Sweden
Highlights The real culprit for the mushrooming U.S./euro area trade imbalance is the ECB, and specifically its post-2014 experiment with ultra-loose monetary policy. There could be a major sea-change in ECB policy after November 2019 when Draghi's Presidency ends - just as there was after the last two changes in the ECB Presidency in November 2003 and November 2011. The yield spread between 30-year U.S. T-bonds and German bunds has much more scope to tighten than to widen. The euro's undervaluation - as calculated by the ECB itself - will ultimately correct. European exporters and equity markets heavily exposed to exporters - such as Sweden's OMX - will find the going tough, one way or another. If a stronger currency doesn't hit them, then President Trump surely will. Feature Chart of the WeekThe U.S./Euro Area Trade Imbalance Is A Near-Perfect Function Of Relative Monetary Policy Here in London last week President Trump trumpeted one of his biggest gripes: "The European Union treats the United States horribly. And that's going to change. And if it doesn't change, they're going to have to pay a very big price... Last year, we lost $151 billion with the European Union. We can't have that. We're not going to have that any longer, okay?" 1 President Trump is absolutely right about the size of the U.S. trade imbalance with Europe. But he is wrong to place the blame entirely on "trade barriers that are beyond belief". At least half of the imbalance - including with Germany - has appeared since 2014 (Chart I-2). Therefore, by definition, this part of the bilateral deficit is neither a structural issue, nor about trade barriers. Chart I-2Half of Germany's Export Surplus Appeared After 2014 The Real Culprit For The Mushrooming U.S/Euro Area Trade Imbalance As we have identified on these pages many times, the real culprit for the mushrooming U.S./euro area trade imbalance is the ECB, and specifically its post-2014 experiment with ultra-loose monetary policy. This experiment has resulted in a significantly undervalued euro, which has made the euro area grossly over-competitive vis-à-vis the United States, as calculated by the ECB itself. The Chart of the Week provides the damning and incontrovertible evidence: the U.S./euro area bilateral deficit is a near-perfect function of relative monetary policy. Of course, the ECB is targeting neither the euro nor the trade imbalance; the ECB is targeting its definition of price stability. The trouble is that the ECB definition of price stability omits owner-occupied housing costs, and thereby understates true euro area inflation by 0.5 per cent. To the extent that the ECB thinks in terms of real interest rates based on its own (faulty) definition of inflation, this means that the ECB is setting real interest rates that are far too low for the euro area's true economic fundamentals, resulting in the significantly undervalued euro and the associated trade imbalance (Chart I-3 and Chart I-4). Chart I-3Relative Monetary Policy Has Driven The Euro's Undervaluation... Chart I-4...And The Euro's Undervaluation Has Driven The U.S./Euro Area Trade Imbalance The bilateral deficit, by definition, is based on a true cross-border comparison, so it is tracking the 'apples for apples' real interest rate differential almost tick for tick, as our charts compellingly show. This true real interest rate differential is stretched relative to the fundamentals. In effect, while incorrectly measured inflation is deceiving the ECB, the mushrooming trade imbalance tells us that something is seriously awry. That something is not trade barriers that are too high; that something is ECB monetary policy that is too loose. The Target2 Imbalance Reaches €1.5 Trillion The ECB's ultra-loose policy has spawned another huge distortion: the euro area Target2 banking imbalance, which now amounts to an unprecedented €1.5 trillion (Chart I-5). What is the Target2 imbalance (Box 1), and why should we care about it anyway? Chart I-5ECB Policy Has Lifted The Target2 Banking Imbalance To Euro 1.5 Trillion BOX 1 What Is Target2? Target2 stands for Trans-European Automated Real-time Gross settlement Express Transfer system. It is the settlement system for euro payment flows between banks in the euro area. These payment flows result from trade or financial transactions such as deposit transfers, sales of financial assets or debt repayments. If the banking system in one member country has more payment inflows than outflows, its national central bank (NCB) accrues a Target2 asset vis-à-vis the ECB. Conversely, if the banking system has more outflows than inflows, the respective NCB accrues a Target2 liability vis-à-vis the ECB. Target2 balances therefore show the cumulative net payment flows within the euro area. The ECB has delegated its QE sovereign bond purchases to the respective national central banks within the Eurosystem. In the case of Italian bonds, Italian investors have offloaded their BTPs to the Bank of Italy and deposited the received cash cross-border in countries with healthier banking systems - like Germany. Strictly speaking, this flow of Italian investor cash to German banks is not the same as the deposit flight during the depths of the euro debt crisis in 2012. Rather, we might call it precautionary cash management. Nevertheless, in Eurosystem accounting terms it still means that the Bundesbank has a new liability to German banks denominated in 'German' euros, while the Bank of Italy has a new asset - the BTP - denominated in 'Italian' euros (Chart I-6 and Chart I-7). The Target2 imbalance is the aggregate of such mismatches between Eurosystem liabilities denominated in 'German and other core' euros and assets denominated in 'Italian and other periphery' euros. Chart I-6The Target2 Imbalance Reflects The##br## Cross-Border Flow Of Italian Investor Cash... Chart I-7...To German Banks Does any of this Target2 accounting gymnastics really matter? No, so long as a 'German' euro equals an 'Italian' euro, the imbalance is just an accounting identity within the Eurosystem. But if Germany and Italy started using different currencies, then suddenly all hell would break loose. The Bundesbank liability to German banks would be redenominated into deutschemarks, while the Bank of Italy asset would be redenominated into lira. Thereby the ECB would end up with much greater liabilities than assets, and a solvency shortfall potentially equivalent to hundreds of billions of euros would end up on the shoulders of the ECB's shareholders - largely, German taxpayers. Some people might argue that by increasing the cost of a divorce, an actual split becomes less likely. But this reasoning is weak. As we have seen in recent election and referendum outcomes, the biggest risk comes from a populist backlash against the status quo. And populist backlashes do not stop to do a detailed cost benefit analysis. A Sea-Change For The ECB In 2019? Although the ECB is unlikely to broadcast the undesired side-effects of its ultra-loose policy, it must by now be acutely aware that it is spawning huge imbalances. The costs are rising while the benefits are becoming questionable. The irony is that the one euro area economy that arguably does need stimulus - Italy - has a dysfunctional banking system which makes ultra-loose monetary policy largely ineffective anyway. Despite record low interest rates through the past four years, Italian bank credit growth has been virtually non-existent (Chart I-8). As we pointed out last week in Monetarists Vs Keynesians: The 21st Century Battle, the M5S/Lega coalition government is right to say: Italy would be better off with fiscal stimulus, not monetary stimulus.2 Chart I-8Italian Banks Have Not Been Lending The ECB will end its QE purchases at the end of this year, though the central bank has promised to maintain its current constellation of negative and zero interest rates "at least through the summer of 2019". However, it might be problematic to extend this forward guidance much beyond that. This is because Mario Draghi's eight year term as ECB President ends on October 31 2019, and it would be difficult both politically and operationally to tie the steering hands of his successor, especially if he/she comes from outside the current Governing Council. Interestingly, the last two changes in the ECB Presidency marked major sea-changes in policy direction: in 2003, Jean-Claude Trichet immediately stopped the rate cutting of his predecessor, Wim Duisenberg; and in 2011, Mario Draghi immediately reversed the rate hikes of his predecessor, Trichet. We would not bet against another major sea-change at the end of 2019 (Chart I-9). Chart I-9A Sea-Change For The ECB In 2019? If the end of 2019 does mark a turning point in relative monetary policy, investors should plan for three medium-term repercussions: The yield spread between 30-year U.S. T-bonds and German bunds has much more scope to tighten than to widen. The euro's undervaluation - as calculated by the ECB itself - will ultimately correct. European exporters and European equity markets heavily exposed to exporters - such as Sweden's OMX - will find the going tough, one way or another. If a stronger currency doesn't hit them, then President Trump's vow that "they're going to have to pay a very big price" surely will (Chart I-10). Chart I-10If A Stronger Currency Doesn't Hit European Exporters, Then President Trump Surely Will! 1 At the joint press conference with Theresa May. 2 Please see the European Investment Strategy Special Report 'Monetarists Vs Keynesians: The 21st Century Battle' July 12 2018 available at eis.bcaresearch.com. Fractal Trading Model* This week's recommended trade is to go long gold, whose 65-day fractal dimension is close to the lower bound that has reliably signaled previous tradeable trend reversals. Set a profit target of 3% with a symmetric stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 * 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 - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Global Inflation has upside on a cyclical basis, but this narrative is well known and investors have already placed their bets accordingly, buying inflation protection in a wide swath of markets. However, global growth has not yet found its footing, suggesting a mini-deflation scare, at least relative to expectations, is likely this summer. The U.S. dollar will benefit in such a scenario, and NOK/SEK will depreciate. While GBP/USD has downside, the pound should rally versus the euro. Weakness in EUR/CAD has not yet fully played out; the recent bout of strength was only a countertrend move. Feature Inflation is coming back, and this will obviously have major consequences for both asset and currency markets. However, macro investing is not just about forecasting fundamentals correctly; often, just as importantly, it is about understanding how other investors have priced in these expected economic developments. Therein lies the problem. While we understand why inflation could pick up, so too have most investors, and they have positioned themselves accordingly. With global growth currently looking shaky, we believe a better entry point for long-inflation plays will emerge in the coming months. In the meanwhile, a defensive, pro-U.S. dollar posture still makes sense. Investors Are Long Inflation Bets We have long argued that inflation was likely to make a cyclical comeback, a return that would begin in the U.S. before spreading to the rest of the globe. This story is currently playing out. However, in response these developments, investors have placed their bets accordingly, and the story currently seems well baked in. Prices of assets traditionally levered to inflation have already moved to discount a significant pick-up in inflation. The most evident dynamics can be observed in the U.S. inflation breakevens. Both the 10-year breakevens as well as the 5-year/5-year forward breakevens just experienced some of their sharpest two-year changes of the past 20 years, notwithstanding the pricing out of a post-Lehman, depression-like outcome (Chart I-1). Breakevens are not alone. Other assets have displayed similar behavior. In the U.S., investors have aggressively sold their holdings of utilities stocks, which have been greatly outperformed by industrial stocks. Traditionally, investors lift the price of XLI relative to that of XLU when they anticipate global inflation to pick up (Chart I-2). Chart I-1Markets Are Positioning Themselves##br## For Higher Inflation Chart I-2U.S. Sectoral Performance Suggests Investors ##br##Have Already Bet On Higher Inflation... It is not just intra-equity market dynamics that support this assertion. The behavior of the U.S. stock market relative to Treasurys further buttresses the idea that investors have already aggressively discounted an upturn in global consumer prices (Chart I-3). Potentially, the best illustration of investors' preference for inflation protection is currently visible in EM assets. A seemingly paradoxical phenomenon has been puzzling us: How have EM equities managed to avoid the gravitational pull that has caused EM bonds to nearly flirt with the nadir of early 2016? After all, EM equities, EM currencies and EM bonds are normally closely correlated, driven by investors' wagers on the direction of global growth. A simple variable can explain this strange dichotomy: anticipated inflation. As Chart I-4 illustrates, the performance of a volatility adjusted long EM stocks / short EM bonds portfolio tends to anticipate fluctuations in global inflation. The current price action in this basket indicates that investors have made their bets, and they think inflation is going up. Chart I-3...So Does The Stock-To-Bond Ratio Chart I-4Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Anecdotal evidence suggests that in recent quarters, pension plans have been aggressive buyers of commodities - a move that normally coincides with these long-term investors putting in place some inflation hedges. Moreover, positioning in the futures markets corroborates these stories: speculators are still very long commodities like copper and oil - commodities traditionally perceived as efficient protectors against inflation spikes (Chart I-5). Finally, despite the potentially deflationary risks created by Italy three weeks ago, speculators remain short U.S. Treasury futures, bond investors are underweight duration, and sentiment toward the bond market remains near its lowest levels of the past eight years (Chart I-6). Again, this behavior is consistent with investors being positioned for an inflationary environment. Chart I-5Money Has Flown Into Resources Chart I-6Bond Market Positioning Is Still Very Short Bottom Line: There is a well-defined case to be made that a global economy that was not so long ago defined by the presence of deflationary risks is now morphing into a world where inflation is on the upswing. However, based on inflation breakevens, sectoral relative performance, equities relative to bonds in both DM and EM as well as on the positioning of investors in commodity and bond markets, this changing state has been quickly discounted by investors. The Decks Are Stacked, But Where Does The Economic Risk Lie? The problem facing investors already long inflation protection every which way they can be is that the global economy is slowing, which normally elicits deflationary fears, not inflationary ones. This seems a recipe for disappointment, albeit one that is likely to help the dollar. Our global economic and financial A/D line, which tallies the proportion of key variables around the world moving in a growth-friendly fashion, has fallen precipitously. This normally heralds a slowdown in global economic activity (Chart I-7). Chart I-7Global Growth Is Losing Traction In similar vein, global leading economic indicators have also begun to roll over - a trend that could gain further vigor if the diffusion index of OECD economies experiencing rising versus contracting LEIs is to be believed (Chart I-8). The global liquidity picture has also deteriorated enough to warrant caution. Currency carry strategies - as approximated by the performance of EM carry trades funded in yen - have sagged violently. This tells us that funds are flowing out of EM economies and moving back to countries already replete with excess savings like Japan or Switzerland (Chart I-9). Historically, these kinds of negative developments for global liquidity have preceded industrial slowdowns, as EM now accounts for the lion's share of global IP growth. Finally, China doesn't yet look set to bail out the world's industrial sector. This month's money and credit numbers were weaker than anticipated, and our leading indicator for the Li-Keqiang index - our preferred gauge of industrial activity in the Middle Kingdom - points to further weakness (Chart I-10). This makes it unlikely that China's imports will rise, lifting global growth. Additionally, China has re-stocked in various commodities, suggesting it is front-running its own domestic demand, highlighting the risk that its commodities intake could become even weaker than what domestic growth implies. Chart I-8More Weakness In LEIs Chart I-9Global Liquidity Tightening Chart I-10China Not Yet Set To Bail Out The World With this kind of backdrop, we expect the current slowdown in global growth to run further before ebbing, probably in response to what will be a policy move out some kind from China to put a floor under growth. As a result, the current infatuation with inflation hedges among investors may wane for a bit as slower growth could shock inflation expectations downward, especially in a global context that has been defined by excess capacity since the late 1990s. An environment where global inflation expectations could be downgraded in response to slower growth is likely to be an environment where the dollar performs well, particularly as U.S. growth continues to outperform global growth (Chart I-11). This also confirms our analysis from two weeks ago that showed that when bonds rally the dollar tends to outperform most currencies, with the exception of the yen.1 Moreover, with the Federal Open Market Committee upgrading its path for interest rates by one additional hike in 2018, this reinforces the message from our previous work noting that once the fed funds rate moves in the vicinity of r-star, the dollar performs well, nearly eradicating the losses it incurred when the fed funds rate rises but is well below the neutral rate (Table I-1). This is especially true if vulnerability to higher rates rests outside - not inside - the U.S., as is currently the case.2 Chart I-11The Dollar Likes Lower Global Inflation Table I-1Fed And The Dollar: Where We Stand Matters As Much As The Direction Beyond the dollar, one particular currency cross has historically been a good correlate to investors betting on higher inflation: NOK/SEK. As Chart I-12 illustrates, when investors buy inflation hedges such as going long EM equities relative to EM bonds, this generates a rally in NOK/SEK. These dynamics played in our favor when we were long this cross earlier this year. However, not only are EM equities extended relative to EM bonds, the current economic environment portends a growing risk of investors curtailing these kinds of bets. The implication is bearish for NOK/SEK, and we recommend investors sell this cross at current levels. Chart I-12NOK/SEK Suffers If Inflation Bets Are Unwound Bottom Line: Investors have quickly and aggressively positioned themselves to protect their portfolios against upside inflation risks. However, the global economy is still slowing - a development that has further to run. As a result, this current anticipation of inflation could easily morph into a temporary fear of deflation, at least relative to lofty expectations. This would undo the dynamics previously seen in the market. This is historically an environment in which the dollar performs well, suggesting the greenback rally is not over. Moreover, NOK/SEK could suffer in this environment. The Bad News Is Baked Into The Pound There is no denying that the data flow out of the U.K. has been poor of late. In fact, despite what was already a low bar for expectations, the U.K. economy has managed to generate large negative surprises (Chart I-13). One of the direct drivers of this poor performance has been the complete meltdown in the British credit impulse (Chart I-14). Additionally, the slowdown in British manufacturing can be easily understood in the context of slowing global growth (Chart I-15). Chart I-13Anarchy In The U.K. Chart I-14The Credit Impulse Has Bitten Chart I-15U.K. Exports Are Slowing Because Of Global Growth But, the bad new seems well priced into the pound, especially when compared to the euro. Not only is the GBP trading at a discount to the EUR on our fundamental and Intermediate-term timing models, speculators have accumulated near-record short bets on the pound versus the euro (Chart I-16). This begs the question: Could any positive factor come in and surprise investors, resulting in a fall in EUR/GBP? We think the answer to this question is yes. First, despite the negatives already priced in, incremental bad news have had little traction in dragging the pound lower versus the euro in recent weeks, suggesting that EUR/GBP buying has become exhausted. Second, a falling EUR/USD tends to weigh on EUR/GBP, as the pound tends to act as a low-beta version of the euro (Chart I-17). Chart I-16Investors Are Well Aware Of Britain's Problems Chart I-17EUR/GBP Sags When EUR/USD Weakens Third, the economic outlook for the U.K. is improving. It is true that in the context of slowing global growth, the manufacturing and export sectors are unlikely to be a source of positive surprises for Great Britain. However, the domestic economy could well be. As Chart I-14 highlights, the credit impulse has collapsed, but the good news is that outside of the Great Financial Crisis it has never fallen much below current levels, suggesting that a reversion to the mean may be in offing. Additionally, U.K. inflation is peaking, which is lifting British real wages (Chart I-18). In response, depressed consumer confidence is picking up. This is crucial as consumer spending, which represents roughly 70% of the U.K.'s GDP, has been the key drag on growth since 2016. Any improvement on this front will lift the whole British economy, even if the manufacturing sector remains soft. Fourth, Brexit is progressing. This week's vote in the House of Commons was confusing, but it is important to note than an amendment that gives Westminster the right to force a renegotiation between the U.K. and the EU if no deal is reached in 2019 has been passed. This also decreases the risk of a completely economically catastrophic Brexit down the road, but increases the risk that PM Theresa May could be ousted over the next 12 months. Our positive view on the pound versus the euro (or negative EUR/GBP bias) is not mimicked in cable itself. Ultimately, despite the GBP/USD's beta to EUR/GBP being below one, it is nonetheless greater than zero. As such, it is unlikely that GBP/USD will be able to rally if the DXY rallies and the EUR/USD weakens (Chart I-19). Therefore, while we recommend selling EUR/GBP, we are not willing buyers of GBP/USD. Chart I-18A Crucial Support To Growth Chart I-19Cable Will Not Avoid The Downward Pull Of A Strong Dollar Bottom Line: The British economy has undergone a period of weakness, which is already reflected in the very negative positioning of investors in the GBP versus the EUR. However, the bad data points are losing their capacity to push EUR/GBP higher, and the British economy may begin to heal as consumer confidence is rebounding thanks to improving real wages. The low beta of GBP/USD to the euro also implies that a falling EUR/USD will weigh on EUR/GBP. However, while the pound has upside against the euro, it will continue to suffer against the dollar if EUR/USD experiences further downside. What To Do With EUR/CAD? One weeks ago, we were stopped out of our short EUR/CAD trade. Has EUR/CAD finished its fall, or was the recent rally a pause within a downward channel? We are inclined to think the latter. Heated rhetoric on trade has hit the CAD harder than the EUR, as exports to the U.S. represent a much larger share of Canada's GDP than of the euro area, forcing the pricing of a risk premium in the loonie. However, even after a rather explosive G7 meeting, we do believe that a compromise is still feasible and that NAFTA is not dead on arrival. A deal is still likely because, as Chart I-20 demonstrates, Canadian tariffs on U.S. imports are not only marginally in excess of U.S. tariffs on Canadian imports, they are also in line with international comparisons. This suggests only a small push is needed to arrive to a deal that salvages NAFTA, which ultimately is much more important to Canada than the dairy industry. Chart I-20Canada And The U.S. Can Find A Compromise Despite this reality, we cannot be too complacent, U.S. President Donald Trump is likely to be playing internal politics ahead of the upcoming mid-term elections. U.S. citizens are distrustful of free trade (Chart I-21), a trend especially pronounced among his base. However, a good result for the GOP in November is contingent on the Republican base showing up at the polls. Firing this base up with inflammatory trade rhetoric is a sure way to do so. This means that risks around NAFTA are still not nil. Chart I-21America Belongs To The Anti-Globalization Bloc However, EUR/CAD continues to trade at a substantial premium to fair-value on an intermediate-term horizon (Chart I-22). Moreover, as the last panel of the chart illustrates, speculators remain massively short the CAD against the EUR. This creates a cushion for the CAD versus the EUR if global growth slows. Moreover, technicals are still favorable of shorting EUR/CAD. Not only is EUR/CAD still overbought on a 52-week rate-of-change basis, it seems to be in the process of forming a five-wave downward pattern, with the fourth one - a countertrend wave - potentially ending (Chart I-23). Chart I-22EUR/CAD Is Still Vulnerable Chart I-23Wave Pattern Not Completed Finally, EUR/CAD tends to perform poorly when the USD strengthens, which fits with our current thematic for the remainder of 2018. Bottom Line: The headline risk surrounding NAFTA has weighed on the loonie against the euro, stopping us out of our short EUR/CAD trade with a small profit. However, the valuation, positioning and technical dynamics suggest the timing is ripe to short this cross once again. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Rome Is Burning: Is It The End?", dated June 1, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different", dated May 25, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was stellar: NFIB Business Optimism Index climbed to 107.8, outperforming expectations; the price changes and good times to expand components are also very strong; Headline and core PPI both outperformed expectations, auguring well for future consumer inflation; Headline and core retail sales grew by 0.8% and 0.9% in monthly terms, beating expectations; Both initial and continuing jobless claims also came out below expectations, highlighting that the labor market is still tightening, and wage growth could pick up further. The Fed raised interest rates this week to 2%, and added one additional rate hike to its guidance for 2018. FOMC members once again highlighted the "symmetric" target, suggesting that the Fed expects the economy to overheat slightly. An outperforming U.S. economy relative to the rest of the world is likely to propel the greenback this year. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Economic data was largely disappointing: Italian industrial output contracted by 1.2% on a monthly basis, and grew only by 1.9% on a yearly basis; The German ZEW Survey declined substantially across all metrics; European industrial production increased by 1.7% annually, less than the expected 2.8% increase; However, Spanish headline inflation spiked up from 1.1% to 2.1%. Yesterday, ECB President Mario Draghi announced the ECB's plan to taper asset purchases to EUR 15 bn a month in September, and phase them out completely by year-end. Moreover, Draghi highlighted that the ECB was not anticipating to implement its first hike until after the summer of 2019. Furthermore, the ECB President highlighted the current slowdown in global growth, as well as the rising protectionist risk from the U.S. potentially negatively impacting the European economy and the ECB's decisions going forward, suggesting that the plans are not set in stone. 2018 is likely to remain a volatile year for the euro. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Japanese data has been strong this week: Machine orders increased on a 9.6% annual basis, and a 10.1% monthly basis, in April, outperforming expectations by a large margin; The Domestic Corporate Goods Price Index also increased by 2.7% annually, higher than the expected 2.2% increase. As political and economic risks in Europe and South America having subsided for now, the yen has lost some of its glitter. However, with ongoing uncertainty on trade and populism across the globe, we maintain our tactically bullish stance on the yen, especially against commodity currencies and the euro. However, beyond the short-term horizon, the BoJ will remain determined to cap any excess appreciation in the yen, as a strong JPY tightens Japanese financial conditions, weighing on the BoJ's ability to hit its inflation target. This will ultimately limit the yen's upside on a cyclical basis. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Data from the U.K. was somewhat disappointing: Manufacturing and industrial production both increased less than expected, at 1.4% and 1.8%, respectively; The goods trade deficit widened to GBP 14.03bn from GBP 12bn, and the overall trade deficit widened to GBP 5.28bn from GBP 3.22bn; Average earnings grew by 2.8%, less than the expected 2.9%; However, headline inflation came in at 2.4%, less than the expected 2.5%, while retail price inflation also underperformed expectations. This means that the uptrend in real wages continues. Given the limited movement in the pound, it seems that a lot of the bad news was already priced in by last month's depreciation. However, Theresa May's ongoing blunders in parliament represent a continued source of risk for the pound. While the GBP has downside against the EUR, it is unlikely to see much upside against the greenback. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Do Not Get Flat-Footed By Politics - March 30, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was weak: NAB Business Confidence and Conditions surveys both declined, also underperforming expectations; Australian employment grew by 12,000, less than expected. Moreover, full-time employment contracted. While the unemployment rate dropped as a result, this was largely due to a fall in the participation rate. RBA's Governor Lowe, in a speech on Wednesday, announced that any increase in interest rates "still looks some time away" as the slack in the labor market does not seem to be diminishing. Annual wage growth has been constant at 2.1% for the past three quarters, and did not pick up despite an improvement in full-time employment earlier this year. We remain bearish on the AUD. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The NZD is likely to face significant downside against the greenback along with the other commodity currencies as global growth slows down. However, due to its weaker linkages to Chinese industrial demand, the kiwi is likely to see less downside than the AUD. Nevertheless, it is likely to weaken against the CAD and the NOK as the NZD is expensive against these oil currencies, and oil's is likely to continue to outperform other commodities will support this view. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has been on an uptrend given the greenback generally strong performance since February year, a force magnified by the volatile rhetoric surrounding NAFTA negotiations. However, the Canadian economy has been accelerating this year, thanks to robust growth in the U.S., to a strong Quebecer economy, and to a pickup in Alberta. In addition, the Canadian labor market is tightening further and wage growth is above 3%. Furthermore, risks surrounding NAFTA seem already reflected in the CAD's behavior and valuation. There is more clarity on the CAD versus its crosses than on the CAD versus the USD. Outperforming U.S. and Canadian growth relative to the rest of the world mean that the CAD should outperform most other G10 currencies. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data out of Switzerland was decent: Industrial production increased by 9% in annual terms, albeit less than the previous 19.6% growth; Producer and import prices increased by 3.2% year on year, in line with expectations, however the monthly increase underperformed markets anticipations. With global trade tensions rising, and Germany having entered President Trump's line of sight, the CHF could experience additional upside against the euro in the coming months. However, the SNB is unlikely to deviate from its ultra-accommodative stance, which means that any downside in EUR/CHF will proved to be short lived. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Both headline and core inflation underperformed, coming in at 2.3% and 1.2%, respectively. However, the Regional Network Survey hinted at a pickup in capacity utilization as expectations for industrial output remained robust, as well as at an additional strength in employment. This led to a forecast of a resurgence in inflationary pressures. We expect the NOK to outperform the EUR. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish inflation rose from 1.7% to 1.9%, coming in line with expectations. Additionally, Prospera 1-year inflation expectations survey rose to 1.9% from 1.8% in the March survey. This is likely to provide the Riksbank with reasons to turn gradually more hawkish, which should support the very cheap krona. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The following four investment themes are likely to play out over the next couple of years: The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. The 10% undervaluation of the trade-weighted euro - as assessed by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually adjusts, euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos. Swedish real estate and Swedish real estate equities, which are both very richly valued, will underperform. Feature What connects last Sunday's dysfunctional G7 Summit with this week's ECB policy meeting? The answer is the euro area's €450 billion export surplus. Specifically, the €300 billion export surplus in Germany which equals 8% of its GDP - an export surplus that is squarely in President Trump's cross-hairs (Chart of the Week). Chart of the WeekECB Policy Has Driven Up Germany's Export Surplus The interesting thing is that the euro area hasn't always run an export surplus. Before 2012, the euro area's trade with the rest of the world was more or less in balance. Even Germany's export surplus was half of its current size. To put it in Trumpian terms, fewer Mercedes were "rolling down New York's Fifth Avenue." What caused the imbalance to surge in recent years? Was it punitive tariffs or restrictive trade practices in Germany? No, the answer is much simpler than that. ECB Policy Has Driven Up Germany's Export Surplus The export surplus in the euro area and in Germany is just a mirror-image of the euro exchange rate (Chart I-2). As the euro became undervalued, it made euro area exports more competitive and foreign imports into the euro area less competitive. This assessment of euro area over-competitiveness comes straight from the horse's mouth. The ECB's own indicators show that the euro area remains over-competitive by around 10%, meaning the euro is still undervalued by about 10%.1 In turn, the euro's substantial undervaluation is a near perfect function of the yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts (Chart I-3). It follows that the ultimate cause of the euro area's glaring imbalance is ECB policy itself - specifically, the extreme experiment with bond buying and negative interest rates. Chart I-2ECB Policy Has Driven Up The ##br##Euro Area's Export Surplus Chart I-3The ECB's Expansive Monetary Policy Is ##br##Responsible For The Euro's Undervaluation As Germany's former Finance Minister, Wolfgang Schäuble, explained: "When ECB chief Mario Draghi embarked on the expansive monetary policy, I told him he would drive up Germany's export surplus... I promised then not to publicly criticise this policy. But then I don't want to be criticised for the consequences of this policy." The ECB counters that it targets neither the euro exchange rate nor the trade balance; it sets policy to achieve its mandate for price stability. It argues that it is further from its mandate for price stability compared with the Federal Reserve because, ostensibly, the euro area is at a different point in the economic cycle compared with the U.S. This requires the ECB to set an ultra-accommodative policy compared with other central banks. The undervalued euro and trade surplus are the unavoidable spill-overs of this relative monetary policy. ECB Spill-Overs Felt Far And Wide However, one important reason that euro area inflation is underperforming U.S. inflation has nothing to do with the economic cycle. Rather, it is because the official measures of inflation in the euro area and the U.S. are defined differently (Chart I-4 and Chart I-5). The euro area's Harmonized Index of Consumer Prices (HICP) omits the consumption costs of owner-occupied housing, whereas the U.S. consumer price basket includes them at a very substantial 25% weight. Homeowners will testify that the cost of maintaining their homes constitutes one of their largest expenses, and that these costs tend to rise faster than other prices. Using the U.S. as a guide, we estimate that a euro area inflation measure that correctly included home maintenance costs would be running higher than HICP inflation by an average of 0.5 percentage points a year (Chart I-6). Chart I-4Euro Area Inflation##br## Is Underperforming... Chart I-5...Because Euro Area Inflation Omits ##br##Owner-Occupied Housing Costs Chart I-6Including Owner-Occupied Housing ##br##Costs Adds 0.5% To Inflation Just because the statisticians do not measure owner-occupied housing costs in the euro area HICP, it doesn't mean that homeowners do not feel these costs. In Germany, measured inflation is now running at 2.3%, so the true inflation that households feel is running closer to 3%. Meanwhile, interest rates on savings accounts are stuck near zero, which means that German savers are seeing the real value of their savings erode by 3% every year. As Der Spiegel magazine put it to ECB Chief Economist, Peter Praet: "Can you understand why so many Germans regard the ECB as the greatest threat to their personal wealth?" Spill-overs from the ECB's ultra-accommodative policy have also been felt across the Baltic Sea. The Riksbank and the Norges Bank have had to shadow the ECB to prevent a sharp appreciation of their currencies versus the euro. The trouble is that ultra-low and negative interest rates have been absurdly inappropriate for the booming Scandinavian economies. So ECB policy may have generated spill-over housing bubbles in Sweden and Norway (Chart I-7 and Chart I-8). Chart I-7ECB Spill-Overs Felt In Scandinavia Chart I-8Scandinavian Real Estate Appears Richly Valued Hence, a seemingly innocuous 'definitional' difference between the consumer price baskets in the euro area vis-à-vis the U.S. explains: the bulk of the shortfall in euro area inflation; the ECB's justification for ultra-accommodation; the undervalued euro; the euro area's €450 billion trade surplus; deeply negative real interest rates in Germany; and putative housing bubbles in Sweden and Norway. The main argument we hear in the ECB's defence is that the central bank is at the mercy of its treaty. If the treaty demands ultra-accommodation then the ECB must deliver it. But this argument is wrong. The ECB treaty only asks that the central bank delivers "price stability", leaving the ECB with substantial flexibility in how it precisely defines price stability. With this in mind, the ECB - and other central banks - should use this definitional flexibility to minimize differences with other central banks. Because in a world of integrated capital markets, the spill-overs from seemingly innocuous definitional differences are felt far and wide, resulting in political backlashes and economic imbalances. Imbalances Must Correct In The Long Run Ultimately though, economic imbalances must correct, and the corrective mechanism is economic, financial, or political feedback loops, or some combination of these. On this basis, we reiterate four investment themes that are likely to play out over the next couple of years: The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. The 10% undervaluation of the trade-weighted euro - as assessed by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually adjusts, euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos (Chart I-9). Chart I-9As The Euro's Undervaluation Corrects, It Will Help Euro Area Domestics And Hurt Exporters Swedish real estate and Swedish real estate equities, which are both very richly valued, will underperform. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see https://www.ecb.europa.eu/stats/balance_of_payments_and_external/hci/html/index.en.html The ECB uses three metrics to assess the euro area's competitiveness versus its major trading partners: GDP deflators, CPIs, and unit labour costs. The average of the three metrics suggests that the euro is undervalued by around 10%.The assessment of euro undervaluation assumes that the major euro area economies entered the monetary union at a broadly correct level of competitiveness against each other and against their other major trading partners. This assumption seems valid, given that the net external position of these economies were all in equilibrium at the onset of monetary union. Fractal Trading Model We are pleased to report that our long SEK/GBP currency position hit its profit target of 3% and is now closed. This week we note that the relative performance of two classically cyclical sectors, oil and gas versus financials, is technically stretched and at a 65-day fractal dimension which has accurately predicted the last two major reversals. Hence, our recommended trade is short euro area oil and gas versus euro area financials. Set a profit target of 6% with a symmetric stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights In this Weekly Report, we review all of the individual trades in our Tactical Overlay portfolio. These are positions that are intended to complement our strategic Model Bond Portfolio, typically with shorter holding periods, and sometimes in smaller or less liquid markets that are outside our usual core bond coverage (like Swedish government bonds or euro area CPI swaps). This report includes a summary of the rationale for each position, as well as a decision on whether to retain the position, close it or switch it into a new trade that has more profit potential for the same theme underlying the original trade (Table 1). Table 1Global Fixed Income Strategy Tactical Overlay Trades Feature U.S. Long 5-year U.S. Treasury bullet vs. 2-year/10-year duration-matched barbell (CLOSE AND SWITCH TO NEW TRADE) Long U.S. TIPS vs. nominal U.S. Treasuries (HOLD) Short 10-year U.S. Treasuries vs. 10-year German Bunds (HOLD) Chart 1UST Curve Trading More Off The Funds##BR##Rate Than Inflation Expectations We have three U.S.-focused tactical trades that are all expressions of our core views on U.S. inflation expectations and future Fed monetary policy moves. We first recommended a U.S. butterfly trade, going long the 5-year U.S. Treasury bullet and short a duration-matched 2-year/10-year Treasury barbell (Chart 1), back on December 20th, 2016. We have kept the recommendation during periodic reviews of our tactical trades since then. This is a position that was expected to benefit from a bearish steepening of the U.S. Treasury curve as the market priced in higher longer-term inflation expectations. The trade has not performed according to our expectations, however, generating a loss of -0.40% since inception.1 There was a positive correlation between the slope of the Treasury curve, the butterfly spread and TIPS breakevens shortly after trade inception. However, the Treasury curve flattened through 2017 as the Fed continued to hike rates, even as realized inflation fell (2nd panel), pushing the real fed funds towards neutral levels as measured by estimates like r* (3rd panel). This has left the 2/5/10 Treasury butterfly cheap on our valuation model (bottom panel), Looking ahead, the case for a renewed bear-steepening of the U.S. Treasury curve, and widening of the 2/5/10 butterfly spread, rests on the Fed accommodating the current rise in U.S. inflation by being cautious with future rate hikes. Recent comments from Fed officials suggest that policymakers are in no hurry to rapidly raise rates in order to cool off an "overheating" U.S. economy. Yet at the same time, U.S. inflation continues to rise and the economy is in good shape, so the Fed can't take a pause on rate hikes. This will likely leave the Treasury curve range bound, with the potential for some periods of bear-steepening as inflation expectations rise. Our conviction on this Treasury butterfly spread trade has fallen of late. Yet with our model suggesting that the belly of the curve is somewhat cheap to the wings, and given our view that U.S. inflation expectations have not reached a cyclical peak, we are reluctant to completely exit this position. Instead, we are opting to switch out of the 2/5/10 U.S. Treasury butterfly into another butterfly that our colleagues at BCA U.S. Bond Strategy have identified as cheap within their newly-expanded curve modeling framework - the 1/7/20 butterfly (long the 7-year bullet vs. short a duration-matched 1/20 barbell).2 That butterfly offers better carry than the 2/5/10 butterfly (Chart 2), and is nearly one standard deviation cheap to estimated fair value. Another of our U.S.-focused tactical trades has been to directly play for rising U.S. inflation expectations by going long TIPS versus nominal U.S. Treasuries. This is a long-held trade (initiated on August 23rd, 2016) which has performed very well, delivering a return of 4.13%.3 We continue to see the potential for TIPS breakevens to widen back to levels consistent with the market believing that inflation can sustainably return to the Fed's 2% target on the PCE deflator, which is equivalent to 2.4-2.5% on CPI-based 10-year TIPS inflation expectations. Given the persistent strong correlation between oil prices and breakevens, and with the BCA Commodity & Energy Strategy team continuing to forecast Brent oil prices jumping above $80/bbl over the next year (Chart 3), there is still solid underlying support for wider breakevens. This is especially true given the uptrend in overall global inflation (middle panel), and the likelihood that core U.S. inflation can also continue to rise alongside an expanding U.S. economy (bottom panel). We are sticking with our long TIPS position vs. nominal Treasuries. Chart 2Switch The UST Butterfly##BR##Trade From 2/5/10 to 1/7/20 Chart 3Stay Long U.S. TIPS##BR##Vs. Nominal Treasuries Our final U.S.-focused tactical trade is actually a cross-market trade where we are short 10-year U.S. Treasuries versus 10-year German Bunds. We initiated that trade on August 8th, 2017 when the Treasury-Bund spread was at 179bps. With the spread now at 252bps, the trade has delivered a solid total return of 4.23%. This was driven primarily by the rapid move higher in Treasury yields in response to faster U.S. growth (Chart 4), more rapid U.S. inflation and Fed rate hikes versus a stand-pat European Central Bank (ECB).4 From a medium-term perspective, those three fundamental drivers of the Treasury-Bund spread continue to point to U.S. bond underperformance (Chart 5). From this perspective, the peak in the spread will not be reached until U.S. economic growth and inflation peak and the Fed signals an end to its current tightening cycle. None of those outcomes is on the horizon, and we continue to target an eventual cyclical top in the 10-year Treasury yield in the 3.25-3.5% range as inflation expectations move higher. Yet the Treasury-Bund spread has reached an overvalued extreme according to our "fair value" model (Chart 6). In other words, the markets have moved to more than fully discount the cyclical differences between the U.S. and euro area - a trend that surely reflects the huge short positioning in the U.S. Treasury market. Yet it is also important to note that the fair value spread continues to steadily climb higher. In our model, the spread is primarily a function of differences in central bank policy rates between the Fed and ECB, relative unemployment rates and relative headline inflation rates. All three of those factors continue to move in a direction favorable to a wider Treasury-Bund spread, and the gap is only growing wider with both growth and inflation in the euro zone losing momentum. Chart 4Stay Long 10yr UST##BR##Vs. 10yr German Bund Chart 5UST-Bund Spread Widening##BR##Due To Relative Fundamentals... Chart 6...But The Spread##BR##Has Overshot A Bit The spread is currently being pushed to even wider extremes by the current turmoil in Italy, which is pushing money out of Italian BTPs into safer assets like Bunds. The situation remains fluid and new elections are likely in Italy later this year, thus it is unlikely that any more to restore investor confidence in Italy is on the immediate horizon. This will keep Bund yields depressed versus Treasuries, even as the ECB continues to signal that it will fully taper its asset purchases by year-end (rate hikes remain a long way off in Europe, however). We continue to recommend staying short Treasuries versus Bunds, and would view any tightening of the spread back towards our model estimate of fair value as an opportunity to enter the position or add to an existing position. Euro Area Long 10-year euro area CPI swaps (HOLD, BUT ADD A STOP AT 1.5%) Short 5-year Italy government bonds vs. 5-year Spain government bonds (HOLD) Chart 7Stay Long 10-Year Euro Area CPI Swaps We have two tactical trades that are purely within the euro area: positioning for higher inflation expectations through a long position in 10-year euro CPI swaps, and playing relative credit quality within the Peripheral countries by shorting 5-year Italian bonds versus a long position in 5-year Spanish debt. The long 10-year CPI swaps trade, which was initiated on December 20th, 2016, has generated a total return of +0.45% over the life of the trade so far (Chart 7).5 The rationale for the recommendation, and our conviction behind it, has evolved over that time. We first recommended the trade when the ECB was aggressively easing monetary policy and there was clear positive momentum in euro area economic growth that was driving down unemployment. At a time when oil prices were steadily climbing and the euro was very weak, the case for seeing some improvement in inflation expectations in the euro area was a strong one. Inflation expectations stayed resilient in 2017, however, despite the unexpected strength of the euro. Continued gains in oil prices and above-trend economic growth that rapidly absorbed spare capacity in the euro area more than offset any downward pressure on inflation from a stronger currency. Looking ahead, the combination of renewed weakness in the euro and firm oil prices should allow headline inflation in the euro area to drift higher from current levels in the next 3-6 months (2nd panel). However, the euro area economy has lost the positive momentum seen last year with steady declines in cyclical data like manufacturing PMIs, industrial production and exports (3rd panel). Admittedly, that deceleration has come from a high level and leading indicators are not yet pointing to a prolonged period of below-potential growth that could raise unemployment and reduce domestic inflation pressures. Yet with core inflation still struggling to climb beyond the 1% level (bottom panel), any worsening of euro area economic momentum could lead to inflation expectations stalling out well before getting close to the ECB's 2% target level. Thus, we continue to recommend this long 10-year CPI swaps position, but we are adding a new stop-out level at 1.5% to protect against downside risks if the euro area growth outlook darkens. On our other euro area tactical trade, we have been recommending shorting Italian government bonds versus Spanish equivalents. We initiated that trade on December 16th, 2016 and it has produced a total return of +0.57% over the life of the trade. The original logic for the trade was based on an assessment that Italy's medium-term growth potential, sovereign debt fundamentals and political stability were all much worse than that of Spain (Chart 8), yet Italian bond yields were still trading at too low a spread to Spanish debt. The cyclical improvement in the Italian economy in 2017 helped pushed Italian yields even closer to Spanish yields, yet we stuck with the trade given the looming political risk from the Italian parliamentary elections. The recent political turmoil in Italy has justified our persistence with this trade, with the 5-year Italy-Spain spread widening out by 46 bps over just the past two weeks. With the situation remaining highly fluid as the Italian coalition partners (the 5-Star Movement and the League) struggle to form a new government, Italian assets will continue to trade with a substantial risk premium to Spain and other European bond markets. Yet with the Italian economy now also showing signs of losing cyclical momentum, the case for continued Italian bond underperformance is a strong one, and we moved to a strategic underweight stance on Italian debt last week.6 Looking ahead, we see the potential for additional spread widening between Italy and Spain in the coming months. Spain is enjoying better economic growth, the deficit outlook is worsening for Italy with the new coalition government proposing a stimulus that could widen the budget deficit by as much as 6% of GDP, and Spanish support for the euro currency is far higher than it is in Italy. All those factors justify a wider risk premium for Italian debt over Spanish bonds (Chart 9). Chart 8Spain Trumps Italy On All Fronts Chart 9Stay Short 5-Year Italy Versus 5-Year Spain Our view on Italian debt, both from a tactical and strategic viewpoint, is bearish. We are maintaining our tactical trade, and we also advise selling into any rallies in Italy rather than buying the dips. U.K. Long 5-year Gilt bullet vs. duration-matched 2-year/10-year Gilt barbell (HOLD) We entered into a U.K. Gilt butterfly trade, long the 5-year bullet versus the duration-matched 2-year/10-year barbell, back on March 27th, 2018.7 The logic of the trade was a simple one. We simply did not believe that the Bank of England (BoE) would follow through on its hawkish commentary by hiking rates as much as was discounted in the Gilt curve. Our view came to fruition as the BoE held rates steady at the May monetary policy meeting, which resulted in a bullish steepening at the front end of the Gilt curve. Our butterfly trade has returned +0.25% since inception, and we see more to come in the coming months.8 The U.K. economy has lost considerable momentum, with no growth shown in Q1 (real GDP only expanded +0.1%). The OECD leading economic indicator for the U.K. is at the weakest level in five years, and now consumer confidence is rolling over as rising oil costs are offsetting the pickup in wages (Chart 10). Overall headline inflation has peaked, however, after the big currency-fueled surge in 2016 and 2017 (bottom panel). With both growth and inflation slowing, and with the lingering uncertainty of the Brexit negotiations weighing on business confidence and investment, the BoE will have a tough time hiking rates even one more time this year. There are still 34bps of rate hikes priced into the U.K. Overnight Index Swap (OIS) curve, which leaves room for 2-year Gilts to decline as the BoE stays on hold for longer (Chart 11). This will cause the front-end of the Gilt curve to steepen. Meanwhile, longer-term Gilt yields will have a difficult time falling given the deceleration of global central bank asset purchase programs that is slowly raising depressed term premia on government bonds (3rd panel). Another factor that will help keep the Gilt curve steeper, all else equal, is the path of the inflation expectations curve. Shorter-dated expectations are likely to fall faster as growth slows and headline inflation continues to drift lower (bottom panel). Chart 10Fading Momentum For##BR##U.K. Growth & Inflation Chart 11Stay Long The 5yr U.K. Gilt Bullet##BR##Vs. The 2/10 Gilt Barbell Although some narrowing of the butterfly spread is already priced in the forwards (top panel), we see that outperformance of the 5-year happening faster, and by a greater amount, than the forwards. Stay long the belly of the Gilt curve versus the wings. Canada Long 10-year Canada inflation-linked government bonds vs. nominal Canada government bonds (HOLD) We recommended entering a long Canada 10-year breakeven inflation trade on January 9th, 2018.9 Since then, the 10-year breakeven inflation rate rose by 6bps along with the rise in oil prices denominated in Canadian dollars (Chart 12). This has helped our tactical trade deliver a return of +0.64% since inception.10 More fundamentally, the breakeven has risen as strong Canadian growth has helped close the output gap and push realized Canadian inflation back to the middle of the Bank of Canada (BoC)'s 1-3% target band. The rapid rate of real GDP growth has decelerated a bit after approaching 4% last year, and the OECD leading economic indicator for Canada may be peaking at a high level (Chart 13). Growth in consumer spending is also look a bit toppy, with bigger downside risks evident in the sharp declines in the growth of retail sales and house prices (3rd panel). Both were affected by a harsher-than-usual Canadian winter, but the cooling of the overheated Canadian housing market (especially in Toronto) is a welcome development for financial stability. Chart 12Stay Long Canadian##BR##Inflation Breakevens Chart 13Canadian Inflation At BoC Target,##BR##But Has Growth Peaked? On balance, however, the current state of Canadian economic data shows an economy that is slowing a bit from a very overheated pace, but is still likely to grow above potential with no spare capacity available. Both headline and core inflation will remain under upward pressure against this backdrop, at a time when the BoC's policy rate is still well below neutral. We continue to recommend staying long Canadian inflation-linked government bonds over nominal equivalents with a near-term target of 2% on the 10-year breakeven inflation rate. We will re-evaluate the position with regards to Canadian growth and inflation trends once that target is reached. Australia Long December 2018 Australian Bank Bill futures (SELL AND SWITCH TO NEW TRADE). We entered into a long December 2018 Australian Bank Bill futures trade on October 17, 2017 as a focused way to express the view that the Reserve Bank of Australia (RBA) would stay on hold for longer than markets expect. The trade has worked out nicely, generating a profit of +0.25%. The potential for further upside is fairly low at these levels so we are now closing the trade. However, our view remains that the RBA will not be able to hike as early as markets are pricing. As such, we are opening a new position - long October 2019 Australia Bank Bill futures. Markets expect the first rate hike will occur in nine months' time. The October 2019 Australia Bank Bill futures are currently pricing in a massive 180bps of rate hikes over the next sixteen months. That will not happen. The RBA will not be able to hike this much given the lack of inflation pressures and a wide output gap. Our Australia Central Bank Monitor, which measures cyclical growth and inflation pressures, has pulled back to the zero line, confirming that there is no current need to tighten policy (Chart 14). Real GDP growth slowed to 2.4% in Q4 2017, from 2.9% the previous quarter. Weakness in the OECD leading economic indicator and Citigroup economic surprise index for Australia suggest that the Q1 reading will also disappoint. Consumer spending will be dampened by weak wage growth, softening consumer sentiment and the recent decline in house prices in multiple major cities. As a result of easing house prices, the growth rate of household net wealth was considerably lower in 2017 relative to the previous four years. Additionally, credit growth has been slowing, even before the recent news of the bank scandals that will force banks to be more stringent with lending practices. Most importantly, however, inflation remains below the RBA's target and there is a lack of inflationary pressures. The inflation component of our Central Bank Monitor has collapsed and is now well below the zero line. Both headline and core inflation readings are stable but remain persistently below 2%. Tradeable goods prices have declined for nine consecutive months despite the currency weakness seen in the Australian dollar over the past twelve months. The IMF is not projecting Australia to have a closed output gap until 2020, and that is with the optimistic expectation that Australia achieves 3% growth. Labor markets have plenty of slack as evidenced by rising unemployment rate, nonexistent wage growth and elevated level of underemployment. The RBA estimates that the current unemployment rate is still approximately 0.5% above full employment. Against this backdrop, it is unlikely that inflation will sustainably rise enough to force the RBA's hand, leaving scope for interest rate expectations to decline (Chart 15). Chart 14The RBA Will##BR##Stay Dovish Chart 15Switch Long Australia Bank Bill Futures##BR##Trade From Dec/18 Contract To Oct/19 Contract New Zealand Long 5-year New Zealand government bonds vs. 5-year U.S. Treasuries, currency-hedged into U.S. dollars (HOLD) Long 5-year New Zealand government bonds vs. 5-year German government bonds, with no currency hedge (HOLD) One of our more successful tactical trades has been in New Zealand (NZ) government bonds. We entered long positions in 5-year NZ debt versus 5-year U.S. Treasuries and 5-year German Bunds on May 30th, 2017, but we reviewed, and decided to maintain, those positions in a recent Weekly Report.11 The NZ-US spread trade has returned 4.67% since inception, hedged into U.S. dollars (Chart 16).12 The NZ-Germany trade, however, was a very rare instance where we recommended a cross-country spread trade on a currency UN-hedged basis, based on the negative view on the euro that we had last year. With the euro rising sharply against the New Zealand dollar, the unhedged return on that trade has been -2.87% (a return that, if hedged back into the euro denomination of the German bonds, would have generated a return of +3.56%). Looking ahead, we see continued scope for NZ bond outperformance, although the return potential is far less than it was when we first put on the trade. NZ economic growth is in the process of peaking, with export growth already rolling over (Chart 17, top panel). Net immigration inflows, which have been a major support for the NZ housing market and overall consumer spending over the past five years, have already begun to slow with the Reserve Bank of New Zealand (RBNZ) projecting bigger declines in the next couple of years (2nd panel). Both headline and core CPI inflation took a surprising downward turn in Q1 of this year, and both are well below the midpoint of the RBNZ target band (3rd panel). Chart 16Stay Long NZ 5yr Bonds##BR##Vs. The U.S. & Germany... Chart 17...With NZ Growth &##BR##Inflation Losing Momentum With both growth and inflation slowing, the RBNZ can remain dovish on monetary policy. An additional factor is the NZ government has recently changed the mandate of the RBNZ to include both inflation targeting and "maximizing employment" in a similar fashion to the Federal Reserve. With inflation posing no threat, the RBNZ can focus on its employment mandate by maintaining highly accommodative policy settings. With the NZ OIS curve still discounting one full 25bp RBNZ hike over the next year (bottom panel), there is scope for NZ bonds to outperform as that hike will not happen. This will allow NZ bond spreads to tighten, or at least outperform versus the forwards where some modest widening is currently priced. We are sticking with both spread trades, but we are choosing to leave the NZ-Germany trade currency unhedged given the renewed weakness in the euro (the unhedged return has already improved by over two full percentage points since the euro peaked earlier this year). We will monitor levels of the NZD/EUR currency cross rate to determine when to potentially hedge the currency exposure of our trade back into euros. Sweden Long Sweden 10-year government bond vs. 2-year government bond Short 2-year Sweden government bond vs. 2-year German government bond We recently entered two Sweden tactical bond trades on May 8, 2018, going long the Swedish 10-year vs. the 2-year and shorting the Swedish 2-year vs. the German 2-year (Chart 18).13 We expect that strong growth momentum, rising inflation and a tight labor market will force the Riksbank to raise rates earlier, and by more, than markets expect. Since inception for these "young" trades, each has returned -1bp.14 Sweden's economy made a solid recovery in 2017, with year-over-year real GDP growth reaching 3.3% in Q4. Going forward, export growth will remain supported by strong global activity, low unit labor costs, and a weak krona. Our own Swedish export growth model is already signaling a pickup over the rest of 2018. Consumption has been resilient and should continue to be supported by steadily recovering wages. Capital spending has been robust and industrial confidence remains in an uptrend. Additionally, leading indicators are still signaling positive growth momentum. The Riksbank's preferred measure of inflation, CPIF, slowed to 1.9% in April after briefly touching the central bank's target last month (Chart 19). In our view, this is a minor pullback rather than the start of a sustained reversal. Our core inflation model projects a gradual increase in the coming months, driven by above-trend growth that has soaked up all spare capacity. Labor markets have tightened considerably, and the unemployment rate is now more than one percentage point below the OECD's estimate of the full-employment NAIRU. During the last period when unemployment was this far below NAIRU, wage growth surged to over 4%. Chart 18Stay In A Sweden 2/10 Curve Flattener##BR##& Short 2yr Swedish Bonds Vs Germany Chart 19The Riksbank Will Not Ignore##BR##The Coming Inflation Overshoot For the curve flattener trade, our expectation is that the Riksbank will shift to a more hawkish tone in the coming months, leading markets to reprice the shape of the Swedish yield curve, as too few rate hikes are discounted in the short-end. With their mandates met, the Riksbank will be forced to act more aggressively. Importantly, there is no flattening currently priced into the Swedish bond forward curve, thus there is no negative carry associated with putting on a flattener now. In the relative value trade, we shorted the Swedish 2-year relative to the German 2-year. Growth in Sweden is likely to outpace that of the euro area once again in 2018. Swedish inflation is almost at the Riksbank target while euro area inflation continues to undershoot the ECB benchmark. The ECB is signaling that it is in no hurry to begin raising interest rates, therefore policy rate differentials will drive the 2-year Sweden-Germany spread wider over the next 12-18 months, with no spread move currently priced into the forwards. South Korea Short Korea 10-Year Government Bonds Vs. Long 2-Year Korea Government Bonds (CLOSE) We first introduced this trade on May 30th, 2017, after the election of Moon Jae-In as the South Korean president.15 The new government made major campaign promises to greatly expand fiscal spending on social welfare, public sector job creation, and increased aid to North Korea. With the central government's budget balance set to worsen significantly, we expected longer-term Korean bond yields to begin to price in faster growth and rising future debt levels, resulting in a bearish steepening of the yield curve (Chart 20). Since the new president was elected, however, the Korean economy worsened - even as much of the global economy was enjoying a cyclical upturn - with the trend likely to continue (Chart 21). The OECD leading economic indicator for Korea is weakening, while the annual growth in industrial production now sits at -4.2% - the worst level since the 2009 recession. Capital spending and exports are also slowing rapidly. Chart 20Close The 2yr/10y Korean##BR##Government Bond Curve Steepener Chart 21Korean Curve Stable,##BR##Despite Slower Growth & Fiscal Stimulus Due to the slowdown in the economy, Korean firms' capacity utilization is now at the worst level since the middle of 2009. Although businesses were already suffering from downward pressure on revenues, the Moon administration dramatically increased the minimum wage last year, directly leading to a rise in bankruptcies for small and medium size firms (the bankruptcy rate rose from 1.9% in the first half of 2017 to 2.5% in the latter half). Looking ahead, the Moon government will continue to increase spending on welfare and financial aid for North Korea, especially if the domestic economy continues to struggle. We still believe that the rise in deficits and debt will eventually lead the market to price in some increase in the fiscal risk premium and a steeper Korean yield curve. Yet with the Bank of Korea (BoK) having already surprised the markets last November with a rate hike, and with Korean inflation now ticking higher alongside a stable won, we fear that any renewed steepening of the Korean curve awaits a shift to a more dovish BoK that is not yet on the horizon. For now, given the competing forces on the Korean yield curve, we are choosing to close our 2/10 Korea curve steepener at a loss of -0.63%.16 We will continue to monitor the Korean situation to look for opportunities to re-enter the trade at a later date. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Returns are calculated using Bloomberg pricing of the total return of a 2/5/10 butterfly. 2 Please see BCA U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15th 2018, available at usbs.bcaresearch.com. 3 Return is taken directly from Bloomberg Barclays index data on the duration-adjusted excess return of the entire TIPS index versus the entire Treasury index. 4 This return is calculated using Bloomberg data on actual U.S. and German bonds, and is shown on a currency-hedged basis into U.S. dollars - the currency denomination of the bond we are short in this spread trade. 5 Returns are calculated using Bloomberg Barclays inflation swap index data for a euro area CPI swap with a rolling 10-year maturity. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "Is It Partly Sunny Or Mostly Cloudy?", dated May 22nd 2018, available at gfis.bcaresearch.com. 7 Please see BCA Global Fixed Income Strategy Weekly Report, "Nervous Complacency", dated March 27th, 2018, available at gfis.bcaresearch.com. 8 Returns are calculated using Bloomberg data on actual Gilts, rather than bond index data. 9 Please see BCA Global Fixed Income Strategy Weekly Report, "Let The Good Times Roll", dated January 9th 2018, available at gfis.bcaresearch.com. 10 This return is measured as the total return of the Canadian inflation-linked bond index less that of the nominal Canadian government bond index from the Bloomberg Barclays family of bond indices. 11 Please see BCA Global Fixed Income Strategy Weekly Report, "Serenity Now", dated May 15th 2018, available at gfis.bcaresearch.com. 12 Returns are calculated using Bloomberg data on actual New Zealand government bonds, with our own adjustments for the impact on returns from currency hedging. 13 Please see BCA Global Fixed Income Strategy Special Report, "Sweden: The Riksbank Cannot Kick The Can Down The Road Anymore", dated May 8th 2018, available at gfis.bcaresearch.com. 14 Returns are calculated using Bloomberg data for actual individual Swedish government bonds, rather than bond index data. Both legs of the trade are duration-matched. 15 Please see BCA Global Fixed Income Strategy Weekly Report, "Distant Early Warning", dated May 30th 2017, available at gfis.bcaresearch.com. 16 Returns are calculated using Bloomberg data for actual individual Korean government bonds, rather than bond index data. Both legs of the trade are duration-matched and funding costs are included. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Stay tactically long the SEK. Our preferred expression is long SEK/GBP. Stay tactically short the NOK. Our preferred expression is long AUD/NOK. Take profits in the underweight to Poland... ...and open a tactical countertrend position: long Poland's Warsaw General Index, short Italy's MIB. A coalition of populists governing Italy might ruffle some feathers in Brussels, but the main risk appears to be contained. Both The League and 5 Star Movement have dropped calls for a referendum on Italy's membership of the monetary union. Feature Italy And The U.K. Compete For Political Risk The European political lens is once again focussed on Italy as the two anti-establishment parties - The League and 5 Star Movement - negotiate to form a government. A coalition of populists governing Italy might ruffle some feathers in Brussels, but the main risk appears to be contained. Both parties have dropped calls for a referendum on Italy's membership of the monetary union, and have instead turned their fire on the EU's fiscal rules, specifically the 3 per cent limit on budget deficits. Chart of the WeekThe SEK Is Due A Tactical Rebound The populist demand for some fiscal relaxation is actually smart economics. When the private sector is paying down debt - as it is in Italy - private sector demand shrinks. To prevent a recession, the government must step in to borrow and spend the paid-down debt. And what seems to be fiscal largesse does not lead to crowding out, inflation, or surging interest rates. This means that as long as Italian populists correctly push back on the EU's draconian fiscal rules rather than the monetary union per se, the market is right to regard Italian politics as a drama, rather than an existential risk to the euro (Chart I-2). Chart I-2The Market Remains Unconcerned ##br##About Euro Break-Up Risk Maybe the European political lens should be focussed instead on Britain. The Conservative party remains as bitterly divided as ever on its vision for the U.K.'s future trading and customs relationships with the EU and the rest of the world. Paralysed and frightened by this division, Theresa May is delaying the legislative passage of three crucial bills - the EU Withdrawal Bill, the Trade Bill, and the Customs Bill. When these bills eventually reach a vote in the House of Commons later this year, any one of them could result in a humiliating defeat for May - and, quite likely, resignations from the government. Meanwhile, as the government kicks the issue into the long grass, firms are holding fire on long-term spending commitments in the U.K. and rechannelling the investment to elsewhere in Europe. Buy SEKs, Avoid NOKs For all the recent swings in the euro versus the dollar and pound, the trade-weighted euro has remained a paragon of relative stability (Chart I-3). This is because the moves versus the dollar and pound have largely cancelled out (Chart I-4). Earlier this year, euro weakness versus the pound coincided with strength versus the dollar; more recently, euro weakness versus the dollar has coincided with strength versus the pound. Chart I-3The Trade-Weighted Euro Has ##br##Remained Relatively Stable... Chart I-4...Because Moves Versus The Dollar And The ##br##Pound Have Largely Cancelled Out Interestingly, the driver of the trade-weighted euro remains the same as it has been for the past fifteen years - it is simply the euro area's long bond yield shortfall versus the U.K. and U.S. (Chart I-5). With the ECB already at the realistic limit of ultra-loose policy, the path for policy rate expectations cannot go meaningfully lower. This means that the trade-weighted euro has some long-term support given that the BoE and/or the Fed have tightening expectations that could be priced out, while the ECB effectively doesn't. Chart I-5The Trade Weighted Euro Is A Function Of The Euro Area's ##br##Long Bond Yield Shortfall Versus The U.K. And U.S. Put another way, for the trade-weighted euro to drift significantly lower, relative surprises in the economic, financial and political news have to be significantly worse in the euro area than in both the U.K. and the U.S. We think this configuration is unlikely. Nevertheless, the more interesting tactical opportunities lie elsewhere: the Swedish krona and the Norwegian krone. Recent tweaks to monetary policy frameworks in Sweden and Norway are responsible, at least partly, for technically exaggerated moves in their currencies which are likely to reverse. In the case of Sweden, the inflation target is unchanged at 2 per cent but the Riksbank introduced a variation band of 1-3 per cent, because "monetary policy is not able to steer inflation in detail." Given that Sweden's inflation rate is now close to 2 per cent, the market interpreted this tweak as very dovish - because it permits the continuation of ultra-accommodative policy. The upshot was that the SEK sold off. But our tried and tested indicator of excessive groupthink suggests that the currency may have overreacted (Chart of the Week). Hence, the tactical opportunity is to stay long the SEK, and our preferred expression is long SEK/GBP. In the case of Norway, a Royal Decree on Monetary Policy lowered the Norges Bank inflation target from 2.5 to 2.0 per cent. This followed years of failure to achieve the higher target. The market interpreted this change as hawkish, as it created the scope for tighter - or at least, less loose - policy than was previously expected. The upshot was that the NOK rallied. But again, the market reaction shows evidence of a technical overreaction (Chart I-6). Hence, the tactical opportunity is to stay short the NOK, and our preferred expression is long AUD/NOK. Chart I-6Our Preferred Expression Of Short NOK Is Versus The AUD Financial Markets Are Not Complicated, But They Are Complex The words 'complicated' and 'complex' appear to be interchangeable, but their meanings are quite distinct. The distinction is important because financial markets are not complicated, but they are complex. Something that is complicated is the sum of a large number of separate parts or processes. For example, making a car is complicated. But predicting the performance of financial markets over the medium term - say, a year or longer - is uncomplicated. The philosophy of Investment Reductionism teaches us that investment strategy is not made up of many separate parts or processes. It reduces to just three things: Predicting the evolution of the global economy. Predicting central bank reaction functions. Predicting tail-events: political, economic and financial. For example, this week's lesson in Investment Reductionism is to illustrate that the medium term decision to allocate between emerging market equities and the Eurostoxx600 largely reduces to the prospects for global metal prices (Chart I-7). Chart I-7EM Versus Eurostoxx600 = Metal Prices By contrast, something that is complex is not the sum of its parts, because the parts interact in unpredictable ways. Complexity characterizes the behaviour of financial markets over the short term - say, up to around six months. Therefore, the best way to model the behaviour of any investment over the very short term is to think of it as a complex adaptive system. A complex adaptive system is a system with a large number of mutually interacting agents, which can learn from their interactions and thereby adapt their subsequent behaviour. Examples include traffic flows, crowds in stadiums, and of course financial markets. A crucial property of all such systems is they possess an endogenous tipping point of instability, at which the behaviour undergoes a 'phase-shift'. This is the essence of how we identify likely short-term trend reversals in any investment such as the SEK and the NOK. This week's final trade recommendation uses this idea once again. Poland's equity market has underperformed recently in line with the general underperformance of the emerging market basket - and our underweight in the Warsaw General Index versus the Eurostoxx600 is handsomely in profit. However, looking at the market as a complex adaptive system, the extent of Poland's underperformance is overdone (Chart I-8). Chart I-8The Extent Of Poland's Underperformance Is Overdone Hence we are taking profit on our underweight in Poland and putting on a short-term countertrend position: long Poland's Warsaw General Index, short Italy's MIB. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* As discussed in the main body of the report, this week's new trade recommendation is a pair-trade: long Poland's Warsaw General Index, short Italy's MIB. The profit target is 5% with a symmetrical stop loss. Our preferred expression of long SEK is versus the GBP which is already in profit since initiation. 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-9 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 EUR/USD will eventually drift up to the ECB calculated equilibrium range of 1.30-1.35. Tactical short NOK/AUD. Tactical long SEK/GBP. On a six month horizon, stay underweight Basic Materials and Financials and own some government bonds. The overall equity market will lack any sustained direction. Sell any sharp rallies and buy any sharp dips. Feature We have seen the shape of things to come. Norway has just lowered its inflation target from 2.5 to 2.0 per cent. This follows years of failure to achieve the higher target (Chart of the Week). More important, Norway's Royal Decree on Monetary Policy emphasizes flexibility: Inflation targeting shall be forward-looking and flexible so that it can contribute to high and stable output and employment and to counteracting the build-up of financial imbalances. Norway follows hot on the heels of Sweden. Last September, the Riksbank also added flexibility to its inflation mandate. The inflation target remains 2 per cent but the central bank introduced a variation band of 1-3 per cent, because "monetary policy is not able to steer inflation in detail." We applaud the Riksbank for its honesty, but we would go a step further. It is near impossible to sustain an arbitrary point target, like 2 per cent (Chart I-2). Chart of the WeekNorway Has Given Up On##br## Its 2.5% Inflation Target Chart I-2Sweden Has Also Struggled To ##br##Achieve Its Inflation Target One Per Cent And Two Per Cent Are Indistinguishable In 1979, Daniel Kahneman and Amos Tversky formalized a new branch of behavioural finance called Prospect Theory, which would ultimately win Kahneman the Nobel Prize for Economics. One of the key findings of Prospect Theory is that the human brain is incapable of distinguishing between very small numbers. In the case of inflation, very few people can really distinguish between an inflation rate of, say, 1 per cent and a rate of 2 per cent. For most people, anything within a range of around 0-2 per cent is indistinguishably perceived as 'negligible inflation'. Since prices rising at 1 per cent or 2 per cent are indistinguishable to most people, Prospect Theory finds that it is near impossible for monetary policy to fine tune inflation expectations - and therefore inflation itself - to a point-target like 2 per cent (Chart I-3). Chart I-3Mission Impossible: 2% Inflation The good news - as we are seeing in Scandinavia - is that central banks are creating, or already have in place, a degree of flexibility and tolerance in their inflation mandates: the Swiss National Bank targets an inflation range of 0-2 per cent; the BoE has a variation band of 1-3 per cent; the Fed has a dual mandate of price stability and maximizing employment;1 New Zealand's government recently asked its Reserve Bank to balance its inflation goal with another aimed at employment; and the BoJ keeps extending the timeframe which it needs to achieve 2 per cent inflation. One of the original reasons for the 2 per cent inflation target has disappeared. To counter a recession, central banks wanted the freedom to take real interest rates to around -2 per cent. With the lower bound of nominal interest rates thought to be zero, this implied an inflation target of 2 per cent. However, we now know that the lower bound of nominal rates is not zero, it is somewhere close to -1 per cent. On this basis, the 2 per cent inflation target should become 1 per cent. All of which makes the ECB's fixation on a 2 per cent point-target for inflation look positively antediluvian. The ECB treaty defines 'price stability' as its single mandate, but the precise definition of price stability is up to the central bank. Given the powerful findings of Prospect Theory, and the general direction of travel of all the other central banks, it is only a matter of time before the ECB interprets or creates more flexibility in its mandate too. Small Differences In Central Bank Mandates Amplify To Huge Moves In Currencies Are we just splitting hairs in pointing out small differences in central bank mandates? No, Prospect Theory finds that people cannot distinguish between inflation rates within a 0-2 per cent range. Yet, for central banks, there can be a huge difference between 0 per cent, 1 per cent and 2 per cent. Hence, within this range, small differences in central bank mandates and definitions of inflation can amplify to huge differences in monetary policies. As we highlighted last week in Where President Trump Is Right About Europe, core consumer prices in the euro area and the U.S. - measured on a like-for-like basis - have increased at a near identical rate over the long term (Chart I-4) and the short term.2 In the euro area, consumer prices exclude the consumption costs of owner-occupied housing; in the U.S. they include it. But both can't be right. Either owner-occupied housing should be excluded from the price basket, and U.S. inflation is running lower than we think; or owner-occupied housing should be included, and euro area inflation is running higher than we think. In 2014, like-for-like inflation was running at exactly the same rate in the two economies (Chart I-5). Yet the small differences in central bank mandates and definitions of inflation led to diametrically opposite policies: ultra-accommodation from the ECB and tightening from the Fed. The upshot is that the EUR/USD exchange rate has seen huge swings: from 1.39 to 1.03 and then back up to 1.24 today. To repeat, like-for-like inflation was not, and is not, that different. Which makes the huge moves in the currency markets highly undesirable and highly unnecessary (Chart I-6). Chart I-4The Euro Area And U.S. Have Experienced ##br##The Same Like-For-Like Core CPI Inflation Chart I-5In 2014, The Euro Area And U.S. Had The ##br##Same Like-For-Like Core CPI Inflation... Chart I-6...Yet Monetary Policy Went In Opposite ##br##Directions And EUR/USD Had Huge Swings In the medium term, we expect the ECB will have no choice but to interpret or create more flexibility in its price stability mandate. If the ECB reaction function becomes less differentiated from its peers, EUR/USD will eventually drift up to the ECB calculated equilibrium range of 1.30-1.35. Returning to Norway, the recent rally in the NOK is overdone. Lowering the inflation target from 2.5 per cent to 2.0 per cent does create the scope for tighter (or at least, less loose) policy than was previously expected. But our tried and tested indicator of excessive groupthink suggests that the currency may have overpriced the pace of change (Chart I-7). Play this through a tactical short in NOK/AUD. Chart I-7The Recent Rally In The NOK Is Overdone In Sweden, the same indicator of excessive groupthink suggests that the recent sell-off in the SEK is also overdone (see page 7). Play this through a tactical long in SEK/GBP. Distinguish Catalysts From Causes Finally, a quick comment on the equity market's struggles this year. To explain these struggles, it would be easy to fixate on the news stories that are dominating the international headlines. But it is always important to distinguish catalysts from causes. When a tree loses its foliage in the autumn, a day of strong winds is the catalyst, it is not the cause. The underlying cause is that the autumn leaves are fragile and due to fall anyway. Likewise, for the market's struggles, trade war skirmishes and missile attacks in Syria are simply catalysts, they are not the cause. The underlying cause is that risk-assets were fragile and due a setback. On price to sales, world equities are as highly valued as at the peak of the dot com bubble (Chart I-8). Meanwhile, global economic growth has entered a mini-deceleration phase which we expect to continue at least into the summer months. In such mini-downswings, bond yields tend to be capped, or even trace down. And cyclical sectors such as Basic Materials and Financials always underperform (Chart I-9). Therefore, on a six-month horizon, own some government bonds and stay underweight Basic Materials and Financials. Chart I-8World Equities As Highly Valued As ##br##At The Peak Of The Dot Com Bubble... Chart I-9...And Global Growth Is Entering##br## A Mini-Downswing The overall equity market will meet both resistance and support. A mini-deceleration in growth implies downside to economic surprises. Against this, if bond yields stabilise or trace down, it will underpin all valuations. Taken together, this suggests that the overall equity market will lack any sustained direction. Sell any sharp rallies and buy any sharp dips. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Some people even argue that the Fed has a triple mandate which includes financial stability. 2 Please see the European Investment Strategy Weekly Report 'Where President Trump Is Right About Europe' April 12, 2018 available at eis.bcaresearch.com Fractal Trading Model* As discussed in the main body of the report, this week's trade recommendation is long SEK/GBP. The profit target is 3% with a symmetrical stop loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations
Highlights The global economic mini-cycle is set to weaken while the euro is set to grind higher. Upgrade Telecoms to overweight. Also overweight Healthcare and Airlines. Underweight Banks, Basic Materials and Energy. Overweight France, Ireland, U.K., Switzerland and Denmark. Underweight Italy, Spain, Sweden and Norway. The Eurostoxx50 will struggle to outperform the S&P500. Feature We are strong believers in Investment Reductionism, a philosophy synthesized from the Pareto Principle and Occam's Razor.1 Investment reductionism offers a liberating thesis - the incessant barrage of investment research, newsfeeds and ten thousand word commentaries is largely superfluous to the investment process. What seems like a complexity of investment choice usually reduces to getting a few over-arching decisions right. Chart of the WeekIn Quadrant 4, Overweight Domestic Defensives And Underweight International Cyclicals For equity sector and country allocation, two over-arching decisions dominate: Whether the global economic mini-cycle is set to strengthen or weaken (Chart I-2). Whether the domestic currency is set to strengthen or weaken. Chart I-2The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The four permutations of these two decisions create the four quadrants of cyclical investing (Chart of the Week). Right now, European investors find themselves in quadrant four: the global economic mini-cycle is set to weaken while the euro is set to grind higher. This favours an overweight stance to defensives, especially domestic-focused defensives. Therefore today, we are upgrading Telecoms to overweight. We also recommend an underweight stance to the most cyclical sectors, especially international-focused cyclicals such as Basic Materials and Energy. Country allocation then just drops out of this sector allocation. The Global Economic Mini-Cycle Is Set To Weaken We can predict the changes of the seasons and the tides of the sea with utmost precision. How? Not because we have an ingenious leading indicator for the seasons and tides, but because we recognise that these phenomena follow perfectly regular cycles. Regular cycles create predictability. Significantly, global bank credit flows also exhibit remarkably regular cycles with half-cycle lengths averaging around eight months. Recognizing these mini-cycles is immensely powerful because, just as for the seasons and the tides, it creates predictability. Furthermore, if most investors are unaware of these cycles, the next turn will not be discounted in today's price - providing a compelling investment opportunity for those who do recognise the predictability. The empirical evidence for credit mini-cycles is irrefutable. The theoretical foundation is also rock solid, based on an economic model called the Cobweb Theory.2 This states that in any market where supply lags demand, both the quantity supplied and the price must oscillate. Given that credit supply clearly lags credit demand, the quantity of credit supplied and its price (the bond yield) must experience mini-cycles (Chart I-3). And as the quantity of credit supplied is a marginal driver of economic activity, economic activity will also experience the same regular oscillations. Today, the global 6-month credit impulse is turning from mini-upswing to mini-downswing, with all three subcomponents - the euro area, the U.S. and China - now in decline (Chart I-4). This is exactly in line with prediction. Mini half-cycles average eight months, and the latest mini-upswing started eight months ago. Chart I-3The Global Economic Mini-Cycle##br## Is Set To Weaken Chart I-4All Three Subcomponents Of The Global 6-Month ##br##Credit Impulse Are Now Declining More importantly, as we enter a mini-downswing, we can also predict that global growth is likely to experience at least a modest deceleration through the coming two to three quarters. The Euro Is Set To Grind Higher, Except Versus The Yen Chart I-5Lost In Translation Nowadays, mainstream stock markets tend to be eclectic collections of multinational companies which happen to be quoted on bourses in Frankfurt, Paris, New York, and so on. For example, BASF is not really a German chemical company, it is a global chemical company headquartered in Germany. For operational hedging, multinational companies like BASF will intentionally diversify their sales and profits across multiple major currencies, say euros and dollars. But of course, the primary stock market quotation will be in the currency of its home bourse, euros. Therefore, when the euro strengthens, the company's multi-currency profits, translated back into a stronger euro, will necessarily weaken (Chart I-5). Clearly, more domestic-focused companies like telecoms will not experience such a strong currency-translation headwind. We expect the main euro crosses to continue strengthening over the next 8 months, with the exception being the cross versus the Japanese yen. Our central thesis is that the payoff profile for a foreign exchange rate just tracks the bond yield spread. This means that when a central bank has already taken bond yields close to their lower bound, its currency possesses a highly attractive asymmetry called positive skew. In essence, as the ECB is at the realistic limit of ultra-loose policy, long-term expectations for the ECB policy rate possess an asymmetry: they cannot go significantly lower, but they could go significantly higher. Exactly the same applies to long-term expectations for the BoJ policy rate. In contrast, long-term expectations for the Fed policy rate possess full symmetry: they could go either way, lower or higher. This stark asymmetry of central bank 'degrees of freedom' favours the euro and the yen over the dollar. Which Sectors And Countries To Own And Which To Avoid? Pulling together the preceding two sections, the global economic mini-cycle is set to weaken while the euro is set to grind higher. This puts Europe in quadrant four of our four quadrant framework for cyclical investing. Unsurprisingly, the relative performance of the most cyclical sectors - Banks, Basic Materials and Energy - very closely tracks the regular mini-cycles in the global 6-month credit impulse. In a mini-downswing these cyclical sectors always underperform (Chart I-6, Chart I-7 and Chart I-8). Accordingly, underweight these three sectors on a two to three quarter horizon. Chart I-6In A Mini-Downswing, ##br##Banks Always Underperform Chart I-7In A Mini-Downswing,##br## Basic Materials Always Underperform Chart I-8In A Mini-Downswing,##br## Energy Always Underperforms Conversely, overweight the relatively defensive Healthcare sector. Also overweight the Airlines sector. Airlines' performance is a mirror-image of the oil price cycle, given that aviation fuel comprises the sector's main variable cost. Furthermore, as aviation fuel is priced in dollars, it also insulates European Airlines against a strengthening euro. Today, we are also upgrading the Telecoms sector to overweight given its relative non-cyclicality (Chart I-9), its domestic-focus, and the excessively negative groupthink towards it (Chart I-10). Chart I-9In A Mini-Downswing, ##br##Telecoms Always Outperform Chart I-10Telecoms Are Due ##br##A Trend Reversal In summary: Overweight: Healthcare, Telecoms, and Airlines Underweight: Banks, Basic Materials and Energy Then to arrive at a country allocation, just combine the cyclical view on the major sectors with the country sector skews in Box 1. The result is the following unchanged European equity market allocation. Overweight: France, Ireland, U.K., Switzerland and Denmark Neutral: Germany and Netherlands Underweight: Italy, Spain, Sweden and Norway Lastly, what is the prognosis for the Eurostoxx50 relative to the S&P500? Essentially, this reduces to a battle between the multinational cyclicals - especially banks - that dominate euro area bourses and the multinational technology giants that dominate the U.S. stock market. With the global economic mini-cycle set to weaken and the euro set to grind higher, the Eurostoxx50 will struggle to outperform the S&P500. Box 1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The Pareto Principle, often known as the 80-20 rule, says that 80% of effects come from just 20% of causes. Occam's Razor says that when there are many competing explanations for the same effect, the simplest explanation is usually the best. 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11, 2018 and available at eis.bcaresearch.com. Fractal Trading Model* This week's recommended trade is to short the Helsinki OMX versus the Eurostoxx600. Apply a profit target of 3% with a symmetrical stop-loss. In other trades, we are pleased to report that short Japanese Energy versus the market achieved its 8% profit target at which it was closed. This leaves four open positions. 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 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