April Monthly Review

Four major forces shaped the investment climate in the first quarter: the evolution of the virus and the rollout of the vaccine, the rising long-term interest rates driven by higher oil prices, Americas large fiscal stimulus, and optimism about the outlook, a sharp divergence between the US and other high-income countries, and a recovery in the US dollar after sliding in November and December 2020. These forces will continue to dominate at the start of the second quarter.

Among the G7 countries, the UK and the US have been the most successful in vaccinating their populations, though as the EC has argued, its production facilities and trade policy allowed it to export to the UK around 2/3 of its vaccines. It appears that while the EU has the vaccine-producing capacity, it did not partner with the private sector producers the way the US and UK did and backed laggards in the race to produce a vaccine. The UK has contracts with the right producers, but it does not have much manufacturing capacity, to produce the vaccine, and must rely on the friendly-export policies of others, like the EU and India, which may be coming to an end. The US has both manufacturing capacity and contracts. It is possible that before the second quarter is over, the shortage of vaccines turns into a surfeit in the US.

The UK has a four-step plan that will lead to the complete re-opening of the economy by the first day of summer, and it has begun being implemented. In the US, states are under pressure from the Biden administration to make vaccines available for all adults by the beginning of May, with the hope that by Independence Day, a couple weeks into the summer, that a return to normalcy may be considered. The vaccine rollout in Europe has been terribly disappointing for various reasons, and not all of which are the fault of their own decision-making, and this may be helping to facilitate a new wave of the virus. Several EU members have extended some social restrictions well into April. Also, the entire experience, including “vaccine diplomacy” and medical nationalism, will encourage countries to maintain or secure their own production capability in medical supplies and some medicines, including, apparently, mRNA capacity. Of course, it will be a “necessity.” that only large and/or rich countries will be able to afford.

Benchmark 10-year yields have risen sharply in the quarter, and perhaps, counterintuitively, the roughly 80 bp rise in the US 10-year was not the most among the developed countries. The honor goes to Canada with an 86 bp increase in the 10-year yield. Australia and New Zealand yields increased by a little more than 80 bp. The 10-year‘s nearly 65 bp increase was more than twice the increase of most other European countries, including Germany and France. Italy's benchmark 10-year yield rose by about 12 bp. However, in March, the divergence was clearer. The US 10-year yield rose by 30 bp, and 20 bp in Canada. Yields in the large eurozone countries increased by less than five basis points, the UK’s by seven basis points. Japan and Chinas 10-year yields slipped five-six basis points.

Surveys seemed to confirm the elevated expectations, which is what nearly all the central banks noted in explaining the rise in yields. However, oil is a traditional driver of inflation expectations, and until last month, an under-appreciated driver of higher yields. The price of light sweet crude oil rose by more than 60% between early November US elections and vaccine announcement to the end of February, while the price of Brent oil rose by more than 75%. Oil prices consolidated in March.

Most G7 countries likely contracted in Q1. The US is a notable exception and between the December 2020 fiscal stimulus ($900 bln) and the rebuilding of inventories, economists are projecting around 6% growth (at annualized pace), for which the first estimate will be available at the end of April. Canada also appears to have expanded in the first part of 2020. The Bundesbank warned of a German contraction in Q1, but the PMIs this may have been avoided. China will report its Q1 GDP in the middle of April. Growth may stay above pre-Covid levels, helped by strong net exports, but the high-frequency data is consistent with a downshift in growth from the 2.6%-3.0% seen quarterly in the H2 20.

Between the US stimulus at the end of 2020 and the new package approved last month, the US has committed almost 14% of GDP to the efforts. The OECD was so impressed that the US fiscal efforts were the single biggest factor in revising up its 2021 forecast for world growth. US growth itself was lifted by 3.8 percentage points. It might be worth about one percentage point for Canadian's growth and half as much for the eurozone and Chinese economies.

