The surge in Delta variant cases has dealt a blow to the full-economic-reopening story. Meanwhile, the Fed has signaled a lower acceptance of inflation.
The surge in Delta variant cases has dealt a blow to the full-economic-reopening story. The consequent hedging against downside risks has occurred against a backdrop of crowded short-duration positions, and a lower acceptance of inflation by the Fed, thus prompting a sharp rally in global long-term rates. While it seems too early to assume that central banks’ response will be to keep policy ultra-loose for longer and to delay their QE tapering, this does not mean that markets won’t trade as if they indeed will.
Even so, we assume for now that the Fed remains on track to announce tapering at the end of summer. As regards the ECB, we already assumed PEPP would not end in Q1 2022, while the strategy review outcome provides fresh ammunition to strengthen its pledge to keep policy rates on hold. Meanwhile, the BoJ is gradually diluting the role of QE and shifting its policy emphasis strongly to its Yield Curve Control (YCC) framework. The dovish turn from Chinese policymakers in the context of growing downside growth risks vindicates our earlier preference for keeping a skew to lower rather than higher policy rates.
The Fed is uncertain about inflation and will not permit any meaningful overshoot of its 2% target. That much is clear from communication since the June FOMC meeting. This is a substantial deviation from its earlier message of allowing a moderate overshoot of inflation in the new Flexible Average Inflation Targeting (FAIT) regime. The combination of hawkish Fed rhetoric, legacy short positions in long-term bonds and worries about the Covid-19 Delta variant have resulted in a substantial drop in long-term yields.
Infections with the Delta variant have been rising in the US, which makes Fed communication from the second week of July onwards quite relevant. In a 9 July interview, the dovish San Francisco Fed president Mary Daly commented on the virus outlook and connected it to global growth and rates. There was no mention of a change in view about tapering, though. This suggests that the more dovish members believe they should be able to make a decision on tapering in the coming months. The September FOMC meeting seems the most likely moment for a strong signal on tapering, although it is possible that such a hint would be given at the 26-28 August Jackson Hole conference. The Fed will use the summer months to design a tapering strategy. Our base case remains for tapering to start in January and to be completed in December 2022. However, we do think the Fed will signal some flexibility in its tapering strategy.
As expected, the ECB tried to quash expectations of an impending PEPP tapering at the June meeting. ECB President Lagarde explicitly stressed it was premature to discuss an exit from PEPP, as she announced net purchases were expected to continue to be conducted “at a significantly higher pace” over the third quarter. In practice, this means the ECB will likely keep the net monthly run rate at around EUR 80bn, versus EUR 55-60bn in the first two months of the year, notwithstanding a probable seasonal slowdown in August due to the lower market liquidity.
However, during the press conference President Lagarde highlighted that the ECB had become more optimistic on the economic outlook, and that the ECB staff had made a slight upward revision to the projections for Eurozone core inflation. Still, at 1.4% in 2023, it remains below the ECB’s current medium-run target of “below but close to 2%”. Against this backdrop, the forward guidance on policy rates – which still hints at a possible lowering of policy rates – was left unchanged.
Dovish ECB governors will be pleased to see that, since the June meeting, both real and nominal (GDP-weighted) bond yields have eased, in the wake of the sharp rise in Delta variant cases across Europe – and associated expectations for a looser-for-longer monetary policy stance. With vaccinations progressing, however, it seems premature to us to fully price in an extension of PEPP. Indeed, for now we stick to the baseline view that PEPP will be gradually phased out by mid-2022 and that the current PEPP envelope of EUR 1,850bn won’t be expanded.
While vaccine roll-out seems to be progressing well in China, it is clear that regional Covid-19 outbreaks are still having a disruptive effect on economic activity. Meanwhile, leading economic indicators – especially those on the money and credit side – keep moving lower, further challenging the bullish consensus for future growth. On the inflation front, PPI inflation seems to be peaking, as foreshadowed by the development in commodity prices and relapse in PMI input indices in June. And there remains little sign of spillover from high PPI inflation into CPI inflation, with the core CPI rate holding below 1% in June – despite a further uptick in rental inflation.
Notably, we have witnessed quite a dovish turn from policymakers in recent weeks. First, the statement published after the Q2 Monetary Policy Committee (MPC) meeting pledged to engineer “a further decline in real lending rates”. Then, in early July, a former PBoC official – in an article – argued in favor of “cutting rates in a reasonable and moderate manner in H2”, to “mitigate increasing downward pressure to growth”. And on 7 July, the State Council meeting called for using cuts in banks’ required reserve ratio (RRR) to support the economy and in particular small and medium-sized companies. A 50bps RRR cut was quickly delivered by the PBoC, effective from 15 July.
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