Macro & FICC Research Published: 2021 02 05 06 59
SEB FI & FX Strategy
Inflation: Back with a vengeance
Summary:
In market focus. Inflation; Real yields; Dollar; US stimulus; Recovery; Race between vaccines and Covid 19.
Global macro and risk appetite. Diverging recovery prospects for the US and the euro area. Massive stimulus and more successful vaccinations are supporting the US outlook and raising the question if the US economy might be on a way of overheating. Markets turning focus increasingly on inflation. Positive risk sentiment expected to prevail in the coming months aided with improving recovery prospects and long real yields remaining near record lows.
Inflation: Back on the radar screen. We expect US headline CPI to surge from 1.4% in December to 3.5% in May and 10y inflation expectations (BEI) rise 20 30bps in the coming months. In the euro area, inflation in January surprised on the upside but with little evidence contradicting our view that euro area inflation pressure will remain subdued for an extended period of time.
USD rates: Renewed upside pressure. Rising inflation expectations expected to be the key driver pushing long nominal rates higher in H1. The massive debt avalanche will exert upward pressure on long rates in the course of 2021 despite Treasury’s downwardly revised borrowing forecast for Q1.
EUR rates: Higher but not so fast. The ECB is likely to continue tapering its monthly purchases, but financial conditions will remain unchanged. Euribors to remain close to ESTR fixing at least until mid 2022. Higher short rate expectations continue to gradually lift EUR rates beyond the 4 5y point of the curve. Past few days have seen our recently recommended EUR 2y15y vs. 2y2y curve steepener moving higher. Risks of a near term correction in the long end have increased and would represent a new entry opportunity for entering bear steepeners.
FX: The declining dollar trend is yet unlikely to turn around. Global stimulus efforts are likely to keep the appetite for risk firm, which is a necessary, but not a sufficient condition for the continued dollar weakness.
The US real interest rates play an important role as well. We believe the Fed continues to devalue the currency by keeping real rates at artificially low levels by printing money for Treasury purchases and letting inflation expectations to rise. The BOE fuelled GBP rally yesterday, which we believe will continue for some time.
Forecasts. We reiterate our 1.30 1.40% target range for the 10y Treasury yield in Q2-Q3 but upside risks are increasing. We also maintain our 0.40% target for the German Bund, also with upside risks due to spillover from the US. Find comprehensive forecasts here.
Trade highlights:
- New target: USD 6m10y vs. 6m2y. Entered at 64.4bps 13 Nov); currently 104.4bps; new target 115bps;
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Comprehensive list of trades at the end of this report.
Recovery gaining credibility but with diverging prospects
The last two weeks were characterized by flaring tempers in Europe due to much slower than expected Covid 19 vaccine deliveries, some stock market jitters with excessive movements in individual stocks caused by Reddit campaigns and an extreme but short-lived spike in VIX volatility. The turmoil didn’t spread to rates
or FX markets, which remained mostly calm, and in the commodities market only the silver price was affected. As regards central banks, the Fed maintained its policy unchanged 27 January) with Chair Powell emphasizing that it is too early to think about the exit policy. The Fed also repeated its pledge to refrain from hikes until maximum employment has been reached, inflation is at 2%, and “on track” to moderately overshoot for some time, and promised to continue “at least” at the current pace of USD 120bn per month until “substantial further progress” has been made towards the goals for employment and inflation (more here). While Chair Powell managed to calm markets’ tapering fears for now, the issue will not go away. If the Fed wants to start tapering in 2022, which we see as likely, then it will have to start communicating it in H2 this year. At the same time, the long-end Treasury supply is mounting in 2021, which will exert an increasing upside pressure on long yields over time. Resilient macro data, massive fiscal stimulus and a relatively fast pace of vaccinations in the US is indeed lending credibility to the reflation scenario gaining further pace in the coming months, whereas prospects for the euro area are bleaker in comparison. With US headline inflation set to rise rapidly from 1.4% currently to around 3.5% in May, prospects are for interesting and eventful months ahead, where our base scenario is that the US growth will continue to be positive for the risk sentiment, at least as long as real yields remain near record low levels. In this edition of SEB FI & FX Strategy, we have a closer look at many of these issues.
Covid 19: Race between vaccines and new virus variants
The past two weeks have seen increasingly diverging developments in Covid 19 cases between Europe and the US, with the EU continuing to lag behind the US and the UK in vaccinations and a public dispute on whether AstraZeneca has failed to live up to expectations on vaccine deliveries. New Covid 19 variants are also gaining ground and Moderna said that it has already started to work on a booster with research suggesting that its current vaccine might be less effective against the South African strain of Covid 19.
Novarax, another Covid 19 vaccine producer, said that its vaccine works well except against the South African variant.
Recent developments appear supportive for an early reopening in the US but a slow rollout of vaccines suggest a delay in the EU. The hopes are still that vaccine coverage even in Europe will extend to a sufficiently large share of the population by the autumn, thus avoiding a new wave of lockdowns later this year. The slow rollout of vaccines in Europe also increases the risk of new Covid 19 strains may emerging before a herd immunity has been reached, possibly requiring modifications to vaccines and potentially questioning whether those who have already received vaccines are protected against such new strains.
Vaccine doses administered, % of population
In many EU countries, less than 3.5% of the population have received a jab, compared with over 15% in the UK and 10% in the US. The speed of administering doses in the US but also the UK suggests that prospects are for those countries reopening substantially earlier than the EU.
Vaccine doses administered, % of population
Looking at recent developments of the pandemic, new Covid 19 cases have turned quite sharply lower from high levels since early January in the US and the UK, whereas only a minor decline has been recorded in the euro area.
Covid 19: Daily change on confirmed cases 7d MA)
The ongoing decline daily Covid 19 cases in the US and the UK suggests a decline also in fatalities soon if the recent trend continues. The diverging developments between the countries are also reflected in new restrictions and lockdowns that have been introduced recently in many European countries whereas no significant new restrictions have been imposed in the US since they were ramped up in November and December and some US states have already begun to ease restrictions. The first cases of the more infectious South African Covid 19 variant in the US were confirmed as recently as on 28 January, which may pose a risk to the recent positive trend.
To conclude, the pandemic related setbacks, especially eventual new strains, poses a risk to a return to normality and the slow rollout of vaccines will weigh on the European growth outlook due to lockdowns and deteriorating sentiment among households. Eventual negative effects on financial markets, however, are likely to be only modest and temporary as long as the expectations of depressing the pandemic during 2021 remain intact, which is also our base scenario.
German recovery in halt – Diverging prospects between the US and euro area
In the euro area, the first preliminary Q4 GDP estimates were published on Friday last week with slightly better than consensus outcomes in Germany 0.1% q/q), France ( 1.3% q/q) and Spain 0.4% q/q). The flash estimate for the euro area Q4 GDP 2 February) came in at 0.7% q/q. While the Eurostat does not present any details, but judging from the French and Spanish numbers, households’ consumption is the key drag.
Euro area manufacturing PMIs have generally held up better than expected. January PMIs showed the euro area manufacturing PMI retreating only slightly to 54.8 in January from 55.2 in December and services PMI declined less than feared 45.4 vs. 46.4) and it seems that expectations of a return to normality have continued to support the sentiment among corporates. However, tightened restrictions and disappointing pace of vaccinations in the EU is an increasing headwind in Q1.
In Germany, the Ifo Business Climate Index 25 January) fell to 90.1 in December from 92.2 a month before with both the current assessment and the expectations component declining. While the manufacturing sector showed only a minor weakening, services declined more drastically and trade nosedived, altogether signalling that the recovery of the German economy has come to a halt. Among households, a collapse of the GfK forward-looking consumer confidence indicator 27 January) from 7.5 in January to 15.6 in February and especially the plunge in the propensity to buy sub-index, comparable to the size of the collapse in April, implies gloomy prospects for German consumption which is also depressed by the expiry of the temporary VAT reduction. Interestingly, the GfK presents a surprisingly gloomy interpretation of the data, saying that the recent extension of the lockdown to mid-February makes it more likely that the affected industries will be hit by a wave of bankruptcies and job losses. In France, consumer confidence turned lower 27 January) amid the surging pandemic and the recent imposition of a nationwide curfew.
In the US, growth slowed 28 January) in Q4 as expected to 4.0% SAAR (corresponding to a 1% q/q increase if measured in the same way as European GDP changes), but the data still point towards a resilient economy with continued growth in sectors not directly affected by the pandemic such as business equipment spending and residential investments. Durable goods orders for December 27 January) came in slightly weaker than expected but excluding transportation the outcome was a solid 0.7% m/m increase. Together with the ISM survey, it continues to paint a positive picture for business investments, which have remained resilient compared to earlier recessions. In the service sector, sentiment improved in January with the services ISM increasing to 58.7 in January 3 February), which is the highest level since February 2019.
While we see risks for a slowdown of the growth to more of a standstill in Q1, longer term prospects remain promising.
To conclude, recent data suggest diverging recovery prospects for the US vs. the euro area. Massive stimulus and more successful vaccinations are not only supporting the US outlook but also raising the question if the economy really needs all this stimulus or whether there are risks for overheating.
Large package by reconciliation - overheating risks in the US?
Our base case has been that the new Biden administration will push through most of its proposed USD 1.9tn 9% of GDP) package in Congress before the end of March and the expiry of expanded unemployment support measures. We have assumed that Democrats will go it alone, using the budget reconciliation process rather than negotiating a smaller bipartisan package. This assumption has been supported by recent developments. The Republican counterproposal, of around USD 600bn, was embraced by the minimum 10 Republican votes, which would be enough to reach a 60 supermajority only if all Democrats supported the decision too. In fact, no Democrats supported the proposal. Hence, the prospect of this happening is very small. At the same time, even Senate Democrats from more conservative-leaning states seem to be broadly on board with President Biden’s USD 1.9tn proposal. The Democrats unanimously voted for starting the reconciliation process this week. The final details will still have to be worked out and President Biden has opened for making some adjustments to the total size of the package as well as to the threshold for who will get the new USD 1400 checks. But the total size should not be too far below the initial USD 1.9tn.
Reduced short-term borrowing needs but debt avalanche down the road
The financing burden for all this stimulus has at least in the short-term brightened somewhat. The US Treasury earlier in the week downwardly revised its forecast for borrowing in Q1, from over USD 1.1tn to USD 274bn, due to a larger than expected cash balance in the beginning of the quarter. The Fed currently purchases US Treasuries at a quarterly pace of USD 240bn and will thus offset most of this borrowing pressure.
The Treasury now foresees a cash balance of USD 500bn by the end of Q1 and USD 500bn by the end of Q2.
However, the forecast is based on already decided policy and thus includes the December USD 900bn Covid- 19 Emergency Relief bill but not President Biden’s USD 1.9tn American Rescue Plan. The borrowing avalanche is still coming, but with a delay. In addition, the Rescue Package will be followed by a green
infrastructure & research Build Back Better Recovery plan later in the year. The exact details or size of this package will be laid out in the coming months and, contrary to the rescue package, it could at least partly be financed by higher taxes. The election platform proposed a USD 2tn package over a four-year period accompanied by tax hikes of USD 3.8tn over 10 years.
Treasury bonds: Net borrowing and Fed purchases of bonds (USD bn)
The effectiveness of stimulus will depend on factors such as the propensity of households to spend the checks (earlier surveys for the 2020 checks suggest that more than half went to savings or paying off debt) and the reaction function of the Fed. The Brookings Institution in a fresh analysis suggests that the Biden plan will lead to the US economy temporarily rising above the earlier trend by the end of 2021. Positive outlook for recovery prospects have also brought inflation back on investors’ radar screens.
Inflation: Back on the radar screen
Questions are starting to arise on what will happen with inflation when economies reopen. Also long term considerations are becoming increasingly interesting with structural changes like the green energy transformation and electrification only at their inception and set to require massive investments that boost the demand for many key commodities for years to come. With inflation increasingly in focus, we aim to cover different aspects of global inflation on a regular basis in the upcoming editions SEB FI & FX Strategy biweekly.
In previous editions of SEB FI & FX Strategy, most recently on 22 January, we have highlighted the ongoing increase in US spot inflation and argued for the crucial role of market inflation expectations (BEIs) as determining the development of long real yields. Below, we take a closer look at the outlook for US inflation for the coming months.
US headline inflation projected to hit 3.5% in May
A combination of higher energy prices and base effects from declining prices on both energy and core goods and services last spring mean that the US inflation rate is set to rise sharply in the beginning of this year. We have revised our near term forecast for headline CPI higher and now predict the headline year-on-year inflation rate to peak at 3.5% y/y in May. Prices have increased also on other commodities than energy.
However, these prices most often have very limited impact on inflation and the correlation between e.g.
prices paid according to manufacturing PMIs and core CPI is low as illustrated in the chart below. A marked increase in international prices on food commodities is, however, an upside risk for headline inflation.
US core CPI and ISM prices: Correlation 0.16
The relatively sharp upturn in global food commodities is driven by a mixture of production disturbances and increased demand, both caused by the Covid 19 restrictions. The upturn is mainly driven by higher prices in emerging markets, but there are also some early signs of higher prices in the US. Large upturns in global food prices have historically affected CPI prices in the US, although this is not always the case. Furthermore, the outlook for US food prices is mixed with large upturns during the lockdowns last spring having been reversed in producer prices, but not in the CPI. There is thus most likely some payback from earlier price hikes that will exert downward pressure on food prices this year.
US: CPI, food and global food commodities
Base effects from weak prices last spring will exert upward pressure on the year-on-year inflation rate up until May, but thereafter base effects will shift to the downside. The outlook for underlying trends is mixed with several potentially strong forces working in opposite directions. An expected consumption boom later this year following the US support packages made us revise our forecast for core inflation slightly higher, but it has not changed our view that underlying price trends will be weak due to low capacity utilisation.
Important for the trend will be the development for rents, which carries a weight of around 40% in core CPI.
Rents inflation has trended lower since the start of the Covid 19 crisis, but there are some signs that rents could be about to accelerate again. However, rents have a lower weight in the core PCE (the deflator for personal consumption in national accounts), which is the key focus for the Fed.
US CPI: Actual and SEB forecast
As discussed previously, based on our CPI forecast we expect US 10y inflation expectations (BEI) to increase by 0.2 0.3%-points in the coming six months, from around 2.15% to around 2.40%. Expecting the 10y nominal Treasury yield to increase 1.30 1.40% during the same period means that the 10y real yield is predicted to remain near its current level at around 1.0%. Such a scenario should continue to be supportive for the risk sentiment and negative for the dollar. Our expectation is that the Fed will not allow long yields to rise too fast and will redirect Treasury purchases from short to longer maturities if necessary. Still, with the recovery expected to gain pace, risks for rising real yields will increase going into H2.
Patient Fed - but how about markets?
The development in long US Treasury yields suggests that the market is pricing rising inflation risks, with 10y TIPS BEI at around 2.15%, up from around 1.70% in September-November last year. As the increase in yields is currently driven by inflation expectations rather than funding pressures, how should the Fed react?
The message from Chairman Powell at the press conference following the January FOMC was that the Fed has not changed its view on underlying inflation dynamics and that it was willing to overlook temporarily higher inflation resulting from either base-effects in early 2020 or a temporary burst of spending as the economy fully reopens later this year. The Fed will, according to Powell, be patient and is still planning to let inflation moderately overshoot for some time. There are likely wide differences among Fed members on the appropriate size of fiscal stimulus, but we see it as unlikely that this will affect policy in the short-term. A strong recovery will make the Fed’s job easier and could facilitate an earlier start to rate hikes, but with the Fed still uncertain on underlying inflation pressures it is unlikely to markedly change the outlook for the start of rate hikes or tapering until later this year. Consequently, we expect the Fed to continue to verbally push- back on tightening expectations while welcoming rising inflation expectations.
Markets, however, may be much less patient than the Fed. While the increase in spot inflation in H1 2021 has been widely anticipated, forecasts have been revised gradually higher. A 3% CPI print may also act as a wake-up call for the wider market, which could possibly lead to an upside overreaction in market inflation expectations and increase speculations on the Fed hiking policy rates in earlier or more than is currently priced. Altogether, coming months have potential to become quite nerve wrecking and call for Fed’s continued guidance to calm down the market. As regards the positioning, we maintain our strategic USD curve steepeners and the USD vs. EUR IRS wideners at the long end.
US short rate expectations: OIS 1m forwards
EUR money market: ECB is tapering, money market rates to remain very low
The ECB has been open about its willingness to start tapering. President Lagarde has said many times that the bank is looking to maintain the current financial conditions while the monthly PEPP purchases could slow down. In January, the ECB bought in net terms only EUR 53bn of assets under the PEPP envelope, which is the lowest level since March last year. The total size of the PEPP would allow the bank to buy around EUR 70bn per month. It is also worth noting that the temporary EUR 120bn QE envelope, which was announced before the PEPP, ended last year and it has reduced the total monthly purchases by around additional EUR 10bn this year. We believe the ECB will slowly keep reducing the monthly purchases while monitoring the market conditions and test how low they can go without resulting in any adverse moves in the market.
Monthly PEPP purchases and cumulative projection if used in full
Euro money market spreads have been under constant downside pressure since mid-last year when the ECB crisis measures eased the funding stress and the policy measures have slowly erased much of the credit and basis risk in the market. The Euribors have been fixing only a couple of basis points above the ESTR rates this year and the Euribor futures have also slowly declined through the EONIA rates closer to the corresponding ESTR forwards. The very high amount of excess liquidity and the cheap TLTRO funding for the banks are expected to keep Euribor fixing very low, although at a marginally higher level than the fixings seen just after year-end. We believe the tapering is supporting the basis in the very long end, where we recommended to pay the 5y5y EUR 3s6s basis late last year.
We expect Euribors to remain at current or lower levels as long as their tenor stays within June 2022, which currently is the period where banks can achieve funding through the TLTRO at 1%. Next TLTRO auction settles March 24. At the December ECB meeting the Governing Council decided to raise the total amount that counterparties will be entitled to borrow from 50% to 55% of their stock of eligible loans. Hence, we view it likely that March auction, the TLTRO take-up will increase by 10%, justifying Euribors at current or lower levels.
1y1y EUR swap vs. ESTR forward
The declining dollar trend is yet unlikely to turn around.
EUR/USD has been trading higher along with equity markets since Q3 last year, but this week the correlation seems to have broken down. Despite somewhat higher volatility, the equity market is holding up well, but the EUR/USD has traded lower. The equity market is of course not the only driver of the pair. The good appetite for risk is necessary, but not sufficient condition for the dollar weakness. The improving growth outlook in the US supports the equity market globally and is therefore supportive for the pro-cyclical currencies like the euro vs. the dollar. However, the improving growth outlook in the US also lifts market expectations on the future level of interest rates that is supportive for the dollar. So far, long nominal interest rates have been increasing driven by inflation expectations, while real interest rates have remained low. This can be interpreted as a signal that the Fed’s inflationary policies are working and inflation is generally bad for any currency. Policy rate expectations have not really moved in the US and without increasing real interest rates the turn of the weakening dollar trend is probably too early to call at this point.
In the euro area, inflation expectations are also increasing and they have largely been matched by the increase in nominal interest rates. Looking at 5y5y EUR IRS vs. the corresponding CPI swap, the residual real 5y5y forward rate is increasing, if anything. We believe that the recent dollar strength may be a reflection that the FX market has started to price in policy tightening in the US, which is too early in our view at this point. Our expectation for a continued dollar weakness relies on an assumption that the Fed continues to devalue the currency by keeping rates at an artificially low level by printing money for Treasury purchases while inflation expectations increase. Our higher EUR/USD view is therefore conditional not only on the solid continued risk appetite but also on real dollar rates remaining low. We expect that the dollar real interest rates start increasing in the second half of this year, which could turn the dollar weakness around.
Good appetite for risk has lifted EUR/USD
USD/JPY: Dollar strength broke the downward trend, but we remain bearish
After consolidating between 103.5 and 104 for most of January, USD/JPY broke out of the top. Since 26 January, the pair has been moving up driven by the bounce in the greenback. After breaking a technical level at 104.30, the historical correlation between the risk sentiment and the yen’s safe haven status was interrupted. Moreover, foreign flows into Japanese bonds eased in the last week of January, falling below the 4-week average. Considering that the gains in USD/JPY have started to wane, it may take some time before the next resistance at 105.60 is broken. Corporate hedging may limit further upside to USD/JPY providing ample supply around 105. In the medium term, we continue to remain bearish on the pair.
BOE fuels GBP rally by closing the door for a near-term rate cut
The Bank of England told banks yesterday to start preparing for negative interest rates, while also emphasizing that the message should not be taken as a signal that such a policy move would be imminent.
The BOE said that banks need at least six months to prepare for negative rates which erased almost half of the rate cut pricing and sent the pound stronger. The GBP OIS curve was pricing in around 0.05% overnight rate in one year's time before the meeting. Given that the overnight fixing has been at around 0.05%, the market reduced rate cut expectations from 10bps to around 5bps. Despite Brexit and the Covid 19 crisis having created large twin deficits and long-term growth worries, the rapidly proceeding vaccination program has improved the near-term recovery prospects which has supported the pound. We expect further decline in EUR/GBP.
Real money value finder
The table below shows yields (YTM) in assorted countries in respective local currency government benchmark bonds and yields from SEK, NOK, DKK, EUR and USD investors’ point of view by accounting for respective currency hedge costs with the aim of providing investors in different domiciles an overview of FX hedged government bond yields. Note that actual relative expected returns over an investment horizon shorter than to maturity will crucially depend on spread movements.
Benchmark bonds: Yield to maturity, local currency and FX hedged
Source: SEB
Summary of macro, fixed income and currency views
Source: SEB
Open trade recommendations
Source: SEB
Closed trade recommendations in 2021
Source: SEB
Systematic currency strategies
Source: SEB
Jussi Hiljanen jussi.hiljanen@seb.fi
46850623167
Olle Holmgren olle.holmgren@seb.se
46850623268
Claus Hvidegaard claus.hvidegaard@seb.dk
45 24 60 39 23
Elisabet Kopelman elisabet.kopelman@seb.se
Eugenia Victorino eugenia.victorino@seb.se
65 65050583
