The ECB joined the ranks of other DMs who have already shifted hawkish in the face of high inflation. However, in some EMs who were hiking last year, a dovish shift is now occurring. This divergence will be a key driver of macro returns this year
Last week may prove to be pivotal in terms of both setting the macro landscape for this year, and signaling what type of price action we can expect as we head further into the post COVID normalization cycle.
The most important development was in Europe, where the ECB delivered a surprising hawkish pivot that indicated that a hiking cycle may begin as early as Q3 this year. Specifically, President Lagarde in her press conference did not push back against market pricing for 2022 hikes, and stated that there was “unanimous concern” about inflation surprises, and that policy may need to be recalibrated in the coming meetings. Necessarily, 2022 hikes would also mean an earlier finish to the Pandemic emergency purchase programme (PEPP). This hawkish and data dependent stance was directly contradictory to her messaging at December's ECB meeting (where she said 2022 hikes are unlikely), and a significant shift from recent, detailed public comments from Isabel Schnabel and Chief Economist Lane.
Therefore, while European rates had moved higher in expectation of a policy shift at some point, the timing of such a shift was a major surprise to the market. This resulted in European rates having multi standard deviation moves higher in yield, with significant curve bear flattening and spread widening. Notably, German and Italian 2y yields had 4+ weekly standard deviation moves higher (with Thursday's move recording 6+ daily standard deviations in German 2y yields).
EUR 1y1y Interest rates have risen by 50bps in February month to date
There were also bearish developments for global fixed income in the UK, where the 4 members of the BoE voted for a 50bp hike, and in the US, where Friday's payroll data came out much stronger than expected, with employment increasing by 467,000 in January vs 150,000 expected. Further, record-high upward revisions to November and December accompanied this US data, and possibly most importantly, average hourly earnings surprised to the upside at 0.7% mom vs 0.4%e, with year on year wage inflation rising to 5.7%. US rates rose sharply on Friday, as this number suggests that both inflation risks remain tilted to the upside, as well as an economy with meaningful signs of strength. Both factors support a longer and steeper Fed hiking cycle in the context of the Fed's recent statements.
However, unlike the hawkish developments in core rates, EM central banks of countries that started hiking early in 2021 and are now nearing the end of their hiking cycle were dovish. In Brazil, the COPOM raised rates by 150bps, but signaled future hikes will not necessarily be at a pace of 150bps (unless inflation re-accelerates), the first dovish signal that indicates we are likely close to the end of the cycle. More surprisingly, the Czech central bank (one of the most hawkish central banks of 2021) surprised the market by signaling that even though there is still a chance of further hikes, they expect cuts to happen from the middle of the year. CZK 1y1y rates fell by 60bps Thu-Friday, and spread to German rates tightened by close to 85bps.
We think there are two key takeaways from this week's developments.
1. DM Central banks that have been dragging their feet are now forced to catch up as they are coming to terms with the non-transitory nature of inflation. This means higher volatility and the end of forward guidance.
This ECB move is a significant pivot, but it is similar to the pivots we have seen in the US, UK, Canada in DM and Poland in EM. Ultimately, long-term forecasts of easing inflation pressures are overridden by the acute political and market pressure associated with rising inflation today.
Therefore we are now in the stage of “data dependency” in European monetary policy. This means much higher volatility, and that the skew of rates is to the upside in Europe as long as inflation remains high. What has also characterized other rate markets is that the market aggressively flattenens curves in response to inflation prints, and therefore the flattening we have seen in EUR swaps is likely to continue as long as inflation remains high. This is a more positive environment for the EUR but the picture is more mixed for European financials which may benefit from higher rates but may suffer in a weakening credit environment.
However, the more complicated issue in Europe is that bond purchases play two roles - a) easing financial condition and b) compressing spreads between core and peripheral EU country bonds. Reduced bond purchases, rising rates and greater volatility are likely to pressure spreads wider. Peripheral spreads have been much wider in recent history, and it will be important to track the tolerance level of the ECB regarding this dynamic.
2. 2022 is about trading the divergence in monetary policy cycles.
As we wrote on 1NOV2021 - “At its essence, what has happened in higher beta developed market rates markets over the last 6 weeks is what has already happened in emerging markets this year. Central Banks have delayed tightening due to a belief in the transitory nature of inflation, falling behind the curve, and then subsequently capitulating.” - Now, 3 months later, core DM central banks have capitulated. However, many EM central banks are well into their hiking cycles and in the case of the CNB, clearly signaled a cutting cycle.
This view is open to challenge in Czechia, especially if inflation remains high but the price action shows that as we head towards the end of cycles (where fiscal risks are contained), the convexity in rates may no longer be to the upside.
The key link between what is happening in DM curves and in EM curves is that the market does not believe we have seen a structural shift higher in underlying growth and relatedly, long term inflation dynamics. Therefore, in EMs which have already responded to the inflation shock, there is a lot of premium that can be unwound, supporting fixed income. If we see sustained positive real rates this will further support EM currencies.
Overall this remains an exceptionally volatile macro trading environment as divergences in cycles, data and policy reaction functions continue to deliver unprecedented variance in global markets. Forecast uncertainty is exceptionally high driven by the after effects of the pandemic shock, stimulus flood, renewed lockdowns, supply chain bullwhip and structural shifts within the economy, and this compounds shifts towards data dependency from central banks. In our portfolio we remain long European financials and travel stocks beta hedged, are paid in the front end of the US and have added shorts in German 5y rates following the ECB. Our systematic FX model is tactically long USD vs high yield FX and is long EURCZK, a trade that lines up with the policy shifts we have seen last week.