DPAM Blog

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.