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STATE OF AFFAIRS
Not surprisingly, the reflation momentum was alive and kicking over the past week in markets, as expectations of a floor vote by the end of February for a Biden stamped US fiscal package became consensus. Time to go big was uttered by Janet Yellen and endorsed by the IMF. The bill is based on USD 1.9 trillion of fiscal spending directed at food stamps, unemployment benefits, USD 1400 per person payments showing an individual income of less than USD 75k and an acceleration of vaccine deployment and testing capacity. In parallel, negotiations kicked off to discuss a sweeping infrastructure bill the moment the virus aid is approved. The infrastructure bill will carry a multi trillion tag. We want to stress that, for financial markets, the canary in the coalmine might be the infrastructure bill instead of the current disaster relief spending. The canary in the coalmine, not because it would lift, let’s hope, potential growth, but because this bill would require an increase in taxation for corporates and high earners. Both groups have seen their valuations and net worth increase substantially, increasing the gap with middle and lower classes. One could say that the bill under discussion, finishing around USD 1.4 to USD 1.5 trillion given reconciliation impact, is a one-off income subsidy, directed at left behind lower and middle classes. The relief package might positively impact 2021 real GDP but peter out completely by 2022. Indeed, one should refrain from extrapolating the package as having a multi-year positive impact on US GDP. The fiscal multiplier will be closer to 0 than to 1, as the propensity for households to spend the paycheques will be modest. On the other hand, the propensity to reduce household indebtedness might be high. If that would be the case, the pent-up demand narrative might be very short-lived
Last Thursday, February 11, the US Congressional Budget Office released their Budget and Economic outlook: 2021 to 2031. With real growth of 3.7% over 2021, the US economy would return to its pre-pandemic level over the summer. Real growth would average 2.6% over 2021 till 2025, thereby closing the output gap by early 2025. One cannot underestimate the importance of the above, as markets should distinguish between growth recovery and the growth path required to close the output gap or slack, underutilisation of capacity, in the economy. The 2021 budget deficit forecast sits at USD 2.3 trillion, or 10.3% of GDP. It dips to -3.6% over 2024 to still run at -5.7% in 2031. For the people in doubt, the above fiscal largesse will push the US central bank in maintaining its asset purchase intensity intact for longer. Calling for policy normalisation through early 2022, QE tapering is premature. The trajectory for real GDP that the CBO depicts concurs with the view reflected in previous editions. After a 3.7% recovery expected over 2021, real GDP drops towards 2.2% and 2.3% over 2022 and 2023 but slides towards 1.6% over 2026-2031. That is 0.2% below the 1.8% potential US growth rate reached by FED analysts. I believe it is once more premature to expect higher long-term potential growth conditions that would explain higher long-term rates.
The infrastructure proposal will include expansions of rural broadband, road and bridge repairs, half a million charging stations for electric cars amongst other projects creating millions of jobs. Whether the Biden-Harris administration will opt for immature deficit financing versus responsible and redistributive taxation is a crucial choice and decision. For inflated risk-free and risk assets, most choices are suboptimal. We have witnessed and welcomed some decompression in core rate markets. Spread-based financial instruments show resilience but might crumble if core yield curves steepen further. On this latter question of steepening potential for the US yield curve, I dare to make a forecast. If the future will prove me wrong or right is not important. The purpose is merely to keep vigilance intact.
A majority of market strategists predict that the US yield curve steepens further. Let’s have a look at the 2-year versus 30-year interest rate differential. This measure closed at 1.90% last Friday. Over the past 44 years, the average 2y30y steepness stands at 128.7bp. For simplicity, we will use 1.30% or 130bp. Interestingly, since the global financial crisis (GFC) of 2008-2009, this metric has never touched the zero bound. Indeed, the zero- interest rate policy rolled out by the FED has made yield curve inversion as good as impossible. The low over the post GFC-cycle was around 40bp, observed over September 2018 and September 2019. Both were moments where markets estimated that the FED tightening cycle was coming to an end. This 40bp low was about 40bp away from the 1 standard deviation (SD) level that sits at the 0.00% level over the observation period. The 1 SD on the upside prints at 2.55%. Applying the ‘undershoot’ of 40bp from the 1SD on 2y30y curve flatness to the steepness potential we arrive at a target steepness level of 215bp or 2.15% i.e. 2.55% minus 0.40%. With current 2y Treasury rates anchored around 10bp we arrive at 2.25% on the US 30-year long bond. The 30-year long bond closed at 2.00%, leaving us with a mere 25bp from target on this back-of-the-envelope scenario. 2-year rates might indeed test the 0.00% level, making the current 2.00% even more interesting. I repeat, a disclaimer is in order, as bond investing is not at all about timing. The purpose of the above exercise is merely to provide some guidance in an era where markets tend to re-price fast and furiously on the upside as well as on the downside.
US January CPI readings came in line with a MoM reading of +0.3% and YoY posting a +1.4%. Base effects will push these readings well above 2.00% over late spring and summer. The US yield curve bear steepened another notch. 2-year Treasuries barely move around the 0.10% post. The 30-year US long bond added another 3bp, closing at 2.00%. US TIPS were less resilient, as the steepening was led by the higher fiscal effort – higher growth narrative. 30-year real rates rose 4bp to -0.17%. Overall inflation expectations stood their ground.
In the State of Affairs section, we did not dwell on Eurozone fiscal initiatives, as, for the moment, there is little to dissect. The EU Next Generation plan is just what its name says: a plan. OK, maybe a bit too harsh, as several governments have staged preliminary allocation schedules across infrastructure, health and educational projects. One cannot avoid connecting the lacklustre progress in EMU vaccination results to the fate of various national and cross-border investment plans. Speed and quality of execution will be ingredients that allow for higher potential development. German 10-Year bunds start to feel comfortable around the -40bp marker, closing up 2bp at -0.43%. Italian rates converged nicely with 10-year BTP’s finishing at +0.47%. The spread to 10-year Spanish rates, at 0.15%, stands at 32bp. The market might quite possibly picture a 0-spread driven by the Draghi aura. A condition that was present over the summer of 2016. During the era with no ECB QE, Italian 10-year rates plotted persistently below Spanish 10-year rates! The JP Morgan EMU index lost 20bp over the week and settled for -1.13% year-to-date.
The European Investment Grade Iboxx corporate bond universe shed 2bp in performance, holding at -0.31% year-to-date. The European ICE Bank of America High Yield (HY) index raked in another +0.12%, finishing at +1.37% over 2021. European HY spreads dropped to 318bp, offering a yield around 2.5%. In the US, we observe similar spread levels, with the yield dropping below 4.00% for the first time in history.
Emerging market (EM) yields moved sideways last week. The yield of the JP Morgan local currency Index is now at 4.30%, slightly higher than the 4.22% at the end of last year. Looking at spreads, hard currency in the Sub-Saharan region has tightened most, around 10bp so far this year. Our positive view for the asset class remains well in place. Growth recovery against a background of monetary and fiscal stimuli will boost exports of many emerging economies. Given the high beta between the change in global growth and the value of EM currencies, especially commodity exporters, we believe that most of the performance will come from EM FX appreciation.
Since the start of the year, the JP Morgan EM currency index has moved sideways, within a 57/58 range. Over the same period, the Dollar Index strengthened around 0.90%. Regular readers of this letter have learned that a weaker USD is an important driver of EMFX performance, but that other factors, like global growth, evolution of commodity prices and EM FX volatility, are equally important. Despite a somewhat stronger USD, the average EM FX performance of the 70+ countries in the universe we monitor, is indeed positive. Biggest gain is for Turkish Lira (+6.3% YTD in EUR terms), followed by Paraguay Guarani (+4.1%) and Ukrainian Hryvnia (+3.2%), worst performers are Jamaica Dollar (-3.5% YTD in EUR terms), Argentine Peso (-3.2%) and Sri Lanka Rupee (-2.4%). EM FX volatility continues to decrease (9.60%) and is now at its lowest level since March last year.
Central European inflation figures in Poland (2.40%) and Hungary (2.70%) showed stable prints, but in Czechia (2.20% vs 1.70% consensus) and Romania (2.99% vs 2.45% consensus), they came in higher than expected, leading to a flattening of the swap curve in the Czech Republic and a steeper cash curve in Romania. We have been positive on Romania for a long time now. The recent election result strengthened this view, as we believe the new administration will run a market-friendly course. Looking at the spread between the local curve (ROMGB) and the external (ROMANI) in EUR, we believe the value is more in ROMANI, given the recent rally in ROMGB.
Serbian local currency bonds got a boost after the announcement of GBI-EM inclusion as of June 30th, 2021. Serbia’s weight is estimated to be approximately 33bp. The increase of the issued benchmark size of SERBGB’s has increased the liquidity in recent years. Achieving ‘Euroclearablity’, the next big project of the Serbian DMO, will attract investors without local clearing capabilities and increase liquidity further.
On the one hand it is premature to extrapolate 2021 growth recovery too far into the future. CBO projections issued last Thursday read like a cold shower. With US government deficits fluctuating persistently around 5% of GDP over the next 10 years, our call for an accommodative US FED, including continued asset purchase support, stands firm. On the other hand, we closely track the Biden administration as they discuss the future infrastructure bill. It would receive an immature label the moment more deficit spending would be preferred over correct taxation in order to finance this core long-term project.
The call for realism with respect to future GDP growth as well as US growth potential might signal that we have entered the last stages of US yield curve steepening. Under stable 10-year to 30-year US yield curve steepness, our 2.25% maximum target translates to 1.45% on the US 10-year note. However, with the level on 5-year US Treasury rate 5-years forward at 1.95%, we already feel comfortable, as such a reading balances well against an investment in 10-year US Treasury rates at 1.21% on Friday’s close.