The next big economic initiative will be on the infrastructure. The Biden administration argues that in order for the US to compete more successfully, and especially to respond to Chinas challenge, there is work to do at home, and this includes better and more sustainable transportation, communication, and power infrastructure. It also requires a greater and more equitable investment in upgrading the skills of the workforce. The price tag could be $2-$4 trillion, and at least some of it may be paid by corporations and high-income households.

Biden has suggested hiking the corporate rate to 28% from 21%, raising the tax on foreign income, instituting a minimum corporate tax rate. One estimate suggested, the measures could cost 9% of next years S&P 500 earnings. With the help of some moderate Democrats, a compromise corporate tax rate of 25% would be closer to create a more manageable 3% drag, according to the estimate. Recall that the 2017 tax cuts lower the corporate rate from 35% to 21%. Most recently, Biden has talked about raising the marginal tax rate on households earning more than $400,000, and during the campaign, advocated lifting capital gains tax on those earning more than a million-dollar. The capital gains would be taxed at the top marginal rate of wages and salaries, which Biden proposes to raise to 39.6% from 37%.

The US is looking at a budget deficit this year of nearly 14.5% of GDP after about 15.6% in 2020. Japan‘s deficit was half as large last year at 6.7% of GDP. This year’s deficit is projected to be near 5.7%, though another supplemental budget cannot be ruled out. The eurozone‘s aggregate fiscal shortfall this year is projected to be around 6.5% of GDP, down from 9.3% in 2021. This may be a bit on the low side because growth in Q1 has been weaker than expected, and some countries, including Germany and France, are boosting spending. The much-awaited 750-bln euro Recovery Fund may not be operational until the middle of the year, and even then, it may be slow. In fact, partly owing to a slower rollout of the EU’s Recovery Fund, Spain, the second-largest recipient of the assistance after Italy, revised down this years growth and pushed it into 2022.

As Federal Reserve Chair Powell noted the press conference following the March FOMC meeting, the US had a more aggressive response after the Great Financial Criss as well. This time the divergence has been compounded by the vaccine. The divergence has helped fuel the dollar‘s recovery after sliding in the last two months of 2020. The dollar rose against nearly all the major currencies in March. The Canadian dollar and Norwegian krone managed to hold their own. The two countries are seen to be among the first to begin normalizing policy. Norway’s central bank has indicated it is anticipating the first hike in Q4 21, followed by two more hikes in 2022. The Bank of Canada is still far from hiking, but the confidence that the recovery is taking hold, with some spillover from the US, and it has terminated and/or not renewing emerging liquidity facilities. A decision to taper the C$4 bln a week in government bond purchases may be announced as early as this month's central bank meeting.

While the dollar-bullish divergence story does not appear to have been completely played out, leaving scope for additional greenback gains, our medium and longer-term view holds. The debt-financed growth that underpins the dollar in the near-term is also its Achilles Heel. The growth differentials will generate a significant widening of the US current account deficit. The deficit was over 3% of GDP in 2020 for the first time since 2008 and may head toward 4% this year. While everyone has a budget deficit, the US is unique among the large countries as it also experiences a current account deficit. Arguably, the role of the dollar (and Treasuries) in the world economy allow it to more easily finance its current account deficit than other countries, but the US dollar has often depreciated when attention turns to the “twin deficit” challenge. One sign that this process may have begun is when the dollar does not benefit from rising yields, which we see as a cyclical rather than a linear relationship.

BWCI Index

The Bannockburn World Currency Index (BWCI) trended lower through the first quarter. It finished the quarter having given back almost two-thirds of the gain scored in the November-December 2020 period, marked by the US election and the vaccine announcement. The Canadian dollar among the majors, and the Indian rupee and Mexican peso from the emerging markets, prevented a larger decline in the BWCI. Brazil and Russia hiked rates in March, and both are likely to move again. Russia‘s central bank meets on April 23 and Brazil’s meets next on May 5.

Dollar

The US is in an enviable position, an accelerating economy, a vaccine rollout that is gaining momentum, averaging more than 2 mln jabs a day, at the end of Q1, and interest rates that remain low by any standard except when during the heart of last year's shutdown. Last March, the headline CPI fell by 0.3%, and the core rate was flat. These will be dropped out of the year-over-year comparison with the March 2021 figures that will be reported on Apr. 13 and starts a three-month period that inflation appears to have accelerated.

The message coming from the Apr. 28 FOMC meeting will likely be one of greater confidence in the vaccine's progress and labor market developments. The Biden administration wants to stay focused on the infrastructure initiative, but immigration and voter bills are vying for attention. The dollar finished the quarter with strong momentum against most European currencies and the Japanese yen. Relations with China and Russia remain strained and are more likely to deteriorate than improve in the period ahead.

Euro

The euro fell for the third consecutive month in March, and the nearly 2.4% decline was the largest monthly since May 2018. The divergence with the US is reflected in the widening of the 10-year interest rate differential against Germany that finished 2020 near 150 bp. It jumped about 35 bp last month to move above 200 bp for the first time since last February. With a dramatic increase in vaccines expected starting in Q2, the rollout should accelerate, though social restrictions into at least the first part of the Q2. The new social restrictions in Germany, a kickback scandal implicating some CDU/CSU officials, and a poor showing in state elections make the political situation in Germany ahead of the fall elections particularly fluid. The euro rallied from around $1.16 as the US polls closed in early November and peaked in early January near $1.2350. The unwinding brought it to almost $1.1700 last month. The bulk of the adjustment/correction seems behind, but a bottom may take some time to forge, and a push to $1.15-$1.16 cannot be ruled out.

(end of March 2021 indicative prices, previous in parentheses)

Median Bloomberg One-month Forecast $1.1830 ($1.2200)

One-month forward $1.1735 ($1.2085)

One-month implied vol 5.8% (6.8%)

Yen

The dollar rose by nearly 4% against the Japanese yen in March, the biggest monthly advance since the 9.2% gain in November 2016. Rising US interest rates seemed to be the most important driver, though Japanese investors' appetite for foreign assets seemed to have been dampened by the weaker yen. In February, speculators in the futures market began trimming the net long yen position in the futures market. The move was accelerated in March and swung to the largest net short position in more than a year. The BOJ clarified that under yield curve control, the 10-year yield can move +/-25 bp on either side of zero and announced that going forward, it would focus its ETF buying on Topix. It also reduced the bonds it will buy across the curve, which is part of a gradual effort to have greater flexibility given the long-run nature of the operations. The formal emergency in Tokyo and other areas was extended through the middle of March, and a fire at a semiconductor chip factory and powerful earthquake point to a possible contraction of 4%-5% in Q1 before a rebound in Q2.

Spot: JPY110.71 (JPY106.55)

Median Bloomberg One-month Forecast JPY109.30 (JPY105.95)

One-month forward JPY110.65 (JPY106.50) One-month implied vol 6.4% (7.0%)

Sterling

Sterling's recovery from the March 2020 low (~$1.1415) stalled in late February (~$1.4235). It remained below $1.40 for most of last month and bottomed near $1.3660. The success in rolling out the vaccine, the four-step process toward fully opening up by June 21, which has begun, makes investors optimistic of sterling's outlook. Brexit is off to a rocky start as the Northern Irish border remains problematic. The UK is not ready to fully implement the new checks, much to the EU's chagrin. Separately, there seems to be some headway with financial services that were excluded from the trade agreement, but regulatory equivalence still seems to be a way off. A split within the Scottish National Party may distract, if not dilute, the push for another referendum on independence. The regional election is part of the May 5 local elections throughout the UK. The Bank of England next meets the day after the elections.

Median Bloomberg One-month Forecast $1.3825 ($1.3900)

One-month forward $1.3785 ($1.3940) One-month implied vol 7.0% (9.1%)

Canadian Dollar

The Bank of Canada announced it was ending the emergency liquidity programs launched last year, which included facilities to purchase provincial and corporate debt. This, coupled with officials increasing confidence that the recovery is strengthening, helped in part by the spillover from the significant US stimulus, is fanning speculation that the Bank of Canada could announce plans to taper its C$4 bln a week of federal government bonds at its next meeting on Apr. 21. So far, there has been no official attempt to pushback against the speculation. The US dollar recorded new three-year lows on Mar. 18 near CAD1.2365 before rebounding to almost CAD1.2650 into the end of the month. Along with the Norwegian krone, the Canadian dollar was the only major currencies to gain against the dollar in March. It often fares well on the crosses in a strong US dollar environment. The Canadian dollar's 1% gain made it the strongest currency in the world in Q1. Recall that gained about 2% in 2020, the least among the major currencies.

Spot: CAD1.2565 (CAD 1.2740)

Median Bloomberg One-month Forecast CAD1.2575 (CAD1.2730)

One-month forward CAD1.2560 (CAD1.2735) One-month implied vol 6.6% (8.1%)

Australian Dollar

The Australian dollar set three-year highs in late February, a little above $0.8000. It proceeded to fall to below $0.7700 within days and was unable to recover much in March. It was not able to get above $0.7850, and toward the end of March made a marginal new low for the year a touch below $0.7565. Commodity prices were broadly lower, and this may have weighed on sentiment. The Australian 10-year premium over the US, which reached a four-and-a-half year-high at the end of February over 50 bp, trended lower in March and finished the month at a small premium after briefly trading at a discount. The Reserve Bank of Australia will buy A$100 bln of government bonds from mid-April through the middle of October. Some local banks already expect the bond-buying program will get extended again. The RBA is linking monetary policy closer to the labor market. The government, however, seems to be tacking the other way as it let the job-support program (JobKeeper) expire in late March. In fairness, Australia has recaptured nearly all the jobs lost as the pandemic first struck, and that includes full-time positions (~378k lost and 358k grown in the last nine months). The participation rate has been at 66.1% since last October. It was at 65.9% at the end of 2019.

Median Bloomberg One-Month Forecast $0.7635 ($0.7705)

One-month forward $0.7605 ($0.7610) One-month implied vol 9.7% (12.0%)

Mexican Peso

The peso rose by about 2.0% against the dollar in March, leaving it off about 3.25% through the first three months of the year. Speculators in the futures market had their largest net short peso position in four years in the middle of March. The economy appears to have contracted in Q1, but with the help of a strong US economy, growth can return in Q2. Weak domestic demand will support the external surplus. However, if there is a country that we are reviewing there that is experiencing stagflation, Mexico is it. The economy is weak enough, and fiscal support has been lacking; monetary assistance is needed. However, price pressures have been rising, and the bi-weekly rate rose above the upper end of the 2%-4% range. This was the backdrop of the central bank's unanimous decision not to cut rates, as it previously indicated was likely at the March 25 meeting. Banxico does not meet again until May 13. However, with other emerging market central banks, like Brazil and Russia, raising rates, its yield advantage is set to diminish.

Median Bloomberg One-Month Forecast MXN20.4350 (MXN20.6350)

One-month forward MXN20.5115 (MXN20.9335) One-month implied vol 14.8% (17.1%)

Chinese Yuan

The dollar traded in a fairly narrow range against the yuan in January and February (mostly CNY6.43-CNY6.50), but as Chinese equities weakened and the interest rate premium over the dollar fell, the yuan came under pressure. The dollar rose above CNY6.57, a level not visited since the end of last November. The PBOC's daily reference rate has been near what bank models implied, which suggests that the mild depreciation of the yuan may have been driven by market forces. The yuan fell by about 1.25% in March, leaving it down 0.35% for the year, the third-best emerging market currency after the Hong Kong dollar (~-0.25%) and the Indian rupee (virtually unchanged). Domestically, China's clampdown on Ant and its threat of anti-trust action is adding to the uncertainty emanating from the rapid expansion of credit and increased failures. Internationally, China has faced a more united front of sanctions by the US, Canada, and Europe. The US has begun toughening the enforcement of rules that require all listed companies must allow regulators to review the audits, which Chinese companies eschew.

Median Bloomberg One-month Forecast CNY6.5140 (CNY6.4680)

One-month forward CNY6.5760 (CNY6.4955) One-month implied vol 5.0% (5.2%)

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