The demise of America and the dollar has been an often-told tale. Some even suggested that the sharp appreciation of the purely speculative crypto-token (Bitcoin) confirmed the loss of the US and the dollar's privileged position in the world economy. In fact, quite the opposite appears to be taking place. The latest reserve data from the IMF shows that foreign central banks held more dollars in reserves than ever before at the end of last year, over $7 trillion. The more timely custodian holdings at the Federal Reserve show that Treasuries held for foreign central banks reached a new record high last month.
Instead of continuing to decline as it has done since last March on a trend basis and accelerating as it did last November and December, the dollar appreciated in Q1 and is beginning Q2 at elevated levels. The critical consideration is that no country can match the US fiscal and monetary stimulus and the combination of contracts with vaccine developers and the manufacturing capacity to deliver. The US recorded a budget deficit in 2020 of more than 15% of GDP. This year's deficit is expected to be over 14% of GDP. Despite the fiscal stimulus and a labor market recovering faster than projected, the Federal Reserve's asset purchases are also larger than others at $120 bln a month.
The doom and gloom camp bemoans that America cannot even produce the things it invented. They miss the point and ignore all the work about the production life-cycles. Ultimately, they do not appreciate the US manufacturing sector's flexibility demonstrated through the pandemic and vaccine. The US can make consumer products, PPE, and vaccines. Businesses chose instead to focus on higher-value-added activity, like equipment and machinery. What it does produce, it often uses capital-intensive techniques, and still, on the eve of the pandemic, unemployment was the lowest in a generation.
While the US is the driver of the divergence, it is not like Europe is doing well. Caught up in another wave of contagion, some countries are extending social restrictions for most of this month. The vaccine rollout has been poor at best. The contraction being experienced throughout the eurozone will increase counter-cyclical spending, but the actual stimulus seems marginal. On aggregate, after running a budget deficit of less than 1% in 2017-2019, it jumped to 9.3% last year and is expected to be between 6.0%-6.5% this year.
Great hopes were pinned to the EU Recovery Fund. Even though the US has its own dysfunctional fiscal process, combine Europe's conservative approach with Brussel's bureaucracy and the Recovery Fund was always going to be a laborious process. Hopes that it can be rolled out near mid-year may be optimistic. Spain, for one, disappointed by the slowness, cited it as a factor behind the cut in its official GDP forecast. And that was before the latest setback. After both chambers of the German parliament approved the EU recovery plan and was ready for the president to sign-off to complete the process, the German Constitutional Court objected. It wants to first examine claims by the AfD party and a civic group that the Recovery Fund violates EU Treaties. We suspect that the German court will ask the European Court of Justice for an opinion, as it has done previously about whether the ECB had overstepped its authority.
As promised by ECB President Lagarde, the bond-buying program has accelerated. It is not clear how much the buying has risen in the short period since the announcement, but the early reports suggest it is increased by around a third to 20 bln euros a week. However, market participants are confused over the goal. If the goal is to resist curve steepening or widening of spreads between the periphery and core, the bond-buying, then the PEPP can be regarded as successful so far.
The ECB's Chief Economist Lane suggested a different goal, one of driving yields back to levels that prevailed in mid-December, which would be mostly 20-30 bp lower (with Italy closer to 15 bp, and the Dutch closer to 35 bp). This is going to be increasingly difficult to achieve, especially at the current bond-buying pace. This seems to be especially true as US real rates begin to rise.
At first, the rise in nominal US yields appeared to have been primarily driven by inflation expectations. To balance the consensus view that it was about fiscal and monetary policy, we noted the strong historical link between inflation expectations and the oil prices, where OPEC+ reined in supply and demand was still constrained. We also noted that supply chain bottlenecks, like the shortage of semiconductor chips or cargo containers in Asia, were not a function of stimulative policies.
The price of oil doubled from the low set on November 2 to the peak in early. May WTI rallied from $33.65 on November 2 to almost $68 on March 8. Brent for May delivered peaked near $71.40 on the same day after beginning from $35.75 on November 2. However, prices have eased 10%-15% over the past few weeks.
In January, the 10-year breakeven (difference between the conventional and inflation-linked note yields) rose more than nominal yield did (15 vs. 20 bp). However, things began changing. In February, it turned around (34 vs. 5 bp) as yields began rising faster. In March, the nominal yield rise continued to outstrip this measure of inflation expectations (32 bp vs. 11). In aggregate, in Q1, the US nominal yield rose slightly more than 80 bp while inflation expectations rose about 35 bp. This exercise suggests that there has been an increase in US real yields.
The dollar-yen exchange rate is often perceived as sensitive to US interest rates. The correlation of the exchange rate and the US 10-year yield (rolling 60-day) actually was inverse for a relatively prolonged period from late-October 2020 through early February 2020. However, since then, the exchange rate has moved in lockstep with the 10-year yield, and as the second quarter begins, it is near 0.96, the highest in five years.
Japan had some bad luck to start the year. A combination of the virus and the extended emergency in Tokyo and other areas, the earthquake, and fire at a semiconductor chip factory exacerbated the shortage experienced by automakers, point to a contraction in the world's third-largest economy in Q1. A state-of-emergency has been declared for Osaka and a couple of nearby areas. The second quarter ought to be kinder. Last week's Tankan survey showed an improved outlook for large businesses.
Japan reports the February trade and current account figures on April 7. Japan's trade balance has very strong seasonal patterns. Every January for the past 21 years, including this year, Japan sees its trade balance deteriorate (on balance of payment terms). Every February for the last 20 years, Japan reports an improvement in the trade balance. March has shown a more mixed performance, while new deterioration is seen in April (17 of the past 20 years).
Most of the high-frequency data next week may pose headline risks but are unlikely to change underlying views. This is also true of the US trade deficit. However, we suspect it is like a fissure in another otherwise good story. From 2015 through 2017, the US monthly trade deficit mainly was between $35-$45 bln. In 2018 and 2019, the monthly shortfall largely was between $40 and $53 bln. In 2020 it deteriorated markedly. It averaged almost $57 bln in 2020 and more than $66 bln in H2 20. The expected growth differentials alone warn of a dramatic widening of the trade deficit this year. The February shortfall, which will be reported on April 7, may exceed $70 bln for the first time.
China will report March inflation figures, and it looks as if headline CPI will rise out of deflation territory where it has been in three of the four months through February. A 0.3% year-over-year reading would be the highest since last October, helped by rising food prices. Producer prices are rising at an accelerated pace. It had been falling since the middle of 2019 and turned positive on a year-over-year basis in January for the first time. The year-over-year increase in producer prices may have doubled from the 1.7% pace reported in February. On the margins, the end of deflation may allow the PBOC to begin contemplating removing some monetary accommodation, but it is in no hurry.
A strong Canadian employment report on April 9, on the heels of a better than expected January GDP, and growing confidence that it has avoided a contraction in Q1 may boost speculation that the Bank of Canada is almost ready to announce a tapering of its C$4 bln a week of federal bond purchases. The central bank meets on April 21. The Reserve Bank of Australia meets on April 6. Its new A$100 mln bond-buying program will be launched on April 15. The RBA continues to struggle to defend its yield-curve control policy and keep the 3-year yield at 10 bp, but it does not appear prepared to abandon this course. Look for Governor Lowe to stress wage pressure as a critical factor in signaling when less monetary accommodation is needed. That point is not yet been reached. The next employment report is scheduled for early on April 14 in Canberra.