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Too Much of a Good Thing is a Bad Thing

USD: Expectations of a rapid US economic recovery and even overheating, once the lockdown restrictions are eased, have been driving US treasury yields and global bond yields higher. The bond vigilantes’ argument is fairly simple. Congressional Budget Office estimates the current US output gap to be c.3% of GDP and the Biden administration is trying to pass through US Congress a fiscal package of c.9% of GDP. This comes on the back of the December stimulus of c.3% of GDP that has already led to a blowout retail sales print in January. Also boosting the yield rally is growing government bond supply as well as the rebound of global commodity prices. Moreover, the USD weakness persists and fuels the commodity price rally as investors that, with may sectors of the US economy still shut down, any fiscal stimulus would only aggravate the US trade deficit and hurt the USD. For today, US data in the form of personal spending and the PCE deflator shouldn’t necessarily upset the bond market. Yet we fear we are in a fragile window for asset markets, where a continuation of this correction can drive the dollar broadly stronger. We cannot rule out, say, a further 2% advance in the DXY, but would still see this is a bear market bounce.

CAD: Could remain supported especially if market expectations of a fairly aggressive growth rebound in 2021 and thus a BoC QE taper materialize. That said, we also believe that the recent CAD rally has captured most of these positives already. We further note that some important downside for the currency lingers like the green energy policies, a more persistent negative impact from Covid on the global demand for fuel and a potential thawing of the relationship between the US and Iran, all of which could undermine the longer-term outlook for oil prices and thus the outlook for the CAD. In all, we upgrade our outlook for the CAD but see fairly limited upside for the currency this year with any more meaningful gains likely to come in 2022.

EUR: The early rise in European debt yields is being resisted by ECB speakers as an unwarranted tightening of financial conditions. This puts the focus fairly and squarely on Monday’s report of ECB PEPP activity, where a dramatic step-up in buying will be needed to be seen to avoid a further bond sell-off. We expect EUR/USD higher over the medium term to range between 1.20-1.25. Look out for a speech from ECB’s Schnabel.

GBP: This looks to be another bull market correction in Cable and would suspect buyers return anywhere near the 1.38 area. In effect, recovery hopes expressed in the bond market aren’t going to kill the recovery.

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