Central banks are likely to keep policy exit expectations in check. But, while they may prefer to stay in control the near term, they will eventually – just like economies everywhere – have to open up.
We see markets continuing along a path towards higher yields and (modestly) steeper curves in coming months, punctuated by brief periods of consolidation. Indeed, as the global economy opens up further, higher nominal GDP and inflation prints should lead to confirmation of the consensus view of higher yields – which will test central banks’ ultra-loose policy stance. However, policymaker caution is understandable in the face of the lingering pandemic risks. We therefore expect central banks to ensure policy exit expectations don’t spin out of control. The Fed wants to see further confirmation of a recovery in the labor market before it can shift towards QE tapering, while the ECB will aim to control bond yields to ensure financing conditions remain loose enough.
The balancing act of loose monetary policy versus financial stability of the PBoC and BoJ also remains in play; both central banks choose to control interest rates in the interim. In short, central banks prefer to stay in control near term but, like the economies, they will eventually have to open up.
Reopening of the US economy has given rise to some exceptionally strong economic data in recent weeks and the positive momentum in especially consumer spending and labor market data is likely to continue in the coming months. In addition, US President Biden announced a plan to invest USD 2.3trn in (broadly defined) infrastructure and another trillion-dollar announcement on social spending is expected soon.
While the fundamental backdrop for higher US rates remains in place, there is probably some unwinding of positioning and a fresh impulse needed for a new leg upwards to materialize. Sharp intraday moves lower in yields in recent days (mid-April) suggest some of the unwinding is taking place. For a potential new impulse to bearish sentiment, we have our eyes on any signals pointing to a tapering of the Fed’s bond purchases.
The Fed wants to avoid surprising the market, which suggests the signaling will be well in advance of the official announcement and start of the tapering process. Our base case is for the reduction in asset purchases to start in January 2022 and to take a full year for completion.
Despite the lingering lockdowns across the Eurozone, and the latest hiccups in vaccinations, we still believe that economic reopening could be well under way during the course of May. This implies that as the June meeting draws closer, the ECB might turn more tolerant of nominal yield rises. What is more, the market’s focus could increasingly turn to what will happen to the PEPP purchase pace after Q2 – which seems to be decided upon in June.
All this highlights a readiness to slow the PEPP pace after Q2. To be sure, according to our calculations there is room to continue PEPP at the January-February pace into Q2 2022 before fully using the EUR 1,850bn envelope. But markets might well interpret a Q3 slowdown as a first step towards phasing out PEPP – even though we would point out that a tapering of the ECB’s PEPP will be different from the Fed’s easing of QE, given the ongoing open-ended APP running in the background.
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