As we have written in the past, European rates have risen and the euro has strengthened due to an improved U.S. outlook with the associated pricing-in of Federal Reserve normalization. Because the rise in European yields is inconsistent with fundamentals, the European Central Bank (ECB) needed to push against it and did so by pulling forward pandemic emergency purchase program (PEPP) firepower.
There are two ECB events later this year that are worth watching, as they could have implications for the euro. The first is the growth outlook. There is a feeling in the markets that the ECB’s growth outlook is on the optimistic side and is contingent on an early reopening. With Europe underperforming on the vaccine distributions and suffering from extended lockdowns, a downward revision of the ECB’s growth outlook seems likely, if not inevitable. The second event to watch is the strategy review that should be complete by this summer. In theory, the review is supposed to reinforce the ECB’s policy toolkit and provide the bank with more flexibility and allow it to keep monetary conditions accommodative after PEPP ends early next year. Of course, it remains to be seen what actually happens and how credible the markets view the results of the review.
Ultimately the ECB’s “holistic” approach to keeping financing conditions favorable is likely too vague to sustainably drive the euro lower. Instead, U.S. data and the Fed remain the key market drivers. The U.S. just delivered another round of massive fiscal stimulus and appears to be on track for an early reopening that raises the possibility of Fed normalization and policy decoupling.
As such, the market’s focus has now shifted to this week’s Fed meeting, at which Fed Chair Jay Powell will try to balance a number of challenges. Topics that Powell and the Fed are expected to address include the liquidity issues that accompanied the recent rates sell-off, recent market volatility and the Fed’s stance on a further rise in real yields given the still-high level of uncertainty.
However, unlike with yields in Europe, it is hard to argue that current yields in the U.S. and market pricing for the Fed are inconsistent with fundamentals. Powell himself has acknowledged that the outlook for the U.S. economy has improved, with the recently passed stimulus package providing another boost. Furthermore, the date for which the U.S. is expected to complete the vaccination of the U.S. population keeps moving forward, with many U.S. states already starting the reopening process. Notably, the Fed will also update its growth and inflation forecasts for the first time this year, likely upward. So even if Powell comes off as dovish this week, it will be increasingly hard to maintain that stance over the coming months with the U.S. economy on a solid recovery path.
Beyond the U.S. dollar, there are some interesting trends within the G10. The British pound, Norwegian krone, Canadian dollar and Australian dollar have all done well, while the Swiss franc and Japanese yen have not. This is consistent with the view that rate volatility is primarily driven by “good” factors, namely the global recovery from the pandemic. This is why risk sentiment remains positive despite markets starting to rightfully price in Fed policy normalization. | |
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