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Prospect of a Vaccine Signals a New Game is Afoot

Summary:
Pfizer's extraordinary results on developing a vaccine for Covid-19 has injected a new factor into the investment climate, even as many countries around the world continue to wrestle with a new and powerful spread of the virus.  In the US equity market, a rotation, which may have been underway previously, gained ground.  It can be illustrated by the fact that the FAANG-driven NASDAQ trailed the other major benchmarks, including the Russell 2000.  European and Japanese equities extended rallies and outperformed the US handily.  Investors had previously discounted negative interest rates in the UK and New Zealand but no longer does.  The respective currencies were among the best performing major currencies last week.  On the other hand, the safe-haven appeal of the Japanese yen and Swiss

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Prospect of a Vaccine Signals a New Game is Afoot

Pfizer's extraordinary results on developing a vaccine for Covid-19 has injected a new factor into the investment climate, even as many countries around the world continue to wrestle with a new and powerful spread of the virus.  In the US equity market, a rotation, which may have been underway previously, gained ground.  It can be illustrated by the fact that the FAANG-driven NASDAQ trailed the other major benchmarks, including the Russell 2000.  European and Japanese equities extended rallies and outperformed the US handily.  

Investors had previously discounted negative interest rates in the UK and New Zealand but no longer does.  The respective currencies were among the best performing major currencies last week.  On the other hand, the safe-haven appeal of the Japanese yen and Swiss franc dimmed, and both underperformed. 

The surging virus renders much of incoming high-frequency data a bit dated now.  The risk of a new contraction after a powerful rebound in Q3 looks more likely in Europe than the US.  Europe's new lockdowns, curfews, and social restrictions seem more severe than in the US, where all 50 states were seeing increased cases at the end of last week, and some areas have not spare hospital capacity.  That said, important data from the US, including the October employment report and the expected bounce back in October industrial output after a 0.6% decline in September, suggests a solid start to Q4.  

Still, there is no way that Q4 US GDP can be anywhere close to the record 33% annualized surge of economic activity in Q3.  Consumption drives around 70% of the US economy, and retail sales account for around 40% of consumption.  It is here that the slowdown will be more evident.  The median forecast in the Bloomberg projects a 0.5% increase in October after averaging 1.1% in Q3.  More Americans are working, and on average, working a little longer and getting paid a little more.  That should underpin consumption.  Retail sales rose by an average of 0.5% in 2019.  Forecasts for Q4 growth are coming around 3-4%.  

Although the world is watching the political drama unfold as President Trump exhausts his legal options resisting what now seems inevitable, the focus is on the virus and vaccine.  New safety data from Pfizer is expected next week, which is need to seek emergency approval.  An update on Moderna's vaccine may be provided in the coming days.   It relies on the same novel technology as Pfizer, which uses messenger RNA to spur one's body to create the proteins that produce the virus's antibodies. 

It is still common to see references to the "Japanification" of the US or Europe, which generally means slow growth and low inflation and low-interest rates.  Yet, the "secular stagnation" that Japan arguably is experiencing is taking place as the population shrinks.  Japan's per capita GDP has fared better than many other high-income countries.  It was also the European Central Bank that was the first to introduce negative interest rates (June 2014 vs. January 2016 for the BOJ). 

The BOJ did innovate and introduced yield curve control, but so far, only Australia has implemented its own version.  Rather than target the 10-year yield as BOJ does, the RBA targets the three-year bond yield.  The BOJ innovated again last week and illustrated how monetary policy can be used despite claims that there is nothing else it can do.  To strengthen banks' intermediary function, especially small and regional banks, the BOJ offered to pay 10 bp on the part of the reserves held at the central bank. The offer was conditional on the bank committing to a major structuring of its overhead or merge with another.  The facility will last through March 2022.  

Japan's new Prime Minister Suga has been candid with his assessment that Japan is over-banked.  The shrinking population, low-interest-rate environment for a quarter of a century, and now the pandemic has squeezed the regional banks.  There will be a couple of legal/regulatory inducements.  First, a law is expected to be approved in the next few weeks that exempts banks from anti-competitive measures.  Second, regional banks that do not use the new facility could be subject to an inquiry by the Financial Services Agency about the bank's viability.  

This initial effort to facilitate consolidation may encourage cost-cutting and the streamlining of existing operations.  However, the inducement for mergers and acquisitions seems too small and temporary to generate much activity.  The BOJ estimates that if all the banks participated, the cost could reach JPY50 bln (~$475 mln).  The implication that monetary instruments can be used more creatively to strengthen intermediation, the transmission mechanism of monetary policy, is a worthy addition to the playbook.    

In the US, the Federal Reserve may lose authorization for some or all emergency facilities launched in March and April rather than take new measures.  The 2008-2009 financial crisis reforms legislated a role for Congress and the US Treasury in establishing emergency facilities.  The facilities initially were to be in place through September. Well ahead of the termination, the Treasury and the Federal Reserve agreed to extend the programs until the end of the year.  Treasury Secretary Mnuchin appears to be balking at authorizing a further extension, even though that is what Fed officials have been advocating. 

Most of the pushback is on the facility that can buy state and local government debt.  It has not been used very much.  In fact, it appears that the Fed has bought two securities for a total of around $1.65 bln.   One issuer was the state of Illinois, and the other was NY's Metropolitan Transportation Authority. Still, the US Treasury notified Congress in mid-October that it does not believe the facility is needed after the end of the year.  Some Senators, noting that the markets were functioning normally, express some concern that the facility could be used as a backdoor way to aid city and state in lieu of fiscal support.  Aid to state and local governments has been a sticking point in stimulus negotiations.  

Some of the same arguments can apply to other facilities the Fed launched with Treasury's support and funded by the Cares Act.  The markets are functioning well, and that the facilities are not needed is supported by reference to their use.  Still, the Federal Reserve has defended them and seeks an extension before a vaccine is available. Its arguments invoke prudence and the signaling impact,  as aptly illustrated by the market reaction to the corporate bond facility's announcement, which also has been barely used.  

That said, the Treasury Department seems more sympathetic to extending the Main Street lending facility.   A legal issue may at stakeThe decision to extend one or more facilities past the end of the year may require congressional approval.  That is the argument put forth by some Senators.  

The ECB has the opposite problem.   Its purchases of bonds, which some estimate to be larger than the net new issuance next year (issuance minus interest payments and maturities), may be so successful that some countries may be reluctant to access EU funds if there are conditions attached.   Indeed, the much-heralded Recovery Fund embedded in the EU's budget faces the risk of veto by Hungary and/or Poland. In Japan, the government and the central bank are pulling in the same direction.  In the US, space has opened between the Federal Reserve, who is advocating more fiscal stimulus and an extension of its facilities, and the legislative branch, which was stalemated ahead of the election. . In Europe, the ECB's bond purchases may offer an alternative to the conditionality.

Since the end of February, the ECB's balance sheet has risen by almost 45% to around 6.80 trillion euros as of November 6.  It is near 62% of GDP, up from 39% at the end of last year.  The Fed's balance sheet has increased by about 72.5% to $7.175 trillion as of November 11.  It was less than 20% of GDP at the end of last year and now is closer to 34%.  In comparison, the BOJ's balance sheet stood at 133% of GDP at the end of October.  It was 103.5% of GDP at the end of last year.  

The most interesting central banks next week, though, will not be the ECB, the Fed, or the BOJ.  The People's Bank of China (PBOC) and the Central Bank of the Republic of Turkey (CBRT) are important even if one does not have direct exposure to either.  The Deputy Governor of the PBOC has warned that it will be exiting some easing measures, and it is just a matter of time.  In addition, a large funding shortage has spurred a surge in money market rates, some of which were at their highest levels since January last week.  Policy loans are maturing this month, and banks face other debt repayments and the need to buy government bonds by the end of the year. 

The  PBOC injected CNY160 bln in the banking system through seven-day repo agreements before the weekend, which is the most in over a month.  The PBOC's medium-term lending facility (MLF) is the focus now.  The PBOC will inject funds through the facility on Monday.   There are roughly CNY600 bln of MLF loans coming due this month and the same amount next month.  Anything less than a CNY400 bln-CNY600 bln injection on Monday may be regarded as stingy by participants, and the pressure on money market rates could increase again.  China is seen as the first to likely exit the emergency programs, and it could impact others.  Foreign portfolio flows into China are increasingly seen to come at the expense of other emerging market economies.  An early move by the PBOC would also likely encourage a stronger yuan.  

Turkey has a new central bank governor and a new treasury minister.  President Erdogan has signaled a monetary regime change.   Recall that CBRT cut rates aggressive from 12% at the end of last year to 8.25% by May.  Despite the currency's depreciation, the loss of reserves,  and higher inflation, officials under pressure from the president did not raise rates repo rate until September.  It did tighten other lending facilities, but like last month, investors' confidence was not won back.   

The CBRT will set the one-week repo rate on November 19. The median estimate in the Bloomberg survey sees a 4.75% hike to 15%.   There is a great dispersion of survey responses.  There is a cluster around 14.00%-14.25% and another cluster of forecasts around 15.00%-15.25%.  There is only one forecast for an unchanged rate.  We suspect that anything less than 300 bp will disappoint the market, which now expects the CBRT Governor Agbal to lead in a more orthodox fashion.   It appears that the new Elvan, the new treasury, and finance minister, who replaced Erdogan's son-in-law, was approved by Agbal.  

The Turkish lira jumped nearly 11% last week, paring this year's loss to about 22.5% year-to-date, leaving Brazil real (-26.3%) and the Argentine peso (-24.9%) at the bottom of the EM currency table. We note that late last week, in the face of a jump in inflation (3.8% month-over-month and 37.2% year-over-year), Argentina's central bank hiked rates, including the Leliq by 200 bp to 38%, and the peso's depreciation accelerated ahead of the weekend.   The takeaway may be that the credibility of policy, broadly understood, maybe as important as the substance.  


  Disclaimer


Marc Chandler
He has been covering the global capital markets in one fashion or another for more than 30 years, working at economic consulting firms and global investment banks. After 14 years as the global head of currency strategy for Brown Brothers Harriman, Chandler joined Bannockburn Global Forex, as a managing partner and chief markets strategist as of October 1, 2018.

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