“Some might say that sunshine follows thunder"
- Oasis, Some Might Say
Last week, we discussed the recent emergence and spread of the newly discovered Omicron variant, and the (very strong) November US employment report. We also commented on the ‘5 and done’ implication of market pricing, stressing our view that not only were markets underestimating the potential economic and monetary cycle, but that the Federal Reserve (Fed) were behind the curve on inflation, as the market remained behind the Fed. Finally, we emphasised the view that “the Federal Open Markets Committee (FOMC), European Central Bank (ECB), Bank of England (BoE) and Bank of Japan meetings will shape the monetary dynamic for 2022 and give us a greater understanding of the respective central bank sensitivities to growth and inflation".
Some might say that we should never ponder?
The BoE, in a decision that they reiterated was a “close call”, elected to raise the BoE base rate by 15bps this week (earlier than our long-stated view of February 2022), after similar deliberations last month. The decision was ultimately based on a more persistent interpretation of price pressures, a labour market that is likely to continue to tighten and an inflation rate likely to peak at 6% in coming months. Despite doubts about the implications of Omicron (on inflation and growth) and even the impact of inflation on growth, the BoE statement suggested just “modest tightening ” of monetary policy is likely through 2022 - certainly less than markets had exuberantly priced in until a few weeks ago.
While the UK remains a fascinating case study into the implications of active rate normalisation on demand and inflation expectations in Developed Markets, today we focus on the Fed and the ECB.
Some might say we will find a brighter day?
Going into the December Fed meeting, there was an odd dichotomy. Not between the market inflation expectations and Fed pricing, but between the relative hawkishness of economists and forecasters in relation to the Fed’s interest rate projections or the ‘dots’, and the market pricing of rate hikes in the futures and bond market curves. Our initial impressions from the December FOMC are that the Fed are starting to address the prospect of being behind the curve on inflation, not only by accelerating the pace of tapering (to provide greater optionality on rate hikes in early 2022), but also in terms of signalling more rate hikes over the forecast horizon.
What was perhaps more notable however, was the emphasis or confidence that the Fed Chair l and the Fed placed on US growth. The updated forecasts show growth of 5.5% in 2021 and 4.0% in 2022, supported by further solid job gains (attaining full employment in 2022) in an increasingly tight labour market. The Chair further emphasised the strength of the economy, labour market and consumer directly, stating that the strong economy is one in which “it is appropriate for interest rate hikes” and also in his elaboration on the sequencing of monetary policy - in that there is no need for an explicit ‘forward guided’ delay between taper and rate hikes given the fact that growth is so far above potential.
Furthermore, while the BoE may be concerned about the potential for inflation itself to have a negative impact on demand, the Fed Chair stated it is possible that high inflation may be the chief threat to maximum employment - thus further reinforcing the hawkish reaction function of the Fed.
Lastly, and in a point that we have made several times over recent months, the Fed Chair commented on foreign demand for Treasuries as a distortion to the information value of the US yield curve, essentially suggesting that there has been huge demand for US Treasuries as a function of safe haven status, positive yield and a global collateral shortage - highlighting the attractiveness of the yield on Treasuries relative to Bunds or JGB’s, even on a currency hedged basis Many times, we have pushed back on commentator rhetoric that the yield compression at the long end of the curve was an indicator of a shallow or weak economic cycle and thus low terminal rate (or even impending recession); perhaps the Fed Chair will have better luck dispelling that viewpoint.
Standing at the station in need of education in the rain?
This week was also the much-awaited ECB meeting. Much awaited not least because the decision on the path of Pandemic Emergency Purchase Programme (PEPP)/ Asset Purchase Programme (APP) purchases up to and beyond March 2022 had been pushed back to December from September. What we got this week was a package of measures - a tactic introduced by the Italian Prime Minister, likely to specifically address differing emphasis from different viewpoints on the Governing Council.
(i) PEPP purchases will be conducted at a slower pace of accumulation through Q1, before the discontinuation of the programme on schedule at the end of March. (ii) An extension of the PEPP reinvestment horizon to the end of 2024 (iii) The reinvestment of maturing PEPP holdings will maintain the flexibility of PEPP - flexible by time, jurisdiction and asset class. (iv) Monthly net purchases of APP will rise to EUR 40B per month in Q2, followed by EUR 30B per month in Q3, and then back to EUR 20B from October… “until shortly before key interest rates rise”. In addition to this the ECB also pledged to reaffirm policy rates and continue to monitor bank funding and TLTRO tiering in terms of their implications for policy transmission.
We have discussed in previous pieces that one problem the ECB faces is widening divergence in member state economies (growth, debt, inflation,...) and thus divergent opinions on the governing council. From this perspective, it is easy to view the ECB’s package of measures this week as a big compromise - an end, as promised, to the PEPP Quantitative Easing (QE) purchases and a relatively short bridge towards the ongoing APP QE programme, while at the same time keeping the flexibility of the PEPP programme via the channel of reinvestment. The stated aim of the flexibility of the programme is to counter the potential for widening intra eurozone credit spreads (despite the widening intra eurozone credit metrics). The ECB narrative for this particular process is ‘maintaining the transmission mechanism for monetary policy’ - the reality is direct intervention to prevent spread widening.
Some might say.
Stepping back from the specifics of the near-term policy debate, it is very clear that there is substantial, and in our view widening differentiation between the Fed and ECB policies. Most importantly, this likely means further widening of growth and yield differentials between the US and the eurozone, with important implications for EURUSD. In Europe, the drivers of inflation are energy prices and supply bottlenecks (while growth slows in the near term); in the US the emphasis is on growth, consumption (excess demand) and labour market tightness.
The ECB President was clear today that you cannot compare the US or even UK with the Eurozone in terms of policy progression. They are at different stages in the cycle… in a different universe.
Some might well say that sunshine follows thunder, but on a comparative basis the divergence between the US and the eurozone remains stark. Indeed, the more commanding growth narrative at the Fed is suggesting the US may soon find “a brighter day” as the US recovery is well and truly in train, while the eurozone (with the ECB still needing to educate the market on the evolution of its monetary policy) may well be left standing at the station…in the rain”
A note from Neil and all at Eurizon SLJ Capital:
This is the last 'Long & Short' blog of 2021, but we will be back in the new year with further insights. We want to wish you a happy, healthy and restful Christmas & Holiday season and thank you for taking the time read our blog.
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