Currencies
Highlights Globalization is recovering to its pre-pandemic trajectory. But it will fail to live up to potential, as the “hyper-globalization” trends of the 1990s are long gone. China was the biggest winner of hyper-globalization. It now faces unprecedented risks in the context of hypo-globalization. Global investors woke up to China’s domestic political risks this year, which include arbitrary regulatory crackdowns on tech and private business. While Chinese officials will ease policy to soothe markets, the cyclical and structural outlook is still negative for this economy. Growth and stimulus have peaked. Political risk will stay high through the national party congress in fall 2022. US-China relations have not stabilized. India, the clearest EM alternative for global investors, is high-priced relative to China and faces troubles of its own. It is too soon to call a bottom for EM relative to DM. Feature Global investors woke up to China’s domestic political risk over the past week, as Beijing extended its regulatory crackdown to private education companies. Our GeoRisk Indicator shows Chinese political risk reaching late 2017 levels while the broad Chinese stock market continued this year’s slide against emerging market peers (Chart 1). Chart 1China: Domestic Political Risk Takes Investors By Surprise A technical bounce in Chinese tech stocks will very likely occur but we would not recommend playing it. The first of our three key views for 2021 is the confluence of internal and external headwinds for China. True, today’s regulatory blitz will pass over like previous ones and the fast money will snap up Chinese tech firms on the cheap. The Communist Party is making a show of force, not destroying its crown jewels in the tech sector. However, the negative factors weighing on China are both cyclical and structural. Until Chinese President Xi Jinping adjusts his strategy and US-China relations stabilize, investors do not have a solid foundation for putting more capital at risk in China. Globalization is in retreat and this is negative for China, the big winner of the past 40 years. Hypo-Globalization Globalization in the truest sense has expanded over millenia. It will only reverse amid civilizational disasters. But the post-Cold War era of “hyper-globalization” is long gone.1 The 2010s saw the emergence of de-globalization. In the wake of COVID-19, global trade is recovering to its post-2008 trend but it is nowhere near recovering the post-1990 trend (Chart 2). Trade exposure has even fallen within the major free trade blocs, like the EU and USMCA (Chart 3). Chart 2Hypo-Globalization Chart 3Trade Intensity Slows Even Within Trade Blocs Of course, with vaccines and stimulus, global trade will recover in the coming decade. We coined the term “hypo-globalization” to capture this predicament, in which globalization is set to rebound but not to its previous trajectory.2 We now inhabit a world that is under-globalized and under-globalizing, i.e. not as open and free as it could be. A major factor is the US-China economic divorce, which is proceeding apace. China’s latest state actions – in diplomacy, finance, and business – underscore its ongoing disengagement from the US-led global architecture. The US, for its part, is now on its third presidency with protectionist leanings. American and European fiscal stimulus are increasingly protectionist in nature, including rising climate protectionism. Bottom Line: The stimulus-fueled recovery from the global pandemic is not leading to re-globalization so much as hypo-globalization. A cyclical reboot of cross-border trade and investment is occurring but will fall short of global potential due to a darkening geopolitical backdrop. Still No Stabilization In US-China Relations Chart 4Do Nations Prefer Growth? Or Security? A giant window of opportunity is closing for China and Russia – they will look back fondly on the days when the US was bogged down in the Middle East. The US current withdrawal from “forever wars” incentivizes Beijing and Moscow to act aggressively now, whether at home or abroad. Investors tend to overrate the Chinese people’s desire for economic prosperity relative to their fear of insecurity and domination by foreign powers. China today is more desirous of strong national defense than faster economic growth (Chart 4). The rise of Chinese nationalism is pronounced since the Great Recession. President Xi Jinping confirmed this trend in his speech for the Communist Party’s first centenary on July 1, 2021. Xi was notably more concerned with foreign threats than his predecessors in 2001 and 2011 (Chart 5).3 China has arrived as a Great Power on the global stage and will resist being foisted into a subsidiary role by western nations. Chart 5Xi Jinping’s Centenary Speech Signaled Nationalist Turn Meanwhile US-China relations have not stabilized. The latest negotiations did not produce agreed upon terms for managing tensions in the relationship. A bilateral summit between Presidents Biden and Xi Jinping has not been agreed to or scheduled, though it could still come together by the end of October. Foreign Minister Wang Yi produced a set of three major demands: that the US not subvert “socialism with Chinese characteristics,” obstruct China’s development, or infringe on China’s sovereignty and territorial integrity (Table 1). The US’s opposition to China’s state-backed economic model, export controls on advanced technology, and attempts to negotiate a trade deal with the province of Taiwan all violate these demands.4 Table 1China’s Three Demands From The United States (July 2021) The removal of US support for China’s economic, development – recently confirmed by the Biden administration – will take a substantial toll on sentiment within China and among global investors. US President Joe Biden and four executive departments have explicitly warned investors not to invest in Hong Kong or in companies with ties to China’s military-industrial complex and human rights abuses. The US now formally accuses China of genocide in the Xinjiang region.5 Bottom Line: There is no stabilization in US-China relations yet. This will keep the risk premium in Chinese currency and equities elevated. The Sino-American divorce is a major driver of hypo-globalization. China’s Regulatory Crackdown President Xi Jinping’s strategy is consistent. He does not want last year’s stimulus splurge to create destabilizing asset bubbles and he wants to continue converting American antagonism into domestic power consolidation, particularly over the private economy. Now China’s sweeping “anti-trust” regulatory crackdown on tech, education, and other sectors is driving a major rethink among investors, ranging from Ark-founder Cathie Wood to perma-bulls like Stephen Roach. The driver of the latest regulatory crackdown is the administration’s reassertion of central party control. The Chinese economy’s potential growth is slowing, putting pressure on the legitimacy of single-party rule. The Communist Party is responding by trying to improve quality of life while promoting nationalism and “socialism with Chinese characteristics,” i.e. strong central government control and guidance over a market economy. Beijing is also using state power and industrial policy to attempt a great leap forward in science and technology in a bid to secure a place in the sun. Fintech, social media, and other innovative platforms have the potential to create networks of information, wealth, and power beyond the party’s control. Their rise can generate social upheaval at home and increase vulnerability to capital markets abroad. They may even divert resources from core technologies that would do more to increase China’s military-industrial capabilities. Beijing’s goal is to guide economic development, break up the concentration of power outside of the party, prevent systemic risks, and increase popular support in an era of falling income growth. Sociopolitical Risks: Social media has demonstrably exacerbated factionalism and social unrest in the United States, while silencing a sitting president. This extent of corporate power is intolerable for China. Economic And Financial Risks: Innovative fintech companies like Ant Group, via platforms like Alipay, were threatening to disrupt one of the Communist Party’s most important levers of power: the banking and financial system. The People’s Bank of China and other regulators insisted that Ant be treated more like a bank if it were to dabble in lending and wealth management. Hence the PBoC imposed capital adequacy and credit reporting requirements.6 Data Security Risks: Didi Chuxing, the ride-sharing company partly owned by Uber, whose business model it copied and elaborated on, defied authorities by attempting to conduct its initial public offering in the United States in June. The Communist Party cracked down on the company after the IPO to show who was in charge. Even more, Beijing wanted to protect its national data and prevent the US from gaining insights into its future technologies such as electric and autonomous vehicles. Foreign Policy Risks: Beijing is also preempting the American financial authorities, who will likely take action to kick Chinese companies that do not conform to common accounting and transparency standards off US stock exchanges. Better to inflict the first blow (and drive Chinese companies to Hong Kong and Shanghai for IPOs) than to allow free-wheeling capitalism to continue, giving Americans both data and leverage. Thus Beijing is continuing the “self-sufficiency” drive, divorcing itself from the US economy and capital markets, while curbing high-flying tech entrepreneurs and companies. The party’s muscle-flexing will culminate in Xi Jinping’s consolidation of power over the Politburo and Central Committee at the twentieth national party congress in fall 2022, where he is expected to take the title of “Chairman” that only Mao Zedong has held before him. The implication is that the regulatory crackdown can easily last for another six-to-12 more months. True, investors will become desensitized to the tech crackdown. But health care and medical technology are said to be in the Chinese government’s sights. So are various mergers and acquisitions. Both regulatory and political risk premia in different sectors can persist. The current administration has waged several sweeping regulatory campaigns against monopolies, corruption, pollution, overcapacity, leverage, and non-governmental organizations. The time between the initial launch of one of these campaigns and their peak intensity ranges from two to five years (Chart 6). Often, but not always, central policy campaigns have an express, three-year plan associated with them. Chart 6ABeijing Cracked Down On Monopolies, Corruption, Pollution... Chart 6B...NGOs, Overcapacity, And Leverage Chart 7China Tech: Buyer Beware The first and second year mark the peak impact. The negative profile of Chinese tech stocks relative to their global peers suggests that the current crackdown is stretched, although there is little sign of bottom formation yet (Chart 7). The crackdown began with Alibaba founder Jack Ma, and Alibaba stocks have yet to arrest their fall either in absolute terms or relative to the Hang Seng tech index. Bottom Line: A technical bounce is highly likely for Chinese stocks, especially tech, but we would not recommend playing it because of the negative structural factors. For instance, we fully expect the US to delist Chinese companies that do not meet accounting standards. The Chinese Government’s Pain Threshold? The government is not all-powerful – it faces financial and economic constraints, even if political checks and balances are missing. Beijing does not have an interest in destroying its most innovative companies and sectors. Its goal is to maintain the regime’s survival and power. China’s crackdown on private companies goes against its strategic interest of promoting innovation and therefore it cannot continue indefinitely. The hurried meeting of the China Securities Regulatory Commission with top bankers on July 28 suggests policymakers are already feeling the heat.7 In the case of Ant Group, the company ultimately paid a roughly $3 billion fine (which is 18% of its annual revenues) and was forced to restructure. Ant learned that if it wants to behave more like a bank athen it will be regulated more like a bank. Yet investors will still have to wrestle with the long-term implications of China’s arbitrary use of state power to crack down on various companies and IPOs. This is negative for entrepreneurship and innovation, regardless of the government’s intentions. Chart 8China's Pain Threshold = Property Sector Ultimately the property sector is the critical bellwether: it is a prime target of the government’s measures against speculative asset bubbles. It is also an area where authorities hope to ease the cost of living for Chinese households, whose birth rates and fertility rates are collapsing. While there is no risk of China’s entire economy crumbling because of a crackdown on ride-hailing apps or tutoring services, there is a risk of the economy crumbling if over-zealous regulators crush animal spirits in the $52 trillion property sector, as estimated by Goldman Sachs in 2019. Property is the primary store of wealth for Chinese households and businesses and falling property prices could well lead to an unsustainable rise in debt burdens, a nationwide debt-deflation spiral, and a Japanese-style liquidity trap. Judging by residential floor space started, China is rapidly approaching its overall economic pain threshold, meaning that property sector restrictions should ease, while monetary and credit policy should get easier as necessary to preserve the economic recovery (Chart 8). The economy should improve just in time for the party congress in late 2022. Bottom Line: China will be forced to maintain relatively easy monetary and fiscal policy and avoid pricking the property bubble, which should lend some support to the global recovery and emerging markets economies over the cyclical (12-month) time frame. China’s Regulation And Demographic Pressures Is the Chinese government not acting in the public interest by tamping down financial excesses, discouraging anti-competitive corporate practices, and combating social ills? Yes, there is truth to this. But arbitrary administrative controls will not increase the birth rate, corporate productivity, or potential GDP growth. First, it is true that Chinese households cite high prices for education, housing, and medicine as reasons not to have children (Chart 9). However, price caps do not attack the root causes of these problems. The lack of financial security and investment options has long fueled high house prices. The rabid desire to get ahead in life and the exam-oriented education system have long fueled high education prices. Monetary and fiscal authorities are forced to maintain an accommodative environment to maintain minimum levels of economic growth amid high indebtedness – and yet easy money policies fuel asset price inflation. In Japan, fertility rates began falling with economic development, the entrance of women in the work force, and the rise of consumer society. The fertility rate kept falling even when the country slipped into deflation. It perked up when prices started rising again! But it relapsed after the Great Recession and Fukushima nuclear crisis (Chart 10, top panel). Chart 9China: Concerns About Having Children China’s fertility rate bottomed in the 1990s and has gradually recovered despite the historic surge in property prices (Chart 10, second panel), though it is still well below the replacement rate needed to reverse China’s demographic decline in the absence of immigration. A lower cost of living and a higher quality of life will be positive for fertility but will require deeper reforms.8 Chart 10Fertility Fell In Japan Despite Falling Prices At the same time, arbitrary regulatory crackdowns that punish entrepreneurs are not likely to boost productivity. Anti-trust actions could increase competition, which would be positive for productivity, but China’s anti-trust actions are not conducted according to rule of law, or due process, so they increase uncertainty rather than providing a more stable investment environment. China’s tech crackdown is also aimed at limiting vulnerability to foreign (American) authorities. Yet disengagement with the global economy will reduce competition, innovation, and productivity in China. Bottom Line: China’s demographic decline will require larger structural changes. It will not be reversed by an arbitrary game of whack-a-mole against the prices of housing, education, and health. India And South Asia Chart 11China Will Ease Policy... Or India Will Break Out Global investors have turned to Indian equities over the course of the year and they are now reaching a major technical top relative to Chinese stocks (Chart 11). Assuming that China pulls back on its policy tightening, this relationship should revert to mean. India faces tactical geopolitical and macroeconomic headwinds that will hit her sails and slow her down. In other words, there is no great option for emerging markets at the moment. Over the long run, India benefits if China falters. Following the peak of the second COVID-19 wave in May 2021, some high frequency indicators have showed an improvement in India’s economy. However, activity levels appear weaker than of other emerging markets (Chart 12). Given the stringency levels of India’s first lockdown last spring, year-on-year growth will look faster than it really is. As the base effect wanes, underlying weak demand will become evident. Moreover India is still vulnerable to COVID-19. Only 25% of the population has received one or more vaccine shots which is lower than the global level of 28%. The result will be a larger than expected budget deficit. India refrained from administering a large dose of government spending in 2020 (Chart 13). With key state elections due from early 2022 onwards, the government could opt for larger stimulus. This could assume the form of excise duty cuts on petroleum products or an increase in revenue expenditure. These kinds of measures will not enhance India’s productivity but will add to its fiscal deficit. Chart 12Weak Post-COVID Rebound In India – And Losing Steam Chart 13India Likely To Expand Fiscal Spending Soon Such an unexpected increase in India’s fiscal deficit could be viewed adversely by markets. India’s fiscal discipline tends to be poorer than that of peers (see Chart 13 above). Meanwhile India’s north views Pakistan unfavorably and key state elections are due in this region. Consequently, Indian policy makers may be forced to adopt a far more aggressive foreign policy response to any terrorist strikes from Pakistan or territorial incursions by China over August 2021. The US withdrawal from Afghanistan poses risks for India as it has revived the Taliban’s influence. India has a long history of being targeted by Afghani terrorist groups. And its diplomatic footprint in Afghanistan has been diminishing. Earlier in July, India decided temporarily to close its consulate in Kandahar and evacuated about 50 diplomats and security personnel. As August marks the last month of formal US presence in Afghanistan, negative surprises emanating from Afghanistan should be expected. Bottom Line: Pare exposure to Indian assets on a tactical basis. Our Emerging Markets Strategy takes a more optimistic view but geopolitical changes could act as a negative catalyst in the short term. We urge clients to stay short Indian banks. Investment Takeaways US stimulus contrasts with China’s turmoil. The US Biden administration and congressional negotiators of both parties have tentatively agreed on a $1 trillion infrastructure deal over eight years. Even if this bipartisan deal falls through, Democrats alone can and will pass another $1.3-$2.5 trillion in net deficit spending by the end of the year. Stay short the renminbi. Prefer a balance of investments in the dollar and the euro, given the cross-currents of global recovery yet mounting risks to the reflation trade. A technical bounce in Chinese stocks and tech stocks is nigh. China’s policymakers are starting to respond to immediate financial pressures. However, growth has peaked and structural factors are still negative. The geopolitical outlook is still gloomy and China’s domestic political clock is a headwind for at least 12 more months. Prefer developed market equities over emerging markets (Chart 14). Emerging markets failed to outperform in the first half of the year, contrary to our expectation that the global reflation trade would lift them. China/EM will benefit when Beijing eases policy and growth rebounds. Chart 14Emerging Markets: Not Out Of The Woods Yet Stay short Indian banks and strongman EM currencies, including the Turkish lira, the Brazilian real, and the Philippine peso. The biggest driver of EM underperformance this year is the divergence between the US and China. But until China’s policy corrects, the rest of EM faces downside risks. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 Dani Rodrik, The Globalization Paradox: Democracy and the Future of the World Economy (New York: Norton, 2011). 2 See my "Nationalism And Globalization After COVID-19," Investments & Wealth Monitor (Jan/Feb 2021), pp13-21, investmentsandwealth.org. 3 Our study of Xi’s speech is not limited to this quantitative, word-count analysis. A fuller comparison of his speech with that of his predecessors on the same occasion reveals that Xi was fundamentally more favorable toward Marx, less favorable toward Deng Xiaoping and the pro-market Third Plenum, utterly silent on notions of political reform or liberal reform, more harsh in his rhetoric toward the outside world, and hawkish about the mission of reunifying with Taiwan. 4 The Chinese side also insisted that the US stop revoking visas, punishing companies and institutes, treating the press as foreign agents, and detaining executives. It warned that cooperation – which the US seeks on the environment, Iran, North Korea, and other areas – cannot be achieved while the US imposes punitive measures. 5 See US Department of State, "Xinjiang Supply Chain Business Advisory," July 13, 2021, and "Risks and Considerations for Businesses Operating in Hong Kong," July 16, 2021, state.gov. 6 Top business executives are also subject to these displays of state power. For example, Alibaba founder Jack Ma caricatured China’s traditional banks as “pawn shops” and criticized regulators for stifling innovation. He is now lying low and has taken to painting! 7 See Emily Tan and Evelyn Cheng, "China will still allow IPOs in the United States, securities regulator tells brokerages," CNBC, July 28, 2021, cnbc.com. Officials are sensitive to the market blowback but the fact remains that IPOs in the US have been discouraged and arbitrary regulatory crackdowns are possible at any time. 8 Increasing social spending also requires local governments to raise more revenue but the central government had been cracking down on the major source of revenues for local government: land sales and local government financing vehicles. With the threat of punishment for local excesses and lack of revenue source, local governments have no choice but to cut social services, pushing affluent residents towards private services, while leaving the less fortunate with fewer services. As with financial regulations, the central government may backpedal from too tough regulation of local governments, but more economic and financial pain will be required to make it happen. The Geopolitics Of The Olympics The 2020 Summer Olympics are currently underway in Tokyo, even though it is 2021. The arenas are mostly empty given the global pandemic and economic slowdown. Every four years the Summer Olympics create a golden opportunity for the host nation to showcase its achievements, infrastructure, culture, and beauty. But the Olympics also have a long history of geopolitical significance: terrorist acts, war protests, social demonstrations, and boycotts. In 1906 an Irish athlete climbed a flag pole to wave the Irish flag in protest of his selection to the British team instead of the Irish one. In 1968 two African American athletes raised their fists as an act of protest against racial discrimination in the US after the assassination of Martin Luther King Jr. In 1972, the Palestinian terrorist group Black September massacred eleven Israeli Olympians in Munich, Germany. In 1980 the US led the western bloc to boycott the Moscow Olympics while the Soviet Union and its allies retaliated by boycotting the 1984 Los Angeles Olympics. In 2008, Russia used the Olympics as a convenient distraction from its invasion of Georgia, a major step in its geopolitical resurgence. So far, thankfully, the Tokyo Olympics have gone without incident. However, looking forward, geopolitics is already looming over the upcoming 2022 Winter Olympics in Beijing. How the world has changed. The 2008 Summer Olympics marked China’s global coming-of-age celebration. The breathtaking opening ceremony featured 15,000 performers and cost $100 million. The $350 million Bird’s Nest Stadium showcased to the world China’s long history, economic prowess, and various other triumphs. All of this took place while the western democratic capitalist economies grappled with what would become the worst financial and economic crisis since the Great Depression. In 2008, global elites spoke of China as a “responsible stakeholder” that was conducting a “peaceful rise” in international affairs. The world welcomed its roughly $600 billion stimulus. Now elites speak of China as primarily a threat and a competitor, a “revisionist” state challenging the liberal world order. China is blamed for a lack of transparency (if not virological malfeasance) in handling the COVID-19 pandemic. It is blamed for breaking governance promises and violating human rights in Hong Kong, for alleged genocide in Xinjiang, and for a list of other wrongdoings, including tough “Wolf Warrior” diplomacy, cyber-crime and cyber-sabotage, and revanchist maritime-territorial claims. Even aside from these accusations it is clear that China is suffering greater financial volatility as a result of its conflicting economic goals. Talk of a diplomatic or even full boycott of Beijing’s winter games is already brewing. Sponsors are also second-guessing their involvement. More than half of Canadians support boycotting the winter games. Germany is another bellwether to watch. In 2014, Germany’s president (not chancellor) boycotted the Sochi Olympics; in 2021, the EU and China are witnessing a major deterioration of relations. Parliamentarians in the UK, Italy, Sweden, Switzerland, and Norway have asked their governments to outline their official stance on the winter games. In the age of “woke capitalism,” a sponsorship boycott of the games is a possibility. This is especially true given the recent Chinese backlash against European multinational corporations for violating China’s own rules of political correctness. A boycott which includes any members of the US, Norway, Canada, Sweden, Germany, or the Netherlands would be substantial as these are the top performers in the Winter Olympics. Even if there is no boycott, there is bound to be some political protests and social demonstrations, and China will not be able to censor anything said by Western broadcasters televising the events. Athletes usually suffer backlash at home if they make critical statements about their country, but they run very little risk of a backlash for criticizing China. If anything, protests against China’s handling of human rights will be tacitly encouraged. Beijing, for its part, will likely overreact, as these days it not only controls the message at home but also attempts more actively to export censorship. This is precisely what the western governments are now trying to counteract, for their own political purposes. The bottom line is that the 2008 Beijing Olympics reflected China’s strengths in stark contrast with the failures of democratic capitalism, while the 2022 Olympics are likely to highlight the opposite: China’s weaknesses, even as the liberal democracies attempt a revival of their global leadership. Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Section II: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia Section III: Geopolitical Calendar
The Australian dollar has been under pressure recently, falling below its 40-week moving average on June 18. AUD/USD is down 7.5% since its late-February apex and over the past three months it has been among the worst performing currencies against the US…
Highlights The decline in US Treasury yields has once again reduced the appeal of US paper, relative to foreign developed and emerging market bonds. Historically, lower US bond yields relative to other markets has been dollar bearish. The caveat is that if declining yields are due to a flight to safety, the dollar initially benefits due to US bond inflows. The academic research on which yields matter for currencies is mixed. Historically, short rates have mattered more. But with short-term interest rates anchored at zero, there is evidence investors are moving out the curve. Our bias is that looking across the yield curve will provide a more accurate picture of the countries that will benefit from bond inflows. More importantly, it is the sum of portfolio flows that drive a currency. This means equity flows will be important as well. Feature Global bond yields have rolled over, driven by the long end of the curve. The US 10-year yield has fallen from a high of 1.74% at the end of March to 1.29% today. While other bond yields have rolled over, the move has been more pronounced in the US. For example, the spread between the US 10-year Treasury and the 10-year German bund has narrowed from 200bps to 175bps. Given the correlation between relative interest rates – especially in real terms – and the dollar, a rare divergence has opened up in favor of short dollar positions (Chart I-1). A fall in yields can be driven by prospects of either slowing growth, lower inflation expectations, or a combination of the two. In the case of the US and to a certain extent the eurozone, the culprit behind lower yields has been a drop in both the real and the nominal component. This suggests that the markets are worried about central banks becoming too hawkish at the exact moment global growth is set to slow. Across maturities, the US yield curve has thus flattened (Chart I-2). Chart I-1Real Yields And Currencies Have Diverged Chart I-2Flattening Yield Curves A few questions arise from the setup above. How do you trade the dollar in the current environment? What is the future path for yields, especially relative yields? Should investors focus on a specific maturity as a signal for future currency moves? Finally, are yields the key driver of currencies in the current environment or should investors focus on other factors as well? Explaining Recent Dollar Strength Chart I-3Rising Demand For Hedges If the decline in rates globally has been led by the US, then why has the dollar remained strong? The first reason is rising safe-haven demand, especially as global growth peaks. Usually, as a counter-cyclical currency, the dollar benefits in a risk-off environment. The latest Treasury International Capital (TIC) data show that foreign inflows into US bonds have been part of the reason for the decline in Treasury yields since March. A reset in equity markets has also been a driver. The DXY index has been very closely correlated with the put-call ratio in the US, and increased demand for hedges, including long dollar positions, have benefited the greenback (Chart I-3). This has been consistent with the outperformance of the more defensive US equity market. The third reason has been a slowdown in relative economic momentum between the G10 and the US. Chart I-4 shows that the Citigroup economic surprise index for the euro area relative to the US remains strong but has rolled over. The story is similar using relative PMIs between the US and the rest of the G10. Relative economic performance has usually tended to dictate currency movements in the near term. Chart I-4Relative Economic Momentum Is Slowing Finally, as we highlighted a fortnight ago, the dollar was oversold and due for a tactical bounce. Leveraged funds have been covering their short positions in recent weeks, while speculators are now long the dollar (Chart I-5). Chart I-5Speculators Are Now Long The Dollar Going forward, most of these trends should reverse. While the Delta variant of COVID-19 is raging across countries, hospitalizations are low, and thus the case for renewed lockdowns is weak. Meanwhile, non-US growth should regain the upper hand, especially in countries like Japan where vaccinations are ramping up quite fast. Global yields should also rise, as output gaps close and inflation remains well anchored. The Dollar And Interest Rates: Real Versus Nominal? As Chart 1 highlights, it is important to think about relative rates when looking for the next move in the dollar. The historical evidence is that there is little correlation between the dollar and the absolute level or direction of bond yields. Over the last few decades, global bond yields have collapsed while the dollar has undergone rolling bull and bear markets. Currencies react more to the path of relative real rates than nominal rates. By definition, a currency is the mechanism by which prices are equalized across borders. Rising inflation lowers the purchasing power of a currency, which in turn forces the currency to adjust lower in a globally competitive pricing system. Across the G10, there has been a longstanding relationship between real interest rate differentials and the path of the currency (Chart I-6). Chart I-6Negative Real Rates In The US Across The Curve Chart I-7The US Sports A Very Negative ##br##Real Yield Importantly, US real rates, especially at the short end of the curve, are very depressed. In fact, compared to other G10 countries, the US sports one of the worst 2-year real yields (Chart I-7). Based on the historical precedent illustrated in Chart I-6, a significant increase in US real rates is required to allow the dollar to rise on a structural basis. What About Hedged Yields? It is true that hedged yields in the US are positive for foreign investors. For example, hedged 10-year US yields for German bond investors provide 97 bps of pickup. For a Japanese investor, the yield pickup in the US is 96 bps, and for a British investor, it is 73 bps (Chart I-8A, Chart I-8B, Chart I-8C). Chart I-8BUS Hedged Yields For Japanese Investors Chart I-8AUS Hedged Yields For Euro Investors Chart I-8CUS Hedged Yields For British Investors However, there is little correlation between the hedged yields and currency performance, and for good reason: Under covered interest rate parity, a hedged yield will be an arbitrage opportunity, which should be duly uncovered by efficient markets. This arbitrage window for hedged yields disappears if you extend the maturity of your hedging, as economic theory suggests. For example, hedging a 10-year bond with a 3-month currency forward can lead to massive losses as you roll over these contracts. This is because the cost of hedging in the short term tends to have wild fluctuations. For example, hedging in euros for a German investor buying Treasurys was over 300bps at the end of 2018. This wiped out the positive spread between the two bonds. Many investors do not hedge currency exposure. In fact, the “least regrets” approach of hedging 50% of currency exposure has been quite popular.1 Therefore, focusing on the real yield, rather than the hedged or nominal yield (Chart I-9), has been a far more robust solution in gauging the direction of currencies. By definition, a hedged yield means buying a currency at spot and selling it forward. This should be currency neutral, and especially, arbitrage away the yield differential. Chart I-9Hedged Yields And Currencies: No Correlation Which Bond Yields Matter? The academic evidence suggests that short-term interest rates matter more for currencies, especially when policy is close to the zero bound. According to a BIS paper,2 not only has the FX impact of monetary policy grown significantly in the last few years, but short maturity bonds have had the strongest impact. Moreover, at a lower level of interest rates, the foreign-exchange impact is greater as the adjustment burden falls onto the exchange rate. Looking purely through the lens of the US dollar, our view is more nuanced. Foreign inflows into US long-term Treasurys have been improving tremendously, while flows into T-bills are relapsing (Chart I-10). This suggests longer-term rates have been a bigger driver of inflows into the US, and, more recently, the dollar rally. It is similar to what occurred at beginning of the dollar bull market last decade. Admittedly, the picture shifted over time, with shorter term flows becoming increasingly important as the Fed began to hike interest rates. Taking a step back, bond investors tend to span the duration spectrum, with pension funds investing in bonds many years out. As 1-year and 2-year yield differentials are not meaningfully different across countries (Chart I-11), this curtails the appeal of short-term paper. If inflation differentials are considered, it reduces the appeal of US paper even further. Chart I-10Long-Term Versus Short-Term Flows Chart I-11Narrow Gap In Short Term Yields Let’s not forget quantitative easing. If a central bank explicitly targets a bond yield near zero, like in Japan or Australia, that makes it difficult for that same yield tenor to generate positive inflows or send a reliable signal about the economy. This suggests a better method is looking at a spectrum of indicators, including yields at various maturities. Charts I-12 plots the yield differentials across maturities and countries. It shows that currencies have been correlated across the relative yield maturity spectrum. As such, we recommend investors monitor both short- and long-term yields in evaluating currency decisions. Chart I-12AYield Differentials Across Different Maturities Chart I-12BYield Differentials Across Different Maturities Chart I-12CYield Differentials Across Different Maturities Chart I-12DYield Differentials Across Different Maturities Chart I-12EYield Differentials Across Different Maturities Chart I-12FYield Differentials Across Different Maturities Chart I-12GYield Differentials Across Different Maturities Chart I-12HYield Differentials Across Different Maturities Chart I-12IYield Differentials Across Different Maturities Other Asset Classes There are multiple drivers of exchange rates. Bond yields are just one of them. Equity and other flows also matter. It is the sum of portfolio flows that drive a currency. In fact, inflows into US equities and agency bonds have been the bigger drivers of the US dollar this year (Chart I-13). Outside the US, the correlation between interest rates and the currency can be very weak. The Canadian dollar is much more correlated with terms of trade than with real interest rate differentials. Rising oil prices attract inflows into Canadian corporate bonds and equities, which are positive for the currency. The key point is that flows tend to gravitate to capital markets with the highest expected returns. As such, monitoring flows other than government bond purchases is important. We expect that yields will be higher on a cyclical horizon. This will be beneficial for cyclical stocks, especially banks. This will also be beneficial for flows into non-US bourses, that have a higher weighting of cyclical stocks.. In short, the US equity market has become very tech heavy. Rising interest rates will hurt higher duration sectors such as technology and health care. At the margin, this hurts the relative performance of US equities (Chart I-14). Given that equity inflows have been a key driver of the US dollar, this will also hurt at the margin Chart I-13Agency Bonds And Equity Purchases Have Driven US Inflows Chart I-14US Valuations Benefit From ##br##Lower Rates Concluding Thoughts US real interest rates have deteriorated relative to the rest of the world. As such, it will require a significant rise in US real rates to seriously question a dollar bearish view. Meanwhile, a modest rise in global rates will also be bearish for US stocks compared to non-US bourses. US rates are usually high beta, and so could rise more in an improving growth environment. But relative rates are correlated to relative growth. As such, if non-US growth picks up relative to the US, like the IMF expects, this will provide a modest fillip to non-US yields (Chart I-15). US real rates are also very negative, so the bar to create a genuine dollar rally is very high. Finally, the market still expects the Federal Reserve to lead the hiking cycle. This means that there is still potential for an upside surprise in interest rates outside the US, compared to within (Chart I-16). Chart I-15Relative Bond Yields And Relative Economic Momentum Chart I-16The Market Is Still Relatively Hawkish On The Fed Housekeeping Our long Scandinavian basket was triggered at our buy point of a -2% pullback from July 9th levels. As such, we are now short EUR/NOK, USD/NOK, EUR/SEK, and USD/SEK. We were also stopped out of our long silver/short gold position for a small loss. We will be looking to reopen this trade in the coming weeks. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Michenaud, S., and Solnik, B., , “Applying regret theory to investment choices: Currency hedging decisions,” Journal of International Money and Finance 27, 2008, 677-694. 2 Ferrari, Massimo, Kearns, Jonathan and Schrimpf, Andreas, “Monetary policy’s rising FX impact in the era of ultra-low rates,” Bank of International Settlements, April 2017. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Data out of the US this week was mixed: June retail sales came in better than expected. The control group rose 1.1% month on month, versus a -1.4% decline in May. For July, the University of Michigan survey showed inflation expectations continue to edge higher, but the sentiment of current conditions and expectations was well below consensus. Inflows into US assets reversed in May, with net outflows of $30.2bn. Existing home sales rose by 1.4% month on month in June to 5.9 million units. The US dollar DXY index rose modestly this week. Technically, the dollar is now approaching overbought territory. Our intermediate-term indicator has broken above 60, speculators are now long the dollar and sentiment on the greenback has turned up at a time when real rates remain negative in the US. This suggests much optimism is in the price. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Data out of the eurozone this week was robust: The trade balance came it at €9.4bn for May. Final June CPI was in line with expectations – 1.9% for headline and 0.9% for core. The ECB kept rates unchanged in their July 22 meeting, but added to their framework of forward guidance. The euro fell by 40bps this week. Following Christine Lagarde’s Bloomberg interview last week, the ECB made some policy changes. First, they will allow for an inflation overshoot should this be consistent with longer-term inflation at 2%. They will also likely extend the PEPP beyond the March deadline, so no tapering before then. Finally, interest rates are expected to remain negative as far as the eye can see. This is nudging the euro towards becoming a low-beta currency. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 There was some positive news out of Japan this week: Exports rose 48.6% year on year in June. Imports also expanded at a 32.7% year-on-year pace, signaling rising domestic demand momentum. National CPI for June was in line with expectations. The core measure was at 0.2%. Supermarket sales continued to improve in June. The yen was down 0.3% against the dollar this week. The yen is the most shorted developed-market currency, and our intermediate-term indicator is at bombed-out levels. This is occurring at a time when domestic data is on the mend. This is bullish from a contrarian perspective. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 There was some mixed data out of the UK this week: Rightmove house prices rose 5.7% year on year in July. The CBI survey was softer than expected in July. Total orders fell from 19 to 17, while the component of selling prices and business optimism fell 4 and 5 points respectively. The pound fell by 0.5% against the US dollar this week. Momentum on the pound continues to suggest near-term downside. Our intermediate term indicator is still blasting downward, and speculators are cutting their long positions from very aggressive levels. This suggests continued near-term downside in cable. Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 There was scant data out of Australia this week: NAB business confidence for Q2 fell from 19 to 17. The RBA minutes confirmed that the central bank will stay dovish in the near term. The AUD fell by 0.7% this week against the USD, the worst performing G10 currency. COVID-19 will continue to dictate near-term developments in Australia, with the latest lockdowns having slowed economic activity. Speculators have started shorting the AUD on this basis (in addition to the risk of a decline in metal prices). In the end, if the COVID-19 crisis proves transient, it will create a coiled spring response for the AUD. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The was scant data out of New Zealand this week: Credit card spending rose 6.3% year on year in June. The performance services index rose from 56.1 to 58.6 in June. The NZD was down 23bps versus the US dollar this week. Last week’s rally in the NZD, following the signal that the RBNZ will end QE this week, is fizzling. From a technical standpoint, speculators are neutral the NZD, but our intermediate-term indicator has not yet bottomed out. We are long CHF/NZD, as a reset in global asset prices could increase currency volatility and benefit the pair. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data out of Canada this week has been robust: June housing starts came in at 282.1K versus expectations of 270K. Foreigners continued to accumulate Canadian securities in June, to the tune of C$20bn. House prices remain on fire. The Teranet/National Bank index rose 16% year on year in June. The Bloomberg Nanos Confidence index held steady at 66.3. The CAD rose by 0.2% this week, performing better than other G10 currencies. The longer-term outlook for the loonie is clearly positive as the BoC will hike interest rates ahead of the Federal Reserve. Near term, USD/CAD could retest the 1.28 level as our intermediate-term indicator continues to work off overbought conditions. Ultimately, we will be selling this pair between 1.28 and 1.30. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There was scant data out of Switzerland this week: Exports fell 3% month on month in June. However, watches continued to sell well, with exports rising 71% year on year. Total sight deposits were unchanged at CHF 712 bn for the week of July 16. The Swiss franc was down 0.2% this week. A rebound in global bond yields is a threat to franc long positions. However, we believe the period of volatility in both economic data and equity markets is not over. As such, the franc will benefit from safe-haven inflows. We are long the CHF/NZD cross on this basis. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Data out of Norway is improving: Industrial confidence came in at 11.3 for Q2, from 8.6 the previous quarter. The NOK was down by 0.5% this week against the dollar. This triggered our limit-buy on Scandinavian currencies at the -2% trigger level we had originally been targeting. As such, we are now short EUR/NOK and USD/NOK. With real yields in Norway much higher than in the US or Europe, portfolio flows should benefit the NOK. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data from Sweden have been somewhat mixed: There is a slight upward revision to the Bloomberg economic forecasts. GDP growth is now expected to be 4% year on year in 2021, from a previous estimate of 3.5%. However, CPI was revised down 10bps to 1.7% this year, and 1.4% next year, considering the disappointing CPI print last week. The SEK was down 20bps this week. The SEK remains one of our most potent plays on a global growth recovery. Historically, the SEK has correlated very well with global growth variables and relative economic growth between Sweden and the rest of the world. This week, our limit-buy on Scandinavian currencies was triggered. As such, we are now short EUR/SEK and USD/SEK. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
The DXY failed to break below the 89 critical resistance level earlier this year and has instead been appreciating since the beginning of June. The global growth scare which is testing the reflation narrative is fueling the rally in this counter-cyclical…
Highlights The ECB has changed its inflation target, but its credibility remains weak. Inflation will not allow the ECB to tighten policy anytime soon. Instead, the ECB will have to add to its asset purchase program next year and may even consider dual interest rates. EUR/USD should continue to appreciate because of the weakness in the USD, but EUR/GBP, EUR/NOK, and EUR/SEK will soften. The SNB will follow the ECB; buy Swiss stocks / sell Eurozone defensives as an uncorrelated trade. China matters more than COVID-19 for the cyclical/defensive ratio. Despite our pro-cyclical medium- to long-term portfolio bias, the reflation trade is pausing. Remain tactically long telecom / short consumer discretionary as a hedge. European momentum stocks are near critical levels relative to growth equities. Feature The European Central Bank has found a new way to shed its Bundesbank heritage further and to justify the continuation of its QE program well after other central banks around the world will have ended their asset purchases. The early results of the Strategy Review and the subsequent comments by President Christine Lagarde will make it near impossible for the ECB to taper its asset purchases anytime soon. Practically, this means that the European yield curve will steepen relative to that of the US. Additionally, this policy should not hurt EUR/USD, but it will hurt EUR/GBP, EUR/NOK, and EUR/SEK. In the equity space, Swiss stocks will outperform European defensive equities, creating an opportunity for an uncorrelated trade. A New Tougher Target The ECB has abandoned its long-standing target of “close but below” 2% inflation. Even more importantly, the ECB followed the Bank of Japan and the Fed in adopting an approach whereby both downside and upside deviations from the 2% inflation target are to be fought. The ECB’s credibility was already hurt by its inability to achieve its more modest previous inflation target. Since 2009, the Euro Area HICP only averaged 1.2% (Chart 1). To prevent losing further credibility under its new mandate, the ECB will have to increase its stockpile of assets. Moreover, the ECB is far from achieving its new mandate, which will add to the ECB’s need to expand stimulus to the system even once the impact of owner-equivalent rent is included in CPI. Chart 1Mission Impossible Chart 2Narrow Inflationary Pressures Today, the ECB’s measure of core inflation stands at 1%, while headline inflation is 1.9%. As the economy re-opens, a surge in inflation is likely, but this spike will be transitory, even more so than in the US. As we recently showed, our estimate of the Eurozone trimmed-mean CPI has plunged close to 0%, which highlights that inflation pressures remain narrow (Chart 2). The labor market is another hurdle that will prevent Eurozone inflation from durably reaching 2% anytime soon. Currently, the total hours worked in the Euro Area remains well below the equilibrium level implied by the working-age population (Chart 3), which historically constrains wages. Moreover, it generally takes many quarters after labor shortages become prevalent before inflation begins to inch higher (Chart 4). Chart 3No Wage Pressure Yet Chart 4No Inflation Labor Shortages For A While The euro is the last force that caps European inflation. Despite the recent depreciation in EUR/USD, the trade-weighted euro remains near all-time highs, which historically imparts strong deflationary pressures to the economy (Chart 5). Beyond the time it will take for realized inflation to reach the ECB’s new target, inflation expectations are still inconsistent with 2% inflation. As the top panel of Chart 6illustrates, market-based inflation expectations in the Eurozone remain well below both 2% and the levels that prevailed before the Great Financial Crisis, even though rising commodity prices are lifting global inflation expectations. Market participants are not alone in doubting the ECB; professional forecasters do not see inflation at 2% in the near-term or the long-term (Chart 6, bottom panel). Chart 5The Euro Is Deflationary Chart 6The ECB Lacks Credibility In addition to the continued inability of the ECB to achieve its previous inflation target, let alone its present one, sovereign risk still hamstrings the central bank. The Italian economy remains fragile, because little structural reform has taken place. The Spanish economy cannot stand on its own two feet while the tourism industry continues to suffer due to COVID-19 related fears. And the exploding debt load of the French economy as well as its structural current account deficit raise the possibility that OATs will become unmoored. The ECB will ensure that spreads in those nations do not widen, or Eurozone inflation will never reach the new 2% target. Bottom Line: When it was time to achieve near—but below—2% inflation, the credibility of the ECB was already limited. The new target will be even harder to reach, but the symmetry around it gives the ECB more leeway to provide additional support to the Eurozone economy. Market Implications The ECB is now bound to maintain policy accommodation beyond the scheduled end of the PEPP program in March 2022, or the new policy target will be even less credible than the previous one. BCA Global Fixed Income Strategy team expects the ECB to maintain its asset purchase program beyond the stated end of the PEPP. Practically, this means that the ECB will fold the program into the pre-pandemic APP. The ECB cannot tighten policy while it remains so far from its target, especially now that missing the goalpost to the downside is as problematic as missing it to the upside. We expect the ECB to hint at this on Thursday. Chart 7The EONIA Curve Anticipated The Strategy Review The ECB will also not increase interest rates for the foreseeable future, which the EONIA curve already anticipates (Chart 7). Money markets only expect a first hike in late 2024, which is appropriate. Compared to a month ago, overnight rates 10-year forward fell by more than 10bps, from 0.75% to 0.61%. We are inclined to fade this move. More stimulus raises the outlook for long-term policy rates. Amid the correction in global bond yields, betting against the decline in the long-term EONIA rate is akin to catching a falling knife; however, because the ECB is easing relative to the Fed, a box trade of buying European steepeners at the same time as US flatteners remains appropriate. The ECB could also lower the rate on TLTRO operations, resulting in a dual interest rate regime in the Eurozone. As Megan Greene and Eric Lonergan have argued, this policy would provide a further lift to the Euro Area economy by boosting the attractiveness of borrowing; at the same time, it would limit the deleterious impact of ever-more negative deposit rates on the profitability of the banking sector, because banks would borrow at extremely negative rates to finance lending activities. Chart 8JPY And YCC The effect of the policy on the euro is more complex. When Japan announced its Yield Curve Control strategy in September 2016, it defined price stability as achieving a 2% inflation rate over the span of the business cycle. In other words, the BoJ implemented a backdoor average inflation mandate. Following this announcement, USD/JPY strengthened (Chart 8), but this move reflected the dollar rally and the global bond selloff around the US election, not yen-specific factors. This suggests that the euro will continue to track the USD inversely. BCA’s FX Strategy team remains bearish on the greenback, as a result of the growing US current account deficit and the fact that the Fed continues to target an overshoot in inflation, which suggests that, even if US nominal interest rates rise, real rates will lag behind. The EUR is nonetheless set to underperform compared to other European currencies. In the UK, house price gains are accelerating, the jobless count is declining rapidly as the economy re-opens, and the cheapness of the pound is accentuating positive inflation surprises. This combination suggests that the BoE is likely to follow the path of the Bank of Canada or the Reserve Bank of New Zealand, by beginning to tighten policy by early next year. Norway also faces a similar set of circumstances and has already announced it will lift interest rates this year. As we argued two months ago, the Riksbank is likely to follow its western neighbor, because the Swedish housing market is roaring, and the economy will remain well supported by the upcoming global capex boom. Hence, EUR/GBP, EUR/NOK, and EUR/SEK will depreciate. The Swiss National Bank should be the outlier that will follow the ECB. Swiss headline and core inflation linger at 0.6% and 0.4%, respectively. Wage growth is a meager 0.5%, because the Swiss output gap remains a massive 5.5% of GDP (Chart 9, top panel). Meanwhile, consumer confidence and retail sales are much weaker than those of Sweden, Norway, or the UK. Finally, Swiss private debt stands at 270% of GDP, which means that this economy still risks falling into a Fisherian debt-deflation trap. As a result, the SNB will continue to try to cap the upside in the CHF vis-à-vis the EUR, because the currency remains the main determinant of Swiss monetary conditions. Moreover, according to the central bank, the Swiss franc is still 10% overvalued relative to the euro, which is weighing on the country’s competitiveness (Chart 9, bottom panel). To fight the recent depreciation of EUR/CHF, the SNB will not raise rates for a long time and will intervene further in the FX market. The liquidity injections should prompt additional increases in the SNB’s domestic sight deposits, which since 2015 have resulted in a rise of Swiss bond yields relative to those of Germany (Chart 10). While counterintuitive, this relationship reflects the reflationary impact of the SNB’s asset purchases. It also means that the Swiss real estate market is set to become ever bubblier. Chart 9The SNB Will Follow The ECB Chart 10Swiss/German Spreads To Widen For Swiss shares, the picture is more complex. Swiss equities are extremely defensive, but, while they underperform Euro Area stocks when global yields rise, widening Swiss / German spreads often provide a lift to the SMI. A simple model, assuming US 10-year Treasury yields rise to 2.25% by the end of 2022 (BCA’s US Bond Strategy forecast) and that Swiss/German spreads widen to 20bps as the SNB domestic sight deposits swell, suggests that Swiss stocks will underperform that of the Euro Area over the coming 18 months (Chart 11). However, if we compare Swiss equities to European defensive sectors, then the widening in Swiss/German spreads should prompt an outperformance of Swiss equities, because their multiples benefit from ample liquidity conditions in Switzerland (Chart 12). Chart 11Swiss Stocks Are Too Defensive To Outperform Durably... Chart 12...But They Will Beat Euro Area Defensives Bottom Line: The results of the ECB Strategy Review will force this central bank to remain a laggard and continue to expand its balance sheet well after the expected end of the PEPP program. Eurozone interest rates will also fall behind that of other major economies. The ECB may even consider cutting the interest rate on TLTROs to boost lending. These policies will have a minimal impact on EUR/USD, which will continue to be dominated by the dollar’s fluctuations. However, EUR/GBP, EUR/SEK, and EUR/NOK will suffer. Finally, the SNB will follow the ECB and expand its balance sheet further, which will paradoxically lift Swiss/German spreads. As a result of their defensive nature, Swiss stocks will underperform Euro Area ones over the next 18 months, but they will outperform European defensive equities. Go long Swiss equities relative to European defensives, as a trade uncorrelated to the broad market. Follow China, Not Delta Chart 13 In recent days, doubts have grown about the European re-opening trade because of the resurgence of COVID-19 cases. The Delta variant (or any subsequent mutation for that matter) will cause hiccups along the way, but, ultimately, the re-opening will continue to proceed. As a result of the growing rate of vaccination, hospitalizations and deaths remain stable even if new cases are climbing rapidly in many countries (Chart 13). As long as the burden on the healthcare system remains limited, governments will find it difficult to justify further large-scale lockdowns. Instead, measures such as Macron’s Pass Sanitaire will provide increasing, widespread incentives for greater vaccination. Despite this sanguine take on the Delta variant, we remain concerned for the near-term outlook for cyclical equities because of the Chinese economy, even after the recent 50bps cut in the Reserve Requirement Ratio. BCA’s China Investment Strategy service believes that the RRR cut does not signal the beginning of a policy easing cycle. More evidence would be needed, such as additional RRR cuts, rising excess reserves, or supportive policies for the infrastructure and real estate sectors. For now, we heed the message from PBoC official Sun Guofeng that “the RRR cut is a standard liquidity operation.” Chart 14Fade The RRR Cut The dominant force for the Chinese economy remains the previous deterioration in the credit impulse, which suggests that Q3 and Q4 growth will decelerate materially (Chart 14, top panel). Moreover, the softening impulse is consistent with weaker global economic activity, as approximated by our Global Nowcast (Chart 14, middle panel), especially since the lingering effect of the past RRR increases is still consistent with a global deceleration (Chart 14, bottom panel). In this context, we continue to hedge our long-term preference for cyclical stocks because of the near-term risks created by China and the excessively rapid move in the cyclical-to-defensives ratio (Chart 15). In response to this pause in the reflation trade, we continue to favor a long telecom/short consumer discretionary tactical position, which is supported by valuations and RoE differentials, as well as the still extended relative momentum (Chart 16). The period of risk to the global reflation trade should also allow the dollar to remain firm in the near-term, which means that for the coming months, the euro will not go beyond its trading range in place since the beginning of the year. Chart 15Cyclicals Remain Tactically Vulnerable Chart 16Stay Long Telecom / Short Consumer Discretionary Bottom Line: China’s RRR cut is not yet enough to bet against the temporary pause in the global reflation trade. Thus, investors should continue to hedge pro-cyclical long-term bets in their portfolios via a long telecom / short consumer discretionary position. An Exciting Chart A chart caught our eye this week: The underperformance of Eurozone momentum stocks relative to growth stocks is massively overdone (Chart 17). For now, we only want to highlight the phenomenon, but, in the coming weeks, we will delve deeper into the topic to gauge if these oversold conditions constitute an attractive opportunity. Chart 17Washed Out Moment Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance
Highlights The dollar smile theory was valid around the COVID-19 crisis but does not stand the test of time. A more useful framework for determining the long-term trend in the dollar is observing global business cycle dynamics. The 2000s experience could provide a useful roadmap for the dollar this coming decade. We remain dollar bears over a 9-to-12-month horizon, although the dollar could stage a short-lived rally in the interim. Feature The “dollar smile” theory1 is the premise that the dollar tends to rise when the US economy is either too strong or too weak. Only in the precise environment, when the US economy is neither too hot nor too cold would you experience a dollar decline (Chart I-1). Chart I-1The Dollar Smile Theory This theory particularly resonates with traders and financial speculators as each handle of the smile can be explained by economic theory. For example, when the US economy is running hot, this usually prompts the Federal Reserve to hike interest rates. This supports the dollar. When the US economy is entering a recession, this is generally accompanied by a flight to safety. Inflows into safe-haven US bonds and defensive sectors of the stock market would also tend to boost the dollar. The fact that the dollar can rise in these polarizing set of circumstances makes a long dollar view particularly attractive as the default position. The key questions therefore for investors are: First, how does this theory hold up in terms of evidence? and, second, how should FX portfolios be positioned in the current environment? The Evidence During the height of the COVID-19 crisis, the smile theory certainly proved correct. Chart I-2 shows that the DXY index tended to rise approximately 58% of the time when the S&P 500 was either up by 2% or down by 2%. However, when the sample size is broadened, even to a few years, the theory falls apart. From 2010-2020, the DXY index rose only 37% of the time when the S&P 500 was up 2%, while it rose almost 50% of the time when the S&P 500 was down 2% (Chart I-3). Meanwhile, this sample size is particularly biased since during that period, the dollar was in a bull market, and the US economy was quite strong. Chart I-2The Dollar Smile Around The 2020 Pandemic Chart I-3The Dollar Smile Around Full Business Cycles Chart I-4US Industrial Production And The Dollar: No Correlation In economic terms, we get a similar picture. The relationship between US industrial production and the greenback is weak at best, with little evidence of a smile (Chart I-4). For example, there was no discernable trend in the dollar when US industrial production was between 0-5%, or even 5-10%. Admittedly, the dollar does rise when US manufacturing is in recession. A More Useful Framework Chart I-5US Relative Growth And The Dollar: Linear Correlation While the dollar is a complex variable, explaining its longer-term trend boils down to two simple rules of thumb: Is the global economy recovering or contracting? And if so, is the US leading or lagging this recovery? Chart I-5 shows that the dollar tends to rise when US economic activity is picking up relative to the world, but tends to fall otherwise, albeit with a few outliers. Meanwhile, one of the reasons the US dollar has done well during recessions is that the US economy generally has had more shallow recessions than other advanced economies in recent years. Through this lens, the US performs comparatively better during global downturns (Chart I-6). Going forward, the IMF predicts that non-US growth should fare better than growth in the US over the next few years. We side with the IMF: The global economic recovery will remain intact and will rotate from the US to other economies. Chart I-6US Growth Usually Outperforms During Recessions Chart I-7Spectacular Recovery In Vaccinations Outside The US The primary rationale is that most G10 countries lagged the US in their vaccination campaigns in 2020 and earlier this year. That is starting to change now, as vaccinations in the rest of the G10 are ramping up (Chart I-7). Meanwhile, vaccinations are proving effective against death and hospitalizations for the Delta variant of the COVID-19 virus. A turnaround in the vaccination campaign would not only boost public opinion about the COVID-19 response but would also be a welcome fillip to much subdued consumer and business sentiment outside the US. Taking a step back, there is a strong case to be made that cyclically, both eurozone and Japanese growth could surprise to the upside due to pent-up demand. For the eurozone, the debt crisis from 2010-2012 was a severe blow to the recovery. In Japan, rolling crises from the Fukushima disaster in 2011 to the consumption tax hikes both in 2014 and 2019 were growth handicaps. Chinese monetary tightening in 2015 caused a sharp manufacturing recession that was a severe blow to non-US economies, including Japan and the eurozone. This time around, coordinated monetary and fiscal stimulus could allow for a few years of a genuine growth recovery. In a nutshell, the dollar smile that occurred around the pandemic last year was due to the uncertainty about the future path of growth, while the US was leading the world in both monetary and fiscal stimulus. The US also led in the vaccination campaign. As other economies adopt this template, the smile should fade, as has empirically been the case over time. Echoes From The 2000s The 2000s experience could provide a useful roadmap for the dollar in this coming decade (Chart I-8). US growth was underperforming the rest of the world during that time. The primary driver was a commodity boom driven by massive infrastructure spending in China. This time around, a concerted push towards green energy will sustain bull markets in metals such as copper, nickel, cobalt, aluminum, and silver, benefiting the economies of producer countries (Chart I-9). Leaders in building renewable energy infrastructure, such as Europe, could also see a boom as demand for their goods and services rise. Chart I-8A Roadmap For The Dollar In The Next Decade Chart I-9At The Cusp Of A New Commodity Super Cycle? The aftermath of the tech bubble bust created extremely easy policy settings for the US. The Federal Reserve cut interest rates to a low of 1% in 2003. Meanwhile, fiscal policy was much more accommodative than what was needed to close the output gap. The combination led to a massive expansion in the US twin deficits, a similar situation to today (Chart I-10). Chart I-10A 2000s Roadmap Chart I-11Real Yields: Now Versus Then Excess demand in the US started to create inflationary pressures, with headline inflation consistently between 2-4% from 2000-2008. Real rates in the US cratered, which hurt the dollar. This time around, inflation is rising fastest in the US (even if it is transitory). Meanwhile, The Fed is the only central bank that has an asymmetric inflation target. Other central banks (such as the Reserve Bank of New Zealand, the Bank of Canada or Norges Bank) have stated they will normalize policy, even though they also view their inflation as transitory. So real rates are and will be rising faster outside the US (Chart I-11). In short, most of the conditions that have usually characterized a dollar bear market for a decade or so are in place today. The Federal Reserve is committed to staying easy, US real rates are depressed, and growth should be stronger outside the US compared to within it, a similar template to what we saw in the 2000s. From A Dollar Shortage To An Avalanche The dollar smile theory works particularly well when there is a shortage of dollars, like in 2020. The lack of dollar liquidity was a tailwind behind the dollar bull market during the last decade. Today, the Fed’s balance sheet is still expanding, and the massive liquidity injection from quantitative easing has tremendously improved the global supply of dollars. One measure of global dollar liquidity is the sum of the Federal Reserve’s custody holdings together with the US monetary base. Every time this measure has severely contracted in the past, the shortage of dollars has exacerbated a blow-up somewhere, typically among other countries running twin deficits (Chart I-12). For example, since the global financial crisis, a deceleration in this measure coincided with the European debt crisis, the China slowdown, and more recently, the COVID-19 crisis, with steep depreciation in many procyclical currencies and a vicious rally in the dollar. Chart I-12An Explosion In The US Monetary Base Fast forward to today and it is difficult to imagine such a scenario playing out over the next 9-12 months. The Fed has swap lines with many foreign developed and emerging market central banks that can draw on dollar liquidity until the end of this year. These lines are likely to be extended if the economic environment deteriorates before year-end. Meanwhile, the lack of uptake from these lines suggests foreign central banks are flush with dollars (Chart I-13). The Federal Reserve’s custody holdings also argue that there is little shortage of dollars internationally, compared to 2008 or 2020 (Chart I-14). With the US current account deficit widening, outflows of US dollars will continue to keep global dollar liquidity flush. Chart I-13Swap Lines Are Not Being Tapped Chart I-14Custody Holdings Are Picking Up Cross-currency basis swaps are well contained, suggesting no US dollar funding pressures abroad. Chart I-15Rising Non-USD Debt It is important to note that euro- and yen-denominated debt are also expanding (Chart I-15). These are smaller in outstanding amounts than US-denominated debt but reflect the gradual shift in the allocation of currencies away from dollars. In a nutshell, the system is awash with both dollars and other international reserve currencies, limiting the negative feedback loop that dollar shortages have usually triggered. Concluding Thoughts We made the case last week that the dollar is experiencing a countertrend bounce, likely to continue over the next month or so. Beyond that, however, the dollar should depreciate towards the end of the year into next year. Meanwhile, our analysis suggests the dollar smile theory works best near recessions when the US economy is likely to outperform and the safe-haven status of US Treasuries is likely to buffet the greenback. Outside of these periods which represent only 5% of the last four decades, the dollar smile theory falls apart. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies US Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 There were a few strong data releases out of the US: Inflation continues to inflect higher in the US. Headline CPI came out at 5.4% versus expectations of 4.9% in June. Core came in at 4.5% versus expectations of 4.0%. The PPI report was equally robust, with core prices rising well above expectations to the tune of 5.6%. The NFIB small business optimism survey jumped from 99.6 to 102.5. Empire manufacturing data for July was 43 versus 17.4 the prior month. The US dollar DXY index is up 0.4% this week. The big data release was the increase in US inflation but relative calm in bond markets seems to cement the view that financial participants consider it transitory. There is still scope for the US dollar to work off oversold conditions, but our bias is that it will be lower in the next 9-12 months. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 There was scant data out of the eurozone this week: The Bloomberg GDP survey showed that both Q2 and Q3 GDP growth were revised higher. 2022 growth was also revised higher from 4.2% to 4.3%. In the same survey, there was no change expected in policy rates in the foreseeable future. CPI across eurozone countries was in line with expectations: 2.5% in Spain, 2.1% in Germany and 1.9% in France for the month of June. Over the weekend, in a Bloomberg interview, Christine Lagarde told us to expect a significant update to the eurozone’s monetary policy and forward guidance in the July 22 meeting. Our bias is that given the new symmetric inflation target, PEPP will be rolled over into a new program, revised asset purchases will be announced to accommodate for climate change, and possibly more forward guidance that gives us a window into when the ECB will exit negative rates. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 There was some positive news out of Japan this week: Core machine orders rose 12.2% year on year in May, versus an expectation of a 6.3% increase. PPI came in at 5% year on year in June, in line with expectations. Machine tool orders rose 97% year on year in June. Importantly, domestic orders grew faster. The yen was down 0.14% against the dollar this week, after a stellar performance last week. The yen continues to sit in a sweet spot among G10 currencies. Falling nominal yields elsewhere are increasing the appeal of yen cash in real terms. Meanwhile, there is the upshot of cyclical improvement in Japan, which will benefit inflows into yen assets. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 There was significant data out of the UK this week: The 3-month-on-3-month GDP release for May came in at 3.6%, below expectations. Industrial production growth for May was 20.6% year on year, below the 27.5% increase in April. The trade deficit improved from GBP 11bn to GBP 8.5bn. CPI was above target in June, with core at 2.3% and the RPI at 3.9%. The house price index rose 10% year on year in May. Employment increased 25K in May, which disappointed expectations of a 91K increase. The pound rose 0.5% against the US dollar this week. The market reacted positively to the upside surprise in inflation, suggesting the BoE might normalize policy sooner than expected. Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 There were a few important data releases out of Australia this week: NAB business conditions deteriorated. The conditions component fell from 37 to 24 in June, while the confidence component fell from 20 to 11. Westpac consumer confidence rose slightly to 108.8 from 107.2 in July. The employment report was better than expected. There were 29.1K jobs added in June, pushing the unemployment rate down to 4.9%. The mix was also great with 51.6K full-time jobs added versus a loss of 22.5K part-time jobs. The AUD was up 0.13% this week against the USD. Melbourne has joined Sydney in the lockdown, and so there is room for economic data to keep disappointing over the next few weeks. In hindsight, the RBA’s decisively dovish bias relative to other central banks seemed to be the appropriate strategy. In the end, if the COVID-19 crisis proves transient, it will create a coiled spring response for the AUD. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The was scant data out of New Zealand this week: REINZ house prices rose 6.2% year on year in June. Net migration for May was 1182 versus 1087 the prior month. The NZD was up 60bps versus the US dollar this week. While the RBNZ kept interest rates at 0.25%, it signaled QE will end on July 23, a full year ahead of schedule. Markets are now priced for a rate hike as early as August. Our long CHF/NZD position was offside in this environment. Our conviction on this trade has fallen given the hawkish shift from the RBNZ, but we recommend holding onto this trade, as a reset in global asset prices could increase currency volatility and hurt the pair. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data out of Canada this week has been robust: The employment report was stellar. 231K new jobs were added in June. The unemployment rate fell from 8.2% to 7.8%. The participation rate also increased from 64.6% to 65.2%. The BoC kept interest rates on hold at 0.25% but cut its weekly asset purchases from C$3 billion to C$2 billion. The Bloomberg Nanos Confidence index held steady at 66.4. The CAD fell by 0.2% this week and was flat on the announcement. The loonie has softened since the bottom in the DXY index, as overbought conditions are being worked off. There was no new information out of the recent BoC meeting – the central bank is on pace to start lifting rates ahead of the Fed as long as Canada approaches full employment and inflation remains above target. This will limit downside on the CAD. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The was scant data out of Switzerland this week: Producer prices rose by 2.9% year on year in June. Total sight deposits were unchanged at CHF 712 bn for the week of July 9. The Swiss franc was down 0.3% this week, after a nice run-up last week. Falling yields will continue to improve the relative appeal of the franc, like the yen. The franc will also benefit from safe-haven inflows if equity markets correct. We are long the CHF/NZD cross on this basis and are sticking with this recommendation. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Data out of Norway is improving: June CPI came in at 2.9% as expected. Underlying CPI was also 1.4%. PPI came in at 37.1% year on year in June, driven by high oil prices. The trade balance improved from NOK 15.5bn to NOK 25bn in June. The NOK was down by 1.7% this week against the dollar. We have a limit-buy on the Scandinavian currencies at -1.4% from current levels, on expectation that the sell-off is short lived. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data from Sweden have been somewhat soft: Headline CPI fell from 1.8% in May to 1.3% in June. The core measure also fell from 2.1% to 1.6% but was better than expectations. The core core measure came in at 0.9% as expected. The SEK was the weakest G10 currency this week, falling by 0.7%. A disappointment in Swedish inflation is a surprise, given the inflationary overshoots we are seeing elsewhere. As Sweden is a small, open economy, inflation there will pick up (via imported inflation), which will lift expectations that the Riksbank will normalize policy. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020 Footnotes 1The theory was proposed by Stephen Jen, a former IMF economist and now a hedge fund manager at Eurizon SLJ Capital in London. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights It is too early to conclude that the PBoC’s surprise rate cut last Friday to its reserve requirement ratio (RRR) marks the beginning of another policy easing cycle. Historically it took more than a single RRR reduction to lower interest rates and to boost credit growth. Overall economic conditions do not yet suggest that Chinese policymakers will initiate a broad-based policy easing to spur demand. The end-of-July Politburo meeting will shed more light on whether there is a decisive turn in China’s overall policy stance. In previous cycles, consecutive RRR cuts led to bond market rallies, but were not good leading indicators for equities, which have been more closely correlated with cyclical swings in credit and business cycle. We recommend patience. Chinese onshore stocks are richly valued and their prices can still correct in Q3 when corporate profits and economic growth slow further. Feature The speed and magnitude of the PBoC’s 50-basis point trim in its RRR rate last week exceeded market expectations. The RRR rate drop, combined with June’s better-than-expected credit data, sparked speculation that China’s macroeconomic policy had shifted to an easier mode. A single RRR cut does not indicate that another policy easing cycle is underway. Rather, the PBoC’s intention is to prevent rising demand for liquidity in 2H21 from significantly pushing up interest rates. In addition, we do not expect that the credit impulse will decisively turn around until later this year. We will remain alert to any signs of additional policy easing, particularly because policymakers will face more pressure to maintain trend growth next year. The July Politburo meeting may provide more information on the direction of Chinese macro policy going forward. Meanwhile, investors should stay the course. In previous cycles there were long lags between the first RRR cut and sustained rallies in China’s onshore stock markets. We will continue to maintain an underweight stance towards Chinese stocks through the next three months, given that economic data and corporate profits will likely weaken further in Q3. Surprise, Surprise! The PBoC lowered the RRR rate only two days after the State Council mentioned the possibility, which exceeded the consensus. Historically, the PBoC has always made more than one RRR reduction during easing cycles, separated by about three months. Are more RRR cuts pending and does the initial decrease mark the beginning of another policy easing cycle? It is too early to conclude that a broad-based easing cycle has started, for the following reasons: First, economic fundamentals do not suggest an urgent need for policy easing. The economy is softening, but it is softening from a very elevated level (Chart 1). Importantly, production is weakening at a faster pace than demand and partially due to COVID-related idiosyncrasies. This supply-side issue cannot be solved by monetary easing. For example, the production subcomponent of the manufacturing PMI fell in June while new orders increased (Chart 2). Since its trough in April last year, the gap between new orders and production has consistently narrowed for 11 of the past 15 months, highlighting that the demand-side recovery has been outpacing the supply-side. The recent resurgence in COVID-19 cases and local lockdowns in Guangdong province, which is China’s manufacturing and export powerhouse, may have curbed June’s manufacturing production and new export orders. Global supply shortages in raw materials and chips also add to the sluggishness in manufacturing production. Chart 1Chinese Economy Is Slowing, But Not Too Slow Chart 2Demand Not As Soft Compared With Production Similarly, China’s service PMI slipped notably in June and has closely tracked the country’s domestic COVID-19 situation. The decline is an issue that policy easing and boosting demand will not solve (Chart 3). Secondly, global supply chains are still impaired and commodity prices remain elevated. Even though China’s PPI on a year-over-year basis rolled over in June, it is at its highest level since 2008 (Chart 4). As such, spurring demand through monetary easing would only exacerbate inflationary pressures among producers. Chart 3Slow Recovery In Services Largely Due To Lingering COVID Effects Chart 4Producer Prices Remain Elevated Apart from COVID-related disruptions, the weakness in China’s economy this year has been driven by slower growth in infrastructure and real estate investment due to tightened regulatory oversights that were put in place late last year (Chart 5). Construction PMI declined sharply from its peak in March and both excavator sales and loader sales have plummeted since Q1 this year (Chart 5, bottom panel). However, regulatory tightening towards the housing market and infrastructure projects remain firmly in place, suggesting that policymakers are not looking to stimulate the old economy sectors to support growth. Lastly, despite weaker home sales, housing prices in tier-one cities continue to escalate (Chart 6). The rising prices will keep authorities vigilant about excessive liquidity in the market. Chart 5It Has Been Chinese Policymakers' Intention To Slow The 'Old Economy' Sectors Chart 6Housing Market Mania Remains Authorities' Pressure Point Bottom Line: Supply-demand dynamics in the global economy and China’s domestic inflationary pressures suggest that it is premature to assume that the RRR cut marks the beginning of another policy easing cycle. Why Now? Chart 7More 'Pain' Needed For Broad Easing The drop in the RRR highlights the PBoC’s determination to maintain a low interest-rate environment without any further easing, and does not indicate that the central bank has shifted its current policy setting framework. The PBoC has been reactive rather than proactive in the past as it typically waits for severe signs of economic weakness before broadly relaxing its policy (Chart 7). The PBoC cited two main reasons for the RRR cut. One is to ease liquidity pressures of small to medium enterprises (SMEs), which have been struggling with rising input prices and subdued output prices (Chart 8). This motive is consistent with the PBoC’s monetary position so far this year –the central bank has kept rates at historical low levels while scaling back credit creation (Chart 9). Chart 8SMEs Under Elevated Pricing Stress Chart 9The PBoC Has Kept Rates At Historic Low Levels Demand for liquidity will rise meaningfully in the second half of the year due to an acceleration in local government bond issuance and the large number of expiring medium-term lending facility (MLF) loans and bonds. The liquidity gap could significantly push up interbank and market-based interest rates without the central bank’s intervention. The amount of maturing MLF and government bonds could be more than RMB1 trillion in July. Thus, the 50bp RRR cut, which the PBoC indicates will free up about RMB1 trillion of liquidity to the banking system, will ensure that interest rates remain stable. Chart 10Bank Lending Rates Have Not Declined With Policy Rates The PBoC also stated that it intends to keep down financing costs for both banks and SMEs. The statement is vague, but the PBoC may mean it plans to guide bank lending rates lower for SMEs and, at the same time, provide banks (particularly smaller banks) with enough liquidity to encourage lending to those enterprises. To achieve this goal, a broad-based RRR cut would be more effective than other monetary policy tools, such as open-market operations or MLF injections, which normally benefit large commercial banks more than their smaller counterparts. While interbank rates have been sliding since Q4 last year, the weighted average lending rates moved sideways and even ticked up slightly this year (Chart 10). As of Q1 2021, more than half of bank loans charged higher interest rates than the loan prime rate (LPR), highlighting a distribution matrix unfavorable to SMEs (Chart 11). Loan demand from SMEs, as shown in the PBoC survey, peaked much earlier and tumbled more rapidly than their large peers (Chart 12). Chart 11SMEs Face Rising Input And Funding Costs Chart 12Waning SMEs' Demand For Bank Credit Lowering lending rates for SMEs is usually at the cost of the banks by bearing higher default risks and lower profits. A RRR reduction, coupled with recent changes in banks’ deposit rate pricing mechanisms,1 are measures that can potentially reduce the banks’ liability costs. Bottom Line: The PBoC is using a RRR cut to avoid a sudden jump in interest rates from their low levels in 1H21, and to reduce funding costs for the SMEs and banks. What About Credit Growth? Chart 13Credit Numbers In June Beat Market Expectations Credit numbers beat the market’s expectations in June. Both credit growth and impulse rose slightly after a fast deceleration in much of 1H21 (Chart 13). We continue to expect the credit impulse to hover at a low level throughout Q3. Local government bond issuance will pick up in 2H21, but the acceleration will not necessarily lead to a reversal in credit growth (Chart 14). On a year-over-year basis, high base during Q3 last year will depress credit growth and impulse in the next three months. Moreover, in the past couple years, on average local government bonds account for only about 18% of annual total social financing. As such, the pace of bank loan expansion would need to substantially accelerate to reverse the slowdown in credit growth in the next three months. In previous cycles, on average it took more than one RRR cut and about two quarters for credit growth to turn around (Chart 15). Therefore, even if monetary policy is on an easing path, we expect credit growth to pick up in Q4 at the earliest. Chart 14LG Bonds Only A Small Part Of Total Credit Creation Chart 15Credit Growth Lags RRR Cuts By About Two Quarters Furthermore, policymakers are unlikely to deviate from targeting credit growth in line with nominal GDP this year. Based on our estimate, the target suggests that the overall credit impulse relative to 2020 will be negative this year (Chart 16). Chart 16Negative Credit Impulse In 2021 Relative To 2020 Chart 17The Credit Structure, Rather Than Volume, Will Improve In 2H21 Meanwhile, we think that the PBoC will focus on improving the structure of credit creation by continuing to encourage medium- to long-term lending, while scaling back shadow banking and short-term loans (Chart 17). Corporate bond financing improved slightly in June. However, room for further improvement in corporate bond issuance is small this year, given tightened financing reglations on local government financing vehicles. Downside potential for corporate bond yields is also limited in 2H21, when the economy slows and corporate bond default risks are rising (Chart 18). Given elevated housing prices and tightened regulations to contain the property sector’s leverage, bank lending to real estate developers and mortgages will continue to trend down in the foreseeable future, regardless the direction of interest rates (Chart 19). Chart 18Limited Upsides For Corporate Bond Issuance In 2H21 Chart 19Bank Loans To Property Market Unlikely To Pick Up In 2H21 Bottom Line: Regardless changes in monetary policy, credit growth will not decisively bottom until later this year. Investment Implications Chart 20Chinese Stock Prices Failed To Break Out Chinese stocks in both onshore and offshore equity markets failed to reverse their trend of underperformance relative to global stocks (Chart 20). Investors should be patient in upgrading their allocation to Chinese stocks from underweight to overweight, in both absolute terms and within a global equity portfolio. Historically, there has been a long lag between an initial RRR trim and a trough in Chinese onshore stock prices (Chart 21). Although prices moved up along with RRR cut announcements in the past, the price upticks were short lived. Stock prices in previous cycles troughed when the credit impulse and/or the economy bottomed. Given our view that a single RRR decrease does not indicate a broad-based policy easing and the credit impulse is unlikely to pick up until later this year, investors should wait for more price setbacks in Q3 before favoring Chinese stocks again. Chart 21Long Lags Between First RRR Cut And Stock Market Troughs We are slightly more optimistic than last month about Chinese bonds because the RRR cut has reduced the possibility for any substantial rise in interest rates in 2H21. However, we maintain a cautious view on Chinese government and corporate bonds in Q3. In previous cycles, onshore bond yields often fluctuated sideways or even climbed a bit following the first RRR reduction. It often took several RRR drops, more policy easing signals and sure signs of economic weakening for the bond market to enter a tradable bull run (Chart 22). Therefore, we recommend investors stay on the sidelines for a better entry price point. Chart 22It Takes More Than One RRR Cut To Start A Bond Market Bull Run It is also unrealistic to expect the RRR cut will lead to significant and sustained devaluation in the RMB relative to the US dollar. We expect the dollar index to rebound somewhat in Q3 on the back of positive US employment data surprises which will push US bond yields higher. However, following previous RRR cuts, the RMB had sizeable depreciations only when geopolitical events (the US-China trade war in 2018/19) or drastic central bank intervention (the August 2015 de-pegging from the USD) coincided with the RRR cuts. These scenarios are not likely to play out in the next six months (Chart 23). As such, we maintain our view that the CNY will slightly weaken against the USD in Q3 but will end the year at around 6.4. Chart 23Expect Muted And Short-Lived Movements In The USDCNY From A Single RRR Cut Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Footnotes 1The reform changes the way banks calculate and offer deposit rates. The upper limit is set on their deposit interest rates by adding basis points to the central bank’s benchmark deposit rates, rather than multiplying the benchmark rates by a specific number. Exclusive: Banks Prepare to Lower Deposit Rates as Rate Cap Reform Takes Effect (caixinglobal.com) Cyclical Investment Stance Equity Sector Recommendations
Feature Since the end of the first quarter, the decline in Treasury yields has been the most important trend in global financial markets. It has contributed to the return of the outperformance of growth stocks relative to value stocks, the underperformance of Eurozone equities relative to the S&P 500, and the tepid results of cyclicals relative to defensive equities. This decline in yields is a temporary phenomenon, because the global economy continues to re-open and inventory levels remain so low that further restocking is in the cards. The cyclical picture is not without blemish; COVID-19 variants remain a concern. However, if these risks were to materialize into another delayed re-opening, then further reflationary efforts by both monetary and fiscal authorities would buoy financial markets. The greatest near-term worry for the global economy and markets comes from China. The Chinese credit impulse is slowing markedly and fiscal support has yet to come to the rescue. This phenomenon is the main reason why this publication maintains a cautious tactical stance on Eurozone cyclical stocks, even if we believe these sectors have ample scope to outperform over the remainder of the business cycle. As a corollary, we believe that yields will likely remain within range this summer and Eurozone benchmarks will lag behind the US. This week, we review key charts, organized by theme, highlighting some of these key concepts. As an aside, none covers inflation. Even if the balance of evidence suggests that any sharp increase in Eurozone inflation will be temporary, the proof will only become more visible by early 2022. The Opening Is On Track… The pace of vaccination across the major Eurozone economies has picked up meaningfully since the spring. Consequently, the number of doses distributed per capita is rapidly approaching that of the US, even as it still lags behind that of the UK (Chart 1). As a result of this improvement, the stringency of lockdown measures is declining, which is allowing European mobility to recover (Chart 2). While this phenomenon is evident around the world, EM still lag in terms of vaccination rates. However, the Global Health Innovation Center at Duke University expects 10 billion vaccine doses to be produced by the year’s end, which will be enough to inoculate most (if not all) the vulnerable people in the world by early 2022. Consequently, the re-opening of the economy will remain a potent tailwind behind global growth for three or four more quarters. Chart 1Vaccination Progress... Chart 2...Leads To Greater Activity … But Near-Term Headwinds Remain The re-opening of the global economy will allow growth to stay well above trend for the upcoming 12 months, at least. Global industrial activity could nonetheless decelerate this summer. Input costs have risen. The two most important ones, oil and interest rates, are already consistent with a peak in the US ISM manufacturing and the global PMI (Chart 3). In this context, the decelerating Chinese credit impulse is concerning (Chart 4) because it portends a hit to global trade and industrial activity. The effect of this slowdown should be most evident in the third and fourth quarters of 2021. However, it will be temporary because Beijing only wants credit to grow in line with GDP, rather than an outright deleveraging. Thus, the credit impulse will stabilize before the year’s end, which will allow the positive effect of the global re-opening to be fully experienced once again. Chart 3Rising Input Costs... Chart 4...And China's Credit Slowdown Matter Domestic Tailwind In Europe Despite the extreme sensitivity of the European economy to the global business cycle, Europe should continue to produce positive surprises. The supports to the domestic economy are strong. The NGEU funds means that Europe will suffer one of the smallest fiscal drag among G-10 nations next year. Moreover, the re-opening will support household income and allow the positive effect of the increase in the money supply to buoy consumption (Chart 5). Finally, rising consumer confidence, and the ebbing propensity to save will reinforce the tailwinds behind consumption (Chart 6). Chart 5Europe's Domestic Activity Chart 6...Will Improve Further Higher Bond Yields Are Coming… The environment continues to support higher yields. Our BCA Pipeline Inflation Indicator is surging, which historically translates into higher global borrowing costs (Chart 7). Most importantly, our Nominal Cyclical Spending Proxy remains very robust, which normally leads to rising yields (Chart 8). While US inflation expectations at the short end of the curve already fully reflect current inflationary pressures, the 5-year/5-year forward inflation breakeven rates will have additional upside. Moreover, the term premium and real rates remain depressed, and policy normalization will cause these variables to climb higher over time. Chart 7Higher Yields Will Come... Chart 8...Later This Year … But Not This Summer It could take some time before the bearish backdrop for bonds results in higher bond yields. First, bonds have yet to purge fully their oversold status created by the 125 basis-point surge that took place between August 2020 and March 2021 (Chart 9). This vulnerability is even more salient in an environment in which the Chinese credit impulse is decelerating. As Chart 10 illustrates, a slowing total social financing number reliably leads to bond rallies. While the chart looks dire for bond bears, it must be placed in context, in which global fiscal policy remains accommodative considering the decline in the private sector savings rate and in which Advanced Economies’ capex will stay strong. Thus, instead of betting on a large swoon in yields in the coming quarters, we expect US yields to remain stuck between 1.20% and 1.70% for a few more months before they resume their upward path once the Chinese economy stabilizes. Chart 9But Bonds Are Still Oversold... Chart 10...And Fundamentals Cap Yields For Now A Positive Cyclical Backdrop For The Euro The near-term forces suggest that the euro will remain range bound over the summer, between 1.16 and 1.23. EUR/USD is a pro-cyclical pair, and so the near-term lack of upside to global growth will act as a temporary ceiling on this currency. Nonetheless, the 18-month outlook continues to favor the common currency. Investors have shed Eurozone exposure for more than 10 years and are structurally underweight this region (Chart 11). Hence, EUR/USD should benefit from any positive reassessment of the growth path in the Euro Area compared to that of the US. Additionally, the euro benefits from a structural current account surplus compared to the USD, which translates into a positive basic balance of payments (Chart 12). In an environment in which US real interest rates are low in relation to foreign ones and in which the Fed wants to maintain accommodative monetary conditions to achieve maximum employment, the capital account balance is unlikely to come to the rescue of the dollar. In this context, EUR/USD still possesses significant cyclical upside and is likely to move back above 1.30 by the year’s end of 2022. Chart 11Investors Underweight Eurozone Assets... Chart 12...And The BoP Favors The Euro The Bull Market In Global Stocks Is Not Over The cyclical outlook for equities remains supportive. To begin with, in most years, equities eke out positive returns, as long as a recession is not around the corner; we do not expect a recession anytime soon. Moreover, while the balance of valuation risk and monetary accommodation is not as supportive of stocks as it was last year, it is not pointing to an imminent deep pullback either (Chart 13). The equity risk premium echoes this message. Our ERP measure adjusts for the expected growth rate of earnings as well as the lack of stationarity of the ERP. According to this indicator, equities are not an urgent buy, but they are not at risk of a bear market either (Chart 14). This combination does not prevent corrections, but it suggests that pullbacks of 10% are to be bought. Chart 13Equities Are Not A Screaming Buy... Chart 14...Nor A Screaming Sell Europe’s Structural Underperformance Is Intact… Eurozone stocks have been underperforming their US counterparts since the GFC. As Chart 15 highlights, this subpar performance reflects the decline in European EPS relative to US ones. There is very little case to be made for this underperformance to end on a structural basis. Europe remains saddled with an excessive capital stock and ageing assets. This combination is weighing on European profit margins and RoE (Chart 16). To put an end to this structural underperformance, either European firms will have to consolidate within each industry (allowing cuts to the excess capital stock, to increase concentration, and to boost profit margins) or the regulatory burden must rise in the US to curtail rates of returns in relation to European levels. Chart 15Europe's Underperformance... Chart 16...Reflects Profitability Problems …But The Window For A Cyclical Outperformance Remains Open Despite a challenging structural backdrop, European equities have a window to outperform US stocks, similar to the outperformance of Japan from 1999 to 2006, which only marked a pause within a prolonged relative bear market. European stocks beat their US counterparts when global yields rise (Chart 17). This is because European benchmarks underweight growth stocks relative to US markets. The effect of higher yields on the relative performance of the Euro Area is not limited to the impact of higher discount rates. Yields rise when global economic activity is above trend. As Chart 18 highlights, robust readings of our Global Growth Indicator correlate with an outperformance of the EPS of value stocks compared to growth equities. Thus, when rates rise, Europe should enjoy both a period of re-rating relative to the US and stronger profits. Chart 17Yields Drive European Stocks... Chart 18...And So Does Global Growth Positives For Euro Area Financials Like the broad European market, the financials’ fluctuations are linked to interest rates. Moreover, Euro Area banks also move in line with EUR/USD (Chart 19). As a result, our positive view on both yields and the euro for the next 18 months or so should translate into an outperformance of financials in Europe. Additionally, European banks are inexpensive, embedding not just depressed long-term growth expectations, but also a wide risk premium. Europe’s structural problems mean that investors are correct to expect poor earnings growth from the region’s banks. However, the risk premium is overdone. Eurozone banks are much safer than they were 10 years ago. Banks now sport significantly higher Tier 1 capital adequacy ratios and NPLs have shrunk considerably (Chart 20). Moreover, governmental supports and credit guarantees implemented during the pandemic should limit the upside to NPL in the coming quarters. Finally, the so-called doom-loop that used to bind government and bank solvency together is not as problematic as it once was, because the ECB is a willing buyer of government paper and the NGEU programs create the embryo of fiscal risk sharing that limit these dynamics. As a result, investors should overweight this sector for the next 18 months. Chart 19Financials Have A Window To Shine... Chart 20...And Are Less Risky A Tactical Hedge Our worries about the impact on the global economy of the Chinese credit slowdown are likely to prompt some downside in European cyclical equities relative to defensive ones. Moreover, cyclicals are still significantly overbought relative to defensives, while our relative Combined Mechanical Valuation Indicator confirms the near-term threat (Chart 21). A high-octane vehicle to play this tactical underperformance of cyclicals relative to defensives is to buy Euro Area telecom stocks relative to consumer discretionary equities. Not only are the discretionary stocks massively overbought and expensive relative to telecoms (Chart 22), they also offer a lower RoE. This backdrop makes the short discretionary / long telecoms bet a great hedge for portfolios with a pro-cyclical bias over one- to two-year horizons. Chart 21Cyclicals Are Tactically Vulnerable... Chart 22...But This Risk Can Be Hedged Away Currency Performance Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance
Highlights Our sense remains that the dollar is undergoing a countertrend bounce, rather than entering a new bull market. The litmus test for this view is if the DXY fails to break above the 93-94 level that marked the March highs. Stay short USD/JPY. The drop in global bond yields should give this trade a welcome fillip. Short GBP/JPY positions also make sense. We are long CHF/NZD as a play on a potential increase in currency volatility. Look to rebuy a basket of Scandinavian currencies versus the USD and EUR at a trigger point of -2% from today’s levels. Remain long silver both in absolute terms and relative to gold. Our limit buy on EUR/USD was triggered at 1.18. Place tight stops given the potential for the dollar rally to continue for the next few weeks. We also believe the change in the ECB’s framework portends another bullish tailwind for the euro beyond the near term. Feature In our webcast last week, we made the case that the recent FOMC meeting (perceived as hawkish by market participants) has not altered the longer-term downtrend in the US dollar. This week, we are revisiting some of the sentiment and technical indicators that could help gauge how high the dollar can rise in the interim. Our view remains that three fundamental forces will continue to dictate currency market trends into the year end and beyond. First, the Federal Reserve will lag other central banks in raising rates amidst a shift in economic momentum from the US towards the rest of the world. This will boost short-term interest rates outside the US and provide a floor for procyclical currencies. Second, US inflation will prove stickier compared to other countries such as the eurozone or Japan. This will depress real interest rates in the US relative to the rest of the world, and curb bond inflows. And finally, an equity market rotation towards non-US stocks will improve flows into cyclical currencies. The transition could prove volatile in the coming month or so. Equity markets remain overbought, bond yields are falling, PMIs have stopped rising, and cyclical stocks are lagging growth stocks. More widespread infection from the Delta variant of Covid-19 will continue to reprice risk to the downside. As a countercyclical currency, the dollar will be a critical variable to watch. Sentiment and technical indicators make up an important component of our currency framework and are usually good at gauging significant shifts in financial markets. Our sense remains that the dollar is undergoing a countertrend bounce, rather than entering a new bull market. The litmus test for this view is if the DXY fails to break above the 93-94 level that marked the March highs. Momentum Indicators Our momentum indicators suggest that while the dollar is very oversold, the bear market remains very much intact. The dollar advance/decline line is sitting below its 200-day moving average (Chart I-1). Historically, bull markets in the dollar have been characterized by our advance/decline line breaking both above its 200-day and 400-day moving averages. This suggests a rally towards these critical resistance levels is in play but will constitute more of a countertrend bounce. Speculators are only neutral the dollar while, admittedly, leveraged funds are very short (Chart I-2). Historically, whenever the percentage of leveraged funds that are short the dollar has dipped near 40%, a meaningful rally has ensued. There are two important offsets to this. First, as Chart I-1 suggests, the dollar is a momentum currency. As such, during the bull market of the last decade, speculators were either neutral or long the dollar. If indeed the paradigm has shifted to a decade-long bear market, we expect speculators to be either short or neutral. Meanwhile, leveraged funds are a small subset of overall open interest, suggesting they are not the elephant in the room when it comes to dictating dollar movements. Leveraged funds were short the dollar during most of the bull market run last decade. Chart I-1The US Dollar Downtrend Is Intact Chart I-2Leveraged Funds Are Short The Dollar Carry trades are relapsing anew, suggesting the environment may be becoming unfavorable for high-yielding developed and emerging market currencies. The dollar has been negatively correlated with the Deutsche Bank carry ETF, DBV, since investors ultimately dump carry trades and fly to the safety of Treasurys on any market turbulence (Chart I-3). High-beta carry currencies such as the RUB, ZAR, MXN, and BRL have been consolidating recent gains. These currencies are usually good at sniffing out a change in the investment landscape, specifically one becoming precarious for carry trades. Our carry index tends to do well when the yield spread between US Treasuries and the indexes’ constituents’ is low. As such, there is some more adjustment underway, but one of limited amplitude (Chart I-4). Chart I-3The Carry Trade Rally Is Relapsing Chart I-4Carry Trades Have Hit An Air Pocket Chart I-5Currency Volatility Is Very Low Both expected and actual currency volatility are extremely depressed. Whenever currency volatility has been this low, the dollar has staged a meaningful rally. For example, the most significant episodes were the lows of 1996-1997, 2007-2008, and 2014-2015, and early 2020 (Chart I-5). Usually, low currency volatility is a sign of complacency, while higher volatility allows for a more balanced and healthy market rotation. The nature in which currency volatility adjusts higher this time around might be the same playbook as in previous episodes. The Asian crisis of the late 90s set the stage for the dollar bear market of the 2000s. The adjustment higher in the dollar during the Global Financial crisis jumpstarted the bull market the following decade. This time around, the Covid-19 crisis might have commenced a renewed dollar bear market. If this analogy is correct, then we should be selling the dollar on strength rather than buying on weakness. It is important to remember that the policy environment remains bearish for the dollar. These include deeply negative real rates, quantitative easing (which, admittedly, will soon end), generous liquidity swap lines to assuage any dollar funding pressures abroad (Chart I-6), and a global economy on the cusp of a renewed cycle. In our portfolio, we are long CHF/NZD since this cross has historically been a good hedge against rising currency volatility (Chart I-7). So is being short AUD/JPY. Being short the GBP/JPY cross might prove even more profitable, given that the UK has been a pandemic winner this year. Chart I-6The Fed Extended Its Swap Lines Chart I-7Buy CHF/NZD As Insurance Bottom Line: The message from our momentum indicators is that the bounce in the dollar was to be expected. We remain in the camp that believes the rally will be short-lived but are opportunistically playing what could be a more volatile environment. Equity Markets Signals A potential catalyst that could trigger further upside in the dollar is an equity market correction. Both the dollar and equities tend to be inversely correlated (Chart I-8). On this front, a few equity market indicators continue to flag that the rally in the dollar has a bit further to go. Chart I-8The Dollar And Equities Move Opposite Ways Chart I-9Global Industrials Are Relapsing Anew The underperformance of cyclical stocks, especially global industrials, suggests equity markets could be entering a more volatile phase (Chart I-9). The dollar tends to strengthen when cyclical stocks are underperforming defensive ones. This is because non-US equity markets have a much higher concentration of cyclical stocks in their bourses. In more general terms, non-US markets are underperforming the US, a clear sign that the marginal dollar is rotating back towards the US (Chart I-10A and I-10B). Technology stocks have also been well bid in recent weeks, on the back of lower bond yields. These are all temporary headwinds for dollar weakness. Chart I-10ANon-US Stock Markets Are Underperforming Chart I-10BNon-US Stock Markets Are Underperforming Chart I-11US Relative Earnings Revisions Are High, But Rolling Over Earnings revisions continue to head higher across most markets, but US profit expectations are still higher compared to other countries (Chart I-11). Non-US bourses will need much higher earnings revisions to stimulate portfolio inflows, and for the dollar bear market to resume. On this front, both the euro area and emerging markets are showing only tentative improvement. The character of any selloff in equity markets will be worth monitoring. Cyclicals and value stocks are at historically bombed-out levels and could start to outperform high-flying stocks on any market reset. Bottom Line: Whether a correction ensues, or the bull market continues, requires a change in equity market leadership from defensives to cyclicals. This is a necessary condition for the dollar bear market to resume. Commodities, Bonds, And The Dollar Commodity and bond prices give important cues about the health of the global economy. For example, rising copper prices and rising yields are a sign that industrial activity is humming, which in turn points to accelerating global growth. As a counter-cyclical currency, the dollar usually weakens in this scenario. Rising gold prices are generally a sign that policy settings remain ultra-accommodative, which also points to a weaker dollar. At the FX strategy service, we tend to focus more on the internal dynamics of commodity and bond markets, which can provide early warning signs. Chart I-12The Copper-To-Gold Ratio Is Consolidating Gains The copper-to-gold ratio is important since it indicates whether the liquidity-to-growth transmission mechanism is working. A rising ratio suggests policy settings are stimulating growth, while a falling ratio is a warning shot that the environment might be becoming deflationary. Correspondingly, this ratio has tended to track the dollar closely (Chart I-12). The copper-to-gold ratio is consolidating at very high levels. This is consistent with a healthy reset, rather than a reversal in the dollar bear market. The gold/silver ratio (GSR) tends to track the US dollar, and its recent price action also appears to be a welcome reset (Chart I-13). Like copper, silver benefits from rising industrial demand, especially in the electronics and renewable energy space. A falling GSR will be a sign that the manufacturing cycle is still humming. We are short the GSR with a target of 50, and a stop-loss at 71. The bond-to-gold ratio has bounced from very oversold levels. Both US Treasurys and gold are safe-haven assets and thus are competing assets. Remarkably, the ratio of the total return in US government bonds-to-gold prices has tracked the dollar pretty well since the end of the Bretton Woods system in the early ‘70s (Chart I-14). Gold has always been considered the perfect anti-fiat asset vis-à-vis the dollar, making the bond-to-gold ratio both a good short-term and long-term sentiment indicator. For now, the bounce in the ratio is not yet worrisome. We have noticed that inflows into US government bonds have risen sharply, while those into gold are falling. This should soon reverse with the fall in US rates, and the correction in gold prices. Chart I-13The Gold-To-Silver Ratio Is Consolidating Losses Chart I-14Competing Assets And The Dollar Bottom Line: The US is ultimately generating the most inflation in the G10, which is dampening real rates, and should curtail investor enthusiasm for gold relative to US Treasurys. The underperformance of Treasurys relative to gold will be a bearish development for the dollar. A Final Word On The Euro The strategic review from the European Central Bank had three key changes. The ECB now has a symmetric 2% inflation target. This is not a game changer, since it brings it in line with other global central banks, including the Bank of Japan. House prices will meaningfully begin to impact monetary policy, as the committee eventually includes owner’s equivalent rent (OER) in the HICP index (the ECB’s preferred inflation measure) for the euro area. This could be a game changer for the ECB’s price objective. Climate change was reiterated as important for price stability. Financial stability was also repeated as an important objective. As FX strategists, the second change was the most important. Shelter constitutes 17.7% of the euro area CPI basket, but it is 32.9% of the US CPI basket (Table I-1). Meanwhile, the shelter component of both the CPI basket in the US and euro area have tracked each other (Chart I-15). Table I-1Euro Area CPI Weights Chart I-15What Will Happen To Eurozone Inflation? An adjustment in the weight of the shelter component in the euro area will boost the European CPI relative to the US and could trigger a major policy shift from the ECB in the coming years. This will especially be the in case if the current environment generates an inflationary shock. Bottom Line: The ECB will stay very accommodative in the next 1-2 years, but the change in its mandate could portend a bullish tailwind for the euro beyond the near term. Investment Implications We expect the current dollar rebound to be short-lived. As such, our strategy is as follows: Stay long other safe-haven currencies. Our preferred vehicle is the Japanese yen, which sports an attractive real rate relative to the US. Investors can also short GBP/JPY from current levels. Chart I-16The Euro, Yen And Real Rates Our limit-buy on EUR/USD was triggered at 1.18. Given our expectation that the dollar could rally in the near term, we are setting the stop-loss at the same level. However, the improvement in real rates in the euro area relative to the US could cushion any downside (Chart I-16). We are also long CHF/NZD, as a bet on rising currency volatility. Correspondingly, we are setting a limit buy on Scandinavian currencies relative to the euro and USD at a trigger level of -2%. Both gold and silver benefit from the current environment, but we prefer silver to gold, due to the former’s call option on continued improvement in global growth. We are short the gold/silver ratio from the 68 level. Overall, we expect the dollar to weaken towards the end of the year, as has been the case since the 1970s (Chart I-17). Chart I-17The Yen And Swiss Franc Are Usually Winners In H2 Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies US Dollar USD Technicals 1 USD Technicals 2 The recent data out of the US have been robust: June non-farm payrolls showed an increase of 850K jobs, versus expectations of a 700K increase. The unemployment rate was relatively flat at 5.9% in June. Factory orders came in at 1.7% year-on-year in May, in line with expectations. The US dollar DXY index is relatively flat this week, but with tremendous volatility. It was a relatively quiet week in the US, due to Independence Day, but the key theme remained a drop in US yields, with the 10-year yield moving from a high of near 1.8% this year to 1.3% currently. This move has catalyzed rallies in lower beta currencies, such as the yen and Swiss franc. The FOMC minutes released this week continue to suggest a Fed that will remain very patient in both tapering asset purchases and lifting interest rates. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro EUR Technicals 1 EUR Technicals 2 Recent data from the euro area were mixed: The PPI print for May came in at 9.6%, in line with expectations. Both the services and composite PMI were revised higher by 0.3 in June. At 59.2, the composite PMI is the highest in over a decade. ZEW expectations for the euro area fell sharply from 81.3 to 61.2. In Germany, there was a big decline in automotive surveys. The euro was flat this week against the dollar, despite gains overnight. The big news was the change in the ECB’s monetary policy objectives, which we discussed briefly in the front section of this report. The euro rallied on the news of three fundamental drivers in our view – real rate differentials are improving in favor of Europe, the ECB’s consideration for house price inflation could allow its price stability objective to be achieved sooner, and consideration for financial stability will be less favorable for negative interest rates. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Yen JPY Technicals 1 JPY Technicals 2 Recent data from Japan remains subpar, but is improving: Labor cash earnings rose 1.9% in May, in line with expectations. Household spending rose 11.6% in May, in line with expectations. The Eco Watchers Survey for June came in at 47.6 from a May reading of 38.1. The outlook component rose from 47.6 to 52.4. The yen was up by 1.6% against the USD this week, the best performer. We argued a month ago that the yen is the most underappreciated G10 currency today. The catalyst that triggered yen gains were a drop in US real rates, that favored other safe-haven currencies. Going forward, further yen gains should materialize on the back of Japan successfully overcoming the pandemic like its Western counterparts. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound GBP Technicals 1 GBP Technicals 2 There was scant data out of the UK this week: The construction PMI rose from 64.2 to 66.3 in June. House prices remain robust, with the RICS house price balance printing an elevated 83% in June. The pound was flat this week against the USD. The new delta variant of the COVID-19 virus is gaining momentum in the UK and will likely erode some of the dividends GBP had priced in from a fast vaccine rollout. As such, short GBP positions may pay off in the near term. Shorting GBP/CHF could be an attractive near-term hedge. Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020 Australian Dollar AUD Technicals 1 AUD Technicals 2 There was scant data out of Australia this week: The Melbourne Institute of Inflation survey came it at 3% year on year in June, from 3.3%. The RBA kept interest rates unchanged at 0.1%, reiterating its commitment to stay accommodative until inflation and wages pick up meaningfully. The AUD was down by 0.4% this week against the USD. The RBA is decisively lagging other central banks in communicating less monetary accommodation in the coming years. This will create a coiled spring response for the AUD, because the RBA will have to eventually play catchup as the global economic cycle gains momentum. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar NZD Technicals 1 NZD Technicals 2 The was scant data out of New Zealand this week: ANZ commodity price index rose by 0.8% in June. The NZD was down 0.3% against the dollar this week. Our long CHF/NZD position paid off handsomely in this environment. We recommend holding onto this trade, as a reset in global rates hurts the hawkish pricing in the NZD forward curve. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar CAD Technicals 1 CAD Technicals 2 Canadian data softened but remained robust: Building permits fell by 14.8% month on month in May. The Markit manufacturing PMI fell from 57 to 56.5 in June. The Canadian trade balance deteriorated from C$0.6bn to a deficit of -C$1.4bn in May. Business Outlook Survey indicator hit the highest level on record. As the Bank of Canada put it, improving business sentiment is broadening. The CAD fell by 0.8% against USD this week. The results of the BoC survey highlight that a reopening phase is categorically bullish for economic activity in general and financial prices. Until recently, the CAD was one of the best performing currencies in the G10. This is a sea change from a country that was previously a laggard in vaccination efforts. CAD should hold up well once the dollar rally fades, but other currency laggards such as SEK and JPY could do even better. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc CHF Technicals 1 CHF Technicals 2 The was scant data out of Switzerland this week: The unemployment rate was near unchanged at 3.1% in June, from 3.0%. Total sight deposits were unchanged at CHF 712 bn on the week of July 2. The Swiss franc was up by 1.1% this week against the USD. Falling yields improved the relative appeal of the franc that has bombed out interest rates. The franc is also benefiting from the rising bout of volatility as a safe-haven currency. On this basis, we are long CHF/NZD cross, which performed well this week. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone NOK Technicals 1 NOK Technicals 2 Data out of Norway is improving: The unemployment rate fell from 3.3% to 2.9% in July. Industrial production growth came in at 2.1% year-on-year in May. Mainland GDP rose by 1.8% month on month in May. The NOK was down by 1.8% this week against the dollar, the worst performing G10 currency. The NOK is bearing the brunt of a reset in the US dollar, but our bias is that we are nearing a buy zone. NOK is cheap, would benefit from high oil prices and the economy is on the mend. We are looking to sell EUR/NOK and USD/NOK on further strength. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 Swedish Krona SEK Technicals 1 SEK Technicals 2 Recent data from Sweden have been mildly positive: The Swedbank/Silf composite PMI fell from 70.2 to 66.9 in June. Industrial production came in at 24.4% year on year in May, after a rise of 26.4% in April. Household consumption jumped 8.8% year on year in April. The SEK was also up this week against the USD. Bombed-out interest rates in Sweden have also improved the appeal of the franc, given falling global bond yields. Meanwhile, the SEK remains one of the cheapest currencies in our models. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades