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EURUSD closed around 1.2020 Friday, slips almost -0.86% on double-dip recession and slow progress of COVID vaccinations (relative to the U.S.). But EURUSD also recovered from the session low of 1.2012 early Monday and made a high 1.2076 amid upbeat economic data (German retail sales) and a report that most of the EU17 states may open their respective border for COVID vaccinated people across Europe as well–as U.S. and rest of the world.
Again on Tuesday, EUUSD slips almost -0.51% and made a European session low around 1.1999 on broader strength of the US dollar amid higher US bond yields. The market is now expecting a blockbuster U.S. NFP job report for April, where the U.S. unemployment rate may dip well below 6%. The Euro Area unemployment rate still above 8%, although the EU figure is not comparable with the U.S. as government-supported employees (under PUA) are not being categorized as unemployed.
And on mid-Tuesday, EURUSD slips again after U.S. Treasury Secretary Yellen said the U.S. may need rate hikes to stop the economy from overheating; decades of tax deficit reallocation may result in some small rate hikes. Yellen may have indicated the deluge of US debt supplies and subsequent rise in bond yield (market interest rate).
Speaking in the Atlantic economic conclave, Yellen said on government spending and interest rates:
"It could cause some very modest increases in interest rates to get that reallocation. But these investments are what our economy needs to be competitive and be productive. I think that our economy will grow faster because of them. We have gone way too long allowing long-term problems to fester---President Biden is addressing long-standing problems with the U.S. economy--- while President Biden's family and jobs plans have high price tags, they are spread out over years--it will not all be deficit spending-- shocking and distressing to see $7T/ decade gap in what people are paying in taxes and what they should be paying--uncollected taxes amount to $7 trillion over a decade-- reallocation may result in some small increases in interest rates-- expects to be in an environment of low-interest rates for some time but still need to make sure deficits remain manageable”.
On Friday, flash data shows that the EU (Euro area) GDP contracted -1.8% in Q1-2021 (y/y). In 2020, the Eurozone economy contracted by around -6.7% (y/y). In Q1-2021, Germany contracted -3.0% further after contracting around -3.3% in Q4-2020 and -5.2% in 2020. Overall, U.S. economy contracted -3.5% in 2020 and grew +0.4% in Q1-2021. The U.S. is in much better shape than the EU even after considering CARES Acts stimulus checks as the COVID vaccinations rate is much higher than the EU. The U.S. has been able to vaccinate almost 32% of its entire population against 9.55% in the EU in 3.5-months (mid-Jan-Apr). In Europe, only U.K. may be comparable to the U.S. as it vaccinated around 23% of its population in the same time frame.
EU GDP growth
The present run rate of COVID vaccination is around 2.7% in the EU. If it’s able to accelerate it to 3% in the coming days, it will take around 13 and 23 months to vaccinate 50% to 80% population; i.e. by May’22 and April’23. The U.S. is slated to vaccinate the same proportion of its population much earlier by June’21 and Sep’21 assuming around a 10% per month run rate. Thus the progress of herd immunity against COVID, reopening of the country and economic recovery may be much swifter in the U.S. than in the EU unless the common bloc can significantly accelerate the vaccination process. Without visible herd immunity, the general public, as well as government/admin, will not feel confident to undertake normal economic/sociological activities.
Assuming some vaccine hesitancies, the U.S. should complete its 100% mass vaccinations by Dec’21. Thus by Mar’22, there should be ‘substantial further progress of the Fed’s dual mandate (from Dec’20 levels). And the Fed should be in a position to start talking about the QE tapering from Mar’22. And theoretically, Fed may start its QE tapering by June’22.
But Fed has already changed its dual mandate goalposts to keep U.S. borrowing costs lower for longer, at least till 2023-24 to fund huge COVID/fiscal/infra stimulus, so that overall interest on debt stays below 15% of revenue (red line). Fed/U.S. Treasury is now emphasizing on nominal debt interest/GDP ratio than nominal debt/GDP ratio to justify increasing U.S. fiscal stimulus and debt.
Biden admin will have to pass $2.25T infra stimulus bill by July-Aug’21 (FY21 period) and $1.80T social security package by Mar’22 (FY22 period and before U.S. mid-term election), so that U.S. treasury could tap the money market for over $4T new debt at lower borrowing costs (before Fed indicates of any QE tapering and gradual rate hikes). Thus whatever may be the FOMC narrative, Fed has to wait for normalization till U.S. Treasury issues fresh debt to fund Biden’s new fiscal stimulus of $4T to rebuild America.
Thus Fed may take the excuse of fragile economic recovery in Europe and Asia (slow COVID vaccinations), lack of tight labor market in the U.S. (muted wage growth, inequality, etc), and transitory spikes in inflation. And Fed may go for gradual QE tapering from Dec’22 and rate hikes from Dec’23. For that Fed may indicate and starts preparing the market for the eventual normalization from at least 3-months in advance; i.e. by Sep’22. Fed/Powell will now try to desperately defend Fed position at least till Dec’21 until U.S. COVID vaccinations get complete and there is visible flattening of the COVID curve. In its Dec’21 dot-plots, Fed may show one rate hike by Dec’23 and will also start thinking about QE tapering.
Against this Fed backdrop, the ECB may be able to start its QE tapering only from Dec’23; i.e. around 12-months later than Fed as the EU will be able to vaccinate around 80% of its population by Apr’23. The ECB may be never able to hike rates or normalize the same as inflation (core CPI) may never reach the target of just below 2% on a sustainable basis. This policy divergence is supporting the US dollar against EUR. The USD is like a reflation/growth currency, while EUR is like a funding/deflation currency. Despite sufficient fiscal space (average debt interest/revenue ratio around 3% against U.S. 8-10% before COVID), the EU is quite reluctant for higher deficit spending or additional fiscal stimulus due to its austerity policy for decades.
The ECB chief Lagarde previously said the ECB will continue to buy assets/bunds under PEPP with a total envelope of €1.85T till at least Mar’22 assuming EU27 member states will complete its mass-COVID vaccinations by Dec’21 and achieve broad herd immunity by mid-Jan’22. But at the present rate, the EU may be able to vaccinate 80% of its population only by Apr’23. Thus ECB maybe eventually be compelled to extend PEPP till at least Mar’23. As the implementation of the EU common recovery fund (Next Generation) is getting delayed and there are still some uncertainties, the ECB will have to extend its PEPP (QE) to at least Mar’23 or even Mar’24 to ensure the lowest borrowing costs to fund the EU growth story.
ECB kept all its policy rates and QE purchase unchanged in its April monetary policy meeting as unanimously expected. On 22nd Apr’21, the ECB President Lagarde said in her official presser statement:
While the recovery in global demand and the sizeable fiscal stimulus are supporting global and euro area activity, the near-term economic outlook remains clouded by uncertainty about the resurgence of the pandemic and the roll-out of vaccination campaigns. Persistently high rates of coronavirus (COVID-19) infection and the associated extension and tightening of containment measures continue to constrain economic activity in the short term.
Looking ahead, progress with vaccination campaigns and the envisaged gradual relaxation of containment measures underpin the expectation of a firm rebound in economic activity in the course of 2021. Inflation has picked up over recent months on account of some idiosyncratic and temporary factors and an increase in energy price inflation. At the same time, underlying price pressures remain subdued in the context of significant economic slack and still weak demand.
Preserving favorable financing conditions over the pandemic period remains essential to reduce uncertainty and bolster confidence, thereby underpinning economic activity and safeguarding medium-term price stability. Euro area financing conditions have remained broadly stable recently after the increase in market interest rates earlier in the year, but risks to wider financing conditions remain. Against this background, the Governing Council decided to reconfirm its very accommodative monetary policy stance.
We will keep the key ECB interest rates unchanged. We expect them to remain at their present or lower levels until we have seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2 percent within our projection horizon, and such convergence has been consistently reflected in underlying inflation dynamics.
We will continue to conduct net asset purchases under the pandemic emergency purchase programme (PEPP) with a total envelope of €1,850 billion until at least the end of March 2022 and, in any case, until the Governing Council judges that the coronavirus crisis phase is over. Since the incoming information confirmed the joint assessment of financing conditions and the inflation outlook carried out at the March monetary policy meeting, the Governing Council expects purchases under the PEPP over the current quarter to continue to be conducted at a significantly higher pace than during the first months of the year.
We will purchase flexibly according to market conditions and with a view to preventing a tightening of financing conditions that is inconsistent with countering the downward impact of the pandemic on the projected path of inflation. In addition, the flexibility of purchases over time, across asset classes, and among jurisdictions will continue to support the smooth transmission of monetary policy. If favorable financing conditions can be maintained with asset purchase flows that do not exhaust the envelope over the net purchase horizon of the PEPP, the envelope need not be used in full. Equally, the envelope can be recalibrated if required to maintain favorable financing conditions to help counter the negative pandemic shock to the path of inflation.
We will continue to reinvest the principal payments from maturing securities purchased under the PEPP until at least the end of 2023. In any case, the future roll-off of the PEPP portfolio will be managed to avoid interference with the appropriate monetary policy stance.
Net purchases under our asset purchase programme (APP) will continue at a monthly pace of €20 billion. We continue to expect monthly net asset purchases under the APP to run for as long as necessary to reinforce the accommodative impact of our policy rates, and to end shortly before we start raising the key ECB interest rates.
We also intend to continue reinvesting, in full, the principal payments from maturing securities purchased under the APP for an extended period of time past the date when we start raising the key ECB interest rates, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.
Finally, we will continue to provide ample liquidity through our refinancing operations. In particular, the latest operation in the third series of targeted longer-term refinancing operations (TLTRO III) has registered a high take-up of funds. The funding obtained through TLTRO III plays a crucial role in supporting bank lending to firms and households.
These measures help to preserve favorable financing conditions for all sectors of the economy and thereby underpin economic activity and safeguard medium-term price stability. We will also continue to monitor developments in the exchange rate with regard to their possible implications for the medium-term inflation outlook. We stand ready to adjust all of our instruments, as appropriate, to ensure that inflation moves towards our aim in a sustained manner, in line with our commitment to symmetry.
Let me now explain our assessment in greater detail, starting with the economic analysis. Euro area real GDP declined by 0.7 percent in the fourth quarter of 2020 to stand 4.9 percent below its pre-pandemic level one year earlier. Incoming economic data, surveys and high-frequency indicators suggest that economic activity may have contracted again in the first quarter of this year, but point to a resumption of growth in the second quarter.
Business surveys indicate that the manufacturing sector continues to recover, supported by solid global demand. At the same time, restrictions on mobility and social interaction still limit activity in the services sector, although there are signs of a bottoming-out. Fiscal policy measures continue to support households and firms, but consumers remain cautious because of the pandemic and its impact on employment and earnings. Despite weaker corporate balance sheets and elevated uncertainty about the economic outlook, business investment has shown resilience.
Looking ahead, the progress with vaccination campaigns, which should allow for a gradual relaxation of containment measures, should pave the way for a firm rebound in economic activity in the course of 2021. Over the medium term, the recovery of the euro area economy is expected to be driven by a recovery in domestic and global demand, supported by favorable financing conditions and fiscal stimulus.
Overall, while the risks surrounding the euro area growth outlook over the near term continue to be on the downside, medium-term risks remain more balanced. On the one hand, better prospects for global demand – bolstered by the sizeable fiscal stimulus – and the progress with vaccination campaigns are encouraging. On the other hand, the ongoing pandemic, including the spread of virus mutations and their implications for economic and financial conditions continue to be sources of downside risk.
Euro area annual inflation increased to 1.3% in March 2021, from 0.9% in February, on account of a strong increase in energy price inflation that reflected both a sizeable upward base effect and a month-on-month increase. This increase more than offset decreases in food price inflation and HICP inflation excluding energy and food. Headline inflation is likely to increase further in the coming months, but some volatility is expected throughout the year reflecting the changing dynamics of idiosyncratic and temporary factors. These factors can be expected to fade out of annual inflation rates early next year.
Underlying price pressures are expected to increase somewhat this year, owing to short-term supply constraints and the recovery in domestic demand, although they remain subdued overall, in part reflecting low wage pressures, in the context of economic slack, and the appreciation of the euro exchange rate. Once the impact of the pandemic fades, the unwinding of the high level of slack, supported by accommodative fiscal and monetary policies, will contribute to a gradual increase in inflation over the medium term. Survey-based measures and market-based indicators of longer-term inflation expectations remain at subdued levels, although market-based indicators have continued their gradual increase.
Turning to the monetary analysis, the annual growth rate of broad money (M3) stood at 12.3 percent in February 2021, after 12.5 percent in January. Strong money growth continued to be supported by the ongoing asset purchases by the Eurosystem, as the largest source of money creation. The narrow monetary aggregate M1 has remained the main contributor to broad money growth, consistent with a still heightened preference for liquidity in the money-holding sector and a low opportunity cost of holding the most liquid forms of money.
Overall, lending to the private sector remained broadly unchanged. The monthly lending flow to non-financial corporations showed a modest pick-up in February compared with the previous month. This was also reflected in a slightly higher annual growth rate of 7.1 percent, after 6.9 percent in January. Monthly lending flows to households continued to be solid with the annual growth rate of loans to households remaining unchanged at 3.0 percent in February.
The latest euro area bank lending survey for the first quarter of 2021 reports a moderate tightening of credit standards for loans to firms, following more significant tightening in the previous two quarters. Heightened risk perceptions among banks were again the main contributor to the tightening, although their impact was less pronounced than in previous survey rounds. Surveyed banks also reported a renewed fall in demand for loans to firms, mainly driven by a continued decline in demand for financing for fixed investment. Regarding lending to households, the survey indicated lower demand for loans for house purchase, while the credit standards for these loans eased slightly, supported by competition among lenders.
Overall, our policy measures, together with the measures adopted by national governments and other European institutions, remain essential to support bank lending conditions and access to financing, in particular for those most affected by the pandemic.
To sum up, a cross-check of the outcome of the economic analysis with the signals coming from the monetary analysis confirmed that an ample degree of monetary accommodation is necessary to support economic activity and the robust convergence of inflation to levels that are below, but close to, 2 percent over the medium term.
Regarding fiscal policies, an ambitious and coordinated fiscal stance remains crucial, as premature withdrawal of fiscal support would risk delaying the recovery and amplifying the longer-term scarring effects. National fiscal policies should thus continue to provide critical and timely support to the firms and households most exposed to the ongoing pandemic and the associated containment measures. At the same time, fiscal measures taken in response to the pandemic emergency should, as much as possible, remain temporary and targeted in nature to address vulnerabilities effectively and to support a swift recovery of the euro area economy. The three safety nets endorsed by the European Council for workers, businesses and governments provide important funding support.
The Governing Council reiterates the key role of the Next Generation EU package and the urgency of it becoming operational without delay. It calls on Member States to ensure a timely ratification of the Own Resources Decision, to finalize their recovery and resilience plans promptly and to deploy the funds for productive public spending, accompanied by productivity-enhancing structural policies. This would allow the Next Generation EU programme to contribute to a faster, stronger, and more uniform recovery and would increase economic resilience and the growth potential of Member States’ economies, thereby supporting the effectiveness of monetary policy in the euro area. Such structural policies are particularly important in improving economic structures and institutions and in accelerating the green and digital transitions.
Further in the Q&A session, Lagarde reiterated the ECB is dependent on the COVID curve and the progress of vaccinations (herd immunity). And as there is still significant economic uncertainty, the ECB GC still not thinking of any QE tapering in late 2021. The ECB is also attentive to the exchange rate (EURUSD) as higher EUR is negative for imported inflation and ECB price stability target. Lagarde also emphasized on speedy implementation of the EU common fiscal stimulus (NGU), which is now under approval stage by various EU27 member states. Lagarde also called for appropriate structural reform for some fragile member states to be a part & parcel of NGU.
Lagarde also pointed out the ECB is now accelerating its PEPP buying pace at a ‘significantly higher’ rate (monthly/weekly) as a targeted manner to ensure lower bund yields, especially for the peripheral regions (fragile EU member states) and may continue to do so in the coming days to ensure favorable financing conditions across Euro area. Lagarde also said the ECB will not follow BOC in quicker QE tapering as each country has a unique scenario.
On policy divergence between ECB and Fed, Lagarde said underlying financial conditions and inflation expectations are quite different. The Fed has a dual mandate of price stability and maximum employment, while ECB has the only single mandate of price stability. Thus the ECB will not follow Fed in tandem. But Lagarde said she hopes EU economic recovery to pre-COVID levels, including employment will be by H2-2022.
Don't take me literally, but it would be nice to move in tandem with the Fed because that would mean that our inflation numbers are aligned. Now, Fed has a dual mandate, 2%, with employment. We are close to but below 2%, but if you look at where the Fed is, where we are when you look at expectations in the United States and expectations in the euro area, we are not on the same page. It would predicate that we will not operate in tandem with the Fed. I think that's very much a given and it's not me looking into a crystal ball; it's where we are. It's pretty obvious.
Slack in the economy, our assessment at this point is that we will – the euro area economies will return on average to the pre-pandemic economic level in the second half of 2022. I'm taking precautions here because when I say on average, there will be divergences. There will be heterogeneity. There will be countries that will be lagging because of multiple factors, but on average we are seeing the euro area economy back to pre-pandemic level, the second half of 2022. It doesn’t mean that all slack will have been absorbed because my take is that entering into the pandemic, there was some slack. My hope as well is that there will be as many jobs, newly created and that the ECB will contribute to such developments by delivering price stability as our mandate so requires.
Tourism is a significant part of the South European economy, which is the biggest victim of COVID mitigation protocols (as a consumer-facing service industry). Lagarde and VP Guindos clarified recovery of such industry will be dependent on the progress of COVID vaccinations and herd immunity:
de Guindos: Well, I think that is going to depend on the evolution of the vaccination process. If the vaccination rollout gains momentum – and we expect that this is going to gain momentum – well, we hope that a high percentage of the population will be vaccinated and that this is a positive sign, a positive indication that perhaps the summer season will not be lost, as it was in 2020. Vaccination is going to be the driver, in my view.
Lagarde: Yes, and I think in quite a few of those countries we are seeing a gradual acceleration of the vaccination base and that's much in demand for those economies that are particularly sensitive to the social distancing rules, as tourism can be.
On the fiscal space or debt sustainability question of EU27 member states, Lagarde clarified higher debt is inevitable for every country in the world post-COVID. For the EU, after initial COVID relief measures (grants), the focus is now on recovery and actual fiscal/infra/green stimulus along with targeted structural reform to improve productivity. And ECB’s role is to ensure the lowest borrowing costs for EU27 member states to help the EU rebuild/growth story.
On the debt question: all countries around the world and the euro area countries are no exception, but all countries around the world had to increase their debt because they had to respond to the worst possible crisis that the economies had had in post-World War times. There was just no question as to whether or not the 60% threshold should or should not be exceeded and whether you were below the 60 or way above the 60, the debt had to be increased, full stop.
The real question is: what use is made of debt now going forward? The use of debt in the first few months of the pandemic had to do with keeping the economy afloat, making sure that businesses were not going down the tube, making sure that people were not left without income.
The real question now is: what use is made of debt? Is the public spending targeted and temporary to cross the bridge of the pandemic, as I have indicated earlier in the first instance? Second, is this public financing going to be spent on productivity-enhancing reforms that will improve the growth potential of those economies?
If that is the case and financing terms remain attractive relative to the growth that can be developed as a result of those targeted temporary measures and productivity-enhancing measures, then this is debt put to good use. I think that has been described much more so by fiscal authorities and governments than by me. This is a matter that will be reviewed by the European Commission, by the European Council members to redefine the terms of the Stability and Growth Pact. But this is a matter which is not for the European Central Bank to decide.
Lagarde also downplayed allegation of any back door YCC and pointed out that the ECB is not too worried about some increase in bond yields:
One thing that you got right – and it's probably because I have repeated it extensively – is that we pledge to preserve favorable financing conditions. As a result of that, back in March we significantly increased the pace of purchase and we have decided today to continue to proceed at this significantly higher pace of purchase relative to the first two months of 2021. When we look at the financing conditions throughout the chain, from upstream to downstream, we are seeing broadly stable financing terms. That's pretty much reflected in all the measurements that we are looking at. We don't only look at bond yields whether they are real or nominal. Of course, we do the difference and we draw the line between what's real and what's nominal. And we try to understand what is the originating factor of any movement up or down. We are seeing broadly stable conditions overall, whether it's bond yields or whether it is corporate or household interest rates and terms and conditions.
As per ECB data, it purchased €133.40B of bonds under PEPP in Feb-Mar’21. The Mar’21 purchase of €73.5B is the highest monthly rate since July’20. Till Mar’21, the ECB purchased cumulative €943.6B worth of bonds under PEPP, almost 52% of total envelope €1850B. Thus, on average, the ECB may buy around €75.53B per month till Mar’22. The ECB is not committing a fixed rate of monthly buying like Fed ($120B) but will buy as per its discretion in a targeted way to keep bond yields lower, where it requires more.
Almost 95% of ECB bond purchase under PEPP is sovereign (public sector), 3% corporate bonds, 1% commercial paper, and 1% covered bonds (till Mar’21). ECB’s purchase of sovereign bonds is mainly in favor of Germany, France and Italy.
The ECB was never able to stimulate the economy even by its ultra-accommodative monetary policy due to lack of adequate fiscal stimulus. Thus ECB miserably failed to achieve its inflation target and was never able to hike after the 2008 GFC. The ECB’s current policy of back-door YCC through targeted PEPP buying may also accelerate ‘Japanification’ of the Eurozone economy, making EUR like Japanese Yen becomes more like funding rather than growth currency. EU is now looking for huge US fiscal/infra stimulus and subsequent spillover of global reflation theme for own reflation.
Fast forward, now ECB is urging EU member states to take necessary steps for implementation of the EU Next Generation fiscal/infra stimulus immediately, while the EU is still divided on the same. This lack of common fiscal authority despite a common currency (EUR) and common monetary authority (ECB) may be the main reason behind EU inequality and fragmentation. The only solution lies in perhaps the formation of the ‘United States of Europe’-USE (like the United States of America-USA) rather than staying only as a common free trading zone for the advantage of a few export-heavy countries like Germany, for which EUR is much devalued than earlier original domestic currency.
Technical outlook: EURUSD
Technically, whatever may be the narrative, EURUSD has to sustain over 1.20100-1.21700 for some rebound; otherwise, expect 1.17100-1.16100 in the coming days.
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