Allowing cheap government funding: As we hit the zero level in interest rates, fiscal policy becomes the main tool. Deficits rise and debts increase. Given record-high levels of indebtedness today, central banks have no choice other than keep policy rates very low to allow cheap government funding and fiscal stimulus. If long-term bond yields rise somewhat as growth picks up, central banks may allow this as long as it’s because of post-pandemic normalisation and expectations of strong activity. They could lean against it if it’s markets pricing in tighter conditions. Relative to what’s currently priced in, this could lead to steeper yield curves for longer in this cycle, especially when the Fed and other central banks begin to scale back the pace of asset purchases.
Facilitating jobs recovery: There’s a limit to how hawkish the Fed could become – unless inflation were to overshoot persistently. If not, an earlier lift-off may call into question the credibility of the Fed’s new framework tolerating higher inflation for a while to make up for past misses, potentially leading to risk-off sentiment. The discussion on tapering the central bank’s asset purchases could trigger market volatility. We expect an announcement over the next few months to start executing after some time, probably for a year or so. Only at that point, after a pause to take stock, rate hikes seem plausible. The Fed has a dual mandate: price stability and full employment. The labour market is improving but, with 7.5 million fewer jobs relative to February 2020, its healing is incomplete.
Here’s why this matters:
Reflation is still in the system: We view the Fed forecast upgrade as the realisation that the economic and inflation outlook is strengthening and no longer justifies the federal funds rate at zero throughout. We don’t believe this is a particularly hawkish shift, despite having caught the markets off guard – at least following the announcement. Put differently, our belief is that the central bank isn’t signalling that monetary policy will lean against the cycle and try to slow things down pre-emptively. The most recent speeches by Chair Powell seem to be consistent with this interpretation: a median expectation of only two 25 bps rate hikes in 2023 in the context of an economic boom and above-target (but hardly out of control) inflation points to continued support for cyclical recovery.
It’s not all about central banks: US equities recorded big weekly gains last week following the post-Fed pullback, with value and growth stock performance fairly even. The Treasury market appears to have stabilised too, with the 10-year yield at around 1.5%. We would expect rising bond yields from here, though at a moderate pace. The US dollar should strengthen further versus the euro. Several other important policy shifts are happening too. US banks have passed the regulatory stress tests, potentially paving the way for another wave of buybacks. US President Biden has negotiated a compromise with moderate senators for a middle-ground infrastructure package: our early read is that roads and bridges are the big winners, while the package looks somewhat light on climate spending.
Meanwhile, the markets may focus on several important data points…
All about reopening and inflation: In the US, the median forecast suggests a nonfarm payroll gain close to 700k and a downtick in the unemployment rate to 5.7%. The purchasing managers’ indices for China could be important too, with port closures and delivery delays possibly impacting negatively. To us, the recent deceleration is more like a post-reopening stabilisation. While these supply setbacks plus regional virus outbreaks point to downside risks, we don’t expect a sharp slowdown from here. Markets may also watch whether euro area inflation begins to spike too (for a few months). While this is likely later this year, the bar for this to happen now is relatively high: German inflation is set to slow as base effects are now acting in a disinflationary way. This is because June last year saw a significant rise in inflation as the economy reopened after the first lockdown. In any case, we wouldn’t expect the European Central Bank to be concerned about a transitory inflation rise.
Daniele Antonucci | Chief Economist & Macro Strategist