Euro

Listen to a short summary of this report.     Executive Summary The Dollar Rises During Recessions How Deep A Recession Is The Dollar Pricing In? How Deep A Recession Is The Dollar Pricing In? At 106.5, the dollar DXY index is certainly pricing in a recession deeper than during the Covid-19 crisis. The dollar tends to rise during recessions and only peaks when a global economic recovery is in sight (Feature Chart). One caveat: contrary to conventional wisdom, US economic data is deteriorating relative to the rest of the world. Historically, that has been a negative for the greenback. The key question facing investors is if markets are entering a riot point. That is a high probability. Historically, high volatility supports the dollar. As such, our recommended stance on the dollar is neutral over the next few months. Our highest conviction bets are short EUR/JPY and long Swiss franc trades. Valuations tend to matter when most investors least expect them to. On this basis, we are negative the dollar on a 12-to-18 month time horizon. Place a limit sell on CHF/SEK at 10.76.   TRADES* INITIATION DATE PERCENT RETURNS Short EUR/JPY 2022-07-21 2.73% Bottom Line: Stand aside on the dollar for now. Continue to opportunistically play trades at the crosses. Short EUR/JPY bets make sense as a volatility hedge.   Chart 1Any Dollar Bears Left? Any Dollar Bears Left? Any Dollar Bears Left? In our conversations with clients, it is rare to find a dollar bear these days. One barometer is price action – the dollar DXY index is up 18% from its 2021 lows. More instructively, net long speculative positions are near a multi-decade high (Chart 1). In our meetings, we sense a specter of capitulation among fundamental dollar bears, as the macroeconomic environment becomes more uncertain. For chart enthusiasts, the DXY index staged a classic breakout, and the next technical level is closer to the 2002 highs near 120. We doubt the DXY index will hit this level, as significant headwinds are building. It is true that as markets increasingly price in the probability of a recession, especially in Europe, the dollar will be bought. But as we argue below, the dollar has already priced in a recession, deeper than was the case in 2020 (or admittedly, at any time since the end of the Bretton Woods system). This suggests that investors with a relatively benign economic backdrop should be fading any strength in the dollar. In other words, if your bet on a recession is low odds, fade dollar strength relatively to your colleagues. As such, our recommended stance on the dollar is neutral over the next few months, but bearish for investors with a longer-term horizon. For today, our highest conviction bets are short EUR/JPY and long Swiss franc trades. The US Dollar And Global Growth Chart 2The Dollar Tracks Global Growth The Dollar Tracks Global Growth The Dollar Tracks Global Growth There are many important drivers of the US dollar. One is the path for global growth. If global activity is going to slow meaningfully, then as a countercyclical currency, the dollar tends to rise in that environment. The dollar has been closely correlated (inversely) to the trend in global PMIs, industrial production, and other measures of global growth (Chart 2). Across the world, global growth is slowing (Chart 3). Most manufacturing PMIs in the developed world peaked in the middle of last year. In the developing world, China’s zero Covid-19 policy has nudged many PMIs close to the 50 boom/bust level. As a rule of thumb, you do not want to be short the greenback when global industrial activity is slowing. That is the bull case. Chart 3AGlobal Growth Is Slowing In Developed Markets Global Growth Is Slowing In Developed Markets Global Growth Is Slowing In Developed Markets Chart 3BGrowth Is Also Soft In Emerging Markets Growth Is Also Soft In Emerging Markets Growth Is Also Soft In Emerging Markets The good news for dollar bears is that most of this information is already priced in. Looking back at recessions since the 1970s, the dollar is pricing in one of the most anticipated slowdowns in history (Chart 4). This alone is not a reason to turn bearish on the greenback, but it is a red flag towards the consensus view. In general, currencies are a relative game. The dollar tends to rise 10%-to-15% during recessions. We are already there, with the DXY index up 18% since the 2021 lows. It is also important to gauge how the US is faring relative to the rest of the world. Quite simply, US economy economic activity is deteriorating vis-à-vis its trading partners. This is visible in the Citigroup economic surprise indices, but also via a simple chart of relative PMIs (Chart 5). Historically, that has been a negative for the greenback outside of recessions. Chart 4The Dollar Overshoots During Recessions How Deep A Recession Is The Dollar Pricing In? How Deep A Recession Is The Dollar Pricing In? Chart 5US Economic Momentum Is Deteriorating US Economic Momentum Is Deteriorating US Economic Momentum Is Deteriorating The US Dollar And Interest Rates The Fed hiked interest rates by 75bps this week. This was as expected but given what the Bank of Canada delivered on July 13th, a 100bps hike was a whisper number in our books. More importantly, interest rate differentials (real and nominal) are increasingly moving against the US. As we go to press, 10-year bond yields are 2.67% in the US, but 2.62% in Canada, 3.41% in New Zealand, and even 3.1% in Australia. Chart 6The Euro And Relative Interest Rates The Euro And Relative Interest Rates The Euro And Relative Interest Rates The key point is that the market consensus is centered around the Fed being the most hawkish central bank. That will face a critical test in the next few months, if the world enters a recession. This is especially true in the euro area. The market is pricing that interest rates in the eurozone will be 200bps lower next year, relative to the US (Chart 6). The historical spread between US and German 2-year yields has been 83 bps. If Europe indeed enters a deep recession, then that is already priced in the euro. If we get any green shoots in economic growth, then the euro is poised for a coiled-spring rebound. The market is also pricing in that US interest rates will peak next year, relative to other G10 economies (Chart 7). This could happen in one of two ways: The Fed turns more dovish and/or non-US growth loses steam, leading to lower interest rates outside the US. It is difficult to forecast how the economic scenario will evolve, but from an investor’s standpoint, the dollar has already overshot the level implied by relative interest rates (Chart 8). Chart 7US Short Real Yields Are Attractive How Deep A Recession Is The Dollar Pricing In? How Deep A Recession Is The Dollar Pricing In? Chart 8The Dollar Has Overshot Rate Fundamentals The Dollar Has Overshot Rate Fundamentals The Dollar Has Overshot Rate Fundamentals A Short Note On USD Valuations Valuations usually get little respect, especially over the last few years. The bull market in the dollar from 2011 to 2022 coincided with higher real interest rates in the US relative to the rest of the developed world. That said, a rising trade deficit (imports > exports) requires a lower exchange rate to boost competitiveness in the manufacturing sector, or less spending to reduce the trade deficit. Therefore, the natural adjustment mechanism for countries running wide trade deficits will have to be the exchange rate. Quite simply, rising deficits are a symptom of an overvalued exchange rate. Within a broad spectrum of developed and emerging market currencies, the US dollar is overvalued on a real effective exchange rate basis (Chart 9 and 10). While valuations tend to matter less until they trigger a tipping point, such inflections usually occur with a shift in animal spirits, especially when investors start to worry about huge external imbalances. Chart 9The Dollar Is Overvalued The Dollar Is Overvalued The Dollar Is Overvalued Chart 10The Dollar Is One Of The Most Expensive Currencies How Deep A Recession Is The Dollar Pricing In? How Deep A Recession Is The Dollar Pricing In? In the US, these imbalances are already starting to spark a shift. The US trade deficit has deteriorated. The basic balance in the US (the sum of the current account and foreign direct investment) is deteriorating. The dollar tends to decline on a multi-year basis when the basic balance peaks and starts deteriorating. It is remarkable that at a time when real rates are quite negative in the US, the dollar is the most overvalued in decades on a simple PPP model basis. This is a perfect mirror image of the dollar configuration at the start of the bull market in 2010, where the dollar was cheap and real rates were more supportive. According to economic theory, a currency should adjust to equalize returns across countries. In the early 80s, an expensive dollar was supported by very positive real rates. The subsequent dollar declines thereafter also coincided with falling real interest rates. If global growth shifts from relative strength in the US to overseas, interest rate differentials will tilt in favor of non-US markets. That will be solace for dollar bears. Conclusions In financial markets, it pays to be humble but also to be bold. Our recommended stance on the DXY (and by association, the euro and cable) is to stay on the sidelines. Our highest conviction trade is to short EUR/JPY. With the drop in commodity prices, resource-related currencies are becoming interesting, a topic we will discuss in upcoming bulletins. But momentum is your friend for now, which suggests prudence.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Listen to a short summary of this report.     Executive Summary The TIPS Market Foresees A Sharp Deceleration In Inflation What If The TIPS Are Right? What If The TIPS Are Right? TIPS breakevens are pointing to a rapid decline in US inflation over the next two years. If the TIPS are right, the Fed will not need to raise rates faster than what is already discounted over the next six months. Falling inflation will allow real wages to start rising again. This will bolster consumer confidence, making a recession less likely. The surprising increase in analyst EPS estimates this year partly reflects the contribution of increased energy profits and the fact that earnings are expressed in nominal terms while economic growth is usually expressed in real terms. Nevertheless, even a mild recession would probably knock down operating earnings by 15%-to-20%. While a recession in the US is not our base case, it is for Europe. A European recession is likely to be short-lived with the initial shock from lower Russian gas flows counterbalanced by income-support measures and ramped-up spending on energy infrastructure and defense. We are setting a limit order to buy EUR/USD at 0.981. Bottom Line: Stocks lack an immediate macro driver to move higher, but that driver should come in the form of lower inflation prints starting as early as next month. Investors should maintain a modest overweight to global equities. That said, barring any material developments, we would turn neutral on stocks if the S&P 500 were to rise above 4,050. US CPI Surprises to the Upside… Again        Investors hoping for some relief on the inflation front were disappointed once again this week. The US headline CPI rose 1.32% month-over-month in June, above the consensus of 1.1%. Core inflation increased to 0.71%, surpassing consensus estimates of 0.5%. The key question is how much of June’s report is “water under the bridge” and how much is a harbinger of things to come. Since the CPI data for June was collected, oil prices have dropped to below $100/bbl. Nationwide gasoline prices have fallen for four straight weeks, with the futures market pointing to further declines in the months ahead. Agriculture and metals prices have swooned. Used car prices are heading south. Wage growth has slowed to about 4% from around 6.5% in the second half of last year. The rate of change in the Zillow rent index has rolled over, albeit from high levels (Chart 1). The Zumper National Rent index is sending a similar message as the Zillow data.  All this suggests that inflation may be peaking. The TIPS market certainly agrees. It is discounting a rapid decline in US inflation over the next few years. This week’s inflation report did little to change that fact (Chart 2). Chart 1Some Signs That Inflation Has Peaked Some Signs That Inflation Has Peaked Some Signs That Inflation Has Peaked Chart 2Investors Expect Inflation To Fall Rapidly Over The Next Few Years What If The TIPS Are Right? What If The TIPS Are Right? TIPS Still Siding with Team Transitory If the TIPS market is right, this would have two important implications. First, the Fed would not need to raise rates more quickly over the next six months than the OIS curve is currently discounting (although it probably would not need to cut rates in 2023 either, given our higher-than-consensus view of where the US neutral rate lies) (Chart 3). The second implication is that real wages, which have declined over the past year, will start rising again as inflation heads lower. Falling real wages have sapped consumer confidence. As real wage growth turns positive, confidence will improve, helping to bolster consumer spending (Chart 4). To the extent that consumption accounts for nearly 70% of the US economy – and other components of GDP such as investment generally take their cues from consumer spending – this would significantly raise the odds of a soft landing.  Chart 3The Fed Is Signaling That It Will Raise Rates To Almost 4% In 2023 The Fed Is Signaling That It Will Raise Rates To Almost 4% In 2023 The Fed Is Signaling That It Will Raise Rates To Almost 4% In 2023 Chart 4Positive Real Wage Growth Will Provide A Boost To Consumer Confidence Positive Real Wage Growth Will Provide A Boost To Consumer Confidence Positive Real Wage Growth Will Provide A Boost To Consumer Confidence Chart 5Long-Term Inflation Expectations Remain Well Anchored Long-Term Inflation Expectations Remain Well Anchored Long-Term Inflation Expectations Remain Well Anchored Of course, the TIPS market could be wrong. Bond traders do not set prices and wages. Businesses and workers, interacting with each other, ultimately determine the direction of inflation. Yet, the view of the TIPS market is broadly in sync with the view of most households and businesses. Expected inflation 5-to-10 years out in the University of Michigan survey has risen since the pandemic began, but at about 3%, it is close to where it was for most of the period between 1995 and 2015 (Chart 5). As we pointed out in our recently published Third Quarter Strategy Outlook, and as I discussed in last week’s webcast, the fact that long-term inflation expectations are well anchored implies that the sacrifice ratio – the amount of output that must be forgone to bring down inflation by a given amount — may be quite low. This also raises the odds of a soft landing. Investors Now See Recession as the Base Case Our relatively sanguine view of the US economy leaves us in the minority camp. According to recent polling, more than 70% of US adults expect the economy to be in recession by year-end. Within the investment community, nearly half of retail traders and three-quarters of high-level asset allocators expect a recession within the next 12 months (Chart 6). Chart 6Many Investors Now See Recession As Baked In The Cake What If The TIPS Are Right? What If The TIPS Are Right? Reflecting the downbeat mood among investors, bears exceeded bulls by 20 points in the most recent weekly poll by the American Association of Individual Investors (Chart 7). A record low percentage of respondents in the New York Fed’s Survey of Consumer Expectations believes stocks will rise over the next year (Chart 8). Chart 7Bears Exceed The Bulls By A Wide Margin Bears Exceed The Bulls By A Wide Margin Bears Exceed The Bulls By A Wide Margin Chart 8Households Are Pessimistic On Stocks Households Are Pessimistic On Stocks Households Are Pessimistic On Stocks Resilient Earnings Estimates Admittedly, while sentiment on the economy and the stock market has soured, analyst earnings estimates have yet to decline significantly. In fact, in both the US and the euro area, EPS estimates for 2022 and 2023 are higher today than they were at the start of the year (Chart 9). What’s going on? Part of the explanation reflects the sectoral composition of earnings. In the US, earnings estimates for 2022 are up 2.4% so far this year. Outside of the energy sector, however, 2022 earnings estimates are down 2.2% year-to-date and down 2.9% from their peak in February (Chart 10). Chart 9US And European EPS Estimates Are Up Year-To-Date US And European EPS Estimates Are Up Year-To-Date US And European EPS Estimates Are Up Year-To-Date Another explanation centers on the fact that earnings estimates are expressed in nominal terms while GDP growth is usually expressed in real terms. When inflation is elevated, the difference between real and nominal variables can be important. For example, while US real GDP contracted by 1.6% in Q1, nominal GDP rose by 6.6%. Gross Domestic Income (GDI), which conceptually should equal GDP but can differ due to measurement issues, rose by 1.8% in real terms and by a whopping 10.2% in nominal terms in Q1. Chart 10Soaring Energy Prices Have Boosted Earnings Estimates Soaring Energy Prices Have Boosted Earnings Estimates Soaring Energy Prices Have Boosted Earnings Estimates How Much Bad News Has Been Discounted? Historically, stocks have peaked at approximately the same time as forward earnings estimates have reached their apex. This time around, stocks have swooned well in advance of any cut to earnings estimates (Chart 11). At the time of writing, the S&P 500 was down 25% in real terms from its peak on January 3. Chart 11Unlike In Past Cycles, Stocks Peaked Well Before Earnings What If The TIPS Are Right? What If The TIPS Are Right? This suggests that investors have already discounted some earnings cuts, even if analysts have yet to pencil them in. Consistent with this observation, two-thirds of investors in a recent Bloomberg poll agreed that analysts were “behind the curve” in responding to the deteriorating macro backdrop (Chart 12). Chart 12Most Investors Expect Analyst Earnings Estimates To Come Down What If The TIPS Are Right? What If The TIPS Are Right? Nevertheless, it is likely that stocks would fall further if the economy were to enter a recession. Even in mild recessions, operating profits have fallen by about 15%-to-20% (Chart 13). That is probably a more severe outcome than the market is currently discounting. Chart 13Even A Mild Recession Could Significantly Knock Down Earnings Estimates Even A Mild Recession Could Significantly Knock Down Earnings Estimates Even A Mild Recession Could Significantly Knock Down Earnings Estimates Subjectively, we would expect the S&P 500 to drop to 3,500 over the next 12 months in a mild recession scenario where growth falls into negative territory for a few quarters (30% odds) and to 2,900 in a deep recession scenario where the unemployment rate rises by more than four percentage points from current levels (10% odds). On the flipside, we would expect the S&P 500 to rebound to 4,500 in a scenario where a recession is completely averted (60% odds). A probability-weighted average of these three scenarios produces an expected total return of 8.3% (Table 1). This is enough to warrant a modest overweight to stocks, but just barely. Barring any material developments, we would turn neutral on stocks if the S&P 500 were to rise above 4,050. Table 1A Scenario Analysis For The S&P 500 What If The TIPS Are Right? What If The TIPS Are Right? What’s the Right Framework for Thinking About a European Recession? Whereas we would assign 40% odds to a recession in the US over the next 12 months, we would put the odds of a recession in Europe at around 60%. With a recession in Europe looking increasingly probable, a key question is what the nature of this recession would be. The pandemic may provide a useful framework for answering that question. Just as the pandemic represented an external shock to the global economy, the disruption to energy supplies, stemming from Russia’s invasion of Ukraine, represents an external shock to the European economy. In the initial phase of the pandemic, economic activity in developed economies collapsed as millions of workers were forced to isolate at home. Over the following months, however, the proliferation of work-from-home practices, the easing of lockdown measures, and ample fiscal support permitted growth to recover. Eventually, vaccines became available, which allowed for a further shift to normal life. Just as it took about two years for vaccines to become widely deployed, it will take time for Europe to wean itself off its dependence on Russian natural gas. Earlier this year, the IEA reckoned that the EU could displace more than a third of Russian gas imports within a year. The more ambitious REPowerEU plan foresees two-thirds of Russian gas being displaced by the end of 2022. In the meantime, some Russian gas will be necessary. Canada’s decision over Ukrainian objections to return a repaired turbine to Germany for use in the Nord Stream 1 gas pipeline suggests that a full cutoff of Russian gas flows is unlikely. Chart 14The Euro Is 26% Undervalued Against The Dollar Based On PPP The Euro Is 26% Undervalued Against The Dollar Based On PPP The Euro Is 26% Undervalued Against The Dollar Based On PPP During the pandemic, governments wasted little time in passing legislation to ease the burden on households and businesses. The European energy crunch will elicit a similar response. Back when I worked at the IMF, a common mantra in designing lending programs was that one should “finance temporary shocks but adjust to permanent ones.” The current situation Europe is a textbook example for the merits of providing income support to the private sector, financed by temporarily larger public deficits. The ECB’s soon-to-be-launched “anti-fragmentation” program will allow the central bank to buy the government debt of Italy and other at-risk sovereign borrowers without the need for a formal European Stability Mechanism (ESM) program, provided that the long-term debt profile of the borrowers remains sustainable. Get Ready to Buy the Euro All this suggests that Europe could see a fairly brisk rebound after the energy crunch abates. If the euro area recovers quickly, the euro – which is now about as undervalued against the dollar as anytime in its history (Chart 14) – will soar. With that in mind, we are setting a limit order to buy EUR/USD at 0.981.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on  LinkedIn & Twitter   Global Investment Strategy View Matrix What If The TIPS Are Right? What If The TIPS Are Right? Special Trade Recommendations Current MacroQuant Model Scores What If The TIPS Are Right? What If The TIPS Are Right?

Executive Summary Don’t Try Catching Falling Euros Don"t Try Catching Falling Euros Don"t Try Catching Falling Euros The euro is inexorably moving toward parity. However, many positives could still save EUR/USD, a cheap currency that will benefit if the fears of a global recession recede and if European inflation peaks by the fall. Nonetheless, many fundamental risks still weigh on the euro, including the dollar’s momentum and the continuing ructions in the European energy market. Moreover, technical vulnerabilities are likely to amplify the potential weakness in the euro. There is greater than a 30% chance that EUR/USD will fall to 0.9 or below. As a result, it is preferable to stay on the sidelines and opt for a neutral stance on the EUR/USD. Selling EUR/JPY offers a more attractive reward-to-risk ratio than EUR/USD. The GBP remains under threat. Bottom Line: Don’t be a hero. At this juncture, the EUR/USD outlook remains particularly uncertain. While EUR/USD possesses ample upside over the coming 12 months, there is roughly a 1/3 chance that it will plunge to 0.9 by the winter. Investors should sell EUR/JPY instead.   The euro’s race toward parity continues. From May 12 to July 1, EUR/USD attempted to form a triple bottom at 1.0375 that could have marked the end of this year’s decline. Alas, the euro did not hold that floor and now traders are inexorably pushing the common currency lower. The outlook for the euro is complex. At current levels, it is inexpensive and discounts many negative developments affecting both the global and European economies. However, the EUR/USD’s weakness is also a story of dollar strength, and the deteriorating global economic momentum remains the Greenback’s best friend, to the euro’s detriment. For now, we stick to our mantra of the past few months: don’t be a hero. The euro may soon bottom, but enough risks lie ahead that a move below 0.9 against the dollar should not be discarded. The risk-reward from bottom fishing is therefore poor. Instead, investors should sell EUR/JPY, for which downside remains ample. What We Like About The Euro… Despite the pervasive negativity engulfing the euro, there are plenty of positives that will soon help EUR/USD form a bottom. First, the euro is cheap on most metrics. The Purchasing Power Parity (PPP) model developed by BCA’s Foreign Exchange Strategists adjust for the different consumption baskets in the Eurozone and the US. It currently shows that EUR/USD trades 25% below fair value, its deepest discount since 2001. This degree of undervaluation is associated with a high probability of strong long-term returns for the euro (Chart 1). Based on interest rate parity and risk aversion, the euro also trades well below its fair value. Steep discounts are often followed by an imminent rebound in the currency (Chart 2). However, the euro hit a similar discount in January, but failed to rally because of the problems in the energy markets prompted by Russia’s invasion of Ukraine. Chart 1Strong Long-Term Returns based on PPP Strong Long-Term Returns based on PPP Strong Long-Term Returns based on PPP Chart 2Oversold on Many Metrics Oversold on Many Metrics Oversold on Many Metrics Second, the euro is oversold. Both BCA’s Intermediate-Term Technical Indicator and the Citi FX Euro PAIN Index are very depressed, which indicates pervasive negative sentiment toward the euro (Chart 2, bottom two panels). This kind of extremes in momentum are often followed by a euro rally. Chart 3Global Recession Fears Hurt EUR/USD Global Recession Fears Hurt EUR/USD Global Recession Fears Hurt EUR/USD Third, global economic pessimism is widespread. EUR/USD is a pro-cyclical pair, which mostly reflects the counter-cyclicality of the dollar and the great liquidity of the euro. It is therefore not surprising that spikes in global recession concerns are associated with a weakening EUR/USD (Chart 3). The recent wave of depreciation happened contemporaneously with a spike in Google searches for the word “recession.” If these fears, which reached extreme levels, subside further in the months ahead, the euro may benefit greatly. Fourth, pessimism toward China may ease, which would lift the euro in the process. Last week, it was announced that Beijing is considering allowing local governments to sell RMB1.5 trillion of special government bonds in the second half of the year to fund infrastructure spending. The news caused a rebound in the AUD, Brazilian assets, and copper. Europe too would benefit from greater activity in China. Chart 4Chinese Salvation? Chinese Salvation? Chinese Salvation? Chinese monetary conditions are also easing, which historically supports industrial activity in Europe relative to the US (Chart 4, top panel). The change in approach in the implementation of the zero-COVID policy is helping Chinese PMIs rebound, which will eventually translate into higher European shipments to China. Moreover, the rate of change of the performance of real estate stocks relative to the broad market has turned the corner, which may facilitate a stabilization of Chinese real estate transactions (Chart 4, second panel). Ultimately, the expanding excess reserves in the Chinese banking system point toward a stabilization of the performance of EUR/USD later this year (Chart 4, bottom panel). Fifth, our expectation that European inflation will peak by the autumn will prove the greatest help to the euro. The EUR/USD’s weakness over the past twelve months has coincided with a surge in European inflation surprises (Chart 5, top panel). This relationship reflects the negative impact on European real rates of both stronger realized and expected inflation (Chart 5, second panel). Investors understand that Europe’s inflation crisis is driven by a relative price shock in the energy market that greatly hurts economic activity in the Eurozone. Hence, even if they expect the ECB to increase interest rates, they believe policy rates will lag inflation because of Europe’s poor growth outlook. This is particularly true when compared to the US Fed. As a result, European real rates continue to lag far behind US ones and the European yield curve is steeper than that of the US, because traders foresee easier policy on the Eastern shores of the Atlantic (Chart 5, panel three and four). Chart 5Inflation Hurts the Euro Inflation Hurts the Euro Inflation Hurts the Euro Chart 6Declining Inflation Expectations? Declining Inflation Expectations? Declining Inflation Expectations? Declining Inflation Expectations? Declining Inflation Expectations? Declining Inflation Expectations? This situation is fluid and inflation expectations have begun to decrease. The recent easing in energy prices has contributed to a decline in long-term inflation expectations (Chart 6). We argued last week that the energy inflation is arithmetically set to decrease over the coming twelve months, which suggests further downside in inflation expectations is likely. Moreover, four of the five largest weights in the Eurozone HICP are running hot, but all are linked to commodity inflation, which confirms our bias that European inflation will soon peak (Chart 7). A top in both headline and core inflation will drag short- and long-term inflation expectations lower, which will help European real rates (Chart 8). Meanwhile, lower imported energy inflation will limit the damage to European economic activity, allowing the ECB to increase rates anyway.   Chart 7Key HICP Components Key HICP Components Key HICP Components Chart 8A durable Decline In Expected Inflation Depends On Realized Inflation A durable Decline In Expected Inflation Depends On Realized Inflation A durable Decline In Expected Inflation Depends On Realized Inflation Chart 9Balance Of Payment Support Balance Of Payment Support Balance Of Payment Support Bottom Line: The euro benefits from important tailwinds that suggest EUR/USD will be higher 12 to 18 months from now. It is cheap and oversold and the pervasive gloom among investors about the state of the global economy indicates that many negatives are already embedded in its pricing. Moreover, the Chinese economy could stabilize in the second half of 2022 and into 2023, which will hurt the dollar and boost the euro. Crucially, a peak in European inflation will allow European real rates to recover and curtail the handicap keeping EUR/USD under pressure, especially as the basic balance of payment remains in the euro’s favor (Chart 9).   … And What We Don’t EUR/USD may benefit from some important tailwinds, but it is still burdened by massive handicaps. The first problem that will place downward pressure on the euro is that its weakness is not unique and that it reflects broad-based dollar strength (Chart 10). This is a problem for the euro because the dollar (and the yen) is the foremost momentum currency in the G10. Its strength begets further strength, and the momentum signal from moving average crossovers remains dollar-bullish.  This headwind for the euro could even intensify in the coming months. JP Morgan EM FX Index is breaking down to new lows, which points to further tightening in EM financial conditions. Historically, tighter EM FCIs translate in both weaker Eurozone stock prices and a weaker EUR/USD, which reflects the closer link between the Euro Area and EM economies than between the US and EM (Chart 11). Chart 10The Dollar's Strength Is Broad-Based The Dollar's Strength Is Broad-Based The Dollar's Strength Is Broad-Based Chart 11More Trouble In Store More Trouble In Store More Trouble In Store This phenomenon is exacerbated by the underlying weakness in global economic activity. Arthur Budaghyan, BCA’s EM Chief Strategist, often reminds us that Asian exports remain soft. Additionally, the deterioration in US economic activity is likely to continue, as suggested by the weakness in the ISM new orders-to-inventories ratio and by the poor readings from the Regional Fed Surveys. Slowing US growth will generate a further decline in the business-sales-to-inventory ratio, which often coincides in a strong dollar and a weak euro. Chart 12Past Chinese Weaknesses Linger Past Chinese Weaknesses Linger Past Chinese Weaknesses Linger The second problem for EUR/USD is that China’s economic outlook may be improving in the future, but, for now, the impact of the recent Chinese slowdown continues to hamper Europe. More specifically, the recent decline in Chinese import volumes is consistent with a euro-bearish backdrop for the remainder of this year (Chart 12, top panel). In fact, even if the CNY remains stable against the USD, this does not guarantee a positive outcome for the euro as the past weakness in Chinese import volumes is also consistent with a depreciating EUR/CNY (Chart 12, bottom panel) The third euro-negative force is the natural gas market. As we showed last week, Dutch natural gas prices must settle between EUR500-600/MWh this upcoming winter to have the same inflationary impact as they did over the past 18 months. This is unlikely to happen, even according to the direst forecasts of BCA’s Commodity and Energy strategists. However, there is a greater than 30% chance that Europe must ration electricity this winter, which would cause a violent output contraction. As a result, any fluctuation in natural gas flows in Europe will cause the market-based odds of a European recession to swing widely. Consequently, the negative correlation between EUR/USD and TTF prices observed over the past twelve months is likely to remain intact (Chart 13). Related Report  European Investment StrategyQuestions From The Road The fourth issue hurting the euro is the US’s comparative isolation from the energy market’s travails. The US is a haven of relative economic stability today. Yes, its growth will slow further, but it is nonetheless set to outperform the Eurozone. The US is not under threat of rationing energy this winter. Moreover, the US terms of trades benefit from rising energy prices, unlike Europe (Chart 14). Furthermore, the US output gap is closing faster than that of in the Eurozone (Chart 14, bottom panel). As a result, the odds of dovish surprises by the ECB are much greater than those by the Fed. Chart 13Neutral Gas Is Still A Drag Neutral Gas Is Still A Drag Neutral Gas Is Still A Drag Chart 14The US As A Haven Of Stability The US As A Haven Of Stability The US As A Haven Of Stability The US’s relative resilience might also impact equity flows over the next few months in a euro-bearish fashion. US EPS have been stable relative to Euro Area ones, even in local currency terms. Interestingly, because relative EPS reflect broader economic forces, EUR/USD follows them (Chart 15). Thus, if the European economic outlook deteriorates further relative to that of the US, chances are high that Eurozone EPS estimates will be revised down relative to the US, which will coincide with a lower EUR/USD. In fact, the recent underperformance of Eurozone small-cap stocks (which are domestically focused) relative to European large-cap equities (which derive a greater proportion of their sales abroad) and US small-cap shares also confirms the worsening relative economic outlook between Europe and the US, and thus portend significant near-term risks to EUR/USD (Chart 16). Chart 15Follow Earnings Estimates Follow Earnings Estimates Follow Earnings Estimates Chart 16Small Caps Indicate More EUR Selling Small Caps Indicate More EUR Selling Small Caps Indicate More EUR Selling Chart 17An ECB Bungle Would Burden The Euro An ECB Bungle Would Burden The Euro An ECB Bungle Would Burden The Euro The last major fundamental risk weighing on EUR/USD is the significant probability that the ECB will disappoint markets with respect to its anti-fragmentation tool to be announced in July. Investor expectations are lofty. However, internal divisions within the ECB Governing Council remain, and, most importantly, the ECB is hamstrung by previous ECJ and German Constitutional Court rulings on bond purchases. Thus, our base case remains that the development of an appropriate bond purchase program will be an iterative process resulting from a back-and-forth between market tensions and ECB responses. As a result, there are risks of further widening in Italian spreads as well as European corporate bond spreads. These developments would further hurt the euro (Chart 17). Chart 18Much Selling To Be Unleashed Sentiment Could Get More Negative Much Selling To Be Unleashed Sentiment Could Get More Negative Much Selling To Be Unleashed Sentiment Could Get More Negative These fundamental problems with EUR/USD do not guarantee that the euro will punch below parity. After all, there are also plenty of positives with this currency. However, the risk of a violent selloff is elevated, at around 30%, because of underlying technical vulnerabilities. Global market liquidity has deteriorated in recent years, and this phenomenon is also impacting FX markets, resulting in sudden jumps being more frequent. Most crucially, the odds are high that automatic selling will be triggered if the euro tests parity, which would result in a cascading decline for a euro entering territory that has not been charted for the past 20 years. Specifically, speculators are marginally short the euro (Chart 18, top panel) and 1-month and 3-month risk reversals in the option markets are not yet at a capitulation point (Chart 18, bottom panel). Thus, if panic sets in, the euro could easily fall below 0.9, where the strongest supports lie. In essence, we worry that a sudden crash in the euro is becoming a growing threat. Bottom Line: The combination of the dollar’s momentum, the lagging impact of China’s economic woes, the risks to Europe’s energy supplies, the relative stability of the US economy, and the heightened chance that the ECB underdelivers with respect to its anti-fragmentation tool later next week all point to significant risks to the euro in the coming months. Moreover, the technical vulnerabilities present in the FX market suggest that, if further downside takes place, it will not only be large but also rapid. Investment Conclusions The dilemma between views and strategy is greatest with the euro today. There are many positives highlighted in this report that suggest that the euro has upside on a 12-month basis. However, the risks are abundant, and the potential downside in the coming six months not only carries a large probability, it is also likely to be pronounced if it takes place. As a result of this configuration, we fall back to the strategy we had adopted for European equities earlier this year: don’t be a hero. Even if the euro bottoms tomorrow, the risks are such that capital preservation remains paramount. Consequently, we recommend that investors stay on the sideline and maintain a neutral stance on EUR/USD. It is just as risky to try to bottom fish this pair as it is to chase it lower from current levels. Chart 19Sell EUR/JPY Sell EUR/JPY Sell EUR/JPY Instead, we follow BCA’s Foreign Exchange Strategists recommendation to go short EUR/JPY as a bet with a lower risk-reward ratio. Global recession worries and weakening commodity inflation are likely to allow for greater downside in global yields, which often results in a lower EUR/JPY (Chart 19). Additionally, investors do not expect much out of the BoJ this year, but if recession risks intensify in Europe because of energy rationing this winter, there is room to curtail the interest rate pricing for the ECB embedded in the €STR curve. Furthermore, the JPY is the cheapest currency in the G10. Finally, investors wanting to build greater exposure to European currencies should do so via the Swiss franc. We argued three weeks ago that the CHF enjoys significant structural tailwinds because of the Swiss economy’s strong productivity. Additionally, the SNB is no longer intervening to limit the CHF upside, as demonstrated by the decline in its current deposits. Instead, a stronger Swiss franc is the most potent weapon in the SNB’s arsenal to combat inflation. Moreover, the CHF offers a hedge against both recession risks in the Eurozone and further widening in European spreads. Bottom Line: Don’t be a hero. EUR/USD’s outlook is uniquely uncertain now. While many factors point to positive returns on a 12-to-18 month basis, if the euro hits parity in response to the many clouds still hanging over Europe, technical factors could plunge this currency to EUR/USD 0.9 into a steep decline. Instead, the clearer call is to sell EUR/JPY. Investors who want to assume a European FX exposure today should do so through the Swiss franc, not the euro. A Few Words On The UK Last week, Prime Minister Boris Johnson resigned. The initial response of the pound was to rebound. This reaction should fade. BCA Geopolitical strategists argue that, even though the person sitting at 10 Downing Street is about to change, the fundamental problems with the UK remain the same. The Labour Party is ascending, but it will still have to deal with the Brexit aftermath, rising populism, and popular discontent across the country. The economy is still fragile and engulfed in an inflationary spiral. Meanwhile, the risks created by a looming Scottish independence referendum are much more significant than was the case in 2014. As a result, the pound is likely to remain under stress over the coming quarters.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary The Dollar And Volatility The Dollar And Volatility The Dollar And Volatility The dollar continues to be bid, as volatility rises. The MOVE volatility index is making fresh cycle highs and has pushed the DXY index above our stop level of 107 (Feature Chart). The move in the dollar suggests that we are experiencing a classic breakout pattern. Historically, this means that flows into the USD will continue, until it becomes clear that drivers of USD strength have abated. These include inflation peaking and global growth bottoming. We are moving our recommended stance on USD to neutral. It is becoming clear that the market sees the risk of a nasty recession in Europe to be high. The euro could break below parity, as speculators short the currency en masse. The yen is becoming a winner in the current context. We are reopening our short EUR/JPY trade this week, in addition to our short CHF/JPY position initiated last week.  Our long AUD/USD position was stopped out at 68 cents this week. Given our shift to a neutral view on the dollar, we recommend investors stand aside for now. Bottom Line: We were stopped out of our short DXY position at 107, for a loss of 2.34%. We are moving to a neutral stance on the greenback. While valuation and sentiment are at contrarian extremes, the current environment dictates that further gains in the greenback are likely in the near term. Feature The DXY index has staged a classic breakout and the next technical level is closer to the 2002 highs near 120. Year-to-date, the DXY has been one of the best performing currencies (Chart 1). In last week’s report, we presented a framework for managing currencies, suggesting that while the path of least resistance for the dollar was up, significant headwinds were also building. One of the closest correlations we have seen in recent trading days is with volatility. As Chart 2 shows, the dollar and the MOVE index have been the same line. As markets increasingly price in the probability of a recession, especially in Europe, the dollar will be bought. This puts central banks in a quandary: focusing on growth or inflation? As such bond volatility is shooting up and the dollar is commanding a hefty safety premium. In the next few sections, we go over the important data releases from our universe of G10 countries, and implications for currency strategy. Chart 1The Dollar Remains King Month In Review: The Euro At Parity, What Next? Month In Review: The Euro At Parity, What Next? Chart 2The Dollar And Volatility The Dollar And Volatility The Dollar And Volatility US Dollar: A Classic Breakout Chart 3A Clean Breakout In The DXY A Clean Breakout In The DXY A Clean Breakout In The DXY The dollar DXY index is up 11.3% year-to-date. Over the last month, the DXY index is up 4.7%. Technical forces are still in favor of the greenback as a momentum currency, given the classic breakout pattern. Looking at incoming data from the US, the case for dollar strength remains in place in the near term. The May CPI print came in well above expectations, at 8.6% for headline, versus 8.3% expected. A few days later, the PPI print was also strong at 10.8% year on year. This is happening at a time when consumer confidence is rolling over. The University of Michigan current conditions index fell from 63.3 to 53.8 in May. The expectations component dropped from 55.2 to 47.5. The conference board measure fell from 103.2 to 98.7 in June. After this print, the Fed met on June 15 and increased interest rates by 75bps, a surprise to the market. The current account deficit widened to $291.4bn US, a record low since the end of the Bretton Woods system . Retail sales disappointed in May. Excluding automobile and gasoline, sales were up 0.1% month on month, versus a consensus expectation of a 0.4% rise. It was also flat for the control group, suggesting basket changes were not responsible for the deterioration. The numbers are on a nominal basis, which suggests that retail sales volumes are contracting meaningfully. The rise in interest rates is filtering into the housing market. Mortgage applications fell 5.4% during the week of July 1. Housing starts declined from 1,810K to 1,724K in May, a 14.4% drop. Building permits also fell 7% month on month, in line with the 3.4% drop in existing home sales.  The ISM manufacturing index fell from 56.1 to 53 in June. US economic data is softening, which raises the odds that the US joins Europe and China in a classic slowdown. In such a configuration, the market is pricing in that the dollar will ultimately be the haven asset, as has been the case in recent history. We went short the DXY index at 104.8, with a stop-loss at 107, that was triggered overnight. We are moving to a neutral stance today and will revisit this position once global economic uncertainty subsides.  The Euro: A European Hard Landing Chart 4The Euro Is Pricing In A Deep Recession The Euro Is Pricing In A Deep Recession The Euro Is Pricing In A Deep Recession The euro is down 10.5% year-to-date. Over the last month, the euro is down 4.7%, and recent trading suggests we will probably breach parity versus the dollar in the coming weeks. Recent data from the eurozone continues to suggest it is trapped in stagflation. The preliminary CPI print for June came in at 8.6%, well above the previous 8.1% print. PPI in the euro area is at 36.3%. Meanwhile, consumer confidence (the European Commission’s measure) is approaching a record low. The Sentix investor confidence index peaked in July last year and has been falling ever since. With a mandate of bringing down inflation, the ECB may have no choice but to knock the eurozone economy to its knees. The proximate expression of this view has been via shorting the euro. Most of the incoming data for the euro area have been deteriorating. For example, on a seasonally adjusted basis, the trade deficit widened to -€31.7bn. This is a record since the creation of the euro. This has completely wiped the eurozone current account, meaning the euro is now becoming a borrower nation. The critical question for Europe lies in the adjustment mechanism towards a possible shut-off in natural gas supplies for the winter. European natural gas prices are soaring anew, though well below the peak this year. A cut-off of Russian supplies is becoming a very real possibility. The question then becomes how deep of a European recession the euro is pricing in. Back in 2020, the euro bottomed at 1.06. At the time, quarterly real GDP in the euro area fell 11.9% in the second quarter. That was worse than both during the global financial crisis, and anytime since the creation of the euro. This means that fundamentally, the euro has already priced in a nasty recession in Europe. If it occurs, the euro could undershoot but if it does not, the potential for a coiled spring rebound is immense. A hedged bet on the euro is to sell the EUR/JPY cross. In a risk-off environment, EUR/JPY will collapse. In a Goldilocks scenario, the yen has sold off much more that the euro, that the cross could move sideways.  The Japanese Yen: Now A Safe Haven Chart 5The Yen Is Becoming An Attractive Safe Haven The Yen Is Becoming An Attractive Safe Haven The Yen Is Becoming An Attractive Safe Haven The Japanese yen is down 15.4% year-to-date, the worst performing G10 currency. Over the last month, the yen is down 2.4%. Incoming data in Japan has been mixed with the domestic economy still showing some signs of weakness, while the external sector is faring relatively better. The Bank of Japan kept monetary policy on hold last month, despite a widely held view in markets that it would pivot, following the surprise hike by the Swiss National Bank. Inflation in Japan has been modest, with nationwide CPI at 2.5% in May. The Tokyo CPI release for June showed that inflation remains sticky around this level. Yet the BoJ views a large chunk of inflation in Japan to be transitory, due to rising energy costs, and base effects from the sharp drop in mobile phone prices last year. For inflation to pick up, ultimately wages need to rise. Labor cash earnings for May came in at 1%. For Japan, this is a healthy print compared to recent history, but still pins real cash earnings at -1.8%, suggesting little risk of a wage inflation spiral. The Tankan survey for the second quarter provided a glimmer of hope. While large manufacturers (mainly exporters) sensed a deterioration in the outlook, domestic concerns were more upbeat. The large non-manufacturing index improved from 9 to 13 in the second quarter. The small non-manufacturing index improved from -6 to -1. Notably, capex intentions rose 18.6%, the highest level since the late 80s. The drivers of the yen remain clear and absolute. First, rising global interest rates put selling pressure on the yen and vice versa. Second, energy prices sap the trade balance, which is also negative. Should these factors abate (as they are currently), the yen will benefit. This week, we are reopening our short EUR/JPY trade, in addition to being short CHF/JPY. From a contrarian perspective, the yen is the cheapest G10 currency according to our PPP models. It also happens to be one of the most heavily shorted currencies, according to CFTC data.  British Pound: Sterling Breaks Below 1.20 Chart 6Politics Will Keep Cable Volatile Politics Will Keep Cable Volatile Politics Will Keep Cable Volatile The pound is down 11.1% year-to-date. Over the last month, the pound is down by 4.5% as a combination of economic and political headwinds hit sterling. Politically, the resignation of Prime Minister Boris Johnson is fueling sterling volatility. According to our geopolitical strategists, investors’ focus should be on whether UK national policy will change. This will require an election that replaces the Conservative Party-led government, or at least removes its single-party majority. Boris Johnson’s approval rating had been collapsing in recent days on the back of a series of scandals, so a less unloved leader under the same party will at least assuage public opinion, while keeping existing policies largely the same. The next milestones to watch for are an early election (unlikely since the Conservative Party still has an interest in prolonging until 2025) and a Scottish referendum for independence next year. Labor will also continue to benefit from a tailwind of high inflation and the mishandling of the pandemic by the Tories that has left voters largely frustrated. Economically, data in the UK continues its whiff of stagflation. CPI came out at 9.1% in May, the RPI accelerated to 11.7%, and nationwide housing prices came in at 10.7% in June, while retail sales are tanking, falling 4.7% year on year in June, excluding auto and fuel costs. The GFK Consumer confidence indicator hit a record low of -41 in June. Our report on sterling suggested that headwinds remain likely in the near term, but the pound is becoming more and more attractive for longer-term investors. We are currently long EUR/GBP. This cross still heavily underprices the risks to the UK economy in the near term. However, if recession fears ease, our suspicion is that cable is poised for a coiled-spring rebound.  Canadian Dollar: The BoC Will Stay Hawkish Chart 7The CAD Has Decoupled From Oil Prices The CAD Has Decoupled From Oil Prices The CAD Has Decoupled From Oil Prices The CAD is down 2.5% year-to-date. Over the last month, it is down 3.4%. Incoming data continues to suggest there is little reason for the BoC to change course in tightening monetary policy. The employment market remains strong. In May, 40K new jobs were added, and the details below the surface were notable. 135K full time jobs were swapped for 96K part time roles. Hourly wages rose 4.5% and the unemployment rate dipped to 5.1%. This sort of data is carte blanche for the BoC to keep hiking, since it signals a soft landing in the economy. Housing has been a point of contention for higher rates in Canada (given indebted households), but the Teranet national house price index shows that home prices are still rising 18.3% year-on-year in Canada as of May. This is occurring within the context of widespread price gains. Headline CPI came in at 7.7% in May, with all measures of the BoC’s trimmed estimates (core-common, core-median, core-trim), well above target and expectations. It will be interesting to watch how the BoC calibrates monetary policy given that the closely watched Business Outlook Survey showed a large deterioration in participants’ outlook for the future. In a world where USD strength persists, CAD will trade on the weaker side, but we remain buyers of the CAD once recession fears ebb.   Australian Dollar: A Contrarian Play Chart 8A Jumbo Hike By The RBA A Jumbo Hike By The RBA A Jumbo Hike By The RBA The Australian dollar is down 5.8% year- to-date. Over the last month, the AUD is down 5.3% as the price of iron ore declined by over 10% and the Chinese economy remained on lockdown. The RBA raised its interest rate by 50bps for a second month in a row this week. This aggressively shifted market expectations for further rate increases, with pricing in the OIS curve one year out rising from 3.35 to 3.51% today. While the RBA admitted global supply chain issues have contributed to inflation, capacity constraints in certain sectors and a tight labor market are also helping fuel domestic inflation. Particularly, the May employment report was robust, with 69.4K full-time jobs added, and a healthy jump in the participation rate to 66.7%. Job vacancies continued to grow at 13.8%. Rising rates in Australia are having the desired effect. Home price inflation is cooling, especially in places like Sydney. Demand for housing and construction remains robust, suggesting the RBA is achieving a soft landing in the economy. For example, home loan values are growing 1.7% and building approvals are growing by 9.9%. Demand also appears strong as manufacturing PMI came out at 56.2 in June. We are bullish the AUD against the dollar; however, short-term headwinds from Chinese lockdowns do not currently make us buyers of the currency. We are exiting our long AUD/USD position after being stopped out at 0.68 for a loss of -5.67%.  New Zealand Dollar: Least Preferred G10 Currency Chart 9Terms Of Trade Are Waning For NZD Terms Of Trade Are Waning For NZD Terms Of Trade Are Waning For NZD The NZD is down 9.7% this year. Over the last month, it is down 4.7%. New Zealand has the highest policy rate in the G10, and that is beginning to take a toll on interest-rate sensitive parts of the economy. REINZ house sales fell 28.4% year on year in May. House price inflation is also rapidly cooling. In June, the ANZ consumer confidence index fell from 82.3 to 80.5. Business confidence deteriorated from -55.6 to -62.6. The external sector is no longer a tailwind for the NZ economy, as grain and meat prices cool off. The price of dairy, approximately 20% of New Zealand’s exports, continues to decline with a 10% drop in June. The 12-month trailing trade balance continues to plummet, hitting -9.5bn NZD in May. The current account for May came in at -6.14 billion NZD versus a consensus -5.5 billion NZD. China is an important economic partner for New Zealand, with circa 27% of Kiwi exports China bound. Restrictions seem to be easing as the latest non-manufacturing PMI from China data came in at 54.7 against a previous 48.4 reading. The number of days required to quarantine on arrival also dropped to 10 days from 21 days in June. If this trend continues, it will be positive for the NZD; however, China does not appear to have an exit strategy for their zero-case COVID-19 policy. Within the G10 currency space, many other currencies appear more attractive than the kiwi, though our view is that NZD will benefit when US dollar momentum rolls over.   Swiss Franc: A Safe Haven Chart 10A U-Turn From The SNB A U-Turn From The SNB A U-Turn From The SNB CHF is down 6.4% year-to-date and flat over the past month versus the dollar. Against the euro, the franc is up 4.7% year-to-date and 5.2% over the past month. Our special report on the franc was timely, given the surprise rate hike announcement from the SNB last month