Goldilocks NFP and no major hawkish surprises from DM central banks is a good outcome for risk assets, however EM policy makers remain on a hawkish path and this policy divergence is likely to continue
Last week was significant for global asset markets. Against a backdrop of historical interest rate volatility, we had several key central bank meetings in both developed and emerging markets, and the first US employment report without meaningful unemployment benefit and Delta related distortions.
Beginning in developed markets, the FOMC announced it would begin tapering the pace of its asset purchases this month at a pace of $15bn per month, which was in line with expectations. In his press conference, Chair Powell successfully walked the fine line of acknowledging the greater uncertainty with respect to the inflation outlook and did not explicitly push back on market pricing, however did emphasize the FOMC commitment to both the inflation and employment part of their mandate. His communication was both credible and dovish, which led to the market reducing risk premium moderately at the very front end; the forward curve steepened, and real yields moved further into negative territory.
However, the following day the BoE and Gov. Bailey surprised the market by keeping rates on hold. A full hike had been priced following increasingly hawkish public communication from Gov. Bailey among other BoE officials through the fall. Indeed, this hawkish “pivot” in rhetoric from the BoE (further amplified by the RBA, which were also more dovish than expected last week) was a major catalyst for the thematic increase in developed market front end interest rates in October. The subsequent failure to deliver on their signaling, combined with a dovish press conference, led to a sharp retracement lower of UK and global front end yields. Notably, the move lower UK 5y gilt yields on Thursday was a 3.6 daily standard deviation move and the largest since Brexit.
In emerging markets, central bank MPCs also delivered surprises, however in contrast to DM central banks these were more hawkish than expected. The National Bank of Poland followed their surprise 40bps hike in October with a 75bps hike at the November meeting vs market pricing of 50bps. While its communication remains opaque, in terms of delivery, the Polish central bank is now moving aggressively, having fallen far behind the curve. In Czechia, the CNB raised rates by 125bps vs market pricing of 100bps and has now tightened rates by 200bps total in 5 weeks. Curves flattened aggressively in CEE, with Polish 1s5s having a 3stdev weekly move lower and Polish 2s10s ending the week 33bps flatter a 2.8 stdev weekly move lower.
The key takeaway is DM central bankers displayed that, when it comes to rate hiking paths, they still see elements of transitory inflation and a willingness to balance inflation and growth factors. Chair Powell executed this communication challenge effectively, Gov. Bailey significantly less so, and the BoE will likely pay a serious credibility price moving ahead. In EM, however, the dynamic is different. Central banks consider inflation to be a material risk. They are, in fact, tightening policy and are attempting to do so aggressively (with respect to market expectations).
This means that for EM, as long as inflation remains high with increasing momentum (note Russia's higher than expected CPI print last week), risk premium will continue to be built at the front end of EM rates curves, and yield curves will likely flatten further. Indeed, we are past the COVID normalization phase in CEE, both Czech and Polish 1y1y rates are well above pre-COVID levels, but this can continue, especially in Poland where real yields are still deeply negative.
In DM the picture is different. As we highlighted last week, “what the market is pricing is an increased risk premium for sharper and steeper hiking cycles driven by rising inflation…. this is not the same as a delivered counter-cyclical hiking cycle”. Last week's DM policy actions reduce this near term risk premium and increase the modal length of accommodative policy. In line with this, real yields moved further negative, curves bull steepened, and financial conditions eased. This positive backdrop for risk assets was enhanced by Friday’s US payroll report, which showed a strong labor market, no acute wage pressures, and a strong recovery out of a Delta affected summer.
Therefore, the near-term outlook for risk assets has improved, and for now, the peak of the rate selloff in the front end of DM curves looks to have passed. The broad market outlook continues to argue for a balanced book, but with a greater tilt towards directional beta exposure given last week's developments. We continue to be positioned for flatter curves in EM and we have added to equity risk exposure in both DM and EM, and continue to hold frontier carry positions. On a medium-term horizon, the rally in longer end yields in the US is an opportunity to re-enter shorts, given our positive outlook for US growth into Q1 next year.
COVID Pandemic
World COVID cases increased last week for the third week in a row, with cases rising in CEEMA, Europe, and the United States while falling in Asia and Latin America. While cases in Asia continued to fall across much of Southeast Asia, cases continued to increase in China. In China, the current Delta outbreak is the most widespread since the initial Wuhan outbreak in early 2020. The Chinese government has responded to the wave by implementing lockdowns in multiple cities across the country and telling residents to stock up on food and other essentials in case of emergencies. In CEEMEA, cases continued to advance in Russia, with cases hitting new all-time highs despite recent restrictive COVID measures.
In Europe, COVID case growth continued to advance over the last week, with cases remaining highest in Central and Eastern Europe. Case growth has also been broadening across Western Europe, with cases rising in France, Italy, and Germany over the last week. In Germany, COVID cases rose to the second-highest daily level since the beginning of the pandemic on Thursday, with 37,640 cases. While most European policymakers have primarily focused new restrictions specifically on unvaccinated individuals, in Belgium, the Health Minister has responded to the rise in infections and hospitalizations by urging people to work from home. As the chart from FT illustrates, the recent increase in European cases (in a change from the summer wave) is increasingly spreading among the elderly, as immunity levels from initial vaccination wane.
In the US, COVID cases were flat last, with an increase of less than 1% week on week. Positivity rates, however, increased to 5.4% from 5.0% the week before - an increase that implies US infections are rising faster than indicated by the headline case numbers. In addition, our COVID Trends Index measure, which tracks US search volumes for COVID tests and symptoms, has started increasing in recent days. The combination of slightly rising US cases, rising test positivity rates, and rising search volumes for COVID tests and symptoms suggests the US will likely have rising cases in the coming weeks. So far, US COVID concern levels remain relatively low, but the experience of the summer Delta wave illustrates that higher case levels can impact COVID concern levels even in the context of high vaccination rates.
On Friday, Pfizer announced its antiviral pill Paxlovid reduced the risk of hospitalization and death by 89% among high-risk individuals who begin taking the drug within three days after the onset of symptoms. The Pfizer’s Paxlovid trial results announcement comes one day after Merck’s 50% effective antiviral pill was approved for use in the UK. An antiviral pill that can eliminate 9/10 hospitalizations is a major advance for the world that, when scaled into full-scale production, can materially reduce the risks of overloaded hospital systems. Pfizer expects to produce over 180,000 packs of Paxlovid by the end of the year and over 50 million in 2022.
Calvion’s View: We see the Pfizer antiviral results (along with the Merck antiviral results) as a very important medium-to-long term positive that will help allow - especially when paired with vaccines - countries around the world to more fully reopen and return to normal against a likely ongoing endemic reality, given that COVID-19 is now one of the common human coronaviruses. More tactically, we see the COVID risks as increasingly elevated in Europe, China, and increasingly the US as the winter. We see risks as particularly elevated in China as a result of their zero-tolerance policy approach, which has the potential to create sizable economic costs if the country is faced with a large-scale winter outbreak.