A vaccine can end the health crisis next year but cannot repair the damage that has been done to the labour market.
While the blow to employment was most intense in the US in the first phase of the crisis, the widespread use of short-time week programmes in the Euro area and general lockdowns reducing participation rate have contributed to ‘hide’ unemployment, with the rise in official unemployment rate muted (EC estimates real unemployment rate was 2.7ppt higher in Q2 or 10.5%). The hit to the labour market in the Euro area is now starting to show in H2.
With US unemployment rate meanwhile falling faster than expected, this points to inflation expectations in the US being better anchored than in the Euro area.
The implication is positive in our view for the EUR, with real rate differentials more supportive vs. USD. The boost could be lasting to the extent that such a trend does not signal the Japanification. In other words, markets can look through the sharp cyclical deceleration in Q4/Q1 reflecting the second wave of Covid19 infections and lockdowns and price the attractiveness of Euro area assets in a post-vaccine world.
Such a scenario requires maintaining continued fiscal support and avoiding a return to financial fragmentation. On both counts, signals from the EU and the ECB this week are constructive: EU fiscal rules could be dropped until 2022, national budgets point to a positive fiscal impulse in 2021 again, and the ECB focuses on capping borrowing costs both for the sovereign and private sector. Our proxy for equity flows into the Euro area has stayed supported, suggesting markets look beyond near-term growth headwinds. QE portfolio rebalancing effect has been muted with resident outflows stable and a rate cut remains unlikely in Dec.
More broadly, the USD is left vulnerable to a recovery in the rest of the world, including EM, especially in view of widening US twin deficits and low real rates in 2021.