Divergence: The Only Macro

The major central banks have met.  The general message is that continued strong monetary support remains necessary, and the coming increase in price pressures is likely to be technical and transitory.  The US fiscal stimulus, on the back of which the OECD revised its global growth forecast up 1.4 percentage points to  5.6%, has been approved.  The ECB's latest targeted three-year loan operation (TLTRO) saw demand for 330.5 bln euros, the most since last June, at a rate as low as 100 bp.  

The race between the vaccine and the virus and its mutations continues at a very uneven pace and has economic consequences. The eurozone has lagged behind in the fiscal and monetary policy response compared to the US, even though it was hit harder by the virus.  It is also lagging behind in vaccinating its population.  While US President Biden has suggested the potential to return to normalcy after early July, Europe may struggle to reach its 70% vaccination target by the end of Q3.  The OECD's latest forecasts have the US economy growing 6.5% this year and 4% next.  The EU economy, on the other hand, is expected to expand by a little less than 4% in both years.  

The preliminary March Purchasing Managers reports are the data highlight in the week ahead, which also sees February US personal income and consumption and UK's employment, inflation, and retail sales.  The PMI will likely show the contrasting performance between the US and EU/EMU.  We continue to suspect that high-frequency data remains considerably less important in the current context than the broader picture.  Instead, it seems that the big macro themes continue to dominate.  Divergence is the most important of these.    

There is simply no other country with the capability and will to provide as much stimulus as the US. Between the $900 bln package at the end of 2020 and the just-approved $1.9 trillion effort, the US has committed almost 14% of GDP.  Treasury Secretary Yellen admits to being somewhat less concerned about fiscal sustainability because debt-servicing costs remain low.  Monetary policy is also stimulative.  The Federal Reserve is committed to buying $120 bln of long-term assets a month.  Its balance sheet is near 38% of GDP, practically double the 19.3% at the end of 2019. 

The ECB's balance sheet is closer to 63% of GDP, up from a little more than 39% before the pandemic. This may understate the size.  When the new TLTRO is fully booked, the ECB's balance sheet could rise by around five percentage points.  The Fed's asset purchases drive its balance sheet, while the ECB's relies on loans a great deal more.  The Bank of Japan's balance sheet was over 102% of GDP at the end of 2019 and is now above 132%.  The Atlanta and New York Fed GDP trackers have the US economy expanding by 5.7% and 6.3%, respectively, this quarter.  The eurozone, Japan, and the UK are likely contracting. 

At the end of last October, before the US election and the announcement of a vaccine, the US premium over German 10-year yields was 150 bp.  It actually slipped in the November-December period as the dollar weakened against the euro.  The euro tested $1.16 the night of the election and peaked in early January near $1.2350.  The premium grew by 10 bp in January, eight in February, and about 35 bp so far here in March to push above 200 bp.   It is back to pre-pandemic levels (~2.10 bp in Q4 19).  

The same theme is evident in comparison with Japan.  At the end of October, the US 10-year yield was 83 bp more than Japan.  It reached 160 bp last week and was near 185 bp at the end of 2019.  Relative to the UK, the US premium has risen from around 60 bp at the end of October to 90 bp last week.  On the eve of the pandemic, the US rate advantage was almost 110.  

Sterling rose a little more than 3% against the dollar last year and is up another 1.5% so far this year.  This month, it has tried three times to re-establish a foothold above $1.40 as it had last month but was rebuffed.  It had done well since the US election and vaccine early last November.  Now the momentum has stalled.  A convincing break of $1.3800 would draw attention.    

The Canadian dollar is the strongest of the major currencies this year, appreciating about 2.25% against the US dollar.  It also is one of the few major countries that have more than kept up with the US rate rise.  At the end of last October, the US offered 20 bp more than Canada, and now it around a dozen basis points.  

China pays a premium over the US to borrow.  It reached a little above 250 bp in the middle of last November, which was the highest in at least 15 years.  It has trended lower and is now about 100 bp below its peak.  The Chinese bond yield itself is little changed since the spread peaked.  The yuan has appreciated around 1.4% against the dollar over this period.  

The short-end of the curve is heavily influenced by the policy rate and outlook. None of the G7 central banks are expected to raise rates any time soon. It is no wonder that two-year differentials have been considerably more stable.  Over the past six months, the US two-year premium has barely changed against Germany and France, Canada, and Japan.  The nearly 22 bp rise in the UK 2-year yield, which now is just below 8 bp, reflects the market accepting that negative rates are off the table.  

The steepness of the yield curve is not only a proxy for the profitability of lending, which may help explain why bank shares have been outperforming in the US and Europe.  It is the cost of hedging the currency.  When foreign investors buy a US bond, they can and often do hedge the currency risk for a shorter period, say three months.  After the currency hedge is accounted for, the yield on long-term US Treasury notes and bonds is the highest for euro and yen-based investors in a few years.   

Federal Reserve Chair Powell observed at the press conference, which followed the FOMC meeting, that the US policy response was quicker and stronger than Europe's to the pandemic, as was the case during the Great Financial Crisis.  In terms of exchange rates, when that Minksy moment struck, the dollar was at extreme levels.  The euro was testing the $1.60 level in April and again in July 2008.  Sterling was trying to reclaim the foothold above $2.00 that it had in 2007.  The greenback was fell to almost CAD0.9050 in November 2007 before gravitating around CAD1.00 for the next eight-nine months.  

The Chinese yuan was in what turns out to be the middle of an eight-nine-year adjustment period after ending the peg around the middle of 2005.  From July 2008 through at least June 2010, it was almost as if the yuan was re-pegged to the dollar around CNY6.8250. The dollar's downtrend resumed in H2 10, and the dollar bottomed in early 2014 near CNY6.04.  

More importantly, divergence is finite.  A couple of months after the EU's Recovery Plan may begin distributing funds, the extension of federal unemployment insurance ends. The apparently "third wave" of the virus is hitting Europe just as the debate over Astra-Zeneca escalated.  Still, despite the poor showing, the revival has been delayed, not canceled.  Previously, it appears that the divergence might peak now or in Q2, but with the latest setbacks (and the more aggressive targets in the US), maybe not until Q3. 

Lastly, we are reminded that nothing fails like success. The idea is the successful response to the crisis plant the seeds of its own demise. The growth differentials generated by the fiscal stimulus will likely boost the US trade deficit. The fiscal stimulus is financed by debt issuance.  Large budget deficits and large current account deficits have haunted the dollar in the past.  

The divergence closes.  The rollout will gain traction in Europe, and the fiscal stimulus (around half the relative size as the US) and Recovery Fund sums will be distributed.  The US drivers are one-off, such as the UBI, or short-lived like the extension of federal emergency employment insurance, come to an end. Simultaneously, the twin deficit challenge may re-emerge for an America that insists on acting boundlessly. Confidence in its willingness to sustain a multilateral commitment has been shaken, if not weakened. The apparent lack of consensus in the US is on display by the Senate's inability to pass a multilateral treaty in fifteen years.  Around the time that divergence morphs into convergence, rising interest rates will be consistent with a weaker dollar.  


Divergence: The Only Macro Divergence:  The Only Macro Reviewed by Marc Chandler on March 20, 2021 Rating: 5
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