It may have to hurt
The Senate passed the fiscal stimulus bill with little concession from Biden. This is likely to lift US long-term rates further, while the Fed remains silent on that front. It would probably take some turmoil on the equity and credit markets to shift the Fed. Conversely, we expect the European Central Bank (ECB) to stand against contagion from the US, with an explicit acceleration in the pace of Pandemic Emergency Purchase Programme (PEPP) to be announced on Thursday, while refraining from triggering the “nuclear options” (raising the PEPP’s envelope or cutting the depo rate again).
Joe Biden managed to get his emergency stimulus plan through the Senate with minimal concessions on the substance of the fiscal measures. While the Democrats had to accept the removal of the minimum wage hike from the bill, the overall quantum of government spending and tax relief is landing very close to their opening gambit. Assuming – as is very likely – the House endorses the Senate version of the bill on Tuesday, the whole process has been swift. The fiscal push will magnify what is shaping up to be a spectacular post-lockdown recovery anyway, given the good progress on the pandemic front in the US. It may not have much impact beyond the end of this year and dealing with “scarring” would be better done via an investment plan for the long-haul which may have become a tough sell. Indeed, the ongoing rebound in market interest rates is making it more difficult to argue the big infrastructure programme would “pay for itself”.
The Fed still does not want to stand in the way of the bond market re-pricing. We suspect many Fed officials believe in a “hump shape” recovery. Once the impact of the fiscal push fades, the economy would start to slow down as 2022 would get in sight, reducing the risk of a lasting surge in inflation. If this scenario turns out right, then the bond market is “wrong” and the ongoing tightening in financial conditions is merely a “bad moment” which will stop spontaneously. It would thus make little sense for the Fed to waste a policy bullet with an operation twist now. The risk is that, left to its own device, the market goes “too far, too quickly”, resulting in an excessive tightening in financial conditions which would smother the recovery after the short stimulus-induced overheating episode. Still, there probably is no “free option”: it’s unlikely that the market can get Fed action – in the form of operation Twist – without first some turmoil on risky assets. In the meantime, if risky markets continue to focus on the improving macro outlook, US long-term rates will continue to rise.
On the other side of the Atlantic, the ECB press conference will focus on how to avoid contagion from the US. We expect the central bank to refrain from using the “nuclear options” (raising the PEPP quantum, cutting the depo rate further), choosing instead to be more explicit in the prepared statement about the need to accelerate PEPP purchases in the current circumstances. The verbal pledge is likely to be strengthened by the publication of data later today reporting, after last week’s negative surprise, an actual rise in the buying pace.