The investment climate is changing.  The reflation trade has gained traction.  Bond yields rose sharply, and curves steepened.  The dollar value of the negative-yielding bonds in the world fell from a peak last December of around $18.4 trillion to $12.6 trillion, the least since last July.    

Commodity prices continue to move higher.  The CRB Index rose nearly 9.5% in February and brings the gain to almost 32% since the end of October.  Equities rallied strongly in the first half of February before a dramatic sell-off in the second half of the month that hit the high-flying tech sector hard. Financials and commodity companies outperformed. In the foreign exchange market, the optimism that the combination of the vaccine and stimulus efforts will make for a strong recovery is expected as the year progresses. It is expressed in the outperformance of the Antipodean and the Scandinavian currencies.  The retreat in equities offered little succor to the perceived safe-haven Swiss franc and Japanese yen, both of whom underperformed in February.

Top honors last month, though, went to sterling with its 1.6% gain.  It has now risen for five consecutive months, matching its longest streak since the end of 2003/early 2004, for a cumulative increase of almost 7.8% against the dollar and nearly 4.3% against the euro.  Sterling’s outperformance may reflect its relatively successful rollout of the vaccine and ideas that this will lead to a favorable economic divergence. Also, speculation swung from the possibility of negative rates to a hike before the Bank of England currently signals. Some observers suspect that outside of the EU, sterling’s quantitative characteristics may change.  There simply has not been sufficient time yet to reach a significant conclusion.  According to SWIFT, sterling’s share on the payment and messaging system slipped to 6.8% in January from a little more than 7% a year ago. 

The reflation theme has three components. The first is the early recovery in Asia, and especially China.  Demand for industrial commodities and foodstuffs begins there.  Chinese demand has boosted inter-Asian trade and helped blunt the impact of weak domestic demand in other countries, including Japan. The second component, optimism, stems from the increasing availability of a few vaccines.  Many countries have struggled with the distribution, but there is good reason to expect that as the kinks are addressed, production of the vaccines will increase, other vaccines will be approved, and inoculations will accelerate. 

The third is the huge fiscal stimulus the US is providing.  President Biden is making good on his campaign pledge for a large fiscal stimulus package.  The exact size is not yet clear, but it may be around $1.5 trillion, on top of the $900 bln approved last December, or something around 14% of GDP.  The economy is already sizzling with strong, and forecasts for H1 21 GDP are being revised higher.  The 5.3% surge in January retail sales more than offset the cumulative 2.4% contraction seen in Q4. Industrial output rose a strong 0.9%, more than twice what economists expected.  The stimulus will be approved before the extended unemployment benefits end in the middle of March.  Linking some support programs to economic performance instead of a fixed date may help minimize the risks of a fiscal cliff.  Shortly after the fiscal measures are passed, attention will turn to the large infrastructure program.  Talk is that this public-private effort could be as much as $2-$4 trillion.  

The monetary and fiscal stimulus has created a great deal of liquidity.  The peak may not yet be at hand. As part of America's fiscal dysfunctionality, the Treasury must run down its cash balances at the Federal Reserve before the end of summer under the terms of the debt ceiling waiver, which must once again be addressed.  Some of the drawdown was going to happen in any event as stimulus funds are spent. As these processes take place, the pressure will mount on the short end of the curve.  In February, for the first time since last March, the four- and eight-week bills were auctioned with no yield, and the six-month T-bill was auctioned at the end of the month with the lowest yield since late 2014.  The overnight repo fell below zero.  

Given the frenzy over the trading in some small company shares in the US, a brief short squeeze in silver, and the incredible rise in the cryptocurrencies and especially Bitcoin (43%+ in February alone) has spurred talk of a “bull market in everything.” The MSCI global equity index is up 1.7% year-to-date after losing 3.3% in the last week of February.  It rose 14.3% last year after a 24% surge in 2019. Japan’s Nikkei reached levels not seen since the bubble in the early 1990s.  Yet, in fairness, "the bull market in everything" was the cover of the Economist in October 2017. 

Central banks, including the Federal Reserve and the European Central Bank will be updating their economic forecasts in March. Given the fiscal stimulus, Fed officials may upgrade their economic outlook.  The ECB staff has good reason to downgrade its projections.  This divergence is an important characteristic of the reflation theme.  Fiscal and monetary policies are more aggressive in the US than in Europe or Japan.  The economic and financial consequences may not be as straightforward and linear as economists often suggest. Central banks have been buying bonds in a rising interest rate environment, implying that they ultimately may be price takers, not givers.  There is probably the most scope for the Bank of Japan to adjust policy.  Market talk has focused on the BOJ possibly pulling back from its ETF purchases and/or allowing the 10-year yield to fluctuate more, i.e., tolerate a greater increase. 

Two state elections in Germany may shed light on the mood of voters ahead of the national elections in the fall that will see a new Chancellor for the first time since 2005.  In Rhineland-Palatinate, the SPD leads a coalition with the FDP and Greens (Alliance 90), with the slimmest of majorities.  The Greens seem to be doing well, and the status quo may continue.  The AfD appears to be doing a little better but could be coming from disenchanted CDU voters.

The election in Baden-Wurttemberg may be more interesting.  It is governed by an intuitively disparate coalition.  The Greens are currently the senior partner with the CDU. It is the first state that the Greens hold the premiership.  After years of cohabitation with the CDU on the national level, the SPD has seen their support flag, and the Greens may become the largest center-left party.  As odd as it may appear, the coalition in Baden-Wurttemberg is seen as a prototype for a possible coalition on the national level.  

The Netherlands goes to the polls as well in the middle of March.  The Dutch political parties are so fragmented that it took 225 days to form a government after the last elections. Public opinion polls suggest little change in party alignments is likely.   Prime Minister Rutte is likely to lead a center-right coalition to head up his fourth government.

The flat performance this year is consistent with our sense that the dollar is at the fulcrum of the reflation theme driving other capital markets.  Among the majors, sterling and the dollar-bloc currencies have been rewarded. Among the emerging markets in our index, the Russian ruble stands out with a 1.5% gain, bolstered by the commodity story, economic recovery, and high rates. Substantial fiscal expansion and market-friendly moves helped lift the Indian rupee before profit-taking at the end of February.  Strong South Korean exports helped blunt the impact of domestic and foreign portfolio investment outflows on the won.  

Year-to-date, the four worst-performing emerging market currencies are in Latam (Brazil real -6.9%, Argentine peso -6.3% Colombian peso -5.0%, and Mexican peso - 4.9%).  Turkey has been rewarded for its shift to more orthodox policies, including high-interest rates. With the broad selloff of emerging market currencies and a nearly 2% drop in February, the lira virtually flat so far this year.  The poor performance of emerging market currencies in general last month means that the modest 0.4% gain of the Taiwanese dollar puts it in a tie with the Chinese yuan (both up 0.75% year-to-date) at the top of the EM universe.  

Dollar:  The US dollar finished February on a firm note as the market is brought forward the likely timing of the first Fed hike to the end of 2022 from late 2023.  The policy-setting is still open spigot. The Federal Reserve is buying $80 bln of Treasuries and $40 bln of Agency MBS a month, and the FOMC meeting that concludes on March 17 will suggest no change is contemplated even as US growth prospects improve.  The lion's share of the $1.9 trillion fiscal stimulus package will be approved before the FOMC meeting.  In light of the market pulling the first rate hike into late 2022 from 2023, the Fed's rhetoric may change.  The rise in the long-end yield reflects a rise in inflation expectations more than real rates, as mediated by the breakevens (the difference between conventional and inflation-linked notes and bonds).  Even, the Federal Reserve's real yield index shows that the 10-year rate is still deeply negative (-0.70%) at the end of February.  This is up from the extremes (-1.10% last August), but well below the  0.15% that prevailed in Q4 19.  While the long-end of the curve has backed up, the short-end of the curve is soft. Short-dated bill yields are threatening to fall below zero as the Treasury Department reduces its cash holdings dramatically in the coming months, which floods the system with liquidity.  The two-year note yield slipped to a record low on February 11, below 10 bp, and finished the month near 14 bp.  

Euro:  The eurozone economy is contracting in Q1, but the outlook is constructive as the vaccine rollout picks up. The manufacturing sector is expanding, and services are not contracting as they did when the pandemic first struck. The selection of former ECB President Draghi as the 30th prime minister of Italy reduced perceived redenomination risks (a country leaving the eurozone).  Even as yields were rising recently, the cost of insuring against default fell.  The ECB meets on March 11, and the risk is that the staff cuts its near-term economic forecasts.  ECB President Lagarde will likely focus her on measuring financial conditions. The central bank's chief economist Lane has relied on four indicators, the overnight-index-swaps to the 10-year curve, money market rates, the exchange rate, and equity prices.  A couple of ECB Executive Board members have suggested that there is scope for another rate cut, if necessary.  The targeted long-term loan rate is below the minus 50 bp deposit rate, which has reduced the sting of negative rates.  In the first instance, we suspect the ECB would step up its bond purchases from the 17 bln to 20 bln euro pace.  Disbursements from the EU Recovery fund are until closer midyear.  Like in the US, the increase in Germany's nominal yields can be accounted for by rising inflation expectations, measured by the difference between the conventional yield and the inflation-linked security. Since early November, the 10-year Bund yield rose by about 36 bp while the break-even has risen 37 bp.  Real yields remain low.   The euro peaked in early January, and although it was firmer than we expected last month, we are not convinced that the corrective or consolidative phase is over.  We suspect the risk may still extend toward $1.18 before what we think is the underlying downtrend in the dollar resumes.  

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

Spot: $1.2075  ($1.2135) 

Median Bloomberg One-month Forecast $1.2200 ($1.2145) 

One-month forward  $1.2085 ($1.2140)    One-month implied vol  6.8%  (5.7%)    

Yen:  The rise in US yields helped lift the dollar to a five-month high against the yen last month (~JPY106.70).  The yen is the weakest of the major currencies through February, off about 3.1% for the year. The Japanese economy appears to be contracting in Q1, but foreign demand, especially in Asia, is an important offset.  In 2020, Japan recorded a JPY3 trillion trade surplus compared with JPY382 bln in 2019.  Japan has been reported a trade deficit in January since 2010, but the JPY324 bln shortfall this past January was the smallest since the pattern began.  The Bank of Japan has been buying ETFs for a decade and holds around JPY47 trillion (~$445 bln).  It is the single largest owner of Japanese shares.  The Topix reached its best level since 1991, the cost-benefit, given the distortions of small-cap issues, some modification seems increasingly necessary.  Some detect a tactical shift recently that could also entail less frequent purchases but a larger average size. The rise in global bond yields has impacted Japan. The 30-year bond yield reached over 0.77%, the highest since late 2018, while and the 10-year matched its highest level (~0.18%), a five-year high.   The 10-year break-even has risen to nearly 18 bp after finishing last year near 3 bp. Some observers expect the BOJ to widen the range that the 10-year yield can trade, from 20 bp on either side of zero to 30 bp, under its yield curve control policy.  The central bank meets on March 19.    

Spot: JPY106.55 (JPY104.70)      

Median Bloomberg One-month Forecast JPY105.95 (JPY104.50)     

One-month forward JPY106.50 (JPY104.75)    One-month implied vol  7.0% (6.3%)  

Sterling:  The British pound has dramatically benefitted from the reflation meme and the vaccine rolling out. Since the end of October (18 weeks), sterling has fallen against in only three weeks, including the last week of February.  Over the span, it has appreciated by about 7.7%.  Also helping the currency was the market's acceptance that the Bank of England was not going to adopt a negative interest rate and instead may hike them by the end of next year. The 10-year Gilt has risen by about 55 bp since the end of October, while the 10-year breakeven increased by around 25 bp.  This suggests an increase in the real rate, unlike in Germany or the US.  Some BOE officials, like some Fed officials, see investor optimism in the rising yields.  However, the BOE chief economist warned that central banks may be complacent about inflation, and rates may have to rise to tame it.  This will likely underpin sterling, even in corrective phases.   Sterling is near its best level against the euro in a year, and this may also help minimize the losses against the dollar.    If sterling's appreciation on a trade-weighted basis, some official comments cannot be ruled out.  With the labor market still stressed, the furlough program in which some 20% of the employees participate is currently set to end on April 30.  Alongside this, the Chancellor of the Exchequer's budget on March 3 may provide other support for the hard-hit small and medium-sized businesses, which all told maybe 5%-7% of GDP.  Sunak is expected to signal the intention of bringing fiscal policy under control, and the UK's corporate tax rate of 19% is the lowest in the G7.  It is one of the areas that the Tories have not promised not to raise taxes.  

Spot: $1.3935 ($1.3710)   

Median Bloomberg One-month Forecast $1.3900 ($1.3695) 

One-month forward $1.3940 ($1.3715)   One-month implied vol 9.1% (7.8%)

Canadian Dollar: Last month and year-to-date, the Canadian dollar lagged behind the other dollar-bloc currencies' appreciation. Although its exports are weighted toward commodities, the positive impact may have been blunted by the Canadian dollar's greater sensitivity to the US NASDAQ.   The Bank of Canada does not see the economic slack being absorbed until 2023 and is committed to keeping rates low until inflation is sustainably at its 2% target. The current wage subsidy ceiling (75%) may be lowered in April but will continue at least through June.  The economy appears to be contracting in Q1, but a stronger second half is anticipated.  It may not regain pre-pandemic output levels until 2022.  Since the end of October, the 10-year bond yield has risen by about 75 bp, while the 10-year breakeven has increased by 68 bp.  The rise in inflation expectations may explain the full increase in nominal yields.  We suspect that the US dollar recorded an important low against the Canadian dollar in late-February and see room into the CAD1.2900-CAD1.3000 area in the coming weeks.  

Spot: CAD1.2740  (CAD 1.2780) 

Median Bloomberg One-month Forecast  CAD1.2730 (CAD1.2770)

One-month forward CAD1.2735 (CAD1.2800)    One-month implied vol  8.1%  (7.0%) 

Australian Dollar:  The macro-themes of reflation, higher commodity prices, and strong Asian, and especially, Chinese demand converge in Australia. Iron ore, coal, and liquified gas account for more than half of Australia's exports. Since the end of October, the Australian dollar has appreciated by around 14.5%, and by some measures of purchasing power parity, it is overvalued.  The OECD's PPP model has the Aussie when it is about $0.7700,  overvalued by around 13%.  The next important chart points are the 2017-2018 highs (~$0.8125-$0.8135), but we suspect an important high is in place and expect it to work its way lower toward the $0.7500 area in the coming weeks.  The Aussie has appreciated by nearly 9% against the Chinese yuan, its biggest trading partner. In addition to competitiveness, it also more broadly highlights the strategic dilemma. Its economic prosperity has been linked to China's growth, while the key to its security lies in Washington.   The upward pressure on global rates poses a challenge for the Reserve Bank of Australia that targets the three-year yield at 10 bp, the cash rate target in its expression of yield curve control.  It may need to expand its bond-buying to achieve its target when it meets on March 2 to bolster the credibility of its stance, with the three-year note above the target at the end of February despite having stepped up its purchases.    

Spot:  $0.7705 ($0.7645)       

Median Bloomberg One-Month Forecast $0.7705 ($0.7640)     

One-month forward  $0.7610 ($0.7650)     One-month implied vol 12.0%  (10.3%)   

Mexican Peso:  In the second half of last year, the Mexican peso appreciated by 15.5%, making it the second strongest emerging market currency after the South African rand.  The peso had fallen by about 17.7% in H1 20. Even before the pandemic, Mexico's economy was contracting.  The AMLO government eschews deficit-financed growth, putting more weight on monetary policy.  Banxico meets on March 25, and the deputy governor suggested that there may be scope for two more rate cuts, which the market took as a signal.  However, investors have turned cold toward the peso.  Rising interest rates, especially in the US, knock an important leg from underneath it.  The other two legs that the peso stood on were its trade surplus and strong worker remittances, and the best news of both are probably past.  The high rates, record trade surplus, and strong worker remittances overshadowed the government's less-than-friendly business policies. Mexico has been hard hit by the virus, slow to roll out the vaccine, reluctant to used fiscal policy to support incomes and demand.  The dollar finished February a little below MXN20.95, its highest close three months.  The risk in the coming weeks may extend toward MXN21.50.  

Spot: MXN20.8550 (MXN20.5750)  

Median Bloomberg One-Month Forecast  MXN20.6350 (MXN20.5050)  

One-month forward  MXN20.9335 (MXN20.5854)     One-month implied vol 17.1% (15.3%)

Chinese Yuan:  The yuan's 1.5% gain in January was halved by the 0.75% loss in February.  This change does not tell you that the dollar has been in a clear trading range against the yuan this year. The dollar traded between CNY6.4235 and CNY6.5150 in January and CNY6.43 and CNY46.49 in February. It is a closely managed currency.  We suspect the PBOC is willing to see some yuan weakness in the dollar stages a broad recovery in March as looks likely.  One of the popular investment themes had been the attractiveness of Chines bonds for the yield pick-up.  Yet, since the middle of November, China's premium has fallen from over 250 bp to around 175 in late February.  China's National People's Congress is scheduled for March 4-5.  It is one of the most important events in Chinese politics.  The 14th Five-Year plan will be approved, and other policy objectives will be announced.  It is about signaling and intentions.  Even with the dramatic decline in US and European shares in late February, China's CSI 300 Index underperformed with a small outright decrease compared to a 2.6% gain in the S&P 500 and a 2.3% increase in the Dow Jones Stoxx 600.  

Spot: CNY6.4735 (CNY6.4285)

Median Bloomberg One-month Forecast  CNY6.46800 (CNY6.4750) 

One-month forward CNY6.4955  (CNY6.4750)    One-month implied vol  5.2% (5.1%)

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