Will the ECB out-hawk the Federal Reserve?

This is the big question as we all get back to work after the US Labour Day holiday. With summer officially over, although it may not feel like that in London after July weather turned up two months’ late, the focus is back on what direction markets will take in the last 3-4 months of the year. As we embark on the new season, financial markets are in fine form, with the global MSCI index of stocks hitting a fresh record high at the start of this week, which was its 8th day of gains to record highs. The question now is, how long can this goldilocks market last? 

When will the global stock rally run out of steam, not any time soon 

The short answer to this, is possibly until October or November, as it all depends on the Federal Reserve meeting later this month. The dismal NFP number for August makes a tapering announcement from the Fed in September unlikely. Since it was the hospitality industry and the all-important service sector in the US that is struggling, this is a clear sign that the Delta variant is having a major impact on US economic growth, thus, until the Delta variant is under control in the US, particularly in the vaccine-hesitant southern states, the Fed can be justified in delaying tapering until late 2021 or early 2022. Thus, the risk that the Fed will reduce or cease its bond buying in the near term has pretty much been eradicated. This could be near-enough confirmed in this week’s Beige Book, which is released on Wednesday. The market is expecting a downbeat assessment from the 12 local Fed banks. The market will be looking for all-important information about the state of the labour market and supply-chain shortages, which is weighing on growth in the US and is also pushing inflation higher. 

How the Fed handles a spate of weak economic data 

The big question is whether or not this report will provide the Fed with enough conviction to cut back on its asset purchases and give the market confidence that the Fed could raise interest rates in 2023. There is a high chance that a pessimistic reading of the Beige Book later this week could be the final straw for the Fed and seal them taking a dovish step away from tapering at this September’s meeting. For those of you trading on Tuesday you may be asking me to “tell that to the dollar”, which is having a resurgent day so far. It is at its highest level of the month, but don’t get too excited, as the technical indicators still suggest the greenback is a sell, and it is only up 50 basis points from its low back on 2/9 at 91.80. Even so, in the short term this is a decent support level with resistance coming in at 92.50 and then 93.20. The dollar has been pushed up by the rise in 10-year treasury yields, which jumped 4 basis points on Friday after the weak NFP report. Sometimes markets do not react as we expect, however, it’s worth noting that the rate-sensitive 2-year yield only rose 1 bp on Friday to 0.21%, thus, the market is still sceptical of a rate hike in 2023. 

What next for the dollar 

Overall, where the dollar goes in the short term will depend on 2 things, firstly, what Treasury yields do on Tuesday, which could see the 10-year yield give back some of Friday’s gains now that the market has had time to digest what the current economic and health situation in the US means for future Fed policy. Secondly, the Beige Book is definitely one to watch this week. 

ECB: hawks at the ready 

The second event that we will be watching closely is the ECB meeting on Thursday. There is an expectation that the ECB could out-Fed the Fed and announce a light taper and scale back its asset purchase programme to EUR 60-70bn per month from EUR 80bn per month. This move is being priced into financial markets – the German 10-year bond yield has risen to -0.33% from -0.39% on Friday. German yields are still deep into negative territory, but they are moving in the direction of a relatively hawkish message from the ECB at this week’s meeting. The 2-year yield is now at its highest level since July and is currently at -0.69%. This yield tends to move upwards at a snail’s pace, so the break to -0.69% is a fairly significant move. We think that the ECB will not want to move too quickly when it comes to tapering, least they spook the market and ruin the Eurozone’s recovery story. However, they are expected to upgrade their growth and inflation forecasts and we expect there to be great debate this week’s meeting as the German officials are likely to take a tough stance against inflation, after national levels of German inflation rose to multi-decade highs. 

Signs that global growth in recovery 

Adding to the argument that the ECB could take a tough line at this week’s meeting is the latest economic data that shows growth is picking up and supply chain bottlenecks are starting to ease. Chinese exports rose by a whopping 15.7% last month, with imports rising by more than 20%, while German industrial production for July beat expectations and rose by 1%, leaving the annual rate at 5.7%, not bad growth for the industrial sector when there are so many headwinds. This data is important for the ECB and for global investors as it suggests that the global economy is coming back into balance and it suggests that supply chains are working well. This is good news for global stocks generally, and it should give the reflation trade a boost. It is notable that the best performers on the FTSE 100 on Tuesday include Burberry, Anglo American and Rio Tinto, companies that are exposed to China. In Germany the car makers, Adidas and Siemens were some of the top performers on Tuesday. 

The benefits of a slow EU vaccination rollout and the fate of the euro 

It is worth noting that the EU’s delayed vaccination programme could have a silver lining, it could mean that the continent avoids the worst of the latest Covid wave. It is interesting that rates of infection are highest in Ireland, compared with other EU members where infection rates are falling. However, while vaccines and boosters are still up for debate in the currency bloc, we think that the ECB do not have to worry about the latest wave of Covid in the same way that the Fed does, for now. This is another reason why the ECB could sound “hawkish” and start scaling back its asset purchase programme this week. For now, ECB expectations are likely to play out in the FX space. As we mention above, the dollar is rising at the start of a new week, however, we think that this is merely down to low levels of liquidity. Instead, we continue to believe that the euro will be in the ascendancy in the short to medium term. The recent rally in the dollar and decline in EUR/USD below $1.19 will give the market opportunities to buy this pair, which could push it back above $1.20 in the next few days.