The reflation trade – marked by a simultaneous rise in sovereign yields, equities, industrial metals and the dollar – is taking a breather. The dollar is losing ground and the advance in global inflation expectations has reached stall speed; the evidence is most pronounced in the US, which also led on the way up. The Fed’s March hike was a vote of confidence in the economic recovery, yet prolonged uncertainty over the specifics of President Trump’s fiscal agenda poses a lingering risk to investor sentiment.
For us, however, the market’s focus on Trump was always overdone. While US fiscal policy could certainly hasten the pick-up in US inflation, the world economy looked reflationary even without US fiscal stimulus. Elevated economic surprise indices have lowered the bar for disappointment, but the global synchronised recovery remains well underway. The surge in China’s domestic demand during Q1 reinforces this view, although we expect policy to tighten and growth to slow for the rest of the year. Nonetheless, the recent simultaneous upswing in Chinese and US trade is likely to reverberate round the world for several months.
What about the euro area? Macro momentum remains positive. Leading indicators suggest the recovery is broadening, with the growth baton set to pass from private consumption to investment. Tre transition bodes well for the sustainability of the recovery as the oil windfall fades away. Core inflation has so far been sticky at below 1%, held back by modest wage growth in spite of a decent improvement in the labour market. However, pay increases should gather pace going forward: corporates have improved their balance sheets and business sentiment indices point to a revival in capex that is underpinning continued strength in hiring intentions.
Growing confidence in the durability of the euro area’s economic recovery should allow Mario Draghi to gradually wind down extraordinary policy accommodation, paving the way for Bund yields to move higher and closer to fair value.
With the ECB set to announce a further shift down in the Asset Purchase Programme (APP) run rate by September, what impact is this likely to have on the yield curve? The behaviour of the Treasury curve during 2013/14 serves as a useful template. However, there are also key differences today which suggest that, as the ECB tiptoes away from emergency monetary settings, a different pattern might unfold.
When Ben Bernanke aired the possibility of tapering in May 2013, it came as a surprise that triggered a major bond market repricing. The US curve shifted higher and bear-steepened in anticipation of the Fed’s taper announcement, especially the 10/2 segment. As the taper was phased in during 2014, the US curve started to flatten. With ‘lift-off’ on the horizon, the 2yr yield continued to drift higher. But the longer end rolled over as investors realised they were pricing in too much too fast; and the sharp decline in Bund yields exerted a gravitational pull on Treasuries. Global deflationary forces intensified during H2 2014; Chinese PPI deflation worsened and oil prices collapsed, pulling the long end of the US curve lower and extending the flattening.
This time round, conditions are somewhat different. While the exact timing of the ECB’s taper is open to debate, there is no surprise factor at play; so the likelihood of a tantrum is much reduced. Macro indicators also point to a world economy that is recovering in sync for the first time since the GFC. Unlike in 2013/14, inflation breakeven rates have been increasing in tandem with sovereign yields. Looking ahead, chances are that rising US yields pull Bunds higher – a complete change of roles from 2014/15.
Importantly, monetary policy normalisation in the euro area encompasses not one but two elements: the phasing out of QE and deposit rate adjustment/forward guidance. In turn, this could afford the ECB better control of the curve. The impact of a reduction in APP purchases should be felt mostly at the longer end, while changes in the deposit rate can be expected to have greater bearing on the short end (and the euro). Mr Draghi has suggested that, at least for the time being, ‘asset purchases first, policy rates later’ remains the ECB’s modus operandi. Whatever the case, the ECB can be counted on to avoid surprises for the foreseeable future. Yields need to be kept low to nurture the recovery, while more evidence is needed on the durability of the pick-up in core inflation.
Besides, the ECB has effectively already announced its taper. It may well be that Mr Draghi implements it in a ‘ratchet’ fashion – tied to progress made on the ECB’s mandate – instead of embarking on a Fed-style pre-set course to zero. The long end of the curve should gradually shift higher, in step with US Treasury yields. With the deposit rate kept unchanged, the curve will probably steepen. As the recovery unfolds, the ECB should become more comfortable with altering its forward guidance on the deposit rate; rising yields at the short end would thereby ‘regulate’ the steepening.
Overall, the ECB’s shift from extreme stimulus could have different yield curve implications than the Fed’s taper during 2013/14. Mr Draghi may well have avoided a tantrum altogether; and the gradual reduction of QE could see the curve steepen against the backdrop of a brightening global growth outlook.
By Konstantinos Venetis, Senior Economist, TS Lombard
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