Norway
Highlights The bottom in the dollar will have to wait for clearer signs that U.S. inflation has hit a trough. DXY is unlikely to punch below its May 2016 low. We examine balance of payments dynamics across the G10. This analysis shows that while the euro has long-term upside, it is too early to bet on any move above 1.20. The Japanese balance of payment dynamics will deteriorate as the BoJ keeps pressing on the gas pedal. Markets will have to price out rate hikes from the U.K. Feature Our most recent attempt at selling EUR/USD ended promptly in failure, as the euro is currently supported by a perfect storm of factors, making the timing of a reversal of its powerful bull run a tricky exercise. On the one hand, European politics continue to enjoy a re-rating among investors. As 2017 began, observers were worried that France was about to fall under the control of populists - euro-skeptic politicians like Marine Le Pen. This could well have spelled the end of the euro. Instead, the French electorate delivered a pro-market outcome with Emmanuel Macron clinching the keys to the Elysée Palace, and his centrist, pro-reform party now controlling Parliament. Meanwhile, German politics remain steady, and the Italian political risk has been pushed back to 2018. On the other hand, investors started the year expecting a hyperactive Trump presidency that would deliver de-regulation and tax reforms. Instead, the U.S. has a Twitterer-in-Chief and a chaotic White House that has been able to only achieve political paralysis. While political developments have grabbed the most headlines, economics have played an even more crucial role. Most importantly, inflation dynamics have been at the crux of the euro's rally. Namely, U.S. inflation has been a big source of disappointment, as the core PCE deflator has fallen from 1.9% in late 2016 to 1.5% today - a move away from the Federal Reserve's 2% target. As a result, the dollar and interest rates have moved away from discounting the Fed's path as implied by the "dot plot" (Chart I-1). However, our work on capacity utilization and financial conditions highlights that the U.S. inflation slowdown has been a reflection of the lagged impact of massive financial tightening in late 2014, and subsequent deceleration in economic activity. In fact, improvements in both capacity utilization and financial conditions witnessed since then point to a turnaround in inflation this fall (Chart I-2). Chart I-1Downward Move In Inflation Rate Expectations Chart I-2U.S. Inflation To Trough Soon What should investors do in the meantime? The market will only believe the Fed's hiking intensions once inflation rears its head again. After so many false starts and disappointments, signs that inflation might be coming will not be enough, as narratives of a near-permanent state of zero percent inflation are taking hold of the general discourse. Because investors have purged their excess dollar longs and are now heavily positioned for a euro rally, the dollar downside is currently limited, and a significant breach below the May 5, 2016 low in the DXY is unlikely. However, the dollar-rebound camp will have to wait for clear evidence that U.S. inflation is exiting its doldrums. This is a story for the fall. A Look At Balance-Of-Payments Dynamics The U.S. Chart I-3U.S. Balance Of Payments The U.S. current account deficit has been hovering below -2% of GDP for most of the post-great-financial-crisis period, and therefore has played little to no role in explaining the dollar's moves since 2011. However, the U.S. basic balance (current account plus net foreign direct investments) registered a sharp improvement in 2015 on the back of a surge in net FDI into the U.S. Despite a small pullback in the past 18 months, the U.S. basic balance remains consistent with levels recorded during the dollar bull market of the 1990s (Chart I-3). Portfolio flows in the U.S. have moved back into positive territory after a period of net outflows in 2015 and 2016. Yet, the total amount of net portfolio flows remains very low by historical standards, suggesting investors have not wagered aggressively on the U.S. economy's outperformance. Together, the aggregate U.S. balance-of-payment paints a neutral picture for the U.S. The deep imbalances in the current account and basic balance that prevailed prior to the financial crisis have been purged, but portfolio flows into the U.S. do not show any excessive optimism. In fact, the recent period of dollar weakness will likely help the U.S. balance of payments: It should support the trade balance, and make FDI and portfolio flows more attractive going forward as easing U.S. financial conditions help economic activity and asset returns. The Euro Area Chart I-4Euro Area Balance Of Payments Since the euro area crisis, the region's current account has surged to a very large surplus of 3.5% of GDP (Chart I-4). This mostly reflects a large correction of imbalances in peripheral nations. Countries like Spain and Italy have seen their own current account balances morph from deficits of 10.2% of GDP and 3.8% of GDP in 2008 and 2011, respectively, to surpluses of 1.9% of GDP and 2.7% of GDP today. The large contraction in imports on the back of moribund domestic demand has been the key driver of this phenomenon. The euro area remains an exporter of FDIs, experiencing near-constant outflows since 2004. As a result, the euro area's basic balance has not experienced as pronounced an improvement as the current account. It is still nonetheless in surplus - something that did not prevent EUR/USD from experiencing a 25% decline from June 2014 to March 2015. Net portfolio flows in the euro area have moved into deeply negative territory, reflecting massive outflows from the bond market. European investors have also been avid buyers of foreign equities, despite the recent increase in foreign buying of euro area stocks. In aggregate, we would interpret the current balance-of-payments dynamic in Europe as potentially supportive of the euro down the line. Aggregate portfolio flows are so depressed that there is a greater likelihood they will improve than deteriorate. However, while the basic balance and portfolio flows bottomed in 2000, the euro was not able to rally durably until 2002. Together, this suggests the euro is unlikely to re-test parity this cycle, but could remain capped below 1.20 for a few more quarters. Japan Chart I-5Japan Balance Of Payments Thanks to large investment income emanating from a net international investment position of 62% of GDP, Japan sports a current account surplus 2.5% of GDP greater than its trade balance. However, as the country continues to export capital abroad, it still carries a 3.1%-of-GDP deficit in terms of net FDI. This means that the Japanese basic balance of payments remains around 0% of GDP (Chart I-5). Meanwhile, net portfolio flows into Japan have improved greatly in 2017, explaining the yen's strength this year. While we see more upside for equity inflows into Japan, the efforts by the Bank of Japan to suppress JGB yields are likely to result into continued outflows on the fixed-income front. Since BCA is calling for higher global bond yields, fixed income portfolio outflows are likely to grow bigger, making the recent improvement in the Japanese balance of payments a fleeting phenomenon. This will weigh on the yen. We continue to expect the JPY to be one of the worst-performing currencies over the next 12-18 months. The U.K. Chart I-6U.K. Balance Of Payments Financing the U.K.'s current account deficit of 4% of GDP has taken center stage in the wake of the Brexit vote last year. However, while the trade-weighted pound has depreciated 12% since then, the British basic balance of payments has improved and moved back into positive territory. Net FDI inflows lie behind this stunning development. FDI into the U.K. has been surging since 2016 (Chart I-6). However, the recent slowdown in M&A deals into the U.K. points to a potential end for this GBP support. The key costs of controlling the free movement of people in the U.K. - a demand of Brexit voters - will be the loss of passporting rights for the financial services sector. Since this sector has been the biggest magnet for FDI in the U.K., net FDI could soon become a drag on the basic balance of payments. In contrast to FDI, net portfolio flows into the U.K. have followed the anticipated post-Brexit script, falling from 5% of GDP in Q2 2016 to zero earlier this year. This development was the biggest contributor to the pound's weakness last year. Going forward, the case for the Bank of England to turn hawkish is likely to dissipate as the inflation pass-through from the weak pound dissipates (see below). For the pound to rally further, a continued expansion in global liquidity will be necessary. However, we anticipate global liquidity to deteriorate for the remainder of 2017 as the Fed begins the runoff of its balance sheet, and the PBoC keeps tightening the screws on the bubbly Chinese real estate market. Hence, we would position ourselves for pound weakness against the USD in the second half of 2017. Canada Chart I-7Canada Balance Of Payments Canada runs a current account deficit of 3% of GDP. This is not a new development. Canada has been running a current account deficit since 2009 (Chart I-7), as weakness in the CAD from 2011 to 2016 was counterbalanced by weak export growth to the U.S. and poor oil prices. From a balance-of-payment perspective, the capacity of the CAD to rally may be limited. A surge in FDI to boost the basic balance of payments is unlikely. In 2001, the Canadian dollar was much cheaper than at present, and the impact of the tech bubble was still influencing M&A inflows into the country. In 2008, oil was trading near US$150/bbl. Today, Canada is a high-cost oil producer in a world of cheap oil, making Canadian oil plays unattractive, at least much more so than in 2007-2008. Additionally, net portfolio inflows into the country are already at near-record high levels, explaining the strong performance of the CAD since January 2016. However, going forward, oil prices are unlikely to double once more, and the combination of elevated Canadian indebtedness along with bubbly house prices and rising interest rates will create headwinds for the Canadian economy. Such an outcome would hurt expected returns on Canadian assets, and thus portfolio flows. However, if the hole in Canadian banks' balance sheets proves much bigger than BCA anticipates, this could prompt a repatriation of funds held abroad by banks - assets that currently equal nearly 50% of their balance sheets, temporarily helping the CAD. Australia Chart I-8Australia Balance Of Payments While the Australian trade balance has moved back in positive territory, the current account remains in deficit, burdened with negative international incomes associated with a negative net international investment position of -60% of GDP. Yet, because the current account has nonetheless improved, the Australian basic balance of payments is back in positive territory, as net FDI inflows have remained steady around 4% of GDP (Chart I-8). From a balance-of-payments perspective, the Australian dollar looks good. The current account balance is likely to remain well supported as the capex needs of Western Australia have decreased - exerting downward pressure on imports - but new mines are coming online and generating revenues and exports. Meanwhile, portfolio flows in Australia are quite depressed, suggesting some long-term upside as investors seem to be underweight Australian assets. That being said, the Aussie is currently trading at 12% above its long-term fair value. Moreover, any tightening in global liquidity thanks to the Fed and the PBoC could increase the cost of financing Australia's large negative net international investment position, and cause a last down leg in metals prices and the AUD. New Zealand Chart I-9New Zealand Balance Of Payments New Zealand's current account has been stable at around -3% of GDP since 2010. While New Zealand has been a constant magnet for FDI (Chart I-9), the positive balance in this account has not been able to lift the national basic balance of payments above the zero line. Interestingly, despite still-higher interest rates offered by New Zealand compared to the rest of the G10, the kiwi has been experiencing net portfolio outflows so far this year, potentially explaining why NZD/USD has not been able to break out like AUD/USD. Balance-of-payment dynamics looks supportive for the AUD relative to the NZD, as Australia runs a positive basic balance while New Zealand does not. Additionally, while Australian portfolio flows are very depressed, New Zealand's could suffer more downside. Mitigating these positives for AUD/NZD, the New Zealand economy is much stronger than that of Australia, and the Reserve Bank of New Zealand is in much better position to increase rates than the Reserve Bank of Australia is.1 Switzerland Chart I-10Switzerland Balance Of Payments The Swiss franc may be expensive relative to its purchasing power parity, and it may also be contributing to the country's strong deflationary tendencies, but it does not seem to be hampering its international competitiveness. The Swiss trade balance is at a massive 6% of GDP. Additionally, thanks to the international income generated by Switzerland's gigantic net international investment position of 127% of GDP, the country runs an incredible current account surplus of around 11% of GDP (Chart I-10). Being a nation with a steady current account surplus, Switzerland re-exports much capital abroad, generating a nearly permanent deficit in its net FDI account. However, this deficit is not enough to generate a basic balance-of-payments deficit. Instead, the BBoP still stands at 6% of GDP, creating a long-term support for the CHF. In terms of portfolio flows, Switzerland has historically run a deficit, reflecting its status as a capital exporter. Only at the height of the euro area crisis did Switzerland experience net portfolio inflows. Today, portfolio flows continue to leave the country, albeit at a slower pace than before the euro area crisis. Over the next 12 months, the CHF is likely to experience continued downside against both the euro and the USD, as the Swiss National Bank remains steadfast in its fight against domestic deflationary forces. However, from a long-term perspective, Switzerland will continue to run a balance-of-payments surplus that will support the structural upward trend in the real trade-weighted CHF. Sweden Chart I-11Sweden Balance Of Payments The Swedish trade balance recently moved into deficit territory, but the nation's current account remains in a healthy surplus of more than 4% of GDP, reflecting large amounts foreign income extracted by Sweden's thanks to its large amount of assets held abroad - a legacy of decades of current account surpluses. The net FDI balance has recently moved into positive territory, as Sweden possesses some of the strongest long-term economic fundamentals in Western Europe. Thanks to this development, the basic balance of the largest Nordic economy is at its highest level in eight years (Chart I-11), representing a long-term positive for the cheap SEK. Finally, portfolio flows into Sweden are at a neutral level. However, we expect the Riksbank to begin increasing rates early next year, putting it well ahead of its European peers. This should result in growing inflows into the country, supporting the SEK, at least against the EUR and the GBP. Norway Chart I-12Norway Balance Of Payments Due to the collapse in oil prices since 2014, the Norwegian trade surplus has melted from a gargantuan 15% of GDP to a more modest 5% of GDP (Chart I-12). However, falling oil prices and North-Sea production have also resulted in a collapse of FDIs into the country. Because of these developments, the Norwegian basic balance of payments has fallen into deficit for the first time in more than 20 years. This combination could explain why the NOK has been trading at its deepest discount to long-term fair value in decades. Ultimately, the constantly positive BBoP has historically been one of the key drivers of the krone. Without this support, since the Norges Bank stands among the most dovish central banks in the G10, the NOK does need a greater-than-normal discount. Norway too has historically experienced net portfolio outflows, also a consequence of its massive current account surplus. Thus, we do not read today's relatively small portfolio outflows as a positive. Instead, they simply reflect the deterioration in the current account and basic balance. Putting it all together, while balance-of-payment dynamics do explain why the NOK is trading at a historically large discount to fair value, we remain positive on this currency relative to the euro. When all is said and done, even accounting for these exceptional factors, the NOK is too cheap. Additionally, BCA does expect oil prices to move back toward US$60/bbl, which should help move the basic balance back into positive territory. Bottom Line: Balance-of-payment dynamics rarely have much impact on G10 currencies in the short run. However, in the long run, they can become paramount. Using this framework, while the USD could experience some upside in the next 12 months or so, any such upside is likely to mark the last hurrah of the bull market: the U.S. balance of payments is relatively neutral, but Europe's is currently excessively handicapped by extremely depressed portfolio flows. This latter situation is likely to be reversed in the coming years. The yen balance-of-payment dynamics will become increasingly tenuous if the BoJ continues on its current policy path. Among commodity currencies, the AUD has the best long-term profile in terms of balance-of-payment dynamics. Finally, the SNB faces a Herculean task: While it is currently keeping the CHF at bay in order to alleviate deflationary tendencies in Switzerland, the country's perennially strong balance of payment will ultimately prove too great a hurdle to overcome. The CHF could overtake the yen as the true risk-off currency of the world in future. BoE Is Stuck With Low Rates For Now In our January 13 Special Report titled, "GBP: Dismal Expectations,"2 we discussed why fears of any calamity that Brexit could bring to the British economy was overdone, and thus why buying the pound was an attractive opportunity. So far, our view has been validated, as cable has rallied by almost 8%. However, although we stand by our analysis on a cyclical horizon, a tactical selloff in the pound may be due. At the beginning of the year, the U.K. economy outperformed almost every forecast. Since then, expectations have risen along with the pound, but the British economy has shifted from star performer to disappointment (Chart I-13). For example, house price growth has collapsed to levels not seen since the euro area crisis (Chart I-14, top panel). Furthermore, the rapid rise in inflation has also caused a contraction in real disposable income comparable to that of 2012 (Chart I-14, bottom panel). Chart I-13Shift In U.K. Surprises Chart I-14Cracks In The U.K. Rate expectations have become too lofty. After the 2016 collapse in the pound, both headline and core inflation rose above the BoE's target. Consequently, rate expectations spiked, particularly after three MPC members voted for hikes. But can this rate of inflation continue? Looking at individual components of inflation, it is clear that the pound selloff was an important culprit behind the inflation surge. Thus, as the pass-through from the currency dissipates, inflation will also subside (Chart I-15). Falling inflation and weaker growth are already forcing the BoE to retreat from its relative hawkishness. Yesterday, as the "Old Lady" curtailed both its growth and wage forecast for 2017 and 2018, only two members voted for a hike. Political dynamics have also supported cable so far this year. Today, the U.K. policy uncertainty index is at par with that of the U.S. as the Trump White House continues to be in disarray, and the outlook for tax reform and/or infrastructure spending looks grim (Chart I-16). But the U.S. is not the country engaging in its most contentious and significant treaty negotiation in 50 years. Instead, the U.K. is this country, with a weakened government at its helm following its recent electoral debacle. Thus, we would expect a reversal of the currently pro-pound relative political uncertainty indexes, as Brexit negotiations heat up in the coming quarters. Chart I-15U.K. Inflation Is Peaking Chart I-16Does Trump Really Trump Brexit? While policy and political considerations are likely to hurt the pound this fall, for GBP/USD to correct, a fall in the euro will be needed as well. In the meantime, investors may look to continue to buy EUR/GBP. Since July 7th, we have been anticipating this cross to hit the 0.93 level. This analysis confirms this view. Bottom Line: The U.K. economy should be able to weather its exit from the European Union. This should help the pound on a cyclical horizon. However, the pound has become overbought and interest rate expectations are too elevated, as the market has forgotten that a price still has to be paid for Brexit. GBP/USD is too dependent on the EUR/USD dynamics to short cable outright right now. As such, investors may keep buying EUR/GBP for now, and look to sell GBP/USD near 1.33. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 Please see Foreign Exchange Strategy and Global Alpha Sector Strategy Special Report titled, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled "GBP: Dismal Expectations", dated January 13, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The U.S. has shown some signs of strength this week, however the data remains mixed: Both headline PCE and core PCE beat expectations, coming in at 1.4% and 1.5% respectively; While the headline ISM manufacturing number weakened, the Price Paid component rebounded to 62. Initial jobless claims beat expectations by 2,000; however, continuing claims underperformed; Factory orders improved on a monthly basis. While the U.S. is still in an inflation slump, we believe that inflation is close to bottoming out. The depreciation in the greenback and the rally in risk assets have greatly eased financial conditions, creating support for the economy. This should push the greenback up as the markets begin to reprice Fed hikes. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Euro appreciation has continued. While the general tone of data remains strong, some leading indicators are showing early cracks: Unemployment, a lagging indicator, decreased to 9.1%, outperforming expectations; Headline inflation remained steady at 1.3%, however core inflation increased to 1.2%; GDP numbers came in as expected, growing at a 0.6% quarterly rate, and a 2.1% annual rate; However, German and EMU Markit Manufacturing PMIs both underperformed expectations. Momentum is on the euro's side, which traded above 1.19 on Wednesday. The euro area owes much of its economic growth to the 25% depreciation since mid-2014. While data has surprised to the upside, the ECB remains the central bank of the peripheries, where inflation has failed to emerge as strongly. Rate differentials will weigh on the euro towards the end of the year, but momentum could continue to push the euro up in the coming weeks. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Japanese data came in positive: Overall household spending yearly growth came in above expectations at 2.3% Japan's job-to-applicants ratio came in at 1.51. Above expectations and growing from the previous month. The unemployment rate fell to 2.8%, coming in below expectations of 3%. These two last data points are important, as they show that the Japanese labor market is getting increasingly tight. However, as evidenced by the last 2 years, inflation will not be able to rise sustainably without a depreciating yen, even if the labor market is tight. Thus, the recent selloff in USD/JPY will only incentivize authorities to remain very accommodative while other central banks are exiting maximum accommodation, reinforcing our negative cyclical view on the yen. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Data in the U.K. was mixed this week: Both Markit Manufacturing and Markit Services PMI beat expectations coming in at 55.1 and 53.8 respectively. However both consumer credit and mortgage approvals fell from the previous month and underperformed expectations. Up to yesterday the pound had gained almost 2% during the week, however following the interest rate decision by the BoE, the pound fell by roughly 1%. The reason for this fall, was that the BoE is becoming less hawkish. Not only did the number of MPC members voting for a hike decrease from 3 to 2, but the bank also lowered its forecast for growth and wages. We believe this will start a trend toward a less hawkish BoE, which will weigh on the pound on the short term. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Momentum is showing signs of topping out. The MACD is rolling over, and is converging with the Signal line; and the RSI is weakening from deeply overbought levels. This week, AUD has displayed broad-based weaknesses. Despite one key blotch, data relevant to Australia has been good: TD Securities Inflation increased at a 2.7% rate in July; Chinese Caixin Manufacturing PMI came out better than expected at 51.1; Building permits increased at a striking 10.9% monthly rate. They contracted at a 2.3% yearly pace, a sharp improvement over the the previous month's 18.7% contraction. However, the trade balance underperformed missed expectations by a large margin, coming in at AUD856mn, compared to the expected AUD1,800mn. The recent RBA statement highlighted that the recent appreciation in the Australian dollar "is expected to contribute to subdued price pressures", and "is weighing on the outlook for output and employment". This could add substantial pressure on the AUD in the near future. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Even as the dollar has fallen, the kiwi has depreciated by almost 1.4% this week, as New Zealand data has come in weak: Both the ANZ Activity outlook and the ANZ business confidence came in below the previous month reading at 40.3% and 19.4 respectively. The participation rate came below expectations at 70%. Meanwhile employment also came below expectations contracting by 0.2% Month-on-Month. Overall we continue to be bearish on commodity currencies in general and the kiwi in particular. Recently, the Chinese authorities have been getting tougher on credit excesses. This could be the trigger for a risk off period in emerging markets, which wouldweigh on the NZD. That being said, we are more bearish on AUD/NZD, as the kiwi economy is on much stronger footing than the Australian one. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The CAD has displayed some considerable broad-based weakness this week following weak data releases: Industrial Product Price contracted monthly by 1% in June; The Raw Material Price Index also contracted, at 3.7%; However, the Markit Manufacturing PMI saw an increase to 55.5 from 54.7. Markets have priced in a 75% probability of a hike by the end of this year by the BoC, compared to 42% for the Fed. Although we agree with the market's perception of the BoC, we disagree that the probability of the Fed hiking is this low. We therefore believe the CAD could correct further in the upcoming weeks. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been positive: The KOF leading indicator came at 106.8, beating expectations. Real retail sales grew by 1.5% year on year, increasing from last month number and beating expectations. The SVME Purchasing Manager Index came in very strong at 60.9, beating expectations and also increasing from last month's reading. While data was positive, EUR/CHF went vertical this week, rising by more than 3%. At this point EUR/CHF is the most overbought it has been in more than 4 years, and at least a small correction seems overdue. The SNB will be satisfied with a depreciating currency, as this dramatic fall should help ease deflationary pressures in the alpine country. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data has been mixed in Norway: The Labor forced survey, which measures unemployment, came in at 4.3% outperforming expectations of 4.5%. The above data point was confirmed by the registered unemployment reading, which also outperformed expectations, coming in at 2.8%. However retail sales contracted by 0.6% month-on-month. Even as the dollar continues to fall, USD/NOK has stayed relatively flat this week. Curiously this has also happened amid rising oil prices. Overall, we expect USD/NOK to rally in the fall, as the Norwegian economy remains tepid, and inflation is not likely to rise above target any time soon, while investors are still underestimating the Fed's will to push interest rates higher. That being said, we are bearish on EUR/NOK, as this cross trades as a mirror image of oil, and the OPEC deal should continue to remove excess supply from the market and push prices higher. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Sweden has been generating substantial inflationary pressures, and increasing economy activity is likely to support these pressures, hence the Riksbank's recent hawkishness. With China tightening policy, SEK strength could be a story of rate differentials going forward, appreciating against EUR, AUD, NZD and NOK, as the Riksbank is likely to become increasingly nervous in the face of rising inflationary pressures. However, as the market currently underprices the risk of a more hawkish Fed, the picture for USD/SEK is less clear. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Dear client, This week, we are sending you an abbreviated Weekly Report as we co-authored a Special Report on Wednesday with our sister Geopolitical Strategy service. In our Special Report, available on our website, we argue that Italy's flirtation with leaving the euro area is rooted in its positive experience with devaluations in the 1990s. However, we note that this time is different and devaluing the euro through exit will not be a panacea, as financial market linkages would cause a deep domestic recession that could be brought forward by the mere reality of a referendum on the topic. As such, we think that Italy is unlikely to leave the Euro Area, but that it will remain a drag on the Eurozone - one that will force the European Central Bank to stay a bit more dovish than warranted by conditions in the broader Euro Area. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Feature Chart I-1The Dollar At A Critical Spot Since the end of last week, the dollar has staged a small rebound. This rebound was of the utmost importance as it materialized at an important level. Had DXY punched below the 96 level, the dollar could have sold off toward 93 in a matter of weeks. However, if the dollar can remain above 96, the greenback is likely to have formed a trough for the remainder of 2017 as it will rest above an important congestion zone that has been in place since early 2015 (Chart I-1). What are the odds of the greenback moving back to 93? We think that right now the balance of probability is in favor of a continued rebound. A call on DXY is first and foremost a call on the euro, as EUR/USD represents 60% of this index. We'll thus focus on the dynamics in this pair. Currently, nominal short rate differentials remain in the dollar's favor. As Chart I-2 illustrates, interbank rate spreads between the Euro Area and the U.S. are broadly supportive of the USD. Additionally, in both the late 1990s and in 2005-06, this spread had been much more negative than at present. BCA still expects the spread to grow more negative as the Federal Reserve continues on its intended policy path, while we also believe it will take a few more years before the ECB can begin lifting rates.1 Real rate differentials paint a similar picture. The euro's strength in the second quarter has emerged in spite of a move in real rate spreads in favor of the USD. As Chart I-3 shows, this divergence has mostly reflected dynamics at the short end of the yield curve, but over the past month and a half the real interest rate difference at the 10-year maturity has also diverged from the EUR/USD's path. Chart I-2EUR/USD Short Rate Differentials ##br##Can Grow Deeper Chart I-3EUR/USD Has Dissociated##br## From A Key Driver Technically, the dollar is beginning to look attractive against the euro as well. Our positioning indicator - based on sentiment, net speculative positions, and the euro's advanced/decline line - shows that investors are already positioned the most euro bullish since 2012 (Chart I-4). Our intermediate-term technical indicator is also at highly overbought levels, highlighting the euro's limited upside potential. Most importantly though, these moves have happened as the Euro Area economic surprise index massively beat the U.S. one (Chart I-4, bottom panel). This means that Europe's economic outperformance has been driving the euro's strength, unlike in 2015 when the surge in the European surprise index relative to the U.S. was reflective of the euro's 2014 collapse. This paints a picture where much good European news has been priced into EUR/USD during the recent rally. At current levels, the mean-reverting nature of the relative surprise index suggests that European surprises are unlikely to continue to beat U.S. ones by such a margin going forward. This means that the already overbought euro is likely to lose a key support. Finally, as we highlighted two weeks ago, global analysts have already ratcheted up their year-end estimates for EUR/USD (Chart I-5). Not only are their forecasts at levels that have in recent years been indicative of a peak, but the speed and magnitude of their adjustments has also been exceptional. This corroborates that the positive momentum in the Eurozone vis-à-vis the U.S. has already been internalized by market participants. If anything, this favorable relative economic momentum must only grow going forward for the euro to rally further. However, European LEIs have already rolled over relative to the U.S. as the latter looks set to exit its soft patch in the coming months (Chart I-6). Chart I-4Good News Already ##br##In The Euro Chart I-5Investors Have Already##br## Bought The Euro Chart I-6The Economic Tailwinds For The ##br##Euro Are Beginning To Fade Bottom Line: DXY has rebounded at a crucial level. If it can stay above 96, this would suggest that its correction is over. We are willing to make this bet as the euro - the key component of the DXY - has dissociated from rate differentials on strong optimism toward the economic outlook for Europe - at the exact time that investors have become more incredulous of the Fed's intentions. Due to these dynamics, EUR/USD is now massively overbought and at risk of a further pullback. Cutting Loose Short USD/JPY Last week, we closed our short USD/JPY position at a 4.2% gain. We did so because we see an increasingly less-supportive environment for the yen. To begin with, the U.S. Treasury notes' fair-value model used by our U.S. Bond Strategy service highlights that U.S. bond yields are currently quite expensive, and could be set to rise anew (Chart I-7). Because JGBs possess a very low beta relative to U.S. yields, an environment where global rates rise tends to be associated with rate differentials moving in favor of USD/JPY, often prompting a rally in the latter. Also, the Bank of Japan is keenly aware that it will be very difficult to achieve its 2% inflation target. The yen's recent strength has exerted a significant tightening in Japanese financial conditions that will drag down inflation (Chart I-8). Hence, the BoJ will continue to be among the most dovish central banks in the world. Additionally, while Japanese industrial production has been strong, it looks set to soften in the coming months, which will give further reason to the BoJ to talk down the yen: Japanese industrial production is very much a function of financial conditions. We are entering a window where the recent tightening in Japanese financial conditions should begin to bite industrial production. The growth rate of the Japanese shipments-to-inventories ratio has rolled over, historically a precursor of a slowdown in industrial production (Chart I-9). Chart I-7T-Notes Are Expensive Chart I-8Japanese FCI Points To Lower Inflation Chart I-9Japanese IP Will Turn Finally, the annual growth rate of Japan's industrial production is heavily influenced by China's economic dynamics, as EM represents 43% of Japanese exports. Two months ago, the Keqiang index - a barometer of strength for the Chinese economy based on credit growth, railway freight volumes, and electricity production - hit its highest level since June 2010, levels only recorded in early 2007, early 2005, and early 2004. Even though we do not anticipate it to crater, we do expect its recent rollover to deepen further in response to the recent wave of policy tightening in China. This should result in some weakness for Japan's industrial production. In practice there is little additional actions the BoJ can implement to ease policy further. However, because investors are currently so negative on the prospects for further Fed rate increases, with only 40 basis points priced in over the next 24 months, a re-assurance by the BoJ that easy policy is here to stay could put upward pressure on USD/JPY. While we remain worried about EM assets, we think that shorting the AUD or the NZD against the yen represents better portfolio protection than shorting USD/JPY. Bottom Line: USD/JPY has a generous amount of upside from here. Investors are too pessimistic regarding the Fed's ability to increase rates over the next 24 months. Meanwhile, the recent tightening in Japanese financial conditions is a headache for the BoJ, as it points to weaker inflation and a slowdown in industrial production. Hence, we expect the BoJ will try to talk down the yen over the coming months. EUR/NOK At An Interesting Spot Chart I-10If Brent Doesn't Fall Below,##br## EUR/NOK Is A Short The price action in EUR/NOK caught our eye this week. EUR/NOK is at a critical level and has rallied as investor optimism toward the Euro Area economy continues to grow. Meanwhile, oil prices have collapsed to US$45/bbl. Since Norway is an economy heavily geared to oil-price gyrations, this bifurcation created an ideal combination to generate a EUR/NOK rally. However, by discounting these developments, EUR/NOK has now entered massively overbought territory. Additionally, as Chart I-10 illustrates, the cross has only traded at higher levels at the depth of the financial crisis in the first quarter of 2009 and the early days of 2016. In both instances, Brent was trading below US$40/bbl. A selling opportunity could soon emerge. Our Commodity And Energy Strategy service continues to expect a deepening of the adjustment in global oil inventories as the OPEC 2.0 deal remains in vigor and compliance stays in place.2 This means a move below US$40/bbl for Brent is very unlikely, and the upside in EUR/NOK is extremely limited. While in the coming weeks a move in Brent to between US$44/bbl and US$42/bbl could happen, we think this limited downside points to an attractive risk-reward ratio to shorting this cross. We are currently long CAD/NOK and short EUR/CAD, with the latter having greater potential downside than EUR/NOK. However, due to Canada's deep integration with the U.S. economy, the EUR/CAD trade is often affected by dynamics in the U.S. dollar. Shorting EUR/NOK is thus a cleaner play on oil and removes much of the risk associated with the greenback's fluctuations. Finally, yesterday, the Norges Bank policy release displayed less dovish tone than anticipated by the market. This kind of surprise would create an additional support to being short EUR/NOK. Bottom Line: EUR/NOK looks set to weaken. Over the past 10 years, it has only traded above current levels when Brent prices were below US$40/bbl. Based on our commodity team's analysis, such a move is very unlikely. Thus, any short-term weakness in oil prices should be used to sell EUR/NOK. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Central Banks Are Sticking To Their Guns", dated June 6, 2017, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report titled "Time For "Whatever It Takes" In Oil?", dated June 2, 2017, available at ces.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights For the time being, our cyclical stance is to underweight the globally-sensitive Energy, Materials and Banks sectors versus Healthcare - in both the equity and credit asset-class. Combined with our expectation of a weakening pound/euro, this necessarily means the following European equity market allocation: Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands and Sweden. Underweight: Italy, Spain, and Norway. We anticipate shifting to a more cyclical sector (and country) allocation by the late summer, especially on dips. Feature It is worth reminding readers that picking mainstream equity markets1 is overwhelmingly about the industry sectors and dominant stocks that you are buying, wittingly or unwittingly. Picking equity markets is seldom about the prospects of the underlying domestic economies or head-to-head valuations.2 Chart of the WeekGlobal Energy Has Just Tracked The Global 6-Month Credit Impulse (Down) The usual top-down approach to picking stock markets ignores two dominant features of these markets. First, they have huge variations in their sector exposures. Second, large industry sector groups like Energy, Banks, Healthcare and Technology tend to move en masse under the influence of global or regional rather than domestic drivers. The combination of these two features means that for most stock markets, the sector (and dominant company) impact swamps the effect that comes from the domestic economy. Right now, by far the most important consideration for country pickers is the relative outlook for the globally-sensitive Energy and Banks sectors versus the more defensive Healthcare. As an example, consider the choice between Spain and Switzerland. Spain's IBEX is at the mercy of its huge weighting to Banks, dominated by Santander and BBVA; while Switzerland's SMI is at the mercy of its similarly dominant weighting in the Healthcare sector, via Novartis and Roche. Box I-1 - Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks (Chart 2). France (CAC) is underweight Banks and Basic Materials (Chart 3). Italy (MIB) is overweight Banks (Chart 4). Spain (IBEX) is overweight Banks (Chart 5). Netherlands (AEX) is overweight Technology, underweight Banks (Chart 6). Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy (Chart 7). And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound (Chart 8). Switzerland (SMI) is overweight Healthcare, underweight Energy (Chart 9). Sweden (OMX) is overweight Industrials (Chart 10). Denmark (OMX20) is overweight Healthcare and Industrials (Chart 11). Norway (OBX) is overweight Energy (Chart 12). The U.S. (S&P500) is overweight Technology, underweight Banks (Chart 13). It follows that if Banks underperform Healthcare, it is highly likely that Spain's IBEX will underperform Switzerland's SMI, irrespective of the performances of the Spanish and Swiss domestic economies. For long-term investors, the large skews in sector exposure also mean that a head-to-head comparison of country valuations can be very misleading. At first glance, Spain, trading on a forward price to earnings (PE) multiple of 15.5, appears 15% cheaper than Switzerland, trading on a multiple of over 18. But this head-to-head difference just reflects the impact of forward PEs of Banks at 11 and Healthcare at 18. The Bank sector's lower multiple does not necessarily make it better value than Healthcare. Unlike two developed economies - whose long-term growth prospects tend to be broadly similar - two industry sectors could end up experiencing very different structural growth outcomes. Which would justify very different multiples. Despite its low multiple, a structural underweight to Banks might nonetheless be a good strategy if the sector's structural growth outlook is poor. In such a case, the low multiple is potentially a value trap. Picking Stock Markets The Right Way To reiterate, the decision to overweight or underweight a mainstream equity index should not be based on your view of the country's underlying economy - unless, of course, the country is the potential source of a major tail-risk event. Instead, the decision should be based on your over-arching sector view, combined with the country's skews to specific dominant stocks and sectors (Box I-1). Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7, Chart I-8, Chart I-9, Chart I-10, Chart I-11, Chart I-12 and Chart I-13 should leave readers in absolutely no doubt. A market's dominant sector skew is by far the most important determinant of its relative performance. Chart I-2Germany (DAX) Is Overweight Chemicals,##br## Underweight Banks Chart I-3France (CAC) Is Underweight Banks##br## And Basic Materials Chart I-4Italy (MIB) Is Overweight Banks Chart I-5Spain (IBEX) Is Overweight Banks Chart I-6Netherlands (AEX) Is Overweight Technology,##br## Underweight Banks Chart I-7Ireland (ISEQ) Is Overweight Airlines (Ryanair) ##br##Which Is, In Effect, Underweight Energy Chart I-8The U.K. (FTSE100) Is Effectively ##br##Underweight The Pound Chart I-9Switzerland (SMI) Is Overweight Healthcare, ##br##Underweight Energy Chart I-10Sweden (OMX) Is ##br##Overweight Industrials Chart I-11Denmark (OMX20) Is Overweight ##br##Healthcare And Industrials Chart I-12Norway (OBX) Is ##br##Overweight Energy Chart I-13The U.S. (S&P500) Is Overweight Technology, ##br##Underweight Banks Which brings us to the key consideration for country allocation right now: how to allocate to the sectors that feature most often in the skews: Energy and Banks versus Healthcare. For Energy relative performance, note the very strong recent connection with the global 6-month credit impulse. The downswing in the impulse - heralding a very clear growth pause - lines up with the setback in energy and resource prices and the underperformance of these globally-sensitive equity sectors (Chart of the Week and Chart I-14). Meanwhile, in the most recent mini-cycle, Banks' relative performance is tracking the bond yield almost tick for tick (Chart I-15). There are two reasons. For banks, lower bond yields presage both slimmer net interest margins and weaker economic growth. Chart I-14Commodity Price Inflation Is Just Tracking ##br##The Global 6-Month Credit Impulse Chart I-15Financials Are Just Tracking ##br##The Bond Yield So for both Energy and Banks relative performance the overriding question is: when will this mini-downswing end? To answer this question, we note that we are 4-5 months into the global mini-downswing, whose average duration tends to be around 8-9 months. On this basis, now is a little too early to switch to an aggressively pro-cyclical sector allocation. But we would look for potential opportunities by the late summer, especially on sharp dips. Hence, for the time being our cyclical stance is to underweight the globally-sensitive Energy (and Materials) and Banks versus Healthcare. Combined with our expectation of a weakening pound/euro, this necessarily means the following European country allocation: Overweight: France,3 Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands, and Sweden. Underweight: Italy, Spain, Netherlands and Norway. Clearly, if you have a different cyclical and over-arching sector view, you will arrive at a different country allocation. That's fine. The important point is that the stock and sector skew approach is the right way to pick between mainstream equity indexes. Financials Drive The European Credit Market Finally, an over-arching sector view is also highly relevant for the European corporate credit market. In the euro area, the credit market is heavily skewed towards bank and other financial sector bonds, which account for almost half of euro area corporate bonds by value. By comparison, the U.S. credit market is not so skewed to one dominant sector. Hence, the outlook for the European credit asset-class hinges on the prospects for one sector: Financials (Chart 16). With the European high yield credit spread already close to a 20-year low, we would again wait for a better opportunity before adding aggressively to the European credit asset-class. Chart I-16Mirror Image: European High Yield Credit Spread And Bank Equity Prices Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In the developed world. 2 Please also see the three European Investment Strategy Special Reports 'Picking 5 European Countries The Right Way' November 13, 2014, 'Picking Countries The Right Way: Part 2' March 26, 2015 and 'Picking Countries The Right Way: Part 3' November 12, 2015. 3 But expect a small near-term countertrend underperformance in the CAC40. See page 11. Fractal Trading Model* There are no new trades this week. Last week's trade, long nickel / short palladium has made an encouraging countertrend move at the classic limit of a trend. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-17 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights On the European side, the key risk to our bullish DXY stance is that European growth is strong, the labor market seems to be tightening, and core CPI has perked up. These risks are real but mitigated by budding signs that European growth is at its best, by the abundance of hidden labor market slack, and by the high chance that the CPI spike was transitory. On the U.S. side of the ledger, the key risks are that wages do not pick up, that credit growth continues to act as a break on activity, and that political risks hamper fiscal dynamics. All would mean a more dovish Fed than we anticipate. These risks are mitigated by the fact that hidden U.S. labor market slack is only now low enough for wages to improve, credit looks set to turn around as financial conditions are supportive, and fiscal policy should surprise to the upside. USD/NOK has upside as Norway experiences declining inflation. Go long CAD/NOK. Feature Last week, we augmented our cyclically dollar bullish view by removing our tactical bearish bias on the USD. In our eyes, the market is underestimating the capacity of the Fed to increase rates and is also overestimating the economic impact of the fiasco surrounding Trump's alleged relationship with Russia. Despite our high conviction view that the dollar can rally 10% or more from current levels, we cannot be blind to the key risks surrounding it. This week, we explore where our stance on Europe and the Fed can go wrong. ECB Tapering = Upcoming Tightening Campaign? The key risk to our negative euro stance is the ECB. The market has moved to discount the first rate hike in Europe to happen in barely two years, an event we judge highly unlikely. However, if the market is right that a tapering of asset purchases in 2018 and a potential increase in the rates on deposit facilities to 0% are the opening salvos of an imminent campaign to push up the repo rate, the EUR/USD rally is only in its early days. Here are the key factors that would support this bullish euro view: The European economy is in a major economic upswing. Not only have PMIs surged, the IFO has hit an all-time high (Chart I-1). If this pace of growth can be maintained for an extended period of time, the European output gap will close faster than we anticipate, providing a stronger basis for the ECB to nudge all rates higher. The euro area labor market is tightening. Euro area unemployment rate is at 9.5%, only 0.7% above the OECD's estimate for NAIRU (Chart I-2). Thus, it would paint a picture where there is little slack in the economy at large and in the labor market in particular. In this environment, a continuation of the elevated growth currently experienced by the euro area could boost wages. Core inflation has picked up to 1.2% (Chart I-3). The ECB has historically displayed a tight reaction function to inflation. In the past, headline CPI mattered, but since Mario Draghi took the helm of this institution, the focus has switched to underlying pricing pressures. Thus, if euro area core inflation continues to move up, especially as U.S. core PCE inflation has weakened to 1.6%, the market will be vindicated and the euro could rebound on a more hawkish ECB. Chart I-1Europe Is Booming Chart I-2Low Labor Market Slack In Europe Chart I-3That Should Help The ECB To Hike Why Are These Factors Risks And Not Base Cases? To begin with, these factors have been discounted by the markets, a fact highlighted by the 42-month fall in the month-to-hike for the ECB since July 2016 to 24 months today. Also, as the European surprise index has outperformed the U.S. one, EUR/USD has rallied by 6%. In the process, investors have switched from being massively short the euro to being the most aggressively long in three years (Chart I-4). Risk-reversals in EUR/USD options are also at elevated levels, highlighting the potentially too-bullish disposition of investors toward the euro. On the growth front, some factors suggest that European growth may soon peak. The large improvement in the amount of industrial activity and capacity utilization in Europe relative to the U.S. was reflective of the big easing in monetary conditions that followed the collapse of the euro after 2014. But, as Chart I-5 illustrates, European industrial production needed a falling euro to beat that of the U.S., soon after the euro stabilized, the growth outperformance began to recede and is now near inexistent based on this metric. Thus, the euro rebound removes one of the key factors that supported the European economy in the first place. Chart I-4Investors Have Discounted##br## The Good News In Europe Chart I-5Europe's Growth Outperformance ##br##Was Because Of Policy Additionally, some economic data are showing disturbing signs. While Germany's IFO stands at a record high, Belgian business confidence has rolled over. In fact, export orders have been particularly weak (Chart I-6). This is of importance as Belgium has long been a logistical center for the euro area, and is a small open economy deeply integrated in the European economic infrastructure. This, therefore, portends to emerging risks to the whole euro area. Monetary dynamics too raise questions. European business confidence, a key piece of soft data that has underpinned investors increased bullishness on the euro is led by dynamics in M1 money supply. The roll over in M1 implies that business conditions in Europe are slowly passing their best period (Chart I-7). If euro area growth peaks, this also raises concerns about the state of the labor market. This is especially worrisome as we think the unemployment gap based on the OECD's estimate of NAIRU misses key elements of the European labor market slack. As we wrote last week, the key problem in Europe is labor underutilization; hidden labor market slack remains a serious concern.1 With workers in irregular contracts being a key source of job creation since the end of the 2013 recession, there are plenty of workers willing to change jobs without the incentive of a higher pay, limiting the upside in wages. Without wage growth, it will be difficult for European core inflation to continue its uptrend, especially as there are many signs that the rebound that has excited investors' imagination may have been a transitory event. Worryingly for euro bulls, our Core CPI A/D line for Europe, which tends to lead core CPI itself, rolled over last year and points to lower core CPI.2 Industrial good prices excluding energy have also been weakening for 15 months now, suggesting this inflation rebound may be an aberration (Chart I-8). Chart I-6Where Belgium Goes, ##br##So Does Europe Chart I-7Money Trends Point To A Deceleration##br## In European Soft Data Chart I-8Europe Core CPI ##br##Will Roll Over Bottom Line: Investors have become very bullish of the euro based on the fact that the economy has been very strong, the European headline unemployment rate is moving closer to NAIRU, and core inflation has perked up; raising the specter of high rates sooner than we anticipate. These economic developments need to be monitored closely, but the growth impulse in Europe is likely to soon deteriorate, broader measures of labor market slack in the euro area are far from being at full employment, and the tick up in core inflation is likely to prove to have been only a temporary blip. These forces should weigh on the euro for the rest of 2017. Maybe The Fed Will Not Tighten That Much? Meanwhile, in the U.S., investors only expect three rate hikes over the next 24 months. Markets have begun doubting the fed's capacity or resolve to hike interest rates as aggressively as we envision. A slew of disappointing data and political developments have cemented this opinion among investors. Among the most crucial factors are the following: Chart I-9Disappointing U.S. Wages Wage growth in the U.S. remains poor, especially as per average hourly earnings which are still only growing at a disappointing 2.3% rate (Chart I-9). This raises the specter that consumption will remain tepid and that inflationary dynamics will never take hold in the U.S. This risk is perceived as especially salient as core inflation and core PCE have slowed below the 2% objective of the FOMC. Slowing credit growth has also garnered a lot of attention among the public. Credit is the life blood of the economy, and this slowdown has prompted many investors to begin questioning whether or not the U.S. economy would ever be able to take off. This compounded worries around the perennially weak Q1 GDP growth. Finally, the myriad of scandals surrounding Trump and his dealings with Russia have raised much questions about his ability to ever implement fiscal stimulus. Moreover, the punitive terms associated with the repeal of Obamacare and the implementation of the American Health Care Act (AHCA) - which according to the CBO could leave as many as 23 million individuals without health insurance by 2023 and cause sharp increases in insurance premia - may dull any growth boosting impact of potential tax cuts. Thus, the political backdrop may prompt the Fed to be easier than was anticipated as recently as December 2016. Why Are These Factors Risks And Not Base Cases? To begin with, BCA still hold the view that wages in the U.S. are set to accelerate in the coming quarters. The Phillips Curve continues to be a reality, as the Atlanta Fed Wage Tracker still display a tight relationship with the unemployment gap (Chart I-10). Moreover, it is often argued that the problem with today's labor market is that much of the job creation is happening in low-skilled positions. This is true, but historically, low-skilled jobs have tended to experience the most upward pressures when the job market tightens significantly. Instead, the key anchor on average hourly earnings has been the hidden labor market slack. However, today, the U-6 unemployment rate is finally ticking at 8.6%, levels where in previous cycles wage growth accelerated (Chart I-11). A rebound in GDP growth, as highlighted by the Atlanta Fed growth forecast of 4.1% in Q2, would accentuate pressures on the labor market and help realized the underlying wage pressures resulting from the current readings of the U6 unemployment rate. Chart I-10The Phillips Curve: It's Alive Chart I-11U.S. Wages Will Pick Up What could support growth? Let's begin with the credit dynamics. As we have argued, credit growth is a lagging indicator of economic activity. The improvement in the ISM through 2016 and early 2017 continues to point to a rebound in C&I loans in the U.S. (Chart I-12). Moreover, aggregate bank credit in the U.S. is already re-accelerating, suggesting that credit will once again add to economic activity, and will stop subtracting from it (Chart I-13). Chart I-12Credit Lags, And It Will Pick Up Chart I-13Momentum In U.S. Loans Is Turning Up Another positive for the U.S. economy has been the substantial easing in financial conditions resulting from the fall in the dollar and bond yields since the beginning of 2017. This easing should help economic activity over the course of the next quarters (Chart I-14). In its most recent minutes, the Fed has alluded to these forces. The fall in the dollar is already showing signs of helping. The ISM export orders index is currently ticking near 60, suggesting that the fall in the USD has had a stimulative impact on the U.S economy (Chart I-15). This is especially salient when contrasted with the euro area industrial production dynamics described above. Chart I-14U.S. Financial Conditions Will Help Growth Chart I-15The Dollar's Easing Is Evident Finally, when it comes to fiscal policy, our Geopolitical Strategy team remains adamant that tax cuts will materialize in the coming quarters. It is becoming imperative for congressional Republicans to achieve this as Trump's popularity remains dismal at the national level, which could prompt a serious electoral rout in the 2018 mid-term elections (Chart I-16). This means that fiscal easing is likely to come through, which should have an impact on asset prices and the dollar: The DXY is back to pre-election levels and the relative performance of stocks most sensitive to changes in tax policy is back to January 2016 levels. These price trends indicate that investors have massively curtailed their expectations for governmental support to growth. Chart I-16If Tax Cuts Don't Pass, Republicans Are Heading For A Huge Defeat In 2018 Moreover, the current format of the AHCA is unlikely to make it through the more moderate U.S. Senate. The loss of coverage and the insurance premia increases implied by the current plan are likely to be electoral poison in 2018, something well understood by key GOP policymakers. An AHCA still up in the air does not preclude tax cuts either. The budget deficit hole created by unfunded tax cuts will likely be patched through aggressive growth assumptions, the magic of dynamic scoring. The recently revealed Trump budget proposal itself is also unlikely to see the light of day in its current form and will evolve toward something more supportive of growth as time and negotiations pass. Bottom Line: Investors have massively curtailed their expectations of Fed tightening over the next two years. This view has been based on the lack of wage acceleration in the U.S., the poor credit growth numbers, and the uncertainty surrounding fiscal policy. These are still important risks to our bullish stance. However, we remain optimist because wage growth is only set to increase now, credit is a lagging indicator that looks about to pick up anew, financial conditions should help future U.S. economic activity, and the potential for tax cuts is far from dead. Stay long DXY. Norway's Passing Inflation Problem It was not long ago when the Norges Bank was facing the daunting task of kick starting a Norwegian economy ravaged by the collapse in oil prices while trying to contain the high inflation brought upon by the sell-off in the krone. However, following the stabilization of the NOK, this dilemma has dissipated as multiple measures of inflation have plunged. The Norges Bank is now free to maintain its dovish bias as the economy remains tired and will require easy monetary to recover going forward. Based on the effect of currency moves, inflation might reach a bottom at the beginning of next year, but it will likely stay below the central bank's target of 2.5 % for the foreseeable future (Chart I-17). Indeed, in spite of the rebound in oil prices, employment is contracting, the output gap is large, and wage growth remains deeply negative (Chart I-18). The Norges Bank is sympathetic to this view, acknowledging in its most recent monetary policy statement that inflation will hover in a 1-2% range in the coming years. Chart I-17A Stable NOK Will Keep Inflation Subdued Chart I-18No Domestic Inflationary Pressures In Norway Lastly, Norway's bubbly real estate market, the last obstacle to the Norges Bank dovish bias, is finally slowing down. Thanks to changes in regulation on residential mortgage lending at the start of the year, banks are tightening lending standards to households, a precursor to a cooling housing market (Chart I-19). With a Fed looking to increase rates, the real rate differential between the U.S. and Norway should move in favor of USD/NOK. Yet, could rising oil prices deepen the USD/NOK weakness? This seems doubtful as USD/NOK continues to be more correlated with real rate differentials than with the price of oil (Chart I-20). Nevertheless, the outlook of the krone against the AUD and the NZD is much more promising: Chart I-19No Need To Raise Rates To Curb Housing Prices Chart I-20Real Rates Matter More Than Oil Yesterday, OPEC Russia agreed to maintain their production cuts in place for the next nine months. This deal should keep the oil market in a deficit, pushing oil prices up and providing a tailwind to the NOK against non-oil commodity currencies. Chart I-21CAD/NOK: A Call On The U.S. Dollar On the other hand, the outlook for industrial metals and other commodities, which are more sensitive to the Chinese economy, continues to be worrying. Monetary conditions are still tightening in China and multiple economic activity indicators have disappointed to the downside. While base metals have already fallen considerably, we believe that additional weakness in the Chinese economy will trigger a selloff in EM assets, bringing the NZD and the AUD down with them. Finally, it may be time to sell the NOK against the CAD. The Bank of Canada struck a hawkish tone on Wednesday, stating that the Canadian economy's adjustment to lower oil prices is largely complete and that consumer spending should be supported by an improving labor market. This change in rhetoric should set the stage for a rally in CAD/NOK. Moreover, our Intermediate-Term Timing Model shows that this cross is 7% cheap, and our bullish USD view implies an outperformance of the loonie versus the krone given the tight correlation between CAD/NOK and the DXY (Chart I-21). Bottom Line: Outperformance of oil in the commodity space will help the krone outpace non-oil commodity currencies. However, the Norges Bank is likely to keep a dovish bias, which should make it difficult for the NOK to rally durably against a cheap U.S. dollar. Go long CAD/NOK. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa Research Analyst juanc@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled "Bloody Potomac", dated May 19, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report titled "The Achilles Heel Of Commodity Currencies", dated May 5, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The greenback suffered some losses following the release of Fed minutes. Puzzlingly, the rhetoric was not dovish, as markets and news outlets confirmed the prospect for a June rate hike. The result was a dollar selloff and a drop in yields. This easing in financial conditions created an additional fillip for the S&P as it traded at a record high, the opposite of what is expected with a looming rate hike. As new home sales contracted on a monthly basis and the manufacturing PMI disappointed, the U.S. soft patch continues. Nevertheless, our base case remains on par with the Fed's: the weakness in data is temporary and the Fed will hike more than the markets expect. We are already seeing this as continuing and initial jobless claims beat expectations at 1.923 million, and 234,000 respectively, and the greenback has found a footing at the 97.1 level. As this scenario further unfolds, gold will retreat as real returns increase, and the greenback will gain upward momentum. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro area continues to surprise with better than expected data: German IFO: Overall Business Climate came in at 114.6 - levels last seen in 1970; Expectations came in better than expected at 106.5; and the Current Assessment also beat expectations of 121.2, coming in at 123.2. Euro area Manufacturing PMI is at 57 for May, beating expectations of 56.5, and the Composite measure also recorded an outperformance, coming in at 56.8. On the consumer side, German Gfk Consumer Confidence Survey came in at 10.4, beating expectations of 10.2. While the euro to be overvalued on short-term metrics, and the euro area is structurally weaker than the U.S., weaker data needs to be seen for the markets to see a correction. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data has been negative in Japan: Manufacturing PMI decreased to 52 in May from 52.7 in April. Exports growth decreased to 7.5%, from 12% the month before and underperforming expectations. Japan's all industry activity Index also underperformed expectations, contracting by 0.6% MoM. We continue to believe that Japanese economic activity will ultimately be determined by the exchange rate. The yen has appreciated since this the start of the year, therefore it is understandable that inflation and economic activity have been subdued. Taking this into account, the BoJ will continue to target a yield of 0% in JGB's, and thus the yen should suffer on a cyclical basis given that real rates differentials with the U.S. will continue to widen. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent British data has been mixed: GDP growth underperformed, coming in at 2%, decreasing from last quarter and underperforming expectations, mostly reflecting poor trade numbers. Meanwhile total business investment grew by 0.8%, outperforming expectations. We are not positive on the pound against the dollar, given that near 1.3 the pound is no longer a bargain tactically. On the other hand we expect more upside against the euro. Powerful inflationary pressures are building in the U.K., and governor Carney, previously concerned about the effects of Brexit in the economy, might be more inclined now to deal with inflation as the U.K. has proved resilient. This will put upward pressure in British rates vis-à-vis European rates. Additionally EUR/GBP has reached overbought levels, indicating it might be a good time to short this cross. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 As the greenback's descent slowed down, so did the Aussie's ascent. The underlying motives for strength in the antipodean currency are misplaced. As data remains unpromising, this week followed through with further disappointments as overall construction work done contracted by 7.2% on an annual basis, with the engineering component contracting by 13%. Research by the RBA illustrates that construction work has a very close relationship with the national accounts of Australia. This could result in a slowdown in the economy - something which the RBA cannot afford amidst flailing inflationary pressures. On a more optimistic note, the commodity selloff is taking a breather. Most crucially for the AUD, iron ore futures have remained flat for almost a month after a 30% depreciation, and natural gas has been flat for almost a month. These developments have limited the AUD's downside for now. However, looming EM risks and the potential resumption of the dollar bull market represent very real risks for the AUD going forward. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi has appreciated by about 1.5% against the dollar this week. Additionally, recent data has been positive: Visitor Arrivals yearly growth skyrocketed to 21.5% on April. The trade balance outperformed expectations coming in at -3.48 Billion The kiwi economy continues to surge, with 7% growth in nominal GDP and retail sales growth at decade-highs. Additionally, dairy prices continue to surge, and are now growing at a 60% YoY pace. For this reason we are bearish on AUD/NZD, as the Australian economy is not only in a more precarious state, but is also more sensitive to the Chinese industrial cycle. Meanwhile, we continue to be bearish on NZD/USD, as a negative view on EM assets necessarily entails a bearish view on the kiwi. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Following on from the dollar's weakness, the CAD displayed further strength after the BoC's decision statement. While keeping rates unchanged, the bank highlighted that "recent economic data have been encouraging" and that "consumer spending and the housing sector continue to be robust on the back of an improving labor market". Furthermore, the Bank more or less expects these supports to growth to "strengthen and broaden over the projection horizon". While wholesale sales increased by less than expected at 0.9%, the BoC also expects that the "very strong growth in the first quarter will be followed by some moderation in the second quarter". This is likely to keep market expectations anchored and the CAD's value intact. Additionally, oil should pare recent weaknesses as OPEC follows through on its cuts. The CAD is therefore likely to see some strength against other commodity currencies. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has continued to depreciate after coming close to reaching 1.1. We continue to be negative on this cross, as the Euro is likely to have limited upside from current levels. The ECB is unlikely to hike rates any time soon, as wage pressures outside of Germany continue to be muted. Furthermore, this is not likely to change any time soon, as the labor market of the periphery continues to be very rigid. Meanwhile, the SNB is likely to take off the floor from this cross next year, as core inflation and retail sales growth have both returned to positive territory. We will continue to monitor the rhetoric by the SNB to have a more clear understanding of when the removal of the floor might occur. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The krone has rallied this week, thanks to the rise in oil prices. However real rate differentials should continue to move in favor of USD/NOK. While the fed is likely to hike more than what is currently anticipated in the OIS curve, the Norges Bank will stay dovish, given that the Norwegian economy is still too weak to sustain a rise in interest rates. Furthermore, macro prudential measures seem to be helping the Norges bank to slow down the housing market. The NOK is also likely to have downside against the CAD. The dollar bull market should help this cross rally, given the tight correlation between CAD/NOK and the DXY. Furthermore the BoC has struck a more hawkish tone as of late, which should further increase the difference between interest rate expectations in these two countries. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Positive data emerged from Sweden this week as consumer confidence picked up to 105.9 from 103.7, beating expectation of a decline to 103.6. The seasonally-adjusted unemployment rate remains on a structural downtrend, coming in at 6.6% according to Statistics Sweden. In terms of crosses, USD/SEK continues to weaken due to the greenback's instability. EUR/SEK has topped out and is also showing some weakness. Against commodity currencies, the movement is mixed. The SEK has shown the most strength against the AUD, while CAD/SEK and NZD/SEK have been flat, and NOK/SEK has seen considerable strength on the back of robust oil prices. We can see the SEK being weak against oil-based currencies as we expect OPEC to remain focused on cutting global oil inventories, while AUD/SEK could see further downside due to poor fundamentals in Australia. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades