Currencies

Highlights Currency markets remain vulnerable to the upcoming US election, Brexit, and a resurgence of Covid-19 infections. Meanwhile, President’s Trump suggested “piecemeal” fiscal deal increases the odds of a correction in the near term. Stay short USD/JPY as a core holding. We eventually expect the passage of a fiscal deal, regardless of who is in the White House. This will favor pro-cyclical trades. CAD/USD is likely to continue strengthening versus the dollar, but underperforming at the crosses. The key reason is that, in the short term, even with an oil price recovery, Canadian crude will remain trapped in Alberta, keeping the WCS-to-WTI discount wide. Meanwhile, domestically, while the Canadian economy has bottomed, a resurgence in new Covid-19 cases puts this recovery at risk. We therefore expect the loonie to touch 80-82 cents but underperform the Australian dollar, Swedish krona, and Norwegian krone. Go short CAD/NOK for a trade. Feature Chart I-1The CAD Has Been A Laggard Since the DXY index peaked on March 19, the Canadian dollar has been an underperformer. Among its G10 peers, only the safe-haven currencies such as the Swiss franc and Japanese yen trail behind the loonie. This is remarkable since other commodity currencies such as the Norwegian krone and Australian dollar have posted very handsome returns since the March lows (Chart I-1). The natural question is whether the loonie’s underperformance is a sign of mispricing, or if other fundamental factors are at play? If the latter, then what are the key drivers of this underperformance and what sort of returns can we expect from the loonie over the next six to 12 months? Finally, are there any opportunities at the crosses that investors can capitalize on? The Loonie: Key Drivers The key drivers of the Canadian dollar are what happens to natural resource prices, specifically crude oil, and the Bank of Canada’s monetary policy stance relative to the Federal Reserve. As a major oil-producing nation, it is well known that an important driver of the loonie has been the price of crude oil. This is because rising domestic income from higher oil prices boosts aggregate demand. This comes both from the private sector through increased capital spending, more hiring and increased wages, and from government spending afforded by higher tax revenues and royalty income. As a result, the higher aggregate demand provides room for the BoC to hike interest rates. As a major oil-producing nation, it is well known that an important driver of the loonie has been the price of crude oil. Meanwhile, an increase in oil prices also implies rising terms of trade. This improves balance-of-payment dynamics, allowing the fair value of the exchange rate to rise in the process. As such, the rise in the currency does not necessarily tighten financial conditions. It is quite remarkable that for most of the last two decades, the difference between Canadian and US interest rates can be explained by swings in the oil price. This in turn has been a powerful driver of the Canadian dollar (Chart I-2). Chart I-2Policy Rates Follow The Oil price Chart I-3A Significant Resource Sector In Canada This should not come as a surprise. As a share of GDP, resources account for almost 20% of the Canadian economy (Chart I-3). The share of commodity exports is also a quite significant at 23%. While the share of services in the economy has risen, much of this is in the orbit of mining and oil and gas extraction support services. In a nutshell, the Canadian economy remains a resource-based one, making the outlook for resources, specifically crude oil, an important consideration. Where To Next For Canadian Crude? The oil industry has been hit by multiple tectonic shocks, including a sudden stop in economic activity, a fallout from the OPEC cartel, divestment from ESG funds, and falling oil intensity in many economies. Just over a decade ago, the price of crude oil was firmly above $100 per barrel. Fast forward to today and many blends are trading south of $45 per barrel (Chart I-4). Chart I-4Many Blends Are Trading Below Going forward, the path for oil prices will be highly dependent on the interplay between demand and supply. Oil demand tends to follow the ebbs and flows of the business cycle, with over 60% of global petroleum consumed by the transportation sector. As a result, crude oil prices have largely tracked Apple mobility data (Chart I-5). Many countries are now entering renewed restrictions due to the second wave of the pandemic, which is showing up in a slowdown in traffic. However, as we discussed last week, the economic effects should be far less lethal that what we experienced in the first half of this year. The reasons include the potential for a vaccine soon and a substantial drop in mortality rates. Our commodity strategists expect oil prices to average $65 per barrel next year, much more than is currently priced in the futures curve. Crude oil prices have largely tracked Apple mobility trends data.  From a bird’s-eye view, oil prices are more likely to enter a broad trading range, as they did in the ‘80s and ‘90s, than a structural bull market. On the positive side, we have probably seen a bottom in oil prices, in that it is unlikely we will revisit negative price territory. However, history suggests that it takes quite a long time for excesses to clear in the oil market. The bull market of the 1970s was followed by a 20-year bear market, as OPEC production surged (Chart I-6). This time around, US shale production has gained significant market share, and with the electrification of the modern economy, a lot of barrels may need to be taken off the market to induce a genuine bull market. Chart I-5Oil Prices Have Tracked The Recovery In Traffic Chart I-6A Secular View On ##br##Oil Prices Canadian players suffer from two additional hiccups: First, the International Maritime Organization has introduced new standards for bunker fuel since January 2020 (IMO 2020). According to the new standards, sulphur content must be cut from 3.5% to 0.5%. Canada’s Western Canadian Select (WCS) blend is one of the world’s heavier crudes with a sulphur content north of 3.5%. This is expected to significantly widen the discount between WCS and light sweet crude. This is bad news for Canadian oil producers. Second, pipeline capacity remains a major hurdle to getting Canadian crude to US refineries. This leads to a transportation discount for Canadian crude oil. The Enbridge Line 3 replacement is facing delays from the state of Minnesota (390K additional barrels). The future of the Keystone XL pipeline, a major release valve for Canadian oil (830K barrels a day in capacity), rests on the US election. Former Vice President Joe Biden has opposed the project, calling Alberta’s oil “tar sands that we don’t need.” The Trans Mountain Expansion project (690K additional barrels), connecting Alberta to the Westridge Marine Terminal and Chevron refinery in Burnaby, is slated to be competed only by the end of 2022. All this could widen the discount between WCS and WTI crude oil, hurting the Canadian dollar in the process (Chart I-7). There are offsetting factors. The drop in Venezuelan oil production has allowed Canadian producers to gain market share in the heavy crude oil market. Production cuts in Alberta have also helped mitigate the oversupply of heavy crude. Canadian oil exports are near record highs, despite the fact that the US is rapidly becoming energy independent (Chart I-8). As a share of imports, Canadian crude represents about half of the US’s intake (Chart I-9). This highlights the importance of heavy crude in oil market dynamics. Specifically, a lot of refining capacity in the US has been fine-tuned to handle the cheaper but heavier blend from Canada. Chart I-7Canadian Oil Discount Could Widen Chart I-8Big US Demand For Canadian Oil Chart I-9Big US Demand For Canadian Oil Netting it all out, we will expect crude oil prices to head to $65 per barrel, while the Canadian discount to widens to $20 per barrel before slowly recovering. This should provide modest upside for the Canadian dollar as terms of trade continue to improve. A Regime Shift Chart I-10Oil Production: US Versus Canada There has been a paradigm shift in oil production, with US shale producers aggressively grabbing market share from both OPEC and non-OPEC producers. Currently, Canada produces only 5.5% of global crude versus 15% for US production. Admittedly, the Canadian market share has also been rising, but the tectonic shift in US production has severely dampened the positive correlation between crude prices and the loonie (Chart I-10). In statistical terms, petrocurrencies had a near-perfect positive correlation with oil around 2010 when US production was about to take off. Since then, that correlation fell from around 0.9 to about 0.2 (Chart I-11). The loss of shale output during the recent downturn has somewhat re-established a strong correlation between petrocurrencies and the crude oil price (bottom panel). But more importantly, should global demand pick up, US shale output will rise again and redistribute market share away from both OPEC and other non-OPEC members and towards the US. Chart I-11Negative Correlation Between Petrocurrencies And Crude Oil Restored Take the Mexican peso as an example. Since 2013, Mexico has become a net importer of oil, as the US moves towards becoming a net exporter. This explains why the positive correlation between the peso and oil prices has weakened significantly in recent years. Put another way, rising oil prices benefit US domestic income much more than they did in the past, while the benefits for countries like Canada and Mexico are slowly fading. The Canadian crude market share has been rising, but the tectonic shift in US production has severely dampened the positive correlation between crude prices and the loonie.  The second seismic shift in oil markets has been the ESG wave. With awareness towards global warming and climate change gaining mainstream support, divestments from energy assets has picked up steam. Currency markets react to net portfolio flows, and divestments from the energy sector in particular and the commodity sector in general have been behind the huge underperformance of the Canadian dollar since 2011 (Chart I-12). Chart I-12Huge Underperformance Of Canadian Equities The good news is that a lot has already been priced in. First, global energy stocks have been in a 12-year bear market in relative performance terms. This represents a 70% peak-to-trough decline, with the latest selloff being symptomatic of a capitulation phase. Second, at a price-to-book discount of 64% and a dividend yield of 7%, energy stocks are very cheap (Chart I-13). Chart I-13A Capitulation In Energy Stocks? It is remarkable that long-term portfolio flows into Canadian assets have started picking up, a sign of bargain hunting by international investors (Chart I-14). This should provide a modest tailwind to the Canadian dollar over the next six to 12 months. Chart I-14A Recovery In Canadian Portfolio Inflows Improving Domestic Conditions The Canadian domestic economy has been holding up well, despite lower oil prices. This has occurred on the back of massive fiscal stimulus, in addition to the BoC dropping rates to 0.25% and engaging in quantitative easing. During his Throne Speech a fortnight ago, Canadian Prime Minister Justin Trudeau vowed to do “whatever it takes” to support people and businesses throughout the crisis. Fitch Ratings estimates that the budget deficit in Canada will remain wide going into 2022 (Chart I-15). Meanwhile, as lockdown measures have eased since April, incoming data has been robust. Chart I-15Lots Of Fiscal Stimulus In Canada Canada continues to create record employment, with 246,000 new jobs added in August. This is leading to the fastest recovery in the unemployment rate on record (Chart I-16). The manufacturing and resources sectors in Quebec, Alberta, and British Columbia, which bore the brunt of the employment declines, are rebounding. Chart I-16Best Job Recovery In Decades Most measures of household confidence are in a V-shaped recovery. Retail sales in Canada have rebounded, reaching above pre-pandemic levels. Mortgage credit has also picked up strongly. Correspondingly, housing starts have overtaken their pre-pandemic peak as well, with new home construction at its highest level since 2007. Working from home has led to a surge in renovation projects. Meanwhile, low rates and rising home prices have encouraged new construction. Residential investment is almost 7% of Canadian GDP, a significant chunk of aggregate demand (Chart I-17). Despite the improvement in domestic conditions, inflationary pressures remain moribund. The output gap measure according to the BoC remains wide at -3.2% of GDP. The latest inflation print shows that domestic prices in Canada still remain anchored below the midpoint of the BoC’s target band. This means that the BoC will be in no rush to normalize policy anytime soon (Chart I-18). Chart I-17Residential Construction Is Important Chart I-18Canadian Inflation Is Below Target Given the government’s commitment to step in as a spender of last resort, real rates in Canada will remain depressed as inflation starts to recover. This will not be as pronounced versus the US, where the Fed is trying to asymmetrically generate inflation, but more so against its commodity peers such as Australia and Norway, where the number of new Covid-19 cases remains under control, giving the governments there less incentive to significantly increase spending. This suggests that while the loonie may have upside against the dollar, it could underperform at the crosses. Investment Implications We expect the CAD/USD to gravitate higher in the next few months. The key catalysts are favorable interest rates versus the US and a gradual recovery in WCS oil prices as global economic activity picks up. From a fundamental perspective, the CAD is still undervalued by 7.3% on a trade-weighted basis (Chart I-19). This puts 80-82 cents within striking distance. Chart I-19The CAD Is Still Cheap Chart I-20Sell CAD/NOK Relative to other commodity currencies, transportation bottlenecks in Canada will prove to be a formidable hurdle in closing the current discount between WCS and WTI and/or Brent. While Canadian crude is likely to remain trapped in the oil sands for now, North Sea crude will face fewer transportation bottlenecks in the near term. This suggests that the path of least resistance for the CAD/NOK is down (Chart I-20). Sell CAD/NOK for a trade. An improvement in economic activity in Asia relative to the West will also favor AUD/CAD. Rising oil prices are a terms-of-trade boost for oil exporters but lead to demand destruction for oil importers. In general, a strategy for playing oil upside is to be long a basket of energy producers versus energy consumers. This suggests that the CAD has upside against the euro, the Indian rupee, and the Turkish lira. We are already long a basket of petrocurrencies versus the euro. Finally, we are long CAD/NZD as a play on policy divergences between the Reserve Bank Of New Zealand and the BoC. However, our conviction on this trade is low due to the resurgence of new cases in Canada. We recommend maintaining tight stops on this position.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data from the US have been positive: The unemployment rate fell from 8.4% to 7.9% in September. Nonfarm payrolls increased by 661K. The ISM Non-manufacturing Index increased from 56.9 to 57.8 in September. The Michigan Consumer Sentiment Index jumped from 74.1 to 80.4 in September. The trade deficit widened from $63.4 billion to $67.1 billion in August. Initial jobless claims increased by 840K for the week ending on October 3. The DXY index fell initially but then recouped the loss, ending flat this week. Trump’s tweet on Tuesday about “halting COVID-19 relief talks until after election” largely reduced the likelihood of any imminent fiscal stimulus. While pre-election uncertainties have been dominant recently, we remain dollar bears in the cycle, especially in a post-election and post-vaccine world. Report Links: Tail Risks In FX Markets - October 2, 2020 The Message From Dollar Sentiment And Technical Indicators - Sept. 25, 2020 Addressing Client Questions - September 4, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mixed: Headline inflation declined from -0.2% to -0.3% year-on-year in September. Core inflation also decreased from 0.5% to 0.2%. The Markit Services PMI edged up from 47.6 to 48 in September. The Sentix Investor Confidence Index increased from -9.5 to -8.3 in October. Retail sales grew by 3.7% year-on-year in August. The euro rose by 0.2% against the US dollar this week. The slip in core inflation this week reinforced the concern about deflation. In the recent strategic review, Christine Lagarde kept a dovish tone and reiterated a desire to keep policy accommodative. We believe that the PEPP with a total envelope of €1,350 billion through the end of June 2021 will continue to support euro area economic recovery. Report Links: Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been positive: The Jibun Bank Services PMI increased from 45 to 46.9 in September. The current account surplus surged from ¥1.5 trillion to ¥2.1 trillion in August. The Eco Watchers Survey Outlook Index increased from 42.4 to 48.3 in September. The Current Conditions Index also grew from 43.9 to 49.3. The Japanese yen declined by 0.3% against the US dollar this week. Incoming data confirms that the Japanese economy is recovering from pre-pandemic lows. Apart from being a cheap safe-haven hedge, the Japanese yen is also supported by lower COVID infection rates and fewer political uncertainties. Stay short on USD/JPY. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data from the UK have been positive: The Markit Services PMI increased from 55.1 to 56.1 in September. House prices grew by 2.3% year-on-year in July. Unit labor costs surged by 27.4% year-on-year in Q2. The British pound has been flat against the US dollar this week. Despite ongoing Brexit chaos, the pound managed to remain well above 1.27 in recent months. Our bias is that a Brexit deal will eventually be reached. We favor the British pound relative to the euro since the pound is tremendously undervalued against the euro. Besides, risk reversals also suggest that the pound is deeply oversold. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data from Australia have been mixed: The Commonwealth Bank Services PMI increased from 50 to 50.8 in September. Exports declined by 4% month-on-month in August while imports expanded by 2%. The trade surplus narrowed from A$4.65 billion to A$2.6 billion.   The NAB Business Confidence Index increased from -8 to -4 in September. The Australian dollar fell by 0.3% against the US dollar this week. On Tuesday, the RBA kept its interest rate steady at 0.25%. Governor Philip Lowe acknowledged the weakness in Australia’s labor market and highlighted that the RBA continues to consider various measures designed to support job growth as the economy opens further. We remain positive on the Australian dollar. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been positive: The ANZ Business Confidence Index improved from -28.5 to -14.5 in October. The Activity Outlook index also shifted from -5.4 to 3.6 in October. The New Zealand dollar fell by 1.1% against the US dollar this week. While still well below pre-pandemic levels, the ANZ Business Confidence Index has undoubtedly improved in October. Investment and employment intensions both moved higher, lifting profit expectations. That said, the services sector is still under severe pressure resulting from strict lockdown measures. Markets are now pricing in a higher than 50% probability of a further rate cut by early next year, which contributes to the relative weakness in the New Zealand dollar. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: The trade deficit marginally narrowed from C$2.53 billion to C$2.45 billion in August. The Ivey PMI declined from 67.8 to 54.3 in September. Housing starts increased by 209K in September, down from 261.5K in the previous month. The Canadian dollar appreciated by 0.3% against the US dollar this week. As an important oil producer and exporter, the Canadian dollar shifts along with the price of oil. In this week’s report, we discuss the key drivers behind the Canadian dollar and discover why it has underperformed other G10 pro-cyclical currencies. Please refer to our front section for more detailed research. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data from Switzerland have been positive: Total sight deposits continue to increase from CHF 704.5 billion to CHF 705.1 billion for the week ending on October 2. The unemployment rate declined from 3.4% to 3.3% in September. The Swiss franc appreciated by 0.2% against the US dollar this week and nearly 6% since January. The unwanted appreciation has been a headache for the SNB, which warrants more intervention against a pricey franc. Interestingly, the franc has been flat against the euro year-to-date. We are looking to buy EUR/CHF on weakness due to the SNB’s intervention and the CHF’s lower beta to growth. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data from Norway have been positive: The industrial production index increased by 1.1% month-on-month in August.  Manufacturing output increased by 3% month-on-month in August. The Norwegian krone rose by 0.7% against the US dollar this week. Incoming data from Norway is consistent with the recent economic recovery there, especially in the resources sector. Industrial production of mining and quarrying, basic metals, and machinery equipment jumped, respectively, by 10.1%, 8.8% and 15.7% month-on-month in August. We continue to favor the Norwegian krone and are looking to purchase the Nordic basket again at a more favorable price. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data from Sweden have been positive: Industrial production increased by 0.2% year-on-year in August, or 7% month-on-month. Manufacturing new orders was unchanged year-on-year in August, but that’s up from a 6.9% contraction in the previous month. The budget balance shifted from a surplus of SEK 19.8 billion to a deficit of SEK 13.1 billion in September. The Swedish krona increased by 0.6% against the US dollar this week. As a bellwether of global growth, Swedish manufacturing activity is one of the indicators we monitor closely in order to gauge where we are in a cycle. Despite recent uncertainties, the Swedish manufacturing sector is showing budding signs of recovery, which is bullish for the Swedish krona. Kelly Zhong Research Analyst Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Long-term investors who can tolerate volatility should buy SEK/USD for a potential 20 percent upside. Short-term investors who cannot tolerate volatility should buy CHF/USD. The dollar’s short-term moves are a perfect mirror-image of the global stock market. US and euro area long-duration bond yields will ultimately converge… …and the euro area’s huge trade surplus with the US will vanish. Fractal trade: Underweight European retailers versus market. Feature Chart of the WeekSEK/USD Is 20 Percent Undervalued Relative To The Sweden/US Bond Yield Differential The demand for a foreign currency serves one of four purposes: To buy goods and services denominated in the foreign currency. To buy long-term investments denominated in the foreign currency, also known as foreign direct investment (FDI). To buy shorter-term financial investments like bonds and equities denominated in the foreign currency, also known as portfolio flows.1 To buy currency reserves denominated in the foreign currency. What Sets The Broad Level Of EUR/USD? Looking at the euro, three of the four components of demand tend to change relatively slowly. The net foreign demand for euro area goods and services is not particularly volatile. Neither is FDI. Demand for euro reserves also tends not to suffer wild gyrations, except at the rare moment that a currency peg starts or ends.  All of which means that the usual driver of demand for euros are portfolio flows (Chart I-2). Chart I-2Euro Area Portfolio Flows Have A High Amplitude Portfolio flows are of two main types: fixed income and equity. However, in the euro area, fixed income portfolio flows usually have the much higher amplitude (Chart I-3). The reason is that most savings are invested in fixed income assets. For example, German households hold 80 percent of their assets in fixed income, cash, or close proxies. This explains why the stock of government fixed income securities in the euro area is almost twice as large as the market capitalisation of all the euro area’s stock markets (Chart I-4). Chart I-3Euro Area Fixed Income Portfolio Flows Have A Higher Amplitude Than Equity Flows... Chart I-4...Because Euro Area Fixed Income Is The Dominant Asset-Class What causes fixed income flows to flood out of the euro area one moment and back in the next? The answer is the expected change in interest rates. The main issue is not the exact timing of short-term interest rate changes. Instead, it is the so-called terminal rate: the average interest rate over the very long term, proxied by the long-duration bond yield. Fixed income investors gravitate to the bonds with the highest potential returns adjusted for currency hedging costs or likely currency moves. In the euro area, fixed income portfolio flows have a higher amplitude than equity flows. When the expected interest rate in the euro area declines relative to that in the US, it diminishes any further price upside of euro area bonds compared with that of US T-bonds. Hence, fixed income investors shift out of the less attractive euro area bonds into US T-bonds. The outflow continues until it has depressed EUR/USD to a level where the potential upside to the exchange rate becomes symmetrically more attractive. At this new lower level for EUR/USD, the fixed income portfolio outflow stops because a new equilibrium has been established. International fixed income investors have less upside from the euro area bond price, but they now have symmetrically more upside from the cheaper EUR/USD – and the two factors cancel out. Chart I-5 provides powerful evidence of this dynamic. For the past 15 years, the broad territory in which EUR/USD trades has been a close function of the euro area/US long-duration bond yield spread.3 A zero yield spread equates to EUR/USD in the broad territory of 1.35 with every +/-100 bps equal to +/- 15 cents. Hence, the current yield spread of -100 bps equates to EUR/USD trading in the broad territory of 1.20. Chart I-5The Euro Area/US Bond Yield Differential Sets EUR/USD... Interestingly, the euro area/US trade imbalance is also a close function of the bond yield spread. This confirms that the euro area’s massive trade surplus with the US is the direct result of the massive imbalance in relative monetary policy – which depressed EUR/USD and boosted the euro area’s relative competitiveness. Put simply, at a narrower (and more normal) bond yield spread, the euro area’s trade surplus with the US would largely vanish (Chart I-6). Chart I-6...And Thereby It Sets The Euro Area/US Trade Imbalance The Euro Area/US Yield Spread Is Likely To Narrow Further The long-term evolution of EUR/USD – as well as the associated trade imbalance – hinges on the long-term evolution of the euro area/US long-duration bond yield spread. Will this spread widen or narrow? At a narrower bond yield spread, the euro area’s trade surplus with the US would largely vanish. From the euro area side, the answer is easy. The spread cannot widen, it can only narrow. With the ECB policy interest rate already expected to be stuck at its lower bound indefinitely, down is not an option. From the US side, the spread could go either way, at least mathematically. However, it is our high conviction view that in the long term it will narrow. The Federal Reserve’s recent strategic review has made its reaction function blatantly asymmetric. The central bank has told us that it will be thick-skinned to reflationary shocks, but trigger-happy to the slightest further deflationary shock. Hence, when the slightest further deflationary shock comes – and sooner or later it will – US long-duration bond yields will converge with those in the UK and Japan in one of two ways. Either the Fed will follow the Bank of England in a volte-face about adding negative interest rate policy into its toolbox. Or the Fed will follow the Bank of Japan in formally implementing yield curve control (Chart I-7).   Chart I-7The US Bond Yield Will Converge With The Others Buy SEK/USD For The Long Term, Buy CHF/USD For The Short Term Other European economies also exhibit the same strong link between their exchange rates with the dollar and their bond yield spreads with the US. In the case of Sweden, there is an attractive opportunity. SEK/USD is still about 20 percent undervalued relative to the long-term relationship with the Sweden/US bond yield spread. Hence, the long-term case for owning SEK/USD does not even require the yield spread to narrow from where it stands today. Of course, if the spread did narrow by a further 50 bps, the potential upside would approach 30 percent (Chart of the Week). SEK/USD is still about 20 percent undervalued relative to the long-term relationship with the Sweden/US bond yield spread.  Nevertheless, for short-term investors, there is an important caveat. While fixed income portfolio flows drive the long-term values of European currencies versus the dollar, equity portfolio flows become dominant in periods of market stress. During such dislocations, equity flows tend to flee to perceived haven assets and markets, many of which are denominated in dollars. As a result, the dollar rallies. The compelling proof is that over the past year, the dollar has traded as a perfect mirror-image of the global stock market (Chart I-8). Chart I-8The Dollar In 2020 = A Perfect Mirror-Image Of The Stock Market In Europe, the haven currency is the Swiss franc. Hence, while SEK/USD fell by 10 percent during this year’s market turbulence, CHF/USD remained unperturbed. Furthermore, CHF/USD is also undervalued relative to its relationship with the Switzerland/US bond yield spread.4 Albeit, the undervaluation is more modest, at around 6 percent (Chart I-9). Chart I-9CHF/USD Is Modestly Undervalued Relative To The Switzerland/US Bond Yield Differential The conclusion is that long-term investors who can tolerate volatility should buy SEK/USD for its greater upside. Whereas short-term investors who cannot tolerate volatility should buy CHF/USD for its greater safety. Fractal Trading System* This week we note that the recent strong outperformance of European retailers is vulnerable to a trend reversal, and especially so if the pandemic resurges. Accordingly, the recommended trade is underweight European retailers versus the market (which can be implemented as EXH8 versus Euro Stoxx 600). The profit target and symmetrical stop-loss is set at 4.2 percent. Chart I-10European Retailers Vs. Market The rolling 1-year win ratio now stands at 56 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com. Footnotes 1 In this discussion, portfolio flows include short-term speculative flows. 2 For example, when the Swiss National Bank broke the franc’s peg with the euro in early 2015, it abruptly stopped buying euro reserves. 3 The euro area bond yield is the issue-weighted average of the euro area’s constituent sovereign bond yields. A good approximation of the euro area’s issue-weighted average is the French bond yield.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields   Interest Rate Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations  

Highlights Three tail risks will continue to dominate the FX market narrative in the coming weeks: The upcoming November elections, Brexit, and the new wave of COVID-19 infections. As such, markets remain vulnerable in the near term and the dollar will continue to benefit from safe-haven flows. That said, most sentiment and technical indicators suggest the dollar is undergoing a countertrend bounce rather than entering a new bull market. Stay short USD/JPY as a core holding. Look to rebuy a basket of Scandinavian currencies versus the USD and EUR at a trigger point of -2%. Overall, the DXY should continue to face significant headwinds in the 94-96 zone, as we have witnessed recently. Feature US political risk remains the key “white swan” risk for currency markets. Unfortunately for investors, this week’s US presidential debate was full of theatrics and low on content. CNN polling showed that former Vice President Joe Biden was the preferred candidate going into the debate, and emerged as the interim winner. To be sure, the CNN polls are biased, with more contribution from Democratic voters compared to Republican ones. That said, it certainly helped that despite President Donald Trump’s constant jawboning, the former Vice President appeared unfazed and managed to slip in some of the key points of his political campaign. A Debate Post-Mortem Chart I-1The Dollar And Political Uncertainty The political theater is likely to continue in the coming days. In terms of timelines, we have the Vice-Presidential debate on October 7 and the second and third Presidential debates on October 15 and October 22. But the most important dilemma for currency markets is not whether we have a Democratic or Republican victory, but if the US becomes the source of political uncertainty compared to the rest of the world. For almost two decades, the most important political driver of the dollar was whether uncertainty in the US was rising or falling relative to the rest of the world (Chart I-1). As markets begin to digest the political outcomes, the ultimate conclusion could be dollar bearish. Let’s start with what is priced in. Political uncertainty in the US has surged relative to the rest of the world as mentioned above. Part of the reason is that betting markets now expect a “blue wave” (Chart I-2).  This was reinforced by the Presidential debates where former VP Biden was the preferred candidate (Chart I-3). A blue wave implies that Bidens wins the White House while Democrats gain control of the Senate, and retain the House. Chart I-2ABetting Markets Expect A Blue Wave Chart I-2BBetting Markets Expect A Blue Wave Chart I-3AFormer Vice President Joe Biden Was A Favorite Chart I-3BFormer Vice President Joe Biden Was A Favorite Such a victory will lead to massive fiscal stimulus, since Democratic leaders have been more aggressive in their demands for a greater government role in the economy. Bigger fiscal spending will lead to a higher US debt burden, widen the twin deficits and be only modestly positive for bond yields given that the Federal Reserve will anchor short term rates at zero. If US inflation takes off from increased aggregate demand, foreign bond investors are likely to continue fleeing the US market as real rates become even more negative, driving down the dollar in the process. Admittedly, there has been a small uptick in political uncertainty in the world relative to the US. President Donald Trump’s approval rating is closely correlated to the state of the economy and the US has been in a V-shaped recovery since the second quarter of this year. But as Chart I-2 shows, the probability of a Republican victory from betting markets has fallen recently. A Trump victory will ensure that the policies that have been favorable for markets since 2016 remain in place. Vice President Joe Biden’s hawkish tax policies, which he stuck with in the debate, will also be off the table. In terms of calculus, Senate Republicans may have to give in to more stimulus before the election to grease the wheels of the economy and support asset prices, which will otherwise fall and torpedo their chances. The most favorable outcome for markets could potentially be for Biden to clinch the White House and the Republicans to maintain control of the Senate. For one, it is likely that taxes will not go up as aggressively as Biden is proposing to raise them, while the likelihood of a global trade war will also fall. The dollar’s safe-haven bid will also fade, as capital starts to gravitate from the US towards other cheaper and beaten-up markets. What, then, are the bullish scenarios for the dollar? Chart I-4Swing State Wages Turning Up First, a failure to pass a stimulus bill will boost the dollar, hijack the recovery, and cause a setback to risk assets. Second, big swings in Trump’s approval ratings will raise the prospect of a contested election. According to our Chief Geopolitical Strategist Matt Gertken, his in-house quantitative election model now pins the probability of a Trump victory at almost 50%. Remarkably, Michigan has risen to the ranks of a toss-up state, as economic indicators have drastically improved. In a nutshell, a V-shaped recovery in wages for the swing states that voted for President Trump boost his chances (Chart I-4). However, these are likely short-term hiccups that will ultimately be resolved. The base case is still for a Democratic win, according to Matt. Either way, we will know who the US President is by December (or, worst case, by January) and a new fiscal bill is likely to be passed, regardless of who sits in the White House. Forward-looking financial markets, by then, will have stopped discounting political uncertainty as they currently are. Therefore, as we argued last week, we continue to pay heed to both sentiment and technical indicators that suggest the dollar is in a counter-trend bounce, rather than a renewed bull market.  What About The COVID-19 Saga? Unfortunately for markets, the US presidential election is not the only source of uncertainty. As we approach the winter season in the northern hemisphere, the potential for a new wave of infections is rising. As we approach the winter season in the northern hemisphere, the potential for a new wave of infections is rising. We are already in full lockdown in Montreal, Quebec, where BCA Research's headquarters are located. Around the G10, a second wave is taking hold in the euro area, UK, and Canada. Even Norway and Switzerland, which had managed to keep the virus under wraps for most of the summer, are seeing a resurgence in cases. Infection trends remain favorable in Australia, Japan, New Zealand, and Sweden, probably due to previous localized lockdowns in most of these countries (Chart I-5). Chart I-5A New COVID-19 Wave The most direct impact for currency markets is relative economic growth. For much of the summer months, the US was under siege from a second wave while the Eurozone, and many other countries, were well into their reopening phases. This affected currency markets (Chart I-6). Specifically, the dollar declined as economic momentum was higher outside the US. More recently, improving relative economic performance between the US and other G10 countries has been a key catalyst behind the dollar’s recent strength (Chart I-7). Chart I-6Rising US Cases And A Fiscal Logjam Chart I-7The Dollar And Relative Growth Going forward, the potential impact from COVID-19 is likely to be much less than what many economies endured for the first half of 2020. There are a few reasons for this. The virus has become less deadly, as mortality rates across many countries have come down. This could be due to a higher incidence of infections among younger people, who are also healthier, or due to the widespread wearing of masks, which has helped mitigate the viral load. Governments are unlikely to introduce the kind of widespread lockdowns we saw during the onset of the outbreak. More likely are localized lockdowns, such as what we are experiencing here in Quebec, and stringent rules on sanitation and social distancing.  We are closer to a vaccine than we were at the start of the year. According to Bio, an association of biotechnology and health care companies, there are currently 739 unique active compounds in development spanning the range from vaccines and antivirals to treatments for COVID-19. Almost 20 of these are in Phase 4 trial. Overall, there are 189 vaccines under trial, a big jump up from nil at the start of the year.  Chart I-8Lots Of Fiscal Stimulus In Canada The big risk is that governments fail to provide fiscal help to bridge economies until the widespread availability of a vaccine. However, outside the US, that does not appear to be the case. For example, during his Throne Speech last week, Canadian Prime Minister Justin Trudeau vowed to do “whatever it takes” to support people and businesses throughout the crisis. The Liberal government has just followed up with a C$10 billion infrastructure spending plan. Fitch Ratings estimates that the budget deficit in Canada will still remain wide going into 2022 (Chart I-8). In Australia, the Liberal-National coalition government has also been very proactive, especially with the “Job Seeker” and “Job Keeper” scheme, which has provided a valuable cushion for domestic economic conditions. The IMF estimates the fiscal thrust in Australia will be positive in 2021. In the euro area, there is still a 750 billion euro stimulus package to be deployed, while France announced a 100 billion euro plan last month. The bottom line is that while the pandemic is likely to induce more shockwaves into markets, spending gridlock appears to be concentrated within the US. At a minimum, this will limit any upside bounce in the dollar, since it will hurt US economic growth relative to its G-10 peers.  An Update On Brexit Chart I-9EUR/GBP Bets Are Lopsided As the pandemic returns in full force again in the UK, political uncertainty is also rising. Brussels is suing the UK on the new “internal market bill” that violates the Brexit withdrawal agreement. The key issue is still Northern Ireland. Last year, the agreement was that Ireland would remain bound to the EU’s customs and trade regime. The UK is seeking an amendment to be able to intervene, if there is “inconsistency or incompatibility with international or domestic law.” As we posited two weeks ago, it provided for UK discretion in state aid and the movement of goods to and from Northern Ireland, which the EU argues is a clear breach of the last year’s treaty. From the UK point of view, if there is no trade deal, why would it allow a division to emerge within its own national borders?    It is remarkable that despite the ramp up in tensions, the GBP/USD remains well bid above 1.28. Odds of a “hard” Brexit have usually been associated with cable near 1.20. This suggests two things: Either we are in a new paradigm, where the dollar is winning the “ugly contest,” or the market is underestimating the potential for a hard Brexit. Fitch estimates that the budget deficit in Canada will still remain wide going into 2022.  We subscribe to the former view. First, because the British government has nothing to gain from failing to agree to a trade deal, since the recession would only deepen, while it has much to lose, since the Scottish independence movement would likely gain steam. Second, risk reversals between cable and the euro are close to the post-referendum lows. This means that investors have already built significant put options on the pound, and call options on the euro (Chart I-9). Our base case remains that a deal will ultimately be reached. The UK side has a more resurgent pandemic to deal with, and will need to offer some concessions to ease economic volatility. Trade links between the two are also quite large.  In terms of targets, cable will trade between 1.35-1.40 over the next six months. In an optimistic scenario, the pound could go 20%-25% higher. The pound is also cheap versus the euro — another sign that the market is not underestimating the no-deal exit risk. Ergo, shorting EUR/GBP (or being long EUR/GBP volatility) should be a good short-term bet on an eventual resolution. Investment Implications We continue to advocate for a prudent strategy when trading foreign exchange markets over the next few weeks: Hold some portfolio protection. Our preferred vehicle is the Japanese yen, which is cheap, although the pricier Swiss franc also make sense. Focus on trades at the crosses. We are short the NZD/CAD and EUR/GBP as a play on relative fundamentals, but are also looking to buy EUR/CHF on weakness and sell CAD/NOK on strength. We will discuss our CAD strategy in the coming weeks. Buy Scandinavian currencies if they drop another 2% versus an equal weighted basket of the euro and USD (Chart I-10). We initially took profits on this trade a fortnight ago, booking solid gains. Stay short the gold/silver ratio but tighten stops to 84. Chart I-10The Scandinavian Currencies Remain Cheap   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data from the US have been mostly positive: The ISM Manufacturing PMI marginally declined from 56 to 55.4 in September. The new orders component slipped but remained elevated at 60.2. The Dallas Fed Manufacturing Index increased from 8 to 13.6 in September. The Chicago Manufacturing Index surged from 51.2 to 62.4 in September.  Durable goods orders increased by 0.4% month-on-month in August. Initial jobless claims increased by 837K for the week ending on September 25. The DXY index fell by 0.6% this week. Market uncertainty continues as the election draws closer and the number of COVID cases keeps rising. The New York Fed Staff Nowcast revised Q4 GDP downward to 5.05% from 7.28% earlier this month. While risks remain tilted to the downside, any positive news on a vaccine and stimulus could revive risk sentiment, which is negative for the US dollar. Report Links: The Message From Dollar Sentiment And Technical Indicators - Sept. 25, 2020 Addressing Client Questions - Sept. 4, 2020 A Simple Framework For Currencies - July 17, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area have been mixed: The Economic Sentiment Indicator increased from 87.5 to 91.1 in September. The Producer Price Index declined by 2.5% year-on-year in August. The unemployment rate ticked slightly up from 8 to 8.1% in August. The euro rebounded by 0.7% against the US dollar this week. The latest EU Economic Sentiment Indicator suggests that the economy continues to recover, albeit at a slower speed than expected. The resurgence of COVID cases might also lead to downward revisions to the Q4 growth outlook, which could trigger further stimulus from the ECB. Report Links: Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan have been improving: Tokyo’s headline inflation declined from 0.3% to 0.2% year-on-year in September. Core inflation remained negative at -0.2% year-on-year.   Vehicle sales contracted by 15.6% year-on-year in September. August saw a contraction of -18.5%. Industrial production rose by 1.7% month-on-month in August, while construction orders surged by 28.5% year-on-year in August. The Japanese yen has been flat against the US dollar this week. Japan’s Q3 Tankan Survey released this Thursday suggests that manufacturers’ sentiment has improved for the first time in three years, showing signs of a recovery supported by pent-up demand. The Japanese yen remains our favorite safe-haven hedge. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data from the UK have been positive: The current account deficit narrowed from £20.8 billion to £2.8 billion in Q2. Nationwide housing prices increased by 5% year-on-year in September. Mortgage approvals surged by 84.7K in August. The British pound appreciated by 0.3% against the US dollar this week. The chief economist from the BoE, Andy Haldane, downplayed the possibility of negative interest rates in the UK in a speech on Wednesday. According to the speech, current conditions don’t warrant any further lowering of interest rates, which is positive for the British pound. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data from Australia have been positive: Building permits fell by 1.6% month-on-month in August, following a 12.2% surge in the previous month. On a year-on-year basis, the August figure grew by 0.6% compared to the same month last year. The AiG Manufacturing PMI slipped from 49.3 to 46.7 in September. However, the final Markit Manufacturing PMI ticked up from 53.6 to 55.4. The Australian dollar increased by 1.6% against the US dollar this week. COVID-19 cases in Australia remain at low levels. As such, the Aussie has benefitted tremendously from the reflation trade. We remain positive on the Aussie both at the crosses as well as versus the USD. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data from New Zealand have been positive: Building permits increased by 0.3% month-on-month in August. The ANZ Business Confidence Index declined slightly from -26 to -28.5 in September, while the ANZ Activity Outlook Index improved from -9.9 to -5.4. The New Zealand dollar appreciated by 1.4% against the US dollar this week. While the New Zealand dollar might outperform the US dollar as the growth outlook improves, it remains likely to underperform at the crosses due to a more dovish RBNZ. Moreover, our FX model downgraded the kiwi to neutral for the month of October. Tactically, we are also short NZD/CAD. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada have been positive: GDP expanded by 3% month-on-month in July. Building permits increased by 1.7% month-on-month in August. The Bloomberg Nanos confidence Index slightly ticked up from 53.1 to 53.2 for the week ending on September 25. The Canadian dollar increased by 0.7% against the US dollar this week. According to Statistics Canada, the economy expanded for a third consecutive month in July as more sectors reopened in the summer. Notably, all 20 industrial sectors posted gains in July. We continue to favor the Canadian dollar against the US dollar and will discuss the loonie more in-depth in the coming weeks. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data from Switzerland have been mixed: The KOF Leading Indicator increased from 110.2 to 113.8 in September.  Headline inflation increased from -0.9% to -0.8% year-on-year in September but remains deep in negative territory. Real retail sales increased by 2.5% year-on-year in August. Total sight deposits increased from CHF 703.9 billion to CHF 704.5 billion for the week ending on September 25. The Swiss franc appreciated by 1% against the US dollar this week. The KOF survey highlighted that Switzerland is in a V-shaped recovery. However, deflation remains pervasive, suggesting a strong franc could torpedo the recovery. We continue to expect the SNB to step up the pace of intervention, and are buyers of EUR/CHF on weakness.  Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data from Norway have been positive: Real retail sales expanded by 8.2% year-on-year, following a 13.8% surge the previous month.  The Norwegian krone rose by 2.2% against the US dollar this week. The latest data from Statistics Norway showed strength in retail sales across various categories, especially in household equipment, recreational goods, food and beverages. We remain NOK bulls based on our positive energy price outlook, the resilience in domestic demand and a less dovish central bank. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data from Sweden have been positive: The Swedbank Manufacturing PMI increased from 53.4 to 55.3 in September. Retail sales grew by 3% year-on-year in August. Consumer confidence increased from 85.1 to 88.3 in September. The trade balance shifted from a surplus of SEK 4 billion to a deficit of 1.6 billion in August. The Swedish krona rebounded by 1.6% against the US dollar this week. We continue to like the Swedish krona along with the Norwegian krone. We are looking to purchase the Nordic basket again at a 2% discount relative to last week’s price levels. Stay tuned. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019   Kelly Zhong Research Analyst Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Near-Term Uncertainties: Investors have grown a bit more nervous in recent weeks, amid signs of a second wave of the coronavirus in Europe and with the contentious US presidential election only five weeks away. The pro-growth cyclical investment backdrop, however, remains unchanged. From a strategic perspective (6-12 months), maintain an overall neutral stance on interest rate duration, with a moderate overweight to global spread product versus government bonds while staying up in quality. EM USD-Denominated Debt: The main drivers of the emerging market hard currency debt rally since March – a weakening US dollar, improving global growth momentum, and massively accommodative global monetary policies – remain in place. Valuations, however, appear more attractive for EM USD-denominated corporates relative to USD-denominated sovereigns. Favor the former over the latter, within an overall neutral strategic allocation to EM hard currency debt. Feature Chart of the WeekMarkets Starting To Get Cautious As the third quarter of 2020 draws to a close, investors have developed a slight case of the jitters about the near-term outlook for global financial markets. The positives that drove risk assets higher during the spring and summer - rebounding global economic activity, fueled by aggressive policy stimulus and a slowing of the spread of COVID-19, along with a weaker US dollar – have given way to some fresh uncertainties. Economic data releases have started to disappoint versus expectations, the rapid expansion of central bank balance sheets in the major developed economies has temporarily stalled, a second wave of new COVID-19 cases appears to have started in Europe and the US, and the US dollar has strengthened by 2.7% from the 2020 lows (Chart of the Week). Risk assets have pulled back in response, with the MSCI World equity index down -6.1% from the 2020 peak and US high-yield corporate credit spreads 66bps wider from recent lows. So far, these moves appear more a correction of overbought markets, rather than a change in trend. From the perspective of our strategic (6-12 months) investment recommendations, we remain generally positive on risk assets. Within global fixed income, that means maintaining a modest overall overweight stance on spread products versus government bonds, while focusing more on relative opportunities between countries and sectors to generate alpha. A Quick Assessment Of The Cyclical Backdrop The recent in increase in market volatility has started to shake out crowded positioning in popular winning trades. For example, high-flying US tech stocks have seen deeper pullbacks than the overall US equity market, while investors yanked nearly $5 billion from US junk bond funds in the week ending last Wednesday according to the Financial Times – the highest such outflow since the apex of the COVID-19 market rout in mid-March. We prefer to judge the health of a market rally by assessing the state of macroeconomic fundamentals underpinning that particular asset class Mainstream financial pundits often dub such corrections of overheated markets as a “healthy” way to ensure the continuation of medium-term bullish trends. We prefer to judge the health of a market rally by assessing the state of macroeconomic fundamentals underpinning that particular asset class – the most important of which remain positive for risk assets, in general, and global fixed income spread products, in particular. Economic Data Chart 2Economic Data Is Mostly Optimistic While data surprise indices like the widely followed Citigroup series are topping out, this is more because of an improvement in beaten-up growth expectations, rather than a sharp decline in the actual data. The global ZEW economic expectations survey continues to point in an optimistic direction, while other reliable measures of business confidence like the German IFO and the US NFIB small business surveys have also continued to improve in recent months. Our own global leading economic indicator (LEI) is firming, with a majority of countries seeing a rising LEI (Chart 2). At the same time, the preliminary release of manufacturing PMI data for September showed continued improvements in the US and Europe. While the news is not 100% upbeat – the services PMI for the overall euro area fell -2.9 points in September, possibly due to the increase in new reported cases of COVID-19 in Europe – the tone of global economic data remains consistent with improving cyclical momentum. The US Dollar Chart 3Growth And Yield Differentials Signalling Dollar Weakness The most likely medium-term path of least resistance for the US dollar remains downward. Economic growth remains stronger outside the US, based on the differential between the US and non-US manufacturing PMI data – an indicator that our currency strategists follow closely given its strong correlation to US dollar momentum (Chart 3). Relative interest rate differentials also remain less positive for the US dollar, with the decline in real US bond yields seen in 2020 pointing to additional medium-term dollar depreciation (bottom panel). US Politics The US general election is now only 35 days away, with the latest polling data showing President Trump closing the lead on the Democratic Party candidate, Joe Biden. Our colleagues at BCA Research Geopolitical Strategy remain of the view that a Biden victory is the more probable outcome, given the more difficult time Trump will have in winning all the key swing states that gave him his narrow election victory in 2016. Chart 4A "Blue Sweep" Is Bearish For Markets The recent peak in US equity markets, and trough in the VIX index, coincided with improving odds of a Democratic Party sweep of the White House, House of Representatives and Senate (Chart 4). Such an outcome would give a President Biden the power, and perceived mandate, to implement many of the more progressive elements of the Democratic Party agenda – including a hike in corporate tax rates that could damage equity market sentiment. Our political strategists think that a “Blue Sweep” would only occur if the Republican Party fails to agree with the Democrats on a new fiscal stimulus bill.1 Both sides are playing hardball in the current negotiations, which is keeping investors on edge given how much of the US economy still requires fiscal support because of the pandemic. The Republicans will not want to take the blame for a failure to reach a stimulus deal, which would likely hand the Democrats the keys to the White House and Congress. Thus, a fiscal deal of sufficient size to calm jittery markets – most likely in the $2-2.5 trillion range sought by the Democrats – should be announced within the next couple of weeks before the final run up to the election. Financial/Monetary Conditions It will take more than a corrective pullback in equity and credit markets to threaten the economic recovery from the COVID-19 recession, given how highly stimulative financial conditions have become since the spring (Chart 5). In more normal times, booming equity and credit markets would eventually lead to upward pressure on government bond yields, since all would be reflecting improving economic growth and, eventually, expectations of faster inflation and tighter monetary policy. That move higher in yields would eventually act to restrain growth and depress the value of growth-sensitive risk assets. Chart 5Financial Conditions Remain Supportive For Growth As we discussed in last week’s report, government bond yields are now likely to stay very low for a period measured in years, with major central banks like the US Federal Reserve leaning dovishly to support growth during the pandemic and trigger a temporary overshoot of inflation expectations.2 Thus, loose monetary settings (including more quantitative easing) will remain a critical underpinning for keeping risk assets well supported, by eliminating the typical cyclical threat from rising bond yields. Summing it all up, the fundamental economic and political backdrop remains cyclically bullish for risk assets, despite recent investor nervousness. Of course, a major wild card could be that the latest surge in new COVID-19 cases becomes large enough to trigger renewed economic restrictions in the US or Europe. Yet any such moves would likely not be as severe as those that occurred back in the spring, given the much lower mortality rates seen during the current upturn in COVID-19 cases, which is reducing the public’s willingness to accept more economy-crushing lockdowns. Bottom Line: Investors have grown a bit more nervous in recent weeks, amid signs of a second wave of the coronavirus in Europe and with the contentious US presidential election only five weeks away. The pro-growth cyclical investment backdrop, however, remains unchanged. From a strategic perspective (6-12 months), maintain an overall neutral stance on interest rate duration, with a moderate overweight to global spread product versus government bonds while staying up in quality. EM USD-Denominated Credit: Focus On Corporates Relative To Sovereigns Chart 6An Overview of USD-Denominated EM Debt Back in July of this year, we turned more positive on emerging market (EM) USD-denominated spread product, upgrading our recommended allocation to both EM USD sovereign and corporate debt to neutral from underweight in our model bond portfolio.3 The change was motivated by signs of rebounding global economic growth after the COVID-19 lockdowns and a loss of upward momentum in the US dollar, coming at a time when EM spreads still looked relatively cheap (wide) compared to developed market corporate debt. An underweight stance was inconsistent with that backdrop. EM credit has done well since our upgrade (Chart 6). Using Bloomberg Barclays index data, the yield on the EM USD-denominated sovereign index has fallen from 5.2% to 4.4%, while the option-adjusted spread (OAS) on that same index tightened from 447bps to 368bps. It has been a similar story for EM USD-denominated corporates, with the index yield falling from 4.1% to 3.9% and the index OAS narrowing from 361bps to 344bps.4 Given the close correlations typically exhibited between EM USD sovereign and corporate yields and spreads, we have tended to change our recommended allocations to both asset classes at the same time and in the same direction. Yet the EM credit universe is quite diverse, incorporating many different issuers of highly varying credit quality and risk (Table 1). Treating the allocations to EM USD sovereign debt and USD corporate debt separately may reveal more profitable relative return opportunities. The fundamental economic and political backdrop remains cyclically bullish for risk assets, despite recent investor nervousness. Table 1Details Of The USD-Denominated EM Sovereign And EM Corporate & Quasi-Sovereign Indices A first step to analyzing the EM USD sovereigns versus corporates investment decision is to develop a list of macro factors that correlate to the relative performance of EM sovereign and corporate credit. From there, we can build a list of directional indicators that can help inform that sovereign versus corporates decision. Treating the allocations to EM USD sovereign debt and USD corporate debt separately may reveal more profitable relative return opportunities. Our colleagues at BCA Research Emerging Markets Strategy have long held the view that overall EM debt performance is mostly driven by just two important macro factors: industrial commodity prices and the US dollar. Specifically, they have shown that the broad cyclical swings in EM sovereign and corporate spreads correlate strongly to the price momentum of a simple blend of industrial metal and oil prices, as well as the price momentum of a basket of EM currencies versus the US dollar (Chart 7). Chart 7EM Credit Spreads: A Commodity And Currency Story On that basis, the recent moderate widening of EM credit spreads is justified by the corrective pullback in industrial commodity prices and a bit of US dollar strength – trends that our EM strategists believe can continue in the near-term. Although they share our view that the medium-term trend in the US dollar is still bearish, thus any near-term EM debt selloff will represent a longer-term buying opportunity.5 The demand for industrial commodities remains largely driven by economic trends in the world’s largest commodity consumer, China. Thus, our China credit impulse (the change in overall Chinese credit relative to GDP), which leads Chinese economic activity, is a good leading indicator of industrial commodity prices. We will use the China credit impulse in our list of directional indicators to forecast EM sovereign versus corporate performance. We also will include the annual rate of change of the index of EM currencies versus the US dollar (shown in Chart 7). We also believe that a global monetary policy variable should be included in our indicator list, particularly in the current environment of super-low developed market interest rates and central bank purchase of government bonds – both of which tend to drive yield-starved investors into higher-yielding EM assets and, potentially, can influence the relative performance of EM sovereigns and corporates. To capture the global monetary policy trend in our indicator list, we use the combined annual growth rate of the balance sheets of the Fed, the ECB, the Bank of Japan and the Bank of England. The message from our indicator list is that EM USD corporates should outperform EM USD sovereign debt over the next 6-12 months. In Charts 8 & 9, we show the relative total return of the Bloomberg Barclays EM USD corporate and USD sovereign indices, expressed in year-over-year percentage terms, versus our list of three potential directional indicators of the relative total return. We have broken up the overall EM universe by broad credit quality, with index data used for investment grade issuers in Chart 8 and below investment grade (high-yield) issuers in Chart 9. For all three of our directional indicators, we have pushed them forward in the charts to look for a potential leading relationship to the relative returns. Chart 8EM Investment Grade Corporates Looking Set to Outperform ... Chart 9... But The High Yield Space Tells A More Mixed Story The charts show that China credit impulse leads the relative total returns of EM USD corporates versus EM USD sovereigns by between 9-18 months for investment grade and high-yield EM credit. The growth of the major central bank balance sheets also leads the relative performance of EM USD corporates versus EM USD sovereigns by one full year, both for investment grade and high-yield EM credit. Finally, the annual growth of EM currencies leads the relative return of EM USD corporates versus sovereigns by around nine months, although the correlation is the weakest of the three indicators in our list. In terms of current investment strategy, the message from our indicator list is that EM USD corporates should outperform EM USD sovereign debt over the next 6-12 months, both for investment grade and high-yield, largely due to aggressive credit stimulus in China and the rapid expansion of central bank balance sheets. In terms of the attractiveness of EM USD-denominated yields in a global fixed income portfolio, however, there is a difference between higher-rated and lower-rated EM debt. In Chart 10, we present a scatter chart that plots the yields on various global fixed income sectors, all hedged into US dollars and compared to trailing yield volatility, versus the average credit rating of each sector. Investment grade EM USD corporate and sovereign issuers offer relatively more attractive yields compared to other sectors with similar credit ratings, like investment grade corporates in the US and Europe. The same cannot be said for high-yield EM USD corporates and sovereigns, which only offer a more attractive volatility-adjusted yield compared to euro area high-yield corporates among the lower-rated global credit sectors. Chart 10EM USD-Denominated High Yield Debt Not Especially Attractive On A Risk-Adjusted Basis Based on this analysis, we are making the following changes in our model bond portfolio on page 14: Upgrading EM USD corporates to overweight Downgrading EM USD sovereigns to underweight Keeping the combined EM USD credit allocation at neutral. This fits with our current overall investment theme of keeping overall spread product exposure relative close to benchmark, while taking more active risks on relative allocations between fixed income sectors. Bottom Line: The main drivers of the emerging market hard currency debt rally since March – a weakening US dollar, improving global growth momentum, and massively accommodative global monetary policies – remain in place. Valuations, however, appear more attractive for EM USD-denominated corporates relative to USD-denominated sovereigns. Favor the former over the latter, within an overall neutral strategic allocation to EM hard currency debt.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research Geopolitical Strategy Weekly Report, "Stimulus Will Come … But May Not Save Trump", dated September 25, 2020, available at gps.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "What Would It Take To Get Bond Yields To Rise Again?", dated September 23, 2020, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism", dated July 14, 2020, available at gfis.bcaraesearch.com. 4 Note that the index data we are using here includes both EM corporate and so-called “quasi-sovereign” debt, the latter being bonds issued by EM companies that are majority-owned by their local governments. 5 Please see BCA Emerging Markets Strategy Weekly Report, "A Reset In The Making", dated September 24, 2020, available at ems.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns