When Markets Collide: Bonds, Stocks & FX
BOND YIELD MOVES CONTINUE TO COMMAND ATTENTION
What happens next to bond yields remains the key near-term focus in markets. Equites rose strongly for much of this w eek as bond yields fell back. The decline in US Treasury yields was given further impetus by a weaker-than-expected US inflation report. The successful passage of the Biden administration’s fiscal stimulus package, which the OECD said could raise US GDP growth by more than 3% this year, initially seemed to provide a further fillip to equities. How ever, by Friday, US 10-year Treasury yields had again rebounded back to new highs for the year and equities now appear to be ending the w eek under pressure.
Against this background, major currency crosses have also been volatile. The US dollar strengthened sharply against sterling and the euro in the first half of the w eek but then slipped only to rally again as the market mood became more ‘risk off’. Sterling has moved higher against the euro as the boost to confidence from the UK’s relatively quick vaccine rollout more than offsets any concerns about uncertainties generated by the Brexit trade deal.
US FED ON HOLD AS ECONOMIC CONDITIONS
IMPROVE Monetary policy updates from the US Federal Reserve and the Bank of England w ill be a key focus for markets in the coming w eek. In particular, whether either central bank w ill say anything new about the ongoing rise in government bond yields. This w eek, the European Central Bank, where key policymakers had already expressed concern about the rise in market interest rates, raised their near-term rate of asset purchases. ECB President Lagarde also said that they w ill continue to closely monitor the situation. In contrast, BoE and Fed policymakers - while making it clear that monetary policy w ill remain supportive and that they think that markets are wrong to worry about a pronounced rise in inflationary pressures - have been more reluctant to go further. Indeed, some policymakers have said that the rise in bond yields may be a justified reaction to improving economic conditions.
The Fed seems certain to maintain its ‘status quo’ stance next w eek and reiterate that it is still too early to even start talking about cutting back its asset purchases and that a rise in policy interest rates is unlikely for a number of years. It is less clear how ever, that there w ill be a consensus amongst Fed policymakers whether to react to the rise in bond yields. If they do so the most likely move would be a statement that they are monitoring market developments and that they w ill act if they feel that those are inappropriate. Less likely is an actual policy change either to increase the near-term pace of asset purchases or to target those purchases more toward longer-term Treasuries.
A key reason for the Fed to stand pat is that US economic conditions are improving. Recent data releases suggest that in contrast to the falls in Q1 GDP that are expected in the Eurozone and the UK, the US is on course to post a decent rise. And that is before the impact of the recently passed fiscal package starts to be felt. That means that there may be some sizeable changes in Fed policymakers’ economic projections in the latest update. The last set in December, projected a median expectation amongst policymakers of a 4.2% rise in GDP in 2021, while an average of the current forecast consensus, reflecting an early reaction to the fiscal package, is for a 5.9% gain. That points to the potential for a big upward revision to Fed policymakers GDP forecast for 2021 and corresponding downward revisions to unemployment rate forecasts. That may lead to an increase in the number of policymakers prepared to forecast an interest rate increase by the end of 2023. On the w hole, the Fed is still likely to argue that there is ample slack for the economy to grow without generating inflationary pressures. Nevertheless, current developments argue against a further easing in monetary conditions
BANK OF ENGLAND ALSO STILL ON HOLD
The Bank of England also seems set to leave monetary policy on hold at Thursday’s update. This is not one of the meetings w here the BoE updates its forecasts with a new Monetary Policy Report or holds a press conference. How ever, there w ill still be substantive commentary on recent developments in both the press statement and in the Minutes. Much has happened since the February update including the continued roll-out of the vaccine, the start of the implementation of the roadmap out of lockdown and confirmation in the Budget that support measures will run for several more months. All of those factors should have reinforced the BoE’s confidence of a decent economic rebound from Q2 onwards. In addition January GDP fell be less than expected pointing to the likelihood that Q1 GDP w ill outperform expectations. As a result, the Bank may point to upside risks compared to its previous forecasts but is also likely to say that these w ill be review ed in May.
Overall, the BoE w ill probably have a similar message to the Fed. That it is increasingly confident of a strong rebound in economic growth. How ever, given the sizeable degree of economic slack it is also likely to signal little concern over the outlook for inflation at this stage. Consequently, it is likely to highlight appropriate that monetary policy w ill remain very stimulatory for a long period of time. Similar to the Fed, it w ill probably be reluctant to go beyond this and say something more substantive about the recent rise in gilt yields. There have been some suggestions that the BoE may accelerate its near-term pace of asset purchases to help cap yields. The BoE does need to provide an update on the weekly pace of purchases next w eek but Deputy Governor Broadbent has said that there is high bar to changing the current weekly rate of £4.4bn. Nevertheless, the Bank may warn that this is a tool it can use if it thinks financial conditions are becoming disorderly
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