Economy

Highlights Uncertainty & Growth: There is currently a strong link between depressed global growth expectations and elevated levels of economic policy uncertainty (U.S.-China trade tensions, Brexit, etc). Monetary Policy: A growing number of central banks have taken “risk management” measures to try and prevent a deeper downturn in actual economic activity by shifting to a less hawkish policy bias – even with tight labor markets. Implications For Bond Yields: We do not expect the current soft patch for global growth to extend into a more prolonged period of weak activity, given that global policy rates remain at highly stimulative levels. This will set up the next wave of rising global bond yields, but likely not until the latter half of 2019 (and focused mostly on U.S. Treasury yields). Feature Central Banks Take Out Some Insurance The list of global central banks taking a more cautious stance on monetary policy expanded last week. The Bank of England and Reserve Bank of Australia both cut their growth forecasts for 2019 and signaled that there was no chance of interest rate increases in the near term. This follows similar guidance provided in recent weeks by the U.S. Federal Reserve, the Bank of Canada and Sweden’s Riksbank. There was even a dovish surprise in the emerging world, with the Reserve Bank of India delivering an unexpected rate cut last week. In Europe, the European Central Bank (ECB) has not yet shifted its already highly-dovish policy guidance (no rate hikes until at least September), but ECB President Mario Draghi recently noted that the downside risks to European growth have increased. The European Commission went a step further and downgraded its growth forecasts for 2019 last week. The Bank of Japan cut its inflation forecast for 2019 last month, also indicating that monetary policy would remain unchanged over at least the rest of the year. The language used by all of these policymakers to explain their dovish turn was eerily similar, highlighting elevated global uncertainty weighing on growth expectations and, through plunging asset prices, tightening financial conditions (Chart of the Week). The sources of that uncertainty are well known to investors: U.S.-China tariff negotiations, slowing global trade, Brexit, domestic U.S. political squabbles (i.e. government shutdowns over “The Wall”). Until those developments begin to get resolved, uncertainty will continue to weigh on economic confidence. Chart of the WeekThe “Risk Management” Approach To Setting Monetary Policy 21st Century central bankers mostly subscribe to a “risk management” approach to policymaking. This means setting policy dovish enough to cut off downside tail risks to growth during periods of elevated uncertainty about the economic outlook – especially when inflation is below policymaker targets. Yet central bankers remain devoted followers of the Phillips Curve framework. There is a limit to how dovish they can become while unemployment is low and wage growth is increasing. This limits how far government bond yields can fall if growth does not slow enough to cause unemployment to rise. So far, the softer global growth seen in recent quarters has not resulted in any increase in unemployment rates in the major developed economies. Of course, employment is a lagging variable. If the current soft patch for growth extends into a more prolonged slowdown in the coming months, resulting in companies cutting hiring or shedding labor to protect weakening profitability, then there is room for bond yields to continue to fall as markets begin to price in easier monetary policy. That is not our expectation. The U.S. economy remains on solid footing, and we anticipate additional policy actions from China to stabilize economic growth and put a floor under global trade activity. This will eventually cause central bankers to move back to a less dovish policy stance more consistent with trends in unemployment and inflation, with the U.S. Fed leading the way on that front in the latter half of 2019. The eventual result will be higher U.S. Treasury yields, both in absolute terms and relative to government bond yields of the other major developed economies. Bottom Line: There is currently a strong link between depressed global growth expectations and elevated levels of economic policy uncertainty. Central banks are taking the appropriate “risk management” measures to prevent a deeper downturn in actual economic activity by shifting to a less hawkish policy bias – even with tight labor markets. The Link Between Economic Confidence & Monetary Policy The pro-risk rally that opened 2019 endured its first test last week, with several major market prices – including the S&P 500 index, U.S. high-yield spreads, the 10-year Italy-Germany government bond yield differential and the DXY index of the U.S. dollar - bouncing off key medium-term moving averages (Chart 2). Purely from a technical analysis perspective, a test of the primary trends established in the latter half of 2018 (bearish equities and credit, bullish the U.S. dollar) was to be expected, particularly given the severity of the past selloff in global equity markets. Chart 2The First Test For The 2019 Risk Rally Investor sentiment towards global growth, however, remains pessimistic. Nervousness over the outcome for the U.S.-China trade talks, with the March 1 deadline fast approaching, is an obvious source of concern given how slowing Chinese import demand has spilled over so dramatically into weaker global trade activity (Chart 3). Yet there are several other dates for investors to fret about in the near term, including the deadline for a deal to avert another U.S. government shutdown (this Friday), the U.S. debt ceiling deadline (also March 1) and “Brexit day” in the U.K. (March 29). Chart 3A China-Led Slowing Of Global Trade Yet this current soft patch for the global economy is occurring alongside an extreme divergence between plunging growth expectations and more stable readings on current economic conditions. The fall in expectations is visible in the most countries, according to data series that measure confidence for businesses, consumers and investors. One such set of data that we pay close attention to is the ZEW survey. The ZEW survey, produced by a prominent German economic think tank, is most well-known for the data related to Germany itself. The ZEW also produces similar survey data measuring readings on “current conditions” and “expectations” for other major developed economies: the U.S., U.K., Japan, France, and Italy (as well as an aggregate measure for the entire euro area). This makes the ZEW data useful for conducting cross-country analysis of economic sentiment, as the survey structure and questions are consistent for each country. Looking at the individual country readings from the ZEW data, shown in Charts 4 and 5, it is clear that the depressed readings on global growth sentiment are similar across all major countries. Yet at the same time, the individual ZEW Current Conditions indices, while off their cyclical peaks, are exhibiting more diverse trends. The U.S., in particular, stands out as having a very robust reading on Current Conditions, which lines up with the overall firmness of the U.S. economic data. Chart 4A Co-Ordinated Decline Of Expectations, Not Actual Growth Chart 5The European Growth Slump Is Broad-Based The strong correlation between the ZEW Expectations readings suggests that there is a common factor causing market participants to become more worried about the outlook for global growth. These can all be summarized under “uncertainty”, for which we also have data available at the country level from the Economic Policy Uncertainty indices developed by researchers Scott Baker, Nick Bloom and Steven Davis.1 In Charts 6 and 7, we plot the Policy Uncertainty indices against the ZEW growth expectations indices for the individual countries/regions for which the ZEW conducts its surveys. The growth expectations data is shown inverted to correlate with the Policy Uncertainty indices. The visual relationship shows that the current period of elevated Policy Uncertainty has occurred alongside the plunge in growth expectations, seen most strongly in the U.S., U.K. and Italy. Chart 6Uncertainty Slamming Sentiment Hardest In The U.S. & U.K. Chart 7Germany Weathering The Storm Better Than Italy & France But can this link between uncertain and growth expectations result in an actual slowing of economic activity? Can slumping expectations become a self-fulfilling prophecy? One way to look at this is to see how growth expectations evolve relative to current economic growth. We show those gaps between the Current Conditions and Growth Expectations components of the ZEW survey in Charts 8 and 9. A rising line indicates a wide gap between Current Conditions and Expectations and vice versa. We also add real GDP growth in each panel of the charts, to compare that “ZEW Gap” to actual growth outcomes. Chart 8The “ZEW Gap” Now At Levels That Have Heralded Past Downturns … Chart 9… Within Europe Too … The current gap between the two measures is at or near the widest levels seen in the history of the ZEW data dating back to the early 1990s. The previous times that the ZEW Gap reached such levels, economic growth slowed for all the countries in the ZEW survey – most notably in the run-up to the recessions in the early 1990s, early 2000s and 2009. The ZEW Gap also accurately signaled the recessions seen within the euro area after the 2011 European Debt Crisis. The first implication of this result is large discrepencies between strong current growth and expectations almost always resolve themselves with actual weaker growth, if not outright recession – not a good sign for the global economy in the coming quarters. Yet one major difference between today and those prior episodes of a wide ZEW Gap is the level of monetary policy accommodation. In those prior episodes that ended in recession, central bankers raised policy rates to restrictive levels that eventually caused the growth slowdown. This can be seen in Chart 10, where we plot the ZEW Gaps vs the “Monetary Policy Gaps”, defined as the difference between actual central bank policy rates and an estimate of neutral rates derived from a simple Taylor Rule formula.2 Chart 10...But Monetary Policy Is Not Tight This Time Today, central banks are maintaining policy rates far below levels of neutral consistent with long-run potential growth and economies operating at or beyond full capacity – even with inflation rates that are below central bank targets. This should help cushion the blow from weakening growth expectations stemming from the current period of elevated economic uncertainty. The root cause of all recessions is always monetary policy that becomes too restrictive. Typically, that occurs directly through central banks hiking rates above neutral and actively engineering a growth slowdown. It can also occur if an external shock to growth is severe enough to depress economic activity faster than policymakers can identify the slowdown and respond with easier monetary policy. The latter appears to be the outcome that investors are most worried about today. Yet with central banks now turning more dovish in response to elevated uncertainty, at a time when monetary policy appears already highly stimulative, the odds of a monetary policy error crushing growth are low. We are more worried about the opposite outcome, where policymakers are giving more stimulus to a global economy that does not necessarily need it, given that overly tight monetary policy is not the main problem at the moment. In other words, policymakers who have become more dovish today will need to become less dovish later, if and when the current laundry list of uncertainties begin to get resolved. We think that is only a real issue in the U.S. at the moment, though. Our Central Bank Monitors continue to indicate that tighter monetary policy is still required in the U.S. (Chart 11), unlike the Monitors from the U.K., euro area and Japan – the other countries where we have looked at the expectations/uncertainty relationship. Thus, we expect U.S. Treasury yields to have more upside than German Bund, U.K. Gilt or Japanese government bonds over the next 6-12 months. Chart 11The Message From Our CB Monitors - Stay Underweight U.S. Treasuries Bottom Line: We do not expect the current soft patch for global growth to extend into a more prolonged period of weak activity, given that global policy rates remain at highly stimulative levels. This will set up the next wave of rising global bond yields, but likely not until the latter half of 2019 (and focused mostly on U.S. Treasury yields).   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Footnotes 1 The full set of global Policy Uncertainty Indices, with data downloads and methodological descriptions, can be found at  www.policyuncertainty.com. 2 Neutral Policy Rate = Potential GDP growth + central bank inflation target + (0.5 x (current inflation minus central bank inflation target)) +( 0.5 * the IMF estimate of the output gap)). Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Treasury Yields & Data Surprises: Our model suggests that positive data surprises are more likely than negative ones during the next couple of months, meaning that the 10-year Treasury yield is biased higher. Positioning data show no long or short consensus among bond investors, but we think below-benchmark portfolio duration will pay off over both short term (0-3 months) and medium term (6-12) investment horizons. Monetary Policy: The Fed cited tighter financial conditions and slower global growth as the two main reasons for pausing the rate hike cycle. Both of those risks appear poised to ease in the coming months. Expect rate hikes to resume in the second half of 2019. Inflation: Year-over-year core inflation appears tame at the moment, but that will change during the next few months as base effects shift from a headwind to a tailwind. Wage acceleration and core services (excluding shelter and medical care) inflation will be the main drivers. Feature It didn’t take very long. Just two days in fact. Two days after Chairman Powell made the Fed’s pause official we learned that the economy added 304k jobs in January (vs. 165k expected) and that the ISM Manufacturing PMI rebounded to a very healthy 56.6 (vs. 54.0 expected). In short, just as the Fed capitulated on rate hikes, the economic data made that decision look offside. Granted, the bond market does not yet see it this way. The economic data surprise index has moved firmly into positive territory, but Treasury yields have so far refused to follow suit, bucking the typical correlation (Chart 1). Still, we can’t help but feel that consensus economic expectations remain overly downbeat, and that this could set the bond market up for a nasty near-term shock. Chart 1Market Set Up For A Surprise Bond Market At Risk In prior research, we documented the strong correlation between economic data surprises and changes in the 10-year Treasury yield.1 We found that if the U.S. economic surprise index ends a given month in positive territory, there is a good chance that the 10-year Treasury yield increased during that month, and vice-versa (Chart 2A). This relationship also holds reasonably well for 3-month and 6-month investment horizons (Charts 2B & 2C). This is a good thing to know, but it is only useful if we can also predict future economic data surprises. That is certainly no easy task. However, we can exploit what we know about market behavior to give ourselves a slight advantage. For instance, we know that investors revise down their economic expectations after a long string of data disappointments, making it easier for future data to surprise on the upside. Similarly, a long string of positive data surprises usually leads to unrealistically strong expectations, setting the market up for a letdown. This dynamic causes the economic surprise index to be a mean reverting series, and we find that we can explain 55% of its historical variation using the following 3-factor auto regressive model: ESIt+1 = 0.87*(ESIt) – 0.25*(ESIt-1) – 0.16*(ESIt-2), where ESIt is the surprise index’s value in the current month Notice that next month’s index value is a positive function of the current month’s value, but a negative function of the values from each of the prior two months. At present, our model predicts that the surprise index will reach 18 one month from now (see the ‘X’ in Chart 1). As shown in Table 1, a reading of 18 from the surprise index coincides with a higher 10-year Treasury yield 53% of the time. Table 1End-Of-Period Surprise Index Levels And Whether The 10-Year Yield Rose Or Fell During That Period (2003 – Present) Bond Market Positioning Investor positioning and data surprises are closely related concepts. When investor economic expectations are downbeat, it is highly likely that bond market participants also carry a lot of duration risk. A large “net long” duration exposure can make the ensuing bond sell-off worse when the data inevitably surprise to the upside. At present, the JPMorgan Duration Survey shows that investors are neither severely long nor short duration risk (Chart 3). Speculators in 10-year Treasury futures are slightly net short (Chart 3, panel 2), and sentiment surveys report that investors are somewhat bearish on bonds (Chart 3, bottom panel). In general, positioning still has a slightly bearish tinge, but is much closer to neutral than it was a few months ago, prior to the sharp plunge in yields. Chart 3Positioning Close To Neutral Bottom Line: Our model suggests that positive data surprises are more likely than negative ones during the next couple of months, meaning that the 10-year Treasury yield is biased higher. Extreme “net long” bond market positioning would exacerbate any related near-term sell-off, but surveys indicate that positioning is close to neutral. This leads us to expect higher yields in the next few months, but no major market dislocation. The Fed’s Dovish Pivot We have not published a regular Weekly Report since the FOMC signaled a pause in its rate hike cycle on January 30. Since then, many have speculated that the Fed’s rate hike cycle is already over and the market has eagerly taken that message on board. As of last Friday’s close, the overnight index swap curve was priced for 11 bps of rate cuts during the next 12 months and 23 bps of rate cuts during the next 24 months. Data Dependence  Unfortunately for bond bulls, the case for rate cuts is simply not supported by the economic data. In fact, a look at the reasons used to justify the Fed’s dovish pivot reveals that the pause in rate hikes will almost certainly prove temporary. In his post-meeting press conference, Chairman Powell attributed the Fed’s dovish turn to the following factors: Tighter financial conditions Slower global growth Government-related risks (i.e. Brexit, U.S./China trade discussions, and the U.S. government shutdown) Financial Conditions Financial conditions tightened sharply near the end of last year, as can been seen by looking at the three components of our Fed Monitor (Chart 4). Our Fed Monitor is a composite indicator designed to predict whether rate hikes or rate cuts are more likely going forward. It includes 44 variables related to either economic growth, inflation or financial conditions. Chart 4Financial Conditions Have Already Eased The most important thing to note from Chart 4 is that all of the Monitor’s recent decline was driven by tighter financial conditions. The economic growth and inflation components of the Monitor remain firmly in “tight money required” territory. This is important because financial conditions can ease as quickly as they can tighten. Ironically, now that the Fed has telegraphed a more supportive policy stance, a rally in risk assets during the next few months is much more likely. As that transpires it will drive our Monitor deeper into “tight money required” territory, and rate hikes will be back on the table. Global Growth The second factor that Powell mentioned was the slowdown in global growth, driven principally by weakness in China and the Eurozone (Chart 5). Interestingly, at the European Central Bank’s (ECB) latest press conference, ECB President Mario Draghi also blamed “softer external demand” for the weakness in European economic data. Chart 5Global Growth Slowdown Driven By China The logical conclusion is that China has been the catalyst for the global slowdown and that the Eurozone economy has come under pressure because of that region’s greater reliance on China as a source of demand. The fact that the Eurozone is more sensitive to Chinese growth than the U.S. is a topic that our Foreign Exchange Strategy service has covered in great detail.2 The Fed obviously cares more about the domestic economy than overall global growth, but weakness abroad has a habit of migrating stateside via a stronger dollar.3 It would certainly help the case for rate hikes if Chinese (and hence global) growth at least stabilized. On that front, some timely global growth indicators are sending positive signals. Our China Investment Strategy team’s Market-Based China Growth Indicator has rebounded strongly (Chart 6), global industrial mining stock prices have jumped (Chart 6, bottom panel), and the CRB Raw Industrials index may finally be turning a corner (Chart 6, panel 2).4 Chart 6Global Growth Indicators Sending A Positive Signal... But for any rebound in those financial market indicators to prove lasting, we will ultimately need to see confirming evidence in the Chinese economic data. Specifically, the money and credit growth data that tend to lead Chinese economic activity (Chart 7). Our China Investment Strategy team’s Li Keqiang Leading Indicator – a composite of six money and credit growth indicators – has flattened off at a low level. Looking at its components individually, those that capture the recent RMB depreciation have pressured the index higher (Chart 7, panel 2), while those that measure broad credit growth remain depressed (Chart 7, bottom panel). Our Global Investment Strategy team has argued that Chinese policymakers’ desire to suppress credit growth will soon abate, since credit growth has already fallen close to the rate of nominal GDP growth.5 Chart 7...But A Lot Depends On China Bottom Line: It seems increasingly likely that financial conditions will ease and that the global growth slowdown will moderate in the coming months. Geopolitical tail risks remain, but they are unlikely to impact the Fed’s reaction function if financial conditions are easing and global growth is on solid footing. The end result is that the Fed will resume rate hikes in the second half of this year, and Treasury yields will move higher as a result. Investors should maintain below-benchmark portfolio duration. The End Of QT At January’s press conference, Chairman Powell was also quizzed repeatedly about the Fed’s balance sheet policy. This is not surprising given that the Fed had just announced that it will operate monetary policy using its current “floor system” indefinitely. This means that it will continue to supply the banking system with more reserves than it demands, and will control interest rates by paying interest on excess reserves and through the overnight reverse repo facility. We explained in detail the differences between a floor system and the pre-crisis “corridor system” in a 2014 Special Report.6 Practically, the continuation of the floor system means that the Fed’s balance sheet run-off will end earlier than if it were to return to a corridor system. The latter requires a paucity of bank reserves while the former requires an abundance. Unfortunately, as we discussed in a recent report, and as Chairman Powell explained at his press conference, nobody knows exactly how much more reserve drainage can take place before the Fed’s floor system ceases to function and the Fed loses control of interest rates.7 From Powell’s press conference: [I]n managing the federal funds rate, we’d rather have it set by our administered rates. So that implies you’d want [outstanding bank reserves] to be a bit above what that equilibrium demand for reserves is. And again, there’s no cookbook here, there’s no playbook. No one really knows. The only way you can figure it out is by surveying people and market intelligence and then, ultimately, by approaching that point quite carefully. In other words, the Fed will continue to shrink its balance sheet – draining reserves from the banking system in the process – until it decides that any further reserve drain will cause the funds rate to break through the upper-end of its target band. There is already some evidence of pressure on this front. The effective federal funds rate has been inching toward the upper-end of its target range in recent months, and the 99th percentile of the daily effective fed funds rate has actually been above the target range. This means that, for the past couple months, a few federal funds transactions every day have occurred outside the Fed’s target range (Chart 8). If this situation persists, then it will hasten the Fed’s decision to cease the run-off of its balance sheet. Chart 8Fed Funds Rate Inching Higher Our sense is that the Fed will cease the unwinding of its balance sheet at some point this year or early next year. However, we don’t view that decision as very important from an investment standpoint. It has been the longstanding view of this publication that any possible impact on bond yields from the Fed’s balance sheet policy pales in comparison to the impact from its interest rate policy. We will elaborate on this view in forthcoming research alongside our Global Fixed Income and U.S. Investment Strategy services. For today, we will simply remind readers of our golden rule of bond investing: If Fed rate hikes exceed what is currently priced into the market, then long duration positions will underperform over that time horizon, and vice-versa.8 All other factors are subordinate to that golden rule. Will Tame Inflation Prevent Further Rate Hikes? At January’s press conference, Chairman Powell noted that one reason why the Fed felt comfortable pausing its rate hike cycle was that inflation appeared relatively tame. Once again, the Chairman accurately described the fact that year-over-year core inflation has moderated during the past few months. Year-over-year core CPI inflation is down to 2.21% as of December, from a peak of 2.33% last July. Data on the Fed’s preferred PCE measure has been delayed due to the government shutdown, with a December update expected on March 1. However, this is another situation where the evidence could look a lot different in a few months. The last three monthly core CPI prints have come in at right around 0.2% month-over-month. If that pace is maintained going forward, then year-over-year core CPI will fall a bit further in the near-term, but will then start rising at a rapid pace (Chart 9). By the middle of this year the discussion surrounding inflation could look a lot different. Chart 9Expect Inflation To Pick-Up By The Middle Of The Year Of course, the simple extrapolation in Chart 9 assumes that core inflation will continue to print at a 0.2% monthly rate. Given the low unemployment rate, accelerating wage growth and persistent elevated monthly hiring numbers, we see no reason why this shouldn’t be the case. However, many clients we talk to have strong doubts that core inflation will move higher. This sentiment is reflected in long-maturity TIPS breakeven inflation rates that remain well below “well anchored” levels. One of the most common questions we receive from clients is: Where will inflation come from? A good starting point to answer that question is to split core CPI into its main components (Chart 10): Chart 10The Components Of Core CPI Shelter (42% of core) Goods (25% of core) Medical Care (8% of core) Services excluding shelter and medical care (25% of core) After making this decomposition we can attempt to identify unique drivers for each component. For shelter inflation, the rental vacancy rate and home price appreciation are the most important variables. Home prices have decelerated in recent months but the rental vacancy rate remains near historically low levels. Taken together, our shelter CPI model shows that shelter inflation should stay near its current level for the next six months (Chart 10, top panel). Core goods inflation tends to track non-oil import prices with a relatively long lag (Chart 10, panel 2). The current message from import prices is that core goods inflation should level off in the coming months, but should not reverse its recent uptrend. The best determinant of trends in core services (excluding shelter and medical care) inflation is wage growth (Chart 10, panel 3). Here we see that services inflation has responded strongly to accelerating wage growth in recent months and is now running at a healthy 2.6% year-over-year pace. With the unemployment rate at 4%, further wage acceleration is probable. Bottom Line: Year-over-year core inflation appears tame at the moment, but that will change during the next few months as base effects shift from a headwind to a tailwind. Wage acceleration and core services (excluding shelter and medical care) inflation will be the main drivers.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “How Much Higher For Yields?”, dated October 31, 2017, available at usbs.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, “The Dollar And Risk Assets Are Beholden To China’s Stimulus”, dated August 3, 2018, available at fes.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity?”, dated August 21, 2018, available at usbs.bcaresearch.com 4 The Market-Based China Growth Indicator is a composite measure of financial market variables that are highly levered to the Chinese economy. For further details please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 5 Please see Global Investment Strategy Weekly Report, “China’s Savings Problem”, dated January 25, 2019, available at gis.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, “Cleaning Up After The 100-Year Flood”, dated June 10, 2014, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “The Fed In 2019”, dated December 18, 2018, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification