The Stumbling Continent

After last weeks ECB meeting it was the Federal Reserves' and the Bank of Englands' turn this week to give some guidance about future monetary policy. Alike at the ECB meeting there was nothing to expect from them concerning a change in the rate of interest: Interest rates will stay at historic low levels. None of the big central banks wants to become the scapegoat who has killed economic growth because of an end in low interest rate policies.

Although one difference become obvious at those press conferences: In contrast to Christine Lagarde and her colleagues at the ECB, Jerome Powell and the Fed is still not worried about the big increase in interest rates and sees no need to act against the rise in US treasury yields.

Christine Lagarde and the ECB is worried about the fast increase in market rates this year. Citing Bloomberg: 

"Lagarde said certain recent market moves would become “undesirable” if they persist, citing negative implications for the economy and inflation."

The ECB has stated that it will accelerate asset purchases if the rise in rates would become too extraordinary, according to their metrics.

Lagarde said that the ECB will purchase flexibly according to market conditions and with a view to preventing a tightening of financing conditions. Therefore you may conclude that the ECB will soon increase its' asset purchases as part of its' PEPP programs. 

A question comes up: Why Jay Powell is not worried about the rise in rates (although I am pretty sure that behind closed doors the Fed is not that comfortable about it), but the ECB is warning about it and that the yields increase is getting ahead of the economic recovery?

While - of course - the US and Europe are still in the middle of this global pandemic, the signs are changing and thus I understand the different statements from Lagarde and Powell. The US and the UK is vaccinating the masses, Europe is vaccinating only moderately.

As a result, both continents are at different points in time when it comes to a reopening of economic life. In the US, states like Texas for example have lifted all all restrictions that where imposed because of the pandemic while in Germany the country has been in an ongoing lockdown with no end in sight. 

A lot of this has to do with the way the EU has ordered vaccines (instead of each country separately, the European Commission took over to order for all EU countries), which turned out to be total disaster. Vaccines are missing everywhere and where they are available they are not used. However, I am not surprised that it turned out this way, given the previous track record of Ursula von der Leyen. Her track record is solely a chronology of failure. 

However, let us turn back to the United States now: The current reopening of the economy has led to rising inflation expectations along with higher expectations of economic growth because of catch-up effects. According to a survey by Bank of America inflation expectations are at an all-time high.

Rising inflation expectations is putting pressure on bond prices because future payments are valued lower today. The same is true for growth stocks where many companies do not have any revenues today but who are valued higher in a low interest rate environment than in one with higher interest rates. Because of that market participants have put their money out of those stocks and bought things which benefit from rising rates: Value stocks, energy and commodities. 

Although inflation expectations have risen in Europe too, they are still way below the US numbers, partly because of the different reopening phases they are in. Because the US is ahead of Europe one can expect that Europe will not grow as much as the United States. 

As a result, the yield spread between 10y treasuries and 10y Bunds has widened again, after being at only 100 bps in the last summer. The chart shows that the spread widening is accelerating, from 13 % in Q3 2020 to 22.19% in Q4 of 2020 to roughly 35 % in this quarter. 

The global bond market is suffering from inflation- and reflation fears. US treasuries marked their third worst start into the year, US investment grade corporate bonds are heading for their biggest loss in Q1 since 1981.

Reopening the economy in the United States and big increases in economic growth (compared to 2020) in Q1 and Q2 will put further pressure on inflation and therefore also on bond prices. Citing Andreas Steno Larsen from Nordea:

"We remain very inflation bullish as the cocktail of widespread money printing and direct transfers is a potentially very inflationary cocktail, while companies are now also more price hawkish than we have seen in decades. Jay Powells commitment to quantifying what moderate overshooting means when overshooting happens will throw the Fed directly into this discussion in 1 or 2 months from now."

And there is another thing that may heat up inflation even more: In the US, some democrats have argued that it will be another push for the economy if the Covid stimulus programs will become permanent on the one hand and a way to fight poverty on the other.

Meanwhile, Christine Lagarde never holds back to call for more fiscal stimulus from governments to push economic growth (as if printing money will create economic growth for sure). Although she is right in one thing: The ECB cannot (at least until now) hand out money to the actors in the real economy, it only can try to keep financial conditions loose. 

However, neither Christine Lagarde and the ECB - nor the Fed, nor the Bank of England - are expecting that the current rise in inflation will become a permanent phenomenon. After last years' big deflationary shock everyone should have expected a pick up in prices compared to last year. Further central bankers have already adopted their inflation target to 2 % over the medium term, meaning that after the deflationary phase of the 2010s an increase of inflation to, let's say, 3 % for some years will be tolerated. 

However, will firms, governments and households be able to deal with a sustainable rise in interest rates? According to the theory, central banks would have to intervene by raising interest rates when inflation runs hot. If we look at the longer term trend we see that rates never managed to get back to pre-crisis levels though. 

Roughly calculated, I'd expect that the US 10y cannot get much above 2.25 % without causing damage to the economy and therefore forces the Fed to intervene. In 2008, when debt was about half the size of today, rates of 4.5 % where unbearable for the economy.

This is a dilemma for Europe: Because of all the bad management concerning the vaccine and its' distribution, I would not expect that Europe reopens broadly before the early summer (my guess would be May, June at earliest). This means that the rising rates in the US also push up European rates with one difference: Europe is still closed.

Currently, demand for bonds from the EU periphery have been strong because at least some of them offered a yield above zero. A bond trade told me lately everything at or above zero is good nowadays. However, rising rates in the United States have changed the environment and could mean big trouble for PIGS-bonds. 

If you are a European investor and buy US-Treasury bonds and hedge your foreign exchange risk you will now earn the same EUR yield as if you buy a greek government bond. A US treasury bond, the most secure asset in the book, pays the same interest as a bond from a country that nearly went bankrupt about 10 years ago? Sounds absurd? It is!

Therefore I suspect that more and more investors will decide to buy US treasuries instead of PIGS bonds, which may cause some trouble for the European Central Bank.

The ECB is not allowed to buy government bonds at auction, only on the secondary market. However, if less and less investors want to buy new issued bonds at auction, rates will rise. I cannot think of a plausible scenario that the ECB would be able to calm the market then solely by buying more bonds on the secondary market (maybe you know some -> I would be happy to hear it). Further it may be against the ECBs capital key, although you know what happens to this criteria in a crisis (nobody cares!). 

This is why I think that ECB officials do not get tired of telling the markets that they are closely monitoring interest rates and will use all of its' tools available if necessary to make sure that rates will not get ahead of the recovery. Because the worst thing that could possibly happen to a company that is highly indebted and has no clients because of government imposed lockdowns is higher interest rates.

It would be highly important for Europe, to get it things in order...



Have a great weekend everyone!

Fabian Wintersberger

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