DPAM Blog

STATE OF AFFAIRS

• • In a surprise move, the ECB decided last week to release the results of their delayed policy review earlier than was expected. Observers had pencilled in September. Maybe the ECB somehow feared that their policy review would be outshined by potential FED announcements on QE tapering over the end of August’s Jackson Hole meeting. This week, we briefly reflect on the policy review, but dig a bit deeper into the reaction function of the ECB come 2022. Indeed, over the remainder of 2021, investors are advised to take the information value of highly volatile economic data series with a large pinch of salt. Base effects distort and devalue year-over-year signal meaning. The global economic and social dislocation propagated by the global pandemic will only reveal its true damage or lack thereof over the next couple of years.

• • The ECB policy review of its two-pillar strategy (economic and monetary pillar) resulted in a change of its primary inflation mandate. This calls for the pursuit of price stability. From maintaining inflation rates below, but close to, 2% over the medium term, the ECB went for an outright 2% symmetric target. We did not have to wait long before the ECB stressed that it was not a US FED style Average Inflation Targeting adjustment. The FED effectively tries to catch up on inflation undershoots by allowing for overshoots to make good on their 2% inflation targeting over time. The FED opted for a make-up strategy. In their communication, the ECB emphasized the difference of their approach so as to seek public cheer and credibility lift. Anyway, from whatever angle you look at this, with this new inflation target, the ECB has put the post further out. It will study the impact on the headline and core Harmonised Index of Consumer Prices (HICP) as it will include house prices to the basket. The inclusion of the costs related to owner-occupied housing would increase the public relevance of the HICP index, adding between 0.2% to 0.3%. A change can only occur as a result of a multi-year project landing possibly in 2025 the moment the ECB assesses the appropriateness of the change in monetary policy strategy. In the meantime, the ECB would take into account ‘initial estimates of the cost of owner-occupied housing to supplement its set of broader inflation measures’. The current ECB estimate for HICP inflation by 2023 sits at 1.4%, a far cry from the 2.00% target. At the same time, the ECB threw climate change into the mix of factors impacting price stability. The direct impact would be most visible in their monetary operations. Their collateral framework, corporate sector asset purchase program, risk assessments would include climate change parameters. Disclosure of climate-related information on their corporate sector purchase program would by attainable by Q1 2023. That might accelerate and deepen the divide between the good versus the bad companies that becomes more and more visible when looking at their respective credit risk premiums (spreads). ESG factor integration becomes standardised and widespread across credit funds in Europe. Market-based finance (the mutual fund industry at large) will only select best-in-class corporates across ESG factors in general or select companies that specifically advance a clear science-based CO2 reduction target. Over the past quarters, the acceleration in sustainability-linked primary issuance across financial and non-financial issuers gains traction. At this rate, one wonders if there will still be ‘traditional’ new bond issues three years out?

• • The new monetary policy will be applied as of the July 22 meeting, but will dominate most meetings over 2021. What about 2022? Expect a complete exhaustion of the Pandemic Emergency Purchase Program (PEPP) until end of March 2022. Expect a PEPP 2.0 QE episode to start immediately thereafter. The original EUR 20 billion a month Asset Purchase Program (APP) will most probably be maintained as-is. The APP has many constraints attached in particular on issue and issuer limits. It has also been contested by the German constitutional court. In the end, it received a thumbs up under pressure of the European Court of Justice. A second PEPP-like program, with fewer strings attached, would be rolled out in support of the economic recovery within the Eurozone. PEPP 2.0 might run for a shorter period of around 18 months till September 2023 with a lower QE amount attached. The current PEPP envelope sits at EUR 1,850 billion of which about EUR 725 billion is left over the next 9 months representing an average monthly purchase rate around EUR 100 billion (EUR 20 billion APP + EUR 80 billion PEPP). By April 2022 HICP inflation, confirmed by ECB analysis, will still undershoot the 2.00% target. Base effects that push up inflation today will work against inflation by then. So, expect the ECB to announce a PEPP 2.0 over H2 2021. This envelope should be commensurate with the hard task of reaching inflation whilst protecting ECB credibility. Expect an envelope around EUR 500 billion over 18 months. Including APP at EUR 20 billion and continued portfolio reinvestments of maturing principal and coupons, we look at a monthly run rate between EUR 50 billion and EUR 60 billion. Such duration absorption will keep the effective ECB yield curve control high. Short term funding conditions across governments and large corporates across the EU will remain anchored. Expect little pressure up to the 5-year sector. Some pressure might potentially be incurred on 10-year rates, but especially 30-year rates as additional inflation risk premium is priced in given the higher 2.00% target. The distribution of possible HICP inflation outcomes shifts to the right and might show fatter right-hand tails in response to the symmetry add-on. The US yield curve has guiding value on this subject. Investors should not be too complacent and prepare for curve steepening above the 10-year point in core EMU government bonds.

• • Has the Euro currency fully priced continuous QE activity till Q3 2023? Has the common currency priced a prolonged status quo for the main ECB policy rates versus other central banks? When we take the main EUR-USD pair as our benchmark, we finished the week at 1.1875. Interest rate parity theory, comparing interest rate differentials as calculated by pure expectations theory (i.e. extrapolating the expected path of short term rates towards longer tenors), gives us a EUR-USD at 1.1970 1-year forward, 1.2250 3-year forward, 1.2675 5-year forward and 1.3750 in 10 years’ time. As often repeated, all directional calls occur against the above expectations that any investor can lock in today. Synchronized global growth conditions create a background for a weaker USD. However, current readings point to hiccups ahead, reflected by increasing growth divergence linked to weakening growth momentum. Peak growth might not be around the corner as excess savings might get partially deployed. Even if only a portion of excess savings will get consumed, growth indicators will receive a tailwind from them. Yet, over 2022, the USD might see the end of its cyclical depreciation cycle as the FED will conduct a steady QE taper and markets might react on increased divergence between ECB (more QE and strong forward guidance) and FED reaction functions (earlier lift-off of FED policy rates). Moreover, expect less fiscal push from an aggressive reduction in the US budget deficit from USD 3 trillion – about 13.4% of GDP – over 2021 towards USD 1.2 trillion as of 2022 or 4.7% of GDP. The Congressional Budget Office expects an average budget deficit of 4.2% of GDP over the decade to 2031. The ensemble of above conditions might see a EUR-USD path well below the path depicted by forwards above. Its stands to reason that the USD will defend its portfolio diversification benefits in style over the next couple of years and cement its safe haven and reserve currency status for global investors.