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STATE OF AFFAIRS
It was as if the ECB meeting of last Thursday was a minor event in bond land. Indeed, the steady sell-off in US long-term rates captured all attention. The ECB’s announcement that the intensity of government bond purchases within the PEPP program would increase over the next quarter did not leave a mark.
The first half of 2021 shapes up badly for EU growth, as containment measures have become more stringent again. Indeed, there have been third wave infection outbreaks across the biggest Eurozone economies i.e. Italy, Germany and France, next to worrying developments in Eastern European countries. This raises a lot of eyebrows. The vaccination debacle is devastating for the credibility of the European Commission. The poor reading in the ability by the ECB to keep financial conditions from tightening is embarrassing. In summary, how do the March 2021 ECB projections stack up? Harmonised Index of Consumer Prices inflation is expected to rise towards 1.5% over 2021 (from 0.3% over 2020), as a result of base and temporary effects. They assess that only ‘a small part of the higher inflation will have a more persistent impact’. ECB researchers expect inflation at 1.2% over 2022 and 1.4% over 2023. Thus, the latter reading of inflation for 2023 remained from the same as last December’s projections. The staff projections do not consider the recently approved fiscal package in the US…and draw up a mild and a severe scenario. Within the mild scenario, we all get a jab before summer and real growth rebounds to 6.4% in 2021. We reach pre-crisis output levels by autumn of this year and inflation ends in 2023 at 1.7%. Christmas comes early across the Eurozone in 2021. Such projections are on par with the vaccination progress: ludicrous. The severe scenario starts from a lingering pandemic and reduced vaccine effectiveness, which pushes governments to maintain containment measures till mid-2023. A sobering 2.0% real GDP growth number for 2021 would ensue. We would not reach pre-crisis output levels within their projection horizon. 2023 inflation would settle at 1.1%. The severe scenario would highly impact growth, but less so inflation. The ECB would receive a rain check. The EC would become the scapegoat. The EC would stomach the insult next to the injury already received on their amateur handling of EU wide vaccination. “It’s complicated” is an argument we all share and understand. But a 1 in a 100-year crisis requires strong leadership. Today’s reality is one of disorder and increasing uncertainty on economic, social and political outcomes within the EU over the next 12 months, year number two of the COVID pandemic.
The change of guard in the US came just in time. President Biden is over-delivering. The new administration made an impressive start. The new fiscal-monetary regime is working its magic. Next to an all-in monetary impulse since March 2020, the fiscal impulse as of March 2021 is marching ahead. The reflationary effects become evident, as the US is organising an orderly opening of key sectors. Healthcare workers and the willing elderly have been inoculated. The acceleration of vaccination towards teachers is smart and targeted. Across various states, the 45 year+ can expect vaccinations over the next couple of weeks. By May 1, all adults would be able to get their vaccination on their own request and initiative. Herd immunity might be reached by early summer. The cooperation between the Yellen-Powell tandem is symphonic. Before FED governors went into their black-out period prior to next week’s meeting, the public received a calm and composed response when questioned over the rise in long-term rates. It merely reflects their successful cooperation. Full stop. The contrast with the EU is staggering. Expect not a lot of fireworks during the press conference next Wednesday. The fiscal response will inflate real economic indicators. The FED remains on autopilot and fully in support of targeted pandemic relief. The FED is not too concerned with whether the multipliers will be high or low. The US low and middle class have been hit hard. The money sent to many households as of this week was a pre-condition that allows last year’s scarring to start healing. The FED is concerned about employment recovery. Maximum employment will take more time than consensus estimates predict. The FED will hail the prudent principle. No tapering over 2021 should be expected, given the USD3.6 trillion demand-supply funding imbalance over 2021. The imbalance will still reach about USD3 trillion over 2022. FED tapering will be very protracted and, if anything, impact T-Bill or mortgage-backed security purchases and (a lot) fewer Treasury purchases. The US Treasury market technical has favoured short sellers over the past month. The sell-off has also alarmed investors across government bond funds. Expect the intensity of the negative feedback loop to wane over Q2 2021. The FED uses the ‘Flexibility’ word within the same context as the ECB. The sole difference is credibility. The FED’s credibility is rising… That portends well for the impact the moment they show their muscle and intervene in order to stem the rise of long-term rates. Expect policy rates to remain unchanged till around the end of 2023. The market expects a more hawkish FED and sees lift by mid-2023. Expect also terminal policy rate to remain unchanged at 2.5% in the FED’s dot plot projections. As we explained in previous letters, the market prices a full normalisation towards 2.5% policy rates over 2025. I want to repeat Powell’s words used during his Wall Street Journal Job Summit speech: ‘The Fed deals with real progress not forecasted progress and strengthens their outcome-based conduct of monetary policy. As we deal with a highly uncertain future, we should expect a marked slowdown in the orderly US rates sell-off over the next couple of quarters’.
Expect the FED to announce an extension of the SLR (Supplemental Leverage Ratio) exemption for Treasury holdings and reserves (held at the FED) by the US banking system. The deadline is March 31. Because this exemption is not a monetary policy decision, it could fall any day over the next two weeks. The SLR is the purest banking leverage indicator. SLR is the ratio of bank equity over bank assets. Excluding Treasuries and reserves from the denominator lifts the SLR by about 1% to 1.5% towards 7% to 8%. Effectively it enables banks to hold higher levels of Treasuries on the balance sheet without having to hold on more capital. Most large bank parent companies took the SLR relief. If the relief were to be partially or fully cancelled, the orderly sell-off in US rates so far would become disorderly. On top, SLR hurts assets that are lower on the risk spectrum and carry lower returns. The repo market would come under pressure. The Treasury market would also receive less support, as banks would offload and lessen their interest in Treasury auctions. Mostly bad outcomes would arise at this juncture in the recovery. So, expect an extension towards year-end as a starter.
After last week’s 16bp sell-off on the 10-year note, we pencil in another 6bp rise to finish at 1.63%. The differential between 10 and 30-year bonds flipped back to 75bp, up 2bp. Shelter was sought in US TIPS. Inflation expectations or break-even rates closed almost at cycle highs across maturities. 2-year and 3-year inflation expectations rose by about 10bp towards 2.70% and 2.60% respectively. The FED will comment at length about the benefits of Average Inflation Targeting. 10-year and 30-year inflation expectations rose less towards 2.28% and 2.20%. There is still some room to adjust higher, 20bp to 30bp, without annoying FED officials.
Once more, European Government Bonds (EGB’s) went counter to the US. 10-year German bund rates were unchanged over the week, closing at -0.30%. The EGB periphery was strong. Spain, Portugal and Italy were buoyed by the ECB announcement to raise weekly purchases probably above EUR 20 billion from about EUR 15 to EUR 16 billion today. Italy stood out dropping 13bp to close at 0.62%. Portugal lost 10bp finishing at 0.19%. Spain has been lagging over the past couple of weeks and dropped 6bp to close at 0.33%. Expect a very dominant ECB intervention over the coming months across government bonds. Given the tight liquidity conditions in investment grade (IG) corporate bonds, one should expect an unchanged EUR 6 billion per month CSPP corporate sector purchasing intensity. The ECB wants to draw a line in the sand. If they fail to achieve a rates consolidation, the already tarnished path becomes even more problematic. The strong non-core performance pushed the JP Morgan EMU government bond index up 26bp over the week. Year-to-date this reference index sits at -2.26%.
European IG corporate bonds stood firm over the week. With a -0.92% year-to-date result, corporate IG replace government bonds as the ‘safe’ asset class. We do expect more interest from US companies to tap the European IG market. European high yield (HY) markets added a strong 27bp over the week to finish at +1.37% since January 1. HY spreads closed at 309bp. The HY sector yields 2.6%. Is the market ready to break historical low readings in credit risk premium across IG and HY sectors? Difficult to point to factors that would stop this attempt.
The yield of the emerging markets local currency index (GBI-EM) rose 7bp to just above 4.80% this week.
In currencies volatility was high. The Emerging Market Currency Index briefly traded below the 56 handle on Tuesday. Looking at weekly changes measured in EUR terms, we see surprising moves. South Africa Rand advanced 3.05%, Brazilian Real 2.40%, Mexican Peso 2.30% and Chilean Peso (2.20%). The most negative returns were for the Armenian Dram (1.45% in EUR terms), Malawi Kwacha (-1.20%) and Uruguay Peso (-1.00%).
The debt restructuring that took place in Argentina last year provided short term liquidity relief via lower coupon payments and delayed amortisation payments. Another agreement with the IMF is a must in order to postpone the USD 49 billion in cumulative payments. The huge mismatch between no USD assets (net FX reserves) and high USD liabilities (the USD 150 billion debt stock) require FX reserve accumulation, needed by 2024, when debt payments under the original DSA start. Without an agreement, the Fernandez government will find it difficult to refinance capital payments, especially the USD 2.4 billion Paris Club due in July. Ahead of the midterm October elections, it is doubtful that fiscal disciple, necessary to relieve payment stress, will prevail. Bonds that have been restructured last year at 56 recovery value, broke the 30-handle this week.
‘The most popular politician on earth’ is back. The Brazilian supreme court overturned graft convictions for which Luiz Inacio Lula de Silva served 580 days in prison and potentially cleared the way for him to run in the 2022 presidential election. The convictions for corruption and money laundering were annulled on the grounds that the provincial court in southern Brazil that tried the case acted outside its jurisdiction. The left-wing politician, who is the father of the social Bolsa Familia program, immediately attacked Bolsonaro on his poor handling of the pandemic and the state of the economy. Rising rates in the US in combination with Lula’s return, propelled the BRL above 5.80 and prompted massive central bank intervention. Brazil has the most negative real policy rate, currently at -3.20%, of all emerging economies. That condition is not going to save the Brazilian Real. Choosing between Bolsonaro or Lula is best expressed with the following metaphor… nobody remembered who played the violin on the promenade deck of the Titanic…except maybe Mrs. Vera Dick.
The cacophony produced by European institutions, trying to rise to the challenges and harsh realities posed by the pandemic, is sounding loud and clear. The lack of fiscal union and genuine solidarity is revealing the fault lines in the EU’s architecture. The EC, under the presidency of Jacques Delors between 1985 and 1995, achieved European unity through the creation of the single market. He also presided the Maastricht Treaty, signed on February 1992. Spirits would be lifted if, 30 years after the Maastricht Treaty, the current European Commission could signal breakthroughs in rewiring the stressed European architecture.
The US rates sell-off is orderly, as reflationary policies take root. The impact on European rates has been limited thus far. However, a disorderly European rates crisis is looming, as the fiscal-monetary experiment on this side of the Atlantic has growing pains.