Major Market Global Overview
In many ways, the outlook is relatively consistent with last quarter. Countries around the world continue to fight the virus with lockdowns even as the vaccine rollout advances. Despite the ongoing risks, markets have priced in stronger global growth this year coupled with easy monetary and fiscal policies. This is the perfect cocktail for risk assets. Indeed, we believe the Blue Wave trade is likely to remain in vogue for Q1, meaning higher equities, higher bond yields, and a weaker dollar.
The unexpected Blue Wave adds to the downward pressure on the dollar. For DXY, we continue to target the February 2018 low near 88.25 but with the unexpected showing for the Democrats, we need to start thinking about the next target that comes in somewhere near late-2014 lows near 85. Likewise, we believe the euro is on track to test the February 2018 high near $1.2555. Following that is the late 2014 high near $1.29. Due to a variety of reasons, sterling is lagging and has yet to break above the recent cycle high near $1.3705 and it will likely struggle to break above the April 2018 high near $1.4375. As a result, EUR/GBP is likely to continue climbing. USD/JPY has largely traded in the 103-104 range since early December. Within the weak dollar environment, the pair remains heavy and should remain on track to test the March low near 101.20.
It’s worth stressing that we've never been in the ultra-bearish dollar camp. For now, we believe the dollar is in a cyclical dollar downturn, not a structural one. The groundwork has been laid for a robust U.S. recovery later this year, especially with more fiscal stimulus coming. Surely, equity and bond markets are already looking ahead to this and the dollar should eventually carve out a bottom late in Q1 or perhaps early Q2. However, we have a lot of work to do in terms of controlling the virus so that the economy can reopen properly. Until that plan has been firmly established, we fear the U.S. will lag other major economies in terms of recovery.
Looking ahead, what could derail this Goldilocks scenario? One warning sign is the rise in U.S. long rates and TIPS breakeven inflation rates. Higher U.S. rates will impact equity valuations as well as spread products such as local currency EM debt. For now, Fed policymakers are sanguine about the recent rise in rates and inflation expectations, but the pace has been picking up. The mutation of the virus poses another risk. While pharmaceutical companies believe that their vaccines will remain effective against the new strains, it’s still too early to be certain.
Recent developments at the U.S. Capitol change nothing from a fundamental standpoint. Simply put, Joe Biden will be inaugurated President on January 20 and it looks likely that the Democrats will hold both houses of Congress. While official results have not yet been declared as of this writing, both Warnock and Ossoff have virtually insurmountable leads. This means that a 50-50 tie will be seen in the current Senate, and incoming Vice President Harris will cast the tie-breaking vote.
Chuck Schumer would become Senate Majority Leader and Democrats would head up the key committees. This will allow the Democrats to set the legislative agenda and so the Senate may actually vote on a host of bills that never made it past outgoing Majority Leader McConnell. Our understanding is that McConnell was able to prevent many votes purely by procedural tactics, and this will change under Schumer. We also suspect the partisan divide may ease, allowing for bipartisan passage of some important bills.
What kind of stimulus can we expect going forward? At a minimum, we believe $1.5 trillion will be proposed. That amount along with the $900 billion passed last month would take the total up to $2.4 trillion, which is the last real compromise the Democrats offered. Could it be larger? A $2.5 trillion price tag would take the total up to $3.4 trillion, which is what the Democrats passed back in May but died in the Senate. How about $2 trillion as a solid compromise? This is of course all guesswork and we will have to wait and see how the new Congress and new administration frame the issue. President-elect Biden has already said the price tag will be big, but no specific numbers have been discussed yet. We also expect a separate infrastructure spending bill of at least $1 trillion this year that both parties can support.
Stimulus lies at the heart and soul of the so-called Blue Wave trades. That is, another round of significant stimulus will be seen this year, and that’s positive for U.S. equities. Yes, there will be some sectoral and company-specific risks, especially in tech. However, we believe the improved U.S. growth outlook is overall positive for equity markets. The stimulus will be funded with increased debt issuance, and that’s negative for bonds.
The U.S. curve continues to steepen. At 104 basis points (bp), the 3-month to 10-year curve is the steepest since March and the year’s high comes in near 120 bp on March 18. The 10-year yield of 1.12% is also the highest since March 18, while the 10-year TIPS inflation breakeven inflation rate of 2.10% is the highest since October 2018. Clearly, the rise in the long end is driven in part by rising inflation expectations. However, we also believe that supply concerns are playing a part since the next round of stimulus will have to be funded by increased debt issuance.
So far, Fed officials do not seem concerned with the steepening curve. Kaplan recently said he expects yields to rise due to an improved economic outlook, adding that the Fed should not intervene to prevent this from happening. Bullard expects longer-term rates to rise as the economy recovers, adding that rising bond yields also reflect hopes for an end to the pandemic. Bullard added that the ingredients for higher inflation are in place and that negative rates are not a good option for the U.S. These two are both non-voters in 2021. That said, Vice Chair Clarida echoed these sentiments. We know from the December FOMC minutes that “a couple” of Fed officials were concerned about rising long rates.
The Fed will keep rates on hold in 2021. And 2022. And most likely in 2023. With so much slack in the labor market, the Fed will see no need to tighten its policy settings for the foreseeable future. Some officials have started to talk about tapering asset purchases while stressing it won’t happen anytime soon. We think this is a 2022 story, if not later. We believe the risks are tilted towards increased QE in 2021, not decreased. Why? The Fed may have to address a significant steepening of the yield curve with some policy changes. The first line of defense is jawboning, followed by shifting asset purchases more to the long end, but keeping the total amount unchanged. Next would be an increase in the total amount of monthly QE that would likely be more weighted to the long end. The final (we think) line of defense would be Yield Curve Control. We continue to believe negative rates are a non-starter for the Fed.