“...It is not even the beginning of the end. But it is, perhaps, the end of the beginning"
- Winston Churchill
The past couple of weeks in financial markets have been very interesting from a macroeconomic perspective. We have discussed of late our views that the global economy is now likely past the peak of monetary accommodation and that the process of normalisation is now in train. This is not to say that the normalisation process is a globally synchronous process. Indeed, quite the opposite.
We have argued for many months (even many quarters) now that the economic recovery will (unlike the recovery from the global financial crisis) see wide differentiation. The process of monetary normalisation will reflect this differentiation clearly, but financial assets, and indeed currencies, may even see wider differentials.
It is not long ago that we found ourselves arguing against the near consensus narrative of the time that there was a real prospect of the European Central Bank (ECB) tapering asset purchases, or tightening monetary policy, before the Federal Reserve (Fed). By extension, the common narrative was clear that the USD would suffer, and that the EUR would continue to rally. Some forecasts were extending as far as 1.30, as the expectation that the Fed was intentionally behind the curve (and would remain so) undermined a USD in a scenario of improving (synchronous?) global growth.
From our perspective, what changed at the June Federal Open Markets Committee meeting was not that the Fed gave a hawkish surprise relative to the data (or the US economic progress), but a Fed that gave a hawkish surprise relative to the consensus expectations (‘intentionally behind the curve’); and to a lesser extent, given the chronological evolution to the recovery, the Fed perhaps surprised relative to the previous Fed narrative.
There continues to be much debate on this topic. While many commentators were quick to accept the importance of the ‘Fed pivot’, few (if any) have been willing to give up their underlying USD negative thesis. As is always the case there are two sides to the story in FX.
In the eurozone
Inflation data this week disappointed expectations and showed (admittedly only tentative) signs that we may have already topped out in the recent (German VAT / energy price distortion) technical inflation spike in Europe. The real problem for the ECB is not whether or not to marginally adjust the pace of emergency bond purchases, but whether it has provided enough accommodation to spur ‘enough’ inflation in the medium term.
Perhaps this accounts for the recent concentration of ECB monetary policy review meetings to discuss proposals for a more symmetric inflation target (away from the ‘close to but below 2%’ target). Such a move would likely facilitate looking through the near term – transitory – inflation price action and concentrating on the persistent demand gap that continues to see inflation projections falling well short of target at the forecast horizon. We could make the case that, far from leading the normalisation process in the G10 countries, the distance from attaining their price stability mandate argues for further accommodation from the ECB.
In the US
We continue to see the current above target inflation as transitory. For example, it is difficult to see the price of second-hand cars or car rentals as continuing to increase at a faster pace indefinitely. Indeed, that is likely true of all components of the basket. While we retain a very positive view of the US growth backdrop, it is unlikely that after decades of acceptance that global structural dynamics (demographics, technological adoption, globalisation of supply...) led to lower inflation pressures, that a temporary supply/demand mismatch on reopening from a global pandemic would reverse or fully counteract these dynamics.
However, at the margin, we are sympathetic to the view that if policymakers look through the topside price distortions this year, they likely have to look through the subsequent downside (reversion) price distortions if prices, forced higher by supply/demand mismatches, correct. This may leave the overall policy balance marginally more hawkish than currently assumed.
Furthermore, with significantly above trend growth over coming years, we see little in the US backdrop (beyond a vaccine resistant variant), that suggests a prevention of policy normalisation. Lastly, if we are correct in our view that there is also a possibility that the strategy of running inflation hot and then hitting the brakes shortens the business cycle, it is perhaps possible that the ECB may not even get to move their deposit rate this cycle! This is not something that markets are currently contemplating - it is certainly not consensus view that we get a full normalisation of US policy (i.e. rates where they were pre-pandemic) and an unchanged ECB deposit rate. From my current vantage point, this feels more likely than not!
From a macro perspective, therefore...
We continue to favour the USD (at the very least in the DM space; a number of relative factors make EM more complex, such as virus trajectories, yield cushion, sensitivity to US yields, sensitivity to commodity price rises, domestic inflation pressures). Indeed, far from what seems to be the current consensus - that the USD move is over - we are of the view that it is only just beginning. Far be it from me to be the first person to mention 1.10 EURUSD in 2021, but the technical setup on a break of 1.1775(ish) supports this.
With the inflation side of the Fed’s ‘Substantial Further Progress’ target likely fully satisfied, the Fed’s reaction function is likely directly linked to the employment data. Our view remains that the labour market is tighter than the recent data suggests and that the pace of labour market gains accelerates through the summer, as seasonal factors (the same factors that artificially depressed April should boost September), virus related aspects such as schools (and by extension childcare) reopening, and the extremely generous unemployment insurance checks resolve.
In short, we remain bullish on the US labour market, relatively hawkish on the Fed (and US rates), and perhaps most urgently, as global capital looks for a home with a strong growth dynamic, well placed corporates, deep and liquid bond markets and a positive carry… the USD rally may only be at the end of the beginning!
Sources
Disclosure
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