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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.
Frothy markets do not require much to get destabilized. A weaker ISM Services index print in the US coming in at 60.1 versus an expected 63.5 stirred markets mid-week. The read-through across the services employment subcomponent slumping to 49.3 from 55.3 a month earlier created some panic. From 1.45% in 10s on Tuesday we hit 1.25% low on Thursday. The expected new range we flagged a couple of weeks ago has been fully explored in about a week. The 5-year rate sector scored best as yields dropped about 7bp to finish at 0.785%. 10-year rates closed at 1.36% down 6.5bp and 30-year was able to close just below 2.00% at 1.99%. Inflation expectations were weak across the board with 30-year break-evens dropping towards 2.23%. US 10-year break-evens finished at 2.29% down 5bp. The FED minutes added more evidence that monetary policy would not fall behind the curve. Our preferred 5Y5Y forward US treasury rate indicator closed at 2.01%, making a low of 1.85% on Thursday. The earning season that truly kicks-off this week will shape rate markets over the summer. Possibly the 1.25%-1.50% range remains intact till the Jackson Hole meeting from August 26 till 28.
European government bond markets got their cue mostly from US rate volatility. 10-year bunds shed 6bp ending at -0.295% on Friday mirroring the US moves. 10-year German bund-Italian BTP spreads closed at 100bp. Spain and Portugal held their turf with spreads to Germany closing just below 60bp. With potentially another 2 years of ECB QE ahead of us, fragmentation risk remains extremely modest. The new symmetric 2% inflation target has the ability to spur steepening pressure on the 10 to 30-year maturity sector.
European investment grade (IG) and high yield (HY) added another lacklustre week to the tally, seeking guidance from rate markets. IG performance added 23bp, HY firmed by 5bp. The resilience might evolve cross 2 levels. Highest resilience might fall on new issues embedded with climate or sustainability linked targets. Less resilience or higher volatility might befall traditional new issues across IG and HY companies. Monitoring of bid-to-cover statistics next to one to three-month performance figures, spread behaviour since issuance will reveal whether public corporate bonds morph into a two-speed market.
Markets move fast. A couple of months ago, financial markets priced a full global recovery. Today, activity indicators (e.g. Caixin China services PMI dropped from 55.10 to 50.30 in June) are signalling that the global recovery may already be behind us. China’s decision to cut the reserve-requirement ratio serves as a warning.
Mixed news on the pandemic across the globe continues to damage the growth outlook indeed. Across regions, the number of cases is decreasing rapidly in Latin America, whilst vaccination rates are gaining traction. In Asia, the opposite is true, cases are increasing at a fast pace, whilst vaccination rates are poor and dependency on less effective Chinese vaccines is high. Emerging markets performed poorly (-0.85% on the week).
The rally in US rates did not convince emerging markets investors and currencies lost 0.25% in EUR terms on the week. Top performer was South African Rand (+0.95 in EUR terms), at the bottom only Latin American countries: Brazilian Real (-4.00% in EUR terms), Peruvian Sol (-2.70%) and Colombian Peso (-1.80%). The acceleration of inflation in Hungary (5.3% YoY, 3.8% core) resulted in poor performance of the Hungarian Forint (-1.7% in EUR terms) despite comments made by Deputy Governor Barnabas Virag of the NMB that there is no reason to stop monetary tightening and that they will proceed with monthly hikes as long as it takes to bring core inflation back into the 1.00%-3.00% target range.
Inflation in Brazil keeps climbing higher and stands at 8.4% YoY in June. At the last meeting, Banco Central do Brasil (BCB) signalled continuation of the tightening cycle in 75bp steps and left the door open for a 100bp hike in August. Even without taking into consideration the political noise (Lula versus Bolsonaro, Bolsonaro vaccine bribery rumours, …), the situation in Brazil is complex. The extremely low water levels (El Niño related) will most probably push energy prices up as a big part of the electricity generation is from hydro power. The alternative, natural gas, will be a costly, especially after the 7% gas price hike Petrobras announced as of August 1 that will feed into inflation. On the other hand, possible power shortages and announced trucker strikes as a result of this price hike can damage the economic recovery. We have witnessed the effect of trucker strikes in 2018, when the whole country was paralyzed for weeks. For the BCR it will be a difficult balancing act between inflation and growth going forward. Since 2016, the rate differential between the Selic rate and the fed funds target rate has been on an impressive downward path (from 1600bp to 200bp). This five-year easing cycle has dramatically weakened the currency, especially in 2020, due to a combination of a (highly) negative real benchmark rate and a weak rate differential with the US relative to Brazil’s weak macro-economic fundaments (especially debt dynamics). It has resulted in a strong weakening of the currency and has increased currency volatility, even when compared to peers in the region. The Mexican central bank for instance, has a more careful and credible approach which consists of keeping a benchmark rate differential in a 400 to 600bp range over fed funds. This has resulted in stable FDI flows, and a more stable currency, with lower drawdown and a much faster recovery after the pandemic.
An early policy review communication by the ECB has dampened uncertainty on the central banks’ reaction function. Investors can rely on a continued highly accommodative monetary policy stance over the next 2 years as APP + PEPP 2.0 take over the baton in April 2022.
ECB policy rate lift-off is so far into the future that increased yield curve volatility will have a hard time to crystallize as a market theme.
Put in context, the path of least resistance might be for the Euro to depreciate instead of the steady appreciation priced by forward exchange rates. An uneven global growth recovery next to a reinstatement of the USD as the safe currency of choice over the next twelve months might stir more rotation away from the ‘lower USD narrative’.
Such easy narratives prove sticky just as the one on ‘higher US long-term rates’ that belong to the same social and financial media family. Both might get contradicted by markets. Watch out.