Currencies
Highlights Fiscal policy is likely to be eased modestly in most advanced economies over the next two years. The U.S. Congress will ultimately cut taxes, although the size of the cuts will be far smaller than what President Trump has proposed. Ironically, fiscal stimulus is coming to America just when the economy has reached full employment. The market is pricing in too little Fed tightening over the remainder of the year. The dollar's swoon is ending. Go short EUR/USD with a target of parity by the end of the year. Feature Fiscal Thrust Around The World In its latest Fiscal Monitor, the IMF estimated that advanced economies eased fiscal policy by 0.2% of GDP in 2016, reversing a five-year streak of fiscal tightening (Chart 1). The Fund expects a further 0.1% of GDP of easing in 2017, followed by a neutral stance in 2018. In the EM universe, the IMF foresees a fiscal thrust1 of -0.2% of GDP in 2017 and -0.4% of GDP in 2018. Chart 1IMF Expects Modest Fiscal Easing In Advanced Economies, Further Tightening In EM Averages can disguise a lot of variation across countries (Charts 2). Comparing 2018 with 2016, the IMF expects Canada and the U.S. to experience a positive fiscal thrust of 0.7% of GDP and 0.4% of GDP, respectively. The fiscal thrust is projected to be -0.2% of GDP in the euro area, -1% of GDP in the U.K., and -0.5% of GDP in Japan. Among the larger advanced economies, Australia is expected to experience the largest degree of fiscal tightening, with a fiscal thrust of -1.2% of GDP. Across the EM universe, most of the fiscal tightening is projected to occur among oil producers. The IMF expects oil-exporting economies to collectively reduce their fiscal deficits by US$150 billion between 2016 and 2018. Political considerations require that the IMF give considerable weight to the stated objectives of governments when formulating fiscal projections. In reality, governments often struggle to meet their budget targets. Consequently, the Fund has typically overestimated the degree of fiscal consolidation that ends up happening (Chart 3). As such, our own projections foresee somewhat less fiscal tightening - and in some countries, a fair bit of fiscal easing - than the IMF projects. In particular: Chart 2Countries Will Follow Different Fiscal Paths Chart 3IMF Forecasts Tend To Overestimate Extent Of Fiscal Consolidation We do not expect much more incremental fiscal tightening out of the euro area. Thanks to a slew of austerity measures, the euro area's structural primary budget balance went from a deficit of 2.6% of GDP in 2010 to a surplus of 1.0% of GDP in 2014. It has remained close to those levels ever since. Now that a primary surplus has already been achieved and interest rates and bond spreads have fallen to exceptionally low levels, the need for further belt tightening has abated. That's the good news. The bad news is that high government debt levels in many European economies rule out any major new stimulus programs (Chart 4). The U.K. will slow the pace of fiscal consolidation. The U.K.'s structural primary budget deficit fell from a peak of 7.1% of GDP in 2009 to 1.3% of GDP in 2016. The IMF expects the primary balance to move into a surplus of 0.6% of GDP in 2019. We think that's unlikely. The Conservatives are under intense pressure to keep the economy afloat during Brexit negotiations. Prime Minister Theresa May has indicated she will delay eradicating the budget deficit until the middle of the next decade, having previously promised a 2020 target date. Japan has limited scope to further tighten fiscal policy. Japan's structural primary budget deficit reached 6.9% of GDP in 2010. The IMF expects it to reach 3.7% this year and fall further to 2% in 2020, provided the government goes forward with raising the VAT from 8% to 10%. We are skeptical that Japan's economy will be strong enough to allow the government to raise taxes. However, even if it is, this will only be because the Bank of Japan gooses growth by keeping long-term yields pinned to zero, thereby allowing the yen to depreciate further. China is making a structural transition to large budget deficits. The IMF estimates that China's structural primary budget balance deteriorated from a surplus of 0.1% of GDP in 2014 to a deficit of 2.8% of GDP in 2016. The increase in the fiscal deficit cannot be explained by the reclassification of off-budget spending as on-budget, since the IMF's "augmented" fiscal balance - which attempts to control for such statistical issues - deteriorated by roughly the same amount (Chart 5). Part of the erosion in China's fiscal balance stemmed from the global manufacturing slowdown in 2015-2016, which hit tax receipts and necessitated a healthy dose of fiscal stimulus. However, there is more to the story than that. As we controversially argued in "China Needs More Debt," now that China is no longer in a position to run gargantuan current account surpluses, large fiscal deficits will be necessary to absorb excess private-sector savings.2 The government's desire to rein in credit growth will only add to the impetus to find new sources of aggregate demand. The era of red ink has begun. Chart 4Government Debt Levels Outside Of Germany Are Still High Chart 5China's Fiscal Deficit Has Been Increasing The U.S. Congress will ultimately cut taxes, although the size of the cuts will be far smaller than what President Trump has ambitiously proposed. After a wave of euphoria following the presidential election, the market has largely priced out meaningful fiscal stimulus. This can be seen in the flagging relative performance of infrastructure stocks and highly-taxed companies, as well as in the sharp decline in inflation expectations (Chart 6). We think this pessimism is overdone. Donald Trump desperately needs a "win," and cutting taxes is one key area where the President and Congress both see eye to eye. Trump's falling poll numbers have heightened the risk that the Republicans will lose control of the House of Representatives next November (Chart 7). This makes passing a tax bill before the midterm elections all the more urgent. The main questions surround the scale and scope of any tax cuts, and just as critically, how they are paid for. We discuss these issues next. Chart 6Markets Have Priced Out Meaningful Fiscal Stimulus Chart 7Challenging Outlook For Republicans In 2018 Trump's Budget Proposal: Fake Math Chart 8Trump In Wonderland? If the definition of a good leader is one who underpromises and overdelivers, then President Trump's budget proposal left much to be desired. Trump's plan assumes that U.S. growth will reach 3% over the next ten years. Even in the unlikely event that the economy manages to avert a recession over this period, such a growth rate would be a remarkable feat. After all, growth has averaged only 2.1% since 2009. And keep in mind that the unemployment rate has fallen from 10% to 4.4% over this interval, consistent with potential GDP growth of only 1.4%. The slow pace of capital accumulation following the Great Recession undoubtedly hurt the supply side of the economy, but it would take a phenomenal - and rather implausible - acceleration in potential GDP growth to justify Trump's 3% target. Many of the other assumptions in Trump's blueprint are no less dubious (Chart 8). Despite projecting much slower growth, the Federal Reserve expects short-term rates to rise to 3% in 2019. In contrast, the Trump administration sees rates increasing to only 2.4%, an assumption that perhaps not coincidentally helps reduce projected debt-servicing costs. Most flagrantly, the plan assumes no decline in the revenue-to-GDP ratio, even though the basis for faster growth largely rests on the assumption of steep tax cuts. When pressed on the issue, officials from the Office of Management and Budget sheepishly noted that there would be offsetting limits on tax deductions, which would have the effect of broadening the tax base. However, no specific information was given on what these would entail. Many theories have been offered as to why Trump offered such an outlandish budget plan. Was he trying to appease conservatives in Congress? Perhaps this was just a sly attempt to gain leverage in future budget negotiations? Our theory is simpler: Trump promised an economic boom during the election campaign, while assuring voters that his tax cuts would more than pay for themselves. Hell would need to freeze over before he released a plan that did not share these assumptions. Congress Will Decide So where do we go from here? The specifics of Trump's plan are irrelevant. Congress will rewrite the budget from scratch. Major spending cuts will be scrapped. So will the onerous cuts to insurance subsidies and Medicaid in the House version of the health care bill. The Senate will ditch those. In contrast, Trump's tax cuts will be preserved, albeit on a smaller scale than envisioned in his budget proposal. Granted, congressional leaders have said they want tax reform to be revenue neutral, meaning that any tax cuts would need to be offset by other revenue-raising measures. That is easier said than done, however. The three main ways that House Republicans have offered to pay for corporate and personal tax cuts - introducing a border adjustment tax, eliminating the deductibility of business interest payments, and jettisoning the deduction for state and local income taxes for individuals - all face severe resistance from vested interests. In Washington, where there is a will there is usually a dishonest way. Budget forecasts are typically made over a 10-year window. Thus, it is possible to lower taxes upfront and promise spending cuts and ill-defined revenue raising measures in the tail end of the budget window. Such a strategy would generate a positive fiscal thrust early on, while leaving the door open for Congress to dump any future spending reduction or revenue measures before they are actually implemented. Add to that the tax revenue that is projected to pour in from supply-side reforms, and the stage is set for a dollop of fiscal easing starting in early 2018. How likely is it that Republicans will pursue such a strategy? Very likely. As evidence, look no further than the fact that White House budget director Mick Mulvaney floated the idea on Wednesday of extending the 10-year budget scoring window to 20 years. Investment Conclusions Chart 9Phillips Curve Is Alive And Well An obsessive focus on fiscal austerity hamstrung the recovery in many countries following the Great Recession. The irony is that fiscal stimulus is coming to America just when the economy has reached full employment. This means that much of the increase in aggregate demand arising from a more expansionary fiscal stance will be reflected in higher inflation rather than faster growth. This does not represent a major threat to risk assets now, but could later next year. Despite all the obituaries that have been written for the death of the Phillips curve, the data show that it is alive and well (Chart 9). Higher inflation will allow the Fed to raise rates once per quarter. The market is not prepared for this. Investors currently expect only 45 basis points in rate hikes over the coming 12 months. That is far too low. On the other side of the Atlantic, the ECB's months-to-hike measure has plummeted from 65 months in July 2016 to only 24 months today (Chart 10). Real rates are projected to be a mere 14 basis points higher in the U.S. than in the euro area in five years' time (Chart 11). Chart 10The Big Shift In Market Sentiment Towards ECB Policy Chart 11The Vanishing Transatlantic Bond Spread Poor demographics and high private-sector debt levels imply that the neutral rate of interest is lower in the euro area than in the U.S. And while the euro area may not be tightening fiscal policy any longer, the fact that its structural primary budget balance is 2.6% of GDP larger than America's means that the euro area's overall fiscal stance will contribute less to aggregate demand than in the U.S. This will force the ECB to keep rates lower for longer, causing the euro to weaken. Chart 12Widening Real Rate Differentials ##br##Support The Dollar Chart 13Speculators Are Long The Euro For ##br##The First Time In Three Years Incredibly, two-year real interest rate differentials between the euro area and the U.S. have widened by 41 basis points in favor of the latter since the end of March, even though EUR/USD has actually rallied over this period (Chart 12). We think this divergence has occurred because investors have been busy covering the euro hedges that they put on in the lead up to the French elections. However, now that net long speculative positions in the euro have risen to a three-year high - having been deeply short just a few weeks ago - the speculative demand for euros will subside (Chart 13). With all this in mind, we are going short EUR/USD today with a year-end target of parity and a stop-loss of 1.14. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 The fiscal thrust is defined as the change in the structural primary budget balance from one year to the next. As a convention, we define a positive thrust as loosening in fiscal policy (i.e., a lower fiscal balance). 2 Please see Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, and "China Needs More Debt," dated May 20, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The political theater in Washington has caused the last inning of the dollar correction to materialize. The U.S. economy remains at full employment, growth will stay above trend, and the Fed will be capable of hiking rates by more than the 66 basis points priced into the OIS curve over the next 24 months. It is time to buy the DXY. Investors are too optimistic on the euro and too negative on the CAD, short EUR/CAD as a tactical bet. The Swedish economy continues to improve. Yet, the SEK has limited upside as the Riksbank continues to find excuses to justify its dovishness. The downside for EUR/SEK is limited to 9.3. Feature Chart I-1Trump Rally Is Gone Four weeks ago, we wrote that the U.S. dollar correction was entering its last inning and recommended investors should wait a few more weeks before betting on renewed dollar strength.1 We think the time to bet on this rebound is now. To begin with, the dollar index has now erased all the gains accumulated since Trump's electoral victory, suggesting that all the hope of fiscal stimulus, deregulation, and tax cuts have now been priced out of the greenback (Chart I-1). In fact, at this point in time we think too many risks have been priced into the dollar. For one, the market is overemphasizing the likelihood of a Trump impeachment. While our Geopolitical Strategy group does think the likelihood of an impeachment procedure is near 100% if the democrats win the House in 2018, the likelihood remains much lower in 2017.2 Simply put, Trump remains a very popular president among republican voters (Chart I-2). Most problematic for many republicans that would like to see Trump out of office, is that his popularity is particularly strong among the "Tea Party" districts and voters (Chart I-3). Chart I-2Trump Still Popular With Republicans Chart I-3Trump Is Popular In Tea Party Territory Second, the chance that tax cuts are part of the upcoming budget negations is high. Tax cuts are espoused by the entire GOP caucus. Additionally, Republicans know that in order to avoid losing the Senate or the House of Representatives, or both, they have to do something popular with voters. Tax cuts definitely fit the bill. This simple political assessment points toward a likely passage of stimulus in the coming quarters despite Trump's personal woes. Finally, if Trump were to be stabbed in the back by the GOP establishment, what would the impact be on the dollar? Would the U.S. default? No. Would the economy enter a recession? No. Would the Fed become dovish? Neither. If anything, a potential removal of Trump from the oval office reduces the risk that he appoints a super-dove at the helm of the Fed, a risk that would have been very negative for our positive dollar cyclical stance. Regarding the economics behind the dollar rally, our positive cyclical stance on the USD predates the election of Trump, and in fact relied on the underlying shifts in the U.S. economy.3 These dynamics are still intact: While wage growth remains anemic, this partly reflects the fact that the long-term determinant of wage growth, productivity growth, is low. When this is taken into account, productivity-adjusted wage growth is in line with levels that in the past have prompted the Fed to tighten policy in order to combat potential inflationary dynamics (Chart I-4). Nonetheless, the risk is that wages begin accelerating going forward. The labor market is at full employment, with the U-3 unemployment rate standing 0.3 percentage points below the Fed's estimate of the neutral unemployment rate. Additionally, hidden labor market slack has also greatly dissipated (Chart I-5), with the U-6 unemployment rate, the number of workers in part-time jobs for economic reasons, and the amount of workers outside of the labor force but that would still like to have a job if economic conditions warranted it all back to levels where historically wage growth has gained momentum. Chart I-4Without Productivity Gains, Current Wage##br## Growth Is Enough For A Tighter Fed Chart I-5U.S. Labor Market##br## Is Tight Moreover, the outlook for consumption remains sturdy. Overall household income growth remains supported by elevated levels of job creation, and our indicator for real household disposable income growth continues to point up. Additionally, Federal income tax withholdings are accelerating, a sign of more robust consumption to come (Chart I-6). With consumer confidence at 17-year highs, positive income developments are likely to be translated into consumption. The outlook for capex is also bright. CEO confidence and capex intentions have all rebounded sharply, moves whose genesis predate Trump's election (Chart I-7). Moreover, elements are in place for these positive feelings to be catalyzed into actual investment. On the back of rebounding revenue growth, thanks to nominal GDP growth exiting levels historically associated with recessions, profit growth will receive a fillip, which should boost capex in the current context (Chart I-8). Chart I-6Income Tax Receipts Points ##br##To Healthy Consumption Chart I-7Capex Intentions Point ##br##To Higher Growth Chart I-8Revenue Growth Exiting ##br##Recessionary Levels Finally, when all major indicators are aggregated, real GDP growth looks set to accelerate. BCA's Beige Book diffusion index, based on the distribution of positive and negative mentions about the state of the economy in the Fed's Beige Book, is pointing to an acceleration in activity (Chart I-9). This suggests that the collapse in U.S. economic surprises may be toward its tail end. With this in mind, we continue to expect the Fed to increase rates more than the 66 basis points currently anticipated in the OIS curve over the next two years, as such, this supports our bullish stance on the dollar. In terms of tactical developments, the recent selloff has brought the DXY toward the levels congruent with the end of the correction.4 Additionally, based on our Intermediate-term timing model, the USD is now cheap enough to justify taking a long bet on the currency. The deeply oversold levels reached by our Intermediate-term momentum oscillator supports this message (Chart I-10). Finally, the Swedish Krona seems to be confirming these signposts. USD/SEK has historically displayed one of the strongest betas to the trade-weighted dollar's movements. The fact that this pair has not been able to break down below a long-term upward slopping trend line put in place since 2014, and that it also managed to stay above its 2015 peaks, gives us more confidence that the dollar correction is likely to have run its course (Chart I-11). Chart I-9BCA's Beige Book Monitor ##br##Improves Growth Will Strengthen Chart I-10Dollar Is ##br##Oversold Chart I-11USD/SEK Giving A Hopeful##br## Signal For DXY Bottom Line: The dollar has taken a beating in the wake of the scandals emerging out of the White House. In our view, these developments were only the catalyst that crystalized the last leg of the USD correction that begun in late 2016/early 2017. Ultimately, the bull case for the dollar predates Trump and rests on the dissipating slack in the U.S. economy. These developments are intact, even with Trump's fiascos in the foreground. Tactically, the dollar is now cheap enough and oversold enough to justify investors buy the DXY again. We are opening a long DXY trade this week. We remain long the dollar against most commodity currencies and EM currencies. The yen may continue to benefit if the budding weaknesses in the EM space gather further momentum. EUR/CAD Is A Short At this juncture, it would be natural for us to begin shorting the EUR against the USD. In fact, we believe the recent spike in the EUR has created a good shorting opportunity against the European currency. While we worry investors are becoming too pessimistic on the U.S., we believe investors are too optimistic regarding the capacity of the ECB to increase rates. Investors moved away from deep short positions on the euro and are now net long this currency. Also, while in July 2016 investors expected the first ECB rate hike to materialize in more than five years' time, they are now expecting the first repo rate hike to happen in just 24 months (Chart I-12). This looks premature. For comparison's sake, in the U.S. we are only seeing the early signs of labor market tightness, despite the last recession ending in the summer of 2009. Europe was victim to a double-dip recession, the last leg of which ended in 2013. This decreases the likelihood of Europe being at full employment today. More concretely, there remains plenty of hidden labor market slack in the euro area. In Europe, the main form of slack exists among workers hired under contracts, contracts that do not offer the same level of benefits and protections as regular employment. The euro area increasingly has a dual labor market, a condition that has weighed on wage growth for more than two decades in Japan. Today, as a result of such dynamics, the level of labor underutilization in Europe is still very elevated, which will continue to limit wage growth going forward (Chart I-13). Hence, core inflation dynamics in Europe are likely to prove disappointing and they will keep the ECB on a more dovish path than investors currently appreciate. Chart I-12Investors Too Optimistic On The ECB Chart I-13Labor Market Slack In The Euro Area Remains High For now we are electing to profit from this view by tactically shorting the euro against the CAD. We do believe there are problems in Canada, a topic we discussed a few weeks ago.5 But at this juncture, these worries seem well digested by markets. The Home Capital Group debacle has been front page news for weeks, but the aggregate banking sector remains strong, especially as loses on the mortgage holdings of Canadian banks will ultimately be passed on to the government through the insurance provided by the Canadian Mortgage and Housing Corporation. Additionally, in the wake of the deepening trade dispute on softwood lumber, the fears of a disintegration of NAFTA have hit Canada especially violently, with the CAD falling 16% against the peso since January 2017. Chart I-14EUR/CAD Is Toppy Tactically, the pieces are falling into place to favor the CAD over the EUR. Our Commodity and Energy group remains positive on the outlook for oil prices. The continuation of the output controls by OPEC and Russia remains binding as oil producers want to further curtail elevated oil inventories. Therefore, oil prices have little downside and may even experience further upside, helping the CAD in the process. Additionally, investor positioning is very skewed. Investors are massively short the CAD, especially when compared to the euro, which historically has provided a signal to short EUR/CAD (Chart I-14). This is re-enforced by our Intermediate-term technical indicator which shows EUR/CAD as massively overbought. Shorter-term momentum measures such as the RSI or the MACD have also been forming negative divergences with actual prices in recent days. Bottom Line: The euro is likely to suffer if the USD correction is indeed finishing. Hidden labor market slack remains a much deeper problem in Europe than in the U.S. and will limit the capacity of the ECB to increase rates in the next two years, as investors are currently expecting. For now, we are electing to short the euro against the CAD instead of against the USD. The Canadian dollar is oversold and oil prices have limited downside from here as supply adjustments remain positive. Moreover, investors are at record shorts on the CAD, especially when compared to the euro. Sweden Is Strong, But The Riksbank Still Haunts The SEK The long-term outlook for both Sweden and the Swedish krona remain bright but the ultra-dovish stance of the Riksbank remains a potent short-term hurdle. To begin with, the SEK offers great value. Not only is it trading at 24% and 8% discounts to its PPP fair value against the USD and the EUR, respectively, but the trade-weight SEK is also trading at a near one-sigma discount against our long-term fair value models (Chart I-15). Chart I-15SEK Is Cheap... But Is It Enough? Additionally, Sweden's net international investment position has moved back in positive territory in 2014, and now stands 16.4% of GDP (Chart I-16). This is not only a reflection of the weakness in the SEK since 2014, but is first and foremost the end-result of more than two decades of accumulated current account surpluses. This development is crucial. Not only does the positive income balance generated by assets in excess of international liabilities put a floor under the current account; historically, currencies with positive and growing net international investment positions tend to exhibit an upward bias. In terms of economic developments, employment growth in Sweden remains steady. Unemployment has been in a protracted downtrend, falling 2.9 percentage points since 2008 (Chart I-17). Yet, despite being well into full employment territory, wage growth has been absent. To a large degree, this reflects entrenched deflationary pressures in the Swedish economy. However, deflationary forces are abating. Chart I-16A Long-Term Driver Pointing North Chart I-17Swedish Labor Market At Full Employment To begin with, Sweden's output gap has recently entered positive territory, which historically has been a reliable indicator of inflationary pressures in this country (Chart I-18). Also, monetary aggregates, M1 in particular, continue to point toward higher inflation in Sweden. This means that with the employment market being at full capacity, the conditions for higher inflation in Sweden are emerging. Our expectation of an upcoming upturn in the Swedish credit impulse - which until now has been contracting and exerting deflationary forces on the economy - reinforces confidence in our inflation view. Credit growth tends to lag industrial activity, but our industrial production model for Sweden is perking up. Improving industrial variables suggest that credit will move from depressing demand back to supporting demand, further rekindling inflationary forces (Chart I-19). Chart I-18Swedish Inflation Is Set To Pick Up Chart I-19Swedish Credit Impulse Will Rebound With this positive backdrop for prices, should investors buy the SEK right now? The Riksbank continues to represent a great hurdle for SEK bulls. The Swedish central bank has one of the strongest dovish biases amongst global monetary guardians. Against expectations, it recently increased the duration of its asset purchase program, giving markets a strong signal that it is unlikely to increase rates soon. This means that the Riksbank is unlikely to tighten policy until it sees the "whites of inflation's eyes". While we are moving in the right direction, we are not there yet. Officially, the Riksbank targets CPIF, which currently clocks in at 2%. Yet, the emphasis of the central bank on domestic price dynamics implies that adjustment away from dovishness will only occur when core inflation itself moves to 2% (Chart I-20). This means that gains in the SEK will be limited. To begin with, EUR/SEK does have downside, and our view that the euro is getting overextended highlights that EUR/SEK could fall toward 9.3. However, beyond this level, gains should prove limited as Sweden is a small open economy and EUR/SEK plays a big role in tightening monetary conditions for that country. As a result, any move in EUR/SEK below 9.3 is likely to be unwelcomed by the Riksbank until core inflation moves closer to 2%. Versus the USD, it will be even more difficult for the SEK to rally. Historically, the SEK has been one of the most sensitive currencies to the dollar's trend, implying that strength in DXY could be magnified in USD/SEK. In fact, the absence of breakdown in USD/SEK in the face of violent dollar selling pressures this week suggests that the SEK could be a serious casualty of a rebounding dollar. Additionally, real rate differentials continue to move in favor of the U.S. dollar, with U.S. 2-year real rates now 180 basis points above that of Sweden (Chart I-21). With the Intermediate-term technical indicator for USD/SEK now hitting oversold levels, the downside for USD/SEK is very limited, further supporting the idea that any rebound in DXY could lead to significant weaknesses in SEK. Chart I-20Core Inflation Needs To Rise Chart I-21Rates Differentials Support A Lower SEK Bottom Line: The Swedish economy has adjusted and several factors are pointing toward a pickup in core inflation in the coming quarters. However, the Riksbank has maintained a strong dovish bias. We need to see an actual pick up in core inflation itself before the central bank moves away from its dovish bias. While EUR/SEK could weaken toward 9.3, more gains for the krona against the euro will prove elusive until the Riksbank sees firmer inflation. USD/SEK is a buy at current levels. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant HaarisA@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled “The Last Innings Of The Dollar Correction”, dated April 21, 2017, available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Special Report titled “Break Glass In Case Of Impeachment”, dated May 17, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report titled “Dollar: The Great Redistributor”, dated October 7, 2016, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report titled “The Last Innings Of The Dollar Correction”, dated April 21, 2017, available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report titled “AUD and CAD: Risky Business”, dated March 10, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The past week has been quite eventful for the greenback, slipping almost 2.3%. Most of the downside is owed to markets revising down rate expectations, on the basis of weak growth numbers and political scandals. The 10-year yield dropped, gold rose, and equities fell. There was also a large sell-off in EM currencies and a sharp appreciation in the yen. Furthermore, the soft patch in U.S. data continued as housing starts and building permits came in especially weak in April: 1.172 million and 1.229 million respectively, both underperforming consensus. Nevertheless, markets calmed after the release of stronger employment numbers with initial and continuing jobless claims beating expectations. The upswing in the Philly Fed index also helped revive sentiment. The dollar picked up Thursday morning following these releases. Interestingly, the DXY is at pre-election levels, which suggests that the dollar is nearing its bottom. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro has enjoyed significant upside as a result of Macron's victory and the dollar's drubbing. Weak data in the U.S. caused markets to revise growth expectations, pressuring the dollar downwards and the euro up. Further lifting the euro were comments by ECB President Mario Draghi, who highlighted that growth in the euro area is performing well. However, he also reiterated that "it is too early to declare success". These forces have lifted the euro to expensive levels on a tactical basis, suggesting the path of least resistance is most likely down as the ECB will find it hard to tighten policy and the dollar resumes its bull market. Data in the euro area has been mixed as of late without too much disappointment, and inflationary pressured remain unchanged. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 After coming slightly above 114, USD/JPY has plunged by more than 3%, as a result of the market pricing increasing odds that president Trump will get impeached. Although we believe that the correction of the dollar has run its course, the end of the Trump trade might have triggered the sell-off we have been expecting in emerging markets. Thus we like to play this risk off period by shorting NZD/JPY. On the data side, news have mostly been negative: Machinery orders contracted by 0.7% YoY, underperforming expectations. Consumer confidence came in lower than last month at 43.2. Bank lending grew by a measly 3% YoY underperforming expectations. However, real GDP for Q1 came in at 0.5% QoQ, beating expectations. This was dampened by the weak GDP deflator, which contracted by tk%. We continue to be yen bears on a cyclical basis, as the fed will raise rates more than the markets expects, while the BoJ will continue anchoring 10-year yields around zero. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K has been mixed: Industrial Production growth came in at 1.4%, underperforming expectations. However retail sales and retail sales ex-fuel growth came in at 4% and 4.5% respectively, both outpacing expectations. Crucially, both core and headline inflation came above expectations at 2.4% and 2.7% respectively. This surge in inflation is important as it raises the odds of a BoE hike this year, especially as the economy remains resilient. Moreover, as long term inflation expectations continue to be well anchored consumption is likely to continue to surprise as households are looking through the inflation caused by the depreciation in the pound. Overall, we continue to be positive on GBP against all other currencies but the U.S. dollar, given that the British economy will likely stay more resilient than investors are anticipating. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA shed some light on the Australian economy through its most recent Minutes, highlighting that monetary policy needs to remain accommodative to support economic trends. It noted the negative hit to terms of trade as a result of Cyclone Debbie curtailing coking coal exports. China's housing market was also identified as a risk to Australia's exports and terms of trade. Nevertheless, this week the AUD was buoyant, helped by a weaker greenback. However, the factors above paint a bleak picture for the AUD's future. The very important employment figures depicted a similar trend to that of last year, with full-time employment in fact contracting while part-time employment picked up. Unemployment also declined by 0.2% to 5.7%, however, wages remain subdued. This corroborates the weaker core CPI measure of 1.5%, while the strong headline figure of 2.1% is likely to be transitory when the recent commodity-prices weakness kicks in. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The RBNZ continues to much more accommodative than warranted. The monetary policy report highlighted that the recent surge in inflation is mainly attributable to tradables, and that non-tradable inflation is bound to increase very gradually. We continue to believe that the RBNZ is understating the inflationary pressures in the economy, as core inflation is already higher than 2%. Additionally, retail sales are growing at 10-year high and nominal GDP growth has skyrocketed to 7.5%, by far the highest in the G10. Right now, the market expects the first rate hike to come in 9 months. We believe that a rate hike at this point would be the bare minimum for the RBNZ to avoid an overheating in the economy. Thus expectations have nowhere to go than up and the NZD now has considerable upside against the AUD. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has been somewhat weaker this past week as oil prices rebounded and the dollar fell. Oil prices are likely to see further upside as OPEC and Russia are likely to agree to another supply cut to support oil prices. Domestically, the economy is improving as unemployment is declining and PMIs are perking up. The BoC also identified the output gap to close earlier than expected in its last meeting. The almost 4% depreciation in the CAD in the past month has made the oil-based currency considerably cheap. When looking at EUR/CAD, the depreciation has been around 7.5%. With the euro now sitting in expensive territory, the ECB is unlikely to change its stance any time soon as inflation has not yet rooted itself, while peripheral economies' inflation remain weak. The CAD, however, is likely to see further upside on the back of increasing oil prices and a strengthening economy. These factors warrant a short EUR/CAD trade. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 And CAD: Risky Business -AUD March 10, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Following the election of Emmanuel Macron as the new president of France EUR/CHF skyrocketed, coming close to hitting 1.1. At this point EUR/CHF is a very attractive short, given that good news for the euro are likely to tapper now that the French election is behind us. When it comes to inflation, the ECB will likely focus on the lowest denominator, because in spite of higher inflation in some countries like Germany or Austria, inflationary pressures remain muted in most other economies. This will prevent the ECB from tightening monetary policy as fast as the market expects. Meanwhile, the possibilities that the SNB takes the floor off EUR/CHF at the end of this year or the beginning of 2018 are rising given that inflation and economic activity are slowly coming back to Switzerland. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has depreciated in the past weeks thanks to the fall in the dollar as well as rising oil prices. Additionally, the fall in inflation is slowing down, with core and headline inflation coming in at 1.7% and 2.2% respectively. Is it time to become bullish on the NOK against the U.S. dollar? We do not believe this is the case. While inflation might be close to bottoming it is unlikely to surpass the Norges Bank target in the coming years, given that inflationary pressures remain muted in Norway. Furthermore, given that USD/NOK is more sensitive to real rate differentials than oil prices, the effect of a dovish Norges Bank on USD/NOK will be much stronger than the impact of rising oil prices. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 We expect the SEK to experience limited upside in the next 3-6 months. The Greenback is bottoming and we expect USD/SEK to pick up on the back of the dollar bull market. Furthermore, EUR/SEK has limited downside as the RIksbank wants to keep monetary conditions easy. Indeed, the Swedish central bank is also planning to officially target CPIF instead of the CPI. While both of these measures are near 2%, the behavior of the Riksbank suggests that it is in fact targeting core inflation. Core inflation itself is still somewhat depressed, as consumer activity remains weak. However, we expect core inflation to pick up on the back of a higher credit impulse and money supply growth, which should help the Riksbank exit its dovish tilt later this year. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The U.S. unemployment rate stands 0.1 points below the FOMC's year-end projection and 0.4 points below its estimate of NAIRU. If the unemployment rate keeps falling, it will have nowhere to go but up - and the U.S. has never been able to avoid a recession whenever the unemployment rate has risen by more than one-third of a percentage point. So far the FOMC has failed in its efforts to tighten monetary policy. U.S. financial conditions have actually eased sharply since the Fed resumed hiking rates in December. The Fed will turn more hawkish over the coming months. Stay short the January 2018 fed funds futures contract and position for a stronger dollar. What happens in the euro area has become increasingly irrelevant for what happens to EUR/USD. Even if the ECB raises rates somewhat more rapidly than expected, this will be largely counterbalanced by hawkish actions by the Fed. Investors should stay cyclically overweight global equities, but be prepared to pare back exposure next summer. Feature Beware Of Full Employment Chart 1Recoveries Usually Lose Steam##br## WhenThe Unemployment Rate Falls Below NAIRU After eclipsing 10% in 2009, the U.S. unemployment rate fell to 4.4% in April, 0.1 points below the median end-2017 dot in the Fed's Summary of Economic Projections, and 0.4 points below the FOMC's estimate of NAIRU.1 The fact that most Americans who want to work are able to find jobs is obviously a good thing. However, today's increasingly tight labor market does have a dark side: As Chart 1 illustrates, recoveries have tended to run out of steam whenever the unemployment rate has fallen below its full employment level. Two points about the unemployment rate are worth keeping in mind: The unemployment rate has rarely been stable over time; usually, it is either rising or falling. The former tends to occur very quickly, while the latter is more drawn out. The unemployment rate displays momentum over short horizons, but is "mean-reverting" over the long haul (Chart 2).2 Since there is a limit to how low the unemployment rate can go, periods when it is below its full employment level typically do not last long. This is confirmed by Chart 3, which shows that there is a clear positive correlation between the degree of labor market slack and the onset of the next recession: High slack means that a recession is usually far away, whereas low slack means that a downturn is approaching. And it doesn't take much of an increase in the unemployment rate to sow the seeds for another recession - the U.S. has never escaped a recession in the postwar period whenever the three-month moving average of the unemployment rate has risen by a mere one-third of a percentage point (Chart 4). Chart 2The Unemployment Rate Is Mean-Reverting Over The Long Haul, But Displays Momentum In The Short Term Chart 3The Degree Of Labor Market Slack And The Onset Of The Next Recession: A Clear Positive Correlation Chart 4What Goes Down Must Come Up? Rising unemployment tends to generate all sorts of vicious cycles. When someone loses their job, they spend less. The resulting decline in aggregate demand forces firms to lay off workers, leading to even less spending throughout the economy. A weaker economy also makes it more difficult for borrowers to pay back loans, causing them to pare back spending. Falling asset prices only serve to exacerbate this problem. Threading The Needle Today's low unemployment rate puts the Federal Reserve in a bind. On the one hand, if the Fed raises rates too quickly, this could precipitate exactly the sort of downturn that it is trying to avoid. On the other hand, if the Fed fails to raise rates quickly enough, this could cause the economy to overheat. This, in turn, may force the Fed to raise rates aggressively - something that would destabilize both the economy and financial markets. The hope is that the Fed succeeds in threading the needle to ensure that the economy achieves a soft landing. There are some reasons to be optimistic about such an outcome, but also several reasons to be pessimistic. On the optimistic side, inflation expectations remain well anchored. This means that an overheated economy is unlikely to produce a powerful price-cost spiral such as the one that broke out in the 1970s. This limits the risk that the Fed will be forced to raise rates dramatically. The real economy is also not suffering from the sort of clear-cut imbalances that plagued the late innings of the last two business cycles - a massive capex overhang in the late 1990s, and an even larger housing overhang in the years leading up to the Global Financial Crisis. Private debt levels have also fallen as a share of GDP for most of the recovery, unlike in past cycles (Chart 5). On the pessimistic side, uncertainty about the level of the neutral rate - the interest rate consistent with full employment and stable inflation - will make it difficult for the Fed to calibrate monetary policy in a way that ensures a soft landing. It typically takes 12-to-18 months for changes in monetary conditions to fully make their way through the economy. Thus, if the Fed does end up either too far behind or too far ahead of the curve in normalizing monetary policy, it may not realize this until it's too late. Structurally slower potential GDP growth could also complicate matters. The Congressional Budget Office estimates that real potential GDP growth will average only 1.8% over the next 10 years, compared to 3.1% between 1980 and 2007 (Chart 6). Today's equity valuations are arguably pricing in faster GDP growth. Should growth settle below 2% - a rate that has often been associated with stall speed - risk assets could suffer, complicating the Fed's efforts in achieving a soft landing. Chart 5The Economy Is Not Showing ##br##Clear-Cut Signs Of Imbalances Chart 6Potential GDP Growth Is Not ##br##What It Used To Be The Fed's Choice Given the choice between erring on the side of raising rates too slowly or too quickly, the Fed has opted for the former. This is a quantitative statement, not a qualitative one. Chart 7 shows that U.S. financial conditions have eased considerably since the Fed resumed raising rates last December, thanks to a weaker dollar, tighter credit spreads, and a soaring stock market. If the whole point of hiking rates is to tighten financial conditions, then the Fed has not done enough. Worries that the headline unemployment rate may understate the true amount of labor market slack partly explain the Fed's angst in raising rates as quickly as it has in past cycles. While the headline rate has fallen back to its 2007 low, the broader U-6 unemployment rate - which incorporates people who are out of the labor market but claim to want a job, as well as those who are working part-time for economic reasons - is still 0.7 points above it. Likewise, the employment-to-population ratio for prime-age workers (ages 25-to-54) is 1.7 points below its pre-recession levels. The "quits rate" - a good measure of labor market confidence - also remains a notch below its pre-recession peak. Perhaps most glaringly, the median duration of unemployment has only fallen back to 10.2 weeks, which is still close to the high of the previous cycle (Chart 8). Chart 7Financial Conditions Have Been Easing Chart 8Headline Unemployment Rate ##br##Back To 2007 Levels, But Other ##br##Measures Still Point To Slack Each of these factoids has a counterargument: The elevated share of involuntary part-time workers may be partly due to the effects of Obamacare, which has made it burdensome for companies to add full-time workers to the payrolls;3 the low quits rate and the high median length of unemployment may reflect the aging of the population as well as lower gross job creation (Chart 9); and automation, globalization, and low-skilled immigration may have depressed real wages for less-educated workers, causing them to abandon the labor market (Chart 10). Nevertheless, with core inflation still below the Fed's 2% target, it is not hard to see why the Fed has elected to take a "go slow" approach so far. Chart 9The Labor Market Has Become Less Dynamic Chart 10Less-Educated Men Are Fleeing The Labor Market The Hawks Spread Their Wings That may be changing, however. The growth in nominal unit labor costs has already surpassed 2% and is close to the peaks reached in 2000 and 2007 (Chart 11). Most other measures of wage growth remain in a clear uptrend (Chart 12). If GDP growth accelerates over the remainder of the year, as we expect, the Fed will pursue a more aggressive tightening path than what the market is currently discounting. Chart 11Unit Labor Cost Inflation Close To Past Peaks Chart 12Most Measures Of Wage Growth Are In An Uptrend Recent communications from the Fed have revealed an increasingly hawkish bias. The latest Fed statement downplayed the slowdown in Q1 as "transitory." This follows Chair Yellen's comment that "waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession."4 Investment Conclusions Higher U.S. rate expectations should give the dollar a boost (Chart 13). We do not agree with the often-heard argument that the actions of foreign central banks will materially weaken the dollar. Consider the case of the ECB. There has been much speculation that the ECB will phase out some of its emergency measures. That may well happen, but even if it does, a full-fledged hiking cycle is nowhere on the horizon. According to a recent ECB study, the rate of labor underutilization still stands at 18% in the euro area, 3.5 points higher than in 2008 (Chart 14).5 Stripping out Germany, the rate of underutilization would be seven points higher (Chart 15). It is still too early for Mario Draghi to begin removing monetary accommodation in a concerted manner. Chart 13Higher U.S. Rate Expectations ##br##Should Give The Dollar A Boost Chart 14Labor Market Slack In The Euro Area Remains High... Chart 15...Especially Outside Of Germany Moreover, anything the ECB does which inadvertently leads to a stronger euro will likely be matched by offsetting hawkish actions by the Fed. Remember that the Fed needs to tighten financial conditions in order to prevent the unemployment rate from falling so much that it has nowhere to go but back up. A weaker dollar runs contrary to that strategy. The argument above can be applied more broadly. The euro rallied in the lead-up to the French election on the now-realized hope that Emmanuel Macron would prevail. Put aside the fact that Macron's platform calls for cutting the budget deficit from 3.2% of GDP this year to 1% of GDP in 2022 - something which, all things equal, would lead to less monetary tightening and a correspondingly weaker euro. Even if Macron's victory somehow did manage to allow the ECB to raise rates earlier than it would have otherwise, it is hard to believe that this would not influence the pace of Fed rate hikes. U.S. financial conditions could tighten through some combination of higher rates and/or a stronger dollar. The only way the Fed could engineer a tightening in financial conditions while the trade-weighted dollar still weakened would be to jack up interest rates by an inordinate amount. However, this outcome would require that other central banks raise rates even more. That's not going to happen. Stay short EUR/USD. We think the euro will reach parity against the dollar later this year. Where does this leave equities? So long as global growth remains solid and corporate earnings are in an uptrend, the path of least resistance for stocks is up. However, the risk is that the Fed overplays its hand and ultimately tightens monetary policy too much. This could lead to a broad-based global slowdown towards the end of 2018. Investors should stay cyclically overweight global equities, but be prepared to pare back exposure next summer. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 The Non-Accelerating Inflation Rate of Unemployment (NAIRU) is the unemployment rate consistent with stable inflation. 2 An Ordinary Least Squares (OLS) regression using monthly data between 1960 and 2017 shows that the change in the unemployment rate over the coming three months is positively associated with a change in the unemployment rate over the prior three months, and negatively associated with the level of the unemployment gap. 3 See, for example: Marcus Dillender, Carolyn Heinrich, and Susan Houseman, "Effects of the Affordable Care Act on Part-Time Employment: Early Evidence," Upjohn Institute Working Paper, 2016. 4 Janet Yellen, "Semiannual Monetary Policy Report To The Congress," February 14, 2017. 5 Please see ECB, "Focus: Assessing Labour Market Slack," Economic Bulletin Issue 3, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Duration: U.S. growth expectations have become overly pessimistic. A Q2 rebound will lead to higher global bond yields and a steeper U.S. Treasury curve. UST / Bund Spread: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. USD Hedging Costs: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Feature Chart 1Global Recovery Will Persist The synchronized global recovery that took hold in the second half of 2016 has stalled so far this year. Measures of economic sentiment, such as the Global ZEW survey and our own Boom/Bust Indicator, have rolled over from high levels and global bonds have clawed back some of last year's lost returns (Chart 1). Year-to-date, the Bloomberg Barclays Global Government Bond index has returned +3%, after having lost more than 9% between the July trough in the Global ZEW index and the end of last year. In our view, a repeat of early 2016's global growth slowdown and bond market rally, which saw the Global ZEW index fall below zero and the Global Government Bond index return 11.6% in 2016H1, is not in the cards. The global economy is on much firmer footing than at this time last year. U.S. Growth: Past Peak Pessimism First quarter U.S. GDP growth was a disappointing 0.7%, but is poised to bounce back strongly in Q2. The volatile inventories component subtracted 0.9% from overall Q1 growth, harsh weather wreaked havoc on the March employment report and there continue to be problems with residual seasonality depressing first quarter GDP data.1 The outlook is much brighter moving forward. The latest employment report showed that the U.S. economy added a healthy 211k jobs in April and our model is pointing toward a further acceleration (Chart 2). Economic growth can be thought of as a combination of aggregate hours worked and labor productivity (Chart 3). With aggregate hours worked growing at 1.7% year-over-year and labor productivity growth having averaged 0.6% (annualized) per quarter since 2012, real U.S. GDP growth of around 2.3% seems like a reasonable forecast. Chart 2Labor Market Still Strong Chart 3Look For Above 2% Growth There is even some reason to suspect that labor productivity could strengthen during the next few quarters. A recent IMF paper2 attributed weak post-crisis productivity growth to a combination of structural and cyclical factors, but also noted that weak investment in physical capital may be responsible for lowering total factor productivity growth by nearly 0.2 percentage points per year in advanced economies during the post-crisis period. With leading indicators pointing to still further gains in fixed investment (Chart 3, bottom panel), we would not be shocked to see productivity growth enjoy a modest late-cycle rebound. Chart 4Stronger Productivity = Steeper Curve All else equal, a late-cycle rebound in productivity growth would slow the increase in unit labor costs. Unit labor costs are a combination of wages (compensation-per-hour) and productivity (output-per-hour), and have historically tracked changes in the slope of the U.S. yield curve (Chart 4). Faster wage growth tends to coincide with Fed tightening, and slower wage growth with Fed easing. For this reason, all wage measures perform reasonably well tracking changes in the yield curve. But unit labor costs perform best because they also incorporate productivity growth, and low productivity growth can flatten the yield curve by pulling down long-dated yields. Rapid increases in compensation-per-hour and muted productivity growth have combined to give the yield curve a strong flattening bias during the past several years. Any increase in productivity growth would slow the uptrend in unit labor costs relative to other wage measures, allowing the yield curve to steepen. In fact, we continue to recommend that investors position for a steeper U.S. yield curve by going long the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This trade produces positive returns when the 2/10 slope steepens (Chart 4, panel 3), but has also returned +19 bps since we initiated the position last December, even though the curve has flattened since then. The reason for the trade's strong performance in an unfavorable curve environment is that the 5-year yield had been unusually elevated compared to the rest of the curve. Our model of the 2/5/10 butterfly spread versus the 2/10 slope showed that the 5-year note was one standard deviation cheap on the curve as recently as mid-March (Chart 4, bottom panel). This undervaluation has mostly dissipated and the 5-year note now appears only slightly cheap. For our curve trade to outperform from here, it will likely require the 2/10 slope to steepen.3 Bottom Line: With weak Q1 GDP now in the rearview mirror, we are likely past the point of peak pessimism on U.S. growth. Expect global bond yields to rise and the U.S. yield curve to steepen as the economic data start to reflect an environment of above-trend growth, in the neighborhood of 2% - 2.5%. European Growth & The Risk From China While the U.S. data have disappointed in recent weeks, as evidenced by the U.S. Economic Surprise Index having dipped below zero (Chart 5), the European economy has consistently bested expectations (Chart 5, panel 2). As a result, the Treasury / Bund spread has narrowed from high levels during the past few months. In practice, economic surprise indexes tend to mean revert because positive data surprises beget increasingly optimistic expectations. Eventually, overly optimistic expectations become too high a hurdle and the data start to disappoint. In our view, U.S. expectations have become unduly pessimistic while the Eurozone surprise index appears overdue for a correction. Against this back-drop, we expect the Treasury / Bund spread to widen in the near term as the large divergence between the U.S. and European surprise indexes starts to narrow. Further making the case for a wider Treasury / Bund spread is the recent performance of the Chinese economy. Our Foreign Exchange Strategy service recently observed that growth differentials between the U.S. and Europe are highly correlated with indicators of Chinese growth.4 This should not be overly surprising since Europe trades more with China and other Emerging Markets than does the United States. Along those lines, the IMF has calculated that a 1% growth shock to Emerging Markets impacts European growth by nearly 40 basis points, while it impacts U.S. growth by only 10 basis points.5 The worry at the moment is that Chinese monetary conditions have started to tighten, and China's Manufacturing PMI is rolling over alongside weaker commodity prices. These trends usually coincide with the underperformance of Europe relative to the U.S. (Chart 6). Chart 5Surprise Indexes Will Converge Chart 6Look To China To Trade UST / Bund Spread Our China Investment Strategy service highlights the importance of the trade-weighted RMB as a driver of Chinese growth.6 The RMB's 30% appreciation between 2012 and 2015 applied a massive deflationary force to China's economy, while its more recent depreciation helped boost producer prices, enhance profit margins and reduce the real cost of funding (Chart 7). Chart 7Monetary Conditions ##br##Still Fairly Stimulative More recently, the pace of the RMB's depreciation has slowed and this likely explains the weakness in China's Manufacturing PMI and commodity prices. Our China strategists are quick to note that while the pace of RMB depreciation has slowed, it is still not appreciating, and real interest rates deflated by the producer price index remain negative. In other words, monetary conditions have become somewhat less stimulative, but they should still be supportive of further economic growth. Although the Chinese economic data are likely to moderate in the coming months, barring the major policy mistake of aggressive tightening, Chinese growth will avoid a collapse and remain reasonably buoyant. Similarly, we would also expect European growth expectations to soften in the coming months, but growth is very likely to remain above trend and the ECB is still on track to adopt a less accommodative policy stance over the next year. In the most likely scenario, a few hints will be given at the June ECB meeting, and then an announcement that asset purchases will be tapered in 2018 will be made at the September meeting. The market will correctly assume that rate hikes will follow the taper, and this re-pricing of rate expectations will open up a window in the second half of this year when the Treasury / Bund spread can tighten. However, it is still too soon to adopt this position. Bottom Line: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. U.S. Bond Investors Should Expand Their Borders Divergences that have opened up between U.S. short-term interest rates and short-term rates in other developed countries mean that U.S. bond investors now face much lower currency hedging costs. In addition, increasingly negative cross-currency basis swap spreads have become a permanent feature of the post-crisis investment landscape, and unless significant regulatory changes occur, we expect they are here to stay. Combined, both of these factors make it incredibly attractive for U.S. bond investors to swap their U.S. dollars for foreign currencies and invest in foreign government bonds. In this week's report we explain why this is an attractive trade for U.S. investors and why it will likely remain so for quite some time. What Is The Basis Swap Spread? An excellent definition of the cross-currency basis comes from the Bank for International Settlements (BIS) who define it as "the difference between the direct dollar interest rate in the cash market and the implied dollar interest rate in the [currency] swap market".7 In essence, the existence of a negative basis swap spread should mean that there is an opportunity to arbitrage the difference between interest rates in the cash market and implied interest rates in the currency swap market. However, post-crisis regulatory constraints on bank balance sheets appear to have made this arbitrage prohibitive. Banks are either unable or unwilling to arbitrage the basis swap spread back to zero, and this increases the cost of U.S. dollars in FX swap markets. As a quick example, we can calculate the 10-year German Bund yield hedged into U.S. dollars using currency forwards. Hedged yield = Unhedged yield - Cost of hedging Where: Cost of hedging = forward exchange rate / spot exchange rate In this case, we define the exchange rates as euros per 1 U.S. dollar. By covered interest rate parity, we can also calculate the cost of hedging as: Cost of hedging = (1 + euro interest rate + basis swap spread) / (1 + USD interest rate) Using current 3-month interest rates, this means that the cost of hedging from euros into U.S. dollars is: Cost of hedging = (1 - 0.36% - 0.3%) / (1 + 1.18%) = -1.82% This means that the 10-year German Bund yield rises from 0.42% to 2.24%, from the perspective of a U.S. dollar investor, after hedging the currency on a 3-month horizon. In other words, U.S. investors can significantly increase the average yield of their portfolios by lending U.S. dollars over short time horizons and investing the proceeds into non-U.S. bonds. In Chart 8 we show the difference this currency hedging makes for German, Japanese and French 10-year government bonds. Current hedged 10-year yields for all the major bond markets are also shown on page 13 of this report. But for how long can this trade continue? In short, it can continue for as long as U.S. short-term interest rates increase relative to non-U.S. short-term interest rates and for as long as basis swap spreads move further into negative territory. At the moment there is no widespread agreement on what drives the day-to-day fluctuations in the basis swap spread. The BIS has posited a model where dollar strength weakens the capital positions of bank balance sheets, causing them to back away from providing liquidity to the FX swap market, and leading to increasingly negative basis swap spreads (Chart 9, top panel). Chart 8Higher Yields Via Currency Hedging Chart 9Basis Swaps, Reserves And The Dollar Meanwhile, Zoltan Pozsar from Credit Suisse has identified a link between basis swap spreads and reserves on the Fed's balance sheet (Chart 9, bottom panel).8 Specifically, as the Fed winds down its balance sheet it will be draining cash reserves from the banking system and replacing them with Treasury securities. This could cause money to leave the FX swap market and flow into Treasuries. The result is less liquidity in the FX swap market and increasingly negative basis swap spreads. Interestingly, the run-up to the debt ceiling in the U.S. has presented a test of this view. To stay under the debt ceiling the U.S. Treasury department has drawn down its cash account at the Fed and removed T-bill supply from the market. The result has been a temporary increase in reserve balances. As the theory would have predicted, basis swap spreads have moved closer to zero as reserves have increased. Going forward, the Fed is very likely to start winding down its balance sheet later this year. In all likelihood this will serve to pressure basis swap spreads even further below zero. Meanwhile, short-term interest rates in the U.S. will probably continue to rise more quickly than in most other developed markets. This means that the cost of hedging should become increasingly negative for U.S. investors. In Chart 10 we show that as the cost of hedging becomes more negative, total returns from a USD-hedged position in German bunds tend to outpace total returns from a position in U.S. Treasuries. Similarly, Chart 11 shows that USD-hedged Japanese government bonds (JGBs) also tend to outperform U.S. Treasuries when the cost of hedging falls. Chart 10Hedging Costs & Bond Returns: Germany Chart 11Hedging Costs & Bond Returns: Japan We should note that the relationships between hedging costs and relative total returns shown in Charts 10 & 11 are not perfect, and there will be instances when Treasuries can outperform even if hedging costs continue to decline. However, in the long run, as long as short-term U.S. interest rates continue to rise more quickly than short-term interest rates in the Eurozone or Japan, and especially if the Fed's upcoming balance sheet contraction leads to more deeply negative basis swap spreads, then U.S. investors should continue to boost their yields by lending dollars and investing in bunds and JGBs. Bottom Line: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our U.S. Investment Strategy service took up the issue of residual seasonality in a recent report. Please see U.S. Investment Strategy Weekly Report, "Spring Snapback?", dated April 24, 207, available at usis.bcaresearch.com 2 IMF Staff Discussion Note, "Gone with the Headwinds: Global Productivity", https://www.imf.org/en/Publications/Staff-Discussion-Notes/Issues/2017/04/03/Gone-with-the-Headwinds-Global-Productivity-44758 3 Our outlook for the U.S. yield curve was discussed in detail in a recent report. Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com 5 IMF Multilateral Policy Issues Report: 2014 Spillover Report https://www.imf.org/external/np/pp/eng/2014/062514.pdf 6 Please see China Investment Strategy Weeky Report, "Has China's Cyclical Recovery Peaked?", dated May 5, 2017, available at cis.bcaresearch.com 7 http://www.bis.org/publ/work592.pdf 8 https://ftalphaville.ft.com/2017/04/13/2187317/where-would-you-prefer-your-balance-sheet-banks-or-the-federal-reserve/ Fixed Income Sector Performance Recommended Portfolio Specification