A Tale of Two Outlooks
US OUTLOOK BRIGHTENS The second quarter starts with expectations of surging US economic growth and a return to growth in the UK, but uncertainty in the Eurozone. The €1.9 trillion fiscal stimulus and a doubling of the vaccine target to 200 million doses in President Biden’s first 100 days in office is set to supercharge US economic growth this year. The administration has also proposed a major infrastructure plan worth $2.25 trillion, although it will be paid for with higher taxes. The IMF (Tue) is set to revise up its global economic growth forecasts from January estimates of 5.5% for 2021, already the strongest since the 1970s, and 4.2% for 2022.
UK SPRINGS FORWARD In the UK, following a likely fall in first-quarter GDP, latest survey evidence shows notable upswings in confidence ahead of Q2. The March composite PMI and GfK consumer confidence surveys surprised on the upside, rising to 56.6 and -16, respectively, while the Lloyds Business Barometer jumped up 13 points to 15% which was the highest in over a year. The UK government said that the schedule for the reopening of the economy remains on track, enabling consumers to spend some of their ‘forced’ savings, with the savings ratio having risen sharply to a record high of 16.3% last year compared with 6.8% in 2019.
EUROZONE DARKENS The situation is more uncertain in the Eurozone. Business and consumer confidence surprised on the upside in March, but the sluggish deployment of vaccines remains a concern, with the EU having administered 16 doses per 100 of the total population, compared with 52 in the UK and 46 in the US. Vaccine supplies and the rate of inoculations in the EU are expected to pick up in Q2, paving the way for countries to reopen their economies. Yet, the latest news underlines the risk that the economic recovery may be delayed again. With the number of cases accelerating, France announced a new four-week national lockdown starting on Saturday, while Germany’s Chancellor Merkel is reportedly mulling over whether to assert federal control on measures to combat the virus.
The differing economic outlooks have been reflected in relative government bond yields and currencies. US 10-year Treasury yields have risen by 78bps this year to 1.70%, while the 2s/10s curve is at its steepest since 2015, as markets bring forward their expectations for the first Fed hike to around early 2023. UK 10-year gilt yields are also up significantly by 62bps to 0.82%, and markets are no longer priced for a Bank Rate cut. In contrast, the ECB has stepped up bond purchases and German 10-year bund yields, which have risen 25bps, are still negative at -0.32%. The US/German 10-year spread has risen above 200bps for the first time in more than a year. In currency markets, the euro has fallen to new lows for this year, while sterling has been one of the strongest major currencies year to date, up 1.3% against the US dollar (although it is off its highs) and 5.4% against the euro.
The recent rise in nominal bond yields have mostly reflected higher inflation expectations. As Chart 2 shows, break-even inflation rates – the difference between yields on nominal and inflation-protected bonds – have increased significantly over the past year. The Fed and the Bank of England have so far remained relatively relaxed about rising market yields, because they think they reflect expectations of economic recovery. The ECB, however, is more concerned about tightening financial conditions, given the more fragile state of the Eurozone economy.
The Fed and the ECB will publish minutes of their most recent policy meetings next week (Wed/Thu). It could be a challenging few months ahead for central banks, especially in the US and UK, as they try to explain the rationale for keeping policy accommodative. Fed policymakers in particular may face pressure to signal the start of the tapering of asset purchases amid accelerating economic growth and inflation. We expect them, however, to continue to point to subdued domestic inflation pressures, given that there is still likely to be significant spare capacity in labour markets.
Our forecast of a strong rise of 630k rise in US March payrolls (released tomorrow) would still leave employment nearly 9 million below pre-pandemic levels. Moreover, while the unemployment rate has fallen from nearly 15% last April to just above 6%, that probably underestimates the ‘true’ degree of slack in the US labour market, because many people who have lost their jobs but are not currently looking for or available for work will not be classified as unemployed.
Overall, while the more than tripling of oil prices since last April’s lows are starting to push up actual inflation rates across the world, the impact is most likely to be transitory. The pickup in inflation is therefore best seen for now as a reversal of last year’s deflationary pressures, and the Fed and other central banks are likely to ‘look through’ them in the absence of evidence of a more permanent rise. Still, there could be market volatility ahead if investors believe policy should be tightened sooner and quicker.
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None of the information in this article is, nor should be construed as, financial advice. All foreign exchange transactions involve risk and you should always seek your own independent financial advice before entering into any foreign exchange transaction.