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STATE OF AFFAIRS
The USD is experiencing a cyclical bout of depreciation during this pandemic. The US Federal Reserve decided to aggressively backstop financial markets, preventing a credit crunch. The US Treasury department reflated the US economy by supporting demand through various pay check support programs. The FED’s decision to bring policy rates to the zero lower bound and roll-out a no-limits, fully-flexible asset purchase strategy resulted in a 25% year-over-year jump in money supply. Against the EUR, the USD has depreciated by about 14% since financial markets made a bottom at 1.0636 the week of March 23, 2020. Between August and early November, the EURUSD pair fluctuated in a 1.1600 to 1.2000 range. Philip Lane, ECB Chief Economist, was expressing concern that too much EUR strength would derail part of their monetary policy objectives. The primary objective of the ECB is to guarantee price stability. An extended period of EUR strength would have a deflationary effect, given the open character of the European economy. Persistent COVID-19 fallout continues to suppress demand. Supply capacity constraints might only exert an inflationary counterbalance over the post pandemic episode. Currently, EUR strength and demand shortfall work in the same direction, keeping headline inflation in deflationary territory. EURUSD strength accelerated after the US elections. Markets expect a Biden-Harris administration will test the frontiers of fiscal policy. Pandemic-related emergency budget deficits, currently around 15% of US GDP, will roll-over into ‘normal policy’ budget deficits, between 5% and 10% of US output. Since early November, this narrative has led to speculative strength among market participants, pushing the EURUSD close to 1.22. The Yellen-Powell tandem prepares for a harmonious ride. A weaker currency serves both of them well.
We already mentioned that the ECB is too reactive and most of the time behind the curve. Consensus for next Thursday’s ECB meeting is for president Lagarde to announce an extension in time and size of the PEPP program next to a relaxation of TLTRO funding conditions. Market consensus calls for no change in official policy rates. A deposit rate of -50bp should still be fair. But is it? I contest this. The main reason relates to an excessive appreciation of the Nominal Effective Exchange Rate (NEER).
Last Friday, the ECB monthly NEER closed at 122.92. This rate is based on weighted averages of bilateral euro exchange rates against 41 major trading partners of the EUR area. At 122.92, we are less than 1% away from the highest level put in back in December 2008, since the launch of the Euro on January 1, 1999. Bloomberg data on this Euro Trade Weighted Index (TWI) go back to 1993. Also over this time frame, we are closing in on all-time highs. According to ECB president Lagarde, the Euro exchange rate is studied and considered as one of the channels measuring the effectiveness of their policy. Well, to this participant, it is maybe time to revisit the primary or standard policy instruments and put less emphasis on secondary or unconventional instruments. Agreed, both are essential in maintaining all channels, by which monetary policy achieves its objectives, open and fluid. However, the competitiveness of the EUR area receives scars. At -0.50%, the deposit rate facility has not reached reversal rate levels. Such levels would tighten financial conditions and lower potential growth. Why not rise up to the challenge and, as other central banks have done; lower the deposit rate towards -0.75%? The signalling function would be loud and clear. The Euro TWI would adjust, whilst restoring the balance between standard and non-standard use of ECB policy instruments.
However, when we look at the EUR area Real Effective Exchange Rate (REER), as measured by the Bank for International Settlements, the situation is less urgent. The REER is the weighted average of NEER, adjusted by the ratio of domestic CPI versus foreign CPI. The EUR REER fluctuates around its 20-year long-term average. So, if the situation is not critical under the REER sky, it does not bode well if the ECB cannot lift European CPI towards its 2% objective. If the US and other countries do succeed in lifting inflation levels, it will be even more to the detriment of our EUR currency that will continue on its appreciation path. Another Japanese-like process that unfolds! At this juncture in the history of the European Monetary Union, our currency should not become a flight to safety instrument. The von der Leyen-Lagarde tandem should kick into higher gear.
For the sake of completeness, I want to provide you with what is already priced by markets today in terms of the EURUSD exchange rate going forward. The EURUSD spot rate closed at 1.2124 last Friday. Now, EURUSD 2 year forward prices at 1.2340. The EURUSD 5 year forward stands at 1.2815. The EURUSD 8 year forward prices at 1.35 today. The interest rate parity theory at work. That means that in the debate among the preference for USD investments versus EUR investments participants take this currency valuation path as their base case scenario over respective investment horizons. Forecasters are sounding alarms on the fate of the USD versus the Euro when de facto a lot is already in the price. No reason for panic in financial markets.
In expectation of a bipartisan fiscal deal worth close to USD 1 trillion, US Treasury rates sold off aggressively. US 10-year rates rose about 13bp closing at 0.966%. It was a bear-steepening week, as 30-year rates sold off about 16bp, finishing at 1.735%. Protection was high for investors in US inflation- linked bonds. US 30-year real rates rose a modest 5bp. However 10-year real rates dropped 2bp to close at -0.949%! Effectively US 30-year inflation expectations shot up towards the symbolic 2.00% level. Given the FED’s Flexible Average Inflation Targeting put in place over the summer, it is a question of time before the 2.20% break-even rate levels reached over 2017 and 2018 will be targeted. Over the past 10-years, we have observed 30-year inflation expectation hovering around 2.50%. Expect also those levels to be reached over the next 3 years. The path of least resistance will push 30-year real rates at -0.28% today deeper in negative territory.
European rates were less affected by the US nominal rate rout. 10-year German rates backed up 4bp towards -0.55%. Southern EMU debt outperformed, adjusting a tiny 2/3bp higher. A similar rediscovery occurred also on this side of the Atlantic, looking at the European inflation-linked sector. Taking the 10-year real German bund rate as an example, we pushed over the week through -1.50%, settling at -1.52%. 10-year German inflation expectations rose a solid 8bp to 0.94%. We are miles away from 2017, 2018 highs that show 10-year break-even rates at 1.40%. Let’s monitor how the ECB will direct policy in order to lift these all-important inflation expectation indicators.
While European IG corporates paused with an almost flat performance over the week, the European HY sector raked in another strong weekly result. European High Yield credit added 72bp to leave us with a respectable YtD result of 2.58%. European IG and HY will end 2020 with similar total returns. It’s as if investors see both quality and speculative credit sectors fully under the protection of ECB policy. Our farfetched spread target of 225bp for the iTraxx Crossover index is almost reality! This HY risk proxy closed at 234bp.
Notwithstanding high levels of issuance, especially in hard currency, investors keep on pouring money into emerging markets assets. Yields on sovereign bonds from the Sub Sahara Region in hard currency tightened most (25bp) to 6.48%. The average yield on local currency (GBI-EM) sits now at 4.33%.
Emerging markets currencies performed very well. The JP Morgan Emerging Markets Currency index moved from 56.40 to 57.25 in one week, while volatility increased slightly from 10.10 to 10.25. Much of this move is explained by a weaker USD. The Dollar Spot index that measures the value of the USD against a basket of mayor currencies, trades now around 90.55, 1.6% weaker in a week and 11.5% weaker when compared to the March peak at 102.75. Brazilian Real (+2.0% in EUR terms), Colombian Peso (+1.9%) and Hungarian Forint (+0.9%) are this week’s top performers. Kenyan Shilling (-2.5% in EUR terms), Nigeria Naira (-2.3%) and Argentine Peso (-2.3%) are this week’s laggards.
This week, Brazilian President Jair Bolsonaro signalled to halt emergency aid paid to informal workers during the pandemic. Since 2016, an institutionally anchored spending cap is in place. Breaching this spending cap is a big risk for Brazil as it would destabilise fiscal accounts even more and hence the announcement was welcomed by the market. Yield in local bonds collapsed by more than 60bp this week. The Treasury took the opportunity to bring USD 2.5 billion global bonds to the market. All hopes are now on the Brazilian government’s commitment to speed up the reform agenda, narrowing the fiscal deficit. As interests on outstanding debt outpace nominal GDP growth, the debt to GDP ratio is still climbing fast, and is expected to breach the 100% mark in 2021.
The MPC members of the Reserve Bank of India voted unanimously to leave interest rates unchanged, despite stubbornly high inflation levels that exceed the fluctuation band (2%-6%) around the midpoint inflation target of 4%. At the same time, the RBI maintained its forward guidance of continuous accommodative monetary policy and support to the bond market via open market operations and operation twists. The RBI is clearly focused on supporting the nascent economic recovery in the country, while it considers the high inflation – caused by high food prices and supply-chain disruptions – to be transitory. Indian bonds rallied and the curve bull-steepened, because the RBI refrained from taking measures to absorb the excess liquidity present in the financial system. This liquidity is causing money market rates to be much lower than the reverse repo rate, but policymakers were concerned that taking measures to absorb the surplus liquidity would be misinterpreted as a signal of tightening in financial conditions.
On the topic of inflation, the Turkish CPI printed higher than anticipated at 14.03% YoY in November (vs 11.89% the previous month). So it seems that real rates in the country are only 1%, which might not be enough to maintain the TRY on an appreciation path, and it is likely the market will challenge the central bank’s credibility sooner or later.
The debate on the fate of the EURUSD exchange rate is running high. The currency war narrative is making a comeback, especially as central banks around the world have driven policy rates towards zero or below.
As is the case for rates and credit, diversification is your only option to alleviate the impact of currency volatility on capital preservation and growth in global bond portfolios.
The ECB Council is confronted with a complex equation to solve. Their credibility would increase if standard and non-conventional policy levers would be activated in order to lift probabilities for success.