Europe
Highlights U.S. Tax Cuts: The ongoing turmoil in the White House, and the negative impact it is having on the popularity ratings of both President Trump and the Republican-led U.S. Congress, will intensify efforts to get a tax cut package done as quickly as possible. Success on this front will help buoy U.S. business confidence and lead to stronger U.S. economic growth, and likely more Fed rate hikes, in 2018. Fed vs. ECB: Economic growth is solid, and inflation expectations remain stable, on both sides of the Atlantic. We expect a December rate hike by the Fed, with more likely in 2018, and a tapering of asset purchases by the ECB beginning in January. Maintain a defensive stance on portfolio duration. U.S. Corporates vs. EM: Emerging market (EM) hard currency debt, both sovereign and corporate looks fully valued, even with a positive global growth backdrop. Reduce EM sovereign and corporate debt in favor of U.S. Investment Grade corporates in global fixed income portfolios. Feature Who's In Charge Here? Table 1A Rough Month For Risk Financial markets are sailing without a rudder at the moment. A clear risk-off flavor has swept over most risk assets, as can be seen in the returns seen so far in August in so many asset classes (Table 1). There have been a number of negative news events for investors to process, from President Trump's Charlottesville controversy to the never-ending staff changes in the White House to the North Korean tensions to last week's terror attack in Spain. On top of that, some of the major central banks have become a bit more wishy-washy in their guidance to the markets, even going as far as questioning their own understanding of the inflation process (does the Philips curve even work anymore?). Investors always prefer a clean narrative when it comes to the "big picture" macro backdrop. Right now, they are not getting that from political leaders and policymakers, especially in the U.S. (Chart of the Week). Trump's popularity rating is steadily declining, even now among Republican voters. This has raised concerns that any of his business-friendly policies tax cuts or initiatives to boost growth like infrastructure spending can be successfully enacted. At the same time, and perhaps for similar reasons, the gap between the market expectation and the Fed's projection for the funds rate is widening with only 24bps of hikes priced over the next year. This is driven largely by investors' persistent lack of belief that U.S. inflation will hit to the Fed's target in the next few years. Simply put, the market is saying that the Fed's current tightening cycle is essentially complete unless there is a turnaround in U.S. inflation and/or a sizeable fiscal stimulus enacted in D.C. On that latter point, we think it is critical to monitor measures of U.S. business confidence. The current cyclical upturn in global growth and corporate profits has certainly lifted optimism among business leaders. Yet it is clear that there was also a boost to business sentiment after the U.S. election (Chart 2) last November as it was believed that Trump's victory, and the likely policies that would follow, would be good for American companies. Right now, business optimism remains at strong levels whether looking at small business measures like the NFIB survey (top panel) or the big business series like the Conference Board CEO confidence index of the Duke University/CFO Magazine indicator for confidence among chief financial officers (middle panel). There has been a slight recent pullback from the post-election peak in all the business sentiment indicators, however, and any sign that Trump will have difficulty pushing his tax cuts through Congress could result in a bigger loss of confidence that could impact future hiring and capital spending activity. Our colleagues at BCA Geopolitical Strategy continue to believe that a tax reform package, including significant tax cuts, is still the most likely outcome. Congressional Republicans will not want to go into the 2018 U.S. mid-term elections "empty-handed". With Congress and the White House on the same page, focused by fears of losing seats next year, even an embattled and unpopular president should be able to get his tax cuts implemented. Any fiscal boost in the U.S. can only help to support the current global cyclical economic upturn. While growth indicators like our global PMI index have come off the highs a bit (Chart 3), the OECD's global leading economic indicator is still rising and pointing to rising real developed market bond yields (middle panel). In addition, the global data surprise index has bottomed out, leaving global bond yields exposed to any improvement in economic momentum (bottom panel). Chart of the WeekLosing Faith In##BR##Trump & The Fed Chart 2U.S. Businesses##BR##Are Still Confident Chart 3Global Bond Yields Are##BR##Vulnerable To Faster Growth The fiscal news flow out of D.C. is likely to remain volatile once Congress returns from its summer recess, particularly with regards to tax cut negotiations and the looming debt ceiling. Yet the big news that investors want to hear, regarding U.S. tax cuts, is more likely to be positive for growth and risk assets and negative for bond yields. Bottom Line: The ongoing turmoil in the White House, and the negative impact it is having on the popularity ratings of both President Trump and the Republican-led U.S. Congress, will intensify efforts to get a tax cut package done as quickly as possible. Success on this front will help buoy U.S. business confidence and lead to stronger U.S. economic growth, and likely more Fed rate hikes, in 2018. The Fed & ECB: Still Sticking To Their Script Chart 4Inflation Expectations Are##BR##Stable In The U.S. & Europe The markets continue to underestimate the likelihood of more Fed rate hikes in the next year. The odds of a hike in December now sit at only 32%, while essentially no hikes in 2018 are currently discounted. This is far too low, given the steady (if unspectacular) growth in the U.S. and tightening labor conditions. The market has clearly responded to the dip in realized U.S. inflation since March as a sign that the real fed funds rate is now close to equilibrium - a point that has also been suggested by some FOMC members - and that the Fed's inflation forecasts are hence unlikely to be realized. Yet measures of U.S. inflation expectations, both survey-based and market-based, have been fairly stable at levels consistent with the Fed's inflation target in recent months, even as headline U.S. inflation has slowed (Chart 4, 2nd panel).1 A similar dynamic is playing out in Europe. Both survey-based and market-based measures of inflation expectations have been stable at levels close to the ECB's inflation target of "just below" 2% on headline inflation (bottom panel), despite the dip in realized inflation. Stable inflation expectations are something that central bankers take very seriously as a sign that their monetary policies are seen as credible. If the recent dip in realized inflation also showed up as an equivalent decline in expected inflation, this would give policymakers in D.C. and Frankfurt second thoughts about making any policy changes in a less dovish/more hawkish direction. The latest readings on realized inflation in both the U.S. and Euro Area suggest some stabilization of the current downturn may be underway. Headline CPI inflation ticked higher from 1.6% to 1.7% in July, ending a streak of four consecutive months of deceleration since March. Core CPI inflation has been stable at 1.7% for three consecutive months up to July, after falling for four consecutive months from January. Data released last week for July inflation in Europe showed a similar dynamic, with core HICP inflation ticking up to 1.2%, the third consecutive month of faster year-over-year inflation. With growth on both sides of the Atlantic maintaining a steady, above-potential pace, amid stable inflation expectations and with realized inflation showing signs of bottoming out, we see both the Fed and the ECB sticking with their current messaging and forward guidance. That means one more rate hike this year by the Fed, most likely in December, following an announcement on beginning the process of reducing the Fed's balance sheet at the September FOMC meeting. After that, at least another 25-50bps of hikes in 2018 will be delivered, which is currently not discounted by the market. As for the ECB, expect a shift to a slower pace of asset purchases for 2018, to be announced at either the September or October monetary policy meetings. Chart 5Has The Euro Already Overshot? The Kansas City Fed's annual Jackson Hole conference, set to take place this weekend, is unlikely to produce any major surprises for investors. Both Fed Chair Janet Yellen and ECB President Mario Draghi will give speeches to an audience of their peers - other global central bankers. Much is being made of Draghi's speech, since he has not spoken at Jackson Hole since 2014 when he gave strong indications of the introduction of the ECB's asset purchase plan in 2015. After his speech at the ECB Forum in Portugal in late June of this year - also to an audience of central bankers - where he mentioned a "reflationary" impulse in Europe that could require some "adjustments" to the ECB's policy settings, investors will be on high alert for any indications that the ECB is about to announce a tapering of its asset purchases. The Account of the July ECB meeting released last week suggested some concern within the ECB Governing Council regarding the potential for an "overshoot" of the euro in response to any policy shift.2 Some are interpreting those comments as a sign that the ECB might be getting cold feet over making any changes to its asset purchase program given the 11% rise in the euro seen this year. However, we think that there was too much attention focused on the fears that a strong euro could derail any plans for an ECB taper, for two reasons: The ECB did note in the July Account that the rise in the euro was a reflection of both the relatively stronger growth seen in the Euro Area this year and the reduction in political risk premia after the French presidential elections in the spring. The Account also noted that the ECB was looking at the totality of its monetary policy measures - policy rates, forward guidance & asset purchases - when assessing its policy stance. This specific quote from the Account, shown with our emphasis on the key passages, highlights that the ECB thinks that a tapering of asset purchases, done on its own with no hikes in short-term interest rates, will still leave monetary policy at very accommodative settings: "...the point was made again that the overall degree of accommodation was determined by the combination of all the monetary policy measures implemented by the ECB, and that the Governing Council's assessment of progress regarding a sustained adjustment in the path of inflation should apply to the overall design and direction of the ECB's monetary policy stance as a whole, and not with reference to any particular instrument in isolation, such as the duration and pace of APP asset purchases." Investors should understandably be worried about the impact of the rising in the euro, which was one of the fastest rates of acceleration seen in the currency's history (Chart 5). Yet given that extreme in price momentum, the lack of support from higher short-term Euro Area interest rates, and with speculative positioning on the euro at very bullish levels, it is unlikely that much further gains in the currency can be expected. This is especially true for the euro versus the U.S. dollar if the Fed delivers additional rate hikes, as we expect. Unless there is decisive evidence that the latest rise in the euro was seriously dampening Euro Area economic growth or inflation, which is not currently visible in the data (bottom panel), then the ECB is still likely to downshift to a slower pace of asset purchases in 2018. Bottom Line: Economic growth is solid, and inflation expectations remain stable, on both sides of the Atlantic. The Fed and ECB remain on course to shift to a less accommodative policy stance towards year-end. That means a December rate hike by the Fed, with more likely in 2018, and a tapering of asset purchases by the ECB beginning in January. Maintain a defensive stance on portfolio duration. Trim EM Debt Exposure Versus U.S. Investment Grade Corporates Emerging market (EM) debt has been one of the strongest performing asset classes so far in 2017. EM USD-denominated sovereign bonds have delivered a total return of 7.5%, while USD-denominated EM corporates have returned 8.7%, according to Bloomberg Barclays index data. These returns have handily surpassed the majority of all other major USD-denominated fixed income sectors. A robust pace of inflows into EM debt, a record $48.6 billion year-to-date to August 9th according to the Wall Street Journal, has helped drive EM debt spreads to tight levels (Chart 6).3 The outperformance of EM debt, both versus its own history and compared with other pro-risk fixed income classes like U.S. corporates, would be justified if EM economic growth was faster than that seen in developed markets. Yet that is not currently the case. An EM (excluding China) PMI Index put together by our colleagues at BCA Emerging Markets Strategy has shown a sharp deceleration of EM growth for most of 2017 (Chart 7, top panel). This stands in sharp contrast to the improving growth seen in both the U.S. and Europe. Chart 6EM Debt Looks##BR##Fully Valued Chart 7Stronger U.S. Growth Favors##BR##U.S. IG Vs EM Sovereigns... The gap between the U.S. and EM (ex China) PMIs has widened to the largest level since 2014. This PMI gap has been a good directional indicator for the spread between U.S. corporate bond spreads (both for Investment Grade and High-Yield) and EM debt spreads (bottom two panels). Right now, it appears that U.S. High-Yield looks fairly valued versus EM USD-denominated sovereign debt but U.S. Investment Grade spreads still look a bit too wide relative to EM sovereigns. A similar story can be told when comparing U.S. corporates to EM USD-denominated corporate debt (Chart 8). Arthur Budaghyan, BCA's Chief Emerging Market strategist, recently made a trade recommendation to go short EM sovereign and corporate debt versus U.S. Investment Grade corporate debt.4 His argument was based on the relatively expensive valuations on EM debt, coming at a time when the outlook for economic growth and corporate profits looks healthier in the U.S. We could not agree more - especially if the Fed begins to hike rates, as we expect, and the U.S. dollar begins to strengthen anew, potentially triggering outflows from EM. Arthur has also pointed out that the gap between the option-adjusted spread (OAS) on EM corporates and U.S. corporates (both Investment Grade and High-Yield) has been an excellent leading indicator of the total return differential between the asset classes (Chart 9). The current relationships show that there is upside potential for U.S. Investment Grade versus EM corporates over the next 12 months, but not for U.S. High-Yield versus EM. Chart 8...And Vs. EM Corporates Chart 9Downgrade EM Debt Vs U.S. IG Corporates Thus, this week, we are cutting our allocations to both EM sovereign and corporate debt in our model bond portfolio, and increasing our allocation to U.S. Investment Grade corporates (see page 12). While this does move us into an asset class with a longer duration, the increase in our overall portfolio duration from this shift is very small given the small weight of EM debt in our custom benchmark. More importantly, U.S. Investment Grade is less risky than EM corporates using the duration-times-spread metric - our preferred measure for spread product risk. Bottom Line: Emerging market (EM) hard currency debt, both sovereign and corporate looks fully valued, even with a positive global growth backdrop. We see better value in U.S. higher-quality corporates vs. EM debt at current spread levels. Reduce EM sovereign and corporate debt in favor of U.S. Investment Grade corporates in global fixed income portfolios. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The inflation expectations data shown in Chart 4 is based off the U.S. Consumer Price Index (CPI) measure of inflation, while the Fed targets growth in the headline Personal Consumption Expenditure (PCE) deflator of 2%. The spread between the two measures have averaged around 50bps in recent years, which suggests that the current CPI-based inflation expectations around 2.5% are in line with the Fed's 2% PCE inflation target. 2 https://www.ecb.europa.eu/press/accounts/2017/html/ecb.mg170817.en.html 3 https://blogs.wsj.com/moneybeat/2017/08/17/emerging-market-bonds-attract-record-inflows/?mg=prod/accounts-wsj 4 Please see BCA Emerging Markets Strategy Weekly Report, "EM: The Focus Is On Profits", dated August 16th 2017, available at ems.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
Highlights Mantra 1 - Europe: First Among Equals - instils awareness that the euro area's long-term growth prospects and 'neutral' real interest rate are not meaningfully different to those in other developed economies. Mantra 2 - Mission Impossible: 2% Inflation - instils awareness that central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. Mantra 3 - Negative Skew: A Ticking Time-Bomb - instils awareness that low observed volatility categorically does not mean that equity market risk has diminished. If anything, it means the exact opposite. Feature The titles of three of our recent reports - Europe: First Among Equals,1 Mission Impossible: 2% Inflation,2 and Negative Skew: A Ticking Time-Bomb3 - can be regarded as mantras instilling awareness of major investment opportunities and threats. This week's report is a recap of the messages encapsulated within these three mantras. Mantra 1 - Europe: First Among Equals Mantra 1 instils awareness that long-term growth in the euro area, adjusted for population, is not meaningfully different to that in other developed economies (Chart of the Week). Through the past 20 years, the euro area has underperformed through multi-year periods encompassing around half the time; but it has outperformed through the multi-year periods encompassing the other half. Chart of the WeekThe Euro Area Is An Economic Equal Seen in this wider context, the euro area's 2008-14 phase of poor economic performance was not structural, it was cyclical - the impact of back to back recessions separated by an unusually short gap. And if the euro area continues its recovery to just the mid-point of its long-term relative cycle, then recent investment trends in the bond and currency markets have much further to run. Bond yield spreads closely follow relative real GDP per head (Chart I-2). As they must, given central banks' self-professed 'data-dependency'. Although nobody expects the ECB to hike interest rates any time soon, expectations for the long-term 'neutral' rate are correctly rising from overly-depressed levels. Hence, the yield spread between long-dated bonds in the euro area4 and the U.S. has compressed from -175 bps last year to -125 bps today. Still, to reach the mid-point of its long-term cycle, this yield spread must ultimately converge to around -40 bps. But why is the mid-cycle yield spread -40 bps? The simple answer is that, over this 20-year period, the euro area versus U.S. inflation differential has averaged -40bps (Chart I-3). In other words, the mid-cycle real yield spread is zero. Chart I-2Bond Yield Spreads Just Follow ##br##Relative GDP Per Head Chart I-3The Euro Area - U.S. Inflation Differential ##br##Has Averaged -40 Bps This leads to a very important empirical observation. The mid-cycle or 'neutral' real interest rates in the euro area and U.S. have been near-identical over the past 20 years. Bear in mind that the past 20 years captures a very wide spectrum of economic and financial backdrops: the launch of the euro, the dotcom bubble and bust, the U.S. subprime credit boom and financial crisis, the euro debt crisis, QE. If this disparate past is a reasonable representation of the disparate future, we should expect the neutral real interest rate in the euro area to remain broadly similar to that in the U.S. The implication is that the yield spread between long-dated bonds in the euro area and the U.S. can compress much more. On a 2-year horizon, stay underweight euro area bonds - especially German bunds - in a European and global bond portfolio. And expect euro/dollar eventually to break through 1.30. Mantra 2 - Mission Impossible: 2% Inflation Mantra 2 instils awareness that central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. The crux of the matter is that the monetary system and inflation form a classic non-linear system. A defining feature of a non-linear system is that it can be very difficult, even impossible, to achieve an arbitrary point target output like '2%' (Chart I-4). Chart I-4Non-Linear: Inflation Flipped From One Mode To A Completely Different Mode In a linear system, if a small input produces a small output, then double the input will produce double the output and triple the input will produce triple the output. But in a non-linear system, double the input could produce no output, half the output, or ten times the output. To be clear, we have no doubt that a fiat monetary system makes it possible to generate rampant inflation, should policymakers be absolutely determined to create it. But central banks are now starting to ask. At what cost? And for what benefit? Central banks are realising that in the struggle to achieve 2% inflation, persistent ultra-accommodative policy endangers the healthy functioning of markets and poses a risk to financial stability. At the same time, the continued undershoot of 2% inflation is not such a terrible thing when the economy is growing well. Chart I-5Relative Interest Rate Expectations##br## Just Follow Relative GDP Per Head The latest to admit this is Kasumasa Iwata, a leading candidate to become the next governor of the Bank of Japan. With the demerits of extraordinary stimulus becoming clearer, the BoJ should slow purchases of government bonds and ETFs even though inflation is nowhere near its target, he said. This follows hot on the heels of respected and influential ECB Governing Council member, Ewald Nowotny, who recently asked whether there should "be an easing of the 2% inflation goal in the sense of setting a range instead of a clear-cut target." And in Sweden, even though inflation has just hit 2% for the first time in six years, the Riksbank has suggested (re)introducing a variation band of 1% either side of the target5 to acknowledge that persistent 2% inflation is very difficult, or impossible, to achieve. Additionally, Riksbank Governor, Stefan Ingves, proposed that "central banks should also have the explicit responsibility for financial stability." The direction of travel is very clear. The most accommodative central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. These central banks are set to dial back accommodation. Hence, the multi-year phase of divergent monetary policies across developed economies is over. The new multi-year phase is re-convergence of monetary policy, and specifically the ECB and Riksbank versus the Fed (Chart I-5). Therefore, mantra 2 - Mission Impossible: 2% Inflation - reinforces the investment conclusions that stem from mantra 1 - Europe: First Among Equals. Mantra 3 - Negative Skew: A Ticking Time-Bomb Mantra 3 instils awareness that low observed volatility categorically does not mean that equity market risk has diminished. If anything, it means the exact opposite. When the equity market is advancing, its observed volatility is low. But this is just a property of so-called 'negative skew'. Up weeks tend to generate small and regular positive returns which means that advances tend to be gradual and gentle. And the longer and more established the advance becomes, the lower the observed volatility goes. Unfortunately, some investors and risk-control algorithms mistakenly use the observed volatility of an investment as a gauge of its riskiness. They incorrectly equate low observed volatility with a lower risk premium, which justifies an additional advance in the market. The additional advance then takes observed volatility even lower - which justifies a further market advance. And so on, in a self-reinforcing positive feedback. Eventually, the truth dawns. Equity market risk hasn't actually declined, but the equity risk premium - the excess prospective return that equities offer over bonds - has almost disappeared. And suddenly, the self-reinforcing feedback phase-shifts from positive to negative. The equity risk premium is the excess prospective return that equities offer over bonds, but a good working approximation is the difference between the equity index earnings yield and the bond yield. The concerning thing is that this measure of the equity risk premium is moving exactly in line with the equity market's observed volatility (Chart I-6), when it shouldn't. Admittedly, it is difficult to know when the time-bomb will go off. But the good news is that when observed volatility is very low - as it is now - options become very cheap. And a long index plus at-the-money put option becomes an excellent absolute return strategy.6 Chart I-6The Equity Risk Premium Is Tracking The##br## Equity Market's Observed Volatility Chart I-7Record Low Observed Volatility ##br##Doesn't Last For those that cannot buy options, record low observed volatility tends to signify a good time to raise a little bit of cash. This should be set aside for reinvestment in the equity market when observed volatility spikes (Chart I-7), as it always ultimately does. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Published on August 3 2017 and available at eis.bcaresearch.com 2 Published on July 20 2017 and available at eis.bcaresearch.com 3 Published on July 27 2017 and available at eis.bcaresearch.com 4 Euro area average over 10-year sovereign yield, weighted by sovereign issue size. 5 The Swedish FSA has said that the Riksbank should delay the change until a parliament review of Riksbank policy rules is completed in about 2 years. 6 For more details of the absolute return strategy, please see the European Investment Strategy Special Report titled "Negative Skew: A Ticking Time-Bomb", dated July 27, 2017 and available at eis.bcaresearch.com Fractal Trading Model Long USD/CAD successfully hit its 2.5% profit target and is now closed. This week's new trade is to short MSCI Turkey versus the Eurostoxx600 with a profit target and symmetric stop-loss set at 5%. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 The post-June 9, 2016 fractal trading model rules are: 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. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * 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 Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations
Highlights Washington must establish a "credible threat" if it is to convince Pyongyang that negotiations offer the superior outcome; The process of establishing such a credible threat is volatile; U.S. Treasurys, along with Swiss and Japanese government bonds have been consistent safe haven assets; The risk of a U.S. attack against North Korea is a red herring, while the crisis itself is not; We suggest that investors hedge the risk with an equally-weighted basket of Swiss bonds and gold. Feature Brinkmanship between Pyongyang and Washington, D.C. has roiled markets over the past week. The uptick in rhetoric has not come as a surprise. Since last year, BCA's Geopolitical Strategy has stressed that souring Sino-American relations were the premier geopolitical risk to investors and that China's periphery, especially the Korean peninsula, would be the "decisive" factor for markets.1 North Korea's nuclear ambitions - which could be snuffed out immediately by a concerted and coordinated effort by China and the U.S. - are a derivative of the broader U.S.-China dynamic. The U.S. is unlikely to use military force to resolve its standoff with North Korea. There are long-standing constraints to war, ones that all of the interested parties know only too well from their experience in the Korean War of 1950-53. The first of these is that war is likely to bring a high death toll: Pyongyang can inflict massive civilian casualties in Seoul with a conventional artillery barrage; U.S. troops and Japanese troops and civilians would also likely suffer. Second, China is unlikely to remain neutral, given its behavior in the 1950s, its persistent strategic interest in the peninsula, and its huge increase in military strength relative to both the past and to the United States. However, the process by which the U.S. establishes a "credible threat" of military action is volatile.2 Such a credible threat is necessary if Washington is to convince Pyongyang that negotiations offer a superior outcome to the belligerent status quo. Viewed from this perspective - which is informed by game theory -President Donald Trump has not committed any grave mistakes so far, but has rather shrewdly manipulated the world's perception that he is mentally unhinged in order to enhance his negotiating leverage. It is unclear how long it will take Trump to convince North Korea that the threat of a U.S. preemptive strike is "credible." As such, it is unclear how long the current standoff will persist. From an investor perspective, it will be difficult to gauge whether the brinkmanship and military posturing are part of this "territorial threat display" or evidence of real preparations for an actual attack. As such, further volatility is likely. The ongoing crisis in North Korea is neither the first nor the last geopolitical crisis the world will face in today's era of paradigm shifts.3 We have long identified East Asia as the cauldron of investment-relevant geopolitical risks.4 This is a dynamic produced by the multipolar global context and the geopolitical disequilibrium in the Sino-American relationship. For now, investors have been able to ignore the rising global tensions (Chart 1) due to the ample liquidity emanating from central banks, but the day of reckoning is nigh (Chart 2). Chart 1Multipolarity Increases Conflict Frequency Chart 2Day Of Reckoning? Q&A On North Korea Back on April 19, we wrote a Special Report, "North Korea: Beyond Satire," which argued that North Korea had at last become a market-relevant geopolitical risk after decades of limited impact (Chart 3).5 Chart 3North Korean Provocations Rarely Affect Markets For Long Looking to the next steps, we introduced the "arc of diplomacy," a framework comparable to the U.S.-Iran nuclear negotiations from 2010-15 (Chart 4). We predicted that the U.S. would ultimately ramp up threats for the purpose of achieving a diplomatic solution. The U.S. was constrained and would only go to war if an act of war were committed, or appeared imminent.6 Chart 4Arc Of Diplomacy: Tensions Ramp Up As Nuclear Negotiations Begin This assessment is now playing out. But not all clients are convinced of our logic, as we have found in our travels throughout Asia Pacific and elsewhere this month. Below we offer a short Q&A based on questions we have received from clients: Q: Diplomacy has already been tried, so why won't the U.S. attack? A: The U.S. public has less appetite for war, especially a preemptive strike, in the wake of the Iraq War, and has not suffered a 9/11 or Pearl Harbor-type catalyst. The U.S. will exhaust diplomatic options before joining a catastrophic second Korean War. And the diplomatic options are far from exhausted. The latest round of sanctions are tighter and more serious than past ones, but still leave categories untouched (like fuel supplies to the North) and are still very hard to enforce (like cutting illegal North Korean labor remittances). Enforcement is always difficult, and the U.S. is currently attempting to ensure that its allies enforce the sanctions strictly, not to mention its rivals (i.e. Russia and China). While we do not think China will ever impose crippling sanctions, we do think it can tighten them up considerably, which could be enough to change the North's behavior. Q: Why doesn't China just take North Korea out? A: China is a formal political, military, and ideological ally of North Korea, and has a strategic interest in maintaining a buffer space on the Korean peninsula - which it defended at enormous human cost in the Korean War. This interest remains in place. China is far more likely to aid and abet a nuclear-armed ally in North Korea than it is to endorse (much less participate in) regime change. The fallout from a new war, such as North Korean refugees flooding into China, is extremely undesirable for China, though it could handle the problem ruthlessly. China would also prefer not to have to occupy a collapsing North, which would be an extensive and dangerous entanglement. Therefore, expect China to twist Pyongyang's arm but not to break its legs. On a more topical note, China is consumed with domestic politics ahead of the nineteenth National Party Congress. It is perhaps more likely to take action after the congress in October-November. Q: Will U.S. allies cooperate with Trump? Why not bandwagon with China to gain economic benefit? A: South Korea is the best litmus test for whether Trump is causing U.S. allies to drift. The new South Korean President Moon Jae-In, who is politically left-of-center, has played his cards very carefully and started out on good footing with President Trump. A disagreement appears to be a likely consequence of Moon's agenda, which calls for extensive engagement with the North and a review of the U.S. THAAD missile defense deployment in Korea. So far, however, Moon is reaffirming the alliance, in his own way, and Trump has not (yet) expressed misgivings about him. If this changes significantly - as in, South Korea joining with China to give North Korea significant economic aid in defiance of U.S. sanctions efforts - then it would be a sign of division among the allies that would benefit North Korea and could even increase the risk of the U.S. taking unilateral action. The odds of that are still low, however. We have been short the Korean won versus the Thai baht since March 1, and the trade is up 6.03%. We also expect greater volatility and higher prices of credit default swaps to plague South Korea while the crisis continues over the coming months. We are closing our long Korean consumer stocks trade versus Taiwanese exporters for a loss of 4.24%. Q: What is Japan's role in the current crisis? What is the impact on Japan? A: Japan is one of the few countries whose relations with the U.S. have benefited under the Trump administration. The Japanese are in lock-step so far in reacting to North Korea. The government has been sounding louder alarms about North Korea for the past year, including by conducting evacuation drills in the case of attack. Japan has long been within range of North Korea's missiles, but its successes in nuclear miniaturization pose a much greater threat. Not only does North Korea pose a legitimate security risk, but Japanese Prime Minister Shinzo Abe also stands to benefit at least marginally in terms of popular support and support for his controversial constitutional revision. This will, in turn, feed into the region's insecurities. Yen strength as a result of the crisis, however, would be a headwind to Japan's economic growth. Thus Abe has a tightrope to walk. We expect him to take actions to ensure the economy continues to reflate. Q: Is Trump rational? How do we know he won't push the nuclear button? A: Ultimately this is unknowable. It also involves one's philosophical outlook. Josef Stalin and Mao Zedong both committed atrocities by the tens of millions but did not use nuclear weapons. Nikita Khrushchev practically wrote the playbook that North Korea's Kim dynasty has used in making its belligerent nuclear threats. Yet Khrushchev ultimately agreed to détente. Kim Jong Un makes Trump look calm. The combination of Kim and Trump is worrisome; but so was the combination of Eisenhower and Khrushchev, one believing nuclear weapons should be used if needed, the other threatening wildly to use them. It may be the case that the threat of an atrocity, or (in Kim's case) of total annihilation, is enough to keep decisions restrained. As we go to press, Kim has ostensibly suspended his plan to fire missiles around Guam and U.S. officials have repeatedly stated that they would not attack unless attacked. Stairway To (Safe) Haven Revisited In expectation of increased frequency of geopolitical risks, BCA's Geopolitical Strategy has produced two quantitative analyses of safe haven assets over the past two years. The first, "Geopolitics And Safe Havens," unequivocally crowned gold as the ultimate safe haven (Table 1), while showing that the USD is not much of a defense against geopolitical events (Chart 5).7 Table 1Safe-Haven Demand Rises During Crises Table 1Safe-Haven Demand Rises During Crises As such, investors should fade the narrative that the failure of the USD to appreciate amidst the latest North Korean imbroglio is a sign of some structural weakness. The greenback continues to underperform due to weak inflation in the U.S., a fleeting condition that our macro-economist colleagues expect to reverse. Mathieu Savary, BCA's currency strategist, believes that more upside exists for the USD regardless of the geopolitical outcome: Chart 5Gold Loves Geopolitical Crises Chart 6DXY Is Cheap... Chart 7...But The Euro Is Not First, the dollar is currently trading at its deepest discount to the BCA Foreign Exchange Service augmented interest rate parity model since 2010 (Chart 6). The euro, which accounts for 58% of the DXY index, is its mirror image, being now overvalued by two sigma, the most since 2010 (Chart 7). Second, bullish euro bets will dissipate as Europe's economic outperformance versus the U.S. fades. Financial conditions have massively eased in the U.S., while they have tightened in Europe, resulting in the biggest upswing on euro area growth relative to the U.S. in over two years (Chart 8). Such an economic outperformance by the U.S. should lead to a strengthening greenback (Chart 9).8 Chart 8Easing Versus Tightening FCI Chart 9PMIs Point To USD Rally Our second attempt to quantify safe-haven assets, "Stairway To (Safe) Haven: Investing In Times Of Crisis," concluded that U.S. Treasurys, Swiss bonds, and Japanese bonds are the best performers in times of crisis.9 We considered 65 assets10 (Table 2) with five different methodologies and back-tested them empirically within the context of 25 financial and geopolitical events since January 1988. Some of these assets have been proven to perform as safe havens by previous academic research, some are commonly utilized in investment strategies, and others could provide alternatives (see Box 1 for further details). Table 2Scrutinizing The World For Safe Havens This report demystifies four key issues related to safe havens: Part I identifies what qualifies as a safe-haven asset. Unsurprisingly, the best performers are U.S. Treasurys along with Swiss and Japanese bonds due to their currency effects. Part II examines if safe havens change over time. We find that gold and Treasurys have changed places as safe havens, and that JGBs and Swiss bonds have a long history as portfolio protectors. Part III breaks down safe havens through an event analysis. We look at the country of origin, the nature of the crisis, and whether the risk is a "black swan" or "red herring" - two classifications of events that BCA's Geopolitical Strategy has established - all of which have an impact on their performance. But red herrings or black swans are only defined after the fact, thus requiring geopolitical analysis or market timing indicators to be able to act on them. Part IV demonstrates that timing plays a crucial part when investing in safe havens as their performance is coincident with that of equities. Box 1 Safe Havens - A Literature Review In a previous Geopolitical Strategy Special Report published in November 2015, it was established that shifts in economic and political regimes alter investors' preferences for safe-haven assets, and that Swiss bonds and U.S. 10-year Treasurys were at the top of that list.11 Also, statistical methods were used to demonstrate that gold had acted as a safe haven from the 1970s to the early 90s, but has since lost its status due in part to a new era of looming deflationary risks. Li and Lucey (2013) have identified a pattern in precious metals, through a series of quarterly rolling regressions testing the significance of the 1st, 5th and 10th percentile movements in U.S. equity movements against safe-haven assets, catching extreme negative events. For instance, the 1st percentile captures the very worst corrections that have occurred, the one that represent the bottom 1% of the equity performances. The 5th and 10th percentiles represent the 5% and 10% lowest returns for equities, respectively. The authors demonstrated that silver, platinum and palladium act as safe havens when gold does not.12 Similarly, Bauer and McDermott (2013) examined the 1st, 5th and 10th percentile movements in U.S. equity movements and proved that both gold and U.S. Treasurys can serve as safe havens, but that gold has the best record in times of extreme financial stress.13 Baele et al. (2015) concentrated on flight-to-safety episodes, which they characterized as events in which the VIX, TED spreads and a basket of CHF, JPY, and USD all increased drastically.14 They found that during flight-to-safety episodes, large cap stocks outperform small caps, precious metal and gold prices (measured in dollars) increase slightly, while bond returns exceed those of the equity market by 2.5-4 percentage points. Baur and Glover (2012) provide further evidence that gold can no longer be utilized as a safe haven due to increased speculation and hedging. Their main finding is that gold cannot be both an investment and a safe-haven asset. That is, gold can only be effective as a safe haven if the periods prior to the event had not generated significant investment demand for gold.15 Using high-frequency exchange rate data, Ranaldo and Soederlind (2010) conclude that the CHF, EUR and JPY have significant safe-haven characteristics, but not the GBP.16 The strongest safe havens are identified as the CHF and JPY, but the returns are partly reversed after a day of safe-haven protection. They also find that the nature of the crisis has a significant effect on safe-haven properties. For instance, a financial crisis and a natural disaster produced drastically different outcomes for the yen. Part I - Safety In Numbers Our first step in identifying safe-haven assets was to review each asset's performance against equities in times of crisis. As such, we conducted a series of threshold regressions to generate a list of true safe-haven assets - assets that have a statistically significant positive performance in times of turmoil. Our method is explained as follows: Step 1 - Percentile Dummies: Following methods from Li and Lucey (2013) and Bauer and McDermott (2013), we created dummy variables for the 1st, 5th and 10th percentile of the S&P 500 daily total returns since 1988. We then multiplied each of these dummies by their corresponding stock returns (see Box 1 for further detail). Step 2 - Regressions: Using the 64 potential safe-haven assets, we ran a series of regressions both in USD and the local currency, testing each asset's returns explained by the three percentile dummies.17 Step 3 - Identifying Safe Havens: We then quantified strong safe-havens as assets having significant coefficients for all three return thresholds (1st, 5th and 10th percentile of the S&P 500 daily total returns). Results - Seek Refuge In Currencies And Government Bonds: Our quantitative results are mainly consistent with what others have found in the past: the Japanese yen and most G10 government bonds are safe havens. Table 3 shows the safe-haven assets that generated negative coefficients versus equities for all three threshold percentiles. Table 3Seeking Protection Against Corrections In our threshold regressions expressed in USD terms, we found that the Japanese yen, Quality Stocks,18 and Japanese, Swiss and U.S. bonds acted as strong safe havens. Currencies play a crucial part in the performance of safe havens. In fact, in local-currency terms, a series of G10 government bonds (U.S., Canada, Belgium, France, Germany, Netherlands, Sweden, Switzerland, and the U.K.) proved to be the most useful safe havens. In sum, true or strong safe havens are government bonds that have currencies that add to positive returns during times of crisis. Unsurprisingly, this select group of strong safe-haven assets is comprised of U.S., Japanese, and Swiss government bonds. Quality Stocks did provide positive and statistically significant results, but the returns were very low - for this reason, we excluded them from our basket of strong safe havens. While gold, the Swiss franc, and the U.S. dollar did generate positive returns during times of crisis, they failed to generate statistically significant results at all three thresholds. Bottom Line: Based on our econometric work, most G10 government bonds can act as safe havens. But due to strong currency effects, our models favor what are already commonly known as safe havens: U.S., Japanese, and Swiss government bonds. Simply put, the difference between this select group and other G10 bonds is that their currencies rise or are stable during turmoil, while the currencies of the other G10 bonds do not. Part II - Are Safe Havens Like Fine Wines? U.S., Japanese, and Swiss government bonds were not always the top assets providing protection against the downside in equities, however. To determine whether safe-haven properties change, we examined the evolution of the relationship between safe havens and U.S. equity markets over time with the following model: Step 1 - Rolling Regressions: Considering the results obtained in Part I, we restricted our sample to G10 governments in USD and local-currency terms, Quality Stocks, gold, JPY, EUR, and USD for this statistical procedure. We put these remaining assets, both in USD and local-currency terms, through a series of 1-year rolling regressions.19 Step 2 - Identifying Trends: Each regression generated a coefficient that explained the relationship between equities and safe havens (B1). We created a new time series by collecting the coefficients for each data point and smoothing them using a five-year moving average, thus depicting a long-term pattern in the evolution of safe havens. Results - A Regime Shift In Gold And Treasurys: Our findings show that safe-haven assets fall in and out of favor through time (Charts 10A, B & C). Most striking are the changes in U.S. Treasurys and gold. Only after 2000 did Treasurys start providing a good hedge for equity corrections. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but has since become correlated with S&P 500 total returns. That said, gold's coefficient has been falling closer to zero lately, illustrating that it could soon resurface as a proper safe haven, especially if deflation risks begin to dissipate. Given that this is precisely the conclusion stated by our colleague Peter Berezin - BCA's Chief Global Strategist - and our own political analysis, we suspect that gold may be resurrected as a safe haven very soon.20 Chart 10ASafe Havens Don't Necessarily Age Well Chart 10BSafe Havens Don't Necessarily Age Well Chart 10CSafe Havens Don't Necessarily Age Well Another important finding is that the currency effect plays a key role during recent risk-off periods (Charts 11A & B). The best protector currencies are the ones that are negatively correlated with equity returns. According to our results, the CHF and the JPY have generally been risk-off currencies, while the USD has only been one since 2007, switching places with the euro. This reinforces the case for U.S., Japanese, and Swiss government bonds, which are supported by risk-off currencies. Chart 11ACurrencies Are Difference Makers Chart 11BCurrencies Are Difference Makers Bottom Line: Safe havens change over time. Gold fell out of favor due to global deflationary dynamics. With inflation on the horizon, we will keep monitoring the relationship between gold and equities for a possible return of the yellow metal as a safe haven. Since the July 4 North Korean ICBM test, for example, gold has rallied 4.8%. Part III - Red Herrings And Black Swans Since 1988, we identified 25 economic and (geo)political events that generated instant panic or acute uncertainty in the media and financial markets.21 We analyzed the short-term reactions of the safe-haven assets, both in USD and local-currency terms. This methodology allowed for the deconstruction of the impact of the events by the following factors: Country of origin of the crisis, the nature of the crisis, and whether the event was a "red herring" or a "black swan." Generally speaking, a red herring event is a crisis of some sort with little lasting financial impact. A black swan, on the other hand, is an event that has a very low probability of occurring but has a pronounced market impact if it does. Quantitatively, our definition of a black swan is an event that produces an immediate negative response in the S&P 500 below -1%, while creating a rise in either U.S., Japanese, or Swiss government bonds above 0% (Table 4). Of course, determining which event is a red herring or a black swan is only obvious post-facto and thus requires thorough geopolitical analysis. Table 4Understanding The Crises Results - Red Herrings And Black Swans Matter: Our event analysis solidifies our findings with regards to U.S., Japanese, and Swiss government bonds, but also builds a case for some European bonds as well as gold during black swan events. Our main findings can be summarized as follows. Fade The Red Herrings: Out of the sixteen geopolitical events, ten were identified as red herrings, in which safe havens underperformed the equity market. This, then, suggests that it is not always beneficial to buy safe-haven assets when tensions are rising. What is interpreted as a major geopolitical crisis - say, Ukraine in 2014 or Greece in 2015 - often ends up being a "red herring." Geopolitical Risk = Gold: Geopolitical black swan events, on the other hand, have a significant, negative impact on the market. During these events, gold emerges as the strongest hedge against a downturn in equities. U.S. Treasurys And The Swiss Franc Provide A Baseline: Under all black swan events considered - geopolitical and non-geopolitical - U.S. Treasurys and the Swiss franc had the strongest performance, generating positive returns on the day of the stock market crash in 85% of the cases. G10 Government Bonds Will Also Do: German, Dutch, Swiss and Swedish government bonds also provided protection during black swan events in local and common-currency terms, albeit to a lesser extent. U.S. And Swiss Bonds Outperform During Financial Episodes: During black swan financial crises, Swiss and U.S. government bonds stand out as the best safe havens due to their capacity to generate positive returns both in USD and local-currency terms in eight out of the nine examined crashes. Other findings that are interesting, yet less robust due to a limited sample size, include: When the crisis originated on U.S. soil, U.S. Treasurys and the dollar performed relatively poorly compared to other safe-haven assets. This is a somewhat surprising finding, as most investors believe that U.S. assets rally even at a time of U.S.-based crises, such as the 2011 budget crisis. We show that they may perform well, but in USD, non-U.S. based assets do better. When the crisis originated in Europe, European bonds performed very well both in USD and local-currency terms. When the crisis originated in Europe, Swiss and U.K. government bonds performed poorly in USD terms, but offered strong protection in local-currency terms. When the crisis originated in Russia, precious metals acted as a poor hedge. Bottom Line: It is crucial to gain an understanding of the nature of any potential crisis. Red herrings should always be faded, not hedged against, as they produce poor results in safe-haven assets. U.S. Treasurys, Swiss and Japanese government bonds have been very consistent safe-haven assets during previous periods of acute risk. Part IV: Timing Is Everything As a final step in our quantitative approach, we put our results through numerous timing exercises to test how the assets would perform in real time. Based on our Risk Asset Spectrum (Diagram 1), which summarizes our findings, one could argue that investing in times of crisis simply boils down to buying an equal-weighted basket of U.S. Treasurys, Swiss, and Japanese government bonds. Although this is technically true, such a strategy would require perfect foresight, unparalleled timing, or dumb luck - since black swan events are, by definition, very difficult to predict. Diagram 1Risk Asset Spectrum Proof Of The Ultimate Safe Haven: The first experiment we conducted was to illustrate how powerful safe havens can be when timed perfectly in a trading strategy. We started off by comparing two baskets. The first was a benchmark portfolio comprised of 60% U.S. equities and 40% U.S. bonds. The other contained the same two assets, but with 100% allocated to a basket comprised of U.S. Treasurys, Swiss, and Japanese government bonds during times of negative returns for equities. Of course, this strategy is not realistic and would be impossible to implement, since the trading rule depends on future events. But as Chart 12 shows, if one were able to predict every single period of negative returns for global equities and hold safe-haven assets instead, the trading rule would outperform almost 10-fold. Chart 12Safe Havens Work Wonders With Perfect Information... One-Month Lag Is Already Too Late: Repeating the same exercise, but with a one-month lag in the execution, produces drastically different results. More specifically, whenever the previous month's equity return is negative (t=0), the portfolio allocates 100% to a single safe-haven asset for the current month (t=1), otherwise it keeps the allocation identical to that of the benchmark. The rationale for using such a simple rule is that average investors are generally late in identifying a crisis and only react once they have validation that the market is in a correction. Chart 13 shows that being late by one month changes the performance of the safe haven basket from astronomically outperforming the benchmark to underperforming it. Chart 13... But Timing Is Everything Reaction Is Key: As a final timing exercise, we analyzed the reaction function of our assets to see how quickly they react after the correction in equities begins (Chart 14). Unsurprisingly, the top assets that we identified start appreciating as soon as the crisis hits (t=0). Gold is, on average, the quickest asset to react from investors seeking refuge. Swiss bonds come in as a close second, almost mirroring gold during the first few days of the correction. But both assets start to flatten out and even roll over after a few days. Japanese bonds react slightly later than gold and Swiss bonds, but keep increasing for a longer period of time and start plateauing around the 30th day after the crisis. U.S. Treasurys and Quality Stocks, on the other hand, remain rather flat and constant over the short term. These results attest to the importance of timing the crisis using the best safe-haven assets. Chart 14Safe Havens React Instantly Bottom Line: Timing plays a crucial part in investing in safe-haven assets, as their performance is coincident to that of equities. Investment Implications: Is Pyongyang A Red Herring Or A Black Swan? The results of our quantitative analysis are clear: hedging geopolitical risk depends on whether it is persistent or fleeting. So, is Pyongyang a red herring or a black swan? From our geopolitical analysis we make three key conclusions: The U.S. is not likely to preemptively attack North Korea; However, the U.S. has an interest in signaling that it may conduct precisely such an attack; Brinkmanship could last for a long time. Even if the risk of a U.S. attack against North Korea itself is a red herring, the crisis itself is not. In fact, between now and when a negotiated solution emerges, investors may face several new crises, which may include limited military attacks or skirmishes. While markets have faded such North Korean provocations in the past, the current context is clearly different. As such, we would suggest that investors hedge the risk with an equally-weighted basket of Swiss bonds and gold. Even though a "buy and hold" strategy with such a "Doomsday Basket" will likely underperform the market if tensions with North Korea subside, we are betting that it may take time for the U.S. and North Korea to get to the negotiating table. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com David Boucher, Associate Vice President Quantitative Strategist davidb@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 6, 2016, available at gis.bcaresearch.com. We upgraded North Korea to the status of a genuine market-relevant risk in "North Korea: A Red Herring No More?" in Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat'," dated April 7, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2017 available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0," dated September 25, 2012, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. In particular, we argued, "the current saber-rattling is carefully orchestrated. But North Korea can no longer be consigned to the realm of satire. The very fact that the U.S. administration is adopting greater pressure tactics makes this year a heightened risk period. Investors should be especially wary of any missile tests that reveal North Korean long-range capabilities to be substantially better than is known to be the case today." Then, on May 13 and July 4, North Korea conducted its first ICBM launches; the UN Security Council agreed to a new round of even tighter economic sanctions on August 5; and the U.S. and North Korea engaged in an alarming war of words. 6 Specifically, we wrote: "Diplomacy is the only real option. And in fact it is already taking shape. The theatrics of the past few weeks mark the opening gestures. And theatrics are a crucial part of any foreign policy. The international context is looking remarkably similar to the lead-up to the new round of Iranian negotiations in 2012. The United States pounded the war drums and built up the potential for war before coordinating a large, multilateral sanctions-regime and then engaging in talks with real willingness to compromise." 7 Please see BCA Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 8 Please see BCA Foreign Exchange Strategy Weekly Report, "Fade North Korea, And Sell The Yen," dated August 11, 2017, available at fes.bcaresearch.com. 9 Please see BCA Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 10 Forty-one assets were denominated in USD only, while G10 bonds, Credit Suisse Swiss Real Estate Fund, and European 600 real estate were used both in local-currency terms and USD, for a total of 65 assets. 11 Please see Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 12 Sile Li and Brian M. Lucey, "What precious metals act as safe havens, and when? Some U.S. evidence," Applied Economic Letters, 2013. 13 Dirk G. Bauer and Thomas K.J. McDermott, "Financial Turmoil and Safe Haven Assets," 2013. 14 Lieven Baele, Geer Bekaert, Koen Inghelbrecht and Min Wei, "Flights to Safety," National Bank of Belgium Working Paper No. 230, 2015. 15 Dirk G. Baur and Kristoffer J. Glover, "The Destruction of Safe Haven Asset?,"2012. 16 Angelo Ranaldo and Paul Soederlind, "Safe Haven Currencies," Review of Finance, Vol. 10, pp. 385-407, 2010. 18 Quality stocks are defensive equity plays with high, steady earnings with an elevated return on investments. They are estimated by Deutsche Bank's Factor Index Equity Quality Excess Return in USD. 20 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com, and BCA Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017, available at gis.bcaresearch.com. 21 Since we were interested in the immediate, often unexpected, response to the event, we did not include economic recessions in our event analysis.
Highlights Duration: An environment characterized by strong global growth and a weak dollar is very bearish for U.S. bonds. According to our model, fair value for the 10-year Treasury yield is 2.6%. Stay at below-benchmark duration. The Fed & The Dollar: A weak dollar eases financial conditions and supports higher core goods inflation. All else equal, this will strengthen the Fed's hawkish resolve in the near term. However, a rebound in core services (excluding shelter and medical care) inflation will be necessary for core inflation to reach the Fed's target on a sustained basis. USD Sovereigns: USD-denominated sovereigns are not attractive compared to domestic Baa-rated U.S. credit. At the country level, Finland, Mexico and Colombia offer the most attractive spreads and Finnish debt offers the best risk/reward trade-off. Feature Please note there will be no U.S. Bond Strategy report next week. Our regular publishing schedule will resume on August 29, 2017. Chart 1Firm Growth, Despite Weaker $ Escalating tension between the U.S. and North Korea captured the market's attention during the past week, causing investors to ignore what in our view is a more important economic development: Global growth has managed to stay firm even in the face of significant dollar depreciation. Not only does this break the pattern of the past few years when periods of substantial dollar weakness were associated with slowing global growth (Chart 1), but in our view it sends a very bearish signal for U.S. bonds. Above all else, a weak dollar amidst strong global growth suggests that the breadth of the economic recovery is improving. This intuition is confirmed by the fact that our Global Manufacturing PMI Diffusion Index, which measures the net percentage of countries with PMIs above the 50 boom/bust line, is fast approaching 90% (Chart 2). Not only that, but PMIs from the four most important economic blocs are all showing signs of strength. Both the Eurozone and Japanese PMIs are holding firm at high levels, while the U.S. and Chinese PMIs have recently reversed their year-to-date downtrends (Chart 2, bottom two panels). Why is the breadth of the global recovery important? Precisely because a more synchronized recovery prevents the dollar from appreciating too quickly. All else equal, a stronger dollar causes investors to reduce their forecasts for future U.S. growth and inflation. This implies a slower expected pace of rate hikes and lower Treasury yields. Conversely, a weaker dollar causes investors to revise up their growth and inflation forecasts, leading to a quicker expected pace of rate hikes and higher yields. To capture the importance of both global growth and the exchange rate we turn to our 2-factor Treasury model (Chart 3). This is a simple model of the 10-year Treasury yield based on the Global PMI and bullish sentiment toward the dollar. A stronger Global PMI pressures the model's fair value higher, as does increasingly bearish dollar sentiment. Chart 2Synchronized Global Growth Chart 310-Year Treasury Yield Fair Value At present, the model pegs fair value for the 10-year Treasury yield at 2.6%, meaning the current 10-year Treasury yield of 2.22% is 38 bps below fair value. This is the most expensive Treasuries have appeared on our model since the immediate aftermath of last year's Brexit vote. Political Uncertainty & Flights To Quality While our 2-factor model does a good job, there is one important driver of Treasury yields it does not capture. That is the tendency for political events to drive a flight to safety into Treasuries (Chart 4). Typically, if it is possible to identify a purely politically-driven flight to safety - one that is unlikely to exert a meaningful economic impact during the next 6-12 months - then the correct strategy is to heed our model's message and position for higher yields. This strategy worked out perfectly following the Brexit vote, and we anticipate it will work again this time around. Chart 4Policy Uncertainty Is A Driver Of Bond Yields With regards to the catalyst for last week's flight to safety, our Geopolitical Strategy service wrote in a recent Special Report1 that a pre-emptive strike by the U.S. on North Korea is extremely unlikely. The theatrics of the past week demonstrate only that the U.S. needs to establish a "credible threat" if it wants to eventually open a new round of negotiations over North Korea - not unlike the Iranian nuclear negotiations of the past decade. Looking further down the road, if those talks eventually fail then the potential for military conflict is high. We therefore conclude that there is not much potential for U.S. / North Korean tensions to exert a meaningful economic impact during the next 6-12 months, and view the recent bond rally as an opportunity to position for sharply higher yields in the near-term. Bottom Line: An environment characterized by strong global growth and a weak dollar is very bearish for U.S. bonds. According to our model, fair value for the 10-year Treasury yield is 2.6%. Stay at below-benchmark duration. How The Fed Views A Weaker Dollar Financial Conditions Chart 5Weak $ Eases Financial Conditions The Fed views the 7% year-to-date depreciation of the dollar as a significant easing of financial conditions. In fact, most broad indicators of financial conditions have eased this year, even though the Fed has lifted rates by 75 bps since December (Chart 5). In the Fed's framework, this means that the pace of rate hikes might need to increase in order to tighten financial conditions as much as desired. New York Fed President William Dudley summed up this approach in a 2015 speech:2 All else equal, if financial conditions tighten sharply, then we are likely to proceed more slowly. In contrast, if financial conditions were not to tighten at all or only very little, then - assuming the economic outlook hadn't changed significantly - we would likely have to move more quickly. In the end, we will adjust the policy stance to support financial market conditions that we deem are most consistent with our employment and inflation objectives. Of course, all else is not equal. Core inflation has disappointed so far this year and our current assessment of monetary policy is that while the Fed will take action to start shrinking its balance sheet next month, rate hikes are on hold until inflation turns higher. We remain optimistic that inflation will show sufficient strength in time for the Fed to lift rates in December.3 Inflation Chart 6Weak $ = Higher Inflation A weaker dollar also increases the Fed's confidence that inflation will head higher. Although so far we have not seen much evidence that this is occurring. Last Friday's July CPI report showed that core CPI rose only 0.1% month-over-month, while the year-over-year growth rate held flat at 1.7%. However, evidence is mounting that core inflation will soon put in a bottom. Our CPI diffusion index bounced back into positive territory in July (Chart 6) and our PCE diffusion index is at its highest level since last October.4 Both of these measures have excellent track records capturing the near-term swings in core inflation. The year-to-date weakness in the dollar has led to a surge in import prices. Stronger import prices will soon translate into higher core goods inflation (Chart 6, panels 2 and 3). Unfortunately, any increase in core goods inflation is unlikely to be sustained beyond the next 12 months. If the year-to-date dollar weakness starts to reverse, as our currency strategists anticipate,5 then import prices will decline anew. Eventually, this will translate into a deceleration in core goods inflation. For core inflation to sustainably reach the Fed's target, improvement in the lagging core services (excluding shelter and medical care) component will be required. Historically, this component is the most tightly linked to wage growth (Chart 6, bottom panel). A Rising Wage Growth Environment Two related methods do an excellent job predicting the direction of wage growth on a cyclical horizon. First, wages accelerate when the unemployment rate is falling, and second, wages accelerate when the prime-age (25-54) employment-to-population ratio is increasing. The top two panels of Chart 7 show the relationship between wage growth and the unemployment rate. The shaded regions in both panels correspond to periods when the unemployment rate is falling. As can be seen, wage growth always rises during these periods. That being the case, we calculate that non-farm employment needs to grow by more than 125k per month (on average) for the unemployment rate to continue its downtrend, assuming the labor force participation rate remains flat. Chart 7A Rising Wage Environment Of course it is not guaranteed that the labor force participation rate will stay flat. In a recent report we discussed the risk that a large cyclical increase in the participation rate might cause the unemployment rate to rise even as the economy continues to recover.6 This is why we also look at the shaded regions in the bottom two panels of Chart 7 and see that wages always rise during periods when the prime-age employment-to-population ratio is rising. By looking at the employment-to-population ratio instead of the unemployment rate we do not need to make an assumption about the trend in labor force participation. Using this method, we calculate that monthly employment growth must exceed 140k (on average) for the prime-age employment-to-population ratio to keep increasing. Non-farm payroll growth has averaged 184k per month so far in 2017 and averaged 187k per month in 2016. In other words, the U.S. jobs machine is running at a fairly steady pace, well above the thresholds we see as necessary for the recovery in wage growth to continue. Bottom Line: A weak dollar eases financial conditions and supports higher core goods inflation. All else equal, this will strengthen the Fed's hawkish resolve in the near term. However, a rebound in core services (excluding shelter and medical care) inflation will be necessary for core inflation to reach the Fed's target on a sustained basis. Sovereigns Not Buying The Weak Dollar USD-denominated sovereign bonds should benefit from a falling dollar. A weaker U.S. dollar makes the debt obligation cheaper in the issuing nation's local currency. However, the USD Sovereign index has actually underperformed the duration-matched Baa U.S. Credit index during the past six months, despite a depreciating U.S. currency (Chart 8). The duration-matched Baa-rated U.S. Credit index is the closest comparable we can find for the Sovereign index. It matches the Sovereign index in terms of duration and average credit rating, although historically it also delivers less excess return volatility (Chart 8, bottom panel). The two main factors we consider when deciding whether to add USD-denominated sovereigns to our portfolio at the expense of domestic U.S. credit are relative valuation and the outlook for the dollar. Historically, spread differential has been an important driver of relative returns. Attractive starting valuations even allowed sovereigns to outperform credit in 2014 and 2015 despite the dollar's surge. But at the moment, relative value is skewed heavily in favor of domestic U.S. credit (Chart 8, panel 1). Chart 8Sovereigns Too Expensive Added to that, with U.S. growth likely to remain strong and U.S. inflation poised to rebound, we think there is a high likelihood that the Fed will deliver more rate hikes than are currently priced in. This will make it difficult for the dollar to decline further from current levels. Taken together, poor relative valuation and a bullish outlook for the dollar lead us to continue underweighting USD-denominated sovereigns in our portfolio. The Sovereign Index: Country Breakdown Even though the overall index is unappealing, opportunities might still exist at the country level. Chart 9 shows a risk/reward picture for each country in the Bloomberg Barclays Sovereign index. The upper panels show the option-adjusted spread for each country relative to its duration and credit rating. The lower panels show a risk-adjusted spread on the y-axis. This risk-adjusted spread is the excess spread that remains after we adjust for differences in credit rating and duration using a cross-sectional model. What sticks out immediately is that Finland, Colombia and Mexico all offer compelling spreads after adjusting for differences in credit rating and duration. The outlook for each country's currency versus the U.S. dollar is obviously also important. And in fact, the lower-right panel of Chart 9 shows that exchange rate volatility is positively correlated with the risk-adjusted spreads from our cross-sectional model. This implies that the extra compensation available in Mexican and Colombian sovereigns is probably compensation for assuming highly volatile currency risk. By this measure, Finland looks even more attractive given the euro's slightly lower volatility. Chart 9USD Sovereign Index: Country Breakdown Bottom Line: USD-denominated sovereigns are not attractive compared to domestic Baa-rated U.S. credit. Remain underweight. At the country level, Finland, Mexico and Colombia offer the most attractive spreads and Finnish debt offers the best risk/reward trade-off. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "North Korea: Beyond Satire", dated April 19, 2017, available at gps.bcaresearch.com 2 https://www.newyorkfed.org/newsevents/speeches/2015/dud150605 3 For further details on our outlook for the near-term path of monetary policy please see U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long", dated August 8, 2017, available at usbs.bcaresearch.com 4 For a chart of the PCE diffusion index please see page 11 of U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long", dated August 8, 2017, available at usbs.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "Fade North Korea, And Sell The Yen", dated August 11, 2017, available at fes.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights U.S. Treasuries: The downturn in U.S. inflation looks to be stabilizing, while the U.S. economy continues to churn along at an above-potential growth pace. Treasury yields are now at risk of a repricing of both inflation expectations and Fed rate hike probabilities. Treasury-Bund Spread: The "leadership" of the global bond market is likely to switch back to the U.S. from Europe in the next few months, which will lead to an underperformance of Treasuries. We are entering a new Tactical Overlay trade this week, shorting 10-year U.S. Treasuries versus 10-year German Bunds. Central Bank Balance Sheets: Central banks with large amounts of maturing bonds on their balance sheets, like the Fed and the Bank of Japan, have had no choice but to signal a slower pace of future bond buying. The ECB is in a similar boat, as its holdings of German debt approach issuer limits in the ECB portfolio. A slower pace of ECB bond buying is certain in 2018, to the detriment of European government bond market performance. Chart 1UST Yields Have Some##br## Catching Up To Do Feature Is the surprising 2017 downdraft in U.S. inflation starting to bottom out? The latest set of readings on growth in prices and wages provides some evidence that the decline may be over. Core PCE inflation rose on a year-over-year basis in June for the first time since January. In July, Average Hourly Earnings had the largest monthly increase since October of last year (Chart 1). With oil prices up 16% off the mid-June lows, and the trade-weighted U.S. dollar down nearly 5% over the same period, the stars are aligned for a pickup in U.S. inflation in the coming months. A sustained rebound in realized inflation would be the catalyst for a renewed rise in U.S. Treasury yields, particularly with U.S. economic data starting to show more upside surprises. With the market only priced for 28bps of Fed rate hikes over the next twelve months, Treasuries are exposed to any improvement in U.S. growth and inflation. Treasuries are certainly due for a bit of catchup to the moves in global bond yields seen over the past couple of months. Rate hike expectations have ratcheted higher in a number of countries that have left policy rates at very low levels as growth has accelerated, such as Canada, the U.K. and Sweden (bottom panel). This has put mild upward pressure on government bond yields in those markets. Yields in the Euro Area have also been rising, not because of rate hike expectations but rather a growing belief that the European Central Bank (ECB) will soon begin paring back the pace of its asset purchases. Reduced central bank buying by the Fed, ECB and the Bank of Japan (BoJ) remains a major threat to the global bond market. It will likely take higher yields to entice other investors to absorb the supply of global duration risk currently taken down by central banks. This is a longer-term factor that will place a gently rising floor underneath global bond yields. In the meantime, the path of least resistance for bond yields in the next 6-12 months remains upward as expectations for U.S. inflation and Fed rate hikes shift higher. The Fed Will Soon Be Back In Play Chart 2Low Unemployment, ##br##But With A Low Equilibrium Rate The July U.S. employment report released last week showed continued strength in hiring activity. The headline number of +209k jobs created was above expectations, bringing the 2017 monthly average up to +184k which is almost identical to the +187k average seen in 2016. The headline U-3 unemployment rate dipped back to a cyclical low of 4.3%, in line with the lows of the previous two business cycles (Chart 2). The broader U-6 measure was unchanged at 8.6% - within hailing distance of the low seen during the last business cycle (8.0% in 2007). Yet despite the historically low levels of unemployment, wage inflation is still only holding steady and not yet accelerating. The annual growth rate of Average Hourly Earnings remains stuck around 2.5%, while other measures like the Employment Cost Index are also showing little upward momentum. Yet as long as wage growth is not decelerating, the Fed is likely to remain confident that inflation should eventually drift back up to the central bank's 2% target IF the economy grows in line with its forecasts and additional spare capacity in labor markets is absorbed. The Fed has been openly debating the appropriate level of the real funds rate in recent weeks. Measures such as the Laubach-Williams "R-star" have been cited as evidence that the Fed may be getting very close to a neutral funds rate. However, this is only true if realized inflation stays at current levels. If inflation begins to reaccelerate, additional interest rate increases would be needed to restore the real Fed funds rate back even to current levels. More increases would be needed to get the real funds rate back to even just the current R-star estimate of -0.2%. A level of the real funds rate above R-star could even be necessary if realized inflation was above the Fed's target, as occurred in the late-1990s and mid-2000s when the U.S. Employment/Population ratio climbed higher alongside a steadily growing economy (bottom panel). For now, however, we see the Fed as remaining in a wait-and-see mode, holding off on any additional rate hikes until higher inflation begins to manifest itself in the actual data. In the meantime, market expectations for U.S. inflation are already starting to drift higher. The 10-year TIPS breakeven is at 1.80%, up +13bps since June 16th. The model for breakevens developed by our sister publication, U.S. Bond Strategy, based on financial market variables has also increased by 6bps to 1.82% over the same period, suggesting that current breakevens are now essentially at fair value. (Chart 3). While breakevens remain well below the 2.5% level that we deem to be consistent with the Fed's inflation mandate, this shift in the direction of expectations is critical given the current low level of Treasury yields.1 Chart 3A Weaker USD Should Soon##br## Boost Growth & Inflation The sharp decline in financial market volatility seen across risk assets over the past few months can largely be traced back to that pullback in realized U.S. inflation since February. Interest rate volatility has collapsed alongside the drop in inflation, as investors have priced in a less hawkish Fed outlook. This also triggered a bout of U.S. dollar weakness that has helped boost demand for assets that typically suffer during periods of U.S. dollar strength, like Emerging Market equities and credit. If inflation begins to soon perk up again, as we expect, then Fed rate hikes will come back into play and both bond volatility and the U.S. dollar will increase, providing a challenge to the current stable return profiles for both equities and corporate credit. We still see the Fed only slowly nudging the funds rate up towards equilibrium levels over the next year, unless inflation rises at a much faster rate than both the Fed and markets expect. Coming at a time when the U.S. economy will continue to churn along at a steady above-potential pace, risk assets can continue to outperform Treasuries even with some appreciation of the U.S. dollar, although with a higher level of market volatility. We still see a December rate hike as the most likely next move on rates by the Fed, with an announcement on reducing the Fed's balance sheet, which has been well-telegraphed, likely in September. This sequence will give the Fed time to assess developments in inflation while still incrementally "normalizing" its monetary policy by beginning to reduce the reinvestment of maturing bonds in its portfolio. A shift to more hawkish Fed expectations would open up the potential for a tactical widening of the spread between U.S. Treasuries and German Bunds. The current spread is too low relative to differentials at the short ends of the respective yield curves, and is holding at the rising trendline that began in 2014 (Chart 4, top panel). At the same time, the gap between the Citigroup economic data surprise indices for the U.S. and Euro Area is starting to widen in a direction that should trigger a wider Treasury-Bund spread (middle panel) - especially given the large net long positions still seen in Treasury bond futures (bottom panel). A tactical widening of the Treasury-Bund spread is not inconsistent with our views on the ECB (Chart 5). We still expect some additional upward pressure on Euro Area bond yields as the ECB announces a tapering of its asset purchases at next month's monetary policy meeting. However, there has already been a considerable adjustment higher in European yields since ECB President Mario Draghi's relatively hawkish Portugal speech in June - one that was not matched by U.S. Treasuries. The next move in "leadership" for global bonds will come from a return of U.S. inflation and Fed hawkishness, not from Europe. Chart 4Higher Volatility On The Horizon? Chart 5Position For A Tactically Wider UST-Bund Spread On the back of this, we are opening up a new trade in our Tactical Overlay portfolio this week, going short 10-year U.S. Treasuries vs 10-year German Bunds. Bottom Line: The downturn in U.S. inflation looks to be stabilizing, while the U.S. economy continues to churn along at an above-potential growth pace. Treasury yields are now at risk of a repricing of both inflation expectations and Fed rate hike probabilities. The "leadership" of the global bond market is likely to switch back to the U.S. from Europe in the next few months, which will lead to underperformance of Treasuries. Thus, we are entering a new Tactical Overlay trade this week, shorting 10-year U.S. Treasuries versus 10-year German Bunds. The State Of The "QE5" The current coordinated cyclical upturn in global growth, combined with booming equity and credit markets, is forcing central bankers to contemplate shifting to a less dovish monetary policy stance. Only the Fed and the Bank of Canada have actually raised interest rates since the oil-driven deflation scare of 2014/15. Yet policymakers in regions that have undertaken asset purchase programs - the U.S., Euro Area, the U.K., Japan and Sweden which we will call the "QE5"- also must consider policy moves that will impact the future size, and composition, of central bank balance sheets. The sums involved are enormous and will have major implications for financial markets. In Table 1, we present data first published in the 2017 BIS Annual Report published in late June (that we have since updated ourselves), showing the details of the QE5's balance sheets.2 A few numbers stand out from the table: Table 1The State Of The "QES" Central Bank Balance Sheets The Fed owns 13% of U.S. general government debt, with an average maturity of 8.0 years; 43% of the holdings mature within two years The BoJ owns 40% of Japanese general government debt, with an average maturity of 6.9 years; 49% of the holdings mature within two years The Bank of England owns 25% of U.K. general government debt, with an average maturity of 12.0 years; 20% of the holdings mature within two years The Riksbank owns 15% of Swedish general government debt, with an average maturity of 5.0 years; 37% of the holdings mature within two years The ECB owns 17% of Euro Area general government debt, with an average maturity of 8.0 years; the specific maturity structure is not publically known, however, as the ECB does not provide the same level of detail on its bond holdings as the other QE5 central banks. It is clear from the data that the Fed essentially has little choice but to begin the process of letting bonds run off its balance sheet, given that nearly half of its holdings will mature by 2019. With the U.S. economy at full employment, there is little need for the Fed to continue sending an unnecessarily dovish message by rolling over its bond holdings and maintaining such a large balance sheet. Similar arguments can be made for the Bank of England and the Riksbank, with both the U.K. and Sweden at full employment and a large share of bond holdings set to mature within two years. Chart 6BoJ Will Peg JGB Yields And Hope ##br##For A Weaker Yen Japan is a unique case, as always. With the economy still struggling to avoid deflation, even with an unemployment rate below 3%, the BoJ must maintain a hyper-easy monetary policy to keep the yen weak enough to generate some imported inflation (Chart 6). Yet the sheer size of its balance sheet, and its bond holdings, makes it increasingly difficult to roll over all of its maturing debt without severely impairing liquidity in the JGB market. Thus, it is no surprise that the BoJ has chosen to shift to a "yield curve" target that aims to peg the benchmark 10-year JGB yield at 0% - a policy which, presumably, would entail only buying bonds when there is upward pressure on yields from growth and inflation. The BoJ has already "tapered" to an annualized rate of bond buying of 70 trillion yen in 2017 - below the central bank's official 80 trillion yen per year target - and even slower amounts of buying could occur in the next couple of years as the maturing bonds in the BoJ's portfolio are not fully replaced. Which brings us to the ECB. The current economic expansion has been impressive in its scope and breadth, with even perpetual laggards like Italy enjoying a solid cyclical upturn. Although inflation remains below the ECB's 2% target, core inflation has clearly bottomed out and is even slowly accelerating in some countries, like Germany and Spain (Chart 7). The central bank has been sending out signals that an adjustment in its monetary policy settings will likely be needed soon. The markets have interpreted this as a sign that the ECB will announce a tapering of its asset purchases in 2018. The ECB has to be a little surprised, and perhaps nervous, over the market reaction to this shift in its communication with the markets. Longer-term bond yields rose sharply, with the benchmark 10-year German Bund more than doubling in a matter of weeks in late June and early July. The central bank has been clear in stating that no change in short-term interest rates is imminent, and there has been very little movement in shorter maturity bond yields. Yet the euro has appreciated 5% since Mario Draghi's Portugal speech on June 26th, following the rise in long-term bond yields rather than the typical short-rate moves that guide currency fluctuations (Chart 8). Chart 7The Case For A Less Accommodative ECB Chart 8Could A Stronger Euro Delay The Taper? The surge in the euro has largely been due to capital inflows by global investors chasing the improving growth in the Euro Area, combined with some short covering of the large short positioning on the currency from earlier this year. Without the support of actual interest rate hikes that more sustainable boost the attractiveness of the currency, additional gains in the euro may be hard to come by - especially if the Fed soon shifts back to a more hawkish stance, as we discussed earlier in this report. As long as the rising euro does not materially impact broader Euro Area financial conditions through falling equity prices or wider corporate credit spreads, the ECB can continue on a path towards signaling a slower pace of asset purchases next year. They essentially have no choice on that front, given the approaching constraints on its bond buying program. The ECB has set internal rules that its asset purchases must: a) be allocated across the Euro Area countries according to the weights of the ECB "Capital Key"; and b) not result in the ECB owning more than 33% of any single countries stock of government debt. Following the first rule means buying far more German and French debt than Spanish or Austrian debt. Yet if they continue to follow the first rule, the second rule will be violated for some countries, most notably Germany. In Chart 9, we show the share of government bonds owned by the ECB for Germany, France, Italy and Spain. We also show projections for the ownership shares based on four scenarios for the pace of ECB asset purchases in 2018. If the ECB was to maintain the current €60bn/month rate of buying, then the 33% threshold for Germany would be breached next year (the green dotted line in the top panel) and the limit would almost be reached for Spain (the green dotted line in the bottom panel). Given these projections, it is perhaps no surprise that the ECB is sending signals about a taper even with inflation still south of the 2% ECB target. The ECB has already starting altering the composition of its monthly asset purchases, buying a lower share of German bonds between April and June, while buying a larger share of French and Italian bonds in excess of the Capital Key limits (Chart 10). To continue to do this would invite potential political criticism of the ECB's policies from Germany and other "hard money" countries in the Euro Area that do not wish to subsidize the high deficit governments. Chart 9ECB Holdings Of German Debt ##br##Approaching Limits Chart 10This Is Politically Unsustainable For that reason, we consider it to be very unlikely that the ECB will maintain the same level of bond purchases next year, but while also moving away from the Capital Key as the weighting scheme. The single country issuer limit could be raised from 33%, but this is also not a sustainable solution as it would potentially create the same problems faced by the other QE5 countries where the central bank ends up absorbing increasing shares of new government bond issuance, impairing market liquidity. We see the ECB as having no choice but to reduce the pace of asset purchases next year. We expect a true taper announcement next month that sets a date when the pace of buying goes to zero. The most "dovish" decision we can envision is a reduction in the pace of buying to €40bn/month that is maintained for all of 2018. This would be an identical move to the decision made last December, but even this would result in the ECB coming very close to the 33% issuer limit for Germany (the black dotted line in the top panel of Chart 9). Net-net, we see the ECB buying fewer Euro Area government bonds in 2018, no matter what. This will continue to put a rising floor underneath bond yields, with risks of bigger increases if inflation begins to accelerate in line with the ECB's projections. Bottom Line: Central banks with large amounts of maturing bonds on their balance sheets, like the Fed and the Bank of Japan, have had no choice but to signal a slower pace of future bond buying. The ECB is a similar boat, as its holdings of German debt approach issuer limits in the ECB portfolio. A slower pace of ECB bond buying is certain in 2018, to the detriment of European government bond market performance. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The Fed targets a growth rate of 2% on the headline Personal Consumption Expenditure (PCE) deflator, but the inflation rate reference in TIPS pricing is the growth of the headline Consumer Price Index (CPI). Given that the spread between headline PCE and headline CPI inflation has averaged around 50bps in recent years, a CPI inflation rate of 2.5% would be consistent with the Fed's stated inflation target. 2 http://www.bis.org/publ/arpdf/ar2017e4.pdf Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
Highlights The bottom in the dollar will have to wait for clearer signs that U.S. inflation has hit a trough. DXY is unlikely to punch below its May 2016 low. We examine balance of payments dynamics across the G10. This analysis shows that while the euro has long-term upside, it is too early to bet on any move above 1.20. The Japanese balance of payment dynamics will deteriorate as the BoJ keeps pressing on the gas pedal. Markets will have to price out rate hikes from the U.K. Feature Our most recent attempt at selling EUR/USD ended promptly in failure, as the euro is currently supported by a perfect storm of factors, making the timing of a reversal of its powerful bull run a tricky exercise. On the one hand, European politics continue to enjoy a re-rating among investors. As 2017 began, observers were worried that France was about to fall under the control of populists - euro-skeptic politicians like Marine Le Pen. This could well have spelled the end of the euro. Instead, the French electorate delivered a pro-market outcome with Emmanuel Macron clinching the keys to the Elysée Palace, and his centrist, pro-reform party now controlling Parliament. Meanwhile, German politics remain steady, and the Italian political risk has been pushed back to 2018. On the other hand, investors started the year expecting a hyperactive Trump presidency that would deliver de-regulation and tax reforms. Instead, the U.S. has a Twitterer-in-Chief and a chaotic White House that has been able to only achieve political paralysis. While political developments have grabbed the most headlines, economics have played an even more crucial role. Most importantly, inflation dynamics have been at the crux of the euro's rally. Namely, U.S. inflation has been a big source of disappointment, as the core PCE deflator has fallen from 1.9% in late 2016 to 1.5% today - a move away from the Federal Reserve's 2% target. As a result, the dollar and interest rates have moved away from discounting the Fed's path as implied by the "dot plot" (Chart I-1). However, our work on capacity utilization and financial conditions highlights that the U.S. inflation slowdown has been a reflection of the lagged impact of massive financial tightening in late 2014, and subsequent deceleration in economic activity. In fact, improvements in both capacity utilization and financial conditions witnessed since then point to a turnaround in inflation this fall (Chart I-2). Chart I-1Downward Move In Inflation Rate Expectations Chart I-2U.S. Inflation To Trough Soon What should investors do in the meantime? The market will only believe the Fed's hiking intensions once inflation rears its head again. After so many false starts and disappointments, signs that inflation might be coming will not be enough, as narratives of a near-permanent state of zero percent inflation are taking hold of the general discourse. Because investors have purged their excess dollar longs and are now heavily positioned for a euro rally, the dollar downside is currently limited, and a significant breach below the May 5, 2016 low in the DXY is unlikely. However, the dollar-rebound camp will have to wait for clear evidence that U.S. inflation is exiting its doldrums. This is a story for the fall. A Look At Balance-Of-Payments Dynamics The U.S. Chart I-3U.S. Balance Of Payments The U.S. current account deficit has been hovering below -2% of GDP for most of the post-great-financial-crisis period, and therefore has played little to no role in explaining the dollar's moves since 2011. However, the U.S. basic balance (current account plus net foreign direct investments) registered a sharp improvement in 2015 on the back of a surge in net FDI into the U.S. Despite a small pullback in the past 18 months, the U.S. basic balance remains consistent with levels recorded during the dollar bull market of the 1990s (Chart I-3). Portfolio flows in the U.S. have moved back into positive territory after a period of net outflows in 2015 and 2016. Yet, the total amount of net portfolio flows remains very low by historical standards, suggesting investors have not wagered aggressively on the U.S. economy's outperformance. Together, the aggregate U.S. balance-of-payment paints a neutral picture for the U.S. The deep imbalances in the current account and basic balance that prevailed prior to the financial crisis have been purged, but portfolio flows into the U.S. do not show any excessive optimism. In fact, the recent period of dollar weakness will likely help the U.S. balance of payments: It should support the trade balance, and make FDI and portfolio flows more attractive going forward as easing U.S. financial conditions help economic activity and asset returns. The Euro Area Chart I-4Euro Area Balance Of Payments Since the euro area crisis, the region's current account has surged to a very large surplus of 3.5% of GDP (Chart I-4). This mostly reflects a large correction of imbalances in peripheral nations. Countries like Spain and Italy have seen their own current account balances morph from deficits of 10.2% of GDP and 3.8% of GDP in 2008 and 2011, respectively, to surpluses of 1.9% of GDP and 2.7% of GDP today. The large contraction in imports on the back of moribund domestic demand has been the key driver of this phenomenon. The euro area remains an exporter of FDIs, experiencing near-constant outflows since 2004. As a result, the euro area's basic balance has not experienced as pronounced an improvement as the current account. It is still nonetheless in surplus - something that did not prevent EUR/USD from experiencing a 25% decline from June 2014 to March 2015. Net portfolio flows in the euro area have moved into deeply negative territory, reflecting massive outflows from the bond market. European investors have also been avid buyers of foreign equities, despite the recent increase in foreign buying of euro area stocks. In aggregate, we would interpret the current balance-of-payments dynamic in Europe as potentially supportive of the euro down the line. Aggregate portfolio flows are so depressed that there is a greater likelihood they will improve than deteriorate. However, while the basic balance and portfolio flows bottomed in 2000, the euro was not able to rally durably until 2002. Together, this suggests the euro is unlikely to re-test parity this cycle, but could remain capped below 1.20 for a few more quarters. Japan Chart I-5Japan Balance Of Payments Thanks to large investment income emanating from a net international investment position of 62% of GDP, Japan sports a current account surplus 2.5% of GDP greater than its trade balance. However, as the country continues to export capital abroad, it still carries a 3.1%-of-GDP deficit in terms of net FDI. This means that the Japanese basic balance of payments remains around 0% of GDP (Chart I-5). Meanwhile, net portfolio flows into Japan have improved greatly in 2017, explaining the yen's strength this year. While we see more upside for equity inflows into Japan, the efforts by the Bank of Japan to suppress JGB yields are likely to result into continued outflows on the fixed-income front. Since BCA is calling for higher global bond yields, fixed income portfolio outflows are likely to grow bigger, making the recent improvement in the Japanese balance of payments a fleeting phenomenon. This will weigh on the yen. We continue to expect the JPY to be one of the worst-performing currencies over the next 12-18 months. The U.K. Chart I-6U.K. Balance Of Payments Financing the U.K.'s current account deficit of 4% of GDP has taken center stage in the wake of the Brexit vote last year. However, while the trade-weighted pound has depreciated 12% since then, the British basic balance of payments has improved and moved back into positive territory. Net FDI inflows lie behind this stunning development. FDI into the U.K. has been surging since 2016 (Chart I-6). However, the recent slowdown in M&A deals into the U.K. points to a potential end for this GBP support. The key costs of controlling the free movement of people in the U.K. - a demand of Brexit voters - will be the loss of passporting rights for the financial services sector. Since this sector has been the biggest magnet for FDI in the U.K., net FDI could soon become a drag on the basic balance of payments. In contrast to FDI, net portfolio flows into the U.K. have followed the anticipated post-Brexit script, falling from 5% of GDP in Q2 2016 to zero earlier this year. This development was the biggest contributor to the pound's weakness last year. Going forward, the case for the Bank of England to turn hawkish is likely to dissipate as the inflation pass-through from the weak pound dissipates (see below). For the pound to rally further, a continued expansion in global liquidity will be necessary. However, we anticipate global liquidity to deteriorate for the remainder of 2017 as the Fed begins the runoff of its balance sheet, and the PBoC keeps tightening the screws on the bubbly Chinese real estate market. Hence, we would position ourselves for pound weakness against the USD in the second half of 2017. Canada Chart I-7Canada Balance Of Payments Canada runs a current account deficit of 3% of GDP. This is not a new development. Canada has been running a current account deficit since 2009 (Chart I-7), as weakness in the CAD from 2011 to 2016 was counterbalanced by weak export growth to the U.S. and poor oil prices. From a balance-of-payment perspective, the capacity of the CAD to rally may be limited. A surge in FDI to boost the basic balance of payments is unlikely. In 2001, the Canadian dollar was much cheaper than at present, and the impact of the tech bubble was still influencing M&A inflows into the country. In 2008, oil was trading near US$150/bbl. Today, Canada is a high-cost oil producer in a world of cheap oil, making Canadian oil plays unattractive, at least much more so than in 2007-2008. Additionally, net portfolio inflows into the country are already at near-record high levels, explaining the strong performance of the CAD since January 2016. However, going forward, oil prices are unlikely to double once more, and the combination of elevated Canadian indebtedness along with bubbly house prices and rising interest rates will create headwinds for the Canadian economy. Such an outcome would hurt expected returns on Canadian assets, and thus portfolio flows. However, if the hole in Canadian banks' balance sheets proves much bigger than BCA anticipates, this could prompt a repatriation of funds held abroad by banks - assets that currently equal nearly 50% of their balance sheets, temporarily helping the CAD. Australia Chart I-8Australia Balance Of Payments While the Australian trade balance has moved back in positive territory, the current account remains in deficit, burdened with negative international incomes associated with a negative net international investment position of -60% of GDP. Yet, because the current account has nonetheless improved, the Australian basic balance of payments is back in positive territory, as net FDI inflows have remained steady around 4% of GDP (Chart I-8). From a balance-of-payments perspective, the Australian dollar looks good. The current account balance is likely to remain well supported as the capex needs of Western Australia have decreased - exerting downward pressure on imports - but new mines are coming online and generating revenues and exports. Meanwhile, portfolio flows in Australia are quite depressed, suggesting some long-term upside as investors seem to be underweight Australian assets. That being said, the Aussie is currently trading at 12% above its long-term fair value. Moreover, any tightening in global liquidity thanks to the Fed and the PBoC could increase the cost of financing Australia's large negative net international investment position, and cause a last down leg in metals prices and the AUD. New Zealand Chart I-9New Zealand Balance Of Payments New Zealand's current account has been stable at around -3% of GDP since 2010. While New Zealand has been a constant magnet for FDI (Chart I-9), the positive balance in this account has not been able to lift the national basic balance of payments above the zero line. Interestingly, despite still-higher interest rates offered by New Zealand compared to the rest of the G10, the kiwi has been experiencing net portfolio outflows so far this year, potentially explaining why NZD/USD has not been able to break out like AUD/USD. Balance-of-payment dynamics looks supportive for the AUD relative to the NZD, as Australia runs a positive basic balance while New Zealand does not. Additionally, while Australian portfolio flows are very depressed, New Zealand's could suffer more downside. Mitigating these positives for AUD/NZD, the New Zealand economy is much stronger than that of Australia, and the Reserve Bank of New Zealand is in much better position to increase rates than the Reserve Bank of Australia is.1 Switzerland Chart I-10Switzerland Balance Of Payments The Swiss franc may be expensive relative to its purchasing power parity, and it may also be contributing to the country's strong deflationary tendencies, but it does not seem to be hampering its international competitiveness. The Swiss trade balance is at a massive 6% of GDP. Additionally, thanks to the international income generated by Switzerland's gigantic net international investment position of 127% of GDP, the country runs an incredible current account surplus of around 11% of GDP (Chart I-10). Being a nation with a steady current account surplus, Switzerland re-exports much capital abroad, generating a nearly permanent deficit in its net FDI account. However, this deficit is not enough to generate a basic balance-of-payments deficit. Instead, the BBoP still stands at 6% of GDP, creating a long-term support for the CHF. In terms of portfolio flows, Switzerland has historically run a deficit, reflecting its status as a capital exporter. Only at the height of the euro area crisis did Switzerland experience net portfolio inflows. Today, portfolio flows continue to leave the country, albeit at a slower pace than before the euro area crisis. Over the next 12 months, the CHF is likely to experience continued downside against both the euro and the USD, as the Swiss National Bank remains steadfast in its fight against domestic deflationary forces. However, from a long-term perspective, Switzerland will continue to run a balance-of-payments surplus that will support the structural upward trend in the real trade-weighted CHF. Sweden Chart I-11Sweden Balance Of Payments The Swedish trade balance recently moved into deficit territory, but the nation's current account remains in a healthy surplus of more than 4% of GDP, reflecting large amounts foreign income extracted by Sweden's thanks to its large amount of assets held abroad - a legacy of decades of current account surpluses. The net FDI balance has recently moved into positive territory, as Sweden possesses some of the strongest long-term economic fundamentals in Western Europe. Thanks to this development, the basic balance of the largest Nordic economy is at its highest level in eight years (Chart I-11), representing a long-term positive for the cheap SEK. Finally, portfolio flows into Sweden are at a neutral level. However, we expect the Riksbank to begin increasing rates early next year, putting it well ahead of its European peers. This should result in growing inflows into the country, supporting the SEK, at least against the EUR and the GBP. Norway Chart I-12Norway Balance Of Payments Due to the collapse in oil prices since 2014, the Norwegian trade surplus has melted from a gargantuan 15% of GDP to a more modest 5% of GDP (Chart I-12). However, falling oil prices and North-Sea production have also resulted in a collapse of FDIs into the country. Because of these developments, the Norwegian basic balance of payments has fallen into deficit for the first time in more than 20 years. This combination could explain why the NOK has been trading at its deepest discount to long-term fair value in decades. Ultimately, the constantly positive BBoP has historically been one of the key drivers of the krone. Without this support, since the Norges Bank stands among the most dovish central banks in the G10, the NOK does need a greater-than-normal discount. Norway too has historically experienced net portfolio outflows, also a consequence of its massive current account surplus. Thus, we do not read today's relatively small portfolio outflows as a positive. Instead, they simply reflect the deterioration in the current account and basic balance. Putting it all together, while balance-of-payment dynamics do explain why the NOK is trading at a historically large discount to fair value, we remain positive on this currency relative to the euro. When all is said and done, even accounting for these exceptional factors, the NOK is too cheap. Additionally, BCA does expect oil prices to move back toward US$60/bbl, which should help move the basic balance back into positive territory. Bottom Line: Balance-of-payment dynamics rarely have much impact on G10 currencies in the short run. However, in the long run, they can become paramount. Using this framework, while the USD could experience some upside in the next 12 months or so, any such upside is likely to mark the last hurrah of the bull market: the U.S. balance of payments is relatively neutral, but Europe's is currently excessively handicapped by extremely depressed portfolio flows. This latter situation is likely to be reversed in the coming years. The yen balance-of-payment dynamics will become increasingly tenuous if the BoJ continues on its current policy path. Among commodity currencies, the AUD has the best long-term profile in terms of balance-of-payment dynamics. Finally, the SNB faces a Herculean task: While it is currently keeping the CHF at bay in order to alleviate deflationary tendencies in Switzerland, the country's perennially strong balance of payment will ultimately prove too great a hurdle to overcome. The CHF could overtake the yen as the true risk-off currency of the world in future. BoE Is Stuck With Low Rates For Now In our January 13 Special Report titled, "GBP: Dismal Expectations,"2 we discussed why fears of any calamity that Brexit could bring to the British economy was overdone, and thus why buying the pound was an attractive opportunity. So far, our view has been validated, as cable has rallied by almost 8%. However, although we stand by our analysis on a cyclical horizon, a tactical selloff in the pound may be due. At the beginning of the year, the U.K. economy outperformed almost every forecast. Since then, expectations have risen along with the pound, but the British economy has shifted from star performer to disappointment (Chart I-13). For example, house price growth has collapsed to levels not seen since the euro area crisis (Chart I-14, top panel). Furthermore, the rapid rise in inflation has also caused a contraction in real disposable income comparable to that of 2012 (Chart I-14, bottom panel). Chart I-13Shift In U.K. Surprises Chart I-14Cracks In The U.K. Rate expectations have become too lofty. After the 2016 collapse in the pound, both headline and core inflation rose above the BoE's target. Consequently, rate expectations spiked, particularly after three MPC members voted for hikes. But can this rate of inflation continue? Looking at individual components of inflation, it is clear that the pound selloff was an important culprit behind the inflation surge. Thus, as the pass-through from the currency dissipates, inflation will also subside (Chart I-15). Falling inflation and weaker growth are already forcing the BoE to retreat from its relative hawkishness. Yesterday, as the "Old Lady" curtailed both its growth and wage forecast for 2017 and 2018, only two members voted for a hike. Political dynamics have also supported cable so far this year. Today, the U.K. policy uncertainty index is at par with that of the U.S. as the Trump White House continues to be in disarray, and the outlook for tax reform and/or infrastructure spending looks grim (Chart I-16). But the U.S. is not the country engaging in its most contentious and significant treaty negotiation in 50 years. Instead, the U.K. is this country, with a weakened government at its helm following its recent electoral debacle. Thus, we would expect a reversal of the currently pro-pound relative political uncertainty indexes, as Brexit negotiations heat up in the coming quarters. Chart I-15U.K. Inflation Is Peaking Chart I-16Does Trump Really Trump Brexit? While policy and political considerations are likely to hurt the pound this fall, for GBP/USD to correct, a fall in the euro will be needed as well. In the meantime, investors may look to continue to buy EUR/GBP. Since July 7th, we have been anticipating this cross to hit the 0.93 level. This analysis confirms this view. Bottom Line: The U.K. economy should be able to weather its exit from the European Union. This should help the pound on a cyclical horizon. However, the pound has become overbought and interest rate expectations are too elevated, as the market has forgotten that a price still has to be paid for Brexit. GBP/USD is too dependent on the EUR/USD dynamics to short cable outright right now. As such, investors may keep buying EUR/GBP for now, and look to sell GBP/USD near 1.33. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 Please see Foreign Exchange Strategy and Global Alpha Sector Strategy Special Report titled, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled "GBP: Dismal Expectations", dated January 13, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The U.S. has shown some signs of strength this week, however the data remains mixed: Both headline PCE and core PCE beat expectations, coming in at 1.4% and 1.5% respectively; While the headline ISM manufacturing number weakened, the Price Paid component rebounded to 62. Initial jobless claims beat expectations by 2,000; however, continuing claims underperformed; Factory orders improved on a monthly basis. While the U.S. is still in an inflation slump, we believe that inflation is close to bottoming out. The depreciation in the greenback and the rally in risk assets have greatly eased financial conditions, creating support for the economy. This should push the greenback up as the markets begin to reprice Fed hikes. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Euro appreciation has continued. While the general tone of data remains strong, some leading indicators are showing early cracks: Unemployment, a lagging indicator, decreased to 9.1%, outperforming expectations; Headline inflation remained steady at 1.3%, however core inflation increased to 1.2%; GDP numbers came in as expected, growing at a 0.6% quarterly rate, and a 2.1% annual rate; However, German and EMU Markit Manufacturing PMIs both underperformed expectations. Momentum is on the euro's side, which traded above 1.19 on Wednesday. The euro area owes much of its economic growth to the 25% depreciation since mid-2014. While data has surprised to the upside, the ECB remains the central bank of the peripheries, where inflation has failed to emerge as strongly. Rate differentials will weigh on the euro towards the end of the year, but momentum could continue to push the euro up in the coming weeks. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Japanese data came in positive: Overall household spending yearly growth came in above expectations at 2.3% Japan's job-to-applicants ratio came in at 1.51. Above expectations and growing from the previous month. The unemployment rate fell to 2.8%, coming in below expectations of 3%. These two last data points are important, as they show that the Japanese labor market is getting increasingly tight. However, as evidenced by the last 2 years, inflation will not be able to rise sustainably without a depreciating yen, even if the labor market is tight. Thus, the recent selloff in USD/JPY will only incentivize authorities to remain very accommodative while other central banks are exiting maximum accommodation, reinforcing our negative cyclical view on the yen. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Data in the U.K. was mixed this week: Both Markit Manufacturing and Markit Services PMI beat expectations coming in at 55.1 and 53.8 respectively. However both consumer credit and mortgage approvals fell from the previous month and underperformed expectations. Up to yesterday the pound had gained almost 2% during the week, however following the interest rate decision by the BoE, the pound fell by roughly 1%. The reason for this fall, was that the BoE is becoming less hawkish. Not only did the number of MPC members voting for a hike decrease from 3 to 2, but the bank also lowered its forecast for growth and wages. We believe this will start a trend toward a less hawkish BoE, which will weigh on the pound on the short term. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Momentum is showing signs of topping out. The MACD is rolling over, and is converging with the Signal line; and the RSI is weakening from deeply overbought levels. This week, AUD has displayed broad-based weaknesses. Despite one key blotch, data relevant to Australia has been good: TD Securities Inflation increased at a 2.7% rate in July; Chinese Caixin Manufacturing PMI came out better than expected at 51.1; Building permits increased at a striking 10.9% monthly rate. They contracted at a 2.3% yearly pace, a sharp improvement over the the previous month's 18.7% contraction. However, the trade balance underperformed missed expectations by a large margin, coming in at AUD856mn, compared to the expected AUD1,800mn. The recent RBA statement highlighted that the recent appreciation in the Australian dollar "is expected to contribute to subdued price pressures", and "is weighing on the outlook for output and employment". This could add substantial pressure on the AUD in the near future. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Even as the dollar has fallen, the kiwi has depreciated by almost 1.4% this week, as New Zealand data has come in weak: Both the ANZ Activity outlook and the ANZ business confidence came in below the previous month reading at 40.3% and 19.4 respectively. The participation rate came below expectations at 70%. Meanwhile employment also came below expectations contracting by 0.2% Month-on-Month. Overall we continue to be bearish on commodity currencies in general and the kiwi in particular. Recently, the Chinese authorities have been getting tougher on credit excesses. This could be the trigger for a risk off period in emerging markets, which wouldweigh on the NZD. That being said, we are more bearish on AUD/NZD, as the kiwi economy is on much stronger footing than the Australian one. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The CAD has displayed some considerable broad-based weakness this week following weak data releases: Industrial Product Price contracted monthly by 1% in June; The Raw Material Price Index also contracted, at 3.7%; However, the Markit Manufacturing PMI saw an increase to 55.5 from 54.7. Markets have priced in a 75% probability of a hike by the end of this year by the BoC, compared to 42% for the Fed. Although we agree with the market's perception of the BoC, we disagree that the probability of the Fed hiking is this low. We therefore believe the CAD could correct further in the upcoming weeks. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been positive: The KOF leading indicator came at 106.8, beating expectations. Real retail sales grew by 1.5% year on year, increasing from last month number and beating expectations. The SVME Purchasing Manager Index came in very strong at 60.9, beating expectations and also increasing from last month's reading. While data was positive, EUR/CHF went vertical this week, rising by more than 3%. At this point EUR/CHF is the most overbought it has been in more than 4 years, and at least a small correction seems overdue. The SNB will be satisfied with a depreciating currency, as this dramatic fall should help ease deflationary pressures in the alpine country. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data has been mixed in Norway: The Labor forced survey, which measures unemployment, came in at 4.3% outperforming expectations of 4.5%. The above data point was confirmed by the registered unemployment reading, which also outperformed expectations, coming in at 2.8%. However retail sales contracted by 0.6% month-on-month. Even as the dollar continues to fall, USD/NOK has stayed relatively flat this week. Curiously this has also happened amid rising oil prices. Overall, we expect USD/NOK to rally in the fall, as the Norwegian economy remains tepid, and inflation is not likely to rise above target any time soon, while investors are still underestimating the Fed's will to push interest rates higher. That being said, we are bearish on EUR/NOK, as this cross trades as a mirror image of oil, and the OPEC deal should continue to remove excess supply from the market and push prices higher. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Sweden has been generating substantial inflationary pressures, and increasing economy activity is likely to support these pressures, hence the Riksbank's recent hawkishness. With China tightening policy, SEK strength could be a story of rate differentials going forward, appreciating against EUR, AUD, NZD and NOK, as the Riksbank is likely to become increasingly nervous in the face of rising inflationary pressures. However, as the market currently underprices the risk of a more hawkish Fed, the picture for USD/SEK is less clear. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The neutral real rate of interest, R*, is low in most economies, and will only rise gradually over the coming years. Currency movements tend to dampen differences in neutral rates across countries. The fact that R* is higher in the U.S. will limit further downside risk for the dollar. While a variety of structural forces will cap the increase in the neutral real rate, the neutral nominal rate could rise more briskly as inflation picks up. As such, investors should reduce duration risk and increase exposure to inflation-linked securities. We are closing our long GBP/JPY trade for a gain of 9.9% and opening a new trade going short EUR/GBP. EUR/USD will trade in a range of $1.10-to-$1.20 over the next 6-to-9 months before moving lower in the second half of next year. Feature Where Is Neutral? As the global economy continues to recover, central banks are increasingly turning to the question of how to best normalize monetary policy. A key issue in this debate concerns the level of the neutral real rate of interest, commonly referred to as R*. If central banks raise rates too far above the neutral rate, growth could stall. If they don't raise rates enough, inflation could accelerate. The concept of the neutral rate is somewhat difficult to grasp, and we apologize in advance that this report is more abstract than what we are normally accustomed to writing. However, we think that readers who stick with the logic of the piece will be well rewarded with the practical implications that it provides. A Conceptual Framework In thinking about the neutral rate, it is worthwhile to recall the familiar macro identity which states that the difference between what a country saves and what it invests is equal to its current account balance.1 Since one country's current account surplus is another's deficit, globally, the current account balance must equal zero. This, in turn, implies that globally, savings must equal investment. What happens when desired global savings exceed desired investment? The answer is that interest rates will fall.2 Lower rates will incentivize firms to undertake more investment projects, while discouraging household savings. Investment will rise and savings will decline by just enough to ensure that the global savings-investment identity is satisfied. The discussion above aptly captures what happened to the global economy after the financial crisis. The desire of households to boost savings and firms to cut capital spending led to a sharp and sustained drop in the neutral rate. Those who understood this point back in 2010, when the 10-year Treasury yield briefly hit 4%, made a lot of money by being long bonds when most others were fretting about the inflationary effects of QE and large government budget deficits. The Exchange Rate As A Mitigating Force The ability of countries to export their excess savings abroad by running current account surpluses implies that the neutral rate has a large global component. To appreciate this point, consider a simple thought experiment. Suppose the global trading system completely breaks down and every country ends up with a trade balance of zero. For the sake of argument, let us ignore the immense economic dislocations that this would cause and focus simply on the arithmetic impact that this would have on aggregate demand. The U.S. trade deficit currently stands at $567 billion (3% of GDP). Getting rid of it would add about six million jobs. This would likely cause the economy to overheat, forcing the Fed to raise rates. In contrast, the German economy would fall into a deep recession if its €224 billion (7.1% of GDP) trade surplus vanished. The ECB would not be able to raise rates for years. Thus, in the absence of trade, the neutral rate would be higher in the U.S. and lower in the euro area. This simple thought experiment illustrates why the neutral rate partly depends on the value of a country's currency.3 If a country's currency strengthens, all things equal, its neutral rate will fall. The extent to which the currency appreciates will depend on how long the forces causing neutral rates to diverge across countries are expected to persist. In general, if the forces are more structural than cyclical in nature, currencies will adjust to a greater degree (Chart 1).4 Chart 1The Longer The Interest Rate Gap Persists, The Bigger The Exchange Rate Overshoot The discussion above helps make sense of currency movements over the past three years. A key reason the dollar began to strengthen against the euro in the second half of 2014 is that investors became convinced that the neutral rate in the U.S. would exceed that of the euro area for a very long period of time. The rally in the euro this year largely reflects a reappraisal of that view. Stronger euro area growth has convinced many investors that the neutral rate in the region may not be as low as previously imagined. The Outlook For The Neutral Rate The savings-investment balance provides a useful framework for thinking about how the neutral rate will evolve over the coming years. With this framework in mind, let us consider the various forces affecting the neutral rate and how they might change over time. The Debt Supercycle Today, almost 60% of Americans want to save more money according to a recent Gallop poll; before the financial crisis, that number was less than 50% (Chart 2). A slower pace of debt accumulation implies less spending and more desired savings. It is possible that households will become more willing to take on debt as the memories of the Great Recession fade. However, a return to the reckless lending standards of the pre-crisis period is unlikely. Thus, while the end of the deleveraging cycle in the U.S. will push up R*, it will remain low by historic standards. Globally, efforts to reduce leverage have been more halting. In fact, in many emerging markets, debt levels are higher today than in 2008 (Chart 3). This will weigh on R*. Chart 2Return To Thrift Chart 3EM Debt At All-Time Highs The "Amazonification" Of The Economy Chart 4Savings Heavily Skewed Towards Top Earners Technological progress is nothing new, but unlike past inventions which typically replaced man with machine, many of today's innovations appear to be reducing the need for both labor and physical capital.5 Companies like Amazon are laying waste to America's retail sector. Uber and Airbnb are providing ways to use the existing stock of capital more efficiently. Fewer shopping malls, taxis, and hotels means less investment, and less investment means a lower neutral rate. Inequality One of the distinguishing features of the "Amazon economy" is that it is dominated by a few winner-take-all firms. This has generated huge payoffs for their owners, but paltry returns for everyone else. While this is not the only trend fueling income inequality, it has certainly exacerbated it. Rising inequality redistributes income from households that tend to live paycheck-to-paycheck to those who save a lot (Chart 4). This increases aggregate desired savings, leading to a lower neutral rate. However, rising inequality may also generate a political backlash. Donald Trump's ability to take over the Republican party was partly driven by the disillusionment of Republican voters over the GOP's pro-business positions on issues such as immigration and trade. Historically, populism has been associated with larger budget deficits. To the extent that budget deficits soak up savings, they lead to a higher neutral rate. Rising populism could also lead to stronger calls for anti-trust policies. Our sense is that we are slowly moving in this direction. Slower Population Growth Demographic shifts can be tricky to assess because they affect savings and investment in offsetting ways and over different time horizons (Chart 5). A decrease in the growth rate of the population will reduce the incentive to expand capacity. Less investment means a lower neutral rate. Slower population growth may also lead to higher savings for a while, as a larger fraction of the population enters its peak saving years (ages 30-to-50). This also means a lower neutral rate. Eventually, however, aging will push more of the population into retirement, increasing the number of people who are dissaving rather than saving. Rising government spending on health care and pensions could also lead to larger fiscal deficits, further depleting national savings. We may be approaching this outcome. Chart 6 shows that the global "support ratio" - defined as the number of workers relative to the number of consumers - has peaked globally and will start falling sharply over the coming years. Chart 5An Aging Population Eventually Pushes Up Interest Rates Chart 6The Ratio Of Workers To Consumers Have Peaked Slower Productivity Growth As with population growth, slower productivity growth is likely to depress R* at first, but could raise R* over time (Chart 7). Initially, slower productivity growth will prompt firms to curb investment spending. It could also lead to less consumer spending, as households react to the prospect of smaller gains in real incomes. All this implies a lower neutral rate. Eventually, however, chronically weak income growth is likely to deplete national savings, leading to a higher neutral rate. The U.S. and a number of other economies may be getting increasingly close to that inflection point (Chart 8). Chart 7A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Chart 8Weak Supply Growth Has Narrowed Output Gaps Lower Commodity Prices Swings in commodity prices may also generate offsetting pressures on the neutral rate that manifest themselves over different time horizons. At the outset, lower commodity prices tend to depress investment spending in the resource sector. This implies a lower neutral rate. Over time, however, lower commodity prices may generate new investment opportunities in downstream industries that use fuel as an input. Lower commodity prices also put money into the pockets of poorer households who are likely to spend it. This raises the neutral rate. Investment Implications Given the conflicting forces affecting R*, it is difficult to have much certainty over how it will evolve. Our best guess is that R* will increase over the next few years, as the scars from the financial crisis recede, deleveraging headwinds abate, fiscal deficits in some economies widen, and population aging and lower productivity growth make more of a dent in national savings. However, the rise in R* is likely to be gradual and from what is currently a very low base. Where we do have greater conviction is on two points: First, the neutral nominal rate will rise more quickly than the neutral real rate, as inflation picks up in most economies. As discussed last week, central banks have a strong incentive to try to engineer more inflation in situations where the economy needs a low real rate to maintain full employment.6 Getting inflation up has been a struggle ever since the financial crisis began, but now that spare capacity around the world is dissipating, central banks are likely to gain more traction over monetary policy. As such, investors should reduce duration risk and increase exposure to inflation-linked securities. Second, the forces pushing down R* outside the U.S. will remain more pronounced than those in the U.S. This, in turn, will provide some support to the beleaguered U.S. dollar. Investors, in particular, may be getting too optimistic about the ability of the ECB to engineer a full-fledged tightening cycle. The euro area is further behind the U.S. in the deleveraging process, suggesting that desired private-sector savings will remain higher there. The overall stance of fiscal policy is also much tighter in the euro area. The IMF estimates that the euro area's structural primary budget surplus currently stands at 0.7% of GDP, compared to a deficit of 1.9% in the U.S. Thus, fiscal policy is currently adding 2.6% of GDP more to aggregate demand in the U.S. than in the euro area. The Fund expects this relative contribution to increase to nearly 4% of GDP by the end of the decade (Chart 9). Furthermore, investment spending has more scope to fall in the euro area. According to the OECD, gross fixed capital formation is actually higher in the euro area than in the U.S. as a share of GDP, despite the fact that potential GDP growth is slower in the euro area (Chart 10). Chart 9Fiscal Policy Is More Stimulative In The U.S. Chart 10Euro Area Investment Spending: Higher Than In The U.S. The appreciation of the euro has led to a tightening in euro area financial conditions in recent weeks, whereas U.S. financial conditions have continued to ease (Chart 11). This will cause relative growth to shift back in favor of the U.S. later this year. Chart 11Diverging Financial Conditions##br## Favor U.S. Over The Euro Area Chart 12The Neutral Rate Is Lowest In The Euro Area The 30-year U.S. Treasury yield is currently 95 basis points higher than the 30-year GDP-weighted euro area government bond yield. This gap in yields does not strike us as being especially large considering that both the neutral rate and long-term inflation expectations are lower in the euro area. We expect EUR/USD to trade in a range of $1.10-to-$1.20 over the next 6-to-9 months before moving lower in the second half of 2018, by which time the Fed will be forced to pick up the pace of rate hikes. The resurgent euro has approached all-time highs against the pound, abetted by a somewhat more dovish-than-expected BoE meeting this week. Yet, with U.K. inflation above target and the unemployment rate at the lowest level since 1975, the Bank of England may need to deliver more than the mere 36 basis points in rate hikes the market is expecting over the next two years. Holston, Laubach and Williams estimate that R* is 1.6 percentage points higher in the U.K. than in the euro area (Chart 12). As such, the balance of risks now favor a stronger pound over a cyclical horizon of 12 months. With that in mind, we are closing our long GBP/JPY trade for a gain of 9.9% and opening a new short EUR/GBP position (Note: The returns of all closed trades are displayed at the back of this report). Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 The difference between what a country saves and what it invests is also equal to the difference between what it earns and what it spends. To see this, note that S=Y-C-G where S is national savings, Y is national income, C is personal consumption, and G is government spending. Hence, the identity S-I=CA can be re-written as Y-(C+G+I)=CA where CA is the current account balance. 2 An obvious question is what happens if desired savings exceed desired investment, but interest rates are already equal to zero. In that case, income will contract. Workers will lose their jobs, making it impossible for them to save. Firms will suffer lower profits or even incur losses in the face of flagging demand. Governments will see tax revenues dry up and spending on welfare programs escalate. This means that household, corporate, and government savings will all decline. Of course, since firms are likely to reduce investment in response to slower growth, this could usher in a vicious cycle where falling demand leads to higher unemployment and even less spending - in other words, a recession or even a depression. 3 Suppose, for example, that the interest rate in Country A were to rise above that of Country B for a period of say, ten years. Country A's currency would appreciate. This would reduce net exports in Country A, leading to a decline in aggregate demand. This, in turn, would prevent the neutral rate in Country A from rising as much as it otherwise would. On the flipside, the cheapening of Country B's currency would push up its neutral rate. 4 In the extreme case where the structural forces are expected to last forever, currencies will adjust to the point where the neutral rate across countries is equalized. Intuitively, this must happen because it is impossible for currency-hedged, risk-adjusted interest rates to be lower in one country than in another for an indefinite amount of time. 5 From a neoclassical economics perspective, one might imagine a "production function" that includes labor, physical capital, and digital capital. Many of today's innovations are raising the return on digital capital relative to those on labor and physical capital. This generates outsized rewards to the owners of this particular form of capital (i.e., internet companies), while potentially undercutting the income of workers and owners of physical capital. 6 Please see Global Investment Strategy Weekly Report, “A Secular Bottom In Inflation,” dated July 28, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades