Global yields have continued their relentless march higher, leading market participants to switch from a singular focus on the global recovery to a view that still expects growth but also acknowledges there will be monetary policy consequences due to the impending surge in growth and upcoming wave of unprecedented fiscal stimulus in the U.S.
From a central banker’s perspective, several central banks, including the European Central Bank, have expressed some discomfort with rising rates and the associated tightening in financial conditions. In contrast, Fed Chair Jay Powell not only failed to protest against rising rates but also came close to welcoming them as a sign of confidence in the recovery.
Clearly central bankers around the world have differing views, but it is the attitude of the Fed that is most important to global markets. As such, yields are rising, not only at the long end but at the belly of many yield curves, as markets question the credibility of “lower-for-longer” guidance during a period of exceptional growth rates. This can be seen by the broad-based pull-forward of central bank rate hike expectations. In the case of the euro and British pound, markets have pulled forward expectations by a full five quarters. As for the USD and Canadian dollar, the first full hikes are now priced for Q1 2023 and Q2 2022, respectively.
This re-pricing of U.S. and global monetary policy has destabilized risk markets. Now, more than at any time since the start of the COVID-19 pandemic, risk markets are more finely balanced between growth optimism and concerns on policy tightening. From a historical perspective, the current situation has no precedent. It is not a 2010-style early cycle recovery with incremental global easing, it’s not a mid-cycle 2013 tantrum nor is it a case of U.S. exceptionalism with deceleration elsewhere, as in 2018. Instead, the current situation shares characteristics of all these instances.
In the near term, the risk is for a continued reassessment of central bank policy and a further de-risking of investor positions. This means crowded trades in foreign exchange are vulnerable to a pullback, although commodity-linked currencies should remain supported by the rise in commodity prices. Further out, the risks then shift to U.S. dollar support—stemming from a quicker rise in U.S. yields, relative to other developed markets—as the U.S. delivers historically large fiscal stimulus. Notably, some analysts now expect U.S. growth to overtake Chinese growth around the middle to the end of the year.
Certainly there remains a global output gap, but unprecedented macro stimulus leads to unprecedented results. This pertains to both an output gap that should close faster than seen in previous downturns, and early cycle economies that have market conditions that feel more mid-cycle and valuations that are even late-cycle.
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One- to two-week view: The euro is expected to continue trading in its recent range. Euro value remains a function of EU growth prospects (employment data out this week), which in turn depend on the current COVID-19 situation. While the number of new COVID-19 cases has fallen, the slow pace of vaccinations (herd immunity projected in September/October in the EU versus June in the U.S.) means the relaxation of lockdown restrictions and full reopening of the economy will come after countries such as the U.S. and U.K. As such, European growth continues to lag U.S. growth (see contrasting PMI performance) on the back of differences in COVID-19 restrictions, the magnitude of fiscal support provided and proposed, and differences in vaccine distribution success. On the monetary front, European Central Bank (ECB) officials continue to take on a dovish bias. Given this, the global COVID-19 narrative and economic outlook continue to improve and the picture for growth in the eurozone looks better now than it did at the turn of the year.
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 push the euro higher in Q1, but the single currency should dip into year-end as U.S. yields rise, the European Central Bank 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: Recent currency strength has been driven by relative vaccine outperformance and markets pricing out negative rate risks, but these factors are now mostly priced in, leaving the bias for continued range trading with downside risks. Prime Minister Boris Johnson released his reopening “road map” outlining how the government plans to ease lockdown rules over the coming four months. Next week brings the chancellor’s budget proposal. With the job market remaining under stress despite government aid, markets will be looking to the budget to provide clarity on how much fiscal support the chancellor is willing to provide.
Three- to six-month view: The U.K.’s vaccine rollout outperformance and resulting economic optimism has provided a boost to the pound. Compounding this support has been the message from the Bank of England 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 simply catching up to them. The second factor is the impact of vaccinations. While the relative pace of vaccinations will affect the relative trajectory of the U.K. economy over the next few quarters, it won’t impact the long-run 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 have to recover not only from its pandemic underperformance, but also from the damage done by the narrow trade deal, which is fundamentally bad.
One- to two-week view: USD/JPY has come under pressure due to the widening U.S.-Japan yield differentials, as overseas yields face increasing upward pressure while Japanese yields remain suppressed by yield curve control (YCC). Given this, expectations remain for the yen to range trade as it tracks the broad dollar trend. Markets are also waiting on the results of the Bank of Japan’s strategic review. Recent comments out of the central bank indicate that the basic framework of policy under yield curve control and negative interest rates would not be altered, but the parameters under which these two policies are operating were open to fine tuning. At present, the most likely outcome appears to be a relaxation of YCC with a strong commitment to further easing. To the extent that an extended state of emergency leads to a sharper deceleration in economic activity and BoJ dovishness, the yen will face depreciation pressure. To this end, the speed of vaccine rollouts, which recently started, remains important.
Three- to six-month view: The medium-term outlook is still biased toward a stronger yen. However, rising U.S. yields have pushed USD/JPY higher and represent the strongest headwind to further yen appreciation. Given this, it should be noted that U.S.-Japan real yield spreads still support a move toward 100 yen per U.S. dollar (USD) even if U.S. yields move somewhat higher. Regarding monetary policy, markets will be looking out for the results of the BoJ’s policy review due in March. If media reports are correct, the BoJ could signal the de facto end of YCC by announcing a wider trading band. An emerging point of discussion is the impact of Japan’s vaccine imports. Estimates put Japan’s vaccine bill at around $2 billion to $3 billion, or roughly half of Japan’s total trade surplus with the U.S. in February of last year. This could provide some support to USD/JPY, although this support is likely temporary.
One- to two-week view: An extension of several government COVID-19 benefit programs should keep the economy supported in the near term. Overall, continued policy support (Bank of Canada and Fed policy broadly aligned), the continued global recovery and vaccination efforts have improved the outlook for growth. A key risk factor to Canada’s economic recovery is the relatively slower vaccine rollout relative to its peers. However, faster vaccine rollouts and large fiscal stimulus in the U.S. should provide support to Canadian exports and investment activity. The upshot to a slow vaccine rollout in Canada is the potential for a quick bounce-back in the economy once inoculations gather pace and allow for restrictions to be lifted. The CAD remains susceptible to global risk sentiment, broad dollar moves and oil prices in the near term, but the view remains constructive.
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 BoC has adopted a more positive tone and laid down the parameters for 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—making the country’s vaccine progress something to keep an eye on. 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: Recent indicators show China’s economy continuing to grow. However, there has been a moderation in the pace of this growth and inflation. Nevertheless, relative economic outperformance, a current account surplus and relatively high yields form the base for a bullish view and support a continued drift lower for USD/CNY. 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. While it has been reported that China is considering measures to allow greater outbound investments as huge inbound flows have led to steady yuan appreciation, expect policymakers to keep a close eye on domestic outflows. On the geopolitical front, China is looking at restricting rare earth mineral supplies to critical U.S. industries. Overall, the U.S. will take a more conventional approach to China, and expectations are for U.S.-China tensions to remain elevated as Biden retains a tough-on-China approach.
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, and while there is medium-term risk that a resumption in production in the rest of the world could undermine Chinese exports, 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 CNY 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: Rising Aussie yields, commodity prices and hopes of a global recovery continue to provide support for the AUD in the near term. Given this, the Reserve Bank of Australia bought a record-matching AUD$5 billion in bonds last week, plus an unscheduled AUD$2 billion purchase. On a broader level, the RBA has signaled its intent to remain dovish with “very significant” monetary support provided for some time, as it will take years to meet its inflation and unemployment goals. The central bank meets this week and should reiterate its dovish commitment, and could step its YCC activities. Meanwhile, tensions between China and Australia continue to linger, but have led to only a limited economic impact thus far. However, Chinese economic activity, while growing, has started to show moderation on the margin and should impact Australian commodity export volume. Expect markets to continue to buy into any dips.
Three- to six-month view: Recent price action has been driven by strength in key commodity prices, with iron ore being a particularly important catalyst as prices continue to benefit from a rebounding Chinese economy and disruptions to supply chains outside of Australia. However, 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 quantitative easing (QE) program. While history shows that QE has had a limited impact on exchange rates, it should still lead to a weaker AUD on the margin. 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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