United States

Highlights Economy – The endpoint of easier-for-longer monetary policy may be coming into view: Elevated inflation readings and discomfort among more hawkish FOMC members may signal that a monetary policy inflection is on the way. Markets – Volatility should pick up as investors reprice financial assets to reflect the end of emergency accommodation: The rumblings in bond, currency and precious metals markets that followed the June FOMC meeting are likely to spread as investors pull their liftoff date expectations forward. Strategy – Maintain below-benchmark duration positioning and ensure that portfolios can withstand increased volatility: Don’t be lulled to sleep by the 10-year Treasury yield’s backing and filling or by the VIX’s foray into the low teens. It is a more auspicious time to be buying insurance than selling it. Feature After fourteen years, investors may be weary of focusing so much attention on the Fed, but there’s been no avoiding its impact since the global financial crisis (GFC) emerged. Zero interest rate policy (ZIRP), large-scale asset purchases and other emergency measures have exerted a strong pull on financial markets as they have been switched on and off. The extended turn of rushing to the rescue appears to be weighing on the Fed as well. Last August’s revisions to its Statement on Longer-Run Goals and Monetary Policy Strategy explicitly acknowledged the challenges of operating in a ZIRP world in which its ability to deploy its primary tool for countering economic weakness – cutting the fed funds rate – is constrained by the zero lower bound. The Fed responded by adjusting its approach to each element of its dual mandate. It adopted an average-inflation-targeting framework that seeks to remediate past inflation shortfalls and indicated that it would only intervene to mitigate shortfalls from its maximum employment estimate. The latter move marked a break with the previous four decades, when the Fed, unwilling to give inflation pressures a chance to take root, proactively tightened policy when it judged that the labor market might be getting too strong. Taken together, the changes amounted to a significant break from doing whatever it took to keep inflation from gaining a foothold to making sure it didn’t completely vanish from households’, businesses’ and investors’ consciousness. If the changes were implemented as outlined, the effects could be wide-ranging. Inflation would be able to gain more traction, all else equal, leading to higher bond yields as markets anticipated that a higher terminal fed funds rate would be required to bring it to heel. A higher terminal fed funds rate might lead to a deeper economic slowdown, ushering in lower bond yields than otherwise would have prevailed. By inducing higher highs and lower lows in Treasury yields, the revisions to the Fed’s framework could promote increased financial market volatility, depending on FOMC members’ ongoing commitment to them and the way that commitment interacted with investors’ expectations. Although the revised framework is eleven months old, it is freshly relevant as the interaction between its implementation and investors’ expectations may be approaching an inflection point. When the FOMC announced the framework revisions last August, it didn’t have any immediate monetary policy implications and investors and committee members could reasonably have figured they would cross the new-framework bridge when they came to it. Elevated inflation readings and some differences in views within the FOMC suggest the bridge might now have to be crossed soon enough to fit within most institutional investors’ time horizons. Volatility may well rise as markets attempt to reprice assets against the backdrop of a novel monetary policy approach. End Of An Era The aforementioned changes that the FOMC made to its monetary policy strategy represented a watershed moment for US monetary policy. Beginning with Paul Volcker’s tenure as Fed chair near the end of the high-inflation ‘70s, the Fed has kept a sharp lookout for inflation pressures (Chart 1). Though it only introduced an annual inflation target in the aftermath of the GFC, its one-way view of inflation was well established. Signs that it might be emerging could be grounds for tighter monetary conditions while dormant readings were nothing to worry about. Chart 1Upholding Volcker's Mantle The average inflation target indicates that inflation shortfalls will henceforth be as much of a concern as inflation overshoots and the Fed will attempt to remediate them with an eye towards keeping inflation expectations from slipping below 2%. On the other hand, the new framework shifts from a two-way to a one-way perspective on employment. Where the committee had previously attempted to conduct policy in a way that mitigated any deviations from its maximum-employment assessment, the new framework seeks only to mitigate shortfalls. Citing the post-crisis experience, when inflation remained in check despite a half-century low in the unemployment rate, and a desire to see expansion gains spread more widely across households, Chair Powell has repeatedly emphasized that too much employment is not a concern. Easier Said Than Done When the Fed announced the changes to its approach, we noted that they would be significant for investors provided it were to follow through on them. It is one thing to promise wide-reaching changes in the indefinite future but quite another to execute them in real time under duress. Financial markets seemed to be aware that turning on a dime would be easier said than done and did not bother to adjust their fed funds rate expectations (Chart 2) or reprice assets that might be most affected by the new policy framework. Among investors with a time frame of a year or less, the talk was all theoretical, anyway – of course policy was going to remain extremely easy when the US and the rest of the world were still knee-deep in a once-in-a-century pandemic and the development of an effective vaccine was a ways off. Chart 2Until Recently, Markets Saw Little Chance Of Rate Hikes On A Two-Year Horizon In other words, talk was cheap when the FOMC unveiled its new framework. Its plans would only matter once the pandemic’s grip eased and central banks regained some discretion. The committee’s resolve to adhere to the new framework would only be tested in the face of uncomfortably high inflation prints and/or inflation expectations that threatened to anchor at levels above its target range. Investors wouldn’t bother to reprice financial assets in line with the new framework until they were certain it would apply. Inoculating Against Deflation As it turned out, effective vaccines appeared on the horizon sooner than anticipated. Pfizer and BioNTech announced the enormously encouraging results from their vaccine’s Phase III trials before the New York open on November 9th, and the Moderna vaccine’s similar clinical successes followed shortly thereafter. Vaccine distribution would begin in January, and the long end of the Treasury curve would begin to reprice, nudged along by rising inflation expectations. Agita sparked by March CPI data caused expectations to peak ahead of the April release, and 10-year breakevens briefly edged above the levels consistent with the Fed’s goals (Chart 3, top panel). Chart 3Coloring Within The Lines Chart 4Unsustainable Outliers We share the view of most mainstream economists that the upside surprises in the March and April inflation prints resulted from transitory reopening factors and do not mark an inflection point. Increases in used car prices will slow once rental car companies rebuild their fleets to match burgeoning demand and new car production can resume at its intended pace, lumber prices will continue to ease as sawmills ramp up operations to capture outsized profits, and the pace of increases in airfares will settle down once staffing bottlenecks can be resolved and more flights can be added to meet resurgent demand (Chart 4). Easier For How Much Longer? Markets’ collective shrug upon the release of the revisions to the Fed’s monetary policy framework reflected the view that they did not amount to a meaningful change over most investors’ time horizons. The second wave of COVID-19 infections had peaked a month before, but at least one other was likely in store as students returned to college campuses, and a vaccine was not yet on the horizon. According to Good Judgment’s professional superforecasters, there was roughly an equal 40% probability that 25 million vaccine doses would be available for distribution in the US between October 1st, 2020 and March 31st, 2021 or between April 1st and September 30th, 2021 (Chart 5). The more optimistic estimate turned out to be right, albeit not quite optimistic enough: nearly 25 million doses were administered by the end of February and nearly 50 million by the March 31/April 1 midpoint of the two periods (Chart 6). Chart 5Vaccine Development And Distribution Wound Up Beating August's Expectations ... Chart 6... By A Considerable Margin The vaccine outlook was relevant because it was hard to envision any incremental tightening of monetary policy while the country was still in the throes of the pandemic. Treasury yields at the longer end of the curve weren’t likely to go anywhere in the absence of increases in the fed funds rate (Chart 7) or increases in inflation or real growth expectations. Just as a still-raging virus was likely to keep the FOMC from hiking rates, it would also put a lid on inflation pressures and economic growth. With economic activity sharply limited by social distancing mandates and individuals’ innate reluctance to risk exposure, it was certain that capacity would continue to surpass aggregate demand. Chart 7Treasury Yields Move With Fed Funds Expectations To the extent investors thought about the FOMC’s new framework when it was unveiled, they seem to have taken it as confirmation that monetary policy would remain easier for longer, consistent with the theme that has prevailed since the Bernanke Fed led the charge to counter the GFC. Treasury yields were subdued even after the vaccine news broke in November (Chart 8, top panel), and with the interest rate structure remaining quiet, there was no major repricing in other rate-sensitive markets. Gold, which might have been expected to benefit from more accommodative policy, slipped nearly 15%, from the mid-$1,900s to the high $1,600s, between the release of the new framework and its March trough. After retracing half of its post-August decline, it shed a fresh 5% following the FOMC’s June meeting (Chart 8, second panel). Chart 8Growth Prospects, Not Fed Prospects Commodity currencies had added 10% versus the US dollar before ceding half of those gains in the wake of the June FOMC meeting, but their rally appears to have been driven by the increased global growth expectations that followed the positive vaccine news as they went nowhere in September and October (Chart 8, third panel). Similarly, the DXY Index had taken its post-revision cue from global growth prospects, moving inversely with pandemic news (rising when bad, falling when good), before rallying after the June meeting (Chart 8, bottom panel). The rise in measured inflation has encouraged some committee members to bring forward their anticipated liftoff dates and accelerate their individual dot plots, as disclosed last month. Now that the Fed no longer seems to be of one mind on the easier-for-longer path, investors have begun to reassess the scene. Prices are moving as capital reportedly exits pro-inflation positions and the money markets now call for two-and-a-half rate hikes by mid-2023 (Chart 2). More volatility could be in store amidst a shift in the Fed consensus as markets pull forward or push back their expected liftoff date and the expected pace of hikes speeds up or slows down. Investment Implications With the moves in measured inflation and inflation expectations seeming to have met the FOMC’s first two criteria for hiking rates (Table 1), a return to full employment looms as the final hurdle to liftoff. We reiterate our view that hiring progress is the swing factor that investors should be watching to anticipate the coming shift in monetary policy settings. Net payrolls expanded by 850,000 in June, topping estimates and putting the three-month moving average, 567,000, ahead of the 375-485,000 pace required to return the economy to full employment by the second half of 2022.1 That may sound like an overly ambitious target on its face, but we contend that annualized monthly payroll expansion of 4% for fourteen months or 3.1% for eighteen months is attainable given the magnitude of the pandemic job losses (Chart 9). Table 1A Checklist For Liftoff Chart 9A 2H22 Return To Full Employment Is Entirely Possible Our outlook for sustained net payroll expansion remains near the optimistic end of the expectations continuum, though the money market consensus has lately caught up with our sometime-before-the-end-of-2022 liftoff date view (Chart 10). Given that we expect that the yield curve will steepen as the hiring strength shows itself, we advise maintaining below-benchmark duration in Treasury portfolios. The optimism embedded in our hiring view implies robust growth over the next twelve months and we therefore recommend overweighting spread product within fixed income portfolios via a high-yield overweight, and overweighting equities within multi-asset portfolios. Hot growth will eventually induce the Fed to start pumping the monetary brakes, slowing the economy and investment returns, but the twelve-month outlook remains favorable for risk assets. Chart 10Looking For At Least One Hike By The End Of 2022 Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com   Footnotes 1 Making the simplifying (and overly conservative) assumption that returning to full employment will require recovering February 2020’s level of nonfarm payrolls, the US is currently short 6.8 million jobs. Regaining those jobs by August 2022 (14 months from now) will require a monthly average of 485,000 net job gains; regaining them by December 2022 (18 months hence) will require a 375,000 monthly average.

Highlights Gold is – and always will be – exquisitely sensitive to Fed policy and forward guidance, as last month's "Dot Shock" showed (Chart of the Week). Its price will continue to twitch – sometimes violently – as the widening dispersion of views evident in the Fed dots keeps markets on edge and pushes forward rate expectations in different directions. Fed policy is important but will remain secondary to fundamentals in oil markets. Increasingly inelastic supply will force refiners to draw down inventories, which will keep forward curves backwardated. OPEC 2.0's production-management policy is the key driver here, followed closely by shale-oil's capital discipline. Between these market bookends are base metals, which will remain sensitive to Fed policy, but increasingly will be more responsive to tightening supply-demand fundamentals, as the pace of the global renewables and EV buildout challenges supply. The one thing these markets will share going forward is increasing volatility. Gold volatility will remain elevated as markets are forced to parse sometimes-cacophonous Fed forward guidance; oil volatility will increase with steeper backwardation; and base metals volatility will rise as fundamentals continue to tighten. We remain long commodity-index exposure (S&P GSCI and COMT ETF) and equity exposure (PICK ETF). Feature Gold markets still are processing last month's "Dot Shock" – occasioned by the mid-June move of three more Fed bankers' dots into the raise-rates-in-2022 camp at the Fed – and the sometimes-cacophonous forward guidance of post-FOMC meetings accompanying these projections. Following last month's meeting, seven of the 18 central bankers at the June meeting now favor an earlier rate hike. This dot dispersion fuels policy uncertainty. When policy uncertainty is stoked, demand for the USD typically rises, which generally – but not always – contributes to liquidation of dollar-sensitive positions in assets like commodities. This typically leads to higher price volatility.1 This is most apparent in gold, which is and always will be exquisitely sensitive to Fed guidance and the slightest hint of a change in course (or momentum building internally for such a change). This is what markets got immediately after the June meeting. When this guidance reflects a wide dispersion of views inside the Fed, it should come as no surprise that price volatility increases among assets that are most responsive to monetary policy. This dispersion of market expectations – as a matter of course – is intensified by discordant central-bank forward guidance.2 Fundamentals Reduce Oil's Sensitivity To Fed Policy Fed policy will always be important for the evolution of the USD through time, which makes it extremely important for commodities, since the most widely traded commodities are priced in USD. All else equal, an increase in the value of the USD raises the cost of commodities ex-US, and vice versa. Chart of the WeekGold Still Processing Dot Shock Chart 2Oil Market Remains Tight... The USD's impact is dampened when markets are fundamentally tight – e.g., when the level of demand exceeds supply, as is the case presently for oil (Chart 2).3 When this occurs, refiner inventories have to be drawn down to make up for supply deficits (Chart 3). This leads to a backwardation in the oil forward curves – i.e., prices of prompt-delivery oil are higher than deferred-delivery oil – reflecting the fact that the supply curve is becoming increasingly inelastic (Chart 4). This backwardation benefits OPEC 2.0 member states, as most of them have long-term supply contracts with customers indexed to spot prices, and investors who are long commodity-index exposure, as it is the source of the roll yield for these products.4 Chart 3Forcing Inventories To Draw... Chart 4...And Backwardating Forward Curves Copper's Sensitivity To Fed Policy Declining Supply-demand fundamentals in base metals – particularly in the bellwether copper market – are tightening, which, as the oil market illustrates, will make prices in these markets less sensitive to USD pressures going forward (Chart 5). We expect the copper forward curve to remain backwardated for an extended period (Chart 6), which will distance the evolution of copper prices from Fed policy variables (e.g., interest rates and the USD). Chart 5Copper USD Sensitivity Will Diminish As Balances Tighten Chart 6Expect Persistent Backwardation In Copper Indeed, our modeling suggests this already is occurring in the metals markets, as can be seen from the resilience of copper prices during 1H21, when China's fiscal and monetary stimulus was waning and, recently, during the USD's recent rally, which was an unexpected headwind generated by the Fed's June meeting. If, as appears likely, China re-engages in fiscal and monetary stimulus in 2H21, the global demand resurgence for metals, copper in particular, will receive an additional fillip. Like oil, copper inventories will have to be drawn down over the next two years to make up for physical deficits, which have been a persistent problem for years (Chart 7). Capex in copper markets has yet to be incentivized by higher prices, which means these physical deficits likely will widen as the world gears up for expanded renewables generation and the grids required to support them, not to mention higher electric vehicle (EV) demand. If, as we expect, copper miners do not invest in new greenfield mine projects – choosing instead to stay with their brownfield expansion strategies – the market will tighten significantly as the world ramps up its demand for renewable energy. This means copper's supply curve will, like oil's, become increasingly inelastic. At the limit – i.e., if new mining capex is not incentivized – price will be forced to allocate limited supply, and may even have to get to the point of destroying demand to accommodate the renewables buildout. Chart 7Supply-Demand Balance Tightening In Copper A Word On Spec Positioning We revisited our modeling of speculative influence on these markets over the past couple of weeks, in anticipation of the volatility we expect and the almost-certain outcry from public officials that will ensue. Our modeling continues to support our earlier work, which found fundamentals are determinant to the evolution of industrial commodity prices. Using Granger-Causality and econometric analysis, we find prices mostly explain spec positioning in oil and copper, and not the other way around.5 We do find spec positioning – via Working's T Index – to be important to the evolution of volatility in WTI crude oil options, along with other key variables (Chart 8).6 That said, other variables are equally important to this evolution, including the St. Louis Fed's Financial Stress Index, EM equity volatility, VIX volatility and USD volatility. These variables are not useful in modeling copper volatility, where it appears fundamental and financial variables are driving the evolution of prices and, by extension, price volatility. We will continue to research this issue, and will continue to subject our results to repeated trials in an attempt to disprove them, as any researcher would do. Chart 8Oil Volatility Drivers Investment Implications Gold will remain hostage to Fed policy, but oil and base metals increasingly will be charting a path that is independent of policy-related variables, chiefly the USD. There is no escaping the fact that gold volatility will increasingly be in the thrall of US monetary policy – particularly during the next two years as the Fed attempts to guide markets toward something resembling normalization of that policy.7 However, as the events of the most recent FOMC meeting illustrate, gold price volatility will remain elevated as markets are forced to parse oftentimes-cacophonous Fed forward guidance. This would argue in favor of using low-volatility episodes as buying opportunities in gold options – particularly calls, as we continue to expect gold prices to end the year at $2,000/oz. We also favor silver exposure via calls, expecting price to go to $30/oz this year. In oil and base metals, we continue to expect supply-demand fundamentals in these markets to tighten, which predisposes us to favor commodity index products. For this reason, we remain long commodity-index exposure – specifically the S&P GSCI index, which is up 6.8% since inception, and the COMT ETF, which is up 8.7% since inception. We expect the base metals markets to remain very well bid going forward, and remain long equity exposure in these markets via the PICK ETF, which we re-entered after a trailing stop was elected that left us with a 24% gain since inception at the end of last year.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish US crude oil stocks (ex SPR) fell 6.7mm barrels in the week ended 25 June 2021, according to the US EIA. Total crude and product stocks were down 4.6mm barrels. Domestic crude oil production was unchanged at 11.1mm b/d over the reporting week. Total refined-product demand surpassed the comparable 2019 reporting period, led by higher distillate consumption (4.2mm b/d vs 3.8mm b/d). Gasoline consumption remains a laggard (9.2mm b/d vs 9.5mm b/d), as does jet fuel (1.4mm b/d vs 1.9mm b/d). Propane and propylene demand surged over the period, likely on the back of petchem demand (993k b/d vs 863k b/d). Base Metals: Bullish Base metals prices are moving higher in anticipation of tariffs being imposed by Russia to discourage exports beyond the Eurasian Economic Union, according to argusmedia.com. In addition to export tariffs on copper, aluminum and nickel, steel exports also will face levies to discourage material from leaving the EAEU (Chart 9). The tariffs are expected to remain in place from August through December 2021. Separately, premiums paid for high-quality iron ore in China (65% Fe) reached record highs earlier this week, as steelmakers scramble for supply, according to reuters.com. The premium iron ore traded close to $36/MT over benchmark material (62% Fe) this week. Precious Metals: Bullish Gold prices continue to move lower following the FOMC meeting on June 16. The yellow metal was down 0.6% y-o-y at $1762.80/oz as of Tuesday’s close after being up a little more than 13% y-o-y before the FOMC meeting earlier this month (Chart 10). We believe the USD rally, which, based on earlier research we have done, could be benefitting from safe-haven demand arising from global concern over the so-called Delta variant of COVID-19, which has spread to at least 85 countries. Public-health officials are fearful this could cause a resurgence in COVID-19 cases and additional mutations in the virus if vaccine distribution in EM states is not increased. Ags/Softs: Neutral Widely disparate weather conditions in the US west and east crop regions – drought vs cooler and wetter weather – appear to be on track to produce average crop yields for corn and beans this year, according to agriculture.com's Successful Farming. In regions where hard red spring wheat is grown, states experiencing low rainfall likely will have poor crops this year. Chart 9 Chart 10   Footnotes 1     We model gold prices as a function of financial variables sensitive to Fed policy – e.g., real rates and the broad trade-weighted USD – and uncertainty, which is conveyed via the Global Economic Policy Uncertainty (GEPU) index published by Baker, Bloom & Davis.  2     Please see Lustenberger, Thomas and Enzo Rossib (2017), "Does Central Bank Transparency and Communication Affect Financial and Macroeconomic Forecasts?" SNB Working Papers, 12/2017. The Swiss central bank researchers find "… the verdict about the frequency of central bank communication is unambiguous. More communication produces forecast errors and increases their dispersion. … Stated differently, a central bank that speaks with a cacophony of voices may, in effect, have no voice at all. Thus, speaking less may be beneficial for central banks that want to raise predictability and homogeneity among financial and macroeconomic forecasts. We provide some evidence that this may be particularly true for central banks whose transparency level is already high." (p. 26) 3    Please see OPEC 2.0 Vs. The Fed, published on February 8, 2018, for additional discussion. 4    Please see The Case For A Strategic Allocation To Commodities As An Asset Class, a Special Report we published on March 11, 2021 on commodity-index investing.  It is available at ces.bcaresearch.com. 5    The one outlier we found was Brent prices, for which non-commercial short positioning does Granger-Cause price.  Otherwise, price was found to Granger-Cause spec positioning on the long and short sides of the market. 6   Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Specs Back Up The Truck For Oil," published on April 26, 2018, in which we introduce Holbrook Working's "T Index," a measure of speculative concentration in futures and options markets. It is available at ces.bcaresearch.com. Briefly, Working's T Index shows how much speculative positioning exceeds the net demand for hedging from commercial participants in the market. 7     Please see How To Re-Shape The Yield Curve Without Really Trying published by our US Bond Strategy group on June 22 for a deeper discussion of the outlook for Fed policy.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Underweight Housing stocks have been resilient to rising interest rates for the most part of the year, but now macro headwinds are taking over this consumer discretionary sub-sector and we recommend a below benchmark allocation. Rising mortgage rates (up 35 bps YTD), and skyrocketing housing prices (up 15% YoY), are starting to hurt housing affordability, suppressing demand, and putting downward pressure on homebuilders’ revenue. To make things worse, oriented strand board prices remain on the ascent despite the outright bear market in lumber futures. The cost of labor is on the rise, too, increasing homebuilders’ expenses. Falling revenue and rising costs are a poisonous cocktail bound to hurt homebuilders’ profitability, putting a halt to what has been a strong run and making them an excellent candidate for an underweight allocation. Looking beyond this macro soft patch, once headwinds dissipate, we will be adding to homebuilders as the industry has compelling long-term prospects: US consumers are facing a housing shortage to the tune of five million units as construction was running under the trend over the past decade. Bottom Line: We are underweight the S&P homebuilding index. The ticker symbols for the stocks in this index are: BLBG: S5HOME – LEN, PHM, DHI, NVR.

Initial public offerings (IPOs) are a source of future small-cap index constituents. Last year was a fruitful year since 165 companies went public. However, just to put things into perspective, 1999 and 2000 saw 476 and 380 IPOs respectively. IPOs are on the tear this year as well – raking in $171B and already topping the 2020 total. Some 80% of IPOs last year were for unprofitable companies, which is nearly two standard deviations above the historical average of 40% (see chart). While a good crop of IPOs is a great feeder ground for the small-cap indexes, it is concerning that so many unprofitable companies hit the market and often at multi-billion-dollar valuations. Euphoria is certainly the word that comes to mind, and investors’ current willingness to back companies without earnings may be a drag on overall small company earnings’ performance over the next few years. Bottom Line: We recommend investors to fade a rebound in small caps and maintain a neutral size preference. For more details, please refer to this Monday’s Strategy Report.