In this week’s podcast, David Atkinson talks with John Coscia, senior vice president and director of Portfolio and Funding with City National’s Treasury group. John uses the chart below to weave a tale of how the macro forces initiated by policymakers are making their way through the banking system and into the economy. John notes that we always hear about the assets on the Federal Reserve’s balance sheet but do not focus enough on the liabilities. Among the topics and questions we discuss are:
What happened with that dip in September 2019 when liquidity in the interbank market seemed to dry up? Whose fault was it, and could it happen again?
Why was the U.S. Treasury holding over $1 trillion in its account at the Fed when this chart came out? What has happened since then?
What is scheduled to happen at the end of this month in terms of regulatory capital, and why could that affect the U.S. Treasury market and interest rates?
While this discussion is focused on domestic economic and banking questions, it leads into larger questions we will be having this year as governments and central banks across the world try to navigate the post-COVID-19 global economy.
One- to two-week view: Moves in U.S. rates remain the main driver of global foreign exchange markets. The U.S. has finalized President Biden’s $1.9 trillion stimulus package, which reinforces market expectations for U.S. growth outperformance relative to European growth due to divergence in fiscal support and vaccine distributions. As such, upward pressure on U.S. rates and depreciating pressure on currencies that can’t match the rise in U.S. yields should continue. They key euro-related event last week was the ECB meeting, where the bank kept its rates and the overall size of its pandemic program unchanged. However, the bank did pledge to “significantly” pull forward asset purchases to contain rising yields. In essence, the bank has put actions to words, and it will provide support to markets. Expect the euro to range trade with a bias for lower as European growth continues to lag U.S. growth and the ECB remains more concerned over rising yields than the Fed.
Three- to six-month view: With the factors that pushed the euro higher in 2020 having faded or starting to fade, gains in 2021 should be harder to come by. Moreover, the prospect of more fiscal stimulus and a faster vaccine rollout in the U.S. relative to Europe increases the chances for a return of U.S. exceptionalism and U.S. growth that outpaces European growth. Near-term optimism on a recovery in global growth helps the euro higher, but the single currency should dip into year-end as U.S. yields rise, the ECB continues to fight deflation and market focus shifts to questionable domestic growth fundamentals. In essence, it is difficult to see a sustained euro rally without European economic exceptionalism and the prospects of ECB rate hikes.
One- to two-week view: The U.K.’s vaccine outperformance has allowed the pound to be one of the best-performing currencies against the U.S. dollar despite the U.K. economy being one of the hardest hit major economies by COVID-19. Given this, relative vaccine outperformance has largely been priced in. The Bank of England (BoE) meets this week and isn’t expected to change policy, but BoE Governor Bailey has struck a cautious tone on the economic outlook that can be seen as belated pushback on the market’s reaction to the BoE’s last meeting. Regarding stimulus, the chancellor’s budget delivered another dose of near-term fiscal easing that becomes contractionary over the long term as tax hikes, to reduce the deficit, hit the economy. Lastly, tensions are rising between the U.K. and EU over vaccines and other export issues as trust on both sides continues to deteriorate post-Brexit. Overall, the pound is expected to hold steady.
Three- to six-month view: The UK’s vaccine rollout outperformance and resulting economic optimism has provided a boost to the pound. Compounding this support has been the message from the BoE that it is unlikely to impose negative rates. While the vaccination program is encouraging, there are reasons to remain cautious. The first reason is that the economy isn’t moving ahead of its peers but is simply catching up to them. The second factor is the impact of vaccinations. While the pace of vaccinations will affect the relative trajectory of the U.K. economy over the next few quarters, it won’t impact the long-term sustainable economic trend rate, which is more relevant for the medium-term GBP. In this respect, Brexit, which has been overshadowed by the pandemic, has been and should continue to be an economic drag. This means that the U.K. economy will not only have to recover from its pandemic underperformance but also from the damage done by this narrow trade deal, which is fundamentally bad.
One- to two-week view: USD/JPY should remain driven by the reflationary narrative as higher U.S. yields push USD/JPY higher and vice versa. U.S.-Japan yield differentials have widened due to contrasting comments out of the Fed and Bank of Japan (BoJ), with Fed Chair Powell declining to push back against rising rates while BoJ Governor Kuroda said it was “unnecessary nor appropriate to expand the band” on yield curve control. As such, the bias is for yen weakness as overseas yields come under increasing upward pressure while Japanese yields remain suppressed by yield curve control. The BoJ meets this week and will officially announce the results of its strategic review. To the extent that an extended state of emergency leads to a sharper deceleration in economic activity, the BoJ will be pushed toward dovishness. To this end, the speed of vaccine rollouts, which recently started, remains important.
Three- to six-month view: While the yen will be influenced by the direction of nominal rates in the near term, the medium term outlook remain downward sloping with moderate yen outperformance versus the dollar still expected. This view reflects Japan’s underlying balance of payment strength, relatively cheap valuation and real rate advantage. Regarding monetary policy, markets will be looking out for the results of the BoJ’s policy review due in March. An emerging point of discussion is the impact of Japan’s vaccine imports. Estimates put Japan’s vaccine bill at around $2-$3 billion, or roughly half of Japan’s total trade surplus with the U.S. in February 2020. This could provide some support to USD/JPY, although this support is likely temporary.
One- to two-week view: The Bank of Canada met this past week and kept its policy rate and QE parameters unchanged, as was expected. The bank also maintained dovish forward guidance despite a stronger near-term outlook and market expectations of earlier tapering and policy normalization. Overall, the tone was neutral as near-term optimism was balanced with concerns about economic slack and uncertainty about the evolution of the virus. While the Canadian dollar (CAD) remains susceptible to global risk sentiment and broad dollar moves, CAD outperformance is still expected as the economy has been resilient (strong labor market report) and the country scores well on high vaccine procurement and falling case numbers. Additionally, the currency should receive support from OPEC+’s supply cut extension.
Three- to six-month view: The medium-term CAD outlook remains constructive. While the USD has picked up some support, further CAD appreciation is supported by the Canadian economy’s proximity to the U.S. due to increased U.S. demand for Canadian exports. Moreover, the CAD should benefit from a move up in commodity prices as the global economy continues to recover. Notably, oil has been a strong performer on a year-to-date basis, and the outlook remains bullish. On monetary policy, the Bank of Canada appears to be moving toward eventual QE tapering, adding to the positive medium-term outlook. In essence, the bank has tied paring back policy support to the economy performing “in line or stronger” than the bank’s forecast, and thus far this is happening. Finally, there is the potential for federal elections this year but the impact on CAD is likely modest and mainly tied to possible changes in fiscal policy.
One- to two-week view: China’s economic data continues to come out positive, as evidenced by exports rising 61% in U.S. dollar terms over the first two months. Granted, this number was skewed by last year’s lockdown economy but also reflected strong global demand. Relative economic outperformance, a current account surplus and relatively high yields still form the basis for a bullish Chinese yen view. Eventually, COVID-19 vaccine distribution will allow the rest of the world to close the growth gap, but for now China’s yield advantage and foreign investor inflows support further gains. Lastly, diplomatic tensions between the U.S. and China are starting to rise again. On the U.S. side, the country held its first-ever summit of the Quad (Australia, India, Japan and the U.S.), aimed at building alliances in competition with China. As for the Chinese, officials issued statements saying the U.S. was “crossing lines and playing with fire” on Taiwan. Given this, China’s foreign minister stressed that cooperation was the primary aim of U.S.-China relations.
Three- to six-month view: The yuan’s year-to-date appreciation against the dollar index reflects supportive fundamentals and solid fund inflows. China’s export sector has outperformed expectations, and while there is medium-term risk that a resumption in production in the rest of the world could undermine this, risks for an immediate setback are limited. On the flow front, bond inflows remain solid and should continue given China’s relative yield advantage. Regarding the central bank, the People’s Bank of China has yet to signal any strong resistance to Chinese yen gains except for a continued relaxation of measures designed to control outflows. This implies that Chinese officials are not yet uncomfortable with recent currency appreciation.
One- to two-week view: The Aussie dollar has underperformed relative to ongoing gains in commodity prices. Further, RBA Governor Philip Lowe has reestablished a dovish bias and pushed back against current market pricing by noting that “over the past couple of weeks market pricing has implied an expectation of possible increases in the cash rate as early as late next year and then again in 2023. This is not an expectation that we share.” Furthermore, the bank announced that it would charge 100 bps to bet against its YCC program. On net, the RBA’s asset purchase program and expectations for U.S. exceptionalism are making it difficult for the Aussie to do well.
Three- to six-month view: Idiosyncratic issues such as negative AUD-USD rate spread and a central bank that is actively pushing against rising yields should see the AUD drift lower over the medium term. While iron ore price had been supporting the AUD, Chinese economic growth has started to moderate, and other producers are ramping up production. This is particularly important as commodity prices are a key driver for the Aussie. Regarding monetary policy, the RBA announced an extension of its QE program and has proven itself to be one of the few central banks willing to push back against rising yields. As for trade, Australia-China trade tensions continue to linger but, critically, China is not expected to put restrictions on iron ore due to the lack of alternative supplies.
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