Unchanged Fed monetary stance in the US only added fuel to the current downward trend in the US dollar and run-up in risky assets. US curve steepening also continued last week. The euro burst through the $1.22 ceiling.
The message from the Fed last week is broadly in line with previous communication. The economic outlook has improved and the prospects for a vaccine do represent light at the end of the tunnel. That said, public policy is still much needed in the short run to make up for lost income as federal unemployment benefits expire. The Fed expressed concerns about the termination at the end of the year of credit facilities decided by the Administration. Jerome Powell made it clear that the Fed was ready and able to restart swiftly these backstop facilities that were targeted to small businesses and municipalities. The republican majority in the Senate however strongly opposes reuse by the Biden Administration of the Treasury’s funds invested in these facilities. This only highlights the importance of the Senate elections in Georgia in early January. It is of the utmost importance to avoid that partisanship in Congress limits room for maneuver of the incoming government at the worst time possible. In turn, the highly politicized debt ceiling debate will come back to haunt markets sometime in 2021.
Jerome Powell indicated that monetary stimulus will be adjusted to incoming economic data. The Fed will hence remain behind the curve both in terms of employment developments and the eventual pickup in the inflation rate. It is akin to a new paradigm in which the Fed reacts to current data releases instead of relying on its best judgment on economic prospects. It is all the more remarkable that the Fed’s macroeconomic projections have been a revised up markedly from September. Economic growth is projected to reach 4.2%y in the fourth quarter of 2021 after a contraction of 2.4%y (4T20). The unemployment rate is forecasted to decline to 5% by end 2021. Fed forecasts imply 4.5%ar growth in the three months to December 2020. Next year, the required sequential expansion rate is about 2% in annualized terms. As regards the Fed Funds rate, zero rates are here to stay until the end of 2023. Five policymakers nevertheless envisage rate liftoff in 2023. Changes in asset purchases may be the best policy tool to smooth out fluctuations in activity. Monthly bond purchases have been maintained at about $80b Treasuries and $40b MBS. Continued support to mortgage markets may be somewhat surprising given that strength in residential investment has been a driving force behind the recovery. The issue may be that lack of coordination of economic policy whereby mortgage refinancing at ever lower rates is being used as a substitute for income transfers to households. This is highly dubious.
As regards bond markets, Treasury yields have ranged between 0.88% and 0.95% on 10-year notes around the FOMC. Curve steepening continues with 5s30s spreads breaking above 130bp (2016 high) as the Fed failed to alter the duration of its bond purchases. Fed intervention may remain neutral in terms of curve as long as mortgage demand remains strong. On the German market, the weekly yield change was more homogenous along the maturity spectrum. The German debt agency announced its issuance program for 2021. It comprises a new 30-year Green bond and increases in 7- and 15-year maturities. Net bond issuance amounting to €130b will be fully absorbed by ECB bond buying. German Bund scarcity will likely reappear with renewed tensions in repo rates. In parallel, sovereign spreads continued to narrow across countries favoring high Italian spreads in particular. The spread on 10-year BTPs now hover about 110bp. Iberian debt spreads are trading about 0% before ECB suspends purchases through the holidays season.
The expected absence of central banks only amplified the trends prevailing in the currency markets. US external disequilibrium weigh on the US dollar (as DXY trades under 90) and stimulate a reach for alternatives including gold and its digital equivalent bitcoin which broke above the $23k ceiling. The euro appreciated above $1.22 driving high-beta Scandinavian currencies higher. Currencies linked to commodity prices (AUD, CAD) have been well oriented. In turn, possible PBoC monetary tightening hints at continued CNY appreciation.
The dollar adjustment does underpin risk-taking in global financial markets. US equities have made new record highs thanks to technology stock gains despite the antitrust regulatory push weighing on the largest companies. Nasdaq is indeed trading above 12 700. Despite higher crude prices, backwardation in oil futures market sparked some profit taking in energy stocks.
The drop in the greenback also magnified the rush into emerging bonds. Final investor flows accelerated cutting spreads further by 11bp last week to 354bp. In Europe, equity markets have remained well oriented. Lastly, the banking regulator will limit dividend payouts, which appeared to have caused some selling across the banking sector.
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