Euro Area
Highlights Global Inflation has upside on a cyclical basis, but this narrative is well known and investors have already placed their bets accordingly, buying inflation protection in a wide swath of markets. However, global growth has not yet found its footing, suggesting a mini-deflation scare, at least relative to expectations, is likely this summer. The U.S. dollar will benefit in such a scenario, and NOK/SEK will depreciate. While GBP/USD has downside, the pound should rally versus the euro. Weakness in EUR/CAD has not yet fully played out; the recent bout of strength was only a countertrend move. Feature Inflation is coming back, and this will obviously have major consequences for both asset and currency markets. However, macro investing is not just about forecasting fundamentals correctly; often, just as importantly, it is about understanding how other investors have priced in these expected economic developments. Therein lies the problem. While we understand why inflation could pick up, so too have most investors, and they have positioned themselves accordingly. With global growth currently looking shaky, we believe a better entry point for long-inflation plays will emerge in the coming months. In the meanwhile, a defensive, pro-U.S. dollar posture still makes sense. Investors Are Long Inflation Bets We have long argued that inflation was likely to make a cyclical comeback, a return that would begin in the U.S. before spreading to the rest of the globe. This story is currently playing out. However, in response these developments, investors have placed their bets accordingly, and the story currently seems well baked in. Prices of assets traditionally levered to inflation have already moved to discount a significant pick-up in inflation. The most evident dynamics can be observed in the U.S. inflation breakevens. Both the 10-year breakevens as well as the 5-year/5-year forward breakevens just experienced some of their sharpest two-year changes of the past 20 years, notwithstanding the pricing out of a post-Lehman, depression-like outcome (Chart I-1). Breakevens are not alone. Other assets have displayed similar behavior. In the U.S., investors have aggressively sold their holdings of utilities stocks, which have been greatly outperformed by industrial stocks. Traditionally, investors lift the price of XLI relative to that of XLU when they anticipate global inflation to pick up (Chart I-2). Chart I-1Markets Are Positioning Themselves##br## For Higher Inflation Chart I-2U.S. Sectoral Performance Suggests Investors ##br##Have Already Bet On Higher Inflation... It is not just intra-equity market dynamics that support this assertion. The behavior of the U.S. stock market relative to Treasurys further buttresses the idea that investors have already aggressively discounted an upturn in global consumer prices (Chart I-3). Potentially, the best illustration of investors' preference for inflation protection is currently visible in EM assets. A seemingly paradoxical phenomenon has been puzzling us: How have EM equities managed to avoid the gravitational pull that has caused EM bonds to nearly flirt with the nadir of early 2016? After all, EM equities, EM currencies and EM bonds are normally closely correlated, driven by investors' wagers on the direction of global growth. A simple variable can explain this strange dichotomy: anticipated inflation. As Chart I-4 illustrates, the performance of a volatility adjusted long EM stocks / short EM bonds portfolio tends to anticipate fluctuations in global inflation. The current price action in this basket indicates that investors have made their bets, and they think inflation is going up. Chart I-3...So Does The Stock-To-Bond Ratio Chart I-4Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Anecdotal evidence suggests that in recent quarters, pension plans have been aggressive buyers of commodities - a move that normally coincides with these long-term investors putting in place some inflation hedges. Moreover, positioning in the futures markets corroborates these stories: speculators are still very long commodities like copper and oil - commodities traditionally perceived as efficient protectors against inflation spikes (Chart I-5). Finally, despite the potentially deflationary risks created by Italy three weeks ago, speculators remain short U.S. Treasury futures, bond investors are underweight duration, and sentiment toward the bond market remains near its lowest levels of the past eight years (Chart I-6). Again, this behavior is consistent with investors being positioned for an inflationary environment. Chart I-5Money Has Flown Into Resources Chart I-6Bond Market Positioning Is Still Very Short Bottom Line: There is a well-defined case to be made that a global economy that was not so long ago defined by the presence of deflationary risks is now morphing into a world where inflation is on the upswing. However, based on inflation breakevens, sectoral relative performance, equities relative to bonds in both DM and EM as well as on the positioning of investors in commodity and bond markets, this changing state has been quickly discounted by investors. The Decks Are Stacked, But Where Does The Economic Risk Lie? The problem facing investors already long inflation protection every which way they can be is that the global economy is slowing, which normally elicits deflationary fears, not inflationary ones. This seems a recipe for disappointment, albeit one that is likely to help the dollar. Our global economic and financial A/D line, which tallies the proportion of key variables around the world moving in a growth-friendly fashion, has fallen precipitously. This normally heralds a slowdown in global economic activity (Chart I-7). Chart I-7Global Growth Is Losing Traction In similar vein, global leading economic indicators have also begun to roll over - a trend that could gain further vigor if the diffusion index of OECD economies experiencing rising versus contracting LEIs is to be believed (Chart I-8). The global liquidity picture has also deteriorated enough to warrant caution. Currency carry strategies - as approximated by the performance of EM carry trades funded in yen - have sagged violently. This tells us that funds are flowing out of EM economies and moving back to countries already replete with excess savings like Japan or Switzerland (Chart I-9). Historically, these kinds of negative developments for global liquidity have preceded industrial slowdowns, as EM now accounts for the lion's share of global IP growth. Finally, China doesn't yet look set to bail out the world's industrial sector. This month's money and credit numbers were weaker than anticipated, and our leading indicator for the Li-Keqiang index - our preferred gauge of industrial activity in the Middle Kingdom - points to further weakness (Chart I-10). This makes it unlikely that China's imports will rise, lifting global growth. Additionally, China has re-stocked in various commodities, suggesting it is front-running its own domestic demand, highlighting the risk that its commodities intake could become even weaker than what domestic growth implies. Chart I-8More Weakness In LEIs Chart I-9Global Liquidity Tightening Chart I-10China Not Yet Set To Bail Out The World With this kind of backdrop, we expect the current slowdown in global growth to run further before ebbing, probably in response to what will be a policy move out some kind from China to put a floor under growth. As a result, the current infatuation with inflation hedges among investors may wane for a bit as slower growth could shock inflation expectations downward, especially in a global context that has been defined by excess capacity since the late 1990s. An environment where global inflation expectations could be downgraded in response to slower growth is likely to be an environment where the dollar performs well, particularly as U.S. growth continues to outperform global growth (Chart I-11). This also confirms our analysis from two weeks ago that showed that when bonds rally the dollar tends to outperform most currencies, with the exception of the yen.1 Moreover, with the Federal Open Market Committee upgrading its path for interest rates by one additional hike in 2018, this reinforces the message from our previous work noting that once the fed funds rate moves in the vicinity of r-star, the dollar performs well, nearly eradicating the losses it incurred when the fed funds rate rises but is well below the neutral rate (Table I-1). This is especially true if vulnerability to higher rates rests outside - not inside - the U.S., as is currently the case.2 Chart I-11The Dollar Likes Lower Global Inflation Table I-1Fed And The Dollar: Where We Stand Matters As Much As The Direction Beyond the dollar, one particular currency cross has historically been a good correlate to investors betting on higher inflation: NOK/SEK. As Chart I-12 illustrates, when investors buy inflation hedges such as going long EM equities relative to EM bonds, this generates a rally in NOK/SEK. These dynamics played in our favor when we were long this cross earlier this year. However, not only are EM equities extended relative to EM bonds, the current economic environment portends a growing risk of investors curtailing these kinds of bets. The implication is bearish for NOK/SEK, and we recommend investors sell this cross at current levels. Chart I-12NOK/SEK Suffers If Inflation Bets Are Unwound Bottom Line: Investors have quickly and aggressively positioned themselves to protect their portfolios against upside inflation risks. However, the global economy is still slowing - a development that has further to run. As a result, this current anticipation of inflation could easily morph into a temporary fear of deflation, at least relative to lofty expectations. This would undo the dynamics previously seen in the market. This is historically an environment in which the dollar performs well, suggesting the greenback rally is not over. Moreover, NOK/SEK could suffer in this environment. The Bad News Is Baked Into The Pound There is no denying that the data flow out of the U.K. has been poor of late. In fact, despite what was already a low bar for expectations, the U.K. economy has managed to generate large negative surprises (Chart I-13). One of the direct drivers of this poor performance has been the complete meltdown in the British credit impulse (Chart I-14). Additionally, the slowdown in British manufacturing can be easily understood in the context of slowing global growth (Chart I-15). Chart I-13Anarchy In The U.K. Chart I-14The Credit Impulse Has Bitten Chart I-15U.K. Exports Are Slowing Because Of Global Growth But, the bad new seems well priced into the pound, especially when compared to the euro. Not only is the GBP trading at a discount to the EUR on our fundamental and Intermediate-term timing models, speculators have accumulated near-record short bets on the pound versus the euro (Chart I-16). This begs the question: Could any positive factor come in and surprise investors, resulting in a fall in EUR/GBP? We think the answer to this question is yes. First, despite the negatives already priced in, incremental bad news have had little traction in dragging the pound lower versus the euro in recent weeks, suggesting that EUR/GBP buying has become exhausted. Second, a falling EUR/USD tends to weigh on EUR/GBP, as the pound tends to act as a low-beta version of the euro (Chart I-17). Chart I-16Investors Are Well Aware Of Britain's Problems Chart I-17EUR/GBP Sags When EUR/USD Weakens Third, the economic outlook for the U.K. is improving. It is true that in the context of slowing global growth, the manufacturing and export sectors are unlikely to be a source of positive surprises for Great Britain. However, the domestic economy could well be. As Chart I-14 highlights, the credit impulse has collapsed, but the good news is that outside of the Great Financial Crisis it has never fallen much below current levels, suggesting that a reversion to the mean may be in offing. Additionally, U.K. inflation is peaking, which is lifting British real wages (Chart I-18). In response, depressed consumer confidence is picking up. This is crucial as consumer spending, which represents roughly 70% of the U.K.'s GDP, has been the key drag on growth since 2016. Any improvement on this front will lift the whole British economy, even if the manufacturing sector remains soft. Fourth, Brexit is progressing. This week's vote in the House of Commons was confusing, but it is important to note than an amendment that gives Westminster the right to force a renegotiation between the U.K. and the EU if no deal is reached in 2019 has been passed. This also decreases the risk of a completely economically catastrophic Brexit down the road, but increases the risk that PM Theresa May could be ousted over the next 12 months. Our positive view on the pound versus the euro (or negative EUR/GBP bias) is not mimicked in cable itself. Ultimately, despite the GBP/USD's beta to EUR/GBP being below one, it is nonetheless greater than zero. As such, it is unlikely that GBP/USD will be able to rally if the DXY rallies and the EUR/USD weakens (Chart I-19). Therefore, while we recommend selling EUR/GBP, we are not willing buyers of GBP/USD. Chart I-18A Crucial Support To Growth Chart I-19Cable Will Not Avoid The Downward Pull Of A Strong Dollar Bottom Line: The British economy has undergone a period of weakness, which is already reflected in the very negative positioning of investors in the GBP versus the EUR. However, the bad data points are losing their capacity to push EUR/GBP higher, and the British economy may begin to heal as consumer confidence is rebounding thanks to improving real wages. The low beta of GBP/USD to the euro also implies that a falling EUR/USD will weigh on EUR/GBP. However, while the pound has upside against the euro, it will continue to suffer against the dollar if EUR/USD experiences further downside. What To Do With EUR/CAD? One weeks ago, we were stopped out of our short EUR/CAD trade. Has EUR/CAD finished its fall, or was the recent rally a pause within a downward channel? We are inclined to think the latter. Heated rhetoric on trade has hit the CAD harder than the EUR, as exports to the U.S. represent a much larger share of Canada's GDP than of the euro area, forcing the pricing of a risk premium in the loonie. However, even after a rather explosive G7 meeting, we do believe that a compromise is still feasible and that NAFTA is not dead on arrival. A deal is still likely because, as Chart I-20 demonstrates, Canadian tariffs on U.S. imports are not only marginally in excess of U.S. tariffs on Canadian imports, they are also in line with international comparisons. This suggests only a small push is needed to arrive to a deal that salvages NAFTA, which ultimately is much more important to Canada than the dairy industry. Chart I-20Canada And The U.S. Can Find A Compromise Despite this reality, we cannot be too complacent, U.S. President Donald Trump is likely to be playing internal politics ahead of the upcoming mid-term elections. U.S. citizens are distrustful of free trade (Chart I-21), a trend especially pronounced among his base. However, a good result for the GOP in November is contingent on the Republican base showing up at the polls. Firing this base up with inflammatory trade rhetoric is a sure way to do so. This means that risks around NAFTA are still not nil. Chart I-21America Belongs To The Anti-Globalization Bloc However, EUR/CAD continues to trade at a substantial premium to fair-value on an intermediate-term horizon (Chart I-22). Moreover, as the last panel of the chart illustrates, speculators remain massively short the CAD against the EUR. This creates a cushion for the CAD versus the EUR if global growth slows. Moreover, technicals are still favorable of shorting EUR/CAD. Not only is EUR/CAD still overbought on a 52-week rate-of-change basis, it seems to be in the process of forming a five-wave downward pattern, with the fourth one - a countertrend wave - potentially ending (Chart I-23). Chart I-22EUR/CAD Is Still Vulnerable Chart I-23Wave Pattern Not Completed Finally, EUR/CAD tends to perform poorly when the USD strengthens, which fits with our current thematic for the remainder of 2018. Bottom Line: The headline risk surrounding NAFTA has weighed on the loonie against the euro, stopping us out of our short EUR/CAD trade with a small profit. However, the valuation, positioning and technical dynamics suggest the timing is ripe to short this cross once again. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Rome Is Burning: Is It The End?", dated June 1, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different", dated May 25, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was stellar: NFIB Business Optimism Index climbed to 107.8, outperforming expectations; the price changes and good times to expand components are also very strong; Headline and core PPI both outperformed expectations, auguring well for future consumer inflation; Headline and core retail sales grew by 0.8% and 0.9% in monthly terms, beating expectations; Both initial and continuing jobless claims also came out below expectations, highlighting that the labor market is still tightening, and wage growth could pick up further. The Fed raised interest rates this week to 2%, and added one additional rate hike to its guidance for 2018. FOMC members once again highlighted the "symmetric" target, suggesting that the Fed expects the economy to overheat slightly. An outperforming U.S. economy relative to the rest of the world is likely to propel the greenback this year. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Economic data was largely disappointing: Italian industrial output contracted by 1.2% on a monthly basis, and grew only by 1.9% on a yearly basis; The German ZEW Survey declined substantially across all metrics; European industrial production increased by 1.7% annually, less than the expected 2.8% increase; However, Spanish headline inflation spiked up from 1.1% to 2.1%. Yesterday, ECB President Mario Draghi announced the ECB's plan to taper asset purchases to EUR 15 bn a month in September, and phase them out completely by year-end. Moreover, Draghi highlighted that the ECB was not anticipating to implement its first hike until after the summer of 2019. Furthermore, the ECB President highlighted the current slowdown in global growth, as well as the rising protectionist risk from the U.S. potentially negatively impacting the European economy and the ECB's decisions going forward, suggesting that the plans are not set in stone. 2018 is likely to remain a volatile year for the euro. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Japanese data has been strong this week: Machine orders increased on a 9.6% annual basis, and a 10.1% monthly basis, in April, outperforming expectations by a large margin; The Domestic Corporate Goods Price Index also increased by 2.7% annually, higher than the expected 2.2% increase. As political and economic risks in Europe and South America having subsided for now, the yen has lost some of its glitter. However, with ongoing uncertainty on trade and populism across the globe, we maintain our tactically bullish stance on the yen, especially against commodity currencies and the euro. However, beyond the short-term horizon, the BoJ will remain determined to cap any excess appreciation in the yen, as a strong JPY tightens Japanese financial conditions, weighing on the BoJ's ability to hit its inflation target. This will ultimately limit the yen's upside on a cyclical basis. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Data from the U.K. was somewhat disappointing: Manufacturing and industrial production both increased less than expected, at 1.4% and 1.8%, respectively; The goods trade deficit widened to GBP 14.03bn from GBP 12bn, and the overall trade deficit widened to GBP 5.28bn from GBP 3.22bn; Average earnings grew by 2.8%, less than the expected 2.9%; However, headline inflation came in at 2.4%, less than the expected 2.5%, while retail price inflation also underperformed expectations. This means that the uptrend in real wages continues. Given the limited movement in the pound, it seems that a lot of the bad news was already priced in by last month's depreciation. However, Theresa May's ongoing blunders in parliament represent a continued source of risk for the pound. While the GBP has downside against the EUR, it is unlikely to see much upside against the greenback. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Do Not Get Flat-Footed By Politics - March 30, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was weak: NAB Business Confidence and Conditions surveys both declined, also underperforming expectations; Australian employment grew by 12,000, less than expected. Moreover, full-time employment contracted. While the unemployment rate dropped as a result, this was largely due to a fall in the participation rate. RBA's Governor Lowe, in a speech on Wednesday, announced that any increase in interest rates "still looks some time away" as the slack in the labor market does not seem to be diminishing. Annual wage growth has been constant at 2.1% for the past three quarters, and did not pick up despite an improvement in full-time employment earlier this year. We remain bearish on the AUD. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The NZD is likely to face significant downside against the greenback along with the other commodity currencies as global growth slows down. However, due to its weaker linkages to Chinese industrial demand, the kiwi is likely to see less downside than the AUD. Nevertheless, it is likely to weaken against the CAD and the NOK as the NZD is expensive against these oil currencies, and oil's is likely to continue to outperform other commodities will support this view. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has been on an uptrend given the greenback generally strong performance since February year, a force magnified by the volatile rhetoric surrounding NAFTA negotiations. However, the Canadian economy has been accelerating this year, thanks to robust growth in the U.S., to a strong Quebecer economy, and to a pickup in Alberta. In addition, the Canadian labor market is tightening further and wage growth is above 3%. Furthermore, risks surrounding NAFTA seem already reflected in the CAD's behavior and valuation. There is more clarity on the CAD versus its crosses than on the CAD versus the USD. Outperforming U.S. and Canadian growth relative to the rest of the world mean that the CAD should outperform most other G10 currencies. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data out of Switzerland was decent: Industrial production increased by 9% in annual terms, albeit less than the previous 19.6% growth; Producer and import prices increased by 3.2% year on year, in line with expectations, however the monthly increase underperformed markets anticipations. With global trade tensions rising, and Germany having entered President Trump's line of sight, the CHF could experience additional upside against the euro in the coming months. However, the SNB is unlikely to deviate from its ultra-accommodative stance, which means that any downside in EUR/CHF will proved to be short lived. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Both headline and core inflation underperformed, coming in at 2.3% and 1.2%, respectively. However, the Regional Network Survey hinted at a pickup in capacity utilization as expectations for industrial output remained robust, as well as at an additional strength in employment. This led to a forecast of a resurgence in inflationary pressures. We expect the NOK to outperform the EUR. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish inflation rose from 1.7% to 1.9%, coming in line with expectations. Additionally, Prospera 1-year inflation expectations survey rose to 1.9% from 1.8% in the March survey. This is likely to provide the Riksbank with reasons to turn gradually more hawkish, which should support the very cheap krona. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The following four investment themes are likely to play out over the next couple of years: The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. The 10% undervaluation of the trade-weighted euro - as assessed by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually adjusts, euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos. Swedish real estate and Swedish real estate equities, which are both very richly valued, will underperform. Feature What connects last Sunday's dysfunctional G7 Summit with this week's ECB policy meeting? The answer is the euro area's €450 billion export surplus. Specifically, the €300 billion export surplus in Germany which equals 8% of its GDP - an export surplus that is squarely in President Trump's cross-hairs (Chart of the Week). Chart of the WeekECB Policy Has Driven Up Germany's Export Surplus The interesting thing is that the euro area hasn't always run an export surplus. Before 2012, the euro area's trade with the rest of the world was more or less in balance. Even Germany's export surplus was half of its current size. To put it in Trumpian terms, fewer Mercedes were "rolling down New York's Fifth Avenue." What caused the imbalance to surge in recent years? Was it punitive tariffs or restrictive trade practices in Germany? No, the answer is much simpler than that. ECB Policy Has Driven Up Germany's Export Surplus The export surplus in the euro area and in Germany is just a mirror-image of the euro exchange rate (Chart I-2). As the euro became undervalued, it made euro area exports more competitive and foreign imports into the euro area less competitive. This assessment of euro area over-competitiveness comes straight from the horse's mouth. The ECB's own indicators show that the euro area remains over-competitive by around 10%, meaning the euro is still undervalued by about 10%.1 In turn, the euro's substantial undervaluation is a near perfect function of the yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts (Chart I-3). It follows that the ultimate cause of the euro area's glaring imbalance is ECB policy itself - specifically, the extreme experiment with bond buying and negative interest rates. Chart I-2ECB Policy Has Driven Up The ##br##Euro Area's Export Surplus Chart I-3The ECB's Expansive Monetary Policy Is ##br##Responsible For The Euro's Undervaluation As Germany's former Finance Minister, Wolfgang Schäuble, explained: "When ECB chief Mario Draghi embarked on the expansive monetary policy, I told him he would drive up Germany's export surplus... I promised then not to publicly criticise this policy. But then I don't want to be criticised for the consequences of this policy." The ECB counters that it targets neither the euro exchange rate nor the trade balance; it sets policy to achieve its mandate for price stability. It argues that it is further from its mandate for price stability compared with the Federal Reserve because, ostensibly, the euro area is at a different point in the economic cycle compared with the U.S. This requires the ECB to set an ultra-accommodative policy compared with other central banks. The undervalued euro and trade surplus are the unavoidable spill-overs of this relative monetary policy. ECB Spill-Overs Felt Far And Wide However, one important reason that euro area inflation is underperforming U.S. inflation has nothing to do with the economic cycle. Rather, it is because the official measures of inflation in the euro area and the U.S. are defined differently (Chart I-4 and Chart I-5). The euro area's Harmonized Index of Consumer Prices (HICP) omits the consumption costs of owner-occupied housing, whereas the U.S. consumer price basket includes them at a very substantial 25% weight. Homeowners will testify that the cost of maintaining their homes constitutes one of their largest expenses, and that these costs tend to rise faster than other prices. Using the U.S. as a guide, we estimate that a euro area inflation measure that correctly included home maintenance costs would be running higher than HICP inflation by an average of 0.5 percentage points a year (Chart I-6). Chart I-4Euro Area Inflation##br## Is Underperforming... Chart I-5...Because Euro Area Inflation Omits ##br##Owner-Occupied Housing Costs Chart I-6Including Owner-Occupied Housing ##br##Costs Adds 0.5% To Inflation Just because the statisticians do not measure owner-occupied housing costs in the euro area HICP, it doesn't mean that homeowners do not feel these costs. In Germany, measured inflation is now running at 2.3%, so the true inflation that households feel is running closer to 3%. Meanwhile, interest rates on savings accounts are stuck near zero, which means that German savers are seeing the real value of their savings erode by 3% every year. As Der Spiegel magazine put it to ECB Chief Economist, Peter Praet: "Can you understand why so many Germans regard the ECB as the greatest threat to their personal wealth?" Spill-overs from the ECB's ultra-accommodative policy have also been felt across the Baltic Sea. The Riksbank and the Norges Bank have had to shadow the ECB to prevent a sharp appreciation of their currencies versus the euro. The trouble is that ultra-low and negative interest rates have been absurdly inappropriate for the booming Scandinavian economies. So ECB policy may have generated spill-over housing bubbles in Sweden and Norway (Chart I-7 and Chart I-8). Chart I-7ECB Spill-Overs Felt In Scandinavia Chart I-8Scandinavian Real Estate Appears Richly Valued Hence, a seemingly innocuous 'definitional' difference between the consumer price baskets in the euro area vis-à-vis the U.S. explains: the bulk of the shortfall in euro area inflation; the ECB's justification for ultra-accommodation; the undervalued euro; the euro area's €450 billion trade surplus; deeply negative real interest rates in Germany; and putative housing bubbles in Sweden and Norway. The main argument we hear in the ECB's defence is that the central bank is at the mercy of its treaty. If the treaty demands ultra-accommodation then the ECB must deliver it. But this argument is wrong. The ECB treaty only asks that the central bank delivers "price stability", leaving the ECB with substantial flexibility in how it precisely defines price stability. With this in mind, the ECB - and other central banks - should use this definitional flexibility to minimize differences with other central banks. Because in a world of integrated capital markets, the spill-overs from seemingly innocuous definitional differences are felt far and wide, resulting in political backlashes and economic imbalances. Imbalances Must Correct In The Long Run Ultimately though, economic imbalances must correct, and the corrective mechanism is economic, financial, or political feedback loops, or some combination of these. On this basis, we reiterate four investment themes that are likely to play out over the next couple of years: The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. The 10% undervaluation of the trade-weighted euro - as assessed by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually adjusts, euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos (Chart I-9). Chart I-9As The Euro's Undervaluation Corrects, It Will Help Euro Area Domestics And Hurt Exporters Swedish real estate and Swedish real estate equities, which are both very richly valued, will underperform. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see https://www.ecb.europa.eu/stats/balance_of_payments_and_external/hci/html/index.en.html The ECB uses three metrics to assess the euro area's competitiveness versus its major trading partners: GDP deflators, CPIs, and unit labour costs. The average of the three metrics suggests that the euro is undervalued by around 10%.The assessment of euro undervaluation assumes that the major euro area economies entered the monetary union at a broadly correct level of competitiveness against each other and against their other major trading partners. This assumption seems valid, given that the net external position of these economies were all in equilibrium at the onset of monetary union. Fractal Trading Model We are pleased to report that our long SEK/GBP currency position hit its profit target of 3% and is now closed. This week we note that the relative performance of two classically cyclical sectors, oil and gas versus financials, is technically stretched and at a 65-day fractal dimension which has accurately predicted the last two major reversals. Hence, our recommended trade is short euro area oil and gas versus euro area financials. Set a profit target of 6% with a symmetric stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights One of Europe's major success stories is the structural and broad-based increase in female labour participation rates. The trend is set to continue for the next decade. Stay overweight the Personal Products sector as a long-term position. Italy's decade-long stagnation is not a deep-seated structural malaise. It is a protracted cyclical downturn resulting from a banking system that was never repaired after the 2008 financial crisis combined with wholly inappropriate fiscal austerity. We expect Italy's new government to push back against the EU's misguided fiscal rules and correct this decade-long error. Buy exposure to Italian real estate as a new long-term position either directly or through Italy's small real estate equity sector. Feature Some analysts persist on comparing economic performances on the basis of real GDP per head of total population. But the total population includes children and the elderly who cannot contribute to economic output. Therefore, a correct assessment of economic performance should look at real GDP per head of working-age population. Chart I-1AWomen Are Powering The European Economy... Chart I-1B ...Less So In The U.S. Admittedly, as the retirement age rises, the definition of 'working-age' will gradually change, but the general principle still holds: only count in the denominator those who can contribute to economic output. GDP per head of working-age population can grow in several ways. One way is to get more output or better output from each hour worked through improvements in efficiency and/or quality. As this improvement is theoretically limitless, it is the main source of productivity gains in the long run. A second way is for each worker to work more hours. But given the physical and legal constraints on productive working time, there is only limited scope to increase output in this way. How Women Are Powering The European Economy There is one other way to increase GDP per head of working-age population: increase the percentage of the working age population that is in the labour force.1 In other words, structurally increase the labour participation rate. If this participation rate is already high - as it is for men - then there is little scope to increase it much further. But if the participation rate is low - as it is for European women - then there is considerable scope to increase it. This brings us to one of Europe's major, and largely untold, success stories - the structural and broad-based increase in female participation rates (Chart I-1-Chart I-5). Over the past twenty years, the EU28 female participation rate has risen from 57% to 68%, with an especially large contribution from the socially conservative southern countries. In Spain, female participation has surged from 47% to 70%. In Italy, it has shot up from 42% to 56% and has clear scope to rise much further. Chart I-2Italy: Labour Force Participation Rate Chart I-3Spain: Labour Force Participation Rate Chart I-4Germany: Labour Force Participation Rate Chart I-5France: Labour Force Participation Rate What is driving this structural trend? Two things. First, the employment sectors that are growing structurally - healthcare, social care, and education - tend to employ more women than men. Second, European countries have legislated a raft of policies encouraging women to join and remain in the labour force: generous paid maternity leave and subsidised childcare. The trend is for further improvements, with the focus now on improving paternity leave. Sharing parental and family responsibilities between mothers and fathers allows more women to enter and stay in the labour force.2 For the ultimate end-point in the trend, look to the Scandinavian countries which started such policies in the early 1970s. In Sweden, labour force participation for women and men is almost identical: 81% versus 84%. If the EU eventually adopts the Scandinavian model, it would mean another 20 million European women in employment and contributing to economic output (Chart I-6). Chart I-6Another 20 Million European Women ##br##Could Join The Labour Force Dispelling Two Myths: The Euro Area And Italy Having established that economic performances should be compared on the basis of GDP per head of working age population, we can now dispel two common myths. The first myth is that the U.S. generates superior productivity growth than the euro area. It is true that the U.S. has been better at getting more output from each hour worked, so on this measure, the U.S. does win. Against this, the euro area has been much better at getting more of its working-age population - albeit mostly women - into employment. So on this measure, the euro area wins (Chart of the Week). The net result is that, over the past twenty years, the U.S and the euro area have generated exactly the same growth in real GDP per working-age population (Chart I-7). Of course, the euro area's structural improvement in female participation rates cannot continue forever, but it can certainly continue for another decade or so, and this is generally the longest time horizon that most investors care about. Chart I-7The Euro Area And The U.S.: Identical Growth In Real GDP Per Head Of Working-Age Population The second myth concerns the subject du jour: Italy. Many people claim that Italy's economic stagnation is due to deep-seated structural problems which differentiate it from other major economies. The problem with this narrative is that from the mid-1990s until 2008 the growth in Italy's real GDP per head of working age population was little different to that in Germany, France or the U.S. (Chart I-8). Chart I-8Italy Performed In Line With Other Major Economies Until 2008 Italy's economic stagnation only started after the 2008 global financial crisis. After a financial crisis which cripples the banking system, there are two golden rules: unleash fiscal stimulus; and repair the banking system as quickly as possible. The U.S. and U.K. followed the golden rules perfectly and immediately; Ireland followed a couple of years later; Spain waited until 2013. But in each case, the economies rebounded very strongly as the fiscal stimulus kicked in and the banks recuperated. Italy neither unleashed fiscal stimulus, nor repaired its banks - so its economy has stagnated for a decade. Moreover, if output stagnates for a decade, it follows arithmetically that productivity growth will also look poor. In a back-to-front argument, critics have pounced on this as evidence of excessive 'red tape' and 'structural problems'. But this is a misdiagnosis of the malaise. To reiterate, Italy's real GDP per working-age population was growing very respectably before 2008. Italy's misfortune is that its indebtedness has an unusual profile: more public debt than private debt. France and Spain (and other major euro area economies) have the usual profile: less public debt than private debt. So the EU's fiscal rules - which can see only public debt and are blind to private debt - have severely and unfairly constrained Italy's ability to respond to financial crises. While every other major economy followed the golden rules to recover from the 2008 crisis, Italy could neither unleash fiscal stimulus to kick start the economy nor recapitalise its dysfunctional banking system. We expect Italy's new government to push back against the EU's misguided fiscal rules and correct this decade-long error. Two Structural Investment Conclusions This week's two investment conclusions are both long term, and require a buy and hold mentality. The first conclusion reiterates a structural position: overweight the Personal Products sector. This is based on our expectation that, in Europe, female participation rates will continue their structural uptrend; while in the U.S. we expect female participation rates to continue outperforming male participation rates. Therefore the sales and profits of the Personal Products sector, in which female spending dominates, will benefit from a multi-year tailwind, at least relative to other sectors. And the extent of this tailwind is not fully discounted in valuations. The second conclusion is a new long-term recommendation: buy exposure to Italian real estate. This is based on our assessment that Italy's decade-long stagnation is not a deep-seated structural malaise. Instead, it is a protracted cyclical downturn resulting from a banking system that was never repaired after the 2008 financial crisis combined with wholly inappropriate fiscal austerity. Removing these shackles will allow a long-term recovery, just as it did for Spain in 2013. If we are right, the best multi-year buy and hold play is Italian real estate which has been in a decade-long bear market (Chart I-9). For those that cannot directly invest in property, Italy has a small real estate equity sector which faithfully tracks the long term profile of real estate prices (Chart I-10), and whose main component is Beni Stabili. The caveat is that the stock has a market cap of just €2 billion; the appeal is that it offers a juicy dividend yield of 4.5%. Chart I-9Italian Real Estate Has Suffered ##br##A Decade-Long Bear Market Chart I-10Italian Real Estate Equities##br## Track Real Estate Prices Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 And in employment. 2 Please see the European Investment Strategy Special Report "Female Participation: Another Mega-Trend" published on April 6, 2017 and available at eis.bcaresearch.com Fractal Trading Model* This week, we note that the 130-day fractal dimension for platinum versus nickel is close to its lower bound, a level which has consistently predicted a tradeable countertrend move over the following 130 days. Hence, this week's trade is long platinum/short nickel on a 130 horizon before expiry. The profit target is 14% with a symmetric stop-loss. Our two other open trades, long SEK/GBP and long PLN/USD, are both in profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Will A Rising U.S. Dollar Alter The Fed's Tightening Plans? U.S. economic growth appears to be accelerating, the labor market continues to tighten, core inflation is approaching the Fed's target and wage growth is grinding higher. A much higher dollar is needed to seriously derail any of those trends. Will The Italian Turmoil Alter The ECB's Tapering Plans? The ECB has been vocal about separating a decision to taper its asset purchases from any subsequent decision to hike interest rates. Delaying the taper would not have a meaningful impact on boosting euro area economic growth, but keeping policy rates stable for longer would help support the recovery at a time of increasing divergence of inflation rates within the euro area. Feature Chart of the WeekThe Year Of Living Dangerously The latter half of May was a wild wide for global financial markets, which had finally shown signs of healing after the VIX shock from earlier in the year. The cause this time was Italian political turmoil as the populist 5-Star Movement/League coalition attempted to form a government full of fiscal largesse, sprinkled with a hint of euroskepticism. Investors got spooked into thinking that a 2011-style euro "redenomination" (i.e. breakup) risk premium might once again need to be priced into Peripheral government bond yields. The rout in Italian BTPs felt like a classic sovereign debt crisis, emerging markets style. There were even reports of Italian banks providing no price quotes for Italian debt on electronic trading platforms - the 21st Century version of dealers "not answering their phones" during a crisis. All that was missing was an IMF delegation heading to Rome with checkbook in hand. The announcement late last week that the coalition would get another shot at forming a government, rather than throwing Italy into fresh elections that could turn into a referendum on euro membership, restored order to Italian financial markets. The meltdown in Italian yields was almost as rapid as the melt-up, with the 2-year BTP yield ending last week around 1%, almost two full percentage points lower than the peak in yields seen just a few days earlier, but still much higher than the sub-zero yields seen as recently as May 15th. We made a timely decision to cut our recommended stance on Italian debt to underweight two weeks and we are maintaining that call despite the respite from the political turmoil.1 (NOTE: we are putting out a joint Special Report next week with our colleagues at BCA Geopolitical Strategy on June 13th, a day later than our usual Tuesday publishing slot, which will discuss the political outlook for Peripheral Europe and what it potentially means for their bond markets). Our more pessimistic view on Italian bonds was based on our assessment that Italian growth was slowing and would continue to do so. For a country like Italy with a large debt stock and structurally low growth, cyclical downturns always lead to increased worries about debt sustainability. Coming at a time when the ECB is looking to begin the long process of exiting its hyper-easy policies, the growth and monetary backdrop was also becoming more challenging for Italian government bonds. The same thing can be said for the rest of the world. The rapid coordinated acceleration in global growth seen in 2017 has clearly peaked, as has the pace of central bank asset purchases that helped support that recovery through low bond yields (Chart of the Week). The growth convergence has turned into a divergence between growth in the still-strong U.S. and most other major economies. This poses a new threat to financial markets - a rising U.S. dollar - which, combined with some cooling of global growth, is already triggering underperformance of emerging market assets. So after the tumultuous market price action of the past few weeks, we think the most critical potential impact on the direction of bond yields, and our recommended below-benchmark overall portfolio duration stance, can be boiled down to two big questions. Will A Rising U.S. Dollar Alter The Fed's Tightening Plans? NO. The U.S. economy continues to exhibit impressive resilience of late, even as the rest of the world has seen some softening in growth. The Payrolls report for May released last Friday showed another sturdy gain of 223,000 jobs, with upward revisions of 15,000 to the prior two months. This pushed the unemployment rate to 3.8% - the lowest level since April 2000 - while boosting the annual growth in Average Hourly Earnings up to 2.7% (Chart 2). The overall employment/population ratio also inched higher. Both wage growth and the employment/population ratio are well below the peaks seen in the past two business cycles, even with similarly low levels of unemployment. During those cycles, the Fed was forced to raise the funds rate to restrictive levels to cool growth to rein in overshooting inflation. The real fed funds rate was consistently above equilibrium measures like the Williams-Laubach "r-star" (bottom panel), which eventually crimped growth and led to a recession in both cases. In the current cycle, wage inflation is struggling to reach 3% and core PCE inflation at 1.8% has still not returned back to the Fed's 2% target. There is no need for the Fed to push harder on the brakes by raising rates faster than inflation is accelerating and pushing the real rate above r-star. If a growing economy continues to absorb labor market slack, however, the Fed could be chasing a higher level of r-star to prevent inflation from continuing to accelerate (bottom panel). Looking ahead, it does look like the Fed will continue to play a bit of catch-up to an accelerating U.S. economy. Leading economic indicators (both from the OECD and Conference Board), as well as our forward-looking models for employment and capital spending, all point to faster growth in the next couple of quarters (Chart 3). This will only support the case for the Fed to continue with its current rate "measured" pace of one rate hike per quarter over the next year. Chart 2Labor Market Tightening##BR##Leads To Fed Tightening Chart 3U.S. Growth Still##BR##In Good Shape With the U.S. dollar now reconnecting to the widening interest rate differentials between the U.S. and other major economies, there is a risk that the implied tightening of monetary conditions from a higher greenback could limit the need for the Fed to continue with its rate hike plans. Yet at the moment, the trade-weighted dollar is still not accelerating on a year-over-year basis, in contrast to the +15% appreciation seen during the 2014/15 dollar bull run (Chart 4). At the peak of that episode, net exports were a drag on real GDP growth of -1% and headline CPI inflation hit 0% (aided by collapsing oil prices). While an appreciation of that magnitude is unlikely, it would still take a much larger increase in the dollar to meaningfully dent growth in a way that could cause the Fed to pause on the rate hikes. A bigger dollar rally could also raise financial instability, primarily by hitting emerging markets where currency weakness versus the dollar would trigger tighter monetary policy and slower growth. That is certainly a risk for the Fed to consider. Yet given the underlying strength of the U.S. economy today, the Fed would only react to any turmoil in emerging markets if it meaningfully impacted U.S. financial markets, but not before then. While the Fed is still likely to continue on its rate hike path over the rest of 2018, the market has largely discounted that outcome - even after the late May decline in U.S. interest rates on the back of Italy-fueled risk-aversion (Chart 5). The market is still not completely priced to the Fed's interest rate projections over the next year, however, which does raise the potential for a return to the +3% level on the 10-year U.S. Treasury yield that was seen before the Italy crisis flared up. However, our colleagues at our sister publication, BCA U.S. Bond Strategy, continue to point out the risks to a continued near-term period of declining (or at least, consolidating) Treasury yields given persistent short positioning in the Treasury market at a time of slowing data surprises (Chart 6). We remain bearish on Treasuries over a strategic horizon, however. Chart 4USD Rally Not Yet##BR##Enough To Impact The U.S. Chart 5Market Still Priced Close To##BR##The Fed's Interest Rate Projections Chart 6UST Yields Likely To##BR##Consolidate In The Near-Term Bottom Line: U.S. economic growth appears to be accelerating, the labor market continues to tighten, core inflation is approaching the Fed's target and wage growth is grinding higher. A much higher dollar is needed to seriously derail any of those trends. Will The Italian Turmoil Alter The ECB's Tapering Plans? PROBABLY NOT. The latest volatility in European financial markets stemming from the Italy crisis came at a difficult time for the ECB. The central bank has been incrementally preparing the market for an eventual tapering of its asset purchase program after it expires in September. Yet the slowdown in euro area growth in the first quarter of the year, amid sluggish readings on inflation, has raised some doubt that the ECB would even be able to announce any sort of withdrawal of monetary stimulus. Chart 7Market Buying Into The ECB's##BR##'Low Rates For Longer' Message It is now a consensus expectation that the ECB will taper its net new asset purchases fully to zero by the end of 2018. What has moved, however, is the market's expectation for the timing of the first rate hike by the ECB. That has now been pushed out to April 2020 after the Italy turbulence (Chart 7). The ECB has been consistently signaling to the markets that it views the two decisions - tapering and rate hikes - as separate choices to make. In other words, tapering does not mean that rate hikes will come soon afterward. So far, the market appears to be listening to the ECB's signals by moving out the timing of any rate hike to nearly two full years from today. Given the magnitude of the slide in euro area growth seen in the first few months of 2018 (2nd panel), that may be taken as a sign that the market thinks the slump can continue. This also is consistent with the market believing the ECB's views on seeing through any impact on euro area inflation from changes in oil prices and the euro. The annual growth of the Brent oil price, in euro terms, has climbed to nearly 50% over the past few months (3rd panel). There has always been a strong correlation of that growth rate to overall headline euro area inflation, as evidenced by the early read on May CPI inflation released last week that came in at 1.9%. Yet core CPI inflation in the euro area is still only 1.1%, well below the ECB's inflation target of "just below" 2%. Market-based inflation expectations are still below the level as well, with the 5-year euro CPI swap, 5-years forward now sitting at 1.7%. So the market pricing is consistent with an ECB that will be very slow to begin raising interest rates. That would also be consistent with the behavior of the ECB when it comes to its past tightening cycles. In Chart 8, we show diffusion indices at a country level for euro area industrial production growth (as a proxy for economic growth), headline inflation and core inflation. These show the percentage of all euro area countries that are seeing accelerating growth or inflation versus those countries seeing slowing growth and inflation. A higher diffusion index means that any acceleration in growth or inflation is broad-based, and vice versa. Chart 8ECB Rate Hikes Happen During Broad-Based Inflation Upturns As can be seen in the chart, the ECB's past tightening cycles since the beginning of the euro in 1998 have all occurred when the diffusion indices for inflation have risen into the 60-80% zone. In other words, the ECB is more aggressive on lifting rates when a large majority of countries in the euro zone is seeing accelerating inflation. During those same tightening cycles, however, the diffusion indices for growth have been decelerating, suggesting less broad-based economic strength. The implication from this analysis is that the ECB cares more about inflation than growth when making its monetary policy decisions. The ECB's reputation for sometimes making overly hawkish policy mistakes, like in 2010-11, is well deserved. Looking ahead, the current readings on the diffusion indices for both growth and, more importantly, inflation are all quite depressed. This suggest that the slowing growth seen in the overall euro area data so far in 2018 has been broad-based, while the increase in the overall euro area inflation data has not been broad-based. This can be seen when looking at the some of the individual country data for the major core euro area countries (Chart 9) and Peripheral countries (Chart 10). For example, Netherlands and Portugal stand out as having inflation trends that are much weaker than the other countries. Yet the more divergent trends in euro area inflation does not mean that the ECB will decide to defer any decision to taper, however. The ECB will have to make that decision at either the June or July meetings, with the current program set to end in September. Absent a significant drop in euro area inflation, the ECB is still likely to signal a full taper by the end of the year. Yet even if they did extend the current program into 2019, at the same pace of 30 billion euros per month, this would likely not have a meaningful impact on the level of euro area bond yields. We have found that is the growth rate of those purchases, and not the absolute level, that is most correlated to the level of euro area bond yields (Chart 11). Even if the current program were to be extended to March 2019, to be followed by a tapering of net purchases to zero by September 2019, then the annual growth rate of the ECB's balance sheet (driven by the asset purchases) would remain mired below 10% - a far slower pace compared to the peak years of ECB bond buying. Chart 9Growth Convergence,##BR##Inflation Divergence In Core Europe... Chart 10And In##BR##Peripheral Europe Chart 11Extending ECB Bond Purchases##BR##Into 2019 Would Have Limited Impact In other words, an extension of the asset purchases would not drive euro area bond yields any lower, and would entail operational constraints on country sizes, etc. The ECB will have better success at driving down yields by keeping policy rates lower for longer, as it is signaling it will do. Bottom Line: The ECB has been vocal about separating a decision to taper its asset purchases from any subsequent decision to hike interest rates. Delaying the taper would not have a meaningful impact on boosting euro area economic growth, but keeping policy rates stable for longer would help support the recovery at a time of increasing divergence of inflation rates within the euro area. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Is It Partly Sunny Or Mostly Cloudy?", dated May 22nd 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Recommended Allocation A Series Of Unfortunate Events Markets have taken a series of hits in recent months - sharp drops in emerging market currencies, a political crisis in Italy, and the ongoing trade war between the U.S. and China - not to mention a slowdown in cyclical growth. But risk assets have been remarkably resilient: the U.S. stock market is in the middle of its year-to-date range, and U.S. small cap stocks (more attuned to domestic conditions) are at record highs (Chart 1). The uncertainty is set to continue for a while. But, with global growth likely to settle at an above-trend pace, fiscal and monetary policy still accommodative, and earnings continuing to grow strongly, the recent resilience says to us that risk assets are likely to grind higher and to outperform bonds over the next 12 months. A major underlying cause of the recent volatility has been the growing disparity between growth in the U.S. and in the rest of the world (Chart 2). This is partly due to the strength of the euro and yen last year, which is now dampening activity in these regions, but the slowdown in Chinese industrial growth and a higher oil price may also be having a disproportionate effect on growth outside the U.S. This growth disparity has widened interest rate differentials, which have again become the major driver of currencies, pushing up the U.S. dollar (Chart 3). Chart 1Small Cap Stocks At A Record High Chart 2Disparity Between The U.S. And The Rest... Chart 3...Means Dollar Has Further To Rise In combination with rising U.S. interest rates (the 10-year Treasury yield rose above 3% last month, before correcting a little), dollar appreciation is a threat for emerging markets. EM assets have long shown a consistently strong inverse correlation with the dollar (Chart 4). We expect the EM sell-off to continue. Further Fed hikes and rising inflation expectations in the U.S. (relative to the euro area and Japan) will increase interest-rate differentials and push the dollar up further: we forecast 1.12 for euro/dollar. Investors are still far from capitulating on EM assets after several years of large purchases (Chart 5). Many EM central banks are being forced to raise rates to defend their currencies, which will dent growth. Some may even be forced into reintroducing capital controls. Several emerging economies besides Argentina and Turkey remain vulnerable, having worryingly high amounts of foreign currency debt (Chart 6). Chart 4Strong Dollar Is Bad For Em Assets Chart 5Em Is Still A Consensus Favorite Chart 6Worrying Levels Of FX Debt Chart 7Not Surprising That Italians Are Fed Up Geopolitics is likely to remain a drag on markets for a while, too. Italy remains the biggest threat. The discontent of the Italian population is unsurprising given the country's stagnation since it joined the euro (Chart 7). The probable coalition government of the Lega and Five Star Movement would introduce aggressive fiscal stimulus, putting it in confrontation with the EU's budgetary rules. But BCA's geopolitical strategists see little risk of Italy exiting the euro in the next two years (though 10 years might be a different story).1 Political gyrations may continue for some months, particularly if the new government persists with its plan to blow the fiscal deficit out to 7% of GDP, but the sell-off in short-term Italian bonds looks to be overdone. Developments in trade tariffs, Iran and North Korea could also weigh on markets in coming months. But ultimately economic fundamentals almost always outweigh geopolitical risk. Global growth is slowing, but to an above-trend pace. Fiscal policy is particularly stimulative this year, with 17 of the 33 OECD countries undertaking large fiscal easing, and a further 11 some easing. The overall cyclically-adjusted primary budget balance in OECD countries is forecast to ease by 0.5% of GDP this year and 0.4% next (Chart 8). Monetary policy remains accommodative almost everywhere. The FOMC, in its May statement, by adding the word "symmetric" to describe its 2% inflation objective, was clearly emphasizing that it sees no need to accelerate the pace of rate hikes, despite the recent pickup in core PCE inflation. We expect the Fed to continue to raise rates once a quarter, meaning that monetary policy will not become restrictive until around Q1 next year. With inflation expectations not yet fully normalized (Chart 9), the Fed could still exercise its "put option" by holding for a quarter or two if global risk were to rise significantly. Italy's problems also make it more likely that the ECB will stay easier for longer, and the probability is rising of its deciding to extend asset purchases into next year. Chart 8Fiscal Stimulus (Almost) Everywhere Chart 9Inflation Expectations Have Further To Rise With the consensus already forecasting global GDP to grow 3.4% this year, and U.S. earnings by 22%, there is no obvious catalyst for risk assets to rebound sharply (Chart 10). However, we find it inconceivable that equity markets will not be higher in 12 months' time - and will not have outperformed bonds over that time - if the macro environment plays out as we expect. We, therefore, continue to recommend an overweight on equities and underweight on fixed income, but might start to turn more defensive around the end of the year if the signs are in place that the recession we expect in 2020 is still on the cards. Equities: For the reasons described above, we remain cautious on EM equities. Within EM, our preference would be for markets such as China, Korea and India, which are likely to be less affected by investors' concerns about current account deficits and foreign-currency denominated debt. In DM, our preference remains for late-cyclical sectors, especially energy, financials and industrials. We mainly view regional and country selection as a derivative of the sector call: this supports our preference for euro zone and Japanese stocks over those in the U.S. and U.K. Fixed Income: A combination of quarterly Fed rate hikes, a further normalization of inflation expectations, and moderate rises in the real rate and term premium are likely to push the 10-year U.S. Treasury yield up to 3.5% by year-end (Chart 11). We, therefore, remain underweight duration and prefer TIPs to nominal bonds. We keep our overweights on spread product within the fixed-income bucket, since it should continue to outperform for another couple of quarters. U.S. high-yield spreads are likely to remain steady, giving an attractive carry even after accounting for defaults; investment grade spreads might start to recover, given that the sell-off of quality bonds by companies repatriating short-term investments held offshore ($35 Bn from the 20 largest U.S. companies in Q1) is now mostly over (Chart 12). Chart 10Can Growth Beat These Expectations? Chart 11Treasury Yield To Rise To 3.5% Chart 12Selective Spread Product Remains Attractive Currencies: Interest-rate differentials, as described above, are likely to push the dollar up further, especially against the euro. This should continue until the effect of a strong dollar/weak euro starts to rebalance growth surprises back to the euro area, perhaps around the end of the year. We see less chance of dollar appreciation against the yen (which is still undervalued against its PPP value of 98, and may benefit from its safe-haven status) and against the Canadian dollar (given the Bank of Canada's hawkish stance). Commodities: Industrial commodities are likely to continue to struggle against headwinds from the appreciating dollar, and the continuing moderate slowdown in China (Chart 13). The oil price has become a tougher call recently, with talk that OPEC may agree later this month to bring back as much as 1 million barrels/day in production, but Venezuelan and Iranian supply likely to exit the market. BCA's energy strategists now forecast WTI and Brent to average $70 and $78 in 2H18, and $67/$72 in 2019, but expect higher volatility in the price over coming months (Chart 14).2 Chart 13Continuing Signs Of China Slowdown Chart 14Forecasting Oil Is Getting Harder Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see BCA Geopolitical Strategy Client Note, "Italy, Spain, Trade Wars... Oh My!," dated 30 May 2018, available at gps.bcaresearch.com 2 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Guiding To Higher Output: Volatility Set To Rise ... Again," dated 31 May 2018, available at ces.bcaresearch.com GAA Asset Allocation
Highlights Italy is a live drama. However, both Italy and Brussels have constraints that should lead to a compromise on fiscal stimulus. Italy will not leave the euro in the foreseeable future, and the European Central Bank has little incentive not to continue accepting Italian bonds. With the recent capitulation in the Italian bond market, the euro could experience a brief respite, potentially rallying toward 1.18 to 1.19. However, for the euro to endure a more durable bottom, global bond yields need to stop falling. Until then, EUR/USD could move toward 1.12. Falling bond yields imply more downside for EUR/JPY and EUR/CHF as well. NOK/SEK is not yet a buy. The trend in gold prices can be used to gauge where the fed funds rate stands vis-à-vis r-star. Feature In July 64AD, the Great Fire of Rome erupted, causing untold damage to the great imperial capital. Various Roman sources suggest that Emperor Nero started the fire to clear land in order to build himself a new palace, the Domus Aurea.1 This fire was a calamity, and was followed by a period of economic tumult and currency debasement. However, Rome recovered, the empire conquered more nations, and ultimately survived another 412 years. We have held a bearish view on the euro for 2018, expressed by recommending investors buy DXY and sell EUR/CAD, EUR/JPY and EUR/CHF. However, this view is underpinned by economic divergences and a softening in global growth. Our negative bias on the euro has greatly benefited from the fire that has engulfed Italian politics and bond markets. Taking stock of this week's political theatre, does it still make sense to be short the euro, and by extension long the dollar? As we foresee more downside in global bond yields, we think yes. However, while Italy is currently burning, it is not at risk of causing a collapse of the euro area. Pricing an end to the "empire" is thus an inappropriate reason to stay short the euro. The Italian Job Italy has once again become a trouble spot for investors. The M5S / Lega Nord coalition's manifesto proposes blowing out the fiscal deficit to above 7% of GDP by instituting a flat tax regime, increasing spending and undoing pension reforms instigated by the Monti government in 2012. In response to these developments, president Mattarella has removed the proposed finance minister, Paolo Savona, arguing he was too anti-euro and that abandoning the euro area was unconstitutional. He went on to nominate Carlo Cottarelli, nicknamed "Mr. Scissors," as a caretaker prime minister tasked with leading a technocratic government until new elections are implemented. However, the coalition rightfully argued that this move was executed under a false pretext, as its current policy proposal does not include leaving the euro area. Even before the drama had fully blossomed, Italy on Monday had been put on downgrade watch by Moody's. In light of the political developments, investors then worried that a new election would result in Italy potentially exiting the euro area. Italian 2-year yields spiked to a spread of 350 basis points against German Schatz. This implied a perceived probability of 11% that Italy will choose to exit the euro area over the course of the next two years. Another possible outcome discounted by investors was that the European Central Bank would stop accepting BTPs as repo collaterals, or stop buying them in its Asset Purchase Program. Chart I-1Italian Support For The Euro##br## Is Low But Well Above 50% Which of these two risks is more likely to materialize? We think the current implied probability of Italy electing to leave the euro over the coming two years is very low. Italians exhibit the lowest support toward the euro of any eurozone member state. However, a majority of Italians, 59% of them, still support the common currency (Chart I-1). In response to this constraint, the very nimble Five Star Movement, while still hell-bent on fiscal profligacy, has already greatly downplayed its Euroscepticism. While Lega Nord still has more Eurosceptic inclinations, it has not put leaving the euro area at the core of its coalition agreement with M5S. BCA has a great degree of confidence in this view, but it is important to not be dogmatic. BCA's Geopolitical Strategy service recommends investors closely follow the statements of these two parties over the course of the summer. The second risk is more real. The fiscal proposal of the coalition would blow the Italian budget deficit from 2.3% to more than 7% of GDP. Ratings agencies are already putting Italy on downgrade watch. Italy has a credit rating of Baa2, and only bonds with ratings of Baa3 or better are eligible at the ECB. It is possible that the central bank, in coordination with Brussels, exerts the same kind of pressure as it did in August 2011 when Jean Claude Trichet and Mario Draghi wrote a letter to Silvio Berlusconi demanding his resignation in exchange for financial market support for Italy. Despite this risk, we expect Italy to ultimately play ball and not blow up the deficit to 7% of GDP - simply because of economic constraints. These constraints are also likely to create an additional limit on the willingness and capacity of Italy to leave the euro area. The arguments we made in a joint Special Report with BCA's Geopolitical Strategy service titled "Europe's Divine Comedy Part II: Italy In Purgatorio," published in June 2017, remain valid: Italy will feel the pain from its transgressions before it can implement them.2 This is happening today as we write. Essentially, Italy's problem is rooted in the poor health of its banking system. Italian banks have capital in the order of EUR165 billion and NPLs of EUR130 billion, leaving EUR35 billion in excess capital. However, Italian commercial banks hold approximately EUR350 billion in BTPs. Thus, any decline in BTP value of 10% or more would render the Italian banking system insolvent (Chart I-2). Since suggesting abandoning the euro or conducting policy that exclude Italian debt from the ECB's window would cause a greater than 10% fall in BTP prices, this would kill off credit issuance in Italy as the banking sector would not have the wherewithal to extend new loans. This would prompt a large collapse in the credit impulse, and thus GDP growth (Chart I-3). The ensuing painful recession would cause Italians to backtrack on their intentions to leave the euro area. If Italy's credit rating and its access to the ECB is the reason for the collapse in BTP prices, the same dynamics will also force the Italian government to adopt a more realistic fiscal policy. This is why we do not believe the current M5S/Lega Nord government will be able to blow up the budget by as much as it currently wants. Chart I-2The Italian Constraints Lies##br## In The Banking Sector Chart I-3Credit Trends Explain##br## Italian Growth There are, however, incentives for Brussels to be more lenient on Italy. Italy is not Greece. The Troika had room to play hardball with Greece. Greek debt was EUR346 billion, or 10% of Germany's GDP (the perceived ultimate backer). The same cannot be said about Italy. Rome's debt stands at EUR2383 billion or 70% of Germany's GDP. In other words, as J. Paul Getty once said, "If you owe the bank $100, that's your problem. If you owe the bank $100 million, that's the bank's problem." Italy is the EU's problem. Chart I-4If You Owe The Bank 442 Billion, ##br##That's The Bank's Problem This problem is most evident in the Target 2 of the Bank of Italy. The Italian national central bank owes EUR442 billion to the Eurosystem, the most of any nation (Chart I-4). Claims on Italy can also be found on the balance sheets of commercial banks across Europe. French, Spanish, German, and Dutch commercial banks have Italian exposure of EUR426 billion, with EUR310 billion held by French banks alone. Italy's problems are definitely Europe's problem. A collapse of Italy could therefore impair the entire European banking sector. This means that the EU and the ECB have a strong built-in incentive to be lenient toward Italy. As a result, we expect that Brussels will be forced to accept a larger Italian deficit than 3% of GDP, as it did at the turn of the millennium when France and Germany were also in violation of the Stability and Growth Pact. The ECB could also make a conditional exception in terms of accepting Italian bonds. So What? The Italian situation remains fluid. While an election this summer, as early as July 29th, has been touted, efforts to form a government are still taking place. No matter what happens, the constraints on both Italy and the European institutions suggest that both sides of the table will have to come to a compromise regarding Italian public spending. The EU will have to tolerate a greater than 3% of GDP deficit, and the Five Star Movement, with whoever it coalesces, will not be able to blow up the budget deficit above 7% of GDP. Investors have made a mistake by pricing in an Italian exit. Hence, Italian 2-year yields could experience downside in the coming week. In fact, the daily move in Italian 2-year yields on Tuesday was the largest on record, despite what are still very low levels of interest rates by historical standards (Chart I-5). This suggests that May 29th represented a day of capitulation in the Italian bond market, at least on a short-term basis. As a result, the very oversold euro, which has declined more or less without a pause for the past 29 trading days, could stage a relief rally as investors re-evaluate the Italian risks (Chart I-6). Chart I-5Capitulation In The BTP Market Chart I-6The Euro Short-Term Rebound Can Continue This begs a crucial question: Is it time to bail on our various short bets on the euro as well as our long bet on the DXY? While a temporary resolution in Italy could easily prompt a euro rally toward 1.18-1.19, many issues that have prompted us to implement these views have yet to fully play out. For example, the euro's fair value, as implied by real short rate differentials, the slope of the euro area yield curve relative to the U.S. and growth differentials between the rest of the world and the U.S. - as captured by the price of copper relative to the price of lumber - still pegs an equilibrium for EUR/USD at 1.12 (Chart I-7). Chart I-7The Euro Has Yet To Purge Its Previous Excesses Additionally, while traders have capitulated on Italian bonds, investors have yet to capitulate on the euro. Speculators are still very long, and investor sentiment is still not consistent with a bottom (Chart I-8). Additionally, the trend in relative inflation still points toward a weaker euro, as it portends to an easing of European monetary policy relative to the U.S. (Chart I-9). The tension in Italy and the widening spreads in innocent Spain could play toward the ECB adjusting its forward guidance toward no hike for longer than is currently priced into the EONIA curve. Chart I-8No Capitulation Here Chart I-9Inflation Dynamics Point To A Lower EUR/USD However, the most important question right now for the euro is the direction of bond yields. Much will depend on the performance of bonds over the course of the coming months. Bottom Line: Italy is a political landmine, and the recent drama has weighed on the euro, causing EUR/USD to depreciate much faster than we anticipated. However, markets are currently embedding too-large a risk premium of an Italian exit. Both Italy and the EU will not stay as intransigent as they currently pretend, suggesting the market action will force a political compromise on the thorny question of deficits. As a result, while a rally in coming weeks of EUR/USD toward 1.18-1.19 is a very probable scenario, we anticipate the euro's weakness to end closer to 1.12 than currently recorded levels. All About Bond Yields BCA believes that bond yields are globally on a cyclical upswing, being lifted by the fact that global central banks are slowly but surely exiting the emergency stimulus measures put in place directly after the great financial crisis. Moreover, we also expect inflation to slowly come back, especially in the U.S. and Canada, also justifying higher yields. In response to these forces, BCA's three factor bond model, based on global manufacturing PMIs, the U.S. employment-to-population ratio and the dollar's bullish sentiment, suggests the fair value of 10-year Treasurys is at 3.3%, 46 basis points above current yields. However, markets do not move in a straight line. The bond market is especially prone to reversals as interest rates are a key determinant of the cost of capital. Thus, higher yields slow global economic activity, diminishing the reason why yields increased in the first place, creating a stop-and-go pattern. This time is no exception. In fact, Ryan Swift has been arguing in BCA's U.S. Bond Strategy service that after their sharp up-move from 2.04% to 3.11%, bond yields have downside on a short-term basis.3 A few factors explain why bond yields could experience a bit more downside in the coming months: Bond aggregates have been oversold (Chart I-10), with their 100-day rate of change hitting levels associated with a subsequent rebound in prices. This rebound is underway and doesn't look to have yet been fully played out. Chart I-10Bonds Were Too Oversold To Keep Falling In A Straight Line Positioning remains too skewed. Speculators are still very short Treasurys, and duration surveys conducted by J.P. Morgan Chase suggest there is still more room to surprise investors, prompting them to lighten their short-duration calls (Chart I-11). The changes in 10-year U.S. yields are very correlated with the U.S. surprise index. However, this economic indicator is highly mean-reverting. The increase in investors' expectations suggests there is room for disappointment on the economic front for market participants. Ryan's autoregressive model for economic surprises, which captures the mean-reverting behavior of this series, suggests that surprises will deteriorate further in the coming weeks (Chart I-12). Chart I-11Still No Capitulation In ##br##Bond Positioning Chart I-12Economic Surprise Index U.S. Surprise ##br##Index Can Mean-Revert Further Global growth continues to show signs of deterioration, as the diffusion index of our global leading economic indicators highlights that only 24% of the world's major economies are experiencing expanding LEIs (Chart I-13). Moreover, the deliquescence of EM carry trades funded in yen also points toward additional deceleration in global industrial activity, and export volumes growth out of Asia continues to slow (Chart I-13, bottom panels). Here, the recent performance of gold is most revealing. The yellow metal is a good gauge of global liquidity conditions, and it tends to perform well when bond yields, especially real rates, weaken. However, despite a fall in real yields in recent weeks, and despite the rising geopolitical risks associated with Italy and the re-emergence of trade wars, gold prices are softer than expected. This implies that bond yields have not yet fallen enough to put a floor under global growth. So why does the absolute trend in Treasury yields matter for EUR/USD? Simply because since 2008, EUR/USD has performed very poorly when bond yields have declined, displaying an average annualized rate of return of -6.3% as well as a median return of -9.7%, and weakening two-thirds of the time (Table I-1). This essentially confirms our previous analysis showing that generally, the euro is a rather pro-cyclical currency. This also suggests that even if the euro could experience a temporary rally in response to a re-pricing of Italian exit risk, it will be hard for the common currency to rally durably so long as bond yields have downside. Chart I-13Global Growth Is Slowing Signs##br## Of Soft Global Growth Table I-1Bond Rallies And The Currency Market Table I-1 also shows that the yen has experienced large upside in a falling yield environment, and most importantly has risen in all instances against the USD. As a result, we remain comfortable with our January 12, 2018 recommendation to sell EUR/JPY.4 Not only does EUR/JPY weaken 83% of the time when bond yields fall, but as Chart I-14 shows, relative positioning in EUR/JPY has more room to deteriorate, as previous excesses on the long side tend to be followed by periods of excessive short positioning. Moreover, as the bottom panel illustrates, a reversal in the performance of momentum stocks also comes hand in hand with a weak EUR/JPY. Chart I-15 also highlights that rising dollar funding costs tend to lead to a weaker EUR/JPY. Chart I-14EUR/JPY Is Still Vulnerable Chart I-15Funding Pressure Point To A Weaker EUR/JPY Table I-1 further shows that despite our positive long-term view on EUR/CHF, if we believe that yields could correct further, it is intellectually coherent to be short EUR/CHF on a tactical basis, as the pair has also fallen in 83% of the occurrences of bond market rallies. We are thus sticking with this short-term trade. Chart I-16CAD Benefits From A Valuation Cushion Table I-1 however, is more mixed for our short EUR/CAD bet. EUR/CAD rallies on half the instances where bond yields weaken, and generates an average annualized gain of 1%. Yields are therefore an unreliable gauge of this cross's trend. Instead, we continue to favor the CAD over the EUR on the basis of relative monetary policy dynamics and valuations. The Canadian economy has no slack, core inflation is at 1.9%, and the Bank of Canada just re-opened the door to hiking rates this year - essentially a mirror image to the euro area. Also, while EUR/USD is overvalued by 4.9% based on our preferred model, USD/CAD is overvalued by 14% based on our model using oil and relative rate expectations (Chart I-16). We are therefore sticking with this position, even though we are likely to experience volatility after a straight move down from 1.61 to 1.5. Yesterday's announcement that the White House is imposing tariffs on steel and aluminium on Canada and the EU is likely to be a crucial contributor to this episode of volatility. Finally Table I-1 shows that our negative view on commodity currencies is the correct one to hold in the current context, especially regarding the AUD, which within this group suffers by the greatest extent when yields fall. Additionally, this analysis confirms our assessment regarding NOK/SEK. We were long this pair, and continue to foresee upside for the Norwegian krone relative to the Swedish krona on a cyclical basis. However, we closed this trade as NOK/SEK was getting very overbought. Adding another justification for this tactical decision, a falling yield environment has been associated with this cross weakening in 83% of cases and depreciating on average by a 4.9% annualized rate - or 5.7% if we take the median fall. We will therefore wait to see a stabilization in bond yields before re-opening our NOK/SEK trade. Bottom Line: The rebound in bond prices expected by our U.S. bond strategist has further to run, as the global economy is experiencing a soft patch and U.S. economic surprises have additional downside. This suggests that EUR/USD is likely to depreciate more, prompting us to stick with our 1.12 target for now. EUR/JPY and EUR/CHF possess ample downside as well. While commodity currencies all weaken when bond yields decline, the AUD declines most often, and by the greatest extent. NOK/SEK can correct further before resuming its uptrend; only once bond yields stabilize will we buy this cross again. Gold, The Fed And R-star Following last week's report where we discussed the interaction of the dollar, the fed funds rate, and r-star,5 we received a few questions regarding the implication of this analysis for the gold market. While the message of this analysis was very clear for the dollar - the dollar weakens when the Fed increases rates and the fed funds rate is below the r-star, but strengthens significantly when the Fed lifts rates above r-star - the implications for gold of the interaction between rates and r-star is much murkier. Table I-2 shows the returns of gold, as well as the batting averages of the results, under the four states explored last week. We use medians instead of means, as average returns have been distorted by a few outliers. Table I-2Gold And The Interaction Between ##br##Rates And R* This table highlights that the best environment to hold gold has been the same environment that was harshest to the dollar: a rising fed funds rate, but one that stands below the neutral rate. Essentially, this suggests that in this environment, despite the efforts of the Fed to tighten monetary conditions, global liquidity remains plentiful, which fuels both global growth and gold prices. In this context, gold rallies 76% of the time by a median annualized rate of 14.4%. Chart I-17Gold As A Gauge For R* Perplexingly, there is no clear implications in the other states. When the fed funds rate rises and stands above the neutral rate, gold falls by a median annualized rate of 1.3%, but this only works 55% of the time. This probably reflects the fact that when the real fed funds rate rises in this environment, while in and of itself this should hurt gold, the growing incidence of accidents in global financial markets and the global economy helps gold, undoing the damage created by tighter monetary policy. When the fed funds rate is falling, gold's annualized returns are mixed, but most importantly the distribution of returns is no better than random. So while this analysis does not provide a clear signal for gold next year, it does help us generate a useful inference. If the Fed is indeed soon set to lift interest rates above the neutral rate, as the Laubach-Williams measure of r-star implies, the violent rally that gold experienced in 2017 should taper off. If gold were to continue to rally vigorously, maintaining its strong trend despite higher rates (Chart I-17), this would imply that the fed funds rate is still below r-star. As a corollary, the business cycle would have greater upside, the dollar greater downside, and EM assets should prove more resilient than we anticipate. Bottom Line: Where we stand in the interest rate cycle is less useful for calling the gold market than it is for calling the dollar. While a rising fed funds rate that stands below the neutral rate creates a very supportive environment for gold, other combinations are more opaque. However, this can help generate useful insights on the equilibrium rate. If faced with higher interest rates, gold remains on the strong upward trend it experienced in 2017, this would mean that U.S. policy is still accommodative as the fed funds rate would still be below r-star. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Tacitus, the main source describing the fire, was unsure of the veracity of these allegations. 2 Please see Foreign Exchange Strategy and Geopolitical Strategy Special Report, titled "Europe's Divine Comedy Part II: Italy In Purgatorio", dated June 21, 2017, available at fes.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, titled "Pulling Back And Looking Ahead", dated May 22, 2018, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, and the Weekly Report, titled "The Yen's Mighty Rise Continues... For Now", dated February 16, 2018, both available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different", dated May 25 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was generally weak this week: Q1 GDP growth was revised down to an annualized pace of 2.2%, profit growth was weak; Core personal consumption expenditure grew at a 2.3% quarterly pace, underperforming expectations of 2.5%; Core PCE inflation came in line with expectations at 1.8%. The March number was revised down to 1.8% as well from 1.9% previously; However, the U.S. labor market continues to tighten, with both continuing and initial jobless claims falling more than expected. Washington is ramping up its hawkish stance on trade, implementing its steel and aluminum tariffs on the EU, Canada, as well as Mexico. The U.S. is nonetheless likely to fare better than the rest of the G-10 in the current soft patch for global growth as it is a less cyclical economy. Furthermore, with the dollar recoupling with rate differentials, Fed hikes will serve as an important tailwind for the greenback for the rest of this year. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Amidst the surfeit of political angst across Italy and Spain, some positive economic data have contributed to some relief to the euro's persistent decline this month. German headline and harmonized inflation surprised to the upside, both coming in at 2.2%; German unemployment declined to 5.2%; German retail sales increased by 2.3% on a monthly pace; Spanish harmonized inflation came in at 2.1%, beating expectations; Euro area headline and core inflation came in at 1.9% and 1.1%, respectively, an improvement over previous figures; Unemployment also declined to 8.5% from 8.6%, but came in higher than the expected 8.4%. In addition to abating political anxiety in Italy, ECB Executive Board Member Sabine Lautenschläger, noted that "all the conditions for inflation to kick in are in place". While these factors provided a relief for the euro, it is likely that interest rate differentials, waning global growth, and a labor market replete with slack will keep the upside in the euro capped for the remainder of this year. The longer-run outlook, however, is bullish, as the common currency remains cheap across several valuation metrics. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Retail trade yearly growth came in above expectations, coming in at 1.6%. It also increased from 1% last month. However, large retailer's sales growth surprised negatively, coming in at -0.8%. Moreover, the jobs/applicants ratio also underperformed expectations, coming in at 1.59. Finally, the consumer confidence index also surprised to the downside, coming in at 43.8. USD/JPY has fallen by roughly 1%, as political risks originating from Italy have helped safe heaven assets like the yen. Overall, we continue to be bullish on this cross on a tactical basis, given that we expect a slowdown in global growth to accentuate the current risk off environment. However the BoJ will likely intervene if the yen keeps going up, which makes a bearish stance on the yen appropriate on a cyc lical basis. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Yen's Mighty Rise Continues... For Now - February 16, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been negative Total Business Investment yearly growth underperformed expectations, coming it at 2%. Nationwide Housing Prices yearly growth also surprised negatively, coming in at 2.4%. Finally, mortgage approvals also surprised to the downside, coming in at 62.455 thousand. GBP/USD has fallen by roughly 0.6% this week. As of this week, we have reached the target of our tactical short GBP/USD trade with a tk% gain. While the rally in the dollar could certainly continue, pushing cable lower in the process, it is more prudent to adopt a more neutral stance toward this cross, given that it has depreciated by more than 7% since its highs on mid-April. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Do Not Get Flat-Footed By Politics- March 30, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was on the weak side: Building permits contracted by 5% in monthly terms, and only increased by 1.9% in yearly terms, much less than the previous 15.6% and the expected 4.1%; Private sector credit grew by 0.4% in monthly terms, in line with expectations; Private capital expenditure also grew by only 0.4%, a weaker result than the expected 0.7%. After a meaningful fall, AUD/USD has been relatively flat for the last month. Markets seem to be fully aware of the slack currently hampering the Australian economy. The Australian interest rates futures curve continues to flatten, pricing in a lower probability of any hikes. Furthermore, U.S. trade protectionism is becoming more aggressive, which may pose a further threat to the AUD as Australian growth is highly levered to global trade. We remain bearish on this antipodean currency in both the short and the long term. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has rallied by roughly 1% this week. Overall, we are negative on the NZD versus the U.S. dollar, given that pro-cyclical currencies like the kiwi tend to suffer in periods of heightened volatility and increasing risks. Continued trade tensions, as well as slowing global growth and political risks emanating from Italy will likely perpetuate the current environment going forward, hurting the kiwi in the process. That being said we are positive on this currency against the Australian dollar, as Australia's economy is much more sensitive to the Chinese industrial cycle than New Zealand's. Therefore a slowdown in emerging markets should weigh more heavily on the AUD than on the NZD. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was disappointing this week: Industrial product price increased by 0.5% in monthly terms in April; The Raw Material Price Index increased 0.7%; The current account decreased to CAD-19.5 billion in Q1 of 2018; Quarterly GDP growth came in at 1.3%, disappointing expectations. On Wednesday, the CAD was buoyed by the BoC's hawkish monetary policy statement. According to the statement, the Governing Council will now take a "gradual" approach to policy adjustments, as opposed to the "cautious" one noted in previous statements. In addition, the reference to continued monetary accommodation and labor market slack was also removed. However, the White House announced on Thursday the imposition of tariffs on Canadian exports, which erased most of Wednesday's gain. While this adds substantial risk to the view, the outlook for trade negotiations is still murky, and could surprise on the upside. The CAD still remains cheap on key valuation metrics, with an economy exhibiting less slack than other G-10 counterparts. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 More Than Just Trade Wars - April 6, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: The trade balance outperformed expectations, coming in at 2,289 million. This measure also came in above last month figure. However, the KOF leading indicator underperformed expectations, coming in at 100. It also decreased substantially from last month's reading. Finally, yearly GDP growth also surprised negatively, coming in at 2.2%. EUR/CHF has depreciated by roughly 1.5% this week. Overall, this cross should continue to depreciate given that we expect the current period of risk aversion to persist. Even if Italian political risks start to subside, investors will still have to worry about trade tensions, slowing global growth, and the deleterious impact of lower bond yields on this cross. This should help safe-haven assets like the franc outperform. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Retail sales growth outperformed expectations, coming in at 0.5%. Moreover the Norges Bank credit indicator came in line with expectations, at 6.3%. USD/NOK has rallied by nearly 1.2% this week, as the rise in the dollar coupled with lower oil prices, have resulted in a toxic combination for the krone. Overall, we are positive on the krone relative to other commodity currencies. The krone has a large NIIP and current account surplus which makes it more resilient to terms of trade shocks. Moreover, oil should outperform other commodities given that it is more levered to DM growth than to the Chinese industrial cycle and given that the supply backdrop for crude is more favorable. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data from Sweden has improved: Retail sales beat expectations, growing at a 0.6% monthly pace and a 3.6% annual pace; GDP growth accelerated to 3.3% in Q1 of 2018, higher than the 2.9% growth recorded last year; The trade balance declined by SEK6.5 billion in May; Consumer confidence also suffered slightly to 98.5 from 101. The SEK has strengthened substantially against the euro since its multi-year lows this month. Political woes subsided the euro, while rosy data from Sweden lifted the krona. Against the dollar, the SEK has weakened in recent weeks, due to the greenback's recent surge. We expect the SEK to remain strong against the euro for the remainder of this year, owing to cheap valuations and resurging inflationary pressures. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades