Canada

Highlights Policy Responses: The COVID-19 pandemic has become a full-blown global crisis and recession. Governments and central bankers worldwide are now responding with aggressive monetary easing and fiscal stimulus. Markets will not respond positively to such stimulus, however, until there is some visibility on the true depth, and duration, of the economic downturn. Fixed Income Strategy: With a global recession now a certainty, bond yields will remain under downward pressure and credit spreads should widen further. Given how far yields have already fallen, we recommend emphasizing country and credit allocation in global bond portfolios, while keeping overall duration exposure around benchmark levels. Model Portfolio Changes: Following up on our tactical changes last week, we continue to recommend overweighting government debt versus spread product. Specifically, overweighting US & Canadian government bonds versus Japan and core Europe, and underweighting US high-yield and all euro area and EM credit. Feature In stunning fashion, the sudden stop in the global economy due to the COVID-19 pandemic has triggered a rapid return to crisis-era monetary and fiscal policies. The battle has now shifted to trying to fill the massive hole in global private sector demand left by efforts to contain the spread of the virus. It is unlikely that lower interest rates and more quantitative easing can mitigate the negative growth effects from travel bans, closing of bars and restaurants, and full scale lockdowns of cities. Fiscal policy, combined with efforts to boost market liquidity and ease the coming collapse of cash flows for the majority of global businesses, are the only plausible options remaining. It is unlikely that lower interest rates and more quantitative easing can mitigate the negative growth effects from travel bans, closing of bars and restaurants, and full scale lockdowns of cities. While the speed of these dramatic policy moves is unprecedented, the reason for them is obvious. Plunging equities and surging corporate bond credit spreads are signaling a global recession, but one of uncertain depth and duration given the uncertainties surrounding the spread of COVID-19 (Chart of the Week). Chart of the WeekCan Crisis-Era Monetary Policies Be Effective During A Pandemic? Can Crisis-Era Monetary Policies Be Effective During A Pandemic? Can Crisis-Era Monetary Policies Be Effective During A Pandemic? Chart 2Risk Assets Will Not Bottom Until New COVID-19 Cases Ex-China Peak Risk Assets Will Not Bottom Until New COVID-19 Cases Ex-China Peak Risk Assets Will Not Bottom Until New COVID-19 Cases Ex-China Peak The ability for policymakers to calibrate stimulus measures is pure guesswork at this point. The same thing goes for investors who see zero visibility on global growth, with the full extent of the virus yet to be felt in large economies like the United States and Germany – even as new cases in China, where the epidemic began, approach zero. The response from central bankers has been swift and bold – rapid rate cuts, increased liquidity programs for bank funding and increased asset purchases. The fact that global financial markets have remained volatile, even after what is a clear coordinated effort from policymakers, highlights how the unique threats to growth from the COVID-19 pandemic may be beyond fighting with traditional demand-side stimulus measures. We continue to recommend a cautious near-term investment stance, particular with regards to corporate bond exposure, until there is clear evidence that the growth rate of new COVID-19 cases outside China has peaked (Chart 2). Policymakers Throw The Kitchen Sink At The Problem The market moves and policy announcements have come fast and furious this past week, from virtually all major economies. We summarize some of the moves below: United States The Fed cut rates by -100bps in a Sunday night emergency move, taking the funds rate back to the effective lower bound of 0% - 0.25%. Importantly, Fed Chair Powell made it clear at his press conference that negative rates are not on the table, suggesting that we may have seen the last of the rate cuts for this cycle. A new round of quantitative easing (QE) was also announced, with purchases of $500 billion of Treasury securities and $200 billion of agency MBS that will occur in the “coming months”; Powell hinted that those amounts could be increased, if necessary (Chart 3). The MBS purchases are a clear effort to help bring down mortgage rates, which have not declined anywhere near as rapidly as US Treasury yields during the market rout (bottom panel). The Fed also cut the discount window rate – the rate at which banks can borrow from the Fed for periods of up to 90 days – by -150bps, bringing it down to 0.25%. The Fed said it is “encouraging banks to use their capital and liquidity buffers” – essentially telling banks to hold less cash for regulatory purposes. The Fed also reduced the rate on its US dollar swap lines with other central banks. The new rate is OIS +25bps. Coming on top of the massive increase in existing repo lines last week, the Fed is attempting to ensure that banks, both in the US and globally, that need USD funding have more liquidity available to support lending. Already, there are signs of worsening liquidity in the bank funding markets, like widening FRA-OIS spreads, but also evidence of illiquidity in financial markets like wide bid-ask spreads on longer-maturity US Treasuries and the growing basis between high-yield bonds and equivalent credit default swaps (Chart 4). Chart 3A Return To Fed QE A Return To Fed QE A Return To Fed QE Chart 4Market Liquidity Issues Forced The Fed's Hand Market Liquidity Issues Forced The Fed's Hand Market Liquidity Issues Forced The Fed's Hand Turning to fiscal policy, the full response of the Trump administration is still being formed, but a major $850bn spending package has been proposed that would provide tax relief for American households and businesses while also including a $50bn bailout of the US airline industry. This comes on top of previously announced plans to offer free testing for the virus, paid sick leave, business tax credits and a temporary suspension of student loan interest payments. Chart 5The ECB Has Limited Policy Options The ECB Has Limited Policy Options The ECB Has Limited Policy Options Euro Area The European Central Bank (ECB) unexpectedly made no changes to policy interest rates last week. It opted instead to increase asset purchases by €120bn until the end of 2020 (both for government bonds and investment grade corporates), while introducing more long-term refinancing operations (LTROs) to “provide a bridge” to the targeted LTRO (TLTRO-3) that is set to begin in June. The terms of TLTRO-3 were improved, as well; banks that accessed the liquidity to maintain existing lending could do so at a rate up to -25bps below the current ECB deposit rate of -0.5%, for up to 50% of the existing stock of bank loans. The ECB obviously had to do something, given the coordinated nature of the global monetary policy response to COVID-19. Yet the decisions taken show that the ECB is much more limited in its ability to ease policy further, with interest rates already negative, asset purchases approaching self-imposed country limits and, most worryingly, inflation expectations falling to fresh lows (Chart 5). The bigger responses to date have come on the fiscal front, with stimulus packages proposed by France (€45bn), Italy (€25bn), Spain (€3bn) and the European Commission (€37bn). The biggest news, however, came from Germany which has offered affected businesses tax breaks and cheap loans through the state development bank, KfW – the latter with an planned upper limit of €550bn (and with the German government assuming a greater share of risk on those new KfW loans). The German government has also vaguely promised to temporarily suspend its so-called “debt brake” to allow deficit financing of virus-related stimulus programs, if necessary. Other Countries The Bank of England cut interest rates by -50bps last week, while also lowering capital requirements for UK banks by allowing use of counter-cyclical buffers for lending. On the fiscal side, a £30bn package was introduced last week that included a tax cut for retailers, cash grants to small business, sick pay for those with COVID-19 and extended unemployment benefits. The Bank of Japan held an emergency meeting this past Sunday night, announcing no changes in policy rates but doubling the size of its ETF purchase program to $56 billion a year to $112 billion, while also increasing purchases of corporate bonds and commercial paper. The central bank also announced a new program of 0% interest loans to increase lending to businesses hurt by the virus. The Bank of Canada delivered an emergency -50bps cut in its policy rate last Friday, coming soon after the -50bp reduction from the previous week. The central bank also introduced operations to boost the liquidity of Canadian financial markets. The Canadian government also announced a fiscal package of up to C$20bn, including increased money for the state business funding agencies. The Reserve Bank of Australia did not cut its Cash Rate last week, which was already at a record-low 0.5%. It did, however, signal that it would begin a quantitative easing program for the first time, and introduce Fed-like repo operations, to provide more liquidity to the economy and local financial markets. The Australian government has also announced A$17bn of fiscal stimulus. Fiscal packages have also been introduced in New Zealand (where the Reserve Bank of New Zealand just cut its policy rate by -75bps), Sweden, Switzerland, Norway, and South Korea. To date, China has leaned more on monetary and liquidity measures – lowering interest rates and cutting reserve requirements – rather than a big fiscal stimulus package. Will all these policy measures be enough to offset the hit to global growth from COVID-19 and help stabilize financial markets? It is certainly a good start, particularly in countries with low government and deficit levels that have the fiscal space for even more stimulus, like Germany, Australia and Canada (Chart 6). Given these competing forces of global recession and monetary policy exhaustion on one side, but with increasingly more expansive fiscal policy on the other, we recommend a neutral (at benchmark) stance on overall global duration exposure on both a tactical and strategic basis. The ability to calibrate the necessary policy response is impossible to assess without knowing the full impact of COVID-19 pandemic on the global economy – including the size of related job losses and corporate defaults/bankruptcies. Policymakers are likely to listen to the combined message of financial markets – equity prices, credit spreads and government bond yields. The low level of yields and flat yield curves, despite near-0% policy rates across the developed world (Chart 7), suggests that investors see monetary policy as “tapped out”, leaving fiscal stimulus as the only way to fight the economic war against COVID-19. Chart 6At Global ZIRP, The Policy Focus Shifts To Fiscal At Global ZIRP, The Policy Focus Shifts To Fiscal At Global ZIRP, The Policy Focus Shifts To Fiscal Chart 7Are Bond Yields Discounting A Global Liquidity Trap? Are Bond Yields Discounting A Global Liquidity Trap? Are Bond Yields Discounting A Global Liquidity Trap? Given these competing forces of global recession and monetary policy exhaustion on one side, but with increasingly more expansive fiscal policy on the other, we recommend a neutral (at benchmark) stance on overall global duration exposure on both a tactical and strategic basis. Bottom Line: The COVID-19 pandemic has become a full-blown global crisis and recession. Governments and central bankers worldwide are now responding with aggressive monetary easing and fiscal stimulus. Markets will not respond positively to such stimulus, however, until there is some visibility on the true depth, and duration, of the economic downturn. Corporate Bonds In The US & Europe – Stay Tactically Defensive Chart 8This Crisis Is Different Than 2008 This Crisis Is Different Than 2008 This Crisis Is Different Than 2008 The COVID-19 global market rout has generated levels of market volatility not seen since the 2008 Global Financial Crisis. The US VIX index of option-implied equity volatility spiked to a high of 84, while the equivalent German VDAX measure reached a shocking high of 93. Equity valuations in both the US and Europe remain much higher on a forward price/earnings ratio basis compared to the troughs seen in 2008, even after the COVID-19 bear market. Yet even though volatility has returned to crisis-era extremes, and corporate credit has sold off hard in both the US and Europe, credit spreads remain well below the 2008 highs (Chart 8). Nonetheless, the credit selloff seen over the past few weeks has still been intense. Both investment grade and high-yield spreads have blown out, and across all credit tiers in both the US (Chart 9) and euro area (Chart 10). Even the highest-rated segments of the corporate bond universe have seen spreads explode, with AAA-rated investment grade spreads having doubled in both the US and Europe. Chart 9Broad-Based Spread Widening For Both Investment Grade... Broad-Based Spread Widening For Both Investment Grade... Broad-Based Spread Widening For Both Investment Grade... Chart 10...And High-Yield ...And High-Yield ...And High-Yield With the COVID-19 pandemic tipping the global economy into recession, it is not clear that the spread widening seen to date has been enough to compensate for the typical surge in downgrades and defaults seen during recessions – even though spreads do look wide on a duration-adjusted basis. With the COVID-19 pandemic tipping the global economy into recession, it is not clear that the spread widening seen to date has been enough to compensate for the typical surge in downgrades and defaults seen during recessions – even though spreads do look wide on a duration-adjusted basis.  One of our favorite metrics to value corporate bonds is to look at option-adjusted spreads, adjusted for interest rate duration risk. We call this the 12-month breakeven spread, as it measures the amount of spread widening over one year that would leave corporate bond returns equal to those of duration-matched US Treasuries. We then look at the percentile rankings of those breakeven spreads versus their history as one indicator of corporate bond value. Chart 11US Corporates Look Cheaper On A Duration-Adjusted Basis US Corporates Look Cheaper On A Duration-Adjusted Basis US Corporates Look Cheaper On A Duration-Adjusted Basis For the US, the 12-month breakeven spreads for the overall Bloomberg Barclays investment grade and high-yield indices are in the 82nd and 97th percentiles, respectively (Chart 11). This suggests that the latest credit selloff has made corporate debt quite cheap, although only looking through the prism of spread risk rather than potential default losses. Another of our preferred valuation metrics for high-yield debt is the duration-adjusted spread, or the high-yield index option-adjusted spread minus default losses. We then look at that default-adjusted spread versus its long-run average (+250bps) as a measure of high-yield value. To assess the current level of spreads, we use a one-year ahead forecast of the expected default rate using our own macro model. Over the past 12 months, the high-yield default rate was 4.5% and our macro model is currently calling for a rise to 6.2%. That estimate, however, does not yet include the certain hit to corporate profits from the COVID-19 recession. By way of comparison, the default rate peaked at 11.2% during the 2001/02 default cycle and at 14.6% during the 2008 financial crisis. In Chart 12, we show the historical default rate, our macro model for the default rate, and the history of the default-adjusted spread. We also show what the default-adjusted spread would look like in four different scenarios for the default rate over the next 12 months: 6%, 9%, 11% and 15%. The placement of these numbers in the bottom panel of Chart 12 indicates where the Default-Adjusted Spread will be if each scenario is realized. Chart 12US High-Yield Is Not Cheap On A Default-Adjusted Basis US High-Yield Is Not Cheap On A Default-Adjusted Basis US High-Yield Is Not Cheap On A Default-Adjusted Basis Right now, our expectation is that there will be a virus driven US recession, but it will be shorter in magnitude than past recessions; this suggests a peak default rate closer to 9%. Such a scenario would still be consistent with a positive default-adjusted spread and likely positive excess returns for US high-yield relative to US Treasuries on a 12-month horizon. However, if a default rate similar to that seen during past recessions (11% or 15%) is realized, that would lead to a negative default-adjusted spread. Adding up both pieces of our valuation framework suggests that, while US high-yield spreads offer value on a duration-adjusted basis, spreads do not compensate enough for potential default losses if the US recession lasts longer than we expect. Thus, we recommend a tactical underweight position in US high-yield until we see better visibility on the severity, and duration, of the US recession. Adding up both pieces of our valuation framework suggests that, while US high-yield spreads offer value on a duration-adjusted basis, spreads do not compensate enough for potential default losses if the US recession lasts longer than we expect.  As for euro area corporates, spreads for both investment grade and high-yield do look relatively wide on a breakeven spread basis, although less so than US credit (Chart 13). However, with the World Health Organization declaring Europe as the new epicenter of the COVID-19 pandemic, the harsh containment measures seen in Italy, Germany, France and elsewhere – coming from a starting point of weak overall economic growth – suggest that euro area spreads need to be wider to fully reflect downgrade and default risks. Chart 13Euro Area Corporates Look A Bit Cheaper On A Duration-Adjusted Basis Euro Area Corporates Look A Bit Cheaper On A Duration-Adjusted Basis Euro Area Corporates Look A Bit Cheaper On A Duration-Adjusted Basis We recommend a tactical underweight allocation to both euro area corporate debt and Italian sovereign debt, as spreads have room to reprice wider to reflect a deeper recession (Chart 14). Chart 14Stay Underweight Euro Area Spread Product Stay Underweight Euro Area Spread Product Stay Underweight Euro Area Spread Product Bottom Line: Corporate bond spreads on both sides of the Atlantic discount a sharp economic slowdown, but the odds of a deeper recession – and more spread widening - are greater in Europe relative to the US. A Quick Note On Recent Changes To Our Model Bond Portfolio In last week’s report, we made several adjustments to our model bond portfolio recommended allocations on a tactical (0-6 months) basis.1 Specifically, we downgraded our overall recommended exposure to global spread product to underweight, while increasing the overall allocation to government debt to overweight. The specific changes made to the model bond portfolio are presented in tables on pages 14 & 15. Within the country allocation of the government bond side of the portfolio, we upgraded US and Canada (markets more sensitive to changes in global bond yields, and with central banks that still had room to ease policy) to overweight, while downgrading core Europe to underweight and Japan to maximum underweight (both markets less sensitive to global yields and with no room to cut rates). On the credit side of the portfolio, we downgraded US high-yield to underweight (with a 0% allocation to Caa-rated debt), while also downgrading euro area investment grade and high-yield debt to underweight. We also lowered allocations to emerging market USD denominated debt, both sovereign and corporate, to underweight. We left the allocation to US investment grade debt at neutral, as the other reductions left our overall spread product allocation at the desired level (35% versus the 43% spread product weighting in our custom benchmark portfolio index). In terms of the specific weightings, the portfolio is now +11% overweight US fixed income versus the benchmark, coming most through US Treasury exposure. The portfolio is now -7% underweight euro area versus the benchmark, equally thorough government bond and corporate debt exposure. The portfolio is now also has a -7% weight in Japan versus the benchmark, entirely from government bonds. Note that these weightings represent a tactical allocation only, as we are recommending a defensive stance on spread product exposure given the near-term uncertainties over COVID-19 and global growth. On a strategic (6-12 months) horizon, however, we are neutral overall spread product exposure versus government bonds. Corporate bond spreads already discount a sharp economic slowdown and some increase in defaults. However, the rapid shift to aggressive monetary and fiscal easing by global policymakers to combat the virus will likely limit the duration and, potentially, the severity of the global slowdown currently discounted in wide credit spreads.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Train Is Empty", dated March 10, 2020, available at gfis.bcarsearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Panicked Policymakers Move To A Wartime Footing Panicked Policymakers Move To A Wartime Footing Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The elevated uncertainty about global growth stemming from the COVID-19 virus in China has not only made investors more anxious, but central bankers as well. This means that, only six weeks into the year, policymakers may already be having to rethink their expected strategies for 2020 - which were, for the most part, sitting on hold after the monetary easing in 2019. This has important implications for the direction of global bond yields, which were starting to see a cyclical increase before the viral outbreak. In this report, we present what we see as the most important data for investors to focus on in the major developed markets to get the central bank call correct. This is based on our interpretation of recent speeches, press conferences and published research. We also provide our own suggested data series to watch for each country – which do not always line up with what central bankers are saying they are most worried about. We conclude that it is still not clear that the global growth backdrop has turned sustainably more bond bullish, but there is no pressure on any of the major central banks to move away from extremely accommodative policy settings. Feature Over the past four weeks, all of the major central banks have had the opportunity to formally communicate their current views to financial markets. Whether it was through post-policy- meeting press conferences or published monetary policy reports, central bankers have tried to signal their intentions about future changes in the direction of interest rates, given the heightened uncertainties about the momentum of global growth. At the moment, our global leading economic indicator (LEI) is still signaling that 2020 should see some rebound in global growth – and bond yields – after the sharp 2019 manufacturing-led slowdown (Chart 1). Unfortunately, the latest read on the global LEI uses data as of December, so it does not include what is almost certainly to be a very severe slowdown in the Chinese (and global) economy in the first quarter of 2020 due to the COVID-19 virus outbreak. Underlying stories within each developed market economy – on growth, inflation and potential financial imbalances – suggest that the additional interest rate cuts now discounted globally may not come to fruition if the China shock is contained to the first quarter of the year.  Central bankers are in the same spot as investors, trying to ascertain the extent of the hit to global growth from the virus, both in terms of size and, more importantly, duration. This comes at a time when many central banks were already formally rethinking how to meet their own individual inflation-targeting mandates given the persistence of low global inflation alongside tight labor markets (Chart 2). Chart 1Global Bond Yields: Think Globally, Act Locally Global Bond Yields: Think Globally, Act Locally Global Bond Yields: Think Globally, Act Locally Chart 2Common Worries For All CBs: China & Global Inflation Common Worries For All CBs: China & Global Inflation Common Worries For All CBs: China & Global Inflation That all sounds potentially very bond-bullish, but a lot of bad economic news is already discounted in the current low level of global bond yields. More importantly, the underlying stories within each developed market economy – on growth, inflation and potential financial imbalances – suggest that the additional interest rate cuts now discounted globally may not come to fruition if the China shock is contained to the first quarter of the year. In this Weekly Report, we provide a brief synopsis of what we believe are the biggest concerns for each of the major developed economy central banks. This is based on our read of recent policy decisions and central banker statements, as well as our own understanding of the current reaction function of policymakers. Our intention is to provide a short list of indicators to watch for each central bank, to help cut through the noise of data and news during this current period of unusual uncertainty, as well as our own assessment of what policymakers should be focusing on more. We conclude that it is still too soon to expect a new wave of bond-bullish global monetary policy easings in 2020. It will take evidence pointing to an extended shock to global growth from the COVID-19 virus to reverse the bond-bearish signal from other indicators like our global LEI. Federal Reserve Chart 3Federal Reserve: Focus On Financial Conditions & Inflation Expectations Federal Reserve: Focus On Financial Conditions & Inflation Expectations Federal Reserve: Focus On Financial Conditions & Inflation Expectations Currently, the Fed’s commentary suggests a policy bias that can be described as “neutral-to-dovish”, but it is giving no indication that additional rate cuts are likely in 2020 after the 75bps of cuts last year. Markets remain skeptical, however, with -42bps of cuts over the next twelve months now priced into the USD overnight index swap (OIS) curve according to our Fed Discounter (Chart 3). What the Fed seems most focused on: Fed officials seem focused on measures of market-based inflation expectations, like TIPS breakevens, as the best indication that current policy settings are appropriate (or not) relative to the growth outlook of investors. While FOMC members have expressed concern about TIPS breakevens being persistently below the 2% inflation target, they would not necessarily respond to a further decline in breakevens with more rate cuts without first seeing the US Treasury curve becoming inverted for a prolonged period, just like in 2019 (middle panel). Right now, with the 10-year TIPS breakeven at 1.67% and the 10-year/3-month US Treasury curve now at only -1bp, another decline in longer-term inflation expectations will likely invert the Treasury curve. What the Fed should be more focused on: US financial conditions are highly stimulative, with equity indices back near all-time highs and corporate credit spreads remaining well-contained at tight levels. Given the usual lead times of financial conditions indices to US cyclical growth indicators like the ISM manufacturing index (bottom panel), a continuation of the most recent bounce in the ISM is still the most likely result – even allowing for a near-term hit to global growth from China. While FOMC members have expressed concern about TIPS breakevens being persistently below the 2% inflation target, they would not necessarily respond to a further decline in breakevens with more rate cuts without first seeing the US Treasury curve becoming inverted for a prolonged period, just like in 2019. Bottom Line: The incoming US growth data is critical to determine the Fed’s next move. If there is no follow through from easy financial conditions into faster growth momentum, the odds increase that the Treasury curve will become more deeply inverted for a longer period of time – an outcome that would likely prompt more rate cuts, especially if equity and credit markets also begin to sell off as growth disappoints. European Central Bank Chart 4ECB: Focus On Manufacturing & Inflation Expectations ECB: Focus On Manufacturing & Inflation Expectations ECB: Focus On Manufacturing & Inflation Expectations The ECB has been clearly signaling that it still has a dovish bias, although central bank officials have acknowledged that the options available to them to ease further are limited with policy rates already in negative territory. The market agrees, as there are only -7bps of cuts over the next twelve months now priced into the EUR OIS curve according to our ECB Discounter (Chart 4). What the ECB seems most focused on: The ECB has been paying the most attention to the contractions in euro area manufacturing data (like PMIs) and exports seen in 2019. Rightly so, as nearly all of the two percentage point decline in year-over-year euro area real GDP growth since the late-2017 peak has come from weaker net exports. The central bank has also been concerned about the depressed level of inflation expectations, with the 5-year EUR CPI swap rate, 5-years forward, now at only 1.23% - far below the ECB’s inflation target of “at or just below” 2%. What the ECB should be more focused on: We agree that the focus for the ECB should be most concerned about the weakness in manufacturing/exports and low inflation expectations – the latter having not yet responded to extremely stimulative euro area financial conditions (most notably, the weak euro). The euro area economy is highly leveraged to Chinese demand, with exports to China representing 11% of total euro area exports. This makes leading indicators of Chinese economic activity, like the OECD China LEI and the China credit impulse, critically important indicators in determining the future path of European export demand. The COVID-19 outbreak in China could not have come at a worse time for the ECB, as there have been tentative signs of stabilization in cyclical euro area indicators like manufacturing PMIs in recent months. Bottom Line: The COVID-19 outbreak in China could not have come at a worse time for the ECB, as there have been tentative signs of stabilization in cyclical euro area indicators like manufacturing PMIs in recent months. If the China demand shock to euro area exports is large enough, the ECB will likely be forced to deliver a modest interest rate cut – or an expansion of the size of its monthly asset purchases – to try and boost growth. Bank Of England Chart 5Bank Of England: Focus On Business Sentiment & Labor Costs Bank Of England: Focus On Business Sentiment & Labor Costs Bank Of England: Focus On Business Sentiment & Labor Costs The Bank of England (BoE) has a well-deserved reputation as having an unpredictable policy bias under outgoing Governor Mark Carney, but the central bank does appear to be currently leaning on the moderately dovish side of neutral. Short-term interest rate markets also feel the same way, with -19ps of easing over the next twelve months priced into the GBP OIS curve according to our BoE Discounter (Chart 5). What the BoE seems most focused on: The BoE has been paying a lot of attention to indicators of UK business sentiment, which had been negatively impacted by both Brexit uncertainty and global trade tensions in 2019. The BoE has focused on the link from depressed business sentiment to weak investment spending and anemic productivity growth as an important reason why UK potential GDP growth has been so low and why UK inflation expectations have been relatively high. What the BoE should be more focused on: We agree that business sentiment should be the BoE’s greatest area of focus. Sentiment has shown a solid improvement of late, after the signing of the “phase one” US-China trade deal in December and the formal exit of the UK from the EU on January 31. The CBI Business Optimism survey (measuring the net balance of optimists versus pessimists) soared from -44 in October to +23 in January – the biggest quarterly jump ever recorded in the series. It remains to be seen if this improvement in confidence can be sustained and begin to arrest the steady decline in UK capital spending and productivity growth, and the associated surge in unit labor costs and inflation expectations, that has taken place since the 2016 Brexit vote. Bottom Line: The BoE’s next move, under the new leadership of incoming Governor Andrew Bailey, is not clear. Inflation expectations remain elevated but the recovery in business sentiment is still fragile. One potential risk to watch: UK Prime Minister Boris Johnson may choose to take a bolder stand on trade negotiations with the EU after his resounding election victory in December, risking an outcome closer to the “no-deal Brexit” scenario that was most feared by UK businesses. Bank Of Japan Chart 6Bank of Japan: Focus On Exports & The Yen Bank of Japan: Focus On Exports & The Yen Bank of Japan: Focus On Exports & The Yen The Bank of Japan (BoJ) seems to have had a perpetually dovish bias since the 1990s. Yet the current group of policymakers under Governor Haruhiko Kuroda, realizing that they have run out of realistic policy options after years of extreme stimulus, has not been signaling that fresh easing measures are on the horizon, even with economic growth and inflation remaining very weak in Japan. Markets have taken the hint, with only -6bps of rate cuts over the next twelve months priced into the JPY OIS curve according to our BoJ Discounter (Chart 6). What the BoJ seems most focused on: The BoJ has been vocally concerned about the recent slump in Japanese consumer spending, which declined -2.9% (in real terms) in Q4 after the sales tax hike last October. That blow to consumption was expected, but could not have come at a worse time for a central bank that was already worried about plunging Japanese manufacturing activity and exports – the latter declining by -8% in nominal terms as of December 2019. There is little hope for a near-term rebound given the certain hit to global growth and export demand from virus-stricken China. What the BoJ should be more focused on: Given that Japan is still an economy with a large manufacturing sector that is levered to global growth, the BoJ should remain focused on the path for Japanese exports. A bigger risk, however, comes from the Japanese yen, which has remained very stable over the past year. It has proven very difficult to generate any rise in Japanese inflation without some yen weakness, and with headline CPI inflation now only at +0.2%, a burst of yen strength would likely tip Japan back into outright deflation. Bottom Line: The BoJ is now stuck in a very bad spot, with no real ability to provide a major monetary policy stimulus for the stagnant Japanese economy. At best, all the central bank could do is deliver a small interest rate cut and hope for a quick rebound in global manufacturing activity and/or some yen weakness to boost flagging inflation. Bank Of Canada Chart 7Bank of Canada: Focus On Housing & Capital Spending Bank of Canada: Focus On Housing & Capital Spending Bank of Canada: Focus On Housing & Capital Spending The Bank of Canada (BoC) surprised many observers by keeping policy on hold last year, even as central banks worldwide engaged in various forms of monetary easing to offset the effects of the global manufacturing downturn. The BoC’s recent messaging has been relatively neutral, in our view, although Governor Stephen Poloz has not completely dismissed the possibility of rate cuts in his speeches. The markets are strongly convinced that the BoC will need to belatedly join the global easing party, with -32bps of rate cuts now priced into the CAD OIS curve according to our BoC Discounter (Chart 7) What the BoC seems most focused on: The BoC remains highly concerned over the high level of Canadian household debt, especially given how Canadian consumer spending has been highly geared towards trends in house price inflation over the past few years. This is likely why the BoC has been reluctant to cut policy rates as “insurance” against the effects of a prolonged global growth slump, to avoid stoking a new Canadian housing bubble. Interestingly, the commentary from BoC officials has taken on a bit more dovish tone whenever USD/CAD has threatened to break down below 1.30, suggesting some fears of unwanted currency appreciation. What the BoC should be more focused: The BoC should continue to monitor developments in the Canadian housing market, given the implications for consumer spending and, potentially, financial stability if there is another boom in house prices. The central bank should also pay even greater attention than usual to the subdued level of oil prices, which has triggered a deep slump in the oil-rich Alberta province that has weighed on the overall level of Canadian business investment spending. Persistently soft oil prices would also force the BoC to continue resisting strength in the Canadian dollar. It would likely take a breakdown in oil prices, or an outright decline in house prices, for the rate cut expectations currently discounted in the CAD OIS curve to come to fruition. Bottom Line: The BoC appears under no pressure to make any near-term interest rate adjustments, especially with realized inflation now sitting at the midpoint of the BoC’s 1-3% target band. It would likely take a breakdown in oil prices, or an outright decline in house prices, for the rate cut expectations currently discounted in the CAD OIS curve to come to fruition. Reserve Bank Of Australia Chart 8Reserve Bank Of Australia: Focus On Underemployment & Housing Reserve Bank Of Australia: Focus On Underemployment & Housing Reserve Bank Of Australia: Focus On Underemployment & Housing The Reserve Bank of Australia (RBA) has been very transparent over the past year, loudly signaling a dovish bias and following through with 75bps of rate cuts that took the Cash Rate to a record low of 0.75%. The latest messaging has been a bit more balanced, while still leaving the door to additional rate cuts if the economy worsens. Markets are expecting at least one more easing, with -24bps of rate cuts over the next twelve months priced into the AUD OIS curve, according to our RBA Discounter (Chart 8). What the RBA seems most focused on: The RBA’s main concerns have centered around the persistent undershoot of Australian inflation, with core inflation remaining below the central bank’s 2-3% target band since the beginning of 2016. The central bank has attributed this to persistent excess capacity in the Australian labor market, as evidenced by the elevated underemployment rate. The RBA is also paying close attention to the Australian housing market and its links to consumer spending, with house prices already responding positively to last year’s RBA rate cuts. The outlook for exports is also on the RBA radar, particularly after the recent surge that lifted the Australia trade balance into surplus but is now at risk from a plunge in Chinese demand. What the RBA should be more focused on: We agree that the labor market should be the main focus for the RBA, particularly the underemployment rate which is still high at 8.3%, signaling that core CPI inflation should remain subdued (bottom panel). We also see the RBA as potentially being more sanguine about the risks of a renewed upturn in the housing market than many observers expect, since that would provide a potential offset to a likely pullback in exports which are now a record 25% of GDP (middle panel). Bottom Line: The RBA still has a clear dovish bias, even though they are currently on hold to assess the impact of last year’s easing. RBA Governor Philip Lowe noted in a recent speech that more cuts may be necessary “if the unemployment rate deteriorates”, suggesting that the labor market is the main area of focus for the central bank. Reserve Bank Of New Zealand Chart 9Reserve Bank Of New Zealand: Focus On The Terms Of Trade & Non-Tradeables Inflation Reserve Bank Of New Zealand: Focus On The Terms Of Trade & Non-Tradeables Inflation Reserve Bank Of New Zealand: Focus On The Terms Of Trade & Non-Tradeables Inflation The Reserve Bank of New Zealand (RBNZ) was one of the more dovish central banks in 2019, cutting the Cash Rate by 75bps to a record low of 1%. The overall tone of the central bank’s recent commentary remains cautious, but has taken on a more balanced tone. Markets are priced appropriately, with only -13bps of rate cuts over the next twelve months discounted in the NZD OIS curve according to our RBNZ Discounter (Chart 9). What the RBNZ seems most focused on: The latest messaging from the RBNZ has highlighted the downside risks to New Zealand from weak global growth, but those are now more manageable since the central bank estimates the economy is operating at full employment. In its latest Monetary Policy Statement (MPS), the RBNZ noted that the economy has been able to weather the weakness in global growth thanks to the positive terms of trade effect from elevated New Zealand export prices – a trend that the central bank expects will persist in 2020 even if external demand remains sluggish (middle panel). The central bank has also expressed some concern over the recent pickup in domestically-driven inflation measures, with core CPI inflation back above 2% (bottom panel). What the RBNZ should be more focused on: The RBNZ is right to focus on global growth, particularly given the coming demand shock from virus-stricken China. While the New Zealand dollar has always been a critical variable for the RBNZ in its policy decisions, the currency now takes on added importance given the central bank’s expectation that export prices and the terms of trade will remain elevated. If the latter turns out to be wrong, the RBNZ will be far more likely to take actions to ensure that the Kiwi dollar stays undervalued. Bottom Line: The RBNZ still has a dovish policy bias, but the hurdle to deliver additional rate cuts after last year’s easing seems a bit higher now. It would likely take a major downturn in global growth, combined with a decline in New Zealand export prices and some cooling of domestic inflation, to get the RBNZ to cut again in 2020. Investment Conclusions Based on our “whirlwind tour” of the major developed market central banks in this report, we can make the following conclusions regarding the expected path of interest rates, and bond yields, in these countries: There are no central banks with anything resembling a hawkish bias – not surprising in the current slow global growth environment with heightened uncertainty. The least dovish central banks are the BoC and the RBNZ, which are not signaling any urgency to cut rates. The most dovish central bank is the RBA, which is indicating a clear willingness to cut again if domestic growth deteriorates. The Fed and the BoE are somewhere in the middle of the “dovishness” spectrum, with both likely willing to ease policy but only under a specific set of circumstances. The ECB and BoJ are clearly boxed in having policy rates already below the zero bound, limiting their ability to ease further if needed. In our view, the rate cut probabilities in the US and Canada seem a bit too aggressive, as we are not anticipating major growth slowdowns in either country over the next 6-12 months.  Looking back at our Central Bank Discounters, the largest amount of rate cuts over the next year are now discounted in the US (-42bps), Canada (-32bps), Australia (-24bps) and the UK (-19bps). At the same time, the fewest cuts are priced in Japan (-6bps), the euro area (-7bps) and New Zealand (-13bps). In our view, the rate cut probabilities in the US and Canada seem a bit too aggressive, as we are not anticipating major growth slowdowns in either country over the next 6-12 months. The odds seem more “fair” in the other countries, in terms of the size of rate cut expectations versus the probability of those cuts actually being delivered because of domestic economic considerations. What does this all mean for global bond investing this year? For that we can turn to our Global Golden Rule framework, which links expected returns of government bonds versus cash to the difference between actual and expected rate cuts.1 US Treasuries and Canadian government bond yields are most at risk of underperforming their global peers in 2020 as the Fed and BoC disappoint the current dovish rate cut expectations discounted in interest rate markets.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Special Report, "The Global Golden Rule Of Bond Investing", dated September 25th 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index What Central Banks Are (Or Should Be) Watching What Central Banks Are (Or Should Be) Watching Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns