Financial Markets
Executive Summary Biden And Democrats Arrest Fall In Public Opinion US policy is essential to the global macro, policy, and geopolitical outlook in the fourth quarter. Our three key views for 2022 are still in place: the Biden administration is facing congressional gridlock and shifting to executive action and foreign policy. Gridlock will be marginally positive for the stock market but foreign policy crises and additional energy shocks will be very negative. Stay defensive. Our three long-term strategic themes – Generational Change, Peak Polarization, and Limited Big Government – are still on track but the first two will take a back seat during the 2022-24 election cycle. Investors should stay overweight defensive sectors versus cyclicals, large caps versus small caps, cyber security, aerospace/defense, oil and gas transportation/storage, and renewable energy. Go tactically long US treasuries but keep the US dollar on watch for a downgrade. Recommendation (Tactical) INITIATION DATE Return Long DXY (Dollar Index) Feb 23, 2022 18.6% Bottom Line: US policy uncertainty will rise then fall over the course of the midterm election, which will produce gridlock. Gridlock is neutral toward inflation, or disinflationary, and a boon for stocks. But geopolitical risk can still wreak havoc and investors should stay defensive. Feature Market-relevant geopolitical analysis begins with the United States, which remains the critical actor in the international system – as reflected today by the US dollar’s extraordinary bull run both in times of global deflation and inflation (Chart 1). Investors need a base case for US national policy over the course of the 2022-24 election cycle to form a base case for global policy and the macroeconomic and financial outlook. Our annual outlook last December argued that the US had entered a period of greater government involvement in the economy and yet that the Biden administration would face rising checks and balances over the course of 2022 due to thin majorities in Congress, midterm elections, an inflationary macroeconomic environment, and an unstable geopolitical backdrop. Chart 1Dollar Strong During Deflation And Inflation This forecast is largely intact today so the question is whether these checks and balances will inhibit inflation going forward. Biden has achieved significant liberal policy spending but now looks to be seriously constrained, having little ability to pass domestic legislation going forward. However, he faces three foreign policy crises (Ukraine, Taiwan, Iran), all of which are inflationary on the margin. In the coming months Biden’s foreign policy crises could morph into larger global supply shocks, most notably energy shocks from Russia and/or Iran. New shocks could kill demand and tip the economy into recession. If these risks fail to materialize, tighter monetary policy will reduce inflation but likely also at the cost of higher unemployment and recession. While we will maintain our defensive positioning, we may book some gains on bearish trades over the course of the fourth quarter, namely if we see compelling signs of US political and geopolitical risk subsiding and inflation rolling over. But we do not see that yet. Checking Up On Our Three Key Views For 2022 Here we update our three key views for 2022. We show how they have developed so far this year and what we expect in the final quarter: 1. From Single-Party Rule To Gridlock: In the third quarter the Biden administration made a “last ditch effort” to turn around its fortunes ahead of the midterm election, mainly by focusing on fighting inflation. This effort succeeded in stabilizing support for Biden and the Democratic Party in opinion polls, albeit at low levels (Chart 2). The midterm is usually a check against the party in power and its major policy victories. In 2006 anti-war Democrats imposed a check on the Bush Republicans and the war in Iraq. In 2010 and 2014 Tea Party Republicans imposed a check on Obama Democrats and government intervention into health care. In 2018 anti-Trump Democrats imposed a check on Trump Republicans and tax cuts. In early 2022 the election was shaping up to be a referendum on the Biden Democrats and inflationary spending. But the Supreme Court’s reversal of Roe v. Wade has muddied the usually clear pattern of the “midterm curse.” In critical swing states a majority of voters opposes extensive new restrictions on abortion access (Chart 3). Chart 2Biden And Democrats Arrest Fall In Public Opinion Chart 3Swing States Support Abortion Access Young voters and women are especially motivated to vote for Democrats in reaction to the high court’s ruling (Chart 4). However, so far support for the Democrats among these groups is still lower than it was in 2020-21. And young people are not thrilled with old man Biden. Chart 4Youth And Women’s Support For Democrats Chart 5Voters Care Most About Economy … Where Biden Scores Lowest As we enter the final stretch of the campaign, the president and his party receive the lowest grades on the economy, which is still voters’ top priority (Chart 5). Democrats face a negative cyclical backdrop and macroeconomic headwinds – namely falling real wages, incomes, and consumer confidence (Chart 6). In the House of Representatives, our quantitative election model considers how many seats the ruling party is defending, Congress’s net approval rating, and popular support for the two parties (the generic congressional ballot). The resulting estimate is that Democrats should lose 21 seats, whereas they only need to lose six to yield to Republican control (Table 1). Democrats can achieve a positive surprise and yet fail to retain control of the lower chamber. Chart 6Pocketbook Voter Is Frowning Table 1Our House Election Quant Model Predicts GOP Victory Democrats are more likely to retain the Senate but they cannot afford to lose a single seat on a net basis. State-level economic data, previous Senate margins of victory, presidential approval, the generic congressional ballot, and the tenure of Senate incumbents all suggest that Democrats will lose seats in Arizona and Georgia without gaining any seats, thus yielding control to Republicans. Yet this prediction from our quantitative election model necessarily excludes some of the idiosyncrasies of the 2022 election (Chart 7). Chart 7Our Senate Election Quant Model Favors GOP … But Too Close To Call By contrast, state-level opinion polls suggest that Democrats will hold the Senate: several critical Republican-leaning races are tied while Democrats have a large lead in Arizona (Charts 8A & 8B). In short, the Senate is too close to call. Chart 8ADemocrats Tied In Red-Leaning States, Leading In Blue-Leaning States Chart 8BDemocrats Tied In Red-Leaning States, Leading In Blue-Leaning States As long as Republicans gain one chamber the effect is the same: gridlock. The prevailing wind is voter discontent over inflation. The Misery Index (headline inflation plus unemployment) is reminiscent of the stagflationary 1970s and points to a negative outcome for Democrats in the House overall (Table 2). Table 2Misery Index Signals Democratic Losses To Come Hence the House will fall to the Republicans and single-party control will be broken. The federal spending spree will grind to a halt in 2023-24, which is positive for investors in an inflationary environment. For example, it is the opposite fiscal outcome from what is happening in the UK and Italy, where bonds are selling off sharply. 2. From Legislative To Executive Power: We expected Biden and the Democrats to pass a second budget reconciliation bill, which ended up being the inaptly named Inflation Reduction Act, signed into law on August 16. After that we expected the president to shift to executive action as his legislative options dwindled. There have already been some signs of this shift to executive power, such as President Biden’s tapping of the US Strategic Petroleum Reserve to release 180 million barrels of oil, which helped lower gasoline prices before the election (Chart 9). Biden also relaxed some regulations on fossil fuel production in a reversal of his 2020 call for “phasing out” oil and natural gas. More generally Biden has imposed a large number of economically significant regulations relative to previous administrations (Chart 10). He also unilaterally forgave $420 billion worth of student debt over 30 years. Chart 9Biden Tapped Strategic Petroleum Reserve Chart 10Biden Flexes Regulatory Muscles This trend toward executive action will intensify if Congress is indeed gridlocked in 2023-24. It is marginally inflationary but likely to be outweighed by disinflationary fiscal drag in 2023. The same trend also feeds into the next point: Biden’s shift from domestic-oriented to foreign-oriented policy. 3. From Domestic To Foreign Policy: Biden did not seek out foreign policy crises. His primary focus lay on domestic legislation and the midterms. His foreign policy intention was merely to solidify US alliances after quarrels under the Trump administration. However, looming gridlock is forcing him to focus more heavily on foreign policy, where presidential powers are greatest. In particular Russia’s invasion of Ukraine has pushed foreign policy to the center of the agenda. Once Biden’s approval ratings collapsed he began to take on greater foreign policy risks, as we noted in May. His foreign policy is reactive and defensive in the sense that he is responding to foreign aggression and trying to avoid any blowback that hurts his party in the midterms. But he can no longer be said to be risk-averse. Instead Biden is doubling down on the enlargement of NATO and military support for Ukraine. He is arming Taiwan and pledging an unequivocal US willingness to defend it in the event of an “unprecedented attack.” He has expanded high-tech export controls on China while maintaining President Trump’s tariffs. And he is threatening to respond “decisively” to Russia in the non-negligible chance that it deploys a tactical nuclear weapon against Ukraine. The US-Iran attempt to rejoin the 2015 nuclear deal is faltering, as we expected, due to mutual distrust. Almost immediately after negotiations failed in August, widespread social unrest broke out in Iran. While Iran’s structural conditions are conducive to social unrest, the Iranian government suspects the US of fomenting unrest, which is possible. Iran is threatening to retaliate. Iran will also continuing making nuclear advances prompting Israel to publicly entertain military options. The Biden administration will be forced to counteract Iranian threats against regional political stability and oil infrastructure. Hence Biden can no longer avoid energy supply risks emanating from the Middle East. The shift from domestic to foreign policy will become even more pronounced in 2023-24, as foreign policy will become more proactive due to gridlock at home. Taken together, gridlock will bring neutral fiscal policy and hawkish foreign policy. Any post-election decline in policy uncertainty will be short-lived. The loss of the House will increase the odds of economic policy mistakes in 2023 and a ruling party change in 2024 (Chart 11). A Republican House can impeach (but not remove) President Biden, put pressure on the Federal Reserve, and engage in brinksmanship over the national debt limit, which will need to be renewed in the third quarter of 2023. Obstructionism will put a floor under policy uncertainty, which will skyrocket as the 2024 election cycle approaches. Chart 11Biden’s 2024 Odds Fall If GOP Wins House Meanwhile proactive US foreign policy is not positive for investors as it risks escalating global instability. None of America’s rivals will be willing to offer major concessions to forge agreements with the Biden administration in 2023-24 because they will fear that President Trump or another populist Republican will retake the White House in 2025 and impose tariffs or sanctions regardless. The US cannot offer credible guarantees. This is how the Iran deal failed and it is likely to prevent a substantial US-China thaw in relations. Bottom Line: The investment takeaways from our key views for 2022 are mostly on track: inflation and policy uncertainty are rising, stocks are performing poorly, bond yields have spiked, and defensive sectors have outperformed cyclicals. These trends could start to shift in the fourth quarter given that domestic policy uncertainty will at least temporarily abate in the US and China after the fall’s political events. However, geopolitical energy shocks could still escalate if Russia or Iran disrupts global oil supply. And investors must plan for the worst. Even without additional energy shocks, Fed rate hikes are likely to precipitate a recession. Gridlock will have a neutral fiscal impact over the course of the subsequent 24 months, which is marginally disinflationary, but proactive US foreign policy will keep high the risk of energy shocks and global policy uncertainty. Checking Up On Our Strategic Themes For The 2020s It is useless to predict specific policy outcomes too far in the future but investors need a framework for understanding the general drift of national policy amid the dramatic macro shifts occurring today. Here is a short update to our strategic themes for the decade: 1. Millennials/GenZ Rising: The death of the Silent Generation, the retirement of the Baby Boomers, and the rise of Generations X, Y, and Z are causing major shifts in the US economy and markets. First, US population growth is not great but better than its developed market peers. Immigration is robust, though it is likely to be restricted somewhat by future administrations (Chart 12). Relatively strong labor force growth implies higher potential growth than developed market peers, assuming US productivity meets or exceeds that of Europe, as it should (Chart 13). As long as this growth is accompanied by decent policy, i.e. not too inflationary, it will produce relatively attractive real returns for investors. Chart 12US Population Growth And Immigration Chart 13US Relative Labor Force And Potential Growth Second, however, inflation will be a recurring problem because population aging is driving a vast redistribution of wealth from older to younger and from generations with a high propensity to save to those with a high propensity to consume. The impact is inflationary since there will be fewer savings to fund investments, according to our Global Investment Strategist Peter Berezin. This trend will drive up equilibrium real interest rates and bond yields (Chart 14). Thus America will witness a tug of war in which a new inflation tendency engenders periodic policy backlashes to keep inflation in check, as is likely in the 2022 midterms. Chart 14Major Redistribution Of Wealth 2. Peak Polarization: There is a large gap when it comes to identity and core values both within the Baby Boomer generation and between the Silent Generation and the younger generations. America has seen rapid change in the population’s ethnicity, religion, education, location, and industry. It is also a free country where self-expression is fully indulged, leading to wide extremes in individual and group behavior. Rapid pluralistic change combined with stark income and wealth inequality have fueled political polarization, which has made it increasingly difficult to generate nationwide policy consensus in recent decades (Chart 15). However, the rising electoral weight of the younger generations will resolve some of the most extreme policy differences in favor of the younger generations. Millennials and Generation Z will become more conservative over time but they will still lean to the left of their parents and grandparents on the economic policy spectrum (positive rights, progressive taxes, social spending, proactive regulation). Meaning that social spending and higher taxes will become more, not less, feasible over the long run (Chart 16). Meanwhile the revival of competition among the world’s great powers (multipolarity) is forcing the US population and policymakers to recognize common foreign challenges. This is leading to a new consensus around certain strategic and national interests having to do with trade protectionism, industrial guidance, and foreign policy realism. Chart 15Inequality As A Driver Of Polarization Chart 16Younger Generations Less ‘Capitalist,’ More ‘Socialist’ This new consensus can be seen in the passage of bipartisan bills to build infrastructure, promote US manufacturing, shift supply chains to US-allied countries, and impose punitive measures against Russia, China, and Iran (Chart 17). Chart 17New Consensus: Nation Building At Home 3. Limited Big Government: The emerging policy consensus will be federalism but not authoritarianism – a larger but not overwhelming role for government in the economy. Popular opinion is demanding a larger role for the government to reduce domestic social grievances and political instability. It is also demanding greater protections from global trade. Elite opinion requires sustained high investment in national defense. All of this ostensibly points to a new era of Big Government but there are important caveats. The US constitution, private institutions, and popular opinion will continue to prevent the full adoption of a statist model, with its inefficient bureaucracy and excessive regulation. The cost of too much government has already appeared in this year’s surge of inflation, which is motivating a political backlash that will moderate the liberal spending trajectory. In short US governance is shifting from decentralization to centralization but it is a marginal not absolute change (Chart 18). The insurrection of 2021 failed but so did the cultural revolution of 2020. Chart 18New Consensus: Limited Big Government Demographics, politics, and economics all point to a new US policy paradigm in which new generations take over and form a new policy consensus – and yet that consensus is not truly socialist. It is rather a continuation of the American combination of federalism, liberalism, and nationalism. Civil war is likely to be avoided because the economy is stable enough and the political system is flexible enough to prevent the inevitable violent movements and domestic terrorism from causing state fragmentation. Bottom Line: US currency and equity markets have greatly outperformed the rest of the world as financial markets priced the US’s structural advantages in the unstable world after the 2008 financial crisis. This trend is intact for now but could suffer setbacks whenever global growth rebounds and the new US policy consensus leads to higher wages, higher taxes, and lower corporate profitability. Investment Takeaways In our annual forecast we noted that US midterm election years tend to produce a flat stock market, rising bond yields, and the outperformance of defensive sectors. This year has been even worse than normal with the S&P500 down 23% to date and the 10-year Treasury up 243 basis points to date (down 17% in terms of total return). Note, however, that stocks typically rise and bond yields typically fall in the year after the midterm, which may bring some relief in 2023 (Chart 19). We expect this bounce in 2023 but it cannot happen until inflation rolls over decisively. Chart 19Worse Than Average Market Performance In Midterm Election Year The dollar rally is in line with, but exceeding, the interest rate differential between US and European government bonds. This makes sense given the geopolitical risk premium. Dollar strength is not only about euro weakness but is broad-based, as becomes clear when looking at the trade-weighted dollar. We have long argued the dollar would rise in line with global policy uncertainty (Chart 20). While our long DXY trade is long in the tooth, momentum is strong. Defensive sectors will outperform in a strong dollar context. Cyclical sectors have more downside relative to defensives and small caps have more downside relative to large caps. But oil and gas equities have become defensive and have more upside relative to the broad market (Chart 21). Energy volatility will continue to be a driving macro force in the fourth quarter due to the crosswinds of geopolitical supply disruptions and global economic slowdown. We are re-initiating our recommendation to overweight oil and gas transportation and storage stocks relative to the S&P 500. Chart 20US Dollar Reaching Extremes, On Watch For Downgrade Chart 21Energy Volatility To Continue In Q4 Renewable energy stocks should also remain an overweight given the new political impetus behind energy security. Tech stocks have more downside in the near term but should bounce back once inflation rolls over and bond yields start to fall. Cyber-security companies will generally trade in line with tech but will also benefit from geopolitical tailwinds. Renewables, cyber-security, and aerospace/defense remain our key overweights (Chart 22), in addition to infrastructure stocks as mentioned earlier in the report. Given the sharp selloff in bonds, the disinflationary aspects of gridlock and eventual recession, and today’s extraordinary geopolitical risks, we recommending buying 10-year treasuries on a tactical basis. Chart 22Stick With Cyber Security, Defense, Renewables Over Long Run Matt Gertken Senior Vice President Chief US Political Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Guy Russell Senior Analyst guyr@bcaresearch.com Yushu Ma Research Analyst yushu.ma@bcaresearch.com Alice Brocheux Research Associate alice.brocheux@bcaresearch.com Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets Footnotes
Executive Summary Upward Repricing Of Bond Yields Continues In this report, we discuss our move last week to shift to a below-benchmark overall global duration stance in more detail. Our strongest conviction view on developed market government bonds is underweighting US Treasuries. The outcome of last week’s FOMC meeting, where the Fed committed to a rapid shift to restrictive US monetary policy, supports that position. Our strongest conviction overweight is on Japan, with the Bank of Japan both willing and able to maintain its cap on longer-term JGB yields. We are also overweight countries where it will be difficult for central banks to lift rates as much as markets expect – core Europe, Australia and Canada. The explosion in UK bond yields, and collapse of the British pound, seen after last week’s UK “mini-budget” shows that investors have not lost the power to punish fiscal and monetary policies that are non-credible - like a massive debt-financed tax cut at a time of high inflation. As a result, the Bank of England will now be forced to raise rates much more than we had been expecting, and Gilts will remain extremely volatile in the near-term. Bottom Line: Maintain a below-benchmark overall duration stance in global bond portfolios. Stay underweight US Treasuries. Upgrade exposure to government bonds in Japan and Canada to overweight, but tactically downgrade UK Gilts to underweight until a more market-friendly policy mix leads to greater stability of the British pound. Feature We shifted our recommended stance on overall global portfolio duration to below-benchmark in a Special Alert published last week. In this report, we go into the rationale for that move in more detail, and present specific details of that shift in terms of allocations by country across the various yield curves. Related Report Global Fixed Income StrategyReduce Global Portfolio Duration To Below-Benchmark The global inflation and monetary policy backdrops remain toxic for bond markets. Last week saw interest rate increases from multiple developed economy central banks, including the Fed and Bank of England (BoE). The magnitudes of the rate hikes unnerved bond investors, with even the likes of perennial low yielders like the Swiss National Bank and Riksbank lifting rates by 75bps and 100bps, respectively. The Fed followed up its own 75bp hike by digging in its heels on the need for additional policy tightening after the 300bps of hikes already delivered this year (Chart 1). Fed Chair Jerome Powell strongly hinted that a policy-induced US recession is likely the only way to return overshooting US inflation back to the Fed’s 2% target. This triggered a breakout of the benchmark US 10-year Treasury yield above 3.5%. But the real fireworks in global bond markets occurred after the UK government announced its “mini-budget” last Friday that included massive tax cuts to be funded by debt issuance, triggering a sharp decline in the British Pound and spike in UK Gilt yields – a move that spilled over into other bond markets, pushing government bond yields to cyclical highs in the US and euro area. Chart 1Central Banks Keep Trying To “Out-Hawk” Each Other Chart 2Yields Are Now Driven By Rate Hike Expectations, Not Inflation We had been anticipating another move upward in global bond yields for this cycle, and we shifted to a below-benchmark overall global duration stance in advance of the Fed and BoE meetings last week. We see this next move higher in yields as being driven not by rising inflation expectations but by an upward repricing of interest rate expectations, leading to additional increases in real bond yields (Chart 2). Trying to pick a top in bond yields has now become a game of forecasting the level to which policy rates must rise in the current global monetary tightening cycle. On that front, there is still scope for rate expectations, and bond yields, to move higher in most developed market countries, justifying our downgrade of our recommended overall duration exposure to below-benchmark. Shifting rate expectations also lead to the changes in country bond allocations we announced last week. Rate Expectations And Country Bond Allocations Our proxy for medium-term nominal terminal rate expectations in developed market countries, the 5-year/5-year forward overnight index swap (OIS) rate, has been tracking 10-year bond yields very closely in the US and UK and, to a lesser extent, Europe (Chart 3). In those regions, the OIS curves are pricing in an increasing medium-term level of policy rates, leading to markets repricing government bond yields higher. In the US, the OIS curve is pricing in a 2023 peak for the fed funds rate of 4.67%, but with only a modest path of rate cuts in 2024 and 2025, leading to a 5-year/5-year OIS projection of 3.36% as of Monday’s market close. After the Gilt market rout, the UK OIS curve is now pricing in a 2023 peak Bank Rate over 6%, with our medium-term nominal rate proxy settling at 3.69%. In the euro area, the OIS curve is discounting a 2023 peak in the ECB policy rate of 3.22%, with a 5-year/5-year forward OIS rate of 2.7%. For all three of those regions, the market is now pricing in the highest peak in rates for the current tightening cycle. That is not the case in Canada or Australia, where rate expectations and longer-term bond yields are still below cyclical peaks (Chart 4). Japan remains the outlier, with the Bank of Japan’s yield curve control keeping 10-year JGB yields capped at 0.25%, even with the Japan OIS curve pricing in a medium-term terminal rate of 0.75%. Chart 3Rising Yields Reflect Higher Terminal Rate Expectations Chart 4Our High-Conviction Government Bond Overweights After looking at all the repricing of interest rate expectations and bond yields, we can determine our preferred government bond allocations within our strategic model bond portfolio framework. The US Remains Our Favorite Government Bond Underweight The new set of interest rate forecasts (“the dots”) presented at last week’s Fed meeting showed that the median FOMC member was forecasting the fed funds rate to rise to 4.4% by the end of 2022 and 4.6% by the end of 2023, before falling to 3.9% and 2.9% and the end of 2024 and 2025, respectively. Those are all significant increases from the June dots, where the expectations called for the funds rate to hit 3.4% by end-2022 and 3.8% by end-2023. The median Fed forecasts are now broadly in line with the pricing in the US OIS curve for 2022-2024, although the market expects higher rates than the FOMC in 2025 (Chart 5). Chart 5USTs Still Vulnerable To Additional Fed Hawkish Surprises There has been a lot of back and forth between the Fed and the markets this year, but the market has generally lagged the Fed interest rate projections for 2023 and 2024 before last week. Market pricing is now in line with the Fed dots, as investors have adjusted to the increasingly hawkish message from Fed officials that are focused solely on slowing growth, and tightening financial conditions, in an effort to bring US inflation down. We see the US Treasury curve as still vulnerable to additional hawkish messaging from the Fed, and a potentially higher-than-anticipated peak in the funds rate versus the FOMC dots. The US consumer is facing a lot of headwinds from higher interest rates and rising food and gasoline prices. However, the latter has fallen 26% from the June 13/2022 peak and is acting as a “tax cut” that also helps reduce US inflation expectations (Chart 6). Consumer confidence measures like the University of Michigan expectations survey have already shown improvement alongside the fall in gas prices, which has boosted real income expectations according to the New York Fed’s Consumer Survey (bottom panel). Even a subtle improvement in consumer confidence due to some easing of inflation expectations can help support a somewhat faster pace of consumer spending at a time of robust labor demand and accelerating wage growth. The Atlanta Fed Wage Tracker is now growing at a year-over-year pace of 5.7%, while the ratio of US job openings to unemployed workers remains near a record high (Chart 7). Fed Chair Powell has noted that the Fed must see significant weakening of the US jobs market for the Fed to consider pausing on its current rate hike path. So far, there is little evidence pointing to a loosening of US labor market conditions that would ease domestically-generated inflation pressures. Chart 6Lower Gas Prices Can Provide A Lift To US Consumer Spending Chart 7A Tight US Labor Market Will Keep The Fed Hawkish Chart 8Stay Underweight US Treasuries We expect overall US inflation to decelerate next year on the back of additional slowing of goods inflation, but will likely settle in the 3-4% range in 2023 given stubbornly sticky services inflation and wage growth. The Fed should follow through on its current interest rate projections, with a good chance that rates will need to be pushed up even higher in response to resilient labor market conditions in the first half of 2023. The risk/reward still favors higher US Treasury yields over at least the next 3-6 months, particularly with an improving flow of US data surprises and with bond investor duration positioning now much closer to neutral according to the JPMorgan client survey (Chart 8). Bottom Line: The US remains our highest conviction strategic government bond underweight in the developed markets. Recommended Allocations In Other Countries The path for monetary policy rates outside the US shows a similar profile as in the US, with a “front loading” of rate hikes to mid-2023 followed by modest rate cuts over the subsequent two years (Chart 9). The OIS-implied path for the level of rates is nearly identical in the US, Australia and Canada. On the other hand, markets are discounting much lower of levels of policy rates in Europe and Japan compared to the US, and a considerably higher path for rates in the UK (more on that in the next section). Chart 9Markets Priced For Global 'Front-Loaded' Rate Hikes We would lean against the US-like pricing of interest rates in Australia and Canada. Based on work we published in a recent Special Report along with our colleagues at BCA Research European Investment Strategy, the neutral real interest rate (“r-star”) is estimated to be deeply negative in Australia and Canada after adjusting for the high level of non-financial debt in those countries (Table 1). That financial fragility makes it much less likely that the Bank of Canada and Reserve Bank of Australia can raise rates as much as the Fed. Table 1Some Big Swings In Our R* Estimates When Including Debt US-like interest rates would almost certainly trigger a major downturn in house prices and household wealth given the inflated housing values in those two countries – the growth of which is already slowing rapidly in response to rate hikes delivered in 2022. We are maintaining our overweight recommendation on Australian government bonds, while we upgraded Canada to overweight from neutral after last week’s duration downgrade. Chart 10Move To Overweight Japan We are also staying overweight on German and French government bonds, as the ECB is unlikely to deliver the full extent of rate increases discounted in the European OIS curve. Our estimated debt-adjusted r-star is also quite negative in the euro area, suggesting that financial fragility issues (due to high government debt in Italy and high corporate debt in France) will likely limit the ECB’s ability to continue with recent chunky rate increases for much longer. In Japan, we continue to view JGBs as an “anti-duration” instrument, given the Bank of Japan’s persistence in maintaining negative interest rates and yield curve control. That makes JGBs a good overweight when global bond yields are rising and a good underweight when global bond yields are falling (Chart 10). Given our decision to reduce our recommended duration exposure to below-benchmark, the logical follow through decision is to upgrade JGBs to overweight. The only remaining country to consider is our view on UK Gilts, which has now become more complicated. Anarchy In The UK The selloff in the UK Gilt market has been stunning in its ferocity. Dating back to last Thursday’s 50bp rate hike by the BoE, the 10-year UK Gilt yield has jumped 120bps and now sits at 4.52%. The increase in yields was identical at the front-end of the Gilt curve, with the 2-year yield jumping 120bps to 4.68%. The surge in longer-term Gilt yields stands out to the rise in bond yields seen outside the UK, as it also incorporates an increase in our estimate of the UK term premium – a move that was not matched in other countries (Chart 11). The rise in Gilt yields was also much more concentrated in real yields compared to inflation expectations (Chart 12), as markets aggressively repriced the path for UK policy rates after the UK government’s announced debt-financed fiscal package, including £45bn of tax cuts. Chart 11Upward Repricing Of Bond Yields Continues Chart 12The Gilt Market Becomes Unhinged The UK’s National Institute for Economic And Social Research (NIESR) estimates that the combined impact of the tax cuts and additional spending measures would increase the UK government deficit by a whopping £150bn, or 5% of GDP. The NIESR also estimated that the fiscal measures, including the previously-announced plan for the UK government to cap energy price increases, would result in positive UK GDP growth in the 4th quarter and also lift annual real GDP growth to 2% over 2023-24. The UK government now faces a major credibility issue with markets on its announced fiscal plans. The sheer size of the package, coming at a time when the US economy was already operating at full employment with high inflation, invites a greater than expected monetary policy tightening response from the BoE. The UK OIS curve now forecasts a peak in rates of 6.3% in October 2023, up from the current 2.25%. That would be a massive move in rates in just one year from a central bank that has been relatively gun shy in lifting rates since the 2008 financial crisis, even during the current inflation overshoot. New UK Prime Minister Liz Truss, and her new Chancellor of the Exchequer Kwasi Kwarteng, have both noted they would prefer a mix of looser fiscal policy (aimed at boosting the supply side of the economy to lift potential growth) with tighter monetary policy that would prevent asset bubbles and inflation overshoots. While there is certainly merit in any plan designed to boost medium-term growth by lifting anemic UK productivity through supply-side reforms, the timing of the announcement could not have been worse. Just one day earlier, the BoE announced a plan to go forward with the sale of Gilts from its balance sheet accumulated during quantitative easing. The Truss government needs to find buyers for all the Gilts that must be issued to pay for the tax cuts and stimulus, but the BoE will not be one of them. In the end, however, the BoE’s expected path for interest rates matters more than the increase in Gilt supply in determining the level of Gilt yields and the slope of the Gilt curve. The NIESR estimates that the UK public debt/GDP ratio will rise to 92% by 2024-25, versus its pre-budget forecast of 88%. While that is a meaningful increase, the correlation between the debt/GDP ratio and the slope of the Gilt curve has been negative for the past few years (Chart 13, top panel). The stronger relationship is between the slope of the curve and the level of the BoE base rate (bottom panel), which is pointing to an inversion of the 2-year/30-year curve if the BoE follows market pricing and lifts rates to 6%. Our view dating back to the early summer was that a low neutral interest rate would prevent the BoE from lifting rates as much as markets were discounting without causing a deep recession, lower inflation and, eventually, a quick reversal of rate hikes. The huge UK fiscal stimulus package changes that calculus, as the nominal neutral rate that will be needed to bring UK inflation back to target is likely now much higher. We have always believed that when a thesis underlying an investment recommendation is challenged by new information, it is best to adjust the recommendation to reflect the new facts. Thus, this week, we are tactically downgrading UK Gilts to underweight in our model bond portfolio framework. We still see a significant medium-term opportunity to go overweight Gilts, as UK policy rates pushing into the 4-6% range are not sustainable. However, the BoE will likely have no choice to begin lifting rates at a much more aggressive pace to restore UK policy credibility, especially with the British pound under immense selling pressure (Chart 14). Despite rumors of an inter-meeting rate hike by the BoE this week to try and support the pound, that is likely too risky a step for the BoE to take as it would invite a battle with investors and currency speculators. Such a battle would be difficult to win without a more credible and market-friendly medium-term fiscal policy from the Truss government. Chart 13The BoE Matters More Than Debt Levels For Gilts Chart 14Tactically Move To Underweight UK Gilts Bottom Line: We will review our UK Gilt stance once there are more clear signals of stability in the pound, but for now, we will step aside and limit our recommended exposure to Gilts – even after the huge selloff seen to date, which likely has more to go. Summarizing All The Changes In Our Model Bond Portfolio All the changes to our recommended duration exposure and country allocations after the past week, including the new weightings in our model bond portfolio, are shown in the tables on pages 14-16. To summarize: We moved the overall recommended global duration exposure to below-benchmark, and shifted the model bond portfolio duration to 0.9 years below that of the custom benchmark index. We increased the size of the US Treasury underweight, and moved Canada and Japan to overweight. We moved the UK to underweight, on top of the reduction in UK duration exposure that was part of last week’s move to reduce overall portfolio duration. We are also cutting exposure to UK investment grade corporates to underweight, as part of an overall move to reduce UK risk in the portfolio. We slightly increased the overweight in Germany. In next week’s report, we will present the quarterly performance review of our model bond portfolio and, more importantly, we will present out scenario-based return expectations after all the changes made this week. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com GFIS Model Bond Portfolio Recommended Positioning Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months)
Executive Summary Global Manufacturing / Trade Will Contract The bar for the Fed to stop hiking rates is still very high. US inflation remains broad based. Core inflation is neither about oil and food prices nor is it about the prices of other individual items. The key variables that will determine inflation’s persistence are wages and unit labor costs. US wage growth is very elevated, and unit labor costs are soaring. Unless the US economy experiences a recession, core inflation will not drop below 3.5%. The Fed and the US stock market (and by extension global risk assets) remain on a collision course. The Fed will not make a dovish pivot until the stock market sell off, and equities cannot rally unless the Fed backs off. The imminent global trade contraction is bad news for EM stocks and currencies as well as global cyclicals. Bottom Line: A hawkish Fed amid a global trade/manufacturing recession is producing a bearish cocktail for global risk assets in general and EM risk assets in particular. Feature The majority of investors and strategists have been expecting an easing of US inflation to allow the Federal Reserve to completely halt or considerably slow the pace of its hiking cycle. For example, the Bank of America Global Fund Managers survey from September (taken before the release of the latest US CPI report) revealed that a net 79% of participants see lower inflation in the next 12 months. We at BCA’s Emerging Markets Strategy team have taken a different view. Even though we have been open to the idea that the annual rate of inflation (especially the headline measure) will drop in the months to come, we have been arguing that US core inflation will remain well above the 3.5-4% range for some time. What matters for the Fed’s policy is the level of core inflation, not just a decline in the inflation rate. With core inflation considerably above the Fed’s 2% target, we have maintained that the FOMC will uphold its hawkish bias. Consequently, global risk assets will continue selling off and the US dollar will overshoot. Analyzing the price dynamics of individual items − such as energy, food, shelter or cars – when assessing the outlook for inflation is akin to missing the forest for the trees. Chart 1US Core-Type Inflation Measures Are Very High When inflation is limited to several individual components of the consumption basket, neither central banks nor financial markets should react. This is true both when the prices of these individual components are rising (inflation) and when they are falling (deflation). However, central banks and, hence, financial markets, should respond to broad-based inflation. Therefore, investors need to look at the forest rather than focus on individual trees. In our February 18, 2022 report, we wrote the following: “US inflation has become broad based. Not only is core CPI surging but also trimmed-mean, median and sticky core consumer price inflation has risen substantially. Median and trimmed-mean price indexes would not be rocketing if inflation was limited to select goods or services. Particularly, the aforementioned measures exclude components with extreme price changes. What might have started as a narrow-based relative price shock has evolved into broad-based genuine inflation. The key to the transition from one-off inflation spikes to persistent genuine inflation is wages, more specifically unit labor costs. Unit labor costs are calculated as nominal wages divided by productivity (the latter is output per hour per employee).” All of these points remain valid today. Chart 1 shows that core, median, trimmed-mean and sticky CPI are all rising at very fast annual rates, ranging from 6% to 7.2%. Hence, underlying inflationary pressures remain broad based and persistent in the US economy. As a result, the bar for the Fed to stop hiking rates is very high. Last week, FOMC member Christopher Waller stated that he would need to see month-on-month core inflation prints of around 0.2% for a period of five to six months before he is comfortable with backing off on rate hikes. In the past three months, the monthly rates of various measures of underlying core inflation have ranged between 0.5-0.65%. Even though oil and food prices have relapsed and freight rates have plunged, US core inflation has still surprised to the upside. The point being is that core inflation is neither about oil and food prices nor is it about the prices of other individual items. We have been arguing for some time that the key variables to watch to determine whether inflation will be persistent are wages and unit labor costs. US wage growth is elevated, and unit labor costs are soaring (Chart 2). Finally, companies have raised prices at an annual rate of 8-9% (Chart 3). Chart 2US Labor Costs Have Been Surging Chart 3US Companies Have Raised Prices At An 8-9% Annual Rate US Stagflation Or Recession? Is the US economy heading into stagflation or recession? How persistent will US inflation prove to be? Over the next several months, US core inflation will prove to be sticky. So, stagflation (weak real growth and high inflation) is the likely outcome over the near term. Beyond this period, say on a 12-month horizon, the US economic outlook is less clear. Chart 4US Corporate Profit Margins Have Peaked One thing we are certain of is that faced with surging unit labor costs, US companies will attempt to raise their prices to protect their profit margins and profitability. Our proxy for US corporate profit margins signals that margins are already rolling over (Chart 4). Hence, business owners and CEOs will attempt to raise selling prices further. This will lead to one of two possible scenarios for the US economy in the months ahead. Scenario 1: If customers (households and businesses) are willing to pay considerably higher prices, nominal sales will remain very robust, and profits will not collapse, reducing the likelihood of a recession. Yet, this means that inflation will become even more entrenched, and employees will continue to demand higher wages. A wage-price spiral could unravel. The Fed will have to raise rates by much more than what is currently priced in financial markets. This is negative for US share prices. Scenario 2: If customers push back against higher prices and respond by curtailing their purchases, then sales and output volume will relapse, i.e., the economy will enter a recession. In this scenario, inflation will plummet, corporate margins will shrink (prices received will rise much less than unit labor costs) and profits will plunge. Suffering a profit squeeze, companies will lay off employees, and wage growth will decelerate sharply. Although bond yields will drop significantly, the benefit to equities will be offset by plunging corporate profits. We are not certain which of these two scenarios will prevail: it is hard to determine the point at which US consumers will push back against rising prices. Nevertheless, it is notable that in both scenarios, the outlook for stocks is poor. Bottom Line: Inflation is an inert and persistent phenomenon. The inflation genie has escaped from the bottle. When this happens, it is hard to put the genie back. In short, unless the US economy experiences a recession, core inflation will not drop below 3.5%. Still On A Collision Course On February 18 of this year, we published a piece titled A Collision In The Fog Of Inflation?, arguing that the Fed and the US equity market are on a collision course amidst the fog of inflation. Specifically, we noted that “the Fed will not make a dovish pivot until markets sell off, and markets cannot rally unless the Fed backs off.” This reasoning still applies. Barring a major US growth slump, US core inflation will not drop below 3.5%. Hence, the only way for the Fed to bring core inflation toward its 2% target is to tighten policy further. Financial conditions play a critical role in shaping the trajectory of the US economy. US domestic demand might not weaken sufficiently and, hence, US core inflation will not subside below 3.5% unless financial conditions tighten further (Chart 5). That is why a scenario in which US stocks and bonds rally despite the Fed’s continuous tightening is currently unlikely. Presently, there seems to be a dichotomy between the signal from the US yield curve and share prices. Despite the extremely inverted yield curve, US share prices have not yet fallen to new lows (Chart 6). Chart 5US Financial Conditions Have Room To Tighten Further Chart 6The US Yield Curve Is In An Equity Danger Zone Chart 7A Negative Bond Term Premium Amid High Volatility Is Paradoxical If US share prices do not break below their June lows, US interest rate expectations will rise further. The basis is that the Fed will not cut rates next year unless the economy is in recession and equities are selling off. In addition, there is a paradox in US long-term bonds. Despite exceptional inflation volatility, the Fed’s QT (reducing its bond holdings) and heightened US bond volatility, the US Treasurys’ term premium − the risk premium on bonds − is close to zero (Chart 7). That is why we expect the US bond market’s selloff to persist with 30-year yields pushing toward 4%. Consequently, US share prices will likely break below the major technical support that held up in the past 12 years (Chart 8). If the S&P 500 breaks below its June low, the next technical support is around 3200. Meanwhile, the US dollar will continue overshooting, as we argued in our recent report. Chart 8The S&P 500: Between Support And Resistance Lines Chart 9The EM Equity Index Is Still Above Its Long-Term Technical Support As for EM share prices, they will likely drop another 13-15% to reach their long-term technical support, as illustrated in Chart 9. Bottom Line: The Fed and the US stock market, and by extension global risk assets, remain on a collision course. A Global Manufacturing Recession Is Looming The latest data have corroborated our theme that global manufacturing and trade are heading into recession: Korean and Taiwanese manufacturing PMI new export orders have plunged well below the important 50 lines (Chart 10). Chinese imports for re-export are already contracting. They lead Chinese exports by three months (Chart 11). Chart 10Global Manufacturing / Trade Will Contract Chart 11Chinese Exports Are About To Shrink Chart 12Emerging Asian Currencies And Global Cyclicals-To-Defensives Stock Performance Chinese import volumes will continue shrinking, and EM ex-China domestic demand will relapse following the ongoing monetary tightening by their central banks. Finally, Emerging Asian currencies have been plunging, and such rapid and large-scale depreciation is a precursor to a global trade/manufacturing recession (Chart 12). Bottom Line: The imminent global trade contraction is bad for EM stocks and currencies as well as global cyclicals. Investment Strategy A hawkish Fed amid a global trade/manufacturing recession is producing a bearish cocktail for EM currencies and risk assets. Absolute-return investors should stay put on EM risk assets. Continue underweighting EM in global equity and credit portfolios. Emerging Asian currencies have more downside given the budding contraction in their exports and the interest rate differential moving further in favor of the US dollar. Commodity prices and commodity currencies remain at risk from the global manufacturing recession and the absence of a revival in Chinese demand. Overall, the US dollar will overshoot in the near term. We continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN and IDR. In addition, we continue to recommend shorting HUF vs. CZK, KRW vs. JPY, and BRL vs. MXN. EM currency depreciation will cause EM credit spreads to widen. Odds are that EM sovereign and corporate bond yields will rise, which is a bearish signal for EM non-TMT stocks, as illustrated in Chart 13. Chart 13EM USD Bond Yields Are Instrumental For EM Share Prices Chart 14Beware Of A Breakdown in EM Tech Stocks EM technology stocks are also breaking down. The share prices of TSMC, Samsung and Tencent have all fallen below their long-term technical supports (Chart 14). This negative technical profile coupled with our fundamental assessment point to a further slide in these share prices. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)
In lieu of next week’s report, I will host the monthly Counterpoint Webcast on Thursday, September 22 (9:00 AM EDT, 2:00 PM BST). In this Webcast, I will discuss the near-term and longer-term prospects for all the major asset classes: stocks, bonds, sectors, commodities, currencies, and real estate. Please mark the date in your calendar, and I do hope you can join. Executive Summary Analysing the economy as the ‘non-linear system’ that it is leads to profound conclusions about how the economy and inflation are likely to unfold, and reveals that some outcomes are impossible to achieve. It is impossible to lift the unemployment rate by ‘just’ 1-2 percent. Therefore, it is impossible to depress wage inflation by ‘just’ 1 percent. The non-linear choice is to not depress wage inflation at all, or to make wage inflation slump. Presented with this non-linear choice, central banks will likely choose to make wage inflation slump, which will take core inflation well south of the 2 percent target within the next couple of years. The structural low in bond yields, the structural low in commodity prices, the structural high in stock market valuations, and the structural high in the US dollar are yet to come. It Is Impossible To Lift The Unemployment Rate By ‘Just’ 1-2 Percent Bottom Line: Inflation will slump to well below 2 percent within the next couple of years. Feature Our non-linear world often surprises our linear minds. If we discover that a small cause produces a small effect, we think that double the cause produces double the effect, and that triple the cause produces triple the effect. But in our non-linear world, double the cause could produce no effect, or half the effect, or ten times the effect. Just as important, in a non-linear world, some outcomes turn out to be impossible. In a non-linear system, some outcomes are impossible to achieve. As I will now discuss, analysing the economy as the non-linear system that it is leads to profound conclusions about how the economy and inflation are likely to unfold, and reveals that some outcomes are impossible to achieve. In A Non-Linear System, Some Outcomes Are Impossible A good physical example of a non-linear system that we can apply to inflation is to attach an elastic band to the front of a brick. And then to try pulling the brick across a table at a constant speed, say 2 mph. It’s impossible! First, nothing happens. The brick is held in place by friction. Then, at a tipping point of pulling, it starts to accelerate. Simultaneously, the friction decreases, self-reinforcing the acceleration to well above 2 mph. Meanwhile, your response – to stop pulling – happens with a lag. The result is that, the brick refuses to budge, and then it hits you in the face. Try as you might, it is impossible to pull the brick at a constant 2 mph (Figure 1 and Figure 2). Figure 1The Forces On A Brick Pulled By An Elastic Band Figure 2The Net Forces On A Brick Pulled By An Elastic Band In mathematical terms, the reduction in friction as the brick starts to move is known as ‘self-reinforcing feedback’. The lag in applying the brakes is called ‘delayed corrective feedback’. Their combined effect is to make it impossible to pull the brick at a constant 2 mph. Now, to model inflation, attach an elastic band to both the front and the back of the brick, and find a friend. Your task, ‘policy loosening’, is to accelerate the stationary brick to a steady 2 mph. The analogy being to run inflation at 2 percent. On the opposite side, your friend’s task, call it ‘policy tightening’, is what central banks are desperate to do now – to rein back an out-of-control brick heading towards your face at 10 mph. But without slowing it to a standstill, or worse, reversing direction. The analogy being to avoid outright deflation. You will discover that you can move the brick sharply forwards (and sharply backwards), but you cannot move it forwards at a steady 2 mph! The brick-on-an-elastic-band analogy explains why it is impossible for policymakers to run inflation at a constant 2 percent. Inflation either careers out of control, as now, or stays stuck below 2 percent, as it did through the 2010s. Inflation cannot run ‘close to 2 percent’. It Is Impossible To Lift The Unemployment Rate By ‘Just’ 1-2 Percent Central to the non-linearity of inflation is the non-linearity of the jobs market, in which some outcomes are impossible. Specifically, it has proved impossible to lift the unemployment rate by ‘just’ 1-2 percent. It has proved impossible to lift the unemployment rate by ‘just’ 1-2 percent. Through the past 75 years, whenever the US unemployment rate has increased by 0.6 percent, it has then gone on to increase by at least 2.1 percent from the trough. In no case has the unemployment rate risen by ‘just’ 0.6-2.1 percent. In other words, the unemployment rate nudges up by 0.5 percent or less, or it surges by 2.1 percent or more. There is no middle ground. Indeed, through more recent history the surge has been 2.5 percent or more (Chart I-1 and Chart I-2). Chart I-1It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent Chart I-2It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent As with the brick-on-an-elastic-band, we can explain this non-linearity through the concepts of self-reinforcing feedback combined with delayed negative feedback. At a tipping point of rising unemployment, consumers pull in their horns and slow their spending, while banks slow their lending. This constitutes the self-reinforcing feedback which accelerates the downturn. Meanwhile, as it takes time for this downturn to appear in the data, policymakers respond with a lag, and when their response eventually comes, it also acts with a lag. This constitutes the delayed negative feedback, by which time the unemployment rate has surged, with every 1 percent rise in the unemployment rate depressing wage inflation by 0.5 percent (Chart I-3 and Chart I-4). Chart I-32001-02: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent Chart I-42008-09: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent All of which brings me to a crucial point: The non-linearity in the jobs market implies a non-linearity in inflation control. Given that it is impossible to lift the unemployment rate by ‘just’ 2 percent, it is also impossible to depress wage inflation by ‘just’ 1 percent. The choice is to not depress wage inflation at all, or to make wage inflation slump. This presents a major dilemma for policymakers in their current battle against inflation. If they choose to not depress wage inflation at all, core inflation will remain north of 3 percent and destroy central banks’ already tattered credibility to achieve and maintain price stability (Chart I-5). In the medium term, this would un-anchor long-term inflation expectations, push up bond yields, and further destabilise the financial and housing markets. Chart I-5Wage Inflation Is Running Too Hot For The 2 Percent Inflation Target On the other hand, if central banks do choose to depress wage inflation, the non-linearity of the jobs market implies that wage inflation will slump, taking core inflation south of the 2 percent target. Central banks could pray that a surge in productivity growth might save their skins. If productivity growth surged, elevated wage inflation might still be consistent with 2 percent inflation, as it was in the early 2000s. But we wouldn’t bet on this outcome (Chart I-6). Chart I-6Don't Bet On A Repeat Of The Early 2000s Productivity Miracle Inflation Will Not Run ‘Close To 2 Percent’ To summarise then, the economy is a non-linear system, and should be analysed as such. In uniquely doing so in this report, we reach a profound conclusion. The non-linearity of the jobs market and inflation control means that it is impossible for core inflation to run ‘close to 2 percent’. Depending on which of the non-linear options that policymakers choose – to not depress wage inflation at all, or to make wage inflation slump – inflation will either remain well above 2 percent, or slump to well below 2 percent within the next couple of years. Which option will the central banks choose? My answer is that they will make wage inflation slump. This is not just to save their own skins, but a genuine belief that the worse long-term outcome for the economy would be if central banks’ credibility to maintain price stability was destroyed. To prevent this outcome, a recession is a price that they are willing to pay. Central banks will choose to make wage inflation slump. Not just to save their own skins, but because the worse long-term outcome for the economy would be if price stability was destroyed. But what if I am wrong, and they choose not to depress wage inflation? In this case, long-term inflation expectations would become un-anchored, pushing up bond yields, and crashing the financial and housing markets. In turn, this would unleash a massive deflationary impulse which would end up creating an even deeper recession. So, we would end up at the same place, albeit later and via a more circuitous route. All of which confirms some long-held views. The structural low in bond yields, the structural low in commodity prices, the structural high in stock market valuations, and the structural high in the US dollar are yet to come. Chart 1Hungarian Bonds Are Oversold Chart 2Copper Is Experiencing A Tactical Rebound Chart 3US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started To Reverse Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 11The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 12The Outperformance Of Tobacco Vs. Cannabis Is Ending Chart 13Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Executive Summary Inflation Surprise Reinforces Gridlock And Fiscal Drag A US recession is increasingly likely as the Fed will have to hike rates more aggressively in the short run to contain inflation. Recession would exacerbate US policy uncertainty during a period of peak polarization in the 2022-24 election cycle. The Fed’s struggle with inflation will become entangled in extreme US politics. The Fed will come under immense pressure to pause rate hikes earlier than warranted in 2023. The Fed could get blamed for both over-tightening and politicization. Investors should fade the risk of another Democratic sweep in the midterm elections. Republicans are still highly likely to gain control of the House, resulting in gridlock and a freeze to fiscal policy. If Democrats lose the House, their odds of retaining the White House will decline. A recession would greatly reduce their odds. In this context the US faces another tumultuous political cycle, as Republicans will stage a comeback. However, reform of the Electoral Count Act could reduce the risk of a catastrophic breakdown in the electoral system. Recommendation (Tactical) INITIATION DATE Return Long DXY (Dollar Index) Feb 23, 2022 12.6% Bottom Line: Stay long US dollar for now but prepare to downgrade to neutral. Feature BCA Research hosted our annual conference at the Plaza Hotel in New York last week. Clients heard a range of views on various topics, including US politics and policy. In this report we touch on some of the insights from the conference while providing our own views on what to expect going forward. A Politicized Federal Reserve? The real Fed funds rate stands at -2.2% today despite the Federal Reserve’s decision to hike rates by 225 basis points this year. The last time the real Fed funds rate was this low was in 1975, under the chairmanship of Arthur Burns – i.e. the epitome of a politicized Fed (Chart 1). Chart 1A Politicized Federal Reserve? Is the Fed already politicized or will it become politicized in the coming years? What would that mean for monetary policy, the economy, and financial markets? The Fed waded into political territory when it began pursuing unorthodox policies in the wake of the 2008 financial crisis and again during the Covid-19 pandemic. Ideally monetary policy sets interest rates across the economy and applies equally to all economic actors. But once the Fed began quantitative easing (bond buying) and coordinating its actions with the fiscal authorities (which had bailed out major banks), it entered the game of income and wealth redistribution. Not least because asset price inflation favors asset owners over others. Now that the Fed and other central banks have pioneered these unorthodox policies, they will continue to use them in the face of future economic and political turmoil. They will also innovate new tools to deal with each crisis. As the pandemic response highlighted, the Fed will continue down the path of redistribution, which will continue to provoke political backlash from legislators and the public. At the same time, the Fed’s policy parameters today have been reined in and disciplined by the post-pandemic inflation overshoot. For example, there is not so much excited talk today about implementing Modern Monetary Theory – debt monetization – as there was in the heady days of 2019. Instead the Fed today is focused almost exclusively on fulfilling its price stability mandate, at least until inflation gets down into the 2%-3% range. The market appears over-eager for interest rate cuts in 2023 when the Fed is expecting to continue hiking rates throughout 2023 (Chart 2). The surprise in core and headline inflation in August reinforces this point. If the Fed cannot bring inflation below 3%, what will it do? Could it accept reality and modify the inflation target to 3%? A higher inflation target has long been discussed – it would enable the Fed to stimulate more effectively in the next recession. But Chairman Jerome Powell and his monetary policy strategy review rejected the idea of raising the long-term inflation target from 2% to 3% or above – and that rejection is likely to be sustained at least until the next review in 2024. Even then a higher inflation target seems unlikely as it would be very hard to achieve politically in the wake of the inflation overshoot. Chart 2Will Fed Cut Rates Next Year? Of course, a lot can happen by 2024 and new deflationary shocks could conceivably force a change to the inflation target. What is clear to us is that the Fed still has a dovish bias that took a long time to develop and has not yet been entirely overturned by the inflation overshoot (Chart 3). Chart 3Dovish Consensus Built Up Over Time And Remains In Place For Now Meanwhile the Fed’s single-minded focus on restoring price stability will bring an entirely different set of political problems – and accusations of politicization. For example, the Fed wants tighter financial conditions – since that will help to cool the economy and bring down inflation – but cannot well speak openly about deliberately driving down stock market prices and home values. The Fed also believes that a recession with unemployment ranging from 4%-5% would not be the end of the world but it cannot well speak openly about deliberately increasing unemployment. Especially because unemployment rarely stays so low in recessions. The Fed acknowledges that it will need to pause hiking interest rates at some point, hopefully before it tightens monetary conditions so much as to trigger a recession, but it does not want to call it a “pause” since financial markets will take that as a hard stop. It could cause a premature loosening of financial conditions and be blamed for a lack of vigilance when inflation revives. Will the Fed ultimately be prevented from tightening monetary policy enough because of the pressure that higher interest rates will put on the government’s fiscal sustainability? It is entirely possible. Sustaining social programs is more popular than paying bond holders. Since the Fed pays market interest rates on reserve balances, it will stop making a profit if it hikes rates to 3.25% or above (which is slated to happen this month). Very soon the Fed will be turning a loss on its holdings, rather than remitting profits to the Department of Treasury, and it will be amply criticized for spending taxpayer money. In that case there will be plenty of ammunition from critics on all sides. When it comes to the Fed’s specific predicament in 2022-24, Chairman Powell does not want to be the next Arthur Burns, i.e. he does not want to go down in history as the chairman who made a historic mistake by not forcing inflation back into an acceptable and containable range of say 2%-3.5%. Neither he nor the Fed can afford to lose control of price stability, which would damage the US economy and the Fed’s credibility. The implication is that Powell will need to hike rates until price stability is obtained. Yet even a conservative estimate would suggest that hiking rates until inflation falls beneath 3% will require the unemployment rate to rise by more than the estimated 0.5-1.0 percentage points, likely considerably more than this, which historically implies a recession in 2023-24. Recession odds have already risen sharply as priced by the bond market, according to Jonathan LaBerge at our Bank Credit Analyst flagship service (Chart 4). Of course, recession odds have an important implication for the 2022-24 political cycle, implying that the Fed’s handling of the economy will become entangled once again in America’s extreme political polarization. Chart 4Recession Odds Rising Our past research has shown that the Fed does not pay close attention to midterm elections. The Fed is more likely to hike rates than cut rates during a midterm election year – and more likely to hike rates during a president’s first midterm election as opposed to his second. Whereas the Fed is about equally likely to cut rates as to hike them during a presidential election year. Most importantly, the Fed is more likely to hike rates during a non-election year than otherwise (Table 1). Table 1The Fed Doesn’t Care About Midterms … But Prefers To Hike In Off-Years While the Fed had no choice but to hike in 2022, supporting these data, a critical decision will emerge in 2023, when the Fed is still expected to hike but the risk of recession grows. Recessions sharply reduce the odds of the incumbent political party staying in the White House (Table 2). Moreover a recession could bring back President Trump or a Trumpist Republican candidate bent on revenge against the political establishment. The result is that the FOMC will be under immense political pressure not to overtighten monetary policy in 2023-24. In normal times, a Fed chair appointed by a Republican president could conceivably have the license to hike rates aggressively to whip inflation, knowing that if a recession occurs and a Republican comes to power, he would be likely to be reappointed. But Powell can have no such assurance from the erratic President Trump, who is still favored for the Republican nomination as things stand. Even aside from Trump, Powell and the FOMC will fear that a populist Republican Party would seek to audit the Fed or curtail its powers. Table 2Biden’s Odds Fall If Recession Occurs In sum, the Washington political establishment believes it is under attack from right-wing insurrectionists and will put immense pressure on the FOMC to avoid triggering a recession in 2023-24. This could produce an inflationary surprise. Bottom Line: A recession is likely to occur as the Fed continues hiking rates to bring inflation below 3%. This increases political uncertainty for the 2022-24 cycle. But a politicized Fed may compromise when inflation is closer to 4% for fear of a populist win in 2024. That would likely prove to be a historic monetary policy mistake, enabling long-term inflation expectations to rise substantially. Midterm Elections: Fade The “Blue Sweep” Risk While the Fed ignores midterm elections, investors are increasingly uncertain over fiscal policy and the outcome of the midterms. Will Congress become gridlocked, as we expect, or will Democrats retain control of Congress and continue the federal spending splurge that has played a large role in the inflation overshoot? Clearly the midterm races have tightened since President Biden changed his tone and started prioritizing the fight against inflation back in June. As inflation has abated, online betting markets have discounted Republican odds of victory, particularly in the Senate where they are now 36% (Chart 5). We anticipated that Biden’s approval ratings would stabilize on the passage of legislation and that the election would tighten in the final months, particularly on the back of women voters turning out to support Democrats in the wake of the Supreme Court’s decision to reduce abortion access. However, we also argued that gridlock would still be the most likely result based on the high odds that the House would flip to Republican control regardless of Roe. This is a consensus view that should be challenged and reassessed as November approaches. Chart 5Bookies Still Expect Gridlock In Midterms Senate elections are held statewide and are therefore more susceptible to a shift in suburban and women voters. State-level polls leave much to be desired but the overall picture is that the races are closer than they were earlier this year – and closer than the Republicans would want them to be (Charts 6A & 6B). Persistent high inflation should be the clincher in favor of Republicans but the Senate is simply too close to call at this stage. Chart 6ANeck-And-Neck Races In Senate Chart 6BNeck-And-Neck Races In Senate Yet the Senate is overrated in this election because if Democrats lose either chamber, gridlock will be the result. Gridlock is what matters most for fiscal policy and hence for investors. The gridlock view rests on the House of Representatives. While the president’s party almost always loses seats in the midterm election, losing seats is not the same as losing control. In fact, over the past 120 years, a party that controls the House and/or Senate is more likely than not to retain control in a midterm election (Chart 7). But in the post-WWII era, the president’s party is slightly more likely to lose control of the House. And in almost all midterms, the president’s party loses seats in the House. Chart 7Presidents Do Not Always Lose Control, But Dems Have Small Cushion In 2022 The key point about 2022 is that the Democrats only have a six-seat buffer in the House. In other words, losing seats is very likely to be equivalent to losing control this year. To save the House, Biden’s Democrats would have to perform as well as John F. Kennedy’s Democrats in 1962, when they only lost four House seats. Our House model predicts they will lose 21 seats (Appendix). While Democrats could beat this prediction, they would be hard pressed to lose fewer than six seats on a net basis: inflation is high and sticky, real wages and incomes have fallen, consumer confidence has fallen, the president’s approval rating is low, and approval of Congress is low. If a president’s party loses control of the House, its odds of keeping the White House in 2024 also fall (Chart 8). This is another reason for investors to expect that fiscal policy will freeze, policy uncertainty will remain high, and the Fed will be under political pressure not to hike rates aggressively in 2023-24. Chart 8Biden’s 2024 Odds Fall If He Loses The House Bottom Line: Fade the “Blue Sweep” risk in 2022. The midterm election is tightening but Republicans are still likely to win the House. Fiscal policy will remain a drag on growth and the 2024 election will become even more uncertain, putting political pressure on the Fed to avoid overtightening. Limited Big Government Another Democratic sweep would greatly reinforce the new US policy trajectory of Big Government: a trajectory that points away from the Washington Consensus and Reagan revolution toward a future of higher taxes, larger budget deficits, higher tariffs, and more extensive regulation (Chart 9).1 But Democrats will be forced to share power. This is why we call the new policy paradigm “Limited Big Government.” It is still a shift in the direction of a larger government role in the economy and society, but it is taking place within the context of the US constitutional system of checks and balances and two-party politics. We do not expect the latter two factors to disappear. Looking at the Obama, Trump, and Biden administrations together we can see that the turn toward Big Government is also compromised by vested interests: Democrats failed to increase corporate taxes, though they did put a floor under the effective tax rate by imposing a new 15% minimum tax on corporate book income. The budget deficit is normalizing after the gargantuan pandemic stimulus. But Democratic legislation will not reduce the deficit substantially over time, contrary to Biden administration propaganda. But Republicans are fiscally profligate themselves, which is clear from Trump’s term in office as well as previous periods of single-party GOP rule. Republicans joined Democrats in passing the infrastructure bill and the Chips and Science Act, which revives US industrial policy in an era of great power competition. Biden has now accepted Trump’s tariff hikes on China. While Republican leadership may push deregulation in future, they may also believe that government regulation will be required to fight back against “woke” or socially left-wing corporations. Chart 9Buenos Aires Consensus equal Spending, Taxes, Tariffs, Regulations Thus the US’s new policy paradigm is bipartisan in nature. Of course, if Republicans take the House they will turn fiscally conservative for tactical reasons. That will put a halt to the spending splurge of 2020-22. But it will not signal a new fiscally austere paradigm since full Republican control in 2025 would be highly likely to lead to another fiscal blowout. This is even more likely to be the case now that Republicans have adopted a populist and pro-working class approach. Bottom Line: The US shift away from limited government toward Big Government is entrenched even if it suffers a setback due to gridlock from 2022-24. Given that partisan checks will prevent the US from moving too radically in any direction, we dub this paradigm “Limited Big Government.” It is marginally inflationary due to the rise in taxes, spending, regulations, and tariffs. US Electoral System: A Possible Positive Surprise Our expectation that the Fed will be politicized and that populist policies will persist stems from the underlying inequality and political polarization in the United States. Yet these same factors serve to increase overall political instability and threaten to cause a fundamental breakdown in political order. Will US institutions be able to handle the strain in the coming election cycle? There can be no doubt that polarization is reaching dangerous extremes. The US has suffered two out of five contested elections in the past 22 years. The last two Republican presidential victories have occurred without gaining the popular vote. The Biden administration’s low approval creates the risk of another tight election in 2024, implying controversy over the vote count and procedure (see Appendix). Another tight election could lead to a single state’s controversy determining the outcome of the entire election. Or it could lead to an electoral college tie in which Congress would decide the election result and could decide against the popular verdict. It is not hard to think of scenarios where contested elections and social unrest get out of hand. For example, one important consequence of the January 6 rebellion is that future governments will suppress protests with force if they attempt to interfere with the electoral process or the workings of the legislature. But imagine if a Republican administration comes to power through a contested election in Congress and then suppresses the resulting protests against it? Or imagine if Democrats retain power and push their “domestic war on terrorism” far enough to provoke a low-level militant insurgency from disaffected nationalists? It is easy to think of scenarios on either side that could lead to a much greater breakdown in public order than what occurred in 2020. It is unlikely that an institutional fix will occur in time for the 2024 election. However, there is one exception on the congressional agenda: a possible revision of the Electoral Count Act of 1887. This law was designed to prevent a failure of the electoral system in the wake of the “Stolen Election” of 1876. Its main achievement was to have the governor of each state certify the electoral votes of that state before sending them to Washington. However, the law also leaves open the door for state legislatures, secretaries of state, and governors to influence their state’s electoral votes. Democrats have written a revised version of the law that would close some of the loopholes and ambiguities. So far 10 Senate Republicans have co-sponsored the bill, making it very likely they will vote for it (Table 3). If these Republicans do not change their minds in the critical hour, and if all Democrats can be brought to vote for the measure, then a 60-vote, filibuster-proof majority will exist to pass the law. Table 3Republican Senators Who Support Revising The Electoral Count Act The original Electoral Count Act took ten years to pass, so there is no reason to be overly optimistic. But if 60 votes can be found in the Senate, then the electoral system will be fortified ahead of the 2024 election and structural US political risks will be at least somewhat reduced. Bottom Line: The US faces serious social and political instability in the coming years and remains at “peak polarization.” But a bipartisan law could help solidify the electoral system prior to 2024, which would reduce some of the risk of election controversies spiraling out of control. Investment Takeaways Headline consumer price inflation for August came in at 8.3% year-on-year versus an expected 8.1%, while core inflation accelerated from 5.9% to 6.3%. Financial markets took it on the chin, with the S&P500 falling by 4.3%, due to the disappointed expectation that inflation had already peaked. This disappointment is the second of its kind this year: investors have been over-eager to call the peak in inflation. Market volatility is likely to continue through the fall as investors now expect that the Fed will hike interest rates by another 75-100 basis points in September and continue hiking until inflation falls more convincingly. Twice-bitten investors will be hesitant to endorse a third rally until they are certain that inflation is coming down – but by then a recession may already be upon them. A significant increase in unemployment is likely necessary to cool inflation, which implies recession. Higher inflation will drive real wages further into the red, which is negative for the Biden administration’s midterm campaign. Otherwise the economy looked to be improving just in time for the vote. Manufacturing and non-manufacturing employment is perking up, labor force participation is reaching pre-Covid levels, and consumer confidence ticked up in the latest data, albeit still much lower than in 2021 (Chart 10). Now the tightening of financial conditions will cool the economy and sentiment in the advance of the election, reinforcing the opposition party and the expected gridlock. Inflation may indeed be peaking but not in time for the election. Throughout this year we bet on the US dollar index. This trade is getting very toppy and net speculative positions have rolled over (Chart 11). The dollar is overvalued but its momentum remains strong given extreme macroeconomic and geopolitical uncertainty. We have put this trade on watch for a downgrade to neutral but we expect the momentum to be sustained at least through the US election and Chinese party congress this fall. Chart 10Small Bounce In Economy Will Not Save Democrats Chart 11Dollar Is Overvalued But Has Momentum Matt Gertken Senior Vice President Chief US Political Strategy mattg@bcaresearch.com Footnotes 1 This trajectory is the opposite of the Washington Consensus. As such, Marko Papic, the founder of BCA’s Geopolitical Strategy, has dubbed it the “Buenos Aires Consensus,” as it resembles Argentine economic policy more so than the Thatcher/Reagan policy mix. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets
Executive Summary This report looks back at seven recent Fed tightening cycles and summarizes evidence concerning how the US Treasury curve behaves relative to the length and magnitude of the tightening cycle. We document a few consistent relationships. For example, the 10-year Treasury yield tends to peak 1-2 months before the last rate hike of the tightening cycle. We also notice that the Treasury slope is usually inverted by the time it troughs and that the 5-year/30-year slope tends to trough before the 2-year/5-year slope. Given our view that the peak fed funds rate may not occur until the second half of 2023, we expect another leg higher in bond yields before we reach the cyclical peak. We also anticipate further flattening of the 5-year/30-year Treasury curve. Timing Fed Tightening Cycles Bottom Line: Investors should keep portfolio duration close to benchmark for the time being and should position in 5-year/30-year curve flatteners by selling the 10-year bullet versus a duration-matched 5/30 barbell. While we maintain neutral portfolio duration for now, our bias is to be short duration on a medium-to-long run horizon and we may re-evaluate our recommended duration positioning after this month’s important CPI release and September FOMC meeting. Feature BCA’s Annual Investment Conference was held last week, and we heard a wide variety of views about the outlook for US bonds. Unsurprisingly, the main difference between those with bond-bullish and bond-bearish views was that the bullish panelists anticipated a much quicker end to the Fed’s tightening cycle prompted by a US recession starting late this year or early next year. This week’s report takes a more formal look at the historical linkages between Fed tightening cycles and trends in US Treasury yields. Our goal is to provide some firm evidence that investors can use to translate their views about the length and magnitude of the Fed tightening cycle into concrete positions across the US Treasury curve. Specifically, we look at seven Fed tightening cycles – the five most recent cycles and the two periods of tightening that occurred during the inflationary surge of the early-1980s. The 1977-80 Cycle Chart 1The 1977-80 Cycle The Fed raised the funds rate by 11.75% between August 1977 and March 1980 in response to sky-high inflation. Then, despite core CPI inflation still running at 12%, it cut rates by 5.5% in 1980 in response to an unemployment rate that had climbed above 6%. This proved to be only a brief reprieve from monetary tightening. With inflation still a problem, the Fed pivoted back to rate hikes later in 1980 even as the unemployment rate continued its ascent. Turning to markets, we see that the Treasury index lost 22% versus a position in cash during the 1977-80 tightening cycle and that index returns troughed in March 1980, around the same time as the last rate hike. The 10-year Treasury yield peaked one month before the last rate hike at 12.72%, 378 bps below the peak fed funds rate that would be attained one month later (Chart 1). As for the shape of the yield curve, the 2-year/10-year Treasury slope troughed at -201 bps one month before the last rate hike of the cycle (panel 4). The 2-year/5-year Treasury slope troughed at -132 bps in the same month as the peak in the funds rate and the 5-year/30-year slope troughed at -123 bps, one month before the last hike (bottom panel). The 1980-81 Cycle After a brief period of cuts in mid-1980, having still not conquered inflation the Fed changed course and lifted the funds rate to a new high in 1981. It did this even with the unemployment rate above 7%. One interesting aspect of this tightening cycle is that the bond market continued to sell off even after the Fed delivered its last rate increase. While the period of Fed tightening spanned from October 1980 until May 1981, excess Treasury index returns versus cash continued to fall until September 1981, losing 20% in the process (Chart 2). The 10-year Treasury yield also peaked four months after the last rate hike at 15.84%, 316 bps below the peak funds rate that was attained four months earlier. Chart 2The 1980-81 Cycle Looking at the Treasury curve, the 2-year/10-year slope troughed at -132 bps three months after the last rate hike (panel 4). The 2-year/5-year and 5-year/30-year slopes also troughed three months after the last rate hike, at -62 bps and -133 bps, respectively (bottom panel). The 1988-89 Cycle The Fed lifted rates from 6.5% in March 1988 to 9.8% in May 1989. Peak-to-trough, the Treasury index lost 7.7% versus cash during this period but returns did trough two months before the last rate hike. The 10-year Treasury yield peaked three months before the last rate hike at 9.32%, 48 bps below the peak fed funds rate (Chart 3). Chart 3The 1988-89 Cycle On the Treasury curve, the 2-year/10-year slope troughed two months before the last rate hike at -43 bps (panel 4). The 2-year/5-year and 5-year/30-year slopes also troughed two months before the last rate hike, at -20 bps and -42 bps, respectively (bottom panel). The 1994-95 Cycle The Fed doubled the funds rate from 3% in February 1994 to 6% in February 1995. Peak-to-trough, the Treasury index lost 9.4% versus cash during this period but returns did trough three months before the last rate hike. The 10-year Treasury yield peaked three months before the last rate hike at 7.91%, 191 bps above the peak fed funds rate (Chart 4). Chart 4The 1994-95 Cycle On the Treasury curve, the 2-year/10-year slope troughed two months before the last rate hike at +15 bps (panel 4). The 2-year/5-year and 5-year/30-year slopes also troughed two months before the last rate hike, at +14 bps and +6 bps, respectively (bottom panel). In contrast to earlier cycles, it’s notable that the yield curve never inverted during the 1994-95 tightening cycle and that the 10-year Treasury yield peaked at a level significantly above the fed funds rate. The most likely reason for this is that the Fed’s pivot from rate hikes to cuts in early 1995 occurred abruptly and came as a surprise to market participants. A quick look at the economic data makes it easy to see why. The core PCE and core CPI inflation rates were elevated at the time, at 2.3% and 3.0% respectively, and the unemployment rate was significantly down from a year earlier. The 1999-2000 Cycle The Fed lifted rates from 4.75% in June 1999 to 6.5% in May 2000. Peak-to-trough, the Treasury index lost 8.2% versus cash during this period but returns did trough four months before the last rate hike. The 10-year Treasury yield also peaked four months before the last rate hike at 6.68%, 18 bps above the peak fed funds rate (Chart 5). Chart 5The 1999-2000 Cycle On the Treasury curve, the 2-year/10-year slope troughed two months before the last rate hike at -47 bps (panel 4). The 5-year/30-year slope troughed one month before the last rate hike at -59 bps but the 2-year/5-year slope didn’t trough until three months after the last rate hike at -15 bps (bottom panel). The 2004-06 Cycle The Fed lifted rates in steady increments of 25 bps per meeting from 1% in June 2004 to 5.25% in June 2006. Peak-to-trough, the Treasury index lost 5.3% versus cash during this period and returns troughed around the same time as the funds rate reached its peak. The peak in the 10-year Treasury yield also occurred at the same time as the peak in the funds rate, though the peak 10-year was 10 bps below the peak funds rate (Chart 6). Chart 6The 2004-06 Cycle On the Treasury curve, the 2-year/10-year slope troughed five months after the last rate hike of the cycle at -16 bps (panel 4). The 2-year/5-year slope also troughed five months after the last rate hike at -20 bps, while the 5-year/30-year slope troughed much earlier, four months before the last rate hike at -10 bps (bottom panel). The 2015-18 Cycle Finally, in the most recent tightening cycle before the current one, the Fed lifted rates off the zero-lower-bound in December 2015, went on hold for 12 months and then delivered a string of rate hikes bringing the funds rate up to 2.5% by December 2018. Peak-to-trough, the Treasury index lost 6.7% versus cash during this period and returns troughed two months before the peak in the fed funds rate. The peak in the 10-year Treasury yield also occurred two months before the last rate hike at 3.15%, 65 bps above the peak funds rate (Chart 7). Chart 7The 2015-18 Cycle On the Treasury curve, the 2-year/10-year slope troughed eight months after the last rate hike of the cycle at 0 bps (panel 4). The 2-year/5-year slope also troughed eight months after the last rate hike at -17 bps, while the 5-year/30-year slope troughed much earlier, five months before the last rate hike at +23 bps (bottom panel). Summarizing The Evidence Tables 1 and 2 summarize the data from the seven tightening cycles that we examined. Four main points jump out. Table 1Timing Fed Tightening Cycles Table 2Fed Tightening Cycles: Peak And Trough Levels First, both the level of the 10-year Treasury yield and the Bloomberg Barclays Treasury Excess Return Index tend to hit inflection points around the time of the last rate hike of the cycle. On average, the 10-year Treasury yield peaks 1.3 months before the last rate hike of the cycle, and it has always hit its peak within a window spanning four months before the last hike and four months after. The timing of the trough in index excess returns versus cash looks similar. Second, the 2-year/10-year Treasury slope also tends to trough near the end of the Fed tightening cycle, but the timing of this inflection point varies a lot more than the timing of the peak in yields. In fact, during the last two cycles the 2-year/10-year slope didn’t trough until well after the last rate hike. Third, the 5-year/30-year Treasury slope always troughs at the same time or earlier than the 2-year/5-year Treasury slope. This is consistent with our intuition that the long end of the yield curve will respond more quickly to changes in the economic outlook than the front end of the curve, which remains more tied to the current policy rate. Fourth, there isn’t much consistency in where the 10-year Treasury yield peaks relative to the peak fed funds rate. On average, the 10-year yield tops out 120 bps below the peak fed funds rate, but there is a wide range of outcomes. The 10-year yield peaked 378 bps below the peak fed funds rate in the 1977-80 tightening cycle and it peaked 65 bps above the peak fed funds rate in the 2015-18 cycle. The same holds true for the slope of the Treasury curve. The trough in the slope exhibits a wide range of outcomes, though it is fair to say that we typically expect the slope to be negative when it bottoms. The 2-year/10-year Treasury slope only failed to invert in two tightening cycles (1994-95 and 2015-18) and in both of those cases the Fed was not expected to deliver a large number of rate cuts. In fact, it could have easily been argued that rate cuts were unnecessary based on the inflation and employment data at the time. Investment Implications In applying the lessons from this analysis to the current environment, the first conclusion we reach is that we should only look to extend portfolio duration to above-benchmark when we think that the last rate hike of the cycle will occur in 1-2 months. Currently, the market is priced for the fed funds rate to peak in June 2023 and we expect that peak could occur even later (Chart 8). For this reason, we anticipate another significant leg higher in Treasury yields before the cyclical peak is reached. Chart 8Rate Expectations Our historical analysis of past tightening cycles also supports our recommended short 10-year bullet, long 5-year/30-year barbell positioning along the Treasury curve.1 Given that the 5-year/30-year Treasury slope has always troughed within a window spanning five months before the last rate hike and three months after, it makes sense to position for another leg down. This is a particularly attractive trade on the 5-year/30-year portion of the curve because that slope remains in positive territory. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on this trade please see US Bond Strategy Weekly Report, “The Great Soft Landing Debate”, dated August 9, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns