EC March 2021 Monthly

The investment climate is changing. The reflation trade has gained traction. Bond yields rose sharply, and curves steepened. The dollar value of the negative-yielding bonds in the world fell from a peak last December of around $18.4 trillion to $12.6 trillion, the least since last July.    

Commodity prices continue to move higher. The CRB Index rose nearly 9.5% in February and brings the gain to almost 32% since the end of October.  Equities rallied strongly in the first half of February before a dramatic sell-off in the second half of the month that hit the high-flying tech sector hard. Financials and commodity companies outperformed. In the foreign exchange market, the optimism that the combination of the vaccine and stimulus efforts will make for a strong recovery is expected as the year progresses. It is expressed in the outperformance of the Antipodean and the Scandinavian currencies. The retreat in equities offered little succor to the perceived safe-haven Swiss franc and Japanese yen, both of whom underperformed in February.

Top honors last month, though, went to sterling with its 1.6% gain. It has now risen for five consecutive months, matching its longest streak since the end of 2003/early 2004, for a cumulative increase of almost 7.8% against the dollar and nearly 4.3% against the euro. Sterling’s outperformance may reflect its relatively successful rollout of the vaccine and ideas that this will lead to a favorable economic divergence. Also, speculation swung from the possibility of negative rates to a hike before the Bank of England currently signals. Some observers suspect that outside of the EU, sterling’s quantitative characteristics may change. There simply has not been sufficient time yet to reach a significant conclusion. According to SWIFT, sterling’s share on the payment and messaging system slipped to 6.8% in January from a little more than 7% a year ago. 

The reflation theme has three components. The first is the early recovery in Asia, and especially China. Demand for industrial commodities and foodstuffs begins there. Chinese demand has boosted inter-Asian trade and helped blunt the impact of weak domestic demand in other countries, including Japan. The second component, optimism, stems from the increasing availability of a few vaccines. Many countries have struggled with the distribution, but there is good reason to expect that as the kinks are addressed, production of the vaccines will increase, other vaccines will be approved, and inoculations will accelerate. 

The third is the huge fiscal stimulus the US is providing. President Biden is making good on his campaign pledge for a large fiscal stimulus package. The exact size is not yet clear, but it may be around $1.5 trillion, on top of the $900 bln approved last December, or something around 14% of GDP. The economy is already sizzling with strong, and forecasts for H1 21 GDP are being revised higher. The 5.3% surge in January retail sales more than offset the cumulative 2.4% contraction seen in Q4. Industrial output rose a strong 0.9%, more than twice what economists expected. The stimulus will be approved before the extended unemployment benefits end in the middle of March. Linking some support programs to economic performance instead of a fixed date may help minimize the risks of a fiscal cliff. Shortly after the fiscal measures are passed, attention will turn to the large infrastructure program. Talk is that this public-private effort could be as much as $2-$4 trillion.  

The monetary and fiscal stimulus has created a great deal of liquidity. The peak may not yet be at hand. As part of America's fiscal dysfunctionality, the Treasury must run down its cash balances at the Federal Reserve before the end of summer under the terms of the debt ceiling waiver, which must once again be addressed. Some of the drawdowns was going to happen in any event as stimulus funds are spent. As these processes take place, the pressure will mount on the short end of the curve. In February, for the first time since last March, the four- and eight-week bills were auctioned with no yield, and the six-month T-bill was auctioned at the end of the month with the lowest yield since late 2014. The overnight repo fell below zero.  

Given the frenzy over the trading in some small company shares in the US, a brief short squeeze in silver, and the incredible rise in cryptocurrencies and especially Bitcoin (43%+ in February alone) has spurred talk of a “bull market in everything.” The MSCI global equity index is up 1.7% year-to-date after losing 3.3% in the last week of February.  It rose 14.3% last year after a 24% surge in 2019. Japan’s Nikkei reached levels not seen since the bubble in the early 1990s. Yet, in fairness, "the bull market in everything" was the cover of the Economist in October 2017. 

Central banks, including the Federal Reserve and the European Central Bank, will be updating their economic forecasts in March. Given the fiscal stimulus, Fed officials may upgrade their economic outlook. The ECB staff has good reason to downgrade its projections. This divergence is an important characteristic of the reflation theme. Fiscal and monetary policies are more aggressive in the US than in Europe or Japan. The economic and financial consequences may not be as straightforward and linear as economists often suggest. Central banks have been buying bonds in a rising interest rate environment, implying that they ultimately may be price takers, not givers. There is probably the most scope for the Bank of Japan to adjust policy. Market talk has focused on the BOJ possibly pulling back from its ETF purchases and/or allowing the 10-year yield to fluctuate more, i.e., tolerate a greater increase. 

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Read more by Marc on his site Marc to Market.

Disclaimer: Opinions expressed are solely of the author’s, based on current ...

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