EC March 2021 Monthly

Two state elections in Germany may shed light on the mood of voters ahead of the national elections in the fall that will see a new Chancellor for the first time since 2005. In Rhineland-Palatinate, the SPD leads a coalition with the FDP and Greens (Alliance 90), with the slimmest of majorities. The Greens seem to be doing well, and the status quo may continue. The AfD appears to be doing a little better but could be coming from disenchanted CDU voters.

The election in Baden-Wurttemberg may be more interesting. It is governed by an intuitively disparate coalition. The Greens are currently the senior partner with the CDU. It is the first state that the Greens hold the premiership. After years of cohabitation with the CDU on the national level, the SPD has seen their support flag, and the Greens may become the largest center-left party. As odd as it may appear, the coalition in Baden-Wurttemberg is seen as a prototype for a possible coalition on the national level.  

The Netherlands goes to the polls as well in the middle of March. The Dutch political parties are so fragmented that it took 225 days to form a government after the last elections. Public opinion polls suggest little change in party alignments is likely. Prime Minister Rutte is likely to lead a center-right coalition to head up his fourth government.

The Bannockburn World Currency Index finished February at a three-week low. The nearly 0.5% decline in February's last session matches the largest single-day pullback since last March. Only four currencies in the basket appreciated in February, sterling, the Canadian dollar, the Russian ruble, and the Australian dollar.  

The flat performance this year is consistent with our sense that the dollar is at the fulcrum of the reflation theme driving other capital markets. Among the majors, sterling and the dollar-bloc currencies have been rewarded. Among the emerging markets in our index, the Russian ruble stands out with a 1.5% gain, bolstered by the commodity story, economic recovery, and high rates. Substantial fiscal expansion and market-friendly moves helped lift the Indian rupee before profit-taking at the end of February. Strong South Korean exports helped blunt the impact of domestic and foreign portfolio investment outflows on the won.  

Year-to-date, the four worst-performing emerging market currencies are in Latam (Brazil real -6.9%, Argentine peso -6.3% Colombian peso -5.0%, and Mexican peso - 4.9%). Turkey has been rewarded for its shift to more orthodox policies, including high-interest rates. With the broad selloff of emerging market currencies and a nearly 2% drop in February, the lira virtually flat so far this year. The poor performance of emerging market currencies in general last month means that the modest 0.4% gain of the Taiwanese dollar puts it in a tie with the Chinese yuan (both up 0.75% year-to-date) at the top of the EM universe.  


The US dollar finished February on a firm note as the market is brought forward the likely timing of the first Fed hike to the end of 2022 from late 2023. The policy-setting is still open spigot. The Federal Reserve is buying $80 bln of Treasuries and $40 bln of Agency MBS a month, and the FOMC meeting that concludes on March 17 will suggest no change is contemplated even as US growth prospects improve. The lion's share of the $1.9 trillion fiscal stimulus package will be approved before the FOMC meeting. In light of the market pulling the first-rate hike into late 2022 from 2023, the Fed's rhetoric may change. The rise in the long-end yield reflects a rise in inflation expectations more than real rates, as mediated by the breakevens (the difference between conventional and inflation-linked notes and bonds). Even, the Federal Reserve's real yield index shows that the 10-year rate is still deeply negative (-0.70%) at the end of February. This is up from the extremes (-1.10% last August), but well below the  0.15% that prevailed in Q4 19. While the long-end of the curve has backed up, the short-end of the curve is soft. Short-dated bill yields are threatening to fall below zero as the Treasury Department reduces its cash holdings dramatically in the coming months, which floods the system with liquidity. The two-year note yield slipped to a record low on February 11, below 10 bp, and finished the month near 14 bp.  


The eurozone economy is contracting in Q1, but the outlook is constructive as the vaccine rollout picks up. The manufacturing sector is expanding, and services are not contracting as they did when the pandemic first struck. The selection of former ECB President Draghi as the 30th prime minister of Italy reduced perceived redenomination risks (a country leaving the eurozone). Even as yields were rising recently, the cost of insuring against default fell. The ECB meets on March 11, and the risk is that the staff cuts its near-term economic forecasts. ECB President Lagarde will likely focus her on measuring financial conditions. The central bank's chief economist Lane has relied on four indicators, the overnight-index-swaps to the 10-year curve, money market rates, the exchange rate, and equity prices. A couple of ECB Executive Board members have suggested that there is scope for another rate cut, if necessary. The targeted long-term loan rate is below the minus 50 bp deposit rate, which has reduced the sting of negative rates. In the first instance, we suspect the ECB would step up its bond purchases from the 17 bln to 20 bln euro pace. Disbursements from the EU Recovery fund are until closer midyear. Like in the US, the increase in Germany's nominal yields can be accounted for by rising inflation expectations, measured by the difference between the conventional yield and the inflation-linked security. Since early November, the 10-year Bund yield rose by about 36 bp while the break-even has risen 37 bp. Real yields remain low. The euro peaked in early January, and although it was firmer than we expected last month, we are not convinced that the corrective or consolidative phase is over. We suspect the risk may still extend toward $1.18 before what we think is the underlying downtrend in the dollar resumes.  

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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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