The global capital markets are adjusting to higher interest rates, and the reflation trade appears to have reached an inflection point. Commodity prices continue to rally, partly on supply issues, including low inventories, and partly in anticipation of more robust demand. The CRB's 1.75% decline before the weekend was the largest since the US election and the announcement of a vaccine, but it still finished higher for the fifth consecutive week. The high-flying technology sector has seen a dramatic bout of profit-taking and appears to be a bit of a rotation into some consumer staples and financials. Without putting too fine of a point on it, rising rates and steeper curves have seen the MSCI World bank index rally more than 16.6% in February.
We had thought the dollar's upside correction after the sharp sell-off in the last two months of 2020 could have been extended on the back of the growing divergence favoring the US, with the help of fiscal stimulus of around 14% of US GDP (December 2020 and the current package). While the US 10-year yield rose about 42 bp in the past month, yields have risen even faster in Australia, New Zealand, and the UK, whose currencies outperformed until the very end of February.
The market seems increasingly skeptical of the pledge not to raise rates for a long time. First, the market pushed back against the Bank of England's forward guidance. The market swung from the risk of negative rates to a rate hike by the end of 2022. The futures contract on three-month sterling deposits ("short-sterling") for December 2022 implied negative rates in early January. It is now implying a rate of 40 bp. Then, in the face of rising forecasts for US GDP and Fed leadership (Powell and Clarida) seemingly dismissing inflation fears, the market reacted dramatically. The implied yield on the December 2022 Eurodollar futures contract rose to 50 bp last week (before settling around 45 bp) from 32.5 bp the week before and 27 bp at the end of January. The swing in the pendulum of market sentiment toward a sooner rate hike by the Fed seemed to finally give the dollar a reprieve.
That offers a helpful segue into the other consideration that may be offsetting the positive growth differentials. As has been previously discussed here and elsewhere, as the US Treasury draws down its cash balance at the Federal Reserve, liquidity pours into the market, driving money market rates lower. This is evident in the T-bill auctions and the decline in other rates. The Treasury paid down about $96 bln in T-bills last week. Some bills maturing in March have a negative yield. The overnight repo rate traded below zero last week for the first time since last March. The benchmark three-month LIBOR is pinned below 20 bp since late January and fell to a record low around 17.5 bp on February 19.
It will take the US Treasury a couple of months at least to reduce its cash balances to around 1/3 of current levels to prepare for the end of the debt ceiling suspension. This means that downside pressure on US money market rates will likely persist. The Fed may respond by tweaking the interest it pays on reserves (not just excess) and its reverse repo rate. At the same time, banks are unsure of their balance sheet constraints, as the current exemption for Treasuries and excess reserves for leverage ratios is set to expire at the end of March. An early announcement to extend the forbearance could help ease some uncertainty and make the plumbing more robust.
Moreover, in the face of the push-back from the market, Powell & Co may modify its rhetoric to suggest flexibility and pragmatism. It could more forcefully acknowledge short-term pressures relating to the base effect, re-opening, and supply bottlenecks are transitory and mostly about relative price changes. The critical issue is persistent and elevated upward pressure on the general price level.
With that as background, let's turn our attention to four big events that dominate the economic agenda in the week ahead. The first is the purchasing manager's index, perhaps the most important non-government high-frequency economic report. However, the preliminary estimate for the major countries is quite accurate, and the final readings' adjustment is typically minor.
There is no flash reading for the world's second-largest economy, China. Its February PMI will be released before markets open for the week. The Caixin manufacturing PMI will also be reported ahead of the open. The expected take-away is that the Chinese expansion appears to be slowing. The composite PMI is expected to have slipped for the third consecutive month.
It peaked in November at 55.7 and may have fallen to around 52 in February. The data may be distorted to the downside by the extended New Year holiday, but the softer tone was already evident late last year. January export figures from Japan, South Korea, and Taiwan suggest Chinese demand. Japanese exports of semiconductor fabrication equipment were particularly strong. Agriculture imports from the US have also increased.
A second highlight is the eurozone's preliminary estimate of the February CPI. Several factors are distorting measured inflation. They include the imposition and the end to the German VAT break. Seasonal sales schedules have been disrupted by the pandemic and lockdowns. The weighting in the CPI-basket has been adjusted to reflect 2020 spending patterns. The weight given to services, including travel and leisure services, was sharply reduced.
Yet, through the distortions, it is becoming more evident that the deflationary threat is receding. Bottlenecks in supply chains and higher energy prices will continue to work their way through the economy and inflation measures. There are two takeaways. First, it is hard to make a generalization across the eurozone. Still, it appears that the backing up of yields is mostly a reflection of rising inflation expectations rather than an increase in real rates. Both the German 10-year yield and the 10-year breakeven have increased by almost 40 bp since the end of October. The Italian yield is actually lower than it was at the end of October, but the breakeven measure of inflation expectations has risen by around the same as in Germany.
The second takeaway is that the ECB will look through the distortions and continue to press ahead with its bond purchases. It may have increased its purchases on the margin recently. Remember, while the Fed is committed to buying $120 bln of bonds a month, the ECB's program works differently. It has given itself the capability to buy 1.85 trillion euros (~$2.2 trillion) under the Pandemic Emergency Purchase Program. ECB President Lagarde has made it clear that the facility is flexible. If more is needed, it will increase the size of the facility. If less is required, it will not use it all. We suspect the key for officials is real rates and spreads. Last week the 10-year spread widened slightly between Germany and Italy, Spain, Portugal, and Greece.
The third highlight is the UK's budget on March 3. Chancellor of the Exchequer Sunak has two big tasks, provide a bridge during what is anticipated to be the last quarter of the pandemic-induced lockdown. Prime Minister Johnson has unveiled a roadmap that leads to England's full reopening by the first day of summer (June 21). Yet, the labor market remains distressed, and for many small and medium-sized businesses, this is still an existential crisis. The cost of the bridge is expected to be between GBP70 bln and GBP100 bln (~5%-7% of GDP).
Roughly a fifth of the UK workforce is on the furlough program, where the government assumes 80% of the employee wages. The program currently expires at the end of April. There seems to be little doubt that Sunak will extend the program. There is also bound to be support for the self-employed. Businesses that have been the hardest hit may receive tax breaks (e.g., property tax and VAT). The GBP 20 a week extra welfare payment will likely be extended beyond the current April 30 termination.
In addition to the bridge, Sunak wants to signal that the Conservative Party is committed to reigning in fiscal policy when the emergency passes. Last November, he froze the pay for public sector workers and cut international aid. He may wait until the fall to provide a more detailed framework for tax and spending policies. Yet, Sunak may signal plans to hike the corporate tax rate. Currently, it is 19% in the UK, the lowest within the G7. The US corporate tax rate is set at 21%. The Biden administration is sympathetic to raising it back to 28%, though why corporate profits should be preferentially treated by tax officials compared to wage income is not clear. The corporate tax rate in the other five G7 countries is above 25%. There is speculation that Sunak could announce a phasing in an increase that would bring the UK corporate tax rate to 25%.
Many investors and businesses, of course, will not like an increase in corporate taxes. Still, the apocryphal answer given by Willie Sutton on why he robbed banks (because that is where the money is ) may illustrate the pickle the Chancellor finds himself. The "manifesto" that the Tories ran on in 2019 when they secured a majority promised not to raise income tax, value-added sales tax, or national insurance. There is not much else to tax, it would appear. Reports suggest that more than 20% of the Tory members of parliament are lobbying against raising the fuel-tax, though it would be consistent with transitioning toward renewables, arguably.
Last but not least, is the fourth highlight is the US employment report. Consider the euro peaked a couple for the December jobs report on January 6. The ADP warned of weak national data. The euro bottomed on February 5, the same day the Bureau of Labor Statistics reported disappointing job growth in January. The Australian dollar peaked on January 6, and February 5 was the last time it traded below $0.7600. It briefly popped over $0.8000 last week before reversing lower.
After the collapse of the labor market last March and April, when nonfarm payrolls collapsed by 22.3 mln, the recovery stalled in December as the virus took its toll. The US shed 227k jobs in December and only regained 49k in January. The median in Bloomberg's survey is 150k growth in February. The fact of the matter is that economists have been underestimating the US economy's strength on several key reports, and not by a little. Retail sales surged by 5.3% in January. The median forecast was for a 1.1% increase. Industrial output rose by 0.9%. Economists said 0.4%. Economists have been slow to adjust to the information. Last week, the January durable goods orders were reported. The 3.4% gain was three-times the median projection.
Given the recent record, the risks are on the upside. The horrible weather did not help matters, but most of it took place after the surveys (establishment and household) were conducted. The US has had what economists have dubbed jobless recoveries before, but it really means the process of absorbing the slack in the labor market is slow. However, this is not a typical recession, and the barriers to entry for many services, including food and drink establishments, barbers and hair salons, and retail, are not exceptionally high or onerous. Moreover, the economy is on fiscal and monetary steroids that will rev-up the economy for few quarters, creating employment opportunities. The economic trackers used by the Atlanta and NY Fed have converged at 8.7%-8.8% for Q1.
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