The Virus, Vaccine, and Economic Velocity

The fact that neither the dollar nor US interest rates rose after the stronger than expected March CPI and real sector that prompted upward revisions to GDP forecasts may be saying something about market sentiment and positioning.  It lends credence to the idea that the markets have entered a new phase.    

Consider the US 10-year yield.  For the two months after the November election, the US 10-year yield traded between 0.80% and 1.0%.  It traded up to 1.20% in early January, but by the end of the month, it was back at 1.0%. From there and then, the yield marched higher for the next six-seven weeks to around 1.75% on March 18.  Since then, it has largely moved sideways, chopping out a range of roughly 1.60% to  1.75%. It fell to 1.55% before the weekend. 

The dollar generally appreciated in the first quarter but has softened here in April.  Four currencies have gained on the greenback.   The Norwegian krone leads with a little more than a 2.6% gain, followed by the Canadian dollar's 1.75% gain.  Sterling has risen by nearly1.2%,  while the Aussie managed to turn higher last week.  Its 1.4% gain put it positive for the year by 0.5%.  

Arguably, this is the reflation trade being expressed in the foreign exchange market.  Norway's central bank indicated that it would hike rates later this year.  That could spill into next year if the AstraZeneca and J&J vaccines are rejected.  Canada's economic recovery is strengthening, and the acceleration of US growth adds to the favorable outlook.  While a Bank of Canada rate hike this year seems unlikely, it could be among the first to begin winding down its government bond purchases.  

The Bank of England does not appear poised to adjust monetary policy in the near term.  In fact, the leading hawk, the chief economist Haldane, who recently has warned about complacency toward inflation and the risk of undue pessimism toward the economy, unexpectedly announced he would step down after the June MPC meeting.  However, the vaccine rollout's economic implications have encouraged participants to recognize sterling as a currency levered for growth.  Sterling has appreciated around 2.75% against the euro, which has stumbled in procuring the right vaccines and is experiencing a powerful contagion wave.  

A year ago, the dollar was undervalued against all the major currencies but the Swiss franc, according to the OECD's model of Purchasing Power Parity.  Now, it is only over-valued against the euro (~17.7%), the yen (~5.5%), the Canadian dollar (~4.6%), and sterling (~1.5%).  Recall that in mid-April 2020, sterling was almost 16% under-valued.  According to the OECD, around 11.75%, the Australian dollar is the second most over-valued currency after the Swiss franc (~19.3%).  

The euro remains the most under-valued of the major currencies, but not as cheap as it was a year ago when it was nearly 29% below the OECD's fair value calculation.  However, when the ECB meets on April 22, the currency will likely be hardly discussed.  Remember last September, as the euro was approaching $1.20 for the first time in a couple of years, there was some consternation and recognition that euro appreciation would feed into forecasts for weaker EMU inflation.  It marked a near-term high for the single currency, and as the US polls closed last November, the euro briefly traded to $1.16.  It trended higher through the end of the year and peaked near $1.2350 on January 6.  

Official comments on the exchange rate were considerably muted, but no doubt the 5.3% pullback in the euro by the end of Q1 21 was welcomed in the halls of the ECB headquarters in Frankfurt.  This month's bounce from $1.17 to almost $1.20 is likely seen as corrective in nature.  At $1.1950, the euro has met the (38.2%) retracement objective of this year's pullback.  The next retracement (50%) is about $1.2025.   

Since last August, speculators in the futures market have been scaling out of long euro positions and cut more than a quarter or about 75k contracts through April 13.  The gross short position had fallen to about 50k contracts at the end of last August.  The bears had the smallest short euro position in a decade.  It has more than doubled to around 124k contracts as of April 13.  It is the largest in more than a year.  

There seems little for the ECB to do or say at this juncture. It has increased its bond purchases, as ECB President Lagarde promised.  So far this year, through the first couple of weeks in April, the ECB's balance sheet has grown by a little more than 7.6%, with loans (e.g., TLTRO) accounting for more than half of the increase.  In comparison, and relying exclusively on asset purchases, the Fed's balance sheet has grown by about 5.8% through April 14.   

Although the rise of US yields seemed to have dragged up European yields, it no longer appears to be the case.  Over the past month, the US 10-year yield has fallen by about six basis points.  Italy's yield has risen by five basis points, and Portugal by 14 bp, while German and French yields have increased by a couple basis points.  

The ECB has to bide its time for now.  The evolution of the virus is problematic, and several member countries have extended their lockdowns, even as the UK slowly unwinds some restrictions.  The cautious official attitude toward AstraZeneca and J&J vaccine may slow the rollout on the margins and will do little to boost confidence amid vocal doubters.  Chinese officials recognize its vaccine is only about 50% effective.   The Russian vaccine could gain market share in Europe if Moscow was more forthcoming about the testing, which would allow the European Medicines Agency to transition from a rolling review (as data becomes available) to a formal application.  

The ECB has been encouraging a robust fiscal response, and while individual countries are boosting counter-cyclical spending, the EU's own efforts have stalled. The process was always going to be more protracted as proposals have to be submitted and approved.  The German constitutional court suspended the ratification process in late March. The risk that Germany cannot participate in the Recovery Fund appears to be practically paralyzing the entire process.  The plan also looks to be struggling to be approved by Poland, and the Prime Minister implied that the end of April deadline will be missed.  

The ECB does not hold a policymaking meeting in May.  The next meeting is on June 10, which promises to be more important than the meeting on April 22.  New forecasts will be provided that will incorporate the impact of the large US fiscal stimulus (Lagarde suggested it could add 0.3 percentage points to EMU growth).  The authorization to accelerate the bond purchases under the Pandemic Emergency Purchase Program will be reviewed. 

The first look at Q1 GDP for the eurozone will be published at the end of April.  Economists are looking at an aggregate contraction of almost 1.0% as the virus, and social restrictions take a toll.  The regional economy also contracted by 0.7% in Q4 20. We suspect the largest national economies, except possibly Spain, are faring better than expected.  If this sense is correct, and the hawks stick to their modus operandi, don't be surprised if unsourced leaks pushing to reduce the bond-buying at the earliest opportunity begin appearing.  

The Bank of Canada meets on April 21, the day before the ECB.  Its meeting may be more interesting in some respects.  The central bank has already wound down the emergency facilities but is still buying C$4 bln a month of government bonds.  The economy is off to a strong start and may have expanded at an annualized rate of more than 5% in Q1. 

Underlying price pressures are steady. The March CPI report will be released around 90 minutes before the Bank of Canada's meeting concludes.  As one might expect, the core median is stable at 2%.  That was the pace at the end of 2019.  More recently, the core median rate has been at 2.0% in five of the past six months. 

The headline rate is obviously noisier, and the year-over-year rate that was at 1.1% in February is about to surge.  Last March and April, consumer prices fell by 0.6% and 0.7%, respectively.  They will drop out of the year-over-year comparison and be replaced with positive prints, sending the year-over-year rate well above 2% this month.  

Officials can be more confident in a strengthening recovery.  The spillover effects of the US stimulus is will also an impetus for Canadian growth.  Canada lost about two million full-time positions when the pandemic struck and has recouped nearly 1.8 mln. That said, this wave of contagion is significant, and on a per capita basis, Canada's recent rate surpassed the US.  Its seven-day average reached a new record high last week.  While it looks to be five or six weeks behind the US, Canada's vaccination effort appears to be accelerating. 

Rising house prices seem to be of increasing concern.  Monthly sales reached a record level in March, and the price of the average existing home rose by 4.4%.  In March, sales in Vancouver soared by more than 22%, while price edged up by a little less than 2%.   However, regulation rather than tighter monetary policy will be used to address it.  Mortgage levels will be used in the upcoming stress test, but the simple announcement may have a cooling-off effect.  

The same logic that got the Bank of Canada to end its emergency liquidity facilities could take it to adjust its forward guidance regarding its bond purchases. It could suggest that it would recalibrate the bond-buying program pending further improvement in the economic conditions and the labor market, which would imply a lower bar than, say, the Fed's call for "substantial further progress."  It would buy time until the June 9 meeting, by which time there will be a clearer picture of the virus, vaccine, and economic velocity.

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