Ahead of the Curve | Friday, 25th June 2021

Curve flattening post hawkish Fed meeting – but fundamentals to point to higher yields.
There was a powerful move in global markets in the days following the June FOMC meeting, with US policy rate expectations moving up and long-term yields moving lower, resulting in a rather significant flattening of the yield curve. This had reverberations across markets, with many “reflation” trades selling off as inflation breakevens moved lower on the perceived policy error. This makes some sense as there was a strongly held view in the market that the Fed was going to let the economy and inflation run “hot” by being unreactive to higher inflation prints. The presumed hawkish pivot by Powell at the last FOMC meeting undercut this view and as a result, bets on inflation getting out of control were pared back. In our view, the moves have been exacerbated by rather stretched positioning with many macro investors caught offsides by betting on a continued steepening of the curve. However, we are unconvinced the Fed has made a meaningful pivot, and note that several Fed speakers (including Chairman Powell) have spoken since the meeting with a broad-based message of the need for continued substantial accommodation. Stepping back, in 1Q21, US GDP was +11% on a nominal basis, and will likely be +15% in 2Q. Core inflation is running in the mid-single digits. Even as these post-pandemic rates of growth and inflation start to subside, they are not at all consistent with nominal interest rates in the 1.5% range. Simply put, we think real and nominal rates are too low and would expect yields to have an upward bias. Crowded short positioning might offset this in the near term but fundamentals should ultimately win out. Perhaps more compelling is the case for higher interest rates in Europe, where on a FX-hedged basis, bund yields are near two-decade lows relative to US Treasury yields. If US rates are set to move higher over the medium term, it is very likely that European rates are, too.

Selloff in global banks – despite greater likelihood of rake hikes sooner.
Banks sold off globally in the aftermath of the FOMC meeting. This is perhaps surprising given the Fed’s pivot was deemed to be hawkish (normally considered a positive for banks), but the banks were caught in the selloff across reflation assets as inflation expectations moved lower. Essentially, while the perceived hawkish move would theoretically be positive for bank earnings (via higher short term rates), this benefit was more than offset by the negative impact on the earnings’ multiple (which tends to decline on a flattening yield curve). However, we would make a couple points. First, while the last Fed taper did cause a flatter curve, the assumption that a flatter curve means lower bank stocks does not necessarily hold up. The US 2/30 curve plummeted from 300 to 50 bps as the Fed tapered (and subsequently hiked) from 2014 to 2018 and the US bank index surged from 70 to 110. Second, while we believe it is far too early to conclude the reflation rally is over (see above), there is much more to like about bank equities than sensitivity to a steeper curve. Significant capital returns, an accelerating earnings upgrade cycle, a nascent M&A cycle, and historically low valuations are all key micro tailwinds which provide a strong fundamental backdrop for European bank equities in the next couple of years.

Economic data accelerating in Europe – strong Q2 to be followed by stronger Q3.
The composite PMI in the Eurozone surged to 59.2 in June – a 15-year high – up from 57.1 in May and beating consensus of 58.8. Demand continues to improve across the board as vaccines are rolled out and economic restrictions lifted. Firms also reported the highest level of new orders in 15 years, and the confidence in the outlook reached a record high. The supply side is still struggling to cope with this surge in demand – backlogs increased at the fastest pace on record along with a sharp increase in uncompleted orders and running down of inventories. As a result firms reported higher supplier prices along with rising wage pressures, and output prices rose at their fastest pace on record. We believe this points to rising inflation above expectations across the Eurozone in the coming months – a sharp divergence from the experience of the past decade – with potential implications for European rates markets which currently expect the disinflationary environment of the last decade to persist indefinitely.