"Singing sweet songs, Of melodies pure and true"
- Bob Marley
The fiscal policy lever remains pressed firmly to the floor globally – though that generalised statement does nothing to highlight the huge differentials that we see as an important driver of the global macro backdrop over coming quarters, even years. It is very valid to debate the trade-offs between the consumption / investment balance and the impact of the multiplier of respective fiscal stimuli. Furthermore there is valid reason to see a targeted, structural investment led fiscal (Recovery Fund) focus expected from Mario Draghi’s technocratic government (should things go according to plan). But ultimately, the sheer size of the US proposal (USD1.9T or a further 10% GDP on top of the ~15% already in place) means that the boost to US growth this year will, in our view, be dominant.
With the global fiscal impulse remaining positive in 2021 (though reduced in many nations), it is difficult to refute the consensus reflation trades: higher equities (US and tech led in our view) and commodity outperformance. However, there remains a consensus view that the USD will weaken against this backdrop – a view that we continue to refute.
Despite the fact that there is little appetite for tighter monetary policy anytime soon from any of the developed market central banks, this week (amid a very light data calendar) has brought some notable rhetoric from the heads of the ECB, Bank of England (BoE) and Federal Reserve (Fed), as the implications of higher inflation rates (driven by a combination of base and technical effects) and inflation expectations become more actively debated.
The ECB President et al. retain a distinctly and intentionally dovish bias, as ECB speakers note that the Governing Council stands ready to adjust all instruments as needed - likely a reminder to markets that the ECB can cut the deposit rate further into negative territory if it is deemed necessary to prevent a rising EUR from further de-anchoring inflation (and inflation expectations) from target. Indeed, just yesterday, the ECB President stated clearly that “inflation is not converging to its goal over the medium term”, that the ECB would look through the near-term technical bounce in headline inflation and that demand remains weak.
In the UK, there is a very slightly more balanced monetary policy setting, where the BoE has added negative rates to the toolbox but remains unwilling (and indeed unable for the next 6 months) to use them. It is possible that the BoE will add further to its quantitative easing (QE) purchases at some stage, however with forecasts suggesting a "rapid" recovery pace in Q2, such a decision is not likely to come until the picture for Q3 and Q4 becomes clearer. Bear in mind that, at the current trajectory, the UK is likely to have vaccinated its entire adult population at that juncture.
In the US however, the situation is a little different, from my perspective. While the ECB paints a picture of a potentially lower rate trajectory, and the UK a symmetric tool kit but little enthusiasm for movement in either direction, the Fed is more akin to a dog walker trying to hold back an excited puppy. The magnitude (and persistence) of the US fiscal stimulus is such that inflation expectations have surged (10y breakevens reached their highest since 2014 this week) - and that is not to mention the prospect for an infrastructure bill from the US administration at some point in the not too distant future. Nominal growth in the US is likely to run at 8-10% this year, as the stimulus finds its way into the economy. Not only will this consumer boom find its way into corporate earnings, it likely ultimately finds its way towards rising expectations of monetary tightening.
This week the Fed Chair was clear in his message that the Fed will remain "patiently accommodative" on monetary policy and that the current pace of QE will be maintained until "substantial further progress" (purposefully leaving the term undefined) is attained. Further, while the Chair noted that the Fed are not even thinking about withdrawing policy support (does that mean they are now thinking about thinking about it?), the direction of the next move from the Fed is clear. In my view, this move towards tightening becomes more explicit sooner than the market expects.
There has also been some debate about the tenure of the Chair (his initial term ends in February 2022) and that his chances of reappointment may be improved by supporting the accommodative stance of the US President, and notably the US Secretary of the Treasury’s stimulus plans (and debt issuance). The difficulty comes with the implications for inflation expectations and negative real yields… as the BoE Governor stated clearly at the Monetary Policy Report press conference last week, central bank independence will be most acutely tested when it comes to raising rates.
Circling back: In theory, the prospect of negative (and indeed falling) real interest rates should encourage funds out of financial securities in order to seek a positive (or at least less negative) yield elsewhere. However, if the assets with the greatest growth are based in the US (US tech driven equities) as we expect, then it is hard to argue that funds should flow out of the USD and into alternative risk assets. As the US moves towards economic normalisation faster than any other economy (excluding China, which for the most part has already normalised), we would argue that the widening growth and yield differentials (and arguably widening tech innovation) should attract, not repel, inflows into the USD.
As for the central bank heads, the ECB President once claimed to be an owl but is currently revealing her dovish side while the Fed Chair continues to refute that he is currently in any way a hawk. It is not clear which kind of bird the BoE Governor is, but he is definitely on the fence… singing don’t worry about a thing!
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