Additional fiscal support and continued easy financial conditions seem essential in bridging economies to a time of widespread vaccination. Central banks, in turn, seem destined to continue as fiscal facilitators.
The positive news on vaccine efficacy matters for US rates. It also reduces the likelihood of the Fed feeling pressured to take unprecedented steps, like introducing negative official rates in the US. This perspective should make it more difficult for rates to reach new lows in times of market stress. It does not, however, mean we are out of the woods regarding the virus. The experience in Europe has shown that a new wave of virus infections almost inevitably creates an economic backlash, with or without lockdowns. With virus infections rising again in the US, lagging Europe by approximately a month, the market should be braced for weaker data. Consensus expectations for US growth in Q4 (4.0%) and Q1 (3.1%) do not seem to reflect this risk.
A second driver for US rates is the likelihood of sizeable fiscal support. While agreeing to terms for additional fiscal stimulus proved difficult in the run-up to the 3 November elections, it remains to be seen whether it has become much easier since. The market is aware of these difficulties and expectations are probably low, but there could well be a response in risk markets and in rates if there is failure to find agreement before year-end on something as critical as fiscal funding for acute matters.
A third key driver is the evolution of the Fed’s asset purchase policies. With official rates at the lower bound, forward guidance in place and 13(3) facilities being limited, all eyes will be on the purchases of Treasuries and MBS in case additional central bank support is needed. From the minutes of the November FOMC meeting, it has become clear that the Fed would consider adding to the purchases, or extending their maturity if needed. There was no urgency signaled to take such steps at this point.
There’s little doubt the ECB will deliver further monetary stimulus at the upcoming December meeting. Indeed, ECB President Lagarde effectively pre-announced more easing in late October, by stating that it was “agreed it was necessary to take action”, by “recalibrating our instruments”. One could argue that the recent news on vaccines has significantly improved the economic outlook for the Eurozone – and hence reduces the need for monetary recalibration. But in a speech on November 11 Lagarde was quick to point out that “we could still face recurring cycles of accelerating viral spread and tightening restrictions until widespread immunity is achieved”. Moreover, underlying inflation in the Eurozone remains worryingly low.
More recent speeches and statements from ECB Governing Council members have shed further light on what the recalibration might look like. These suggest that the appetite to cut interest rates is low, despite the easing bias in the forward guidance on policy rates. Also, a number of officials have emphasized that the main objective of the policy recalibration in December is to maintain “stable financing conditions”, and might focus more on the duration of policy support. This confirms our view that the recalibration includes an extension of the horizon for net PEPP purchases to the end 2021, and to beyond 2022 for the reinvestment horizon.
The ongoing recovery in China amid a seemingly controlled virus situation has made the PBoC more confident that the economy can withstand a tightening of financial conditions. Indeed, a deputy governor at the central bank said in early November that an exit from stimulus is likely “sooner or later”. To be sure, he referred mainly to some of the credit easing measures implemented during the peak of the virus outbreak earlier this year – such as the extension of loan terms and interest payment holidays. An imminent rate hike did not seem to be what he had in mind. This makes sense to us, as underlying inflation in China is low, and headline inflation is in decline, albeit in part due to base effects. In fact, real policy rates haven’t been this high in years. Moreover, further out, a series of rate rises might risk a sharp relapse in the credit impulse and hence in domestic demand growth – also in view of the sharp rise in borrowing rates we have already seen in recent months.
And then there are the recent signs of stress in the corporate bond market. Although these are not perceived as systemic (yet), they have had clear spillovers to the money and rates markets – and have prompted the PBoC to inject extra liquidity into the system.
All in all, we believe the PBoC will not deliver a policy rate hike anytime soon. And further out, in contrast to market pricing, we keep a slight skew to lower rather than higher policy rates, although we do acknowledge that there is some chance of a 10bps tightening next year.