Powell’s Curve

Key points

• COP26: rendez-vous in Sharm El-Sheikh.
• For all the volatility in the US bond market, the Federal Reserve (Fed) is retaining its credibility. This is one of the reasons why Biden should re-appoint Powell.
• Watch the new Covid flare-up in Europe, as well as the EU’s Eastern border.

COP26 left a lot of “unfinished business” and governments are now requested to produce new Nationally Defined Contributions to decarbonization, with a focus on 2030, by the next COP in Sharm El-Sheikh at the end of next year. Optimists will probably choose to focus on the fact that finally, fossil fuels and particularly coal are now explicitly targeted, but the contorted wording leaves a lot of room for interpretation. Yes, the general “direction of travel” is clearer, but attention should shift from “big international events” to closely monitoring implementation country by country.

For all the volatility of the last few weeks, we think a clear narrative is emerging from the US bond market. Investors believe the Fed will be forced into an “early rate lift-off” – that’s the reading from 2-year yields - but judging by market-based inflation expectations, they also think this will be enough to avoid a persistent shift in the inflation regime above the Fed target. This explains as well why the 10 to 30-year segment of the curve has tightened these last few weeks. At the same time, judging by the strong showing of the equity market, investors don’t believe pre-emptive rate hikes by the Fed would cost much in terms of economic growth. In other words, the Fed remains fully credible. As much as we think the market is both too aggressive in its pricing of the Fed and too sanguine about the possibility of a “bloodless monetary tightening”, the Fed’s credibility is one of the reasons why we believe it is strongly in Joe Biden’s interest to re-appoint Jay Powell. Replacing him with a “true dove” would probably trigger a further drift in long-term interest which would be detrimental to the US government’s borrowing costs, while stoking inflation fears in the population would not do much to help Biden’s shaky polls.   Meanwhile, the European Central Bank (ECB) is not demonstrating such a strong grip on the market, and the “mood music” coming from the hawks is being noticed by the market.

While the ECB is mulling its December announcements, the new flare-up of the pandemic in the North of the Euro area could alter slightly the short-term macro outlook.  While we think that the response will be more conversion to the “Franco-Italian model” (strict enforcement of sanitary passes), which would avoid far-reaching and economically destructive lockdowns, some impact on consumption can emerge as worried households would self-restrain on their spending in the most affected areas. We also need to keep an eye on developments on the eastern European Union (EU) border, even though the latest statements by V. Putin have been reassuring.