Yields have been on a bit of a roller-coaster ride, as the U.S. 10-year yield started last week off with a short-lived correction that then pivoted to a continued sell-off after Federal Reserve Chair Jay Powell failed to protest the move higher in yields and the U.S. economy delivered a better-than-expected jobs report. Thus far this week, rate markets have stabilized a bit, with focus now on what the European Central Bank (ECB) will do at its meeting tomorrow and what the Fed will do at its meeting next week.
Beginning with the ECB, markets are likely looking for increased clarity on the central bank’s thinking and a stronger dovish message. The outlook for the eurozone has dimmed relative to the U.S. outlook, partly due to slower vaccination rollouts and extended lockdowns. While European rates have risen, this appears to be due to the ECB’s inability to stop the global trend. As such, it is important for the ECB to re-establish its credibility.
Even before the recent market volatility, ECB communication was already vague and mixed. This is partly due to the Strategy Review that is still in progress and the resulting lack of agreement on the policy reaction function. Unfortunately for the ECB, markets are not waiting for the completion of the Strategy Review. This makes it important for the ECB to deliver a strong message, particularly in light of the bank’s new commitment to keeping monetary conditions supportive. Ideally, this message will also include some insights on the direction of the Strategy Review.
The Fed has a different set of challenges as it works to balance a couple of tasks. The first task that the Fed has to tackle is the liquidity problems that occurred due to regulatory causes that have now become a recurring problem. The second task will be addressing excessive market volatility. Over the past couple of weeks, multiple Fed officials have made note of recent volatility. However, these Fed officials have also acknowledged the improving economic outlook, so the Fed should be accepting of some of the recent rise in rates to the extent that higher real rates reflects better fundamentals. U.S. core CPI data released this morning showed prices rising less than expected. While this somewhat eases inflation concerns, pricing pressures should emerge over the next couple of months due to base effects. Given this, longer-dated inflation expectations remain lower than shorter-dated measures, a result that is in line with the Fed’s new flexible average inflation targeting (FAIT) framework and that shows the markets and the Fed view the impending rise in inflation as transitory.
Overall, expectations remain for the global recovery to continue as economies make progress on reopening, with the U.S. doing particularly well but the eurozone lagging behind. This should ultimately lead to markets pricing in policy divergence between the Fed and ECB that pressures EUR/USD lower. Broadly speaking, the global recovery is positive for risk assets, but Fed normalization remains a risk. Key tail risks (high impact, low probability) include upside surprises to U.S. inflation that forces faster policy normalization and new COVID-19 strains that keep the pandemic around for longer as macro policies lose their effectiveness. | |
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