Policy
Highlights The era of divergent monetary policies between the ECB and the Fed is over. Re-convergence has a lot further to go. As the ECB ends its ultra-accommodation, it will also liberate Sweden's Riksbank. Go long Swedish krone/dollar as an alternative or addition to long euro/dollar. Bond investors should underweight Swedish government bonds versus a European or global benchmark, currency hedged. Equity investors should remain overweight European banks and retailers versus U.S. banks and retailers, currency unhedged. The risk of persistent inflation will rise only after the next severe global downturn. Feature "Is the 2% inflation target still a very realistic aim?" - Ewald Nowotny, ECB Governing Council member As the ECB Governing Council gathers for its latest monetary policy meeting, some voices within its ranks are starting to question the ECB's first commandment: the 2% inflation target. Respected and influential ECB Governing Council member, Ewald Nowotny, has asked whether there should "be an easing of the 2% inflation goal in the sense of setting a range instead of a clear-cut target." Across the Baltic Sea, Sweden's Riksbank is one step ahead. Recently, it suggested (re)introducing a variation band of 1% either side of the 2% inflation target1 to acknowledge that persistent 2% inflation is very difficult, or impossible, to achieve (Chart of the Week). More concerning, the single-minded pursuit of 2% inflation creates risks and instabilities. The Riksbank's inflation target has forced it into an absurd position: with inflation undershooting for over five years, the policy interest rate is now at -0.5% when Swedish GDP growth was recently running at a world-beating 4.5% clip (Chart I-2). Chart I-1Mission Impossible:##br## 2% Inflation Chart I-2Absurd: Interest Rate At -0.5% ##br##When Growth Is At 4.5% Hence, Riksbank Governor, Stefan Ingves, recently proposed that "central banks should also have the explicit responsibility for financial stability." The former governor of the Bank of Japan, Masaaki Shirkawa agrees. "My worry with setting a precise number (of 2%) is that it can crowd out other very important considerations, such as financial stability." What's So Special About 2% Inflation Anyway? Given the almost religious significance of the 2% inflation target for central banks, you would think that there is a well-established theoretical and empirical basis both for inflation targeting and for the 2% number. But you would be wrong. As we explained two years ago in our special report Mission Impossible: 2% Inflation,2 inflation targeting only became established in the 1990s, and the magic 2% number was pulled out of the air. Chart I-3The Riksbank Has Undershot ##br##Its 2% Inflation Target For 5 Years At the Federal Reserve's July 1996 policy meeting, Chairman Alan Greenspan argued that if the aim of inflation targeting was a truly stable price level, it entailed an inflation target of 0-1% (because measured inflation slightly overstates true inflation.) But one of the persons present was not so sure. The dissenter was a Fed governor called Janet L. Yellen. She countered that if inflation ended up at 0-1%, the zero-bound of interest rates would prevent "real interest rates becoming negative on the rare occasions when required to counter a recession." Yellen's pragmatism won the day, and Greenspan summarized "we have now all agreed on 2%" Meanwhile in Europe, the ECB's original inflation target of below 2% was close to Greenspan's proposal of 0-1%. But in 2003 the ECB changed its inflation target to its current "below but close to 2%". The reason, according to Mario Draghi: "The founding fathers of the ECB thought about the adjustment within the euro area, the rebalancing of the different members. To rebalance these disequilibria, since the countries do not have the exchange rate, they have to readjust their prices. This readjustment is much harder if you have zero inflation than if you have 2%." Hence, the Fed, ECB and other central banks are targeting inflation at a low but arbitrary number, 2%, to always allow some leeway for negative real rates; and in the case of the ECB, to allow easier convergence among disparate euro area economies. But as the Riksbank and other central banks have now acknowledged, trying to hit and hold inflation at a point target of 2% is both futile and dangerous (Chart I-3). Why 2% Inflation Is A Mission Impossible The crux of the issue is that inflation is a notoriously non-linear phenomenon. A defining feature of a non-linear phenomenon is that you cannot just turn it up or down like the volume dial on your music system. Non-linear phenomena experience sudden and violent phase-shifts from stability to instability, making it very difficult to hit and hold a point target like 2%. To experience this difficulty for yourself, try pulling a brick across a table using an elastic band. Initially, the brick doesn't move because of the friction with the table. But at a tipping point the brick does move, and the friction simultaneously decreases, self-reinforcing the brick's acceleration. Meanwhile, your pull on the elastic continues to increase as you react with a time-lag. The result is that this non-linear system suddenly phase-shifts from stability - the brick doesn't move - to violent instability - the brick hits you in the face! Try as hard as you might, it is near-impossible to pull the brick across the table at a constant speed of, say, 2mph. A very similar dynamic applies to inflation. The system suddenly phase-shifts from stability - near-zero inflation - to violent instability. It is near-impossible to keep inflation at an arbitrary constant of, say, 2%. To understand why, consider the standard identity of monetary economics: MV = PT M is the broad money supply, V is its velocity of circulation, P is the price level and T is the volume of transactions. PT is effectively nominal GDP. Theoretically and empirically, both M and V are notoriously non-linear phenomena (Chart I-4, Chart I-5, Chart I-6, Chart I-7) - because they are subject to the same conditions as the brick pulled by an elastic band: inertia, then self-reinforcement with delayed controlling feedback. Chart I-4The Velocity Of Money... Chart I-5...Is A Non-Linear Phenomenon Chart I-6The Money Multiplier... Chart I-7...Is A Non-Linear Phenomenon As policymakers try to take inflation away from its natural state of near-zero, nothing happens at first. But at a tipping point, the self-reinforcement of inflation expectations becomes explosive. Whereupon, the money supply, M, gaps up because it becomes rational for banks to lend as much as possible. And its velocity, V, also gaps up because it becomes rational to spend the money - both newly created and pre-existing balances - as quickly as possible. Hence, the product MV experiences an even sharper non-linearity. Well-intentioned policymakers would think they could apply a controlling feedback to MV. But how? Economic and monetary data are noisy, imprecise and take time to collect and parse. As we have shown, inappropriate and/or delayed feedback just adds to the system's instability. Seen in this light, inflation-targeting in the 1990s worked because central banks were just helping economies move from an unnatural state - uncontrolled inflation - towards a natural state - price stability (Table I-1 and Chart I-8). But now that economies have reached a natural near-zero inflation rate, point targeting an unnatural inflation rate is both futile and dangerous. Table I-1For 700 Years U.K. Inflation ##br##Averaged Near-Zero Chart I-8Excluding Wars, Persistent Inflation Was ##br##Very Unusual... Until The Late 20th Century The Investment Implications The ECB's Nowotny argues that "the 2% inflation target should include a certain flexibility." The Riksbank's Ingves agrees, and adds that extreme and unprecedented loose monetary policy endangers financial stability. Central banks tend not to volte-face as it damages their credibility. But to us, it is clear that the ECB and Riksbank are switching their focus from sub-2% inflation to their economies' robust growth. And to the risk that ultra-accommodative policy poses to financial stability and market distortion. Hence, the era of divergent monetary policies between the ECB and the Fed is over. Re-convergence has a lot further to go. As the ECB ends its ultra-accommodation, it will also liberate the Riksbank whose policy has inevitably mirrored Frankfurt - for fear of a sharp appreciation of the Swedish krone versus the euro. Our currency mantra this year has been "euro first, pound second, dollar third." The strategy has performed extremely well, and into this mix we can add the Swedish krone. Go long Swedish krone/dollar as an alternative or addition to long euro/dollar (Chart I-9). Chart I-9Long SEK/USD Is An Alternative ##br##To Long EUR/USD Chart I-10Underweight Swedish Bonds Is An Alternative To Underweight German Bunds The bond market corollary is to underweight Swedish government bonds - just like German bunds - versus a European or global benchmark, currency hedged (Chart I-10). The equity market implication is to remain overweight European banks and retailers versus U.S. banks and retailers, currency unhedged. Finally, given that inflation could ultimately phase-shift to violent instability, when should we worry about it? Not yet. To expand the broad money supply, someone has to borrow money. So if policymakers really want to create rampant inflation, the government has to borrow and spend money at will,3 with the central bank creating it. In other words, the central bank loses its independence and fiscal policy becomes irresponsibly loose. The risk of this remains low until the next severe downturn - when policymakers may be forced into desperate measures for a desperate situation. Until then, own some bonds. Our preference is Spanish Bonos and U.S. T-bonds. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 The Swedish FSA has said that the Riksbank should delay the change until a parliament review of Riksbank policy rules is completed in about 2 years. 2 Published on August 20, 2015 and available at eis.bcaresearch.com. 3 For example, by giving all public sector workers a 50% pay rise! Fractal Trading Model* The sell-off in Spanish media (Mediaset Espana Comunicacion) is technically overdone. This week's trade is to go long Mediaset Espana Comunicacion versus the market with a 5% profit-target and symmetric stop-loss. In other trades, long FTSE100/short IBEX35 hit its 4% profit-target, while short EUR/USD hit its 2% stop-loss For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Monetary Policy: The Fed is still on track to start winding down its balance sheet in September, and will lift rates again in December if inflation starts to move higher. If the Fed continues to lift rates in the face of low inflation, then the real fed funds could soon overtake its estimated neutral level. TIPS: We attribute this year's decline in breakevens to the combination of disappointing realized inflation and the fact that they had appeared too wide on our TIPS Financial Model. Inflation: Core inflation disappointed once again in June. The pass-through from a depreciating dollar and accelerating wages should cause this weakness to reverse in the months ahead. Feature Chart 1Bond Bear Takes A Pause Globally, a shift toward less accommodative monetary policy remains the dominant market theme. However, the U.S. bond selloff did pause last week following some disappointing macro data and comments from Fed policymakers that were interpreted as dovish. The market is now discounting 30 bps of rate hikes during the next 12 months, down slightly from the recent peak of 36 bps (Chart 1). The dovish comments came from Governor Lael Brainard in a July 11 speech1 and were echoed one day later by Fed Chair Janet Yellen in her semi-annual testimony to Congress.2 Both comments related to the stance of monetary policy in relation to its neutral (or equilibrium) level. In my view, the neutral level of the federal funds rate is likely to remain close to zero in real terms over the medium term. If that is the case, we would not have much more additional work to do on moving to a neutral stance. - Fed Governor Lael Brainard Because the neutral rate is currently quite low by historical standards, the federal funds rate would not have to rise all that much further to get to a neutral policy stance. - Fed Chair Janet Yellen Contextualizing "Neutral" Contrary to how many have interpreted the above remarks, neither Chair Yellen nor Governor Brainard meant to suggest that the rate hike cycle is close to finished. In fact, Yellen went on to say in her testimony that: ...we also anticipate that the factors that are currently holding down the neutral rate will diminish somewhat over time, additional gradual rate hikes are likely to be appropriate over the next few years... This is the first important piece of context needed to understand how the Fed views the neutral rate. The Fed views the neutral rate as variable, and sees it increasing over time. This becomes clear when we look at the Fed's Summary of Economic Projections and note that the median forecast calls for a nominal fed funds rate of 2.9% at the end of 2019 and 3% in the longer run. Incorporating a 2% inflation target, we can infer that the Fed anticipates a real neutral rate of 1% in the longer run. Second, the Fed is likely tracking the real neutral fed funds rate using an estimate created by Laubach and Williams (LW).3 Chart 2 shows this estimate of the neutral rate alongside the real federal funds rate - deflated using 12-month trailing core PCE. We observe that the real fed funds rate has risen sharply during the past seven months, in part because the Fed lifted rates three times but also because inflation weakened. Chart 2Real Fed Funds Rate Getting Closer To Neutral We calculate that if the Fed lifts rates once more this year and core inflation stays flat, then the real fed funds rate would end 2017 at 0.02%, only 42 bps below neutral. However, it's more likely that the Fed will need to see inflation rebound before it delivers another rate hike. In a scenario where core inflation rises to 1.9% and the Fed lifts rates once more, then the real fed funds rate would actually decline between now and the end of the year. In sum, the LW neutral rate is a useful tool for assessing the path of Fed policy. If the real fed funds rate gets too close to neutral, then the Fed will probably need to see inflation rise before it delivers another hike. This would appear to be the situation we are in at the moment. We continue to expect that the Fed will start to unwind its balance sheet in September, but will need to see some signs that core inflation is increasing before lifting rates again. Our forecast still calls for higher core inflation during the next few months and another Fed rate hike in December (see section titled "Inflation: Chalk Up Another Bad Month" below). A related issue is why the Fed thinks the neutral rate will rise during the next few years. In arguments that date back to Ben Bernanke's tenure,4 the Fed maintains that headwinds related to household deleveraging and balance sheet repair have depressed the neutral rate since the Great Recession and financial crisis. There is some evidence to support this stance. The LW neutral rate correlates quite strongly with the growth rate of household debt (Chart 3). Although the neutral rate hasn't kept pace so far this cycle, household debt is growing off an unusually low base (Chart 3, bottom panel) and that may mean it takes longer for the neutral rate to rise. There is one final important application for the neutral fed funds rate, and it relates to the timing of the corporate credit cycle (Chart 4). Typically, excess returns to corporate bonds do not start to decline until the following three criteria are met: Chart 3Household Leverage And The Neutral Rate Chart 4Neutral Rate Important For Credit Cycle Deteriorating corporate balance sheet health (Chart 4, panel 2) Restrictive monetary policy i.e. the fed funds rate above its neutral level (Chart 4, panel 3) Tightening bank lending standards (Chart 4, bottom panel) Notice that in the prior two cycles the real fed funds rate actually rose above the LW neutral level before our Corporate Health Monitor started to signal deteriorating corporate health. In contrast, corporate balance sheets have already aggressively added leverage this cycle and accommodative policy is the sole support for spreads. In this environment, we view inflation and the stance of Fed policy as the most important factors determining the medium term outlook for corporate bond returns.5 Policy Wildcard: A New Fed Chair In 2018 One potential wrinkle in our outlook for monetary policy is that Janet Yellen's term as Fed Chair will end in February 2018. If history is any guide, we should expect to learn the identity of the new Fed Chair sometime this fall. While we would not completely rule out the possibility that Janet Yellen is re-appointed, recently, the chatter is that Gary Cohn, the Chairman of President Trump's National Economic Committee, is the frontrunner for the position (see Box). Box 1: Fed Chairs Since 1970 Gary Cohn does not have any experience as a central banker, but that does not preclude him from holding the position. Since the late 1970s, Presidents have tended to select the Fed Chair based on their trust relationship with a candidate (Table 1). Table 1Characteristics Of Fed Chairs Since 1970 Arthur Burns (Chair from 1970 - 1978) was head of President Eisenhower's Council of Economic Advisors (CEA) and was a special counselor to President Nixon. William Miller (1978 - 1979) worked for the presidential campaigns of Hubert Humphrey and Jimmy Carter. Alan Greenspan (1987 - 2006) served as the Chair of Ronald Reagan's Social Security Commission in the early 1980s, was the Chair of President Ford's CEA and advised President Nixon's campaign in 1968. Ben Bernanke (2006-2014) was George W. Bush's chief economist in 2005 and 2006 before Bush chose him to lead the Fed. Janet Yellen (2014 - present) was Chair of Bill Clinton's CEA in the late 1990s, when she worked with many of Obama's economic team. Paul Volcker (1979 - 1987) was the lone exception to this rule, he worked for Nixon, but not Carter, before becoming Fed Chair. Volcker, Bernanke and Yellen, all held posts in the Federal Reserve System before their appointments as Chair. However, Miller was an outside director for the Boston Fed, and Burns and Greenspan had no prior experience at the monetary authority. Party identification is one area where Gary Cohn would stand out. Since at least 1970, the party affiliation of a new Fed Chair has matched that of the President. However, Presidents have crossed party lines to reappoint sitting Fed Chairmen to additional terms. Volcker, Greenspan and Bernanke were all reappointed to lead the Fed by Presidents from opposing political parties. Chart 5Yellen Vs. Summers Drove Markets In 2013 To see how the timing of the Fed Chair appointment can matter for markets in the short-term, we need only look back to the autumn of 2013 when two candidates - Larry Summers and Janet Yellen - were in the running for the position. Rightly or wrongly, Summers was viewed as the more hawkish candidate and once he withdrew from the race on September 15, the market's expected pace of rate hikes plunged and long-dated TIPS breakevens surged on the expectation of a more dovish Fed (Chart 5). Bottom Line: The Fed is still on track to start winding down its balance sheet in September, and will lift rates again in December if inflation starts to move higher. If the Fed continues to lift rates in the face of low inflation, then the real fed funds could soon overtake its estimated neutral level. What's Driving The TIPS Breakeven Rate? We maintain an overweight position in TIPS relative to nominal Treasury securities on the view that long-maturity TIPS breakeven inflation rates will eventually settle into a range between 2.4% and 2.5%, once core inflation gets back to the Fed's 2% target. At the time of publication the 10-year TIPS breakeven inflation rate was 1.76%. In that sense, we view the medium to longer-run driver of TIPS breakevens as the path of inflation itself. However, we also acknowledge that breakevens are highly correlated with other financial asset prices, which can explain many of the near-term moves (Chart 6). In fact, our TIPS Financial Model - a model of the 10-year TIPS breakeven rate based on the oil price, the dollar and the stock-to-bond total return ratio - was flagging that breakevens were far too wide earlier this year (Chart 6, panel 1). Through this lens, the year-to-date decline in breakevens can be attributed simply to overvaluation being wrung out of the market. Digging a little deeper into the model, we find that breakevens have maintained their strong positive correlation with energy prices this year (Chart 6, panel 2), while non-energy commodity prices exhibit a weaker positive correlation (Chart 6, panel 3). Interestingly, the negative correlation between breakevens and the trade-weighted dollar has broken down during the past year (Chart 6, bottom panel). If dollar weakness persists, we would eventually expect it to translate into higher realized inflation - via higher import prices - and also wider breakevens. Other pipeline inflation measures, which tend to correlate with breakevens, are sending mixed signals. Core PPI inflation for intermediate goods remains elevated (Chart 7, panel 2), while the supplier deliveries component of the ISM manufacturing survey is trending higher (Chart 7, panel 3). The prices paid component of the ISM manufacturing survey has followed breakevens lower (Chart 7, bottom panel). Chart 6TIPS Breakevens: Financial Drivers Chart 7TIPS Breakevens: Pipeline Inflation Drivers Bottom Line: We attribute this year's decline in breakevens to the combination of weak realized inflation data (Chart 7, panel 1) and the fact that they had appeared too wide on our Financial Model. Going forward, we expect TIPS breakevens to increase as the realized inflation data bounce back. Inflation: Chalk Up Another Bad Month Core CPI increased just 0.12% month-over-month in June, marking the fourth consecutive downside surprise. The year-over-year growth rate also moderated from 1.74% to 1.71%, and the weakness was once again broad based across the four major components (Chart 8). The cost of shelter continues to decelerate from a high level, and our model - based largely on the rental vacancy rate - forecasts further moderation in the months ahead (Chart 8, panel 1). Core goods prices continue to deflate, though dollar weakness should filter through to higher core goods prices in the coming months (Chart 8, panel 2). In last week's report we showed that non-oil import prices have already moved higher in response to the weaker exchange rate.6 The big drag on inflation in recent months has been the failure of core services inflation (excluding shelter and medical care) to respond to rising wage pressures. The third panel of Chart 8 shows that core services inflation (excluding shelter and medical care) correlates strongly with the employment cost index. Further, the employment cost index itself has been accelerating since 2010 alongside improvement in the prime-age employment-to-population ratio (Chart 9). Chart 8Core CPI Components Chart 9Wages Will Grow As Labor Market Heals We expect wages will continue to accelerate as the labor market remains on a steadily improving path. Eventually this will bleed into core services inflation, as it has in the past. In the near term, the employment cost index for the second quarter will be a crucial input for the direction of both inflation and monetary policy. It will be released on July 28. Bottom Line: Core inflation disappointed once again in June. The pass-through from a depreciating dollar and accelerating wages should cause this weakness to reverse in the months ahead. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/brainard20170711a.htm 2 https://www.federalreserve.gov/newsevents/testimony/yellen20170712a.htm 3 Laubach, Thomas, and John C. Williams. 2003. "Measuring the Natural Rate of Interest," Review of Economics and Statistics, 85(4), November, 1063-1070. 4 https://www.federalreserve.gov/newsevents/speech/bernanke20121120a.htm 5 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Summer Snapback", dated July 11, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights DM Rates Strategy: Many central banks are responding to the strong global economic backdrop by signaling not only a shift in the bias of monetary policy, but actual changes in interest rates or asset purchases. We continue to recommend a below-benchmark overall portfolio stance, but with more diverse views on country allocation: underweight the U.S., Euro Area, & Canada; maximum overweight on Japan; and neutral on the U.K. and Australia. Expect steeper yield curves in the U.S., Euro Area and U.K., and continued flattening in Canada. U.S. Corporate Bond Liquidity: There are few signs of diminished liquidity in U.S. corporate bond markets, despite the sharply reduced inventories of primary dealers. ETFs and institutional investors have picked up the slack from the dealers, as has electronic trading directly between market participants. Feature Chart of the Week2013 Revisited Developed Market (DM) policymakers continue to push towards a less accommodative monetary stance. Last week, the Bank of Canada (BoC) became the second central bank to hike rates this year, following the Fed's earlier tightenings. The European Central Bank (ECB) continues to signal a move to reduce the pace of its asset purchases, likely to be announced at the September policy meeting. A very public debate has opened up among the members of the Bank of England (BoE) policy committee against the stagflationary backdrop of high inflation and cooling growth. This current backdrop is reminiscent of the 2013 synchronized global economic upturn that also put pressure on policymakers to become less accommodative according to our Central Bank Monitors (Chart of the Week). That year was terrible for government bonds, but spread product held in well given the solid growth backdrop. A big difference now is that there is greater evidence of diminished economic slack (lower unemployment rates, higher capacity utilization) than in 2013, so the underlying inflation pressures should be greater. Realized inflation rates remain subdued in most countries (excluding the U.K.), but central bankers are attributing that to temporary factors that should soon fade. That forecast may prove to be wrong, which risks a potential policy mistake if interest rates move up too much or too fast. For now, however, central banks are in charge and bond investors should position accordingly by limiting duration exposure and overweighting growth-sensitive assets like corporate bonds versus sovereign debt. A Country-By-Country Summary Of Our Interest Rate Views With central banks now in the process of adjusting policy settings to varying degrees, financial markets are starting to show a greater level of diversification than in previous years. This can be seen in the moves in bond yields, equity markets and currencies since the speech by ECB President Mario Draghi on June 27 that ignited the latest bond sell-off (Chart 2). The largest yield moves have occurred in the Euro Area, U.K., Canada and Australia, which have also coincided with currency strength and equity market underperformance in those countries. As the markets now try to sort out the growing divergences between monetary policies, this has opened up opportunities for diversification of duration exposures, country allocation and yield curve strategies. This week, we present a brief summary of our individual country recommendations for the remainder of the year. United States: underweight duration, underweight country allocation, steeper yield curve, long inflation protection The Fed remains on track for a move to begin reducing its balance sheet at the September FOMC meeting, with another rate hike expected in December. The inflation data of late has started to raise concern among some FOMC members about how many more interest rate increases will be necessary for this tightening cycle. We expect U.S. growth to show solid improvement over the latter half of 2017, and for this current downdraft in realized inflation to soon bottom out led by tightening labor markets and the lagged impact of this year's decline in the U.S. dollar. Treasury yields will continue to grind higher in the months ahead, led more by rising inflation expectations that will bear-steepen the yield curve. (Chart 3) Chart 2Market Moves Since Draghi's Portugal Speech Chart 3U.S. Rates Strategy Summary Germany: underweight duration, underweight country allocation, steeper yield curve, long inflation protection France: underweight duration, underweight country allocation, steeper yield curve, long inflation protection Italy: underweight duration, underweight country allocation (versus Spain), steeper yield curve The ECB is clearly signaling that a taper of its asset purchase program will begin in 2018. The Wall Street Journal reported last week that Mario Draghi will speak at the upcoming Fed Jackson Hole conference in late August.1 Similar to his speech at the ECB Forum in late June, this will likely be another opportunity for Draghi to prepare financial markets and other central bankers for the ECB's policy shift. We expect an announcement of a "Fed-like" tapering of bond purchases that will begin in January and end sometime in the fourth quarter of 2018. A rate hike is still some time away, most likely in the first half of 2019 at the earliest. The ECB will want to see more signs of lower unemployment and sustainable higher core Euro Area inflation before contemplating higher short-term interest rates - especially given the likely positive impact on the euro from such a move that would risk an unwanted tightening of financial conditions. There is far more risk in longer-dated bond yields to reprice via higher term premia and/or inflation expectations, thus we are recommending a bearish stance not only on European duration and country allocation, but also a bias toward steeper yield curves (Chart 4 & Chart 5). Tapering will also put upward pressure on Peripheral European yields and spreads, particularly in Italy, as risk premiums normalize away from the tight levels seen during the ECB asset purchase program. We do not anticipate a rout in Italian debt given the current improvements in the domestic economy and the positive moves seen in consolidating and recapitalizing the troubled Italian banking sector. However, we do see continued underperformance of Italian debt versus Spanish sovereigns, thus we are maintaining an overweight stance on Spain versus Italy in our model bond portfolio (Chart 6). Chart 4Germany Rates Strategy Summary Chart 5France Rates Strategy Summary Chart 6Italy & Spain Strategy Summary U.K.: underweight duration, neutral country allocation, neutral yield curve We have been maintaining a neutral allocation to U.K. Gilts, but with an underweight duration exposure and a curve steepening bias (Chart 7). The growing rift among the members of the BoE Monetary Policy Committee does suggest that there could be more two-way risk in U.K. interest rates than at any time seen since last year's Brexit vote. The BoE responded to that political surprise with rate cuts and a new round of asset purchases, even though the U.K. economy was operating at full employment at the time and inflation pressures were rising. Now, the chickens have come home to roost for the BoE, with inflation remaining stubbornly high despite signs of slowing growth (Chart 8). With real wage growth slowing substantially and household saving rates at very low levels, the risk of a consumer spending slowdown - that the BoE was flagging earlier in the year - is increasing. Chart 7U.K. Rates Strategy Summary Chart 8Stagflation In The U.K. Given the ongoing uncertainties from the upcoming Brexit negotiations that will likely continue to weight on business confidence and investment spending, and with consumption likely to continue losing steam, we see little case for the BoE to seriously consider a rate hike before year-end. We are only recommending a neutral stance on Gilts, though, as realized inflation continues to run well above the BoE's target, supported by the stubbornly soft British pound. We continue to recommend a steepening bias on the Gilt curve until there is more decisive evidence that U.K. inflation is rolling over. Japan: overweight duration, maximum overweight country allocation, neutral yield curve and neutral inflation protection We continue to recommend a maximum overweight on Japanese government bonds (JGBs). JGBs are a low-beta market with the BoJ still targeting a 0% level on the benchmark 10-year yield, even as other global bond markets sell off. The BoJ has been particularly aggressive in capping any rise in JGB yields of late, offering to buy 10-year bonds in unlimited size and also increasing its purchases at shorter maturities (Chart 9). With Japanese inflation still struggling to stay in positive territory, even with the economy estimated to be operating at full employment, the BoJ will do the only thing it can do to put a floor under inflation - keep JGB yields at low levels to trigger a new wave of yen weakness and, hopefully, some imported inflation pressures via the currency. Against this backdrop, JGBs will continue to outperform other DM bond markets during this move towards strong growth and less accommodative monetary policies outside of Japan. Stay overweight Japan against global hedged bond benchmarks. Canada: underweight duration, underweight country allocation, flatter yield curve, long inflation protection We moved our Canadian country allocation to underweight last week in advance of the BoC's expected rate hike, but we had been recommending bearish Canadian trades (curve flatteners and spread wideners versus U.S. Treasuries) in our Tactical Overlay Trade Portfolio for much of the year so far.2 The BoC's 180-degree policy shift over the past month has taken many investors by surprise, but the very strong upturn in the Canadian economy is forcing the BoC into action. With the BoC now projecting the Canadian output gap to be closed this year, expect another one, even two, rate hikes by the end of 2017. This will put additional upward pressure on Canadian bond yields and bear-flatten the Canadian government bond yield curve (Chart 10). Australia: neutral duration, neutral country allocation, neutral curve Australia has been one of the trickier markets on which to have a strong opinion, given the combination of a tight labor market, low inflation, mixed readings on domestic demand and heavy exposure to China's economy. This has led us to be neutral across the board on Australian bonds (Chart 11). We will be covering the outlook for Australia in a Special Report to be published next week, in which we will re-examine our current Australia recommendations. Chart 9Japan Rates Strategy Summary Chart 10Canada Rates Strategy Summary Chart 11Australia Rates Strategy Summary Bottom Line: Many central banks are responding to the strong global economic backdrop by signaling not only a shift in the bias of monetary policy, but actual changes in interest rates or asset purchases. We continue to recommend a below-benchmark overall portfolio stance, but with more diverse views on country allocation: underweight the U.S., Euro Area, & Canada; maximum overweight on Japan; and neutral on the U.K. and Australia. Expect steeper yield curves in the U.S., Euro Area and U.K., and continued flattening in Canada. An Update On The State Of U.S. Corporate Bond Market Liquidity In the Fed's latest Monetary Policy Report, presented by Janet Yellen to the U.S. Congress last week, an entire section was devoted to the state of U.S. corporate bond market liquidity.3 The Fed's conclusion was that, according to many commonly used metrics like average bid/ask spreads, corporate debt has not become more difficult to trade in recent years. This goes against the intuition of many bond investors who have perceived a deterioration of liquidity in corporate credit markets since the 2008 Financial Crisis. The Fed likely felt compelled to dedicate three pages of its Monetary Policy Report to a topic as mundane as bond market functionality as a defense of its current regulatory framework for U.S. banks. The Fed has taken a lot of flak from major U.S. financial institutions, conservative free-market politicians and, since last November, the Trump White House over the "heavy-handed" rules shackling the banks. Chart 12U.S. Dealers Don't Matter Regulations such as the Volcker Rule and the Supplementary Leverage Ratio have almost certainly reduced the odds of another financial crisis caused by undercapitalized banks speculating in risky assets. Yet the critics continue to point out that banks which are more worried about meeting regulatory targets are less able to make loans or, in the case of investment banks, make markets in risky assets like corporate debt. This is important for bond investors given the sharply reduced footprint of investment banks in corporate debt markets. The Fed's data on primary dealer positioning in corporates shows a massive decline from the pre-crisis peak in 2007 of $280bn to only $20bn this year (Chart 12). Over the same period, the size of the U.S. corporate bond market has more than tripled to $6.5 trillion (using the market capitalization of the Barclays Investment Grade and High-Yield indices as a proxy). On the surface, that indicates that dealers held 10% of "the market" at the peak. Now, dealer inventories barely represent only 0.3% of corporate debt outstanding. While that is low, it is not much lower than the share of corporates held by dealers in the early 2000s. When looking at the full span of the available data, the huge dealer footprint in the U.S. corporate bond market in the years prior to the Financial Crisis was the exception and not the norm. Like most other market participants in those years, the investment banks were seduced by the extended period of low macro and market volatility and ended up taking too much risk on their balance sheets. Now, dealers are much more cautious when trading with clients, acting more as an "agent" that matches buyers and sellers for individual trades and less as a "principal" that holds the bonds themselves. The smaller presence of dealers could create a liquidity problem for corporate debt, especially if dealers in their usual role as market-makers cannot be there to absorb the selling pressure from investors during market sell-offs. Yet corporate bond markets have functioned well since the dark days of the Lehman crisis. According to data from SIFMA, average daily trading volumes in the U.S. corporate bond market rose from a low in 2008 of $14bn to $30bn in 2016 (Chart 13). Corporate bond issuance has surged as well, but corporate bond turnover - total annualized trading volumes relative to total bonds outstanding - has improved by nearly 35% since the 2008 low. In addition, the reduced dealer presence has not resulted in any unusual widening of typical relationships like the basis between Credit Default Swaps and corporate bond spreads (bottom panel). The Fed noted this in its Monetary Policy Report as a sign that market liquidity was not impaired since there were not many "unrealized arbitrage opportunities". It is evident that other market participants have picked up the slack from the dealers in U.S. corporate bond trading. Exchange Traded Funds (ETFs) are the obvious candidate, led by the popular iShares HYG and the SPDR JNK funds that have a combined $30bn in assets under management. According to the Fed's database on the Financial Accounts of the United States (formerly known as the Flow of Funds), the share of corporate bonds held by all retail funds, including ETFs, soared from 6.5% in 2008 to nearly 19% in Q1 of this year (Chart 14). This nearly offset the decline in the share of corporates held directly by households, as individual investors shifted their preferences toward the ease of trading corporate debt ETFs over individual bonds. Chart 13U.S. Corporate Bond Market Turnover Has Improved Chart 14Shifting Ownership Patterns For U.S. Corporates Importantly, institutional investors like insurance companies and pension funds have seen their influence in corporate bond markets increase, as they now hold a combined 35% of corporate debt, up from 26% in 2008 (bottom two panels). These groups will likely control an even greater share of the corporate bond market in the years to come with the growing usage of so-called "all-to-all" electronic trading platforms like MarketAxess or Bloomberg that allow users to trade directly with each other. All-to-all has already established a major market footprint, as activity on MarketAxess now represents 16% of all trading volume in U.S. Investment Grade corporates and 34% for High-Yield, according to The Economist.4 This is a hugely important development. If more professional bond investors can now transact directly with one another, this helps to alleviate any reduction in market liquidity caused by a smaller dealer presence in the market. Even with so much evidence pointing to no serious liquidity problems in U.S. corporate debt, some worrisome issues remain. Chart 15Market Performance Leads Fund Inflows,##BR##Not Vice Versa Average trade sizes in corporates are smaller now compared to pre-crisis levels - perhaps as much as 20% smaller according to estimates by the New York Fed.5 This is likely the result of the reduced risk-taking by the dealers and the growing share of direct electronic trading. This creates an effect where it may feel like liquidity is impaired since it now takes longer to execute a large bond trade, even though transaction costs for individual trades have not been increasing, on average. Corporate bond ETFs are easier to trade than the underlying bonds held in the ETFs themselves. This has worried many investors who fear that a corporate bond market downturn could turn into a much larger rout if rapid ETF redemptions cause "fire sales" of the bonds held in the ETFs to quickly raise cash. Admittedly, the unique ETF structure - where the shares of the ETF are traded and not the underlying bonds, similar to a closed-end mutual fund - has not yet been tested in a true credit bear market. However, there have been several episodes of "risk-off" bond sell-offs over the past few years, most notably for High-Yield ETFs during the 2014/15 oil bear market, which did not result in any disorderly disruption of corporate bond markets. If anything, the historical experience of U.S. corporate bond mutual funds shows that net flows into funds tend to follow, and not lead, the performance of markets (Chart 15). This may exaggerate bond market moves at turning points but, in general, outflows are a symptom, not a cause, of corporate bond downturns. Net-net, we agree with the assessment of the Fed that corporate bond market liquidity shows little sign of impairment and does not represent a threat to market stability. Bottom Line: There are few signs of diminished liquidity in U.S. corporate bond markets, despite the sharply reduced inventories of primary dealers. ETFs and institutional investors have picked up the slack from the dealers, as has electronic trading directly between market participants. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 https://www.wsj.com/articles/draghi-may-address-future-of-ecb-stimulus-at-jackson-hole-1499944342 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Dangerous Duration", dated July 11 2017, available at gfis.bcaresearch.com. 3 https://www.federalreserve.gov/monetarypolicy/files/20170707_mprfullreport.pdf 4 https://www.economist.com/news/finance-and-economics/21721208-greater-automation-promises-more-liquidity-investors-digitisation-shakes-up 5 http://libertystreeteconomics.newyorkfed.org/2015/10/has-us-corporate-bond-market-liquidity-deteriorated.html Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
Highlights BCA's Central Bank Monitors support the case for less stimulus. Yellen's "dovish" testimony does not change our Fed call. The BCA Beige Book Monitor and related indicators support our view on the economy and Fed. Maximum central bank policy divergence has not been reached. Too early to predict Trump's replacement for Yellen. Now that economic surprise index has bottomed, risk assets can outperform as the metric mean reverts. Some wage measures are accelerating as the economy approaches full employment. Feature Chart 1Sell-Off In Global Bond Markets##BR##Triggered By Central Bank Talk Global bond investors were shocked in June when central bankers announced at the ECB's Forum on Central Banking what appeared to be a global recalibration of monetary policy. Until that time, investors had been lulled into a false sense of security that growth headwinds would prevent the Fed from hiking by more than once a year and keep the other major central banks on hold "indefinitely." The heads of the Bank of England (BoE), the Bank of Canada (BoC) and the Riksbank all took a less dovish tone, as they signaled less need for ultra-stimulative policies because the threat of deflation had diminished. Together with some better-than-expected U.S. economic data, this shift in tone led to a sharp sell-off in global bond markets (Chart 1). The BoC followed up last week by kicking off a prolonged tightening cycle. The central bank now expects the Canadian economy to reach full employment and hit the BoC's inflation targets by mid-2018, which is much earlier than expected. The global bond mini-rout actually began before the ECB Forum, when the ECB President gave a very upbeat description of the underlying strength of the Euro Area economy. BCA's Global Fixed Income Strategy service highlights that the Euro Area is about two percentage points closer to full employment than the U.S. was just before the infamous 2013 Taper Tantrum.1 European core inflation is admittedly below target today, but so was the U.S. rate leading up to the 2013 Tantrum. Draghi's comments confirm that the ECB will announce this fall that a further tapering of its asset purchase program will take place in early 2018. The message that "emergency" levels of monetary accommodation are no longer needed is confirmed by our Central Bank Monitors (CB), which measure pressure on central bankers to raise or lower interest rates (Chart 2). The Monitors became less useful when rates hit the zero bound and quantitative easing became popular, but the measures are relevant again. All of our CB Monitors are in "tighter policy required" territory except for Japan (although even that one appears on the verge of breaking above the critical zero line). The Monitors have been rising due more to their growth than their inflation components. Bond investors may be startled by the ECB's posture because inflation remains well below target in all the major economies except the U.K. What is most worrying is the recent deceleration in U.S. inflation, where the economy is very close to or at full employment. Almost all of the major central banks point to temporary factors that will soon fade, which would allow inflation to escalate toward the target. Our Aggregate Inflation Indicators have all signaled a modest building of underlying inflation pressure over the past year (although they have softened recently in the U.S. and Eurozone; Chart 3). In terms of the components of these indicators, rising core producer price inflation has been partly offset by slower gains in unit labor costs in some economies. Chart 2All In The "Tighter Policy Required" Zone Chart 3BCA Aggregate Inflation Indicators These and other indicators support our view that core consumer price inflation will grind higher in the coming months in most of the advanced economies, including the U.S. Admittedly, all models and indicators have been poor predictors of inflation in this recovery. Nonetheless, historical relationships might begin to re-establish now that capacity utilization is rising and labor market slack has moderated significantly. Did Yellen Turn Dovish? June's FOMC minutes indicated that the consensus among Fed policymakers is willing to "look through" low inflation and maintain the current timetable on rate hikes. Yellen's Congressional testimony last week did not deviate from that view, although investors interpreted her remarks as dovish. The financial press focused on her statement that "...the policy rate is not far from neutral." However, this was followed up by the statement that "...because we also anticipate that the factors that are currently holding down the neutral rate will diminish somewhat over time, additional gradual rate hikes are likely to be appropriate over the next few years to sustain the economic expansion and return inflation to our 2 percent goal." The Fed asserts there are two neutral interest rates: short-term and long-term. Yellen argued that the actual policy rate is close to the short-term level, which is depressed by economic headwinds. However, Yellen and others have made the case that the short-term neutral rate is trending up as headwinds diminish, and will converge with the long-term neutral rate over time. The Fed Chair is at risk of confusing investors by discussing the concept of two neutral rates, although this may have been to head off demands by some Congressional lawmakers that the Fed should follow a mechanical policy rule when setting policy (such as the Taylor Rule). Nonetheless, the important point is that Yellen is not saying that the actual policy rate is close to the peak for the cycle. Yellen's testimony has not altered our Fed call for this year: balance sheet runoff beginning in the fall, followed by a rate hike in December. The latter hinges importantly on at least a modest rise in core PCE inflation in the coming months. We expect more rate hikes in 2018/19 than are discounted in the bond market. That said, the soft June CPI data challenges our view that inflation will move higher in the second half. The bottom line is that the backdrop has turned decidedly bond-bearish now that central bankers in the advanced economies are in the process of scaling back the easier monetary policy that followed the deflationary 2014/15 oil shock. Global bond yields have already taken a step up in recent weeks, but they will have to rise further to catch up with the solid pace of global growth and diminishing economic slack. Duration should be kept short. The Beige Book: Another Inflation Anomaly The Beige Book released on July 12 supports the Fed's base case outlook for the economy and inflation. It also keeps the Fed on track to begin to trim its balance sheet in September and boost rates by another 25 basis points in December. Our quantitative approach2 to the qualitative data in the Beige Book points to an acceleration in GDP and inflation, less business unease from a rising U.S. dollar, and ongoing improvement in real estate, both commercial and residential (Chart 4). Chart 4Beige Book Monitors Support Fed's Outlook##BR##On Economy And Inflation At 62%, the BCA Beige Book Monitor remained near its cycle highs in July, providing more confirmation that the economy rebounded in Q2 after a desultory Q1. The July 12 Beige Book covered the period from late May through June 30. Based on the Beige Book, the dollar should not be much of an issue in Q2 earnings season. The greenback seems to have faded as a concern for small businesses and bankers, which is in sharp contrast to 2015 and early 2016 when mentions of a strong dollar in the Beige Book surged. The Q2 earnings reporting season will provide corporate managements with another forum to express their views of currency impact on their operations. Business uncertainty over government policy (fiscal, regulatory and health) remained elevated in the most recent Beige Book (not shown). The implication is that the business community is mindful of the lack of progress by Washington policymakers on Trump's agenda. Our analysis of the Beige Book also shows that real estate was still stout as Q2 ended. This implies that both residential and commercial real estate, the former a source of strength in Q1, will add to growth again in Q2. Moreover, the latest reading on the BCA Real Estate Monitor further widened the gap between the BCA Beige Book Real Estate Monitor and the relative performance of REITS to the S&P 500. Nonetheless, BCA's U.S. Equity Strategy service recently downgraded REITS to neutral,3 citing our expectation of higher Treasury yields, modest rent growth, some cracks in CRE credit quality, and tightening standards for bank lending in the CRE marketplace. Echoing the market's disagreement with the Fed on inflation, the big disconnect in the Beige Book showed up in the number of inflation words. Inflation words hit a new peak in July, in sharp contrast with the recent soft readings on CPI and PCE. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The Beige Book backs the Fed's assertion that the economy will expand around 2% this year and inflation will move higher in the coming months, supporting a gradual removal of policy accommodation. Uncertainty in Washington is distressing, but worries over the dollar seem to be fading. Max Policy Divergence Has Not Been Reached What about the dollar? Tighter Fed policy is dollar-bullish on its own, but some of the major central banks are also starting to remove the monetary punchbowl as well. Recent dollar action suggests that investors have decided that the peak Fed/ECB policy divergence is now behind us. We do not agree. The ECB may be tapering, but raising interest rates is a long way off because there is still a lot of economic slack in the Eurozone. In contrast, the Fed is increasingly concerned that allowing the unemployment rate to fall further below its estimate of full-employment risks too large an overshoot of the 2% target. We still believe that market pricing for the fed funds rate is too benign. As Fed rate hike expectations ratchet up in the coming months, interest rate differentials versus Europe will widen in favor of the dollar. It is the same story for the dollar/yen rate. The major exception is the Canadian dollar, which we expect to appreciate versus the greenback. Does Gary Cohn Have What It Takes? A key wildcard in the financial outlook is the Fed Chair's replacement. Yellen's term as Chair will end in February 2018 and the markets have not yet shown any concerns about her potential replacement. The current frontrunner is Gary Cohn, the Chairman of President Trump's National Economic Committee; his appointment would conform to some historical precedents but violate others. Our March 6 Weekly Report4 provides a list of potential Fed appointees and also provides some background on the potential for the Fed to become more politicized under Trump. Since the late 1970s, Presidents have selected the Fed Chair based on their trust relationship with a candidate. Arthur Burns (Chair from 1970-1978) was the head of President Eisenhower's Council of Economic Advisors (CEA) and was a special counselor to President Nixon. William Miller (1978-1979) worked for the presidential campaigns of Hubert Humphrey and Jimmy Carter. Alan Greenspan (1987-2006) served as the Chair of President Reagan's Social Security Commission in the early 1980s, was the Chair of President Ford's CEA and advised President Nixon's campaign in 1968. Ben Bernanke (2006-2014) was George W. Bush's chief economist in 2005 and 2006 before Bush chose him to lead the Fed. Janet Yellen (2014-present) was Chair of Bill Clinton's CEA in the late 1990s, when she worked with many of Obama's economic team members. Paul Volcker (1979-1987) was the lone exception to this rule; he worked for Nixon, but not Carter, before becoming Fed Chair (Table 1). Table 1Characteristics Of Fed Chairs Since 1970 Cohn does not have any experience as a central banker, but that does not preclude him from holding the position. Volcker, Bernanke and Yellen, all held posts in the Federal Reserve System before their appointments as Chair. However, Miller was an outside director for the Boston Fed, and Burns and Greenspan had no prior experience at the monetary authority. Party identification is one area where Gary Cohn would stand out. Since at least 1970, the party affiliation of a new Fed Chair has matched that of the President. However, Presidents have crossed party lines to reappoint sitting Fed Chairmen to additional terms. Volker, Greenspan and Bernanke were reappointed to lead the Fed by Presidents from opposing political parties. The timing of Trump's announcement on Yellen's replacement may be critical. In the summer of 2013, names were already being floated by the Obama White House (and mainly rejected) by markets, before he finally settled on Yellen. The official announcement came in early October 2013. In August 2009, President Obama reappointed Bernanke for a second four-year term. Bernanke was initially nominated to be Fed Chair by George W. Bush in October of 2005. If the appointment comes in October and the nominee is perceived to be hawkish, the risk is that markets may begin to price in the regime change sometime in the next few months. Our U.S. Bond Strategy service argued in a recent report5 that rate hike expectations may already be ramping up, while the data on the economy and inflation begin to beat expectations again. Bottom Line: It is too early for the markets to be concerned about the next Fed Chair and their policies. The names mentioned in the summer may not be the ones offered the job in the fall. Surprise Index Finally Bottomed Out The June employment report marked a turning point for the Citigroup surprise index, following an extended period of disappointment that depressed the dollar and bond yields. The June reports on CPI and retail sales were disappointing, but June industrial production exceeded expectations. What does this mean for relative asset returns? After 86 days, expectations moved low enough to allow economic reality to begin to run ahead. It took as few as 8 business days (in 2009) and as many as 164 (2015) for the surprise index to return to the zero line, an average of 52 days (Chart 5). Chart 5Risk Assets Tend To Outperform As Economic Surprise Index Rebounds Mean-reversions in the surprise index following troughs have generally been good for risk assets in this recovery (Table 2). We have identified 11 periods since late 2009 when the surprise index bottomed out and then moved up toward zero. In 8 of those episodes, the total return on stocks was higher than 10-year Treasuries. Equities beat Treasuries by an average of 286 bps across all 11 periods, with a median outperformance of 400 basis points. Table 2U.S. Financial Market Performance As Economic Surprise Index Rises The total return on investment-grade corporate debt outperformed Treasuries in 6 of 11 episodes. In those six instances, investment grade credit outperformed on average by 132 bps. Nonetheless over all 11 episodes, the excess return was 0%. In contrast, high-yield bonds beat Treasuries in 7 of the 11 periods, with a median outperformance of 188 basis points. Similarly, small caps beat large caps 72% of the time as the economic surprise index moved back toward the zero line. The median outperformance of small over large in all 11 periods was 124 basis points. The performance of commodities was mixed as economic surprises climbed. Gold rose in 6 of the 11 times, but fell in 5. Oil prices posted increases in only 5 of the 11, but the median return for oil after economic surprise bottomed was -2.7%. Bottom Line: Economic expectations that ramped up post-election have now declined and allowed the economic surprise index to trough. The implication for investors is that risk assets tend to outperform as the economic surprise index moves back to zero. This supports our tactical views of stocks over bonds, small over large caps, and credit over Treasury. What's Up With Wages? The June jobs report released in early July6 only added to the market's fears that the Phillips Curve is dead because wage growth softened even as the labor market tightened. Unfortunately, no Fed officials including Yellen have addressed the topic in depth recently. The market does not believe the Fed when it says that the tighter labor market is pushing up wages. We see it another way. Chart 6 shows that wage inflation has accelerated since mid-to-late 2012, but some measures of wages have made more progress than others. Chart 7 and Chart 8 reinforce that, setting aside the rollover in average hourly earnings (AHE), wage inflation is accelerating, albeit modestly. Chart 6Plenty Of Signs That##BR##Wages Are Accelerating Chart 7Compositional Effects Do Not##BR##Explain Recent Rollover Chart 8Acceleration In Hours Worked Should##BR##Lead To Faster Wage Growth The Employment Cost Index (ECI) excluding bonuses (Chart 6, panel 1) is our favorite measure of labor compensation. It has accelerated steadily since 2010. It adjusts for compositional changes in the labor market (unlike the average hourly earnings measure) and is the broadest and most comprehensive wage metric. Its drawbacks are that it is released with a long lag. For example, the Q2 ECI data will not be released until the end of July. The AHE data is already available for June and Q2. On the other hand, unit labor costs (ULC) (panel 2) have stagnated for the past five years. Data starts in 1947, so it has the most history of any of the wage measures. However, it is even more delayed than the ECI: it is released five weeks after the end of the quarter. Moreover, these data are subject to revisions and tend to be more volatile than other wages measures, which makes it difficult to identify a change in trend. Productivity, which is used to construct ULC, is also very difficult to estimate. A recent BIS report7 notes that there is evidence that the relationship between ULC and labor market slack has diminished over time, but that ULC is a better measure of inflationary pressures than AHE. Median usual weekly earnings (panel 3) have also accelerated. This is not a pure wage measure; it combines hourly pay and hours worked and, therefore, is a good proxy for incomes. Income growth has picked up the pace, providing a solid underpinning for consumer spending. Panel 4 shows compensation per hour worked. It, too, has stalled and is subject to the same strengths and weakness as ULC because it is part of the quarterly Productivity and Costs report. This metric has run near 2% with no trend. Finally, average hourly earnings (panel 5) have sped up since 2012, but rolled over in late 2016. This wage gauge gets most of the market's attention although it is only one of many measures that the Fed watches. AHE is a timely data set, released alongside monthly payroll numbers. It includes average earnings of private non-farm production and non-supervisory positions. The major disadvantage of this measure is that hourly wage earners represent only about 58% of workers and do not account for trends in salaried jobs. Earnings do not include bonus pay or employee benefits. The data are available beginning only in 2006. In Chart 7, we created an "equally-weighted" AHE measure to adjust for shifts in the composition of the labor market, but we found that the recent deceleration is not linked to compositional effects. Since wage growth bottomed out in late 2012, the compositional shifts slightly lowered wage inflation on average, but the growth rates today are roughly the same. The Atlanta Fed wage tracker (not shown) is in a distinct uptrend. The Tracker has the advantage that it is not biased by compositional shifts. Chart 8 shows our update to a study by the Kansas City Fed8 that found only a few industries (mostly in the goods-producing sector of the economy) have accounted for most of the rise in wages, notably manufacturing, construction and wholesale trade. Financial services, retail, professional and business services, and leisure and hospitality - all service sector industries - were the laggards. The report shows that although earnings growth has fallen behind in service-oriented industries since 2015, hours worked have seen faster growth than in the goods-producing sector. We concur with the author that labor demand was strong in the past few years in areas that have not experienced much wage growth. As the labor market continues to tighten, wages in these industries may accelerate, but patience will be required. Bottom Line: The various measures of wage inflation provide a mixed picture. Taken as a group, however, we believe that wage growth has indeed accelerated as the labor market has tightened. The acceleration has admittedly been modest, but it is only recently that unemployment reached a full employment level. The real test for the Phillips curve will be in the coming quarters as the economy moves further into "excess labor demand" territory. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA's Global Fixed Income Strategy Weekly Report, "Central Banks Are Now Playing Catch-Up", dated July 4, 2017. Available at gfis.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report "The Great Debate Continues", dated April 17, 2017. Available at usis.bcaresearch.com. 3 Please see U.S. Equity Strategy Weekly Report "SPX 3000?, dated July 10, 2017. Available at uses.bcaresearch.com. 4 Please see U.S. Investment Strategy Weekly Report "Trump And The Fed", dated March 6, 2017. Available at usis.bcaresearch.com. 5 Please see BCA's U.S. Bond Strategy Weekly Report "Summer Snapback", dated July 11, 2017. Available at usbs.bcaresearch.com 6 Please see U.S. Investment Strategy Weekly Report "Sizing up the Second Half", dated July 10, 2017. Available at usis.bcaresearch.com. 7 Monetary policy: inching towards normalization", Bank for International Settlements (BIS), 25 June 2017. 8 Wage Leaders and Laggards: Decomposing The Growth In Average Hourly Earnings", Willem Van Zandweghe, Federal Reserve Bank of Kansas City, February 15, 2017.
Highlights Yellen pointed out that the U.S. R-star is low but that it will rise as temporary depressing factors pass. The Fed is determined to push rates toward 3% over time. The euro area R-star is substantially lower than that of the U.S., limiting the capacity of the ECB to follow the Fed's path and pace. Traders are massively long the euro. Abe's woes do not signal the end of Abenomics, in fact they point toward more stimulus. The BoC has hiked and will keep doing so, continue to favor the CAD. Feature Janet Yellen offered both a fascinating and telling glimpse on the Federal Reserve's thinking this week. She argued that the equilibrium fed funds rate is currently very depressed, which is limiting the pace at which the FOMC can increase interest rates before plunging the economy into recession. However, she also noted that the Fed anticipates equilibrium interest rates will continue to rise over time, which means the actual fed funds rate has more upside on a multi-year horizon, despite what will be a slow pace of increases. With this additional information on the Fed's mindset, investors should be even more comfortable in their assessment that the period of maximum policy divergence between the euro area and the U.S. is behind us, which justified bullish bets on the euro. However, the broader picture is a bit more complex. Different Equilibria The idea that the neutral fed funds rate is still low but rising explains why the Fed is still pegging its terminal rate at 3%. Currently, the Laubach and Williams formulation of the neutral real fed funds rate (also known as R-star) is at 0.4%, while the current real fed funds rate stands at -0.5%, which implies 0.9% upside in real rates over the next two years or so (Chart I-1). Moreover, if as we expect core inflation moves back toward 2% over the Fed's forecast horizon, the upside to rates would be closer to 150 basis points. In the euro area, however, the same long-term R-star stands at -0.1%, depressed by lower population growth, a higher savings rate and lower structural productivity gains. Since the real policy rate is at -0.7%, this signifies that the gap between the actual real policy rate and its equilibrium is a smaller 0.6% (Chart I-2). This means that euro area rates have much less upside than U.S. ones before generating a deleterious impact on growth. Chart I-1U.S. R-Star Vs. Policy Rates Chart I-2Euro Area R-Star Vs. Policy Rates It is easy to argue that R-star differences are nice theoretical concepts, with little practical implications for currency investors. After all, interest rate differentials at the long end of the curve are clearly a function of the relative GDP per capita between the euro area and the U.S. (Chart I-3). These same GDP-dynamics also have an impact - albeit a less tight one - on EUR/USD. Chart I-3Yield Differentials And Relative GDP Chart I-4How R-Star And GDP Tango Yet, R-star spreads do affect growth differentials between the euro area and the U.S. As Chart I-4 illustrates, when the euro area real policy rate crosses above its equilibrium, euro area real GDP per capita growth sags soon after. The same holds true for the U.S. This suggests the capacity of European GDP per capita to outperform that of the U.S. is currently limited, or at the very least needs rates in Europe to remain quite low relative to the U.S., anchored lower by the depressed level of the R-star in Europe vis-a-vis the U.S. Moreover, the recent outperformance of European GDP per capita relative to the U.S. has a lot to do with the poor performance of U.S. GDP in 2016. However, U.S. GDP should firm in the coming quarters, particularly since household income levels are well supported. As Chart I-5 shows, based on an average of the pay-related and hiring-related components of the NFIB small businesses survey, the aggregate wages and salaries received by U.S. households are set to accelerate, both in nominal and real terms. This represents a boost to aggregate income and should support consumption, or almost 70% of the U.S. economy. Additionally, the rebound in U.S. capex should continue. Both the NFIB and the various regional Fed capex intention surveys remain healthy. This, along with labor market tightness, should be accretive to per capita GDP. As Chart I-6 shows, a composite indicator based on the NFIB survey capex and "jobs hard to fill" components is very strong, which historically has led to an acceleration of real-GDP-per capita growth. Chart I-5U.S. Household Income Will Accelerate Chart I-6U.S. Real GDP Per Capita Will Strengthen As a result, we are inclined to bet on a renewal of strength in the U.S. economy, which will support R-star there and help the Fed hike rates by more than the 43 basis points currently anticipated over the next 24 months. Bottom Line: The U.S. long-term equilibrium real fed funds rate is low, but remains substantially higher than the R-star in the euro area. This suggests that U.S. rates have more upside than European ones. Moreover, the outlook for U.S. per capita GDP is healthy, while that of Europe will continue to require low rates to remain on an upward path. Tactical Considerations Around EUR/USD EUR/USD is well bid, and our base case scenario remains that the 1.15 to 1.16 zone will be retested. However, some technical indicators have made us leery to chase this move, and might even prevent this target zone from ever being breached. To begin with, the number of long speculative bets on the euro has hit a record high, while the number of short bets has collapsed (Chart I-7). Net long speculative positions are not at a record high yet, but are in the upper echelons of the distribution of the past 17 years. Interestingly - and some would argue almost mechanically - while speculators' optimist or pessimist extremes can be used as contrarian indicators, commercial traders tend to be disproportionally short or long the euro at the appropriate time - i.e., when the euro is set to plummet or rally, respectively. Theoretically, commercial and non-commercial traders' positions should be in perfect balance as they are counterparties to one another, but in practice this is rarely the case. Because of this observation, we decided to amplify the message of both series by subtracting the net long commercial positions from net long non-commercial ones. This indicator tends to work best at highlighting tops in EUR/USD. The current reading has been indicative of an upcoming period of weakness in this pair (Chart I-8). The only exception was in 2007, a period when unlike today, the Fed was cutting rates while the ECB policy rate was being lifted all the way to July 2008. Chart I-7Record Longs In The Euro Chart I-8Aggregate Positioning Points To A Lower Euro Moreover, the buying pressure on EUR/USD may be exhausting itself. Wednesday, despite a seemingly dovish message from Fed Chair Yellen and despite stronger-than-anticipated industrial production numbers out of the euro area, EUR/USD weakened 0.6% instead of appreciating. In fact, our European Investment Strategy Senior Vice President Dhaval Joshi's Fractal Dimension indicator - a measure of group-think in the market - is now at 1.25, a level that also warns of an imminent trend change (Chart I-9).1 Chart I-9A Risk Of Reversal As a result, we do not yet think it is time to be betting aggressively on a fall in EUR/USD, especially as next week's ECB meeting might give an occasion for President Mario Draghi to re-affirm his optimism, giving the euro its final push toward 1.15-1.16. However, nimble traders should begin building small short positions in the euro on the optic of expanding their bets if the EUR/USD gathers downward momentum. Bottom Line: The euro may well hit the 1.15-1.16 range, but positioning in EUR/USD is currently extremely overstretched, and the euro's trading action suggests that groupthink has become prevalent, confirming the message of positioning. This means the euro is at risk. Nimble traders should begin building small short positions in EUR/USD, but it is not yet time to bet aggressively on this pair. Shinzo's Troubles Are Not The Demise Of Abenomics Japanese Prime Minister Shinzo Abe's popularity has been in freefall in recent weeks, hitting the most dismal levels of his current premiership (Chart I-10). The flogging received by the LDP in the recent Tokyo Metropolitan Assembly election is indeed being perceived as a rejection of the party's policy stance since 2012. Does this represent the coup de grace that will end Abenomics? We doubt it. The key behind the recent dip in Abe's popularity is not his economic policy but his move away from it. Instead, his focus on changing the pacifist constitution of post-war Japan is the source of the LDP's and Abe's woes, as this topic remains anathema with the Japanese public. Moreover, we are not willing to bet on the demise of the LDP. The Tokyo election was a one-off event. The new Tomin First no Kai (Tokyoites First) party that is now the largest force in the regional assembly is led by the very popular Tokyo governor Yuriko Koike, and will rely on the pacifist Komeito to control the Tokyo Metropolitan Assembly. At the national level, the DPJ remains in tatters, and no potential new party is in place to carry the torch of the opposition. Japan is still effectively a one-party democracy. So what are the market implications of these political developments? We expect a doubling down by Abe on economic stimulus. If Abe ever wants a passing chance to have, let alone win, a referendum to increase Japan's militarism, the economy needs to be stronger than it is. Thus, we think this boot of unpopularity will be key to unlocking more fiscal stimulus out of Tokyo. When more fiscal stimulus finally does materialize, if it boosts growth, it will also lift long-term inflation expectations (Chart I-11). Chart I-10Abe's Plummeting##br## Popularity Chart I-11If Fiscal Stimulus Is Implemented ##br##CPI Expectations Will Rise... In this context, we would expect continued pressure on the Bank of Japan to remain one of the two most dovish central banks in the G10, as to not undo the benefits of fiscal stimulus. Moreover, the BoJ cannot remove stimulus, as realized CPI excluding food and energy remains in negative territory. Tokyo's CPI report, which offers a one-month lead on the national release, shows that core inflation is still in negative territory. National summer wage negotiations point to negative wage growth next year, making a revival of domestically generated inflation a remote event without an easing of financial conditions (Chart I-12). Additionally, the recent rollover in the leading diffusion index suggests the economic upswing may already be fading (Chart I-13). Continued BoJ support and higher inflation expectations would hurt Japanese real yields and handicap the yen. Chart I-12...But That Will Also Require Easy Monetary##br## And Financial Conditions Chart I-13A Slowdown ##br##In Japan The recent upswing in global bond yields is thus likely to continue to weigh on the yen, leading to a higher USD/JPY. As this week illustrated, rising global yields are forcing the BoJ to increase its amount of JGB purchases to cap the upside in Japanese 10-year yields. Tactically, USD/JPY has been in an upswing, but has hit an important resistance close to 114.5. A few more days of weakness could ensue, but such weakness should be used by investors to sell the yen. Bottom Line: Abe's political problems do not represent the end of Abenomics. Instead, they illustrate the Japanese public's lack of appetite toward abandoning Japan's post-war pacifism. If Abe is serious about holding a referendum on this topic, he will have to support growth going forward - which implies higher fiscal stimulus and inflation expectations. Meanwhile, the absence of inflation in Japan continues to hamstring the BoJ in keeping policy extremely supportive, limiting the upside to nominal interest rates across the Japanese yield curve. Real rate differentials will continue to support USD/JPY. Use any weakness in this pair to buy the dollar versus the yen. Canada: Poloz Delivers The Bank of Canada on Wednesday increased interest rates by 25 basis points to 0.75%, the first central bank to follow the Fed's lead. Our analysis two weeks ago suggested that the BoC was faced with some of the most supportive conditions in the world to follow the Fed's path.2 More interesting than the decision itself was the accompanying quarterly Monetary Policy Report. In the report, the BoC moved forward its estimation of the closure of the output gap from 2018 to 2017. Additionally, despite expecting a slowdown in household consumption in 2018, the BoC upgraded its GDP forecast by 0.2% in 2017 and 0.1% in 2018, to 2.8% and 2%, respectively. Obviously, the market took note of these views, with USD/CAD falling three big figures on the news. The tone of the report was quite bullish on the Canadian economy, highlighting robust as well as broad-based growth and increasing signs of vanishing slack. In fact, the message reiterated that of the summer Business Outlook Survey, which showed strong growth, growing difficulty meeting demand, and growing and intensifying labor shortages (Chart I-14). As a result, the BoC expects the weak Canadian CPI to rebound, after the transitory effects of low food inflation, automobile rebates, and Ontario's electricity subsidies dissipate. We are inclined to agree with this assessment. At 2% per annum, Canadian employment growth is robust and the unemployment rate has fallen significantly. Now that oil prices have stabilized, employment is improving, suggesting that even the weakest regions of the economy are participating in the party. Additionally, our Canadian economic diffusion index - based on retail trade, manufacturing sales, building permits and employment data in the 10 provinces - has sharply accelerated, pointing to a continued rise in GDP growth (Chart I-15). Chart I-14Canada Is Booming And Slack Is Shrinking Chart I-15Strong Data Across The Board USD/CAD continues to trade at a discount to real interest rate differentials, signaling further upside on the CAD. Also, while investors have begun to curtail their shorts on the loonie, there do remain enough stale shorts for the CAD advance to persevere. We continue to prefer playing the CAD's strength on its crosses such as versus the AUD and the EUR, as the risk profile seems cleaner on these pairs than versus the USD. Short EUR/CAD looks particularly attractive. Our long CAD/NOK trade is near its target, and we are closing this position. Bottom Line: The Bank of Canada has not only hiked rates, but it has also highlighted that the Canadian economy is strong and inching closer to full capacity. The market has taken note, with the loonie rallying violently. The CAD has more upside going forward, especially against the euro and the AUD. We are booking profits on our long CAD/NOK position. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see European Investment Strategy Special Report titled, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 2 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 Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The greenback has largely been flat this week, despite Yellen's statements regarding rate hikes and balance sheet normalization at her Congressional Testimony, even if, 10-year yields went down. U.S. economic data has a soft tone: NFIB Business Optimism Index came in lower than expected at 103.6, reflecting broad-based softness in the details of the survey; JOLTS job openings also came in lower than expected at 5.666 mn; Initial jobless claims underperformed expectations, coming in at 247,000; Additionally, continuing jobless claims were higher than expected at 1.945 mn. While data remains mixed, the Fed is still intent on tightening policy. The dollar will follow suit, especially if inflation moves as the Fed expects. 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 Data out of Europe this week was reasonably strong: Both exports and imports increased at a 1.4% and 1.2% monthly pace, respectively; The current account beat expectations; Industrial production increased by 4%, more than the expected 3.6%; However, despite this upbeat data, the euro remained largely flat this week. This behavior is justified from a technical perspective: the RSI is close to overbought levels; the MACD line is rolling over and closing the gap with the signal line; the number of speculators with long positions is at its highest level ever. The considerable weakness in EUR/SEK and EUR/NOK on Thursday shows underlying weakness in the euro. This decreases the likelihood that EUR/USD breaches the 1.15-1.16 zone. 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 Recent data in Japan has been mixed: Labor cash earnings yearly growth outperformed expectations and grew from last month, coming in at 0.7%. However, machinery orders yearly growth was far below expectations, coming in at 0.6%. In spite of the selloff in the dollar, USD/JPY has rallied by more than 1% since last week, stopping its ascent after hitting a key technical level at 114.5. We continue to be yen bears, even in the face of the declining popularity of Shinzo Abe: the champion for expansionary fiscal policy in Japan. Instead, we are confident that Abe will double down on fiscal spending as his decline in popularity has been precisely because he has strayed away from this key policy pillar which made him so popular. 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 Recent data in the U.K. has been mixed: Halifax House prices grew by only 2.6% YoY, underperforming expectations of 3.1%. Industrial Production contracted by 0.2% year-on-year, also underperforming expectations. While the unemployment rate decreased, coming in at 4.5% and also beating expectations, average earning growth fell to 1.8%. After appreciating by almost 2% this week, and reaching 0.895, EUR/GBP has come down to 0.885, but the pound is likely to have short term downside against the euro. Furthermore, GBP/USD is also likely to have downside, as the pound is not as attractive as it was in the beginning of the year from a valuation standpoint. Indeed, sentiment has turned much more positive on the outcome of Brexit, which means that the significant discount in the pound has disappeared. 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 The AUD has seen a broad-based increase this week, except for against the CAD. This increase has largely been a factor of Chinese data, although domestic conditions also played a role: Chinese exports and imports both increased at a 11.3% and 17.2% annual pace, respectively; China's trade balance in June was USD 42.77 bn, better than expected; Chinese new loans came in at RMB 1,540 bn; NAB Business Conditions and Confidence both beat expectations; However, investment lending for homes is still contracting at 1.4%, albeit at a lesser than expected pace of 2.3%; Also, home loans are increasing at a lesser than expected pace of 1%. We retain our view of the inherent weakness in the Australian economy, which will restrict the RBA from changing its view. This will weigh 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 AUD/NZD has rallied by almost 1.3% since last week. This in part, was the market reaction to an approved housing infrastructure fund by Prime Minister Bill English worth NZ$1 Billion aimed at increasing the supply of housing in the country. This measure provides the RBNZ with some breathing room, as it is a policy aimed at cooling housing market, which has prices growing at a 14% rate. The increase in housing supply alleviates the pent up demand generated by the dramatic increase in population in New Zealand in recent years. The RBNZ is unlikely to join the BoC and the Fed this year, as they remain cautious, and have opted for macro prudential measures to eliminate any imbalances in the economy. Stay short the NZD against the dollar and the yen. 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 Canada followed the footsteps of its partner in the south, joining the U.S. as the only two central banks in the G10 space raising interest rates. The Bank of Canada highlighted that "the adjustment to lower oil prices is largely complete" and that "both the goods and services sectors are expanding". Alberta's economy validates this stance as all sectors of the economy are growing at a very brisk pace. The BoC estimates that the output gap will now close at the end of 2017, instead of the previous forecast of the first half of 2018, further escalating their hawkish rhetoric. The press release noted that the recent restrain in inflationary pressures will be transitory, as "excess capacity is absorbed". Recent data corroborates this view with strong employment data and stronger than expected housing starts. USD/CAD declined 1.3% at the end of the day of the hike, and outperformed all other currencies. 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 mixed: Unemployment remains very low, coming in at 3.2% However, producer and import prices contracted by 0.1% year-on-year, coming below expectations and decreasing from the previous month. The low unemployment number is not the only indicator that shows a tight labor market, as employment is also growing at an astonishing 5% yearly rate. However, this tightness in the labor market is not translating to higher wages, as wages are growing at a paltry 0.6%, anchored by strong deflationary forces. Thus, the SNB will continue with their ultra-dovish monetary policy and with their interventions in the currency market. Nevertheless, we will monitor if the recent plunge in the CHF against the euro creates any kind of inflationary dynamics in the economy, and causes the SNB to rethink their stance. 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 in Norway has been mixed: Manufacturing output contracted by 0.3%, falling sharply from last month number. Additionally, although both core and headline inflation came above expectations at 1.6% and 1.9% respectively, they still fell from last month reading. The Krone has appreciated sharply the past week, with USD/NOK falling by 1.45% and EUR/NOK falling by 1.15%. This has been a result of the rebound in oil prices caused by the massive draws in inventories the past couple of weeks. Indeed, last week's number, which showed an inventory draw of 7.6 million barrels was the biggest since 2011. Overall, we expect that OPEC should be able to continue managing supply, and therefore, oil should rise until the end of the year. This will be negative for EUR/NOK. 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 The Riksbank's change in rhetoric was perfectly timed, as Sweden's economy is increasingly showing signs of strength. Data has outperformed these past two weeks: Manufacturing PMI came in at 62.4, beating expectations of 59.8; Industrial production increased at a 8% annual pace in May; Inflation in Sweden is firming, coming in at 1.7% in June and beating expectations. The SEK appreciated 0.7% against EUR, and 0.6% against USD. Markets are pricing in stronger growth and a further escalation of hawkish rhetoric from the central bank, especially as Stefan Ingves as tabulated to leave this Riksbank in a few months. Part of the reason for Sweden's strength is also a stronger European economy. With Germany leading the pack, Sweden's largest export partner is also lifting the largest Scandinavian economy. 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
Highlights Coordinated Hawkishness: Central bankers are in the process of taking back the easier monetary policy that followed the deflationary 2014/15 oil shock. Bond yields still have more upside to catch up to the solid pace of global growth and diminishing economic slack. Maintain a below-benchmark stance on overall portfolio duration. ECB Taper Tantrum: The recent European bond sell-off is following a similar pattern to both the 2013 Fed Taper Tantrum and the 2015 Bund Tantrum, suggesting a potential target of 1% on the benchmark 10-year German Bund yield by year-end. Stay underweight Euro Area government bonds. Canada: With the Canadian economy looking very strong, and with the Bank of Canada signaling a desire to begin normalizing monetary policy, the current underperformance of Canadian government bonds will continue. We are maintaining our tactical bearish positions on Canadian bonds, and are also adding a new strategic underweight position (2 out of 5) in our model bond portfolio. Feature A Regime Shift, Not A Regime Change Interest rate risk has returned with a vengeance in global fixed income markets over the past couple of weeks. A string of relatively hawkish policymaker comments has triggered a quick and sharp bond sell-off, as investors reprice the odds of what is looking now like a coordinated recalibration of global monetary policies. Longer-dated bonds have gotten pummeled as yield curves have bear-steepened in most countries, with 30-year government bond prices falling between -5% and -7% in a matter of days (Chart of the Week). With global growth looking very strong at the moment, policymakers are being forced to respond by looking to unwind some of the easing that took place after the crash in oil prices in 2014/15. With that deflation scare now firmly in the rearview mirror, central bankers are having to signal a move away from the emergency stimulus from 2015. The rapid yield responses seen so far suggest that the communication of that subtle policy shift - becoming "less dovish" rather than "more hawkish" - must be handled delicately, or else financial markets may riot and possibly short-circuit the current economic upturn. This yield surge has done very little to dampen investor enthusiasm for risk assets, so far. Equity prices and corporate credit spreads, both in the developed world and emerging markets (EM), have only moved modestly despite the large move in government bond yields (Chart 2). This suggests that the latter was most mispriced compared to the current solid pace of global economic growth. Chart of the WeekA Painful Repricing Chart 2Risk Assets Remain Unfazed With the benefit of hindsight, it now appears that the decline in global bond yields in the spring was an outsized response to a few below-consensus data prints on U.S. economic growth and inflation. Importantly, the numbers in the U.S. are starting to improve again, as indicated by the strong jump in the ISM indices and employment (+220k) in June. Many of our most reliable leading indicators and models are all pointing to further acceleration in U.S. growth in the next few quarters (Chart 3). The U.S. inflation data continues to disappoint, both in terms of price indices and wage growth. Growth in Average Hourly Earnings has drifted lower since the most recent peak, while core PCE inflation is only 1.4%. The latest commentary from the Fed, including the minutes from the June FOMC meeting released last week, suggests that this downdraft in inflation should prove to be temporary and stronger growth should lead to faster inflation. We would agree with that assessment. The U.S. unemployment rate at 4.4% remains below most measures of full employment, while other reliable indicators of labor market tightness, such as the spread between the "jobs plentiful" and "jobs hard to get" components of the U.S. consumer confidence report, are also pointing to an eventual reacceleration of wages (Chart 4, top panel). Meanwhile, the Cleveland Fed Median CPI is hovering around 2.5%, well above the current 5-year/5-year forward cost of inflation compensation embedded in U.S. TIPS prices of 1.83% (middle panel). Furthermore, the Phillips Curve based core PCE inflation model developed by our colleagues at U.S. Bond Strategy is signaling a rebound of core PCE inflation back above 1.9% by year-end, in a scenario of no change in the unemployment rate or U.S. dollar from current levels (bottom panel). Chart 3U.S. Growth Will Rebound Chart 4U.S. Inflation Will Rise Our base case scenario for the Fed is that additional tightening will come in 2017. First through an announcement on starting the process of reducing the Fed's balance sheet, through "tapering" the reinvestment of proceeds from maturing bonds held by the Fed, at the September FOMC meeting. After that, the next rate hike will not be until December. This will allow the Fed to see more inflation prints to confirm its own expectation that inflation will soon rebound before delivering more policy tightening. Of course, if the next couple of inflation releases surprise to the upside, then perhaps a rate hike is possible at the September meeting alongside the announcement on the Fed's balance sheet (which is basically a done deal, at this point). For now, we see the Fed staying cautious, especially given the increasing number of FOMC members who are becoming concerned with the lack of U.S. inflation, according to the June minutes. As for the other major developed economy central banks, this "old-school" cyclical upturn is boosting both capacity utilization and pipeline inflation (Chart 5). Combined with the other measures that have been showing diminished economic slack, like unemployment rates and output gaps, this will give policymakers confidence in their own medium-term growth and inflation forecasts. This will also embolden central bankers to remove some policy accommodation. Our own Central Bank Monitors are indicating a need for tighter monetary policy in every major developed economy except Japan. That is confirmed by Taylor Rule estimates for interest rates. In Chart 6, we present simple Taylor Rule projections for the policy rate in the U.S., Euro Area, U.K., Japan, Canada and Australia. The formula takes potential GDP growth (OECD estimates) and then adds current realized inflation, ½ of the deviation of inflation from the central bank target and ½ of the output gap.1 We also show projections for the Taylor Rule over the next two years, using individual central bank forecasts for inflation and IMF projections for potential growth and the output gap. We then compare those Taylor Rule forecasts with the rate expectations priced into Overnight Index Swap (OIS) curves. Chart 5An "Old-School" Cyclical Upturn Chart 6Rates Too Low, According To The Taylor Rule The first point to note is that policy rates are below the Taylor Rule "equilibrium" level everywhere except Japan, where the 0% interest rate looks appropriate given the lack of actual inflation. Secondly, the Taylor Rule rates are projected to rise in the U.S., Euro Area, Japan and Canada, while remaining around current levels in the U.K. and Australia. Thirdly, the projected rates using Taylor Rule estimates are well above the current path of rates discounted in OIS curves. We do not expect central banks to deliver anywhere near the amount of tightening suggested by these simple Taylor Rules over the next couple of years. Policymakers will likely tolerate some degree of higher realized inflation to ensure that inflation expectations can return to, and sustainably stay at, central bank target levels. This means keeping interest rates below equilibrium levels for as long as possible. However, if central banks believe their own current inflation forecasts (which we have used in our Taylor Rule estimates), then policy rates do have room to move higher without becoming restrictive (i.e. above the Taylor Rule estimates). The markets clearly disagree with these Taylor Rule projections, with much lower OIS rates expected in the next few years. The markets may turn out to be correct. At the moment, however, the gap between the Taylor Rule rate forecasts and market pricing is too large, which suggests there is additional scope for bond yields to rise. Even if central banks ignore their own forecasts of higher inflation and keep rates on hold, this will put upward pressure on bond yields via higher inflation expectations. In other words, the path of least resistance for bond yields is up - at least until there is a major financial market event, like a big pullback in equity prices or widening of corporate bond spreads. Yet until there is evidence that global growth is rolling over and decelerating, a "risk-off" event like that is unlikely. Investors should maintain below-benchmark duration exposure, and overweight allocations of corporate debt to government bonds, in the next 3-6 months. Watch the path of leading economic indicators before looking to reverse those positions. Bottom Line: Central bankers are in the process of taking back the easier monetary policy that followed the deflationary 2014/15 oil shock. Bond yields still have more upside to catch up to the solid pace of global growth and diminishing economic slack. If It Walks Like A Tantrum And Talks Like A Tantrum ... The spike in Euro Area bond yields since June 26th has raised concerns that another bond "tantrum" is unfolding, similar to U.S. Treasury sell-off in 2013 and the German Bund sell-off in 2015. In both cases, bond yields jumped rapidly as investors repriced the outlook for central bank policy. The recent comments from the European Central Bank (ECB) are signaling that a change in its asset purchase program, which is set to end on December 31st, is highly likely and were the trigger for the backup in European yields. We have already shown in previous reports how the benchmark 10-year German Bund yield has been following the same directional path as the 10-year U.S. Treasury yield in the months leading up to the 2013 Taper Tantrum.2 We benchmarked the two markets for the peak in our Months-to-Hike indicator for the timing of the first rate hike priced into OIS curves. In Chart 7, we show the same comparison for the various slopes of yield curves for U.S. Treasuries and German government bonds. Again, the German curve is following the Fed Taper Tantrum experience, which implies more bear-steepening pressure on yields over the rest of 2017. In Chart 8, we show a similar "cycle-on-cycle" comparison of German bonds today compared to the spring of 2015 during the Bund Tantrum episode. That sell-off took place over a much shorter time horizon than the U.S. Taper Tantrum, with the entire sell-off condensed to just over a month. The current backup in German yields looks to be following a similar pattern to the Bund Tantrum, suggesting that this move could take the benchmark 10-year yield back to 1% before it is done. Chart 7Taper Tantrum 2.0?... Chart 8...or Bund Tantrum 2.0? There are major differences between today and the 2015 episode - European economic growth is much faster, the output gap is narrower, and realized inflation is higher than it was two years ago (bottom two panels). The 2015 Tantrum was triggered by two events: a rise in European inflation back above 0% that led to a (misguided) belief among investors that the ECB, which had just started its asset purchase program, would quickly look to exit that program; a massive unwind of long positions in core European bond markets, made worse as speculators who were betting on a reversal of the initial jump in Bund yields got stopped out as yields continued to climb. Roll the tape to 2017, and the growth and inflation backdrop is much different. Now, the ECB is indeed talking openly about exiting/tapering its asset purchase program, supported by a solid European growth backdrop. There is likely less speculative positioning in European markets given the painful experience of the Bund Tantrum. However, with the ECB now owning significant shares of European bonds after two years of steady buying, the potential for a jump in yields driven by less-liquid markets may still be there. Net-net, the current Bund sell-off has additional upside when compared to the previous Tantrums, suggesting the Bund yield could rise to 1% before this move is done. Watch the performance of European equities and the euro for signs that the pain trade in Bunds could stall before 1%. If equities break lower or the Euro breaks higher (or both), the ECB commentary about the timing of a taper could take a more dovish turn. This is not our base case, though. Bottom Line: The recent European bond sell-off is following a similar pattern to both the 2013 Fed Taper Tantrum and the 2015 Bund Tantrum, suggesting a potential target of 1% on the benchmark 10-year German Bund yield by year-end. Stay underweight European government bonds. Move To An Underweight Stance On Canada This week, the Bank of Canada (BoC) meets to determine the next move for Canadian monetary policy. For the first time since 2010, that move will likely be a rate hike. The Canadian economy is booming, and the strength is starting to bump up against capacity constraints. The strong performance of real GDP growth in Q1 (+3%) looks to be followed up by a similar growth rate in Q2. The BoC's latest 2017 Business Outlook Survey made for great summer reading, as expectations for sales, capital spending and employment all remained quite strong (Chart 9). Firms were reporting that an increasing share of capital spending intentions were for the purposes of increasing capacity to accommodate stronger demand, a sign that Canadian businesses are becoming more optimistic that the economic upturn is sustainable. Hiring intentions hit the highest level ever recorded in the Survey, with firms also reporting an increase in employment to meet up with stronger demand. Current Canadian inflation rates remain subdued, but a pickup in output prices is expected over the next 12 months according to the Business Outlook Survey (bottom panel). A net positive number of respondents reported capacity constraints and labor shortages for the first time in the three years that those questions have been asked as part of the Survey. The BoC's growth forecasts are clearly too low and will likely be revised upward at this week's policy meeting, when a new Monetary Policy Report will be presented. This will likely be the reason for a rate hike to either be delivered this week, or strongly hinted at for the next policy meeting. Given the recent comments from BoC Governor Stephen Poloz and other BoC officials discussing the improving health of the economy and the need to "take back" the 50bps of rate cuts in 2015 as oil prices were collapsing, a rate hike is the more likely outcome this week. Already, the markets have moved to price in a more hawkish BoC, with a full 75bps of hikes expected over the next 12 months. This has helped out bearish Canadian rates trades in our Tactical Overlay Portfolio (see Page 15 and Chart 10), which were positions that benefitted from a stronger Canadian economy and more hawkish BoC. With Canadian policy rates still well below equilibrium (see our Taylor Rule estimates shown earlier), and with leading economic indicators still pointing towards accelerating Canadian economic growth in the coming quarters, the case for the BoC to leave rates at these current depressed levels is not a strong one. Chart 9A Robust Canadian##BR##Growth Upturn Chart 10Sticking With Our Winning##BR##Tactical Canadian Trades We see the recent underperformance of Canadian government bonds as the start of a more prolonged trend, thus we are opening up a new strategic position in our model bond portfolio: cutting our Canada country allocation to underweight (2 out of 5). As Canada is only a small part of our benchmark index (only 1%), we are increasing our U.S. exposure as an offset to our lower Canadian weighting. This will not change our below-benchmark allocation to U.S. Treasuries, while making our new position a more explicit bet on additional widening of the Canada-U.S. bond spread. Chart 11Canada Rates Strategy Summary:##BR##Move To Underweight If the economy improves enough to continue absorbing economic slack and put upward pressure on inflation, both realized and expected, then the potential for higher Canadian yields and a flatter Canadian curve - as the BoC becomes even more hawkish - will also increase (Chart 11). One huge caveat to this trade is the state of the Canadian housing market. Even a small move in policy interest rates could have a huge impact on the demand for Canadian housing and the health of Canadian household finances. A recent private-sector survey showed that 70% of Canadian homeowners could not manage even a 10% rise in their interest payments.3 Given the extreme valuations in the Canadian housing market, and some of the recent macro-prudential measures taken to deter speculation in the booming Vancouver and Toronto markets, there is potential for a larger housing downturn after a few BoC rate hikes. This will not prevent the BoC from normalizing rates, but if the housing market responds poorly and there is a spillover into concerns about the state of Canadian banks, then any backup in Canadian bond yields will be short-lived. This is a risk and not our base case over the next year, however. Bottom Line: With the Canadian economy looking very strong, and with the Bank of Canada signaling a desire to begin normalizing monetary policy, the current underperformance of Canadian government bonds will continue. We are maintaining our tactical bearish positions on Canadian bonds, and are also adding a new strategic underweight position (2 out of 5) in our model bond portfolio. Tactical Trade Update We have been recommending a position in our Tactical Overlay Table since March to position for additional Fed rate hikes, shorting the January 2018 fed funds futures contract. That contract is now priced for the fed funds rate to increase 15bps between now and the end of the year. Given that even an optimistic economic scenario would likely only result in one more 25bp increase in the funds rate by year-end, there is no longer much potential for further gains in this trade. We are closing the position this week, taking a tiny profit of +1bp. Chart 12Roll Our Short Fed Funds##BR##Futures Trade To July 2018 Looking further out, we now see an attractive new opportunity to short the July 2018 fed funds futures contract. That contract is currently priced for only 32bps of rate hikes between now and next June (Chart 12), and would therefore turn a profit in the event of two or more rate hikes during that timeframe. We are opening the new trade today, shorting the July 2018 contract. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 We show the inflation gap as the difference between realized inflation and the inflation target, using the actual inflation rate that the central bank is targeting. This could be headline inflation, as in the U.S. and Euro Area, or core inflation, as in Japan. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Central Banks Are Now Playing Catch-Up", dated July 4 2017, available at gfis.bcaresearch.com. 3 http://www.newswire.ca/news-releases/the-debt-truth-unexpected-expenses-could-spell-big-trouble-for-millennial-homeowners-623825354.html Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
Highlights Duration: Investor optimism about U.S. growth and inflation will return in the coming months. Remain at below-benchmark duration and enter a short position in the July fed funds futures contract. Close short positions in the January contract for a small gain. Credit Spreads: Spreads are at risk of widening as Fed rate hike expectations ramp up in the second half of the year, though we would be inclined to view a Fed-driven back-up in spreads as a buying opportunity. Bank Bonds: Banks continue to shore up their balance sheets and are likely to see rising profits in the coming months. Bank bonds also offer a spread advantage compared to other similarly risky sectors. Feature Chart 1Synchronized Global Selloff The bond selloff is now two weeks old. What began as a reaction to perceived hawkish policy shifts from central banks outside of the U.S. - the European Central Bank in particular - is now morphing into a selloff built on optimism about U.S. growth. Needless to say, we think the recent bearish price action has further to run. Global participation makes it more likely that the weakness in U.S. Treasuries will persist because it prevents the dollar from strengthening as yields move higher (Chart 1). In recent years, most U.S. bond selloffs have been met with an appreciating exchange rate. The stronger dollar then caused investors to lower their U.S. growth expectations, and capped the upside in yields. We view the dollar's current stability as a bearish signal for U.S. bonds. But it has not just been non-U.S. factors driving the uptrend in yields. Last week's positive ISM and employment figures are ushering in renewed optimism about U.S. growth. We also think that U.S. growth is poised to bounce back in the second half of the year, and the Fed is inclined to agree. The Fed's median projection calls for one more 25 basis point rate hike before the end of the year, and we also expect the committee to announce the run-off of the balance sheet in September. With the market still only priced for 15 bps of hikes between now and year-end, there remains scope for further upside surprises. Of course, this forecast for balance sheet run-off in September and another rate hike in December hinges on a second-half snapback in growth, continued strength in labor markets and a rebound in core inflation. Growth Is On The Way Although GDP growth averaged just 1.75% during past two quarters, all signs suggest that the next two quarters will be much stronger. As was mentioned above, both the manufacturing and non-manufacturing ISM surveys delivered strong readings in June. The manufacturing ISM came in at 57.8 and the non-manufacturing survey came in at 57.4, both signal stronger GDP growth in the coming months (Chart 2). The crucial new orders-to-inventories figure calculated from the manufacturing survey is also displaying remarkable strength (Chart 2, bottom panel). We can also infer the current trend in growth from the employment and productivity data. In fact, aggregate hours worked - a combination of total employment and average weekly hours - plus labor productivity growth is more or less equivalent to GDP (Chart 3). After last week's payrolls report, aggregate hours worked are now growing at 1.99% year-over-year. If we combine that growth rate with quarterly productivity growth of 0.7%, the average since 2012, we get a tracking estimate of just below 2.7% for GDP growth. The Atlanta Fed's GDPNow model also currently expects that second quarter growth will be 2.7%. Chart 2PMIs Point To Stronger Growth... Chart 3...As Does The Labor Market Labor Markets: Watching The Participation Rate Last week's jobs report showed that the economy added 222k jobs in June, and that the prior two months were also revised higher. This pushed the 3-month moving average up to +180k jobs per month, right in line with the +187k jobs per month averaged in 2016. However, despite robust payroll gains, the unemployment rate actually ticked higher in June. This is because many previously sidelined workers re-entered the labor force, pushing the labor force participation rate up to 62.8%. Going forward, for the Fed to have confidence that wage growth and inflation will continue to rise, the unemployment rate will have to remain under downward pressure (Chart 4). As long as the labor force participation rate remains flat (or declines) this should be relatively easy to achieve. We calculate that the economy needs to add just above 117k jobs per month for the unemployment rate to continue falling. However, if we assume a higher labor force participation rate of 63.2%, we would need to add 195k jobs per month, a much higher hurdle.1 We detailed the main drivers of the labor force participation rate in a recent report,2 and while we do not see much potential for a significant increase in the participation rate, its trend is critical for the monetary policy outlook and should be monitored closely going forward. Inflation: Is The Fed Too Sanguine? The most important question for policymakers is whether inflation will rebound in the second half of the year. While the Fed will probably start winding down its balance sheet in September no matter what, another rate hike in December is likely contingent on core inflation showing some signs of strength in the next few months. We have previously written3 that if the Fed were to proceed with a December rate hike in the face of low and falling inflation, the market would start to price in a "policy mistake" scenario. The yield curve would flatten, credit spreads would widen, TIPS breakevens would narrow and long-dated Treasury yields could even decline. However, we do expect that core inflation will trend higher in the coming months, mostly driven by strength in the core services (excluding shelter and medical care) component. That component is historically the most sensitive to tight labor markets and rising wage growth (Chart 5). Chart 4Falling Unemployment Rate = ##br##Rising Inflation Chart 5A Boost From Import##br## Prices Is Coming Although it is unlikely to be a long-run driver of inflation, the core goods component also has some upside in the coming months in response to recent dollar weakness and rising non-oil import prices (Chart 5, bottom 2 panels). Investment Strategy Chart 6Too Few Hikes In The Price We think U.S. growth and inflation are poised to snap back during the second half of the year, probably by enough for the Fed to deliver another hike before year-end. We therefore continue to recommend that investors maintain below-benchmark portfolio duration. We have also been advising clients to hold short positions in the January 2018 fed funds futures contract since March 21.4 That contract is now priced for the fed funds rate to increase 15 bps between now and the end of the year. Given that even an optimistic economic scenario would likely only result in a 25 bps increase in the funds rate, there is not much potential for further gains in this trade. We close this position, booking a small profit of +1 bp. Looking further out, we now see an attractive opportunity to short the July 2018 fed funds futures contract. That contract is currently priced for 32 bps of rate hikes between now and next June (Chart 6), and would therefore turn a profit in the event of two or more rate hikes during that timeframe. Bottom Line: Investor optimism about U.S. growth and inflation will return in the coming months. Remain at below-benchmark duration and enter a short position in the July fed funds futures contract. Close short positions in the January contract for a small gain. Credit Spreads: When Good News Is Bad News Chart 7High Risk Of A Near-Term Selloff Renewed optimism on U.S. growth and inflation could ironically pose a problem for credit spreads, at least in the very short term. As we have often discussed in the context of our Fed Policy Loop,5 hawkish shifts in Fed policy tend to result in wider credit spreads and tighter financial conditions more broadly. Fortunately, these periods are usually short lived. Once financial conditions tighten, the Fed backs away from its hawkish stance, allowing financial conditions to ease once again. An extreme example of this dynamic is the 2014/15 selloff in credit markets. Of course, the plunge in oil prices and related stress in the energy sector was the chief catalyst, but what is often overlooked is that Fed rate hike expectations were also quite elevated during that period (Chart 7). It is the combination of stress in the energy sector and unsupportive Fed policy that resulted in the prolonged rise in spreads. A more benign example is the price action from this past March. Junk spreads widened from 344 bps on March 2 to 406 bps on March 22, as rate hike expectations ramped up heading into the March FOMC meeting. Ultimately, this period of spread widening represented a buying opportunity in credit markets. It is a March 2017 style selloff that we see as quite likely in the coming months as growth recovers by just enough to give the Fed cover for another rate increase. Bottom Line: Credit spreads are at risk of widening as Fed rate hike expectations ramp up in the second half of the year. But with inflation and inflation expectations still well below target, the Fed will ultimately be forced to remain supportive. We would therefore view any period of Fed-driven weakness in credit markets as a buying opportunity. Bank Bonds: Still A Strong Buy The Federal Reserve released the results of its annual bank stress tests last month and for once it did not object to the capital plans of any of the 34 participating bank holding companies, a recognition of the fact that banks have dramatically boosted their capital ratios since the first round of stress tests in 2009 (Chart 8). For the most part bank profit growth has also outpaced debt growth during this period, with the exception of last year when profit growth turned negative and debt growth surged (Chart 8, panel 2). A large portion of last year's increase in debt growth was likely a response to the new Total Loss Absorbing Capital (TLAC) regulations which require banks to issue a specified minimum amount of securities that can be easily written off in case of bankruptcy. This includes capital and long-term unsecured debt. Regardless, bank debt growth has already fallen back close to zero and we see upside for bank profits in the next 6-12 months. Meanwhile, non-financial corporate profits have had a much more difficult time outpacing debt growth in recent years (Chart 8, bottom panel). Bank Profits On The Rise A number of forward looking loan growth indicators suggest that credit and capital formation are on an upward trajectory (Chart 9). Our U.S. Equity Strategy service's proprietary Capex Indicator,6 consumer and business confidence, manufacturing new orders and our own C&I loan growth model all point to accelerating loan growth in the coming months. Net interest margins also have scope to widen. A recent blog post from the Federal Reserve Bank of New York7 showed that net interest margins are sensitive to both the level of interest rates and the slope of the yield curve (Chart 10). Lower rates and a flatter curve have both compressed margins in recent years. In addition, net interest margins tend to narrow when banks take less risk on the asset side of their balance sheets, we proxy this by showing banks' risk-weighted assets as a percent of total assets (Chart 10, bottom panel). Chart 8Bank Health Still Improving Chart 9Loan Growth Will Accelerate Chart 10A Higher, Steeper Curve Will Help NIMs Going forward, higher rates and a steeper yield curve8 will apply widening pressure to net interest margins. Similarly, risk-weighted assets have already risen considerably as a fraction of total assets and will increase further as the Fed starts to drain reserves from the banking system. Bank Bonds Are Still Cheap The truly remarkable thing is that even though banks have been raising capital while the non-financial sector has been taking on leverage, bank spreads still look attractive compared to most non-financial sectors after adjusting for credit rating and duration (Chart 11). This is true for both senior and subordinated bank debt. As can be seen in Chart 11, senior bank debt has a low duration-times-spread (DTS) compared to the overall index. This means that it acts as a "low-beta" sector, underperforming the investment grade benchmark during rallies and outperforming during selloffs. Conversely, subordinate bank bonds are a high-DTS sector. They tend to outperform during rallies and underperform during selloffs (Chart 12). Chart 11Corporate Sector Risk Vs. Reward* LegendCorporate Sector Abbreviations Chart 12Add "Beta" With Subordinate Bank Debt While we strongly recommend grabbing the extra spread available in both senior and subordinate bank debt relative to other similarly risky alternatives, subordinate bank bonds look particularly attractive in the current environment. This is because they both add some pro-cyclical risk ("beta") to a corporate bond portfolio and offer a spread advantage compared to other similarly risky bonds. Bottom Line: Banks continue to shore up their balance sheets and are also likely to see rising profits in the coming months. Meanwhile, bank bonds still offer a spread advantage compared to other similarly risky sectors. Remain overweight both senior and subordinate bank debt. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 These calculations assume population growth of 0.08% per month, or 1% per year. 2 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Equity Strategy Weekly Report, "Unfazed", dated June 12, 2017, available at uses.bcaresearch.com 7 http://libertystreeteconomics.newyorkfed.org/2017/06/low-interest-rates-and-bank-profits.html 8 For further details on the case for a bear-steepening yield curve please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Near record high levels for stocks are not an impediment to gains in the stock-to-bond ratio in the next 12 months. Minutes from June's FOMC meeting confirmed that policymakers agree that monetary policy should continue to normalize in the coming quarters. None of the main indicators that have provided some leading information in the past are warning of an equity bear market. Solid ISM and industrial production readings herald bullish profit growth in the second half the year. Treasury yields are headed higher in 2017, supporting our stocks over bond view. Within the U.S. bond market, we prefer short over long duration and investment-grade and high-yield bonds over high-quality debt; MBS will be hurt more than Treasuries as the Fed pares its balance sheet. Feature U.S. stocks will continue to reach all-time highs if inflation remains low, the economic backdrop fosters EPS growth and the Fed only gradually raises rates. We expect these conditions to stay in place in the second half of 2017 and into 2018, allowing stocks to outrun bonds. We note below that neither valuations nor technicals are flashing a red warning sign. Chart 1 shows that most of the time, even when equities are at record highs, valuations are above average (but not extreme) and the Fed is slowly removing accommodation, stocks can still rise. Moreover, none of the indicators that provided leading information in the past now warn of an equity bear market. Chart 1Macro Conditions Favorable For More Gains In Equities Chart 2Labor Market Strong But Wages Still Stagnant The June jobs report suggests that the environment of solid economic growth and still muted wage pressures remains in place, a positive backdrop for equity markets. The report showed that the economy added 222,000 jobs in June, well above the consensus forecast of 178,000. Prior months were also revised higher by 47,000 pushing the 3-month moving average up to 180,000 jobs per month. This is right in line with the 187,000 jobs per month averaged in 2016. Despite robust payroll gains, the unemployment rate actually ticked higher in June, from 4.3% to 4.4%, as previously sidelined workers were drawn back into the labor force. Meanwhile, wage growth continues to underwhelm, rising only 0.2% in June with the year-over-year growth rate holding steady at 2.5%. The deceleration in the 3 month change in average hourly earnings from 2.7% in December 2016 to 1.9% in June challenges the Fed's view on inflation (Chart 2). The recent moderation in wage growth is not yet severe enough to prevent the Fed from delivering one more rate hike before year-end. However, if the labor force participation rate continues to increase, and especially if this increase occurs alongside a rising unemployment rate, then the Fed's forecast of gradually accelerating wages will come into question. Fed Minutes: No Change To Our Base Case Minutes from June's FOMC meeting show that the debate among policymakers over monetary policy centers on the timing and pace of normalization in the coming quarters. The minutes did not provide any new insight about the Fed's plans to shrink its balance sheet. This will be done using caps on the monthly amount of principal repayments from the Fed's security holdings that will not be rolled over. These caps will rise over time on a pre-set path. The FOMC is still debating the timing of the start of this process. The FOMC was reasonably pleased with the tone of recent economic data, which support the view that GDP has bounced back from a soft patch in the first quarter. The June manufacturing and services ISM surveys, released since the FOMC meeting, undoubtedly reinforced policymakers' confidence in the underlying growth trajectory (see below for more details). The FOMC participants discussed at length the recent pullback in core measures of consumer price inflation. Most policymakers are willing for the time being to believe that inflation is driven primarily by temporary one-off factors. Others are worried that it will be more enduring. The moderation in three-month rates of change of prices this year was widespread across sectors of the CPI (i.e. it is not merely the result of one-offs). Inflation according to the Fed's favored measure, the core PCE price index, has also moderated this year although the disinflation has not been as broadly based as in the CPI (Chart 3). Much of the FOMC's debate focused on the relationship between labor market tightness and inflation. The doves want to see inflation rise closer to the 2% target before tightening even more. The hawks worry that the relationship could be non-linear, which means that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge in inflation. At a minimum, an undershoot could boost risks to financial stability by promoting excess risk-taking in the financial markets. The minutes reveal that the worries about the impact of easing financial conditions on financial stability have intensified since the start of the year. Inflation forecasting has been particularly tricky since the Great Recession for both the Fed and other economic prognosticators. Admittedly, it is difficult to explain the sudden and broadly-based inflation deceleration, even in sectors that have nothing to do with oil prices, shifts in the currency or wage growth. That said, the model shown in the top panel of Chart 4 suggests that core CPI inflation will edge higher in the coming months. This reflects the acceleration in ECI wage growth (feeding into higher core services inflation) and in core goods inflation (reflecting rising import prices), which more than offset the slight moderation in our projection for shelter inflation. Chart 3Inflation Readings Must##BR##Improve In Next Few Months Chart 4Core CPI Should Edge Higher##BR##In Coming Months Bottom Line: The minutes did not change our base case outlook; the FOMC will announce in September that it will begin to shrink the Fed's balance sheet shortly thereafter. The next rate hike will occur in December. Nonetheless, this forecast hangs importantly on the assumption that core inflation edges higher in the coming months. We think it will, but uncertainty is high. Monitoring The Bear Market Barometer The FOMC's seeming determination to stick with the current tightening timetable raises question marks over the equity market, especially given elevated valuations. Chart 5Equity Bear Market Indicators BCA's Chief Economist, Martin Barnes, highlighted the best "equity bear market" indicators to watch in a 2014 Special Report1. He noted that no two bear markets are the same and that there are no indicators that have reliably heralded bear phases. Nonetheless, there are some common elements. The safest time to invest in the market is when monetary conditions are favorable, there are no signs of a looming economic downturn, extreme overvaluation is not present and technical indicators are not flashing red. Some indicators related to each of these fundamental factors are shown in Chart 5: Monetary Conditions: The yield curve is flat by historical standards, but it is far from inverted. Moreover, real short-term interest rates are usually substantially higher than today, and above 2%, when bear markets commence. Excess liquidity, which we define as M2 growth less nominal GDP growth, is also well above the zero line, a threshold that in the past has warned of a downturn in stock prices. Valuation: Our composite valuation indicator is still shy of the +1 standard deviation level that defines over-valued. However, this is due to the components that compare equity prices to bond yields. The other three components of the equity indicator, which are unrelated to bond yields, suggest that stock valuation is stretched. Economic Outlook: Economic data, such as the leading economic indicator and ISM, have been unreliable bear market signals. We do not see anything that indicates that a recession is on the horizon. U.S. growth will remain above-trend in the second half of the year based on its relationship with financial conditions. Technical Conditions: Sentiment is elevated, which is bearish from a contrary perspective. However, breadth, the deviation from the 40- week moving average and our composite technical indicator, all are not flashing red. Earnings: Trends in earnings and margins did not provide any additional reliable signals for timing equity market downturns in the past. Still, it is a bad sign when EPS growth tops out. This is often preceded by a peak in industrial production growth. We expect EPS growth to continue to accelerate for at least a few more months, but we are closely watching industrial production. Bottom Line: The equity market is vulnerable to unforeseen shocks given stretched valuation. Nonetheless, none of the indicators that have provided leading information in the past warn of an equity bear market. ISM Above 50 Supports 2H Profit Outlook The elevated level of ISM sets the stage for EPS growth to gather speed in the second half of 2017. Industrial production is a good proxy for sales of S&P 500 companies (Chart 6). A rollover in the 12-month change in IP would challenge our view. However, strong readings on the ISM, which tracks IP, suggest that IP should accelerate in the next six months (Chart 6, panel 1). Chart 6Solid Backdrop For Earnings And Sales At 57.8 in June, the ISM has rebounded from the recent low of 47.9 in 2015. Investors wonder if it will roll over again or simply fluctuate at a high level. The leading components of ISM, including the new orders index and the new orders-to-inventory ratio, indicate that the ISM will remain above 50 in the months ahead (Chart 7). Moreover, the new export orders component of the ISM has also surged. The implication is that foreign demand (rather than domestic consumer or business spending) is leading the U.S. manufacturing sector. In fact, the 3- and 12-month change in the industrial production indices in advanced economies outside the U.S. have outpaced domestic growth (Chart 8). Chart 7IP Poised To Accelerate Chart 8U.S. IP Lagging Other Developed Markets Bottom Line: Firm readings on ISM are an indication that our bullish profit story for 2017 remains intact. Stay overweight stocks versus bonds. Inflection Point The increase in Treasury yields since late June indicates that growth expectations had become overly pessimistic. Our assessment is that U.S. growth will remain above trend for the rest of 2017. The implication for investors is that Treasury bond yields will move higher, the yield curve will bear-steepen, and that credit will outperform Treasuries in the second half of 2017. Moreover, we expect MBSs to underperform. According to our U.S. Bond Strategy service2, Treasury yields are poised to follow the economic surprise index higher in the coming months. Extreme net long positioning in the futures market supports the view. The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.52%. Our 3-factor version of the model, which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.45% (Chart 9). Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. Small positive excess returns, consistent with carry, remain the most likely scenario for investment- grade credit, where we recommend an overweight. We do not see the potential for much spread tightening from current levels. However, a large spread widening would be equally unlikely given the favorable backdrop of steady growth and muted inflation. We recommend an overweight in the high-yield market. We expect the decline in the 12-month trailing speculative default rate to continue for the rest of the year, aided by a moderation in energy sector defaults (Chart 10, bottom panel). This means that the current compensation offered by junk spreads in excess of expected default losses stands at 221 bps, in line with its historical average (Chart 10, panel 3). In last week's Weekly Report3 our U.S. Bond Strategy team showed that a default-adjusted spread of 221 bps is consistent with excess returns close to 150 bps during the next 12 months. Chart 9Treasury Fair Value Models Chart 10High-Yield Market Overview Our Energy Sector Strategy team stated in a Weekly Report4 last week that our base case of $50-$60/bbl WTI crude oil prices by the end of 2017 should keep high-yield energy spreads contained. We remain underweight MBSs. Nominal MBS spreads are already very tight compared with previous levels, and they appear even tighter relative to trends in net issuance. While refinancing activity will remain depressed, we see potential for option-adjusted spreads to follow net issuance higher, even as the compensation for prepayment risk (option cost) remains low. The Fed's exit from the MBS market, which could occur as early as September, represents an additional upside risk for spreads. Bottom Line: Rates have bounced up after undershooting between March and the end of June. Loftier inflation readings are needed to sustain the bounce. Higher rates in the rest of 2017 support our stocks-over-bond stance. Within the U.S. bond market, we favor short duration over long, and credit over high-quality. MBSs will be hurt more than Treasurys as the Fed begins to shrink its balance sheet. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA Special Report "Timing The Next Equity Bear Market, " dated January 24, 2014, available at bca.bcaresearch.com. 2 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Inflection Point", dated July 5, 2017, available at usbs.bcaresearch.com. 3 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com. 4 Please see Energy Sector Strategy Weekly Report, "HY Debt Update: Offshore Drilling & Transportation Getting Left Behind", dated July 5, 2017, available at nrg.bcaresearch.com.