It’s probably time to explore what’s really going on with markets as we emerge from the Covid-19 pandemic. The most important issue is why investors are becoming increasingly uneasy about a potential spike in inflationary pressures. If we consider this logically, major economies have been mostly closed to consumers for the best part of a year now. Still, large-scale fiscal support has enabled household savings to rise; all the while, low confidence levels have caused consumers to delay big-ticket purchases. However, the successful rollout of vaccine programmes and improved labour market conditions are likely to start fuelling confidence levels just as economies begin to reopen. Combine these factors with an ultra-easy climate of monetary policy, whereby interest-rates remain around the zero percent mark, and the incentive to spend is crystal clear. As a means to justify this argument, the market’s widely accepted break-even inflation rate over the next five years is around 2.5%, the highest it has been since April 2011.
Seemingly, the Federal Reserve is less worried about a spike in inflation. Fed Chairman Jay Powell expressed last week that he holds little worry that the Fed might need to tighten monetary conditions in the near future. Instead, the Fed is willing to see inflation overshoot its 2% target whilst the economy recovers to full employment levels. Subsequently, we’ve seen a pronounced sell-off in US bonds, with the 10-year yield climbing above 1.6% for the first time since February 2020. Investors now worry that the Fed is going to fall behind with inflation expectations and might need to tighten policy by hiking interest-rates if the economy begins to run too hot. All of this has contributed to the US Dollar Index’s 3% rise since February 25th.
Bottom line: What this all means for currency valuations is open to interpretation. On the one hand, rising US bond yields has contributed to the recent sell-off in US equity markets. This has proved supportive for the Dollar as the negative correlation between the Greenback and equity valuations has been compelling throughout the Covid-19 pandemic. However, it’s worth noting that this is not just a US story. Yields are rising in other parts of the G10 bond market such as in the UK, Australia and Norway, and their respective currencies are outperforming respective to the Dollar. Therefore, we might instead see outsized movements in crosses like USD/JPY and EUR/USD where the yield advantage story holds true.
The week ahead
Sterling performed poorly last week as investors piled into the US Dollar and US Treasury yields continued their rise, albeit at a slower rate. It will be interesting to note if this risk-off mood continues this week, as the UK begins its journey out of lockdown with schools returning today. Over the weekend, the UK reached another milestone as 22 million people have now had their first dose of the coronavirus vaccine. Talk of negative interest rates could resurface this week as Bank of England Governor Andrew Bailey is due to speak at the Resolution Foundation.
- Bank of England Governor Andrew Bailey speaks Monday.
- Construction Output m/m forecast to come in at -1.3% in February vs -2.9% in January.
- GDP m/m is to be released on Friday previously recording a 1.2% gain for the month of January.
- Manufacturing Production m/m looks set to read -0.6% for February vs 0.3% in January.
The Euro continued its decline last week trading around the $1.19 level against the Dollar, down more than 2.0% since the beginning of the year. The European Central Bank will aim to calm markets this Thursday by reinforcing its position on keeping bond yields low while also keeping the bloc on course for a recovery later in the year. There is still a possibility for the ECB to increase its asset purchase programme if financial conditions begin to tighten. Slow progress in the Eurozone vaccination campaign is also weighing on the common currency and it is thought the European Commission will turn to the US to combat supply issues.
- German Industrial Production m/m released today at -2.5% for January.
- Italian Industrial Production m/m is forecast to be 0.8% for the month of January.
- French Industrial Production m/m looks set to read 0.6% for January.
- On Thursday, the ECB will deliver an update on economic conditions in the bloc and any change in monetary policy.
- Friday’s Eurozone Industrial Production m/m is predicted to come in at 0.2% for January.
The US Dollar outperformed many of its G10 counterparts last week as the 10-year US bond yield rose above 1.6%. On Friday, it was reported that a further 379,000 jobs were added to the economy in February, compounding Dollar strength. Over the weekend, the US Senate approved Joe Biden’s stimulus package and it looks set to be signed into law by the end of the week. This suite of support measures has given confidence to investors and could potentially create a stronger Dollar in the year ahead as the speed of the recovery begins to gather pace. Of course, this hinges on how well the fiscal support can be utilised to increase vaccinations in the country and then reopen the economy on a wider scale.
- CPI m/m looks set to read 0.4% for February vs 0.3% in January. While Core CPI m/m is expected to be 0.2% for February vs 0.0% in January.
- Crude Oil Inventories are due this Wednesday.
- Unemployment Claims look to be down on last week, predicted to reach 730K vs the previous 745K reading.
- Preliminary UoM Consumer Sentiment is forecast to come in at 78.1 vs 76.8 last month.
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