at least one of the targets required for rate liftoff from the ECB.

Furthermore, the renewed Covid trajectory in Europe has already started to see downward revisions of near term growth expectations across the region, and with wage inflation showing no signs of becoming disanchored, the prospects of rate rises in 2022 continue to appear remote, from our perspective.

It is also worth noting that the seemingly accelerating cash glut across Europe - that this week saw the overnight interest rate rise above the 3m rate for the first time - is only likely exacerbated by the extension of Pandemic emergency purchase programme (PEPP) (or more likely a temporary bridging mechanism towards the APP). The cash glut, and by extension the collateral shortage in the eurozone, likely continues in the near term to drive the domestic yield curve lower and increase the demand for foreign collateral, and of course foreign yield. All, at least at the margin, are likely to continue to weigh on the EUR.

As we move into December next week, we continue to expect the divergence between US and eurozone to widen - in terms of inflation, growth (and within that, labour market momentum), Covid trajectory, and ultimately interest rate differentials.

From our perspective, the fundamental backdrop continues to support USD appreciation… you could even say that the USD is on a roll.

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