Drowning in Dollars: Can Markets Stay Afloat?

Northern Trust Asset Management Monthly Market Commentary for February 2021

Eurozone Market Update

Euro markets saw a relatively mundane month with the front end remaining anchored, as investor outflows across the industry meant there was little movement from a yield perspective. The mid to long term part of core-Euro Sovereign curves moved up 10-30bps month-over-month.

The ECB signalled a divergence to the BoE and Fed on the recent sell-off in rates with ECB President Lagarde and members Schnabel and Lane providing gentle pushback against the move in long end yields and the negative impact it could have on the economic recovery through higher financing conditions.

The market reacted positively to Mario Draghi, the former ECB President, becoming the Prime Minister of Italy. It is expected he will play a critical role in further strengthening the integration of the EU.

UK Market Update

As expected, the Monetary Policy Committee (MPC) made no policy changes. While firms were asked to prepare to handle a negative Bank Rate at any point after six months, the MPC stated this should not be seen as a signal that negative rates are on their way. The Sonia curve then steepened with zero cuts priced in for 2021, while money market fund yields moved slightly higher. UK Gilts joined the global sovereign debt sell off with yields up 20-60bps across the curve.

The Government announced a road-map to open the economy after a successful vaccine roll out. The BoE projects economic activity and inflation to pick up quickly in the second half of the year as a result.

US Market Update

There is an abundance of excess dollar liquidity, caused by an increase in demand and decrease in bill supply. February's Treasury Refunding Announcement included the termination of two Cash Management Bill tenors used since 2Q20, reducing bill supply, while money market funds continued to experience inflows. Meanwhile the Treasury must get cash on hand down as low as ~$130bn by July 30^th  unless the debt ceiling is resolved – currently ~$1.6 Trillion is sitting in the Treasury General Account following the 2020 fiscal stimulus, adding to excess liquidity. In the credit sector, demand continues to outstrip supply.  Fixed bank paper is still relatively in line with last month’s levels, however floating rate securities began to cheapen. Long end Treasury yields continued higher, with 10Yr closing 35bp higher (see Chart of the Month) and the 5Yr/30Yr spread steepening to its highest levels since 2014.

Global Outlook

Excess dollar liquidity will continue to drive front end markets in the coming months.  We continue to believe the Fed will step in to prop up front end rates should funds fall too low. We do not anticipate the Fed will be proactive, but do expect they will intervene if funds reach 5bps or lower for a period of time. To prevent losing control of long end yields, Central Banks are more likely to talk down the rapid moves we have been seeing (see chart of the month) especially if markets begins to price in rate hikes sooner than they have communicated. At the end of February there was an 80% probability of a rate hike from the Fed by the end of 2022, and by the end of 2023, over three hikes were priced into the market. We will be closely watching this evolving market dynamic as well as communication from the ECB, Fed and BoE at their mid-March meetings.

Chart of the Month

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