BlueBay AM: UK Delta peak could renew reflation optimism

BlueBay AM: UK Delta peak could renew reflation optimism

Monetary policy
Corona-virus (05)

By Mark Dowding, CIO at BlueBay Asset Management

Government bond yields continued to fall sharply at the beginning of the week, in the wake of concerns that a building wave of Covid infections could depress the growth outlook in the months ahead. The Delta variant has been responsible for a sharp uptick in cases globally and has seen restrictions imposed in a number of countries. 

However, it has been interesting to observe the pattern in the UK, which has been one of the first countries to be hit by the ‘Delta wave’. Here, high levels of vaccinations have been suppressing serious illness and mortality. Consequently, the UK authorities have continued to ease constraints on activity and it is beginning to appear as if the pace of infections may now be starting to peak. 

If this trend can be confirmed over the next few weeks, there may be renewed optimism in vaccines doing their job. This in turn could refuel hope of a reflationary theme – in countries with high levels of vaccination, at least. Countries which lag behind with respect to vaccine rollouts are unlikely to be able to afford too much complacency.

It has been interesting to observe Australia heading into lockdown for what may be several months, as it comes to appreciate the flaws in trying to maintain a rigid zero-Covid policy, in preference to prioritising vaccine roll-out.

US

In the US, there has been relatively little economic data in the past week. Growth concerns saw a flight to quality, though this proved to be short-lived. Robust equity earnings have pushed indices close to their highs and it seems that investor sentiment remains largely constructive. 

In Washington, relations within Congress appeared to sour, with efforts towards a bipartisan infrastructure bill seeming to run into the buffers. However, we believe that the Democrats may end up rolling more measures through a budget reconciliation process, in which only a simple majority in the Senate will be required.

Consequently, the outlook for further fiscal stimulus remains intact. Meanwhile, fractious discussions around the debt ceiling may make a few headlines but we would doubt these will have a material or lasting impact.             

Europe

The ECB meeting provided the highlight of the week within Europe. Following its policy review, it will target 2% inflation on a symmetric basis, inferring a somewhat more dovish framework for future policy decisions. In this context, inflation targeting may require additional monetary stimulus via asset purchases within the context of the APP programme. 

At the same time, once the pandemic passes, so PEPP purchases will be reduced, though the net result may be that aggregate bond purchases remain close to current levels for some time to come – at least up until the point where the output gap has been closed and the risk of a future downside miss on inflation has been mitigated. 

This policy stance remains broadly supportive for Bunds and eurozone spreads, but with valuations already quite compressed, we may witness further rangebound markets in the bloc.

UK

By contrast, should the UK prove the first major economy to ride out the Delta wave, there may be more of a case for monetary policy to turn hawkish ahead of the ECB. Although the UK continues to lag well behind the US in the context of the recovery, sentiment has scope to strengthen if virus worries pass.

Uncertain trajectories

Elsewhere, we would continue to highlight the disparity between rich and poor countries, where vaccination rates are much more depressed. In such situations, it appears likely that policymakers will need to be quite restrictive in their attempts to limit the spread of infections to mitigate the risk of a public health crisis.

Meanwhile, with rich countries likely to start administering booster jabs in the months ahead, it isn’t clear whether vaccines will be available to all countries as quickly as may be hoped for.

This landscape continues to point to divergent trends between a number of countries, which should lead to opportunities between markets and currencies. 

Having seen Treasuries recoup a large share of their losses from earlier in 2021, there is a sense that we are back to where we were in January – but in the US, we are starting from a point where vaccination has been broadly successful, the economy has re-opened, GDP has surpassed 2019 levels and inflation is running at a 30-year high. 

In this context, it has been a painful period to be bearish on US rates, but there is little reason to adopt a more cautious macroeconomic view on the majority of developed markets. Next week’s Federal Reserve meeting will be closely watched, given the volatility that was triggered in the wake of the June FOMC. Having recently heard from Fed speakers, it seems likely that Powell will want to continue to push a message that policy changes remain a ‘ways away’. 

However, it appears that Fed rhetoric is growing a little more concerned with respect to inflation. In speaking with US policymakers, there has also been considerable confusion at the trajectory of Treasury yields over the past few weeks, which appear to strike many as counterintuitive. 

Nevertheless, a more substantive revision in Fed thinking will be contingent on stronger labour market data and in this context, the next two payroll reports should be a closer guide to the Fed’s thinking, once we approach what we believe could be more of a ‘live’ Fed meeting in September.

Credit & FX

Elsewhere, credit spreads tracked moves in equities and other risk assets but remain broadly stable. In FX, the US dollar has managed to push firmer versus the euro. Covid fears saw the Australian dollar under pressure while a flight to quality impaired the outlook for EM FX, broadly speaking. 

Looking ahead

It appears we are in a choppy market environment in which it is challenging to predict the overall direction from day to day or week to week. However, looking further ahead it seems easier to discern the direction of travel for the global economy, policy and markets. 

For now though, we are riding the waves but retain the conviction that as long as we can pass the crest of Delta variant concerns, so the outlook should see smoother sailing ahead in the coming weeks. 

Short-term turbulence can produce a sense of seasickness, though for those who have seen this play out many times before, there is a sense that what we are seeing isn’t totally out of the ordinary, even if these do remain exceptional times.