3 June 2021
We compare and contrast the monetary policy stances of the European Central Bank (ECB) and the Federal Reserve (Fed), in light of recent economic data prints across Europe and the US.
Upside surprises to actual and expected inflation have been greater in the US than in Europe. In the US, April’s 0.9% month-on-month rise in the core Consumer Price Index (CPI) was the largest since 1982. While the underlying mix of inflation appears to fit within the Fed’s definition of “transitory” (supply chain disruptions and Covid-impacted sectors, such as travel), inflation expectations are pointing towards overheating. For example, the University of Michigan’s 5- to 10-year measure of inflation expectations rose to 3.0% in May. In contrast, core measures of inflation in the eurozone are still hovering around the 1% level and there are few warning signs of base effects feeding into longer-term inflation expectations. In particular, the Eurozone 5-year, 5-year (Eur5y5y) inflation swap curve is sitting at 1.60%, while the core Harmonised Index of Consumer Prices (HICP) is expected to head into 2022 at 1.2%, far off the ECB’s target of close to 2%. Could this suggest the beginnings of a divergence in monetary policy between the two economies? The ECB’s tone in recent weeks has become more dovish after several key speakers failed to take a hard stance on the central bank’s willingness to taper asset purchases. In contrast, several Federal Open Market Committee (FOMC) members, including key centrists, are now “talking about talking about tapering.” Importantly, inflation developments in the US have lowered the hurdle for the Fed to see substantial progress in the labour markets.
US inflation expectations have outpaced those in Europe
While we expect US 10-year Treasury yields to be biased towards the upper end of our year-end expectation of 1.875 – 2.125%, 10-year German Bunds should remain range-bound. Over the next months, Treasury yields are likely to be driven by the balance between inflation and jobs growth, where risk is currently to the upside. German Bund yields (currently at -0.20%) rose 29 basis points (bps) in February to -0.23% amid global rate volatility and looked set to break through the 0% milestone in May. However ECB hawks failed to push back against dovish rhetoric and European government bonds have since re-traced. It would likely to take a significant shift in the inflation picture to push European yields higher. (Data as of 1 June 2021).
Expectations that the ECB will maintain a “significantly higher” purchase pace well into Q3 creates a stronger technical backdrop in Europe than in the US. Net supply in Europe has been negative since purchases were ramped up in March and should remain so for the second half of this year. In addition, usually hawkish speakers, such as Schnabel, noted that any slower pace of purchases could be related more to seasonality rather than an independent commitment. This contrasts with the US, where net issuance has remained positive and is forecast to continue its upward trajectory over the coming year – especially when incorporating forecasts of the initial paring back of policy in Q1 2022, given sufficient labour market progress.
What does this mean for fixed income investors?
We believe the beginnings of a divergence between the ECB and the Fed, driven by different inflation and labour market trajectories in Europe and the US, should translate into European government bond yields remaining range-bound while Treasuries inch higher over the remainder of this year. As such, consensus long positioning in German Bunds vs the US 10-year Treasury should be monitored in tandem with economic data prints over the summer months to see if they provide justification for the Fed to begin tapering in Q1 2022.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum