“Ring out the bells again"
- Green Day, When September Ends
With little on the data calendar again this week, market sentiment continues to be driven by the global central bank narrative – and increasingly by the divergences that are becoming more clearly evident in market pricing. In this regard, the annual European Central Bank (ECB) Forum on Central Banking (more commonly referred to as Sintra, after the stunning Portuguese municipality where it takes place) has acted as an important introspective for central bankers and markets alike.
Last week, we discussed the (linear) pivot from the Federal Reserve (Fed), with the release of the updated Summary of Economic projections (SEPs) and the rate path forecasts (‘dots’):
The Fed marked lower their median SEP growth forecast for 2021, broadly in line with expectations, but also raised subsequent years (through 2024) more than anticipated. Similarly, inflation was marginally higher in the new Fed forecasts through the forecast horizon… and in the press conference, the Fed Chairman went a step further in effectively declaring the goal of “substantial further progress” attained - “in my thinking the test is all but met”. Further, he stressed that the committee deemed ending the “gradual” tapering process around mid-22 as “appropriate”.
Essentially, the September Federal Open Market Committee (FOMC) meeting projected a Fed view of a faster than expected rebound from the (transitory) ‘delta wave’ slowdown and indeed, from the (transitory) supply side disruptions to manufacturing and industrial output. In doing so, the Fed effectively announced the start of a (faster than expected – a ‘per month’, rather than ‘per meeting’) taper process. However, while all of this is important and essential to the current US yield and USD dynamic, it is likely the continued hawkish projections that have mattered more (3 further hikes in the median rate forecast in 2024). This will likely be viewed, in retrospect, as an important milestone: the extrapolated divergence of monetary policy.
Indeed, the median ‘dots’ now project a Fed Funds rate of 1.75% by the end of 2024. Some may argue that the ‘Longer Term’ projections for the Fed Funds rate has stayed pretty constant, at 2.5% throughout. But ‘Longer Term’ is a complicated concept for markets to price, particularly at the currency relevant front end of rate curves. Thus, and in conjunction with the fact that I have not seen a single analyst forecast for ECB policy rate that suggests a move in the ECB deposit rate by 2024, significant rate differentials have become a focus.
Furthermore, while following 2008 there has been a tendency of the market pricing of the US rate curve to persistently under-price Fed projections, only for the Fed to come ‘down to the markets’, this time, given the huge monetary and fiscal stimulus in the system following the Covid crisis (and the underlying strength of the US economy), we would expect the markets to ‘come up to the Fed’. On that basis, the pricing for front end rates still has upside, thus in our view, so does the longer end of the yield curve, and perhaps more pertinently, so does the USD.
This week, the headline panel at the Sintra meeting was, as usual, taken by the Central Bank Heads of the Fed, ECB, Bank of England (BoE) and Bank of Japan (BoJ). In many respects, the debate could well have been titled ‘the extrapolated divergence of monetary policy’, as growth and inflation trajectories drive very different approaches from the ‘big 4’.
The Fed Chair’s panel responses were effectively a carbon copy of the FOMC meeting statement and press conference (September 22nd), as you would expect; in short, as discussed above – the Chair maintained the hawkish (linear) pivot or extrapolation.
Purely from an inflation perspective, it is possibly the UK that stands out, as acute supply chain disruption, massive fiscal support and strong demand dynamics were driven by a dovetailed combination of reopening and excess saving. The fact that the market has now priced three rate hikes in 2022 (a 15bp in Feb followed by two 25bp hikes through the rest of the year) is testament to this inflation pressure and the reaction function of the BoE. However, further out the curve, there is less positivity, and the BoE Governor’s Sintra testimony is likely in keeping with this, stating that while “transitory doesn’t have a fixed time point” that “monetary policy cannot solve supply shocks”.
The ECB President reiterated the prescient line, “the euro area is back from the brink, not out of the woods” – a line that sums up the issues of the eurozone succinctly, while she was also clear that the Euro area may be back to pre-crisis levels by year end. However, in maintaining the view that inflation is transitory and with staff projections highlighting a significant demand led inflation shortfall at the forecast horizon, it is difficult to see a scenario in the near term where eurozone rates rise any time soon.
Furthermore, while the euro area may well reach its pre-crisis growth level by the end of the year, it is already at its pre-crisis level of interest rates. For the US, which is already significantly above its pre-crisis growth level, the pre-crisis level of rates was 1.50-1.75%, (having come from a recent high of 2.25%-2.50% in mid-2019). Thus, if the Fed gets interest rates back to 1.75% by the end of 2024 as per the ‘dots’ then the Fed will be providing greater monetary stimulus (relative to pre-covid levels) than the ECB at -0.50%!
Essentially, we retain our view that the USD can continue to outperform the EUR and the JPY, as rate differentials get fully priced; and over the forecast horizon, we also expect that the US equilibrium growth rate (and thus the expected terminal rate) can move higher, and the differentials to Europe, Japan can widen. As September ends and we move into Q4, we are increasingly of the view that the USD can have a strong end to the year.
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