EC Looking Forward: May Monthly

After generally trending higher in the first quarter, the dollar slumped in April. An important leg of support was cut as interest rates fell. The 10-year yield slid by more than 20 bps at one point despite the unambiguous evidence that the economy was strengthening and input prices were rising, not just stemming from comparisons with last year's depressed levels.

The implied yield of the December 2022 Eurodollar futures contract is lower than at the end of February. Yet, we expect the dollar to perform better in May and for yields to rise.  

Growth was not rewarded broadly last month by the foreign exchange market. Three of the currencies we look at below, sterling, the Canadian and Australian dollars, which were among four top-performing major currencies in Q1, under-performed in April. The Norwegian krone was the exception, and it was in the top three major currencies in April, rising almost 3%.

The Norges Bank has indicated that it is prepared to hike rates toward the end of the year. For its part, the Bank of Canada reduced its bond-buying in late April and brought forward by six months to H2 22 when its economic slack would be absorbed, which is understood as the timeframe of a rate hike. The Bank of Canada's balance sheet has been shrinking since mid-March when the emergency lending facilities formally began winding down. The Bank of England and the Reserve Bank of Australia may recalibrate their monetary policy in Q3.

Neither the Federal Reserve nor the ECB meets in May, but the June meetings will be important. We suspect it will be increasingly difficult for the Fed to justify $120 billion a month of bond buying indefinitely as the economy accelerates and a reasonable case can be made that the bar to tapering ("significant further progress" toward the Fed's targets) has been met.

The consensus at the Fed will begin fraying and some regional Fed presidents favor talking about tapering soon. That said, given the uncertainties around the pandemic, fear of economic scarring, and the more patient stance reflected in targeting the average rate of inflation, the Fed may wait a bit longer. Tapering could be hinted at the Jackson Hole confab in August or at the September meeting.  

The increase in ECB bond purchases starting in March will be reassessed at the June meeting. It is difficult to consider the counter-factual; where yields would be if the ECB had not accelerated its bond-buying under the Pandemic Emergency Purchase Program. What we do know is that European benchmark 10-year yields rose in April, and the premium offered by Italy over Germany rose by almost 15 bps.

Still, barring a new negative shock, the ECB will likely slow the pace of its purchases. Officials may be reluctant to call the exercise of its built-in flexibility "tapering." It will likely assure investors that strong monetary stimulus will continue and that PEPP runs through Q1 23.  

The EU's Next Generation (recovery fund) that will be financed by a common bond has not been ratified by all the members yet, overshooting a self-imposed deadline of the end of April. Poland represents the chief hurdle now as a junior member of the governing coalition has balked. Still, the most likely scenario is that the new facility begins distributing funds in Q3, coincidentally around the time that some US fiscal measures begin expiring and the US debt ceiling looms.  

European politics are moving into the spotlight. The situation seems very fluid. In France, the shift is to the right, and although the national election is not until next year, polls showing Le Pen ahead of Macron have made the news. Germany seems to be moving in the other direction, as recent surveys show the Greens may secure a plurality of votes.

The CDU/CSU selection process was bruising. Some speculate that the Bavaria-based CSU could split from the larger CDU, but it may confirm that while the "realos" are in ascendancy among the Greens, the "fundos" have the reins in the CSU.  

UK local elections on May 6 are center stage. In some ways, it will serve as a referendum on the government's handling of the pandemic and Brexit. The most important race is not for the Mayor of London. Khan will be easily re-elected. The focus is on Scotland. A majority of Scottish voters wanted to remain in the EU and the First Minister Sturgeon was credited with the handling of COVID-19.

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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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