Questions about a vaccine
Investors may be concerned over the decision of a number of continental European countries to suspend the use of one vaccine amid worries over side-effects (which currently have not formally been identified as linked to vaccination).
This will slow vaccination campaigns that had finally been gaining momentum and risk increased mistrust among the to-be-vaccinated, while possibly further delaying economic recovery as the more contagious variants of the virus are gaining ground.
Even so, the scenario of a cyclical recovery has not been abandoned. Growth forecasts continue to be revised upwards, not only in the US on account of President Biden’s colossal USD 1.9 trillion COVID-19 stimulus package.
In the eurozone, manufacturing activity is benefiting from the acceleration in global demand. Germany’s ZEW Financial Market Survey (300 experts from banks, insurance companies and financial departments of selected corporations are interviewed about their assessments and forecasts) registered its third consecutive monthly rise in March. The component reflecting the six-month outlook returned to its highest since September, when the index topped the highs of previous cycles.
Volatile economic indicators
In the US, extreme weather disrupted activity in February: Retail sales contracted by much more than expected, but after a sharp upward revision to January’s data, consumer spending remains on a solid trend. Industrial production also fell by more than expected in February due to the polar cold spell.
These developments do not call into question the strength of the US recovery. They may, however, cloud the picture at a time when the US Federal Reserve is going to have to reaffirm its commitment to a long period of very accommodative monetary policy.
European Central Bank: Text explanation(s)
On 11 March, after its monetary policy meeting, the ECB announced that “(asset) purchases under the PEPP (programme) over the next quarter (are) to be conducted at a significantly higher pace than during the first months of this year.” The aim is to keep financing conditions from tightening.
At her press conference, ECB President Christine Lagarde advanced a lot of information. What is most surprising is that, despite the flexibility (which has been reaffirmed) of the pandemic emergency purchase programme (PEPP), changing the amounts of assets to be purchased is a decision that requires the governing council to be involved.
This explains why the ECB did not react earlier to upward pressure on eurozone long-term bond yields (+35bp between 4 January and 26 February for a GDP-weighted 10-year yield).
President Lagarde also reaffirmed that;
- The ECB is not conducting yield curve control
- Favourable financing conditions are measured using several criteria (from upstream indicators to downstream conditions of credit). It is these indicators that underpin the smooth transmission of monetary policy.
Finally, according to a form of communication that seems to be gradually becoming a habit, the press conference was followed by comments from ‘sources’ providing clarification. It has thus been reported that the purchases will be smaller than they were last spring, but greater than in recent weeks.
So the ECB's commitment does not seem to be based on prices (as per the Bank of Japan’s policy since September 2016), but on quantities.
Other opinions within the ECB
In an interview published on 16 March, Philip Lane, chief economist and member of the executive board of the ECB, emphasised the importance of assessing financing conditions ‘dynamically’ while recalling that the level of long-term rates is fully part of these conditions: ‘Over time, the relation between the appropriate level of yields and inflation will move.’ The aim of monetary policy is to offset the pandemic shock to inflation and to deliver a path to convergence with the inflation target.
The next day, Isabel Schnabel said in an interview that while the recent rise in long-term rates is ‘consistent’ with an improving economic outlook, the speed of the advance was a ‘source of concern.’
- Should we now conclude that the ECB is ready to tolerate higher yields provided their rise remains orderly? Or is it, on the contrary, a recognition of powerlessness to control a specific level?
- Does the ECB favour targeting real rates or nominal rates?
- Will the next step be to move to flexible average inflation targeting as the US Federal Reserve did last summer?
Until these questions are answered, bond investors, too, will need to be flexible. Given the growth and inflation outlook for 2021, short duration, yield curve steepeners (on the intermediate part of the yield curve) and an exposure to inflation-linked bonds appear appropriate, but positions will need to be adjusted as interest rates move.
The ECB's increase in asset purchases should continue to support ‘peripheral’ eurozone bond markets. Italian BTPs should benefit from the search for yield.
Meanwhile, at the US Federal Reserve
Economic and interest rate projections will be the focus at this week’s Federal Open Markets Committee (FOMC) meeting. Since the December meeting, nearly USD 3 trillion (equivalent to 15% of GDP) of additional fiscal accommodation has been legislated, while activity data has been resilient.
As a result, significant upward revisions to the median growth forecasts and correspondingly solid downward revisions to the median unemployment rate forecast by FOMC members are likely. By how much FOMC participants will mark up their inflation forecasts and, as a consequence, their interest rate projections remains uncertain.
The market will focus on the ‘dot plot’. Any move interpreted as hawkish could result in a further rise in yields and more upfront pricing-in of a tapering of monetary support.
The risk remains that markets continue to test the Fed’s recent tolerance for higher yields. The Fed could be forced to intervene if a market-induced ‘taper tantrum’ occurs with financial conditions deteriorating sharply, equity markets correcting, corporate bond spreads widening, and the US dollar strengthening.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
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