The tension between optimism about the medium-term outlook once the health crisis is over and the downside risks to near-term activity remains a key theme for markets. Central banks are expected to help bridge the gap by creating fiscal space and accommodating the recovery.
Flash PMI reports in January both for the Euro area or the US have confirmed elevated business optimism for the next 12 months, arising from vaccination prospects. Yet the gap between GDP growth expectations in the US and the Euro area is widening for Q1: extension or tightening of restrictions on mobility in the Euro area will likely lead to contraction of activity whereas US growth should be supported by some additional fiscal support. Relative economic surprises or relative PMI surveys point to upside risks to the USD vs. EUR. The relationship with relative OECD composite leading indicators also makes a positive cyclical case for the USD. (see charts 1-3)
But currency pairs are driven by a critical combination of economic fundamentals, which may vary depending on the environment, rather than by one unique factor taken in isolation. In the current circumstances, we expect the Fed to accommodate fiscal expansion, thereby gaining traction with its goal of moderate inflation overshoot. Contrary to the Fed, the ECB has yet to unveil a strategy to lift inflation over the medium term. In turn, higher inflation expectations are likely to undermine the USD, including vs. EUR. amid widening US twin deficits. The contrast in inflation forecasts as of Dec 2020 between the Fed and the ECB highlights that point and in turn shapes market inflation expectations, with the Fed gaining much more traction with its goal (see charts 4-5) than the ECB. Of course such a Japanification of the Euro area can only persist as a support for EUR if financial fragmentation risks within EMU remain low (as currently is the case thanks to both the EU Recovery Fund, ECB PEPP and TLTROs) and a subdued but positive growth outlook is maintained (which is kept alive by the vaccine roll-out and fiscal support for the recovery both at national and EU levels instead of a premature return to fiscal consolidation as happened after GFC).
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Picture: European Central Bank (ECB) President Christine Lagarde, in Frankfurt, Germany, March 12, 2020. Kai Pfaffenbach | Reuters