Developed Countries

The dollar is likely to enter the bubbly stage of its bull market within the next 12 months. The key culprit for this move will not be the Fed, but easing by non-U.S. central banks. The euro area economy could enter a temporary soft patch, but this will not result in an imminent easing by the ECB.

The neutral real rate of interest, r*, is likely to remain depressed for the foreseeable future. The Fed is likely to take additional incremental measures to boost long-term inflation expectations, including allowing inflation to overshoot its 2% target more frequently. This should be enough to keep long-term Treasury yields on a gradual upward trajectory.

The financial sector has enjoyed a modest respite as the market has pulled forward Fed rate hike expectations. However, we doubt that will last long if the yield curve continues to narrow and the U.S dollar firms, importing deflationary pressures into the U.S. Historically, a flat yield curve has signaled that monetary policy is too tight and that an economic downturn loomed. An inverted yield curve accurately predicted major market tops in 2000 and 2007, as well as shorter but sharp market declines in 1990 and 1998. The yield curve continues to narrow as the Fed lowers its terminal rate forecast and the insatiable global search for yield persists. It will not take many Fed rate hikes for the yield curve to completely flatten or invert. As such, we continue to deemphasize the overall financial sector, preferring its less cyclical components such as REITs and insurance, which stand a better chance of outperforming as the curve flattens.

If the Fed convinces markets it is on track to lift rates this year and a couple of times next year, we expect a 10% appreciation of the USD over the next 12 months. This would be extremely bearish for commodities.

The downside risks to the RMB are mainly an overshoot of the dollar as the Fed raises rates. The PBoC will allow the RMB to fall against the dollar if the dollar strengthens broadly, but a freefall is not in the cards. The RMB is unlikely to fall more than 5% against the dollar in the next 12 months, unless the latter appreciates by over 10% in trade-weighted terms.

The DM Country Model favored Italy again at the expense of Spain mostly on liquidity change. Japan and the U.K. remain the largest two underweights.

We reveal what our most-trusted leading indicators are predicting about the major economies, and end with a provocative conclusion.

The latest housing data paint a bullish picture for the S&P homebuilding index. New home sales are soaring, and are rapidly regaining as a share of total home sales. Demand for new homes is well supported by increased mortgage availability, rising credit scores and faster income growth. Importantly, faster demand has not yet translated into overproduction, as new home prices are soaring, which bodes well for homebuilder sales growth (third panel). The supply of new homes has recently ticked lower in absolute terms, and plunged in terms of months of supply (bottom panel). The surge in construction job openings reinforces that builders have sufficient backlog to aggressively add staff. In turn, that should boost confidence in the longevity of the housing upcycle, translating into a valuation re-rating. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOME-PHM, DHI, LEN.

Recent shifts in the Fed's policy stance are bullish for the dollar, negative for commodities and emerging markets, and positive for assets with a yield. They also suggest risk assets will continue to perform decently.

Given the rising odds of another Fed move before year-end, and the uncertainty that additional easing can be delivered in Europe and Japan, we re-iterate our tactical call to maintain a below-benchmark duration stance.