US Rates and Dollar: Implications of US macro upgrade – We recently published a major upgrade to our US macro outlook (see here). The huge fiscal support to the economy from the new administration will result in an earlier closing of the output gap and withdrawal of monetary stimulus (with a taper of asset purchases next year and a very slow policy rate hike cycle from the end of 2023). This has major implications for our market forecasts. First, we explain the recent rise in US rates and then we set out our new US rates forecast. Finally we go on to discuss changes in our dollar views.
The recent rise in US yields was driven by higher inflation expectations – The US yield curve steepened following the Democrats’ Senate election victory earlier this month, which is expected to result in significantly more fiscal stimulus. This has led to an increase in the inflation expectations in the US, as shown in the graph on the left below. The increase in the inflation expectations led to an increase in the inflation premium, which increased the term premia as well as the 10y yield in the US. At the same time, real rates in the US seem to be rather resilient given the additional supply of US Treasuries. Indeed, the proposed fiscal stimulus package of USD 1.9 trillion, on top of the USD 900bn package, will result in an significant increase in the supply of US Treasuries. Nevertheless, real rates in the US are moving sideways since the announcement, as shown in the graph on the right below.
US yields seen modestly higher in 2021 and 2022 – In the first half of 2021, we expect that the 10y yield in the US will move sideways from current levels, as shown in the table below. The US Treasury supply might result in some upward pressure on yields as we expect that USD 1.5 trillion will be approved of the additional fiscal stimulus package. Nevertheless, we expect that accommodative monetary policy by the Fed will cap a rise in the real risk premium and hereby real rates in the US. In addition, a correction in inflation expectations, which are now elevated, might result in some downward pressure on US yields via a lower inflation risk premium. To conclude, we expect that a possible increase in the real risk premium will be offset by a decrease in the inflation risk premium, with short term rates unchanged. As a result, we expect yields in the US to move sideways in the first half of 2021.
Looking further ahead, we expect US yields to edge only slightly higher in the second half of 2021. This is mainly driven by relatively high m-o-m inflation figures over that period, which we expect to push inflation expectations higher. This would then be reflected in a higher term premia driven by a higher inflation risk premium, which will push yields in the US higher.
We judge that the Fed will taper asset purchases in 2022 and will subsequently bring them to an end, due to the more rapid closing of the output gap, which will put upward pressure on inflation over the medium to long term, and therefore our expectations for Fed policy. The Fed has made a clear commitment via its new policy framework to make up for previous shortfalls in inflation. As such, we expect any rate hikes to be extremely limited: perhaps two or three over 2023-24. We expect that these rate hikes will be partly priced in by the market in 2022. Consequently, we expect US yields to move higher in 2022 and the US treasury curve to steepen, with the 10y yield increasing from 1.2% to 1.5%. (Jolien van den Ende)
Dollar seen reversing course – We have changed our outlook for the US dollar from negative to modestly positive. There are several reasons for this. The outlook for the US economy has substantially improved. A strong US economy makes US assets more attractive as well as the dollar. Moreover, we have changed our view on the Fed. The Fed will likely be less dovish than most other major central banks.
In 2020 investors sold the dollar in a risk-on environment as safe haven flows unwound. With the Fed likely to be less dovish than other central banks going forward, investors could start buying the dollar, even in a risk-on environment as the greenback becomes more cyclically-driven. Furthermore we expect government bond yield spreads between the US and other countries widen. In addition, we think that inflation expectations are toppish. As a result, US real yields will rise modestly. These developments are supportive for the dollar.
Last but not least, speculators are considerably net long euro and net short dollar. Consensus among analysts is for the dollar to weaken further and the euro to rally. We long had this view as well. But we now think that the dollar has bottomed. Are there any negatives left for the dollar? Yes there are. First, the dollar is not cheap. Second, a large fiscal deficit is still a negative for the dollar. Taking all together our outlook for the dollar has changed from a dollar negative view to a modestly positive one. Our new year-end forecast for EUR/USD is 1.15, from 1.25 previously. (Georgette Boele)
ECB Preview: A pre-emptive strike against exit expectations – The ECB Governing Council meets on Thursday. Given the package announced in December, there is no prospect of any policy changes. The focus will therefore be on President Christine Lagarde’s communication in the press conference. The ECB’s number one priority will be to sustain the expectation that monetary policy will remain very accommodative for the foreseeable future and to encourage fiscal policymakers to match that with further stimulus. The ECB will be delighted with the rise in market implied inflation expectations over the last week, which look to reflect a spill-over from reflation prospects in the US. However, the central bank will want to pre-emptively make sure that any reflation expectation does not fast translate into an ECB exit narrative in market pricing, which would result in unwarranted tightening of financial conditions. It is well aware that this year’s upcoming spike in eurozone inflation might encourage such a development.
This view has already been recently expressed by Executive Board member Isabel Schnabel (see here). She noted that ‘the decline in energy prices was a major reason for the sharp fall in inflation in 2020. The temporary cuts in VAT also had a downward impact, especially in Germany, because that country has such a large weight in the index. The tax cut in Germany has now expired. And we should soon see a robust rise in energy prices relative to last year, because the prices were so low in the spring of 2020’. In addition ‘the prices for services, such as travel or eating out, may soar on the back of the pent-up demand. But such a short-term development should not be mistaken for a sustained increase in inflation, which is likely to only emerge very slowly. That is why it would not significantly influence our monetary policy decisions, which are oriented towards a medium-term horizon’.
The ECB will likely stick to its base scenario for the economy and continue to point at downside risks and uncertainties. In addition, it should re-state that it is monitoring the euro carefully, as any further strength could prove to be an additional and unwelcome disinflationary force. Though given recent trends in the euro, we do not think that the exchange rate is high up in terms of the issues facing the central bank. (Nick Kounis & Aline Schuiling)