Monetary

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

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

Highlights The Fed’s role is commonly misunderstood, even by sophisticated investors: It seeks to lean against the business cycle, not eliminate it entirely. The idea of the “Fed put” has gone too far: The Fed is indifferent to mundane market moves; it only cares about big swings that could have a material impact on the economy. Investors hoping for an at-the-money put to indemnify them against potential losses will be sorely disappointed. The dual mandate is alive and well: Monetary policy may be better situated to defending price stability than promoting full employment, but the employment mandate was a key catalyst for lower-for-longer rates, and the negative unemployment gap better explains the current tightening cycle than still sluggish inflation prints. The Fed’s propensity to lean against the cycle means that economic strength will prove self-limiting while the expansion is in its latter stages: Risk assets can rally while the Fed’s on hold and economic data are robust, but the stronger the data, the harder the Fed will ultimately have to clamp down. Feature The ranks of BCA researchers include quite a few people who’ve done graduate work in Economics. The modern BCA was initially seeded with Bank of Canada alumni, and the current head of the Bank of Canada, Stephen Poloz, is a BCA alumnus. BCA’s tagline is Independent Investment Research Since 1949, however, not Independent Economic Research. We care about the future direction of the economy only insofar as it informs our expectations for the future direction of financial markets. Financial markets have lately been hypersensitive to all things Fed-related. That helps to make a macro researcher feel wanted, but the Fed fixation has gone so far that the tail is now wagging the dog. In this Special Report, we take a step back to look at the Fed’s role in relation to the business cycle. It is the first in a series of Fed-themed Special Reports in which we attempt to place the Fed’s actions in a market context. The next installment will dig into the link between wage gains and consumer price inflation, and we plan a multi-part series, in collaboration with our fixed-income strategists, on the ins and outs of QE and what investors might expect from its reversal. What The Fed Does Not Do Exhibit A of what the Fed does not do can be found in last week’s Barron’s, where the economics column was headlined, “Can the Fed Stave Off the Next Recession?” Despite popular misconceptions, the Fed’s job is not to prevent recessions, or even to delay their onset. It’s a subtle distinction, but the Fed’s job vis-à-vis the business cycle is to mitigate the effects of recessions so as to maximize long-run economic output. That entails the extraordinary measures the Fed undertook in the wake of the crisis, to prevent dire cyclical swings from metastasizing into permanent economic losses (hysteresis, in economics argot), and reining in boom excesses, which often amounts to inducing a recession before excesses grow larger and potentially more harmful. The Fed also does not act to shield investors from losses. Talk of a “Fed put” initially arose the day after 1987’s Black Monday, with a seemingly innocuous press release: The Federal Reserve, consistent with its responsibilities as the Nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system. Those 30 words, signaling the Fed’s willingness to fulfill its function as the lender of last resort in the wake of a specific event with the potential to spark a crisis, have now had a half-life of 30 years and counting. The enduring notion of the Fed put may also have been helped along by the district banks’ efforts to keep the system functioning in the days after Black Monday. New York Fed president Corrigan twisted lenders’ arms to keep credit flowing so the crash would not infect the banking system and the real economy.1 The Chicago Fed didn’t let the letter of the law keep it from “help[ing to] engineer a solution” when one of the biggest derivatives market participants “ran short of cash.2” The statement, and the vigorous offstage exertions, marked a watershed in terms of the Fed’s public profile. Before Alan Greenspan, monetary policy actions were regarded as something akin to state secrets. Wall Street firms employed “Fed watchers,” who were charged with studying the tea leaves to determine if the Fed had adjusted policy. As late as January 1990, the Bank Credit Analyst could devote an entire Special Report to the question, “Has the Federal Reserve Eased?” We push back against the widespread Fed-put notion that the Fed will do its best to ward off, or mitigate, run-of-the-mill market downdrafts. It is a subtle distinction to be sure, but it’s more accurate to say the Fed attempts to ward off, or mitigate, market crises. With the credit crisis following closely on the heels of the dot-com bust, the Fed-put concept got legs, but stretching the idea to the fourth-quarter selloff is misguided. The Fed simply reacted to a tightening of financial conditions that lessened the need for additional near-term hikes (Chart 1). Straight-talking Jay Powell put it well at the press conference following the January FOMC meeting: Chart 1An Extreme Swing An Extreme Swing An Extreme Swing [W]hen there are changes [in financial conditions,] and those changes are sustained for a period of time, then they become important for us because they have important macroeconomic implications. So we don’t react to … most things that happen in the financial markets. But when we see a sustained change in financial conditions, then that’s something that has to play into our thinking. In fact, our policy works through changing financial conditions so it’s sort of the essence of what we do. Bottom Line: The Fed does not try to prevent recessions, which are a natural counterpoint to expansions. It simply tries to lean against cyclical extremes with the goal of increasing long-run output. Investors and the media overrate the “Fed put.” The Fed only leans against outsized market swings with the potential to destabilize the broader economy. The Fed’s Dual Mandate As directed by the Federal Reserve Reform Act of 1977, and subsequently adjusted by common understanding, the Fed has a dual mandate to promote price stability and full employment. In line with the price stability mandate, the Fed has set a 2% annual target for its preferred inflation measure, the price index for personal consumption expenditures (PCE). The PCE price index has persistently undershot the Fed’s target since the crisis (Chart 2), and in an attempt to raise inflation expectations and persuade the public that it will enforce the minimum speed as well as the speed limit, the Fed has lately stressed that its inflation target is “symmetric,” indicating that it is equally concerned about undershoots and overshoots. Chart 2Mandate 1: Price Stability Mandate 1: Price Stability Mandate 1: Price Stability Full employment is more difficult to quantify because it varies over time and is not directly observable. It is best described with reference to the natural rate of unemployment (“u-star,” or, “u*”) that accrues from structural factors independent of the cycle. The Congressional Budget Office estimates that u-star is currently 4.6%, similar to the FOMC’s 4.5% median estimate. Since the introduction of the dual mandate, the unemployment rate has only occasionally fallen below u-star (Chart 3, bottom panel). Those occasions have all eventually ended in recessions and (typically) lengthy stretches of excess unemployment.3 Chart 3Mandate 2: Full Employment Mandate 2: Full Employment Mandate 2: Full Employment The Fed’s Reaction Function Inflation and unemployment don’t matter all that much to markets in themselves; their import instead derives from the way they affect Fed policy. The Fed’s theoretical inflation reaction is straightforward; it moves to cut off above-target inflation on the grounds that unstable prices hold output below potential by undermining economic actors’ ability to plan confidently for the future. The Fed would be expected to react similarly to long-term inflation expectations that go beyond its comfort zone. The empirical record generally supports the theory: from the late ‘80s to the late ‘90s, when inflation had come off the boil, but was still well above today’s 2% target, the Fed hiked rates when core inflation accelerated (’87 through early ’89, and ’94 through mid-’95, Chart 4). Once core PCE inflation regularly fell below the 2% target, the Fed has hiked when both series have turned up and core CPI has exceeded 2% (early ’97, mid-’99, and mid-’04), and when both series accelerated but were still well below 2% (December 2015).4 Over the last 30 years, the fed funds rate’s relationship with the Cleveland Fed’s long-term inflation expectations series has been even stronger than its relationship with measured inflation (Chart 5). Chart 4When Core Price Indexes Rise, The Fed Hikes When Core Price Indexes Rise, The Fed Hikes When Core Price Indexes Rise, The Fed Hikes   Chart 5Managing Expectations Managing Expectations Managing Expectations The Fed’s unemployment reaction is less clear, as befitting the uncertain relationship between monetary policy and employment.5 Ever since the dual mandate became law, however, the Fed has hiked rates every time the unemployment rate has fallen below the estimated natural rate of unemployment (Chart 6, bottom panel). Viewed in conjunction with core inflation measures (Chart 6, top panel), the reaction function becomes clearer: when the unemployment gap is negative, and inflation is above 2%, the Fed hikes. The holistic reaction function is consistent with the Phillips Curve argument that inflation and unemployment are inversely related (Chart 7). Delving into the controversy around the Phillips Curve is beyond the scope of this survey, but the practical takeaway for investors is that the Fed still generally subscribes to the Phillips Curve relationship, and can therefore be expected to hike when unemployment falls below its natural rate. Chart 6Accelerating Inflation + Negative Unemployment Gap = Rate Hikes Accelerating Inflation + Negative Unemployment Gap = Rate Hikes Accelerating Inflation + Negative Unemployment Gap = Rate Hikes   Chart 7 The Limits Of Monetary Policy We have repeatedly made the point that monetary policy is a blunt instrument that works with long and variable lags. Combined with a dual mandate that focuses on lagging indicators like inflation and the unemployment rate, the Fed is almost certainly condemned to leaning too hard against the cycle at both the bottom and the top. Responding to delayed feedback, it is likely to provide too much accommodation after the economy has already troughed and to clamp down too hard after it’s already peaked. That said, central bankers must be doing something right. Recessions have become shallower and less frequent as the business cycle has become much more stable than it was in the 60 years before World War I (Chart 8). Inflation has been docile ever since the Volcker Fed brought it to heel. The U.S. economy’s post-crisis outperformance versus its developed-world peers owes a great deal to the Fed’s and other domestic regulators’ willingness to act swiftly, boldly and creatively to counteract the effects of the crisis. Chart 8The U.S. Economic Ride Has Gotten Much Smoother The U.S. Economic Ride Has Gotten Much Smoother The U.S. Economic Ride Has Gotten Much Smoother Investment Implications We continue to believe that unnecessary fiscal stimulus, by artificially boosting aggregate demand above the economy’s capacity to satisfy it, will eventually produce inflation. We further believe that an extremely tight labor market will generate upward wage pressure. Though possible, it is not our base case that firms will boost productive capacity sufficient to meet a temporary pickup in demand. It is also not our base case that labor force participation will increase enough to prevent additional hiring from pushing year-over-year compensation gains to 3% and beyond. Inflation pressures have been slower to emerge than we expected, but when they eventually appear, the Fed can be counted upon to attempt to contain them. Once it does, Treasuries will suffer, especially at longer maturities. The economy eventually will, as well, and equities and spread product will perform poorly in the ensuing recession. However, the Fed’s newfound commitment to patience, and inflation’s delay in pressuring the Fed to abandon it, is likely to push out our projected outcomes. The delay will ultimately make the overshoots larger. The Treasury selloff will be worse because yields will stay lower for longer while the Fed remains on the sidelines, and they will rise more than they otherwise would because the Fed will have to drive rates higher to combat inflation that’s been afforded more time to germinate. Spread product and equities will presumably post larger gains while the Fed pauses, and the economy builds up more momentum than it otherwise would, followed by larger losses when the Fed ultimately has to get more aggressive. Economic strength at this point of the cycle is self-limiting, but the limit now appears to be a little further away than we previously estimated. We maintain our recommended positioning – overweight equities and spread product, significantly underweight Treasuries, and equal-weight cash – with the caveats that volatility is likely to be elevated in the latter stage of the cycle and that trade tensions remain a meaningful threat. Generalizing beyond the current cycle, monetary policy settings matter a great deal for relative asset-class returns. The Fed’s predictable reaction to the business cycle should be incorporated into the asset-allocation decision process.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 Greenspan, Alan. The Age of Turbulence: Adventures in a New World, Penguin (New York): 2007, p.108. Greenspan disavowed knowledge of the details, but suggested that Corrigan, “the Fed’s chief enforcer,” “bit off a few earlobes” while encouraging bankers to keep in mind that, “‘if you shut off credit to a customer just because you’re a little nervous about him, but with no concrete reason, he’s going to remember that’.” 2 Greenspan, p. 110. 3 The u* series shown in Chart 3 is a retrospective estimate. Research cited by Chairman Powell in his 2018 Jackson Hole address suggests that faulty real-time estimates of u* are a potential source of policy errors. https://www.federalreserve.gov/newsevents/speech/files/powell20180824a…, accessed February 6, 2019. 4 The Fed targets the headline PCE price index series, but we show the core PCE price index because it is a robust predictor of the headline series. 5 According to a St. Louis Fed blog post intended to explain everyday economic concepts, “the links between monetary policy and employment are weak and inexact.” https://www.stlouisfed.org/open-vault/2018/august/federal-reserve-dual-mandate, accessed February 4, 2019.

Highlights We always strive to develop new analytical methods to complement our focus on judging currencies based on global liquidity conditions and the business cycle. This week, we introduce a ranking method based strictly on domestic factors: We call it the Aggregate Domestic Attractiveness Ranking. Using this method alone, the USD, the NZD, the AUD, and the NOK are the most attractive currencies over the coming three months, while the JPY, the GBP, the EUR and the CHF are the least attractive ones. If we further filter the results using a valuation gauge, the USD, the NOK and the CAD are the most attractive currencies over the coming three months, while the CHF, the JPY and the GBP are the least attractive ones. Ultimately, the message is clear: if the dollar corrects, domestic factors suggest it will be shallow. However, buying pro-cyclical commodity currencies at the expense of countercyclical ones makes sense no matter what. Feature This publication places significant emphasis on understanding where we stand in the global liquidity and business cycle in order to make forecasts for G-10 currencies. However, we also like to refer to other methods to add supplementary dimensions to our judgment calls. In this optic, we have focused on factor-based analyses such as understanding momentum, carry and valuation considerations. This week, we take another approach: We build a ranking methodology using domestic economic variables only, intentionally excluding global business cycle factors. Essentially, we want to create an additional filter to be used independently of our main method. This way, we can develop a true complement to our philosophy rooted in understanding the global business cycle. With this approach, we rank currencies in terms of domestic growth, slack, inflation, financial conditions, central bank monitors, and real rates. We look at the level of these variables as well as how they have evolved over the past 12 months. After ranking each currency for each criterion, we compute an aggregate attractiveness ranking incorporating all the information. We then compare the attractiveness of each currency to their premiums/discounts to our Intermediate-Term Timing Models. Based on this methodology, the USD, the NOK and the CAD are the most attractive currencies over the coming three months, while the CHF, the JPY, and the GBP are the least attractive ones. Building A Domestic Attractiveness Ranking Domestic Growth Chart I-1 Chart I-2 The first dimension tries to capture the strength and direction of domestic growth. We begin by looking at the annual growth rate of industrial production excluding construction, as well as how this growth rate has evolved over the past 12 months. Here, the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. As Chart I-1 illustrates, Sweden is performing particularly well on this dimension, while the euro area, Switzerland, the U.K, and Japan are not. The U.S. stands toward the middle of the pack. When aggregating this dimension on both the first and second derivative of industrial production, Sweden ranks first, followed by the U.S. and Norway (Chart I-2). The U.K. and the euro area rank at the bottom. Chart I-3 Chart I-4 When trying to gauge the impact of domestic growth on each currency’s attractiveness, we also look at the forward-looking OECD leading economic indicator (LEI). As with industrial production, the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. This changes the ranking. New Zealand exhibits the highest annual growth rate, followed by the U.S. Meanwhile, when looking at how the annual rate of change has evolved over the past 12 months, Australia shows the least deterioration, and the euro area the most (Chart I-3). Putting these two facets of the LEI together, Australia currently ranks first, followed by the U.S. and New Zealand. Switzerland and the U.K perform the most poorly (Chart I-4). Slack Chart I-5 Chart I-6 Then, we focus on slack, observing the dynamics in the unemployment gap, calculated using the OECD estimates of the non-accelerating inflation rate of unemployment (NAIRU). Here, the currencies of countries at the top right of the chart are least attractive, while those at the bottom left are most attractive. Switzerland enjoys both a very negative and rapidly falling unemployment gap (Chart I-5). The U.K. also exhibits a clear absence of slack, but in response to the woes surrounding Brexit, this tightness is decreasing. Interestingly, the euro area looks good. Despite its high unemployment rate of 7.9%, the unemployment gap is negative, a reflection of its high NAIRU. Combining the amount of slack with the change in slack, Switzerland, New Zealand and the euro area display the best rankings, while the U.S. and Sweden exhibit the worst (Chart I-6). The poor rankings for both the U.S. and Sweden reflect that there is little room for improvement in these countries. Inflation Chart I-7 Chart I-8 When ranking currencies on the inflation dimension, we look at core inflation and wages. We assume that rising inflationary pressures are a plus, as they indicate the need for tighter policy. We begin with core inflation itself; the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. Canada and the U.S. both sport higher core inflation than the rest of the sample, as well positive inflationary momentum (Chart I-7). Switzerland displays both a very low level of inflation as well as declining momentum. U.K. inflation displays the least amount of momentum. On the core CPI ranking, the Canadian dollar ranks first, followed by the USD. Unsurprisingly, Japan and Switzerland rank at the bottom of the heap (Chart I-8). Chart I-9 Chart I-10   We also use wages to track inflationary conditions as G-10 central banks have put a lot of emphasis on labor costs. Similar to core inflation, we measure each country’s level of wage growth as well as its wage-growth momentum. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. This time, the U.S. and the U.K. display both the highest annual growth rate of wages as well as the fastest increase in wage inflation (Chart I-9). Meanwhile, Norwegian wage growth is very poor, but improving. The U.S. and the U.K. rank first on this dimension, while Switzerland and Canada rank last, the latter is impacted by its very sharp deceleration in wage growth (Chart I-10). Financial Conditions Chart I-11 Chart I-12 The Financial Conditions Index (FCI) has ample explanatory power when it comes to forecasting a country’s future growth and inflation prospects. This property has made the FCI a key variable tracked by G-10 central banks. Here we plot the level of the FCI relative to the annual change in FCI. A low and easing FCI boosts a nation’s growth prospects, while a high and tightening FCI hurts the outlook. Consequently, the currencies of countries at the top right of the chart are least attractive, while those at the bottom left are most attractive. While Switzerland has the highest level of FCI – courtesy of an overvalued exchange rate – the U.S. has experienced the greatest tightening in financial conditions (Chart I-11). Combining the level and change in FCI, we find that New Zealand currently possess the most pro-growth conditions, followed by both Sweden and Norway. On the other end of the spectrum, Japan and the U.S. suffer from the most deleterious financial backdrop (Chart I-12). Central Bank Monitors Chart I-13   Chart I-14 We often use the Central Bank Monitors devised by our Global Fixed Income Strategy sister publication as a gauge to evaluate the most probable next moves by central banks. It therefore makes great sense to use this tool in the current exercise. The only problem is that we currently do not have a Central Bank Monitor for Switzerland, Sweden and Norway. Nonetheless, using this variable to create a dimension, we compare where each available Central Bank Monitor stands with its evolution over the past 12 months. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. Currently, Canada and the U.S. show a clear need for tighter policy, without a pronounced fall in their respective Central Bank Monitors (Chart I-13). However, while the U.K. could stand higher rates right now, the British Central Bank Monitor is quickly falling, suggesting the window of opportunity for the Bank of England is dissipating fast. The euro area and Australia do not seem to justify higher rates right now. On this metric, Canada and the U.S. stand at one and two, while Australia and the euro area offer the least attractive conditions for their currencies (Chart I-14). Real Interest Rates Chart I-15 Chart I-16   The Uncovered Interest Rate Parity (UIP) hypothesis has been one the workhorses of modern finance in terms of forecasting exchange rates. To conduct this type of exercise, our previous work has often relied on a combination of short- and long-term real rates, a formulation with a good empirical track record.1 Accordingly, in the current exercise, we use this same combination of short- and long-term real rates to evaluate the attractiveness of G-10 currencies. This dimension is created by comparing the level of real rates to the change in real rates over the past 12 months. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. The U.S. dollar is buoyed by elevated and rising real rates, while the pound is hampered by low and falling real rates (Chart I-15). This results in the dollar ranking first on this dimension, and the pound ranking last (Chart I-16). Interestingly, the yen ranks second because depressed inflation expectations result in higher-than-average and rising real rates. Aggregate Domestic Attractiveness Ranking and Investment Conclusions Chart I-17 Chart I-18   Once we have ranked each currency on each dimension, we can compute the Aggregate Domestic Attractiveness Ranking as a simple average of the ranking of the eight different dimensions. Based on this method, domestic fundamentals suggest that the USD, the NZD, the NOK and the AUD are the most attractive currencies over the next three months or so, while the JPY, the GBP, the EUR and the CHF are the least attractive ones (Chart I-17). Interestingly, this confirms our current tactical recommendation espoused over recent weeks to favor pro-cyclical currencies at the expense of defensive currencies. However, it goes against our view that the U.S. dollar is likely to correct further over the same time frame. This difference reflects the fact that unlike our regular analysis, the Aggregate Domestic Attractiveness Ranking does not take into account the global business cycle, momentum and sentiment. We can refine this approach further and incorporate valuation considerations. We often rely on our Intermediate-Term Timing Model to gauge if a currency is cheap or not. Chart I-18 compares the Aggregate Domestic Attractiveness Ranking of G-10 currencies to their deviation from their ITTM. Countries at the bottom left offer the most attractive currencies, while those at the upper right are the least attractive currencies. This chart further emphasizes the attractiveness of the dollar: not only do domestic factors support the greenback, so do its short-term valuations. The CAD, the NOK and the SEK also shine using this method, while the less pro-cyclical EUR, CHF and JPY suffer. The pound too seems to posses some short-term downside. Ultimately, this tells us that if the global environment is indeed unfavorable to the U.S. dollar right now, we cannot ignore the strength of U.S. domestic factors. Consequently, we refrain from aggressively selling the USD during the tactical anticipated correction. Instead, if the global environment favors the pro-cyclical commodity currencies on a three-month basis, it is optimal to buy them on their crosses, especially against the CHF and JPY. Meanwhile, the pound has very little going for it, and selling it against the SEK or the NOK could still deliver ample gains.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1  Please see Foreign Exchange Strategy Special Report, "In Search Of A Timing Model" dated July 22, 2016, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. has been mixed: January U.S. consumer confidence index surprised to the downside, coming in at 120.2.  U.S. unemployment rate in January increased to 4.0%, from a previous 3.9% reading; however, this data point was likely distorted by the government shutdown Non-farm payrolls in January surprised to the upside, coming in at 304k. The DXY index rebounded by 0.9% this week. Tactically, we remain bearish on the dollar, as we believe that the current easing in financial conditions will help global growth temporarily surprise dismal investor expectations. Nevertheless, we remain cyclical dollar bulls, as the Fed will ultimately hike more than what is currently priced this year, and as China’s current reflation campaign is about mitigating the downside to growth, not generating a new upswing in indebtedness and capex. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 So Donald Trump Cares About Stocks, Eh? - January 9, 2019 Waiting For A Real Deal - December 7, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The recent data in euro area has been negative: The Q4 euro area GDP on a year-over-year basis fell to 1.2%, in line with expectations. Euro area headline inflation in January on a year-over-year basis decreased to 1.4%, from the previous 1.6% in December 2018, core inflation rose to 1.1%. January Markit euro area composite PMI fell to 51.0. Euro area retail sales in December fell to 0.8% on a year-over-year basis, from the previous 1.8%. In response to this poor economic performance, EUR/USD has fallen by 0.8% this week. We remain cyclically bearish on the euro, as we believe that the Fed will hike more than anticipated this cycle and that Europe is more negatively impacted by China’s woes than the U.S. is. Hence, slowing global growth will force the ECB to stay dovish much longer than expected. Moreover, our Intermediate Term Timing Model, is showing that the euro is once again trading at a premium to short term fundamentals. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Annual inflation increased to 0.4% from previous 0.3%, core inflation increased to 0.7% from 0.6%, and inflation ex fresh food increased to 1.1% from 0.9%. December retail trade weakened to 1.3% from the previous 1.4%. Japanese unemployment rate in December has fallen to 2.4%. January consumer confidence index fell to 41.9, underperforming the expectations. USD/JPY has risen by 0.3% this week. We remain bearish on the yen on a tactical basis. The recent FOMC meeting kept the U.S. key interest rate unchanged, so did many other central banks. The resulting ease in global financial conditions could be a headwind for safe havens, like the yen. Moreover, U.S. yields are likely to rise even after the easing in financial conditions is passed, as BCA anticipates the Fed to resume hiking in the second half of 2019. This will create additional downside for the yen. Report Links: Yen Fireworks - January 4, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 The recent data in Britain has been negative: Markit U.K. composite PMI has surprised to the downside, falling to 50.3 in January; service PMI dropped to 50.1 while construction PMI fell to 50.6.  Halifax house prices yearly growth, surprised to the downside, coming in at 0.8%. Finally, Markit Services PMI also underperform, coming in at 50.1. The Bank of England rate decided to keep rates on hold at 0.75%. GBP/USD has lost 0.8% this week. On a long-term basis, we remain bullish on cable, as valuation for the pound are attractive. However, we believe that the current stalemate in Westminster, coupled with the hard-nose approach of Brussels has slightly increase the probability of a No-deal Brexit. This political uncertainty implies that short-term risk-adjusted returns remains low. Report Links: Deadlock In Westminster - January 18, 019 Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia has been negative: Building permits in December has surprised to the downside, coming in at -8.4% on a month-over-month basis.  December retail sales has slowed down, coming in at -0.4%. Finally, in December, with exports contracted at a -2% pace, and imports, at -6% pace. The RBA decided to leave the cash rate unchanged at 1.5%. While it was at first stable, AUD/USD ultimately has fallen by 2% this week. Overall, we remain bearish on the AUD in the long run. The unhealthy Australian housing market coupled with very elevated debt loads, could drag residential construction and household consumption down. Moreover, the uncompetitive Australian economy could fall into a potential liquidity trap as the credit conditions tighten further. Report Links: CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The recent data in New Zealand has been negative: The participation rate underperformed expectations, coming in at 70.9%. Moreover, employment growth also surprised to the downside, coming in at 0.1%. Finally, the unemployment rate surprised negatively, coming in at 4.3%. NZD/USD has fallen by 2.3% this week. Overall, we remain bullish on the NZD against the AUD, given that credit excesses are less acute in New Zealand than in Australia. Moreover, New Zealand is much less exposed to the Chinese industrial cycle than Australia. This means that is China moving away from its current investment-led growth model will likely negatively impact AUD/NZD. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The recent data in Canada has been negative: GDP has fallen to 1.7% on a year-over-year basis from the previous 2.2%. The December industrial production growth came in at -0.7% month-on-month, a negative surprise. Canadian manufacturing PMI in January decreased to 53. On the back of these poor data and weaker oil prices, USD/CAD rose by 1.6% this week, more than undoing last week’s fall. We expect the CAD to outperform other commodity currencies like the AUD and the NZD, oil prices are likely to outperform base metals on a cyclical basis. Moreover, the Canadian economy is more levered to the U.S. than other commodity driven economies. Thus, our constructive view on the U.S. implies a positive view on the CAD on a relative basis. Report Links: CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2   Recent data in Switzerland has been mixed: Real retail sales yearly growth improved this month, coming in at -0.3% versus -0.6% last month. However, the SVME Purchasing Manager’s Index underperformed expectations, coming in at 54.3. EUR/CHF has fell 0.2% this week. Despite this setback, we remain bullish on EUR/CHF. Last year’s EUR/CHF weakness tightened Swiss financial conditions significantly and lowered inflationary pressures. Given that the Swiss National Bank does not want a repeat of the deflationary spiral of 2015, we believe that it will continue with its ultra-dovish monetary policy and increase its interventionism in the FX market, in order to weaken the franc, and bring back inflation to Switzerland. Moreover, on a tactical basis, the ease in financial conditions should hurt safe havens like the franc. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been negative: The December retail sales missed the consensus estimates, coming in at -1.80%. December credit indicator decreased to 5.4%. Registered unemployment rate in January has increased to 2.6%, surprising to the downside. USD/NOK has risen by 1.8% this week. We are positive on USD/NOK on a cyclical timeframe. Although we are bullish on oil prices, USD/NOK is more responsive to real rate differentials. This means, that a hikes later this year by the Fed will widen differentials between these two countries and provide a tailwind for this cross. Nevertheless, the positive performance of oil prices should help the NOK outperform non-commodity currencies like the AUD. We also expect NOK/SEK to appreciate and EUR/NOK to depreciate. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden has been negative: Consumer confidence surprised to the downside, coming in at 92. Moreover, retail sales yearly growth also underperformed expectations, coming in at 5.6%. Finally, manufacturing PMI came in line with expectations at 51.5. USD/SEK has risen by 2.2% this week. Overall, we remain long term bullish on the krona against the euro, given that Swedish monetary policy is much too easy for the current inflationary environment, a situation that will have to be rectified. However, given our positive view on the U.S. dollar on a cyclical basis, we are cyclically bullish on USD/SEK, since krona is the G-10 currency most sensitive to dollar moves. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The current trajectory in global share prices resembles what took place in 2000 and early 2001. The early 2001 rebound in global and EM stocks lasted several weeks only, despite ongoing easing by the Federal Reserve. Corporate profits – not the Fed – was the key driver in 2001 and remains the principal driver of global and EM stocks today. EM corporate profits are set to contract this year due to China’s continuing slowdown and weakening global trade. This suggests the current EM rally is unsustainable; continue underweighting EM. In Chile, bet on lower swap rates. Continue shorting the peso but overweight the local bourse within an EM equity portfolio. Feature The dovish shift by the U.S. Federal Reserve in the past month has boosted EM risk assets and currencies. Yet, we find that in the medium and long term there is a very low correlation between Fed policy and U.S. interest rates, on the one hand, and EM financial markets on the other. Instead, EM risk assets and currencies correlate with EM/China business cycles and global trade (Chart I-1). We have not detected any improvement in China/EM growth, nor in global trade (Chart I-1). What’s more, we expect Chinese growth and world trade to continue to weaken in the coming six months. Therefore, the EM rebound and outperformance will be reversed sooner than later. Chart I-1Global Growth Indicators Do No Confirm EM Rally Global Growth Indicators Do No Confirm EM Rally Global Growth Indicators Do No Confirm EM Rally Please note this is the view of BCA’s Emerging Markets Strategy team. BCA’s house view is presently positive on global risk assets and global growth. The basis for this difference between our current position and that of the majority of our colleagues is the outlook for China’s growth. A Replay Of 2016 Or 2001? Most investors are betting that 2019 will be a replay of 2016, when the Fed’s dovish turn and China’s stimulus propelled the EM and global equity rallies. It is enticing to compare the current episode in financial markets to the one that occurred only three years ago. To be sure, there are a lot of similarities: the global trade slowdown driven by China/EM, selloffs in global equity and credit markets, a dovish shift in the Fed’s stance and policy stimulus in China are all reminiscent of early 2016. Not surprisingly, this has created a stampede into EM. According to the most recent Bank of America Merrill Lynch survey, as of mid-January some 29% of investors were overweight EM stocks compared to 1% overweight in the U.S., 11% underweight in the euro area and 1% underweight in Japan. By now, the overweight in EM equities is most likely even higher, given the stampede into EM assets that has occurred over the past several weeks. This stands in contrast to the 33% underweight in EM equities in January 2016. It is apparent that the majority of investors are indeed extrapolating 2016 into 2019. We hold a different view and believe China’s slowdown will be more protracted than in 2015-’16, and that EM corporate earnings are set to contract (please refer to Chart I-5 on page 6). A key distinction between China’s current policy efforts and what was implemented in 2015-‘16 is the absence of stimulus for real estate. The odds are that China’s property market will continue to languish, weighing on household and business sentiment as well as spending. Further, the efficiency of monetary transmission mechanisms could be lower today than it was in 2016 due to the regulatory tightening on both banks and non-banks. The fiscal multiplier could also be lower due to the fragile sentiment among consumers and businesses. We discussed these issues in detail in our January 17, 2019 report. Remarkably, it appears that global share prices are tracking the pattern of 1998-2001 – their trajectories are identical in terms of both magnitude and duration (Chart I-2). Chart I-2Global Stocks Are Tracking Pattern Of 1998-2001 In Magnitude And Duration Global Stocks Are Tracking Pattern Of 1998-2001 In Magnitude And Duration Global Stocks Are Tracking Pattern Of 1998-2001 In Magnitude And Duration That said, there are substantial differences between today and 2001 in respect to the economic backdrops in the U.S. and China. Our focal point is to demonstrate that the Fed easing is not sufficient to prop up share prices if it does not lead to a recovery in corporate earnings. We conclude that the latest rebound in EM risk assets is probably late because neither the Fed’s pause nor China’s stimulus will revive EM corporate profits in the next nine months. In terms of market action, one can draw a number of parallels between the trajectory in global share prices today and in 2000-’01. Following an exponential rally in 1999, the global equity index peaked in January 2000 (Chart I-3). The equity selloff accelerated in the last quarter of 2000, with stocks plunging in December of that year. Chart I-3Is Rebound In Global And EM Stocks Late? Is Rebound In Global And EM Stocks Late? Is Rebound In Global And EM Stocks Late? Oversold conditions in global share prices and the Fed’s intra-meeting 50-basis-point rate cut on January 3, 2001, generated a 7% and 15% rebound in global and EM stocks, respectively. The bounce lasted from late December 2000 until early February 2001. The current trajectory in global share prices – the rollover in late January 2018, the top formation lasting several months followed by a dramatic plunge, the bottom in late December, 2018 and the subsequent rebound – closely resemble the path global share prices took in 2000 and early 2001 (Chart I-3, top panel). The same holds true for EM share prices (Chart I-3, bottom panel). Critically, the Fed continued to cut interest rates in 2001 and 2002, yet the bear market in global equities, including EM, persisted until March 2003 (Chart I-4A and I-4B, top panels). The culprit was shrinking corporate profits (Chart I-4A and Chart I-4B, bottom panels). Chart I-4AFed Easing Did Not Help Global Stocks In 2001 Fed Easing Did Not Help Global Stocks In 2001 Fed Easing Did Not Help Global Stocks In 2001 Chart I-4BFed Easing Did Not Help EM Stocks In 2001 Fed Easing Did Not Help EM Stocks In 2001 Fed Easing Did Not Help EM Stocks In 2001 Odds are that EM earnings are set to contract this year as discussed below and shown in Chart I-5. As a result, this view bolsters our conviction that EM equities are likely to roll over soon and plunge anew in absolute terms, and certainly underperform U.S. stocks. Bottom Line: There are many economic differences between today and 2001. Our main point is that the Fed easing-inspired rally in global equities in early 2001 lasted several weeks only and was followed by a new cycle low. The key factor was not Fed policy but corporate profits. Provided our view that corporate earnings in EM and global cyclical sectors will contract this year, the rally in these segments is not sustainable regardless of Fed policy. What Drives EM: Chinese Or U.S. Growth? Predicting the outlook for China and global trade correctly is key to getting the EM call right. First, China’s credit and fiscal spending impulse leads EPS growth of companies included in the EM MSCI equity index by nine months, and it currently points to continued deceleration and contraction in EM EPS in the months ahead (Chart I-5, top panel). The average of new and backlog orders within China’s manufacturing PMI also portends a negative outlook for EM corporate earnings (Chart I-5, bottom panel). Chart I-5EM Profits Are Heading Into Contraction EM Profits Are Heading Into Contraction EM Profits Are Heading Into Contraction The primary linkage between China’s credit and fiscal spending impulse and EM profits is as follows: China impacts EM and the rest of the world via its imports. This explains why EM share prices correlate with Chinese PMI imports (Chart I-6). Chart I-6Chinese Imports And EM Equities Chinese Imports And EM Equities Chinese Imports And EM Equities Second, China’s imports are to a large extent driven by capital spending, especially construction. Some 85% of mainland imports are composed of various commodities, industrial goods and materials, and autos. Consumer goods make up only about 15% of imports. Major capital expenditures in general and construction, in particular, cannot be undertaken without financing. This is why the country’s credit and fiscal spending impulse leads its imports cycles (Chart I-7). This impulse is presently foreshadowing a deepening slump in mainland imports and by extension its suppliers’ revenues and profits. Chart I-7Chinese Imports Are Heading South bca.ems_wr_2019_02_07_s1_c7 bca.ems_wr_2019_02_07_s1_c7 Third, as EM shipments to China dwindle, not only will EM corporate revenues and profits disappoint but EM currencies will also depreciate. The latter bodes ill for EM U.S. dollar and local currency bonds. The basis is that exchange rate depreciation makes U.S. dollar debt more expensive to service, and also pushes up local bond yields in high-yielding EM fixed-income markets. Fourth, The majority of developing economies sell more to China than to the U.S. Remarkably, global trade and global manufacturing decelerated in 2018, even though U.S. goods imports were booming (Chart I-8). Crucially, the more recent strength in the U.S.’s intake of goods was in part due to frontloading of shipments to the U.S. before the import tariffs went into effect on January 1, 2019. Chart I-8U.S. Imports Are Very Robust U.S. Imports Are Very Robust U.S. Imports Are Very Robust Yet despite robust U.S. demand, aggregate exports of Korea, Taiwan, and Japan have done poorly and their manufacturing have slumped (Chart I-9A and Chart I-9B). Chart I-9AAsian Exports: Flirting With Contraction Asian Exports: Flirting With Contraction Asian Exports: Flirting With Contraction Chart I-9BAsian Manufacturing: Flirting With Contraction Asian Manufacturing: Flirting With Contraction Asian Manufacturing: Flirting With Contraction This highlights the increased significance of Chinese demand and the diminished importance of U.S. domestic demand in world trade. In particular, at $6 trillion, EM aggregate goods and services imports, including Chinese imports (but excluding China’s imports for processing and re-exporting), is greater than the combined imports of the U.S. and EU, which currently stand at $4.7 trillion ($2.5 trillion plus $2.2 trillion, respectively). Finally, the media and many investors have exaggerated the impact of U.S. tariffs on the Chinese economy. We are not implying that the tariffs are not relevant at all, or that they have not damaged sentiment among mainland businesses and households. They have. The point is that China’s exports to the U.S. constitute 3.8% of Chinese GDP only (Chart I-10). This compares to Chinese capital spending amounting to 42% of GDP and total annual credit origination and fiscal spending of 26% of GDP. Chart I-10China's Exports To U.S. Are Small (3.8% of GDP) China's Exports To U.S. Are Small (3.8% of GDP) China's Exports To U.S. Are Small (3.8% of GDP) Overall, China’s growth slowdown in 2018 was not due to its plunging shipments to the U.S. – actually, the latter were rising strongly till December due to frontloading – but due to weakness in credit origination, primarily among non-banks (shadow banking). Bottom Line: The Chinese business cycle – not the U.S.’s – is the key driver of EM share prices and currencies and more important than the Fed. EM And The Fed On the surface, it seems that EM is tracking Fed policy. To us, however, this is akin to“not seeing the forest for the trees”. Investors need to stand back and examine the medium- and long-term relationships between U.S. interest rates, DM central banks’ balance sheets, and EM financial markets. In this broader context, the following becomes apparent: There is no stable correlation between EM share prices, EM currencies and EM sovereign credit, on the one hand, and U.S. 10-year bond yields, on the other (Chart I-11). Chart I-11EM And U.S. Bond Yields: No Stable Correlation EM And U.S. Bond Yields: No Stable Correlation EM And U.S. Bond Yields: No Stable Correlation Historically, the correlation between EM share prices and the Fed funds rate has been mixed, albeit more positive than negative (Chart I-12). On this 40-year chart, we shaded the periods when EM stocks did well during periods of a rising fed funds rate. These time spans are 1983-1984, 1988-1989, 1999-2000, 2003-2007 and 2017. Chart I-12EM Stocks And Fed Funds Rate: A Historical Perspective EM Stocks And Fed Funds Rate: A Historical Perspective EM Stocks And Fed Funds Rate: A Historical Perspective The only two episodes when EMs crashed amid rising U.S. interest rates were the 1982 Latin America debt crisis and the 1994 Mexican peso crisis. Yet, it is essential to emphasize that these crises occurred because of poor EM fundamentals: elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits and pegged exchange rates. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Remarkably, there is also no correlation between the size and the rate of change of DM central banks’ balance sheets, on the one hand, and EM risk assets and currencies on the other. In particular, Chart I-13 validates that the annual growth rate of G4 central banks’ balance sheets does not correlate with either EM share prices or EM local currency bonds’ total returns in U.S. dollars. Chart I-13Pace Of QEs And EM: No Correlation Pace Of QEs And EM: No Correlation Pace Of QEs And EM: No Correlation Finally, there is a low correlation between U.S. real interest rates and the real broad trade-weighted dollar (Chart I-14). Notably, Chart I-15 illustrates that the greenback often acts as a countercyclical currency, appreciating when global growth is slowing and depreciating when the global business cycle accelerating. Please note that the dollar is shown inverted on this chart. Chart I-14The U.S. Dollar And U.S. Real Rates The U.S. Dollar And U.S. Real Rates The U.S. Dollar And U.S. Real Rates Chart I-15The U.S. Dollar Is Countercyclical The U.S. Dollar Is Countercyclical The U.S. Dollar Is Countercyclical Bottom Line: Many analysts and investors assign more significance to the Fed policy’s impact on EM risk assets than historical evidence warrants. Unless Fed policy easing coincides with EM growth recovery, the Fed’s positive impact on EM will prove to be fleeting. Investment Considerations Widespread bullish bias on EM among investors currently and a continuous slew of poor growth data in China and global trade give us the conviction to argue that the current EM rally is not sustainable. Even if the S&P 500 drifts higher, EM stocks and credit will underperform their U.S. counterparts (Chart I-16). Chart I-16Stay Short EM / Long S&P 500 Stay Short EM / Long S&P 500 Stay Short EM / Long S&P 500 The EM equity index is sitting at a major technical resistance, and a decisive break above this level will challenge our view (Chart I-17, top panel). The same holds true for many EM currencies and copper (Chart I-17, bottom panel). However, for now, we are maintaining our negative bias. Chart I-17EM Equities And Copper Are Facing Resistance EM Equities And Copper Are Facing Resistance EM Equities And Copper Are Facing Resistance Within the EM equity universe, our overweights are Brazil, Mexico, Chile, Russia, central Europe, Korea, and Thailand. Our underweights are Indonesia, India, Philippines, South Africa, and Peru. We continue to recommend shorting the following EM currency basket versus the U.S. dollar: ZAR, IDR, MYR, CLP, and KRW. The full list of our recommended positions across EM equities, local rates, credit, and currencies is available on pages 17-18. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com   Chile: Favor Bonds Over Stocks Local currency bonds will outperform equities in Chile over the next six to nine months (Chart II-1). Chart II-1Chile: Favor Bonds Over Stocks Chile: Favor Bonds Over Stocks Chile: Favor Bonds Over Stocks The central bank is raising interest rates to cap inflation. However, we believe this is misguided because China’s ongoing deceleration along with lower copper prices, will slow growth in Chile over the course of this year. In addition, the current domestic inflation dynamics are less worrisome than the central bank contends. There is ongoing debate in the policy circles of Santiago over whether the recent large net immigration wave, particularly from Venezuela, is inflationary or disinflationary. On the one hand, net immigration expands the supply of labor and puts downward pressure on wages, and hence is disinflationary (Chart II-2). On the other hand, net immigration bolsters demand, and thereby inflation. Chart II-2Chile: Labor Force Is Expanding At 2% Chile: Labor Force Is Expanding At 2% Chile: Labor Force Is Expanding At 2% The central bank has acknowledged both effects but has cited that the latter will overwhelm the former. We disagree with this assessment and believe that current immigration in Chile will be more disinflationary. There are a number of factors that make us believe so: Both nominal and real wage growth are cooling off rapidly (Chart II-3). This corroborates the thesis that the expanding supply of labor is capping wage increases. Chart II-3Chile: Wage Growth Is Decelerating Chile: Wage Growth Is Decelerating Chile: Wage Growth Is Decelerating Central banks in any country need to be concerned with rising unit labor costs and service sector inflation. Energy and food prices are beyond a central bank’s control. Monetary policy should not respond to fluctuations in these prices unless there are second-round effects on wages and other prices.  There is presently no genuine inflationary pressures in Chile. The average of Chile’s core and trimmed mean inflation rates stands at 2.5%, and service sector inflation is at 3.7% (Chart II-4). This is within the central bank’s inflation target range of 3% +/-1%. Chart II-4Chile: Inflation Is Within Target Range Chile: Inflation Is Within Target Range Chile: Inflation Is Within Target Range Finally, Chile’s exports are set to shrink due to the ongoing deceleration in China and lower copper prices (Chart II-5). With exports accounting for 30% of GDP, a negative external shock will slow domestic demand too. This will be disinflationary. Chart II-5Chilean Exports Are About To Contract Chilean Exports Are About To Contract Chilean Exports Are About To Contract The fixed-income market in Chile is pricing in rate hikes (Chart II-6). We continue to recommend receiving 3-year swap rates. Even if the central bank continues to tighten, long-term interest rates will decline, anticipating rate cuts down the road. Chart II-6Chile: Receive 3-Year Swap Rates Chile: Receive 3-Year Swap Rates Chile: Receive 3-Year Swap Rates Chilean share prices, in absolute terms, are at risk from the EM and commodities selloff. However, we recommend dedicated EM equity portfolios overweight Chile. The economy is fundamentally and structurally solid, and local equity markets are supported by large local investment pools. Importantly, unlike many other commodity producers, currency depreciation in Chile does not stop the central bank from cutting interest rates. Banco Central de Chile does not target the exchange rate and will cut rates to mitigate the adverse external shock. This will ensure that business cycle fluctuations in Chile will be milder than in other developing economies where central banks tighten to defend their currencies. This is positive for Chilean stocks versus other EM bourses. Finally, the peso is at risk of depreciation from lower copper prices. Bottom Line: Local investors should favor domestic bonds over stocks. Fixed-income traders should bet on lower three-year swap rates. Dedicated EM investors should overweight Chilean equities. Currency traders should maintain a short CLP / long USD trade. Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Since 2008, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent before needing to take a breather… and then reverse course. The current vulnerability to further tightening emanates from stock markets and risk spreads. Through the next couple of years U.S. long bonds will strongly outperform German bunds… …and USD/EUR will trend lower. Since October 2017, no stock market rally or sell-off has lasted more than three months. Overweight equities tactically, but don’t get too comfortable. The broad stock market will remain trendless, but offer excellent tactical opportunities in both directions. Feature More than a decade has passed since the Global Financial Crisis. Yet through the past ten years, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent before needing to take a breather… and then swiftly reverse course. 2019 is a pivotal year for monetary policy because it will answer a fundamental question: will the 2 percent limit for monetary tightening that has held since 2008 continue to hold, or finally break? (Chart of the Week). The answer will have a huge bearing on European investment strategy for equities, bonds and currencies. Chart of the WeekSince 2008, The Limit For Sequential Rate Hikes Has Been 2 Percent... So Far Since 2008, The Limit For Sequential Rate Hikes Has Been 2 Percent... So Far Since 2008, The Limit For Sequential Rate Hikes Has Been 2 Percent... So Far A History Of Policy Reversals Swedish interest rates peaked near 5 percent in 2008 before collapsing to the zero bound in the financial crisis. But when the Riksbank started its so-called ‘policy normalisation’ in 2010, the interest rate could only reach 2 percent before the central bank had to backtrack; Norway could manage just 1 percent of tightening before its volte-face. Admittedly, Sweden and Norway were caught in the maelstrom of the euro debt crisis in 2011-12. But on the other side of the world and relatively immune to the crisis in Europe, New Zealand could achieve a tightening of only 1 percent; Korea could manage just 1.25 percent (Chart I-2); the Reserve Bank of Australia marched interest rates up by 1.75 percent before taking a breather… and then marched them down again.   Chart I-2Since 2008, The Limit For Sequential Rate Hikes Has Been 2 Percent Since 2008, The Limit For Sequential Rate Hikes Has Been 2 Percent Since 2008, The Limit For Sequential Rate Hikes Has Been 2 Percent The Federal Reserve has sequentially raised interest rates by 2 percent, and guess what? It has just decided to take a breather! Last week, Chairman Jay Powell was asked the question as plainly as possible: is the next move in interest rates as likely to be up as down? And his answer: “we don’t have a strong prior… we will patiently wait and let the data clarify.”1 There is no requirement at BCA for strategists to agree. In fact, the opposite is true in that we encourage independent thinking and diverse ways of looking at the world. BCA’s house view is that the Fed will resume its sequential hiking later in the year. But I believe this takes a too rosy view on the global financial system’s capacity to tolerate further tightening. The Vulnerability Is In Stock Markets And Risk Spreads   Monetary policy operates on an economy by adjusting its financial conditions: its bond yields, credit availability, currency, stock market, and risk spreads. And the neutral monetary policy stance – the so-called ‘neutral real interest rate’ – is the policy stance consistent with the economy growing at trend. In the past, a simple rule of thumb was that real rates, over time, should approximate to the real growth in the economy. But some studies argue that the neutral real rate may now be close to zero. All the Fed has done is bring the real interest rate out of negative territory to barely above zero. Yet its recent hikes have been blamed for extreme volatility in stock markets and risk spreads. Last week, Powell acknowledged that if there is a sustained change in financial conditions through any one or more of its components then “that has to play into our thinking.” Furthermore, “the policy stance is now in the range of the Committee’s estimates of neutral… and when you get to that (neutral) range we have to put aside our own priors and let the data speak to us.” All of which raises a salutary observation from my colleague Martin Barnes, BCA Chief Economist: if a real interest rate that is barely above zero is enough to trigger extreme market volatility and threaten the economic expansion, then the system is much more vulnerable than generally assumed.2  Martin has hit the nail on the head. At the current level of tightening, the system is much more vulnerable than generally assumed. But the vulnerable components of financial conditions are not bond yields, credit availability, or currency; the vulnerability emanates from stock markets and risk spreads, and specifically their potential for extreme volatility. Previous reports have focused on the source of this vulnerability. To recap, at low yields, bond prices develop the same unattractive negative asymmetry as equities. Therefore, an extended period of ultra-low interest rates removes the need for an equity risk premium, and justifies sharply higher valuations for equities and other risk-assets. But when the 10-year global bond yield rises back to around 2 percent, the process viciously reverses: bond prices lose their negative asymmetry, re-requiring an equity risk premium and sharply lower valuations for risk-assets.3 Put simply, when interest rates rise from low levels they undermine the support for elevated risk-asset valuations in a viciously non-linear way. The consequent plunge in risk-asset prices aggressively tightens financial conditions and thereby sets an unusually low ceiling for nominal interest rates and bond yields. This dynamic proved to be the major feature of the financial market landscape in 2018 and will loom large in 2019 too. It also solves the riddle as to why the neutral real rate may now be close to zero. An unusually low ceiling for the nominal interest rate combined with inflation hovering around 2 percent, translates into a neutral real interest rate that is not much higher than zero. The Investment Implications When the Riksbank paused after its near 2 percent of hiking, it proved to be a good structural entry point for Swedish long bonds, and a good structural exit point for the Swedish krona (Chart I-3 and Chart I-4). Likewise, when the Reserve Bank of Australia paused after its near 2 percent of hiking, it was an excellent moment to buy Australian long bonds and to sell the Australian dollar (Chart I-5 and Chart I-6). Chart I-3When The Riksbank Paused, It Was A Good Structural Entry Point In To Swedish Bonds... When The Riksbank Paused, It Was A Good Structural Entry Point In To Swedish Bonds... When The Riksbank Paused, It Was A Good Structural Entry Point In To Swedish Bonds... Chart I-4...And A Good Structural Exit Point Out Of The Swedish Krona ...And A Good Structural Exit Point Out Of The Swedish Krona ...And A Good Structural Exit Point Out Of The Swedish Krona Chart I-5When The RBA Paused, It Was A Good Structural Entry Point In To Australian Bonds... When The RBA Paused, It Was A Good Structural Entry Point In To Australian Bonds... When The RBA Paused, It Was A Good Structural Entry Point In To Australian Bonds... Chart I-6...And A Good Structural Exit Point Out Of The Australian Dollar ...And A Good Structural Exit Point Out Of The Australian Dollar ...And A Good Structural Exit Point Out Of The Australian Dollar Will the the 2 percent limit for monetary tightening that has held since 2008 continue to hold? If, as we expect, the answer is yes the implication is that through the next couple of years U.S. long bonds will strongly outperform German bunds. Over the same time frame, USD/EUR will trend lower (Chart I-7 and Chart I-8).  Chart I-7A Good Structural Entry Point In To Long T-Bonds/Short Bunds A Good Structural Entry Point in To Long T-Bonds/Short Bunds A Good Structural Entry Point in To Long T-Bonds/Short Bunds Chart I-8A Good Structural Exit Point Out Of USD/EUR A Good Structural Exit Point Out Of USD/EUR A Good Structural Exit Point Out Of USD/EUR Finally, as regards the broad stock market, a quick glance at the MSCI all country world index shows a striking feature. Since October 2017, no rally or sell-off has lasted more than three months (Chart I-9). Given the current highly non-linear relationship between equities and bond yields, this pattern is set to continue. Chart I-9Since October 2017, No Rally Or Sell-Off Has Lasted More Than Three Months Since October 2017, No Rally Or Sell-Off Has Lasted More Than Three Months Since October 2017, No Rally Or Sell-Off Has Lasted More Than Three Months In essence, the broad stock market will remain trendless, but offer excellent tactical opportunities in both directions. The current stance is tactically long, but don’t get too comfortable! Fractal Trading System* The sharp recent rally in government bonds has hit a point where tight liquidity conditions could trigger a temporary reversal. Accordingly, the 65-day trade is to go short 30-year T-bonds, setting a profit target at 3 percent with a symmetrical stop-loss. All of the five other open positions are in healthy profit. 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-10 Short U.S. 30 year T-Bond Short U.S. 30 year T-Bond 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.   Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com  * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnotes 1 The Federal Reserve has raised the federal funds rate by a total of 2.25 percent comprising an isolated 0.25 percent hike at the end of 2015 and a sequential 2 percent hike from December 2016 through December 2018. 2 Please see the BCA Special Report “A Grumpy View Of The Outlook” January 28, 2019 available at www.bcaresearch.com 3 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance”, October 25, 2018 available at eis.bcaresearch.com  Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations