Economy

Special Report

Highlights Rates are going higher ... : Flight-to-quality episodes aside, the bond bear market that began in July 2016 remains in force. Investors should maintain below-benchmark Treasury duration. ... but that doesn't necessarily spell immediate trouble for stocks: Consistent with our work on the fed funds rate cycle, it appears that the level of rates matters more for equity returns than their direction. Empirical evidence of a rates tipping point is elusive ... : The notion that investors migrate from stocks to bonds at a particular level of rates exerts a powerful intuitive appeal, but the data fail to validate it. ... but a 10-year yield Treasury of 3.75 - 4% might halt the bull market in its tracks: Higher rates reliably slow equities only when they rise enough to slow the economy. We estimate that the pinch point is somewhere in the neighborhood of a 3.75 - 4% 10-year Treasury yield. Feature A share of stock is a pro rata claim on the future earnings of the company that issued it. Holding future earnings constant, the price an investor will be willing to pay for a share is wholly a function of the rate used to discount its earnings back to the present day. The simplicity and ubiquity of this valuation approach suggest that equity returns should be predictably related to moves in interest rates. It may also point the way to a tipping point - either in the level of rates, or the magnitude of their rise - at which capital and savings migrate from stocks to bonds. This Special Report reviews the historical record to see how U.S. equities have interacted with real 10-year Treasury yields. It considers the key variables that would logically seem to bear on equity performance and investors' propensity to rotate between asset classes. We find that the relationship between rates and equity returns is conditional, depending on which crosscurrent dominates in any given episode. We did not uncover any predictable rotation pattern. Do The Math As noted above, valuing a stream of future cash flows is a simple mechanical process once one settles on an appropriate discount rate for converting future dollars to current dollars. According to the security analysis textbooks, then, moves in stock prices are inversely related to changes in interest rates. But the textbooks leave out one key point: changes in interest rates don't occur in a vacuum. When they change, earnings estimates are likely to change, too, most often in the same direction as real rates. To be sure, the denominator discounting future cash flows rises when real rates rise, but the future-earnings numerator most likely rises, too. If real rates are rising, the economy is probably gaining momentum, and earnings estimates should probably be revised higher as well. Conversely, falling rates lead to a higher earnings multiple (ex-the not insignificant animal-spirits wild card), but will regularly be accompanied by downward revisions in future earnings. The net effect is uncertain, and depends on whether the multiple change outweighs the change in earnings or vice versa. Bonds Are A Snap Compared To Stocks It's far simpler to compute the impact on a bond portfolio from a given increase in interest rates because the denominator is the only variable that changes. The future-cash-flows numerator is contractually fixed, and it takes a big shift in the state of the economy to spark an economy-wide change in perceived repayment potential.1 This is why bonds' sensitivity to changes in interest rates can be captured in a single universal metric (duration). Stocks are pulled in so many different directions by factors affecting future cash flows that duration has no equity analogue. Investors should therefore be cautious about pinning too much on interest rates as they relate to equities. Bonds move in fixed orbits around the interest-rate sun, according to strictly ordered rules that establish a very clear cause-and-effect relationship. Equities improvise as they go along, taking their cues from a rotating cast of variables that interact differently over time. Attempts to stretch the concept of interest-rate sensitivity beyond bonds regularly trip up equity investors; we cannot know in advance how rates will come together with the other factors that influence equities. Confounding Intuition, Part 1: Equities Prefer Rising Rates (And Multiples Don't Care) U.S. postwar history makes it clear that equity investors need not run from rising rates. The S&P 500 has fared considerably better when real 10-year yields have risen by at least 100 basis points ("bps") than it has when they've declined by that magnitude (Chart 1), gaining 9.4% and 5%, respectively (Chart 2). Rates do not exhibit any sort of a consistent relationship with either forward (Chart 3) or trailing (Chart 4) S&P 500 multiples, though extremely high and extremely low real yields are both associated with lower trailing P/Es. Negative real yields carry an unwelcome whiff of deflation, and their scatterplot data points tend to cluster at below-the-mean forward and trailing multiples. Chart 1Stocks Actually Do Better When Rates Rise ... Chart 2... Considerably Better When Do Higher Rates Hurt The Economy? Charts 3 and 4 show that both forward and trailing multiples almost always decline when real 10-year Treasury yields cross above 5%. What's bad for multiples isn't necessarily bad for earnings, however, and a 5% real threshold is irrelevant to today's cycle. The steady decline in the average fed funds rate over the last several completed cycles (Chart 5) makes it clear that neutral rate thresholds are not constant across time periods. Assessing interest rates' impact on the economy over time requires a sliding scale. Chart 3Hard To See A Trend Through The Windshield ... Chart 4... Or The Rear-View Mirror Estimates of potential economic growth provide a useful yardstick for measuring the impact of real yields. Comparing real long rates to potential output offers insight into the burden of servicing debt across the economy. If real rates exceed the economy's potential growth rate by a material amount, several marginal borrowers are likely to be gasping for air, and their travails will weigh on the economy. Conversely, servicing debt should be easy when real rates are below potential growth, and investors are more likely to invest, businesses are more likely to expand, and consumers are more likely to spend. Chart 5One Size Does Not Fit All There have been 22 instances in the postwar era when real 10-year Treasury yields have increased by at least 100 bps, and Table 1 lists all of them, grouped by their relationship to real GDP's potential five-year growth rate. There are three possible states for interest rate increases in relation to potential output: starting and ending below trend growth, starting below trend growth and ending above it, and starting and ending above trend. The S&P 500 comfortably tops its overall postwar returns when rates go from Below-to-Below and Below-to-Above, but declines outright when rates start above potential growth and go even higher. Earnings consistently rise when rates start below potential growth, making multiples the swing factor - when they expand, S&P 500 gains tend to be very large (Box 1). Table 1Real Rates Versus Potential GDP Growth Box 1 Decomposing S&P 500 Returns Table 2 details the decomposition of S&P 500 returns during rising real rate episodes occurring after S&P 500 earnings estimates began to be compiled in 1979. Except in the crucible of 2009, when they were flat, forward earnings estimates have always risen when rates rise from a below-trend starting point, putting a tailwind behind the S&P 500 that regularly overcomes the multiple contraction that occurs in half of the Below/Above instances. Multiples are the swing factor; when they expand in conjunction with rising earnings estimates, U.S. equities soar. They always contract when rates go from high to higher, dragging stocks down against a mixed earnings expectations backdrop. The action is consistent with our fed funds rate cycle work: stocks do best when rates are below equilibrium and falling because earnings and multiples expand in tandem in that setting, but they do nearly as well after rate hikes commence, in spite of multiple contraction. Earnings surge when the Fed is confident enough about the economy to embark on a tightening cycle, but has not yet hiked enough to choke off the expansion. Multiple expansion in a majority of the Below/Above instances reveals that investors do not rotate out of equities en masse when rates rise, even by a considerable amount. The rotation story has intuitive appeal, but it doesn't show up in these data. Table 2Decomposition Of S&P 500 Returns During Rising Rate Periods A Little More Slicing And Dicing (Potential GDP Matters) Chart 6Mind The Gap Defining Below-to-Below and Below-to-Above states is easy in hindsight, but an investor cannot know in real time where a rising-rate instance that begins with rates below potential output will end. Earnings rise no matter where rates end relative to potential GDP, but re-rating in Below/Below can flip to de-rating in Below/Above, slamming the brakes on phase gains. The empirical data say investors should lighten up on S&P 500 exposure when real rates cross above real potential GDP. S&P 500 returns trounce their overall postwar gain when rates rise from below potential GDP to potential GDP but lag it once rates cross above potential GDP (Chart 6). Confounding Intuition, Part 2: Institutional Investors Don't Rotate Even if S&P 500 returns fail to demonstrate any consistent relationship with interest rates, one would expect that professional investors' asset-class positioning would. Bonds and stocks are alternatives for one another, and institutional investors presumably shift their allocations in line with the asset classes' relative prospects. We examine Pension Funds', Life Insurers', and Mutual Funds' asset-allocation profiles over time using balance-sheet data from the Federal Reserve's quarterly Flow of Funds report. The data show that asset-allocation decisions are made without apparent regard for relative valuations, at least as proxied by the equity risk premium. Pension funds' steady increase in equity allocations across the '90s appears to have been less a function of rate moves than buying into the bull market (Chart 7). Since the dot-com bubble burst in 2000, bond and equity allocations have mainly reflected the performance tides. The extended trend in pension funds' equity-to-bond allocation ratio suggests that the funds set a long-range goal and grind steadily toward achieving it, regardless of relative valuation movements. It also suggests that the funds may not bother with rebalancing, much less dynamic asset allocation. Life insurers kept their fixed income and equity allocations more or less fixed across the '70s (not shown) and most of the '80s. They then reduced equity exposure for three years after 1987's Black Monday, assiduously built it up across the '90s, and have more or less let it drift since the millennium (Chart 8). The equity risk premium does not appear to have been a consideration. Asset-allocation stasis may simply be a reflection of life insurers' stringent regulatory constraints, but their portfolio managers' limited discretion precludes opportunistic allocation shifts. Mutual fund allocations tend to depend much more on past events than future expectations. Equity holdings peak when the equity risk premium bottoms and bottom when the equity risk premium peaks (Chart 9). The problem is that mutual fund managers are structurally hostage to their investors' whims. They are sorted into narrow silos and then straitjacketed by the rigid allocation rules written into their fund prospectuses. Even if they think asset-class rotation is a great idea, only a tiny minority of fund managers can act upon it. Chart 7Pension Funds Don't Allocate Based On Yields Or The ERP ... Chart 8... While Life Insurers Appear To Allocate In Defiance Of Them Chart 9Mutual Funds##BR##Obey Their Owners ... Confounding Darwin's Intuition: Human Investors Never Learn Chart 10... Who Act On Real Emotion, Not Real Yields Kahneman and Tversky's groundbreaking research into decision-making under uncertainty revealed that our species is wired to make suboptimal investment decisions. Prospect theory, loss aversion and an unhealthy fixation on recent data all encourage retail investors to repeatedly shoot themselves in the foot. When it comes to asset allocation, households appear to focus exclusively on the action in the rear-view mirror (Chart 10). Retail investors as a group rotate between equities and fixed income retroactively, in response to recent past returns, not proactively in response to cues about future relative-return prospects. Investment Implications Despite the compelling intuition that investors should set their course by the interest-rate stars, there is no evidence in the flow of funds data that they have done so in the past. We posit that structural constraints on institutional investors, combined with humans' durable cognitive biases, offer no reason to expect that they will do so in the future. While there may not be any predictable rotation pattern, rising rates have given rise to a predictable performance pattern. Equities reliably perform better when real rates are rising by at least 100 basis points than they do when they're falling. Decomposition of S&P 500 returns indicates that the pattern holds because earnings rise a good bit more in rising-rate periods than multiples decline. And multiples don't always decline when rates rise, anyway; sometimes emotion overrides cash flow discounting mechanics. Investors should lighten up on Treasury allocations, while keeping the exposures they do hold at below-benchmark duration. They should not flee equities, however. Rates have not yet risen enough to cool off the economy in any material way, and we judge that they won't until somewhere around a 3.75% 10-year Treasury yield.2 Tight supplies in labor and goods markets will eventually stoke realized inflation and provoke the Fed into tightening enough to cut off the rally, but it hasn't happened yet, and it is far too early to de-risk portfolios on account of interest rates. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 An unusually large drop in rates may well be associated with economic distress, but default-adjusted bond payment streams are much less variable than near- and intermediate-term earnings estimates. 2 Based on the evolution of the Congressional Budget Office's longer-run estimates of real potential GDP growth, and the trend in our own model of long-term inflation expectations, it appears as if nominal potential GDP growth will be somewhere in the neighborhood of 3.75-4% next year. This is a much lower estimate than one would get from adding the Fed's 2% inflation target to the current rate of GDP growth, but we need to look past the immediate boost of the stimulus package to get a read on its longer-run effects. As with all of the estimates produced by our models, we look to it for a general guide to the future, not a precise point estimate.

Highlights The U.S. dollar is likely to correct further over the coming weeks. The CAD should benefit as it is cheap and oversold, and the inflationary back-drop warrants tighter monetary conditions. This will be a bear market rally, not the ultimate trough for the loonie. EUR/SEK should correct as the Riksbank will start tightening policy in December; a pause in the global growth slowdown should also give the cheap SEK a welcome boost. Cheap long-term valuations will not help the yen in the coming weeks; instead, falling Japanese inflation expectations and growing investor expectations of Chinese stimulus will weigh on the JPY. A better opportunity to buy the yen on its crosses will emerge later this year. EUR/CHF has upside over the coming months; the swissie needs additional global growth weakness to rally further. This is unlikely to happen for a few months. Feature Chart I-1DXY Correction Has Further To Run By the middle of the summer, the dollar had hit massively overbought levels, which left it vulnerable to any signs of stabilization in global growth, especially if some key U.S. activity gauges began to soften (Chart I-1). This is exactly what is transpiring. As we highlighted last week, BCA's Global LEI Diffusion Index is rebounding, EM and Japanese exports are stabilizing and U.S. core inflation and building permits have disappointed. This bifurcation in the data suggests the dollar has more room to correct, as neither our Capitulation Index nor our Intermediate-Term Technical Indicator have hit technically oversold levels. Last week we also argued that this correction in the dollar is likely to prove a temporary reprieve, but that in the interim the euro and the Australian dollar were well placed to experience significant rebounds.1 This week, we explore if the same case can be built for the Canadian dollar, the Swedish krona, the yen and the Swiss Franc. CAD: The Bank of Canada Will Proceed Cautiously The first half of 2018 has not been kind to the Canadian dollar. A rout in EM assets, signs of softening global growth and tough rhetoric from the White House on trade generally and NAFTA and Canada in particular have conspired to create fertile grounds for loonie-selling. Since the end of June, the CAD has managed to regain some composure, rallying by 3.3% against the USD. Essentially, much bad news has been embedded in this currency, which now trades at a significant discount to BCA's estimate of its short-term fair value (Chart I-2). Moreover, speculators, who had been aggressively buying the CAD at the end of 2017, now hold large short positions in the currency (Chart I-2, bottom panel). This combination is now resulting in a situation where any pause in the USD's strength is being mirrored in CAD strength. Can this rebound continue? Canadian economic data sends a murky message. Canadian real GDP growth had overtaken that of the U.S., peaking at 3.6% in February last year. However, it is now below U.S. growth (Chart I-3). Canadian consumers have been the main source of the slowdown as Canadian capex growth is in line with the U.S. and the Trudeau government has been spending generously. Can this rebound continue? Canadian economic data sends a murky message. Canadian real GDP growth had overtaken that of the U.S., peaking at 3.6% in February last year. However, it is now below U.S. growth (Chart I-3). Canadian consumers have been the main source of the slowdown as Canadian capex growth is in line with the U.S. and the Trudeau government has been spending generously. Chart I-2No One Is Going Crazy For The Loonie Chart I-3Canada: Growth Picture Is Mixed The weakness in Canadian consumption partly reflects the underperformance of Canadian employment relative to the U.S. However, the slowdown in house prices has played a bigger role (Chart I-4). Canadian households are burdened by a debt load of 170% of disposable income. Now that mortgage rates are rising, Canadians are spending more than 14% of their disposable income servicing their debt, a burden last experienced in 2008 when mortgage rates were 220 basis points higher. Without the benefit of rapidly rising real estate assets, it is much more difficult for Canadian retail sales to grow at an 8.7% annual rate as they did three quarters ago. Despite these weaknesses, it is hard to justify that Canadian monetary conditions - as approximated by the slope of the yield curve, the level of real rates, and the trade-weighted CAD - should be as easy as they are today (Chart I-5). This is even truer when we take into account Canadian inflationary conditions. Chart I-4Canadian Consumers Have A Problem Chart I-5Canadian Monetary Conditons Are Very Easy The three inflation gauges targeted by the Bank of Canada stand between 1% and 3%, or at its objective. This means that the BoC's 1.5% policy rate is negative in real terms. Moreover, this inflationary pressure is unlikely to abate. The BoC estimates that the output gap has closed, and companies are running into growing capacity constraints (Chart I-6, top panel). Despite a correction last month, wages are in an uptrend, powered by growing and severe labor shortages (Chart I-6, bottom panel). Thanks to these conditions, we anticipate that the BoC will track the pace of rate increases by the Federal Reserve over the next 12 months. This is not very different from what is currently priced into Canadian money markets. Chart I-6Canadian Capacity Pressures Point To A Hawkish ##br##BoC Inflation Will Force The BoC's Hand If the BoC does not disappoint, the combination of a cheap and oversold CAD should help the loonie rally against the USD, so long as the current stabilization in global growth continues. A move toward USD/CAD 1.26 is likely. The biggest risk to this view is that trade negotiations between the U.S. and Canada deteriorate further. While we do not anticipate an imminent breakthrough in these negotiations, we do not see much scope for significant deterioration in the relationship either. The energy market could prove to be another positive for the loonie. Bob Ryan, who leads BCA's Commodity and Energy Strategy service, argues that the oil market is currently very tight and vulnerable to supply disruptions.2 Under these circumstances, the removal of Iranian exports, tensions in Iraq, declining Nigerian production and Venezuela's cascading implosion all risk causing a melt-up in oil prices by the first half of 2019. This could help the CAD as well, even if the Canadian oil benchmark remains at a large discount to Brent. Longer-term, the upside in the CAD is likely to be capped. There is only one rate hike priced into the U.S. OIS curve from June 2019 to December 2020. We expect the Fed to hike rates by more than that. Meanwhile, the emerging softness in the Canadian household sector suggests it will be much more difficult for the BoC to keep following the Fed higher over that period. The CAD is not cheap enough to compensate for these long-term headwinds (Chart I-7). Bottom Line: On a short-term basis, the Canadian dollar is cheap and oversold. While the Canadian consumer has begun to disappoint, the inflationary pressures present in Canada should keep the BoC on track to follow the Fed and push rates higher over the coming 12 months. The CAD should therefore benefit from any USD weakness, with USD/CAD moving toward 1.26. Once the short-term undervaluation and oversold conditions are corrected, USD/CAD should rebound toward 1.40. Chart I-7We Like The CAD For Now, But The Rally Has A Limited Shelf Life EUR/SEK Will Trade Heavy Any which way we cut it, the SEK is cheap. The trade-weighted krona is trading at its cheapest levels relative to BCA's long-term fair value since the Great Financial Crisis (Chart I-8). The SEK is not only trading at a 32% discount to its purchasing-power parity against the greenback, it is also trading at a 10% discount against its PPP relative to the euro. Chart I-8The SEK Is An Attractive Long-Term Buy... The SEK is not only cheap on a long-term basis, it is also cheap on a short-term basis. This is most evident against the euro. Currently the SEK trades at a 7% discount to the euro according to our short term fair value model based on real rate differentials, commodity prices and global risk aversion. Historically, this kind of discount in the SEK has been followed by a prompt rebound (Chart I-9). Are there any catalysts to convert this good value into good returns? We see many. First, as was the case in Canada, Sweden's Monetary Gauge has not been at such easy levels since the Great Financial Crisis (Chart I-10). Meanwhile, the economy is also experiencing rising capacity pressures. The OECD's estimate of the output gap stands at 0.7% of GDP, and inflationary pressures are building, as evidenced by the Riksbank's Capacity Utilization measure (Chart I-11). Chart I-9...And A Short-Term One As Well Chart I-10The Riksbank Is Too Easy Chart I-11Swedish Inflation Has Upside This set of circumstances suggests the Riksbank could start hiking rates as early as this coming December, well ahead of the European Central Bank. As a result, we project that Swedish real interest rates could rise further relative to the euro area. Historically, falling euro area / Swedish real interest rate spreads precede depreciations in EUR/SEK (Chart I-12). Chart I-12Real Rate Differentials Point To A Lower EUR/SEK Chart I-13Chinese Liquidity Injections Point To A Lower EUR/SEK The global context also points toward an imminent correction in EUR/SEK. The krona is much more pro-cyclical than the euro. This reflects the more volatile nature of the Swedish economy and the extraordinarily large role of trade in its GDP. EUR/SEK greatly benefited from the tightening in Chinese liquidity conditions, as evidenced by the widening between the 1-month and 1-week Chinese interbank rate (Chart I-13). EUR/SEK essentially sniffed out a slowdown in Chinese capex, a key source of ultimate demand for Swedish goods. However, now that the PBoC is injecting liquidity in the Chinese interbank system, EUR/SEK is likely to suffer. Moreover, the outperformance of Chinese infrastructure and real estate stocks in recent weeks also suggests the SEK could appreciate further against the EUR. The rally of risk assets on the day that U.S. President Donald Trump announced an additional 10% tariff on US$200 billion worth of Chinese exports further confirms that investors may be in the process of discounting additional stimulus out of China, which would further hurt EUR/SEK. To be clear, we have already noted that we do not anticipate the Chinese authorities to attempt to boost growth - we only expect them to limit the damage created by an intensifying trade war with the U.S. As a result, the positive impact of China on the krona should prove transitory. But for the time being, it could be enough to help correct the SEK's 7% discount to the euro. Since we anticipate the USD to continue to correct in the coming weeks, this also implies that USD/SEK possesses ample tactical downside. This negative EUR/SEK view is not without risks. The first comes from the fact that the Swedish current account surplus is now smaller than the euro area's, something not seen since the early 1990s. This is mitigated by the fact that Sweden's net international investment position is now 10% of GDP, while it used to be negative as recently as 2015. The euro area NIIP is still in negative territory. The second risk is that Swedish house prices have begun to contract in response to macroprudential measures. However, we believe that Sweden's inflationary backdrop is likely to dominate the Riksbank's reaction function. Bottom Line: The SEK is cheap against the dollar and the euro on both long-term and short-term metrics. As the Riksbank is set to lift rates in December, we expect EUR/SEK to decline significantly. Recent injections of liquidity by the PBoC and growing expectations among investors of Chinese stimulus could create additional downward impetus under both EUR/SEK and USD/SEK. This is a tactical view. We anticipate the reprieve in the global growth slowdown to be temporary. Once it resumes, the SEK will find it difficult to rally further. JPY: Down Now, Up Later Investors are well aware that the yen is one of the cheapest G10 currencies on a long-term basis. BCA's long-term fair value model shows that the real trade-weighted yen is trading at a 17% discount, close to its cheapest levels in 36 years. However, despite its prodigious long-term cheapness, the yen is not nearly as attractive when compared to its short-term determinants, which show a small premium in the price of the yen versus the dollar (Chart I-14). This means the direction of Japanese monetary policy and global growth will remain more important for the yen's price action over the coming months than its long-term cheapness. When it comes to growth, Japan is doing okay. We witnessed a decline in industrial production driven by foreign demand this summer, but domestic machinery orders are improving and export growth is finding a floor. Actually, BCA's real GDP model for Japan is suggesting that growth could re-accelerate significantly next quarter (Chart I-15). In our view, this improvement reflects the fact that business credit is once again growing after decades of hibernation. Chart I-14Is The JPY A Bargain? Long Term, Yes; Short Term, No! Chart I-15Japanese Growth Doing Just Fine However, we doubt this is enough to prompt any tightening in the Bank of Japan's policy. The most immediate problem facing the BoJ is that Japanese inflation expectations are in free fall (Chart I-16). Since the BoJ assigns the blame of low realized inflation on depressed inflation expectations, this aforementioned weakness, despite the yen's softness, guarantees that the BoJ will stay on the sidelines for much longer. After all, if any little shock can spur such a sharp impact on Japanese inflation expectations, despite an unemployment rate at 2.5% and an output gap at 0.8% of GDP, the BoJ has not anchored inflation expectations higher. Further reinforcing our bias that the BoJ is not set to tighten policy for many more quarters, the VAT is set to be increased to 10% in October 2019. The LDP leadership race is currently underway, and no one is mentioning postponing that hike. This suggests that significant fiscal tightening could emerge next year. The fact that the BoJ will continue to lag behind other global central banks forces us to be negative on the yen. However, could an external event push the yen higher, despite this absence of domestic support? A big downgrade in EM asset prices and global growth would do the trick. While we do think this is likely to happen over the next six to nine months, now does not appear to be the moment to implement such a bet. As we highlighted above, the deceleration in global growth seems to be pausing, and Chinese liquidity conditions have eased. Seven weeks ago, we introduced our China Play Index to track whether or not investors were discounting additional easing on the part of China.3 This indicator looks as if it is forming a base right now (Chart I-17), indicating that pro-growth plays could perform well over the coming weeks while countercyclical plays, like the yen, could perform poorly. Until this indicator begins a new down leg - something we anticipate for the backend of the year - the yen will remain under downward pressure against the dollar, the euro or the aussie. Chart I-16The BoJ's Problem Chart I-17Chinese Plays Are Stabilizing As a result, while we continue to expect more upside in the yen in the latter part of the year, for the time being we will remain on the sidelines as neither short-term valuations, monetary policy dynamics or the global growth environment point to an imminent rally in the yen. Bottom Line: The yen is an attractive long-term play as it displays prodigiously cheap long-term valuations. However, the short-term outlook is less favorable. The yen is not cheap enough based on our augmented interest rate differentials models, the BoJ will remain dovish for the foreseeable future, and an uptick in our China Play Index bodes poorly for countercyclical currencies like the yen. However, since we do expect that global growth will stabilize only on a temporary basis, we will look to open some long yen bets later this fall. Close Short EUR/CHF Trade Last March, we argued that EUR/CHF had more cyclical upside, but that bouts of volatility in global markets would cause periods of weaknesses in the cross.4 Based on this insight, we proceeded to sell EUR/CHF on April 6 as we worried that markets were set to price in a period of weakness in global growth.5 We closed this trade in August, but EUR/CHF kept falling. Now, is EUR/CHF more likely to rally or selloff in the coming quarter? We think a rebound is in the cards. First, the franc is once again highly valued, based on the Swiss National Bank's assessment. It is true that the SNB has not intervened to limit the franc's upside recently, but the CHF's strength is likely to short-circuit the increase in inflation that could have justified betting on the Swissie moving higher (Chart I-18). Ultimately, there is limited domestic inflationary pressures in Switzerland. Moreover, since the import penetration of goods and services in Switzerland is the highest of all the G10, imported deflation will soon be felt. Further, as Swiss labor costs remain very high internationally, the large improvement in full-time jobs witnessed this year is likely to peter off as Swiss businesses work to maintain their competitiveness. Second, the franc received an additional fillip this year as the breakup risk premium in Europe surged (Chart I-19). Every time investors perceive that the probability of a disintegration of the euro rises, they end up pouring money into stable Switzerland. Marko Papic, BCA's Geopolitical Strategy expert, believes that the euro break-up risk will continue to be a red herring in the coming few years. Investors will therefore price out this risk, pulling money out of Switzerland where interest rates remain 30 basis points below the euro area, and boosting EUR/CHF in the process. Chart I-18The Swissie's Strength Will Be Deflationary Chart I-19If A Euro Break-Up Is A Red Herring... Finally, if a temporary stabilization in global growth will hurt the yen, it will also hurt the Swiss franc. As a result, the stabilization in the China Play Index should support EUR/CHF. While we expect EUR/CHF to rally over the coming months, we worry that any such rebound will prove temporary. The current expansion in Chinese stimulus is only a passing phenomenon, and not one powerful enough to put a durable bottom under global growth and EM assets. Hence, while EUR/CHF could easily rally to 1.15, any such rebound should be faded. This move, if followed by a deterioration in our China Play Index, should be used to re-open EUR/CHF shorts. Bottom Line: The Swiss franc remains in a cyclical bear market, punctuated by occasional rallies against the euro when global growth sentiment sours. We just experienced such a rally in the Swissie, but it is ending as the deflationary impact of the CHF's rally will soon be felt. Moreover, the breakup risk premium in the euro is currently too large, and the pricing-in of slowing global growth is likely to take a breather. As a result, EUR/CHF is likely rally over the coming months. We will look to bet again on a CHF rally once the reprieve in global growth ends. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Policy Divergence Are Still The Name Of The Game", dated September 14, 2018, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report, titled "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at ces.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "The Dollar And Risk Assets Are Beholden To China's Stimulus", dated August 3, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Retail sales and retail sales ex autos yearly growth underperformed expectations, coming in at 0.1% and 0.3% respectively. Capacity utilization and building permits also surprised to the downside, coming in at 78.1% and 1.229 million respectively. However, Housing starts and the Michigan Consumer Sentiment Index surprised positively, coming in at 9.2% and 100.8 respectively. DXY has fallen by nearly 1% this week. Overall, we continue to be bullish on the dollar on a cyclical basis, as inflationary pressures inside the U.S. will force the Fed to hike more than the market expects. That being said, the slowdown in the dollar's momentum, the growing Chinese stimulus, and accumulating signs of stabilizing global economic activity are likely to further weigh on the dollar on a more immediate basis. We will monitor these factors closely in order to gauge whether or not this pullback will remain a garden-variety correction or something more serious. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 Rhetoric Is Not Always Policy - July 27, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been positive: Labor costs growth outperformed expectations, coming in at 2.2%. Moreover, construction output yearly growth also surprised positively, coming in at 2.6%. Finally, both core and headline inflation came in line with expectations, at 1% and 2% respectively. EUR/USD has rallied by 1.1% this week We are bearish on the cyclical outlook for the euro, given that core inflation measures are continue to be too weak for the ECB to meaningfully change their dovish monetary policy stance. However, the current tactical rebound is likely to continue, as the weakness in the euro this year has eased financial conditions, which could lead to a temporary boon for the economy. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Industrial production yearly growth surprised negatively, coming in at 2.2%. Moreover, capacity utilization also underperformed expectations, coming in at -0.6%. Finally, both export and import yearly growth outperformed expectations, coming in at 6.6% and 15.4% respectively. USD/JPY has been relatively flat this week. We are bearish on the yen on a structural basis, given that the economy continues to suffer from strong deflationary forces, which will force the Bank of Japan to keep their ultra-easy monetary policy. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been positive: The retail price index yearly growth surprised to the upside, coming in at 3.5%. Moreover, both core and headline inflation outperformed expectations, coming in at 2.1% and 2.7% respectively. Finally, the DCLG House Price Index also surprised positively, coming in at 3.1%. GBP/USD has rallied by roughly 1.5% this week. The GBP's vol is likely to increase further going foirward, as very little political risks is priced into it. A practical strategy will be to lean against large weekly moves, both on the upside and downside. This strategy should be particularly profitable versus the euro. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been positive: The participation rate surprised to the upside, coming in at 65.7%. Moreover, the total change in employment also outperformed expectations, coming in at 44 thousand. Finally, the house price index yearly growth also surprised positively, coming in at -0.6%. AUD/USD has risen by roughly 1.8% this week. We continue to be cyclically bearish on the Australian dollar, as the deleveraging campaign in China will weigh on demand for industrial metals, Australia's main export. Moreover, the AUD will also have downside against the CAD, as oil should continue to hold up relative to other commodities thanks to supply cuts from OPEC. That being said, the AUD's recent rebound is likely to continue on a short-term basis. Hence, investors already shorting the Aussie should consider buying hedges. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has rallied nearly 1.9% this week. We are negative on the New Zealand dollar on a structural basis due to the measures taken by the Ardern government, which include reducing immigration, and adopting_a dual mandate for the RBNZ. Both of these measures will weigh on the real neutral rate, which means that the RBNZ will have to hold rates lower than otherwise. However, on a more tactical basis, this cross could rally, thanks to the temporary stimulus by the Chinese authorities which will help risk assets. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: Manufacturing shipments monthly growth outperformed expectations, coming in at 0.9%. However, capacity utilization surprised to the downside, coming in at 85.5%. Finally, the new house price index yearly growth was in line with expectations, coming in at 0.5% USD/CAD has depreciated by 1% this week. We remain bullish on the CAD among the dollar bloc currencies, given that inflationary pressures continue to be strong in Canada. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has rallied by 0.5% this week. We continue to be bullish on this cross on a cyclical basis, as the Swiss economy is still too fragile for the SNB to remove its ultra-dovish monetary stance. Moreover, the recent appreciation in the franc that has taken place over the last four months should be very negative for inflation, as Switzerland is the country with the most imports as a percentage of demand in the G10, and thus the country with the most sensitive inflation to currency movements. Finally, on a tactical basis we are also bullish on this cross, as the recent easing of monetary policy by Chinese authorities should be weigh on safe heaven assets like the franc. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Yesterday, Norges Bank increased rates for the first time since 2011, yet the NOK was flat against a weak USD, and fell against the euro and the Swedish krona, suggesting that the hike was well anticipated by market participants. Despite this price action, USD/NOK has depreciated by 1.2% this week. We are positive on the NOK against other non-oil commodity currencies, as oil should outperform base metals in the current environment. After all, OPEC supply cuts and geopolitical risk in the Middle East should provide a boon for oil prices. On the other hand, while temporary easing is likely, the Chinese deleveraging campaign will continue once the Chinese economy has stabilized. Finally, the positive NIIP, and positive current account of the NOK should give it an additional advantage against the rest of the commodity currencies. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been negative: Headline inflation underperformed expectations, coming in at 2%. Moreover, the unemployment rate increased from 6% in July to 6.1% on the August reading. USD/SEK has depreciated by almost 2.8% this week. We expect the Riksbank to begin tightening policy in December, as Swedish inflationary pressures remain strong. Moreover, the recent stimulus from the PBoC should put additional downward pressure on EUR/SEK, given the krona's more pro-cyclical profile than the euro. Finally, valuations also support the SEK, as the krona is cheap according to multiple measures. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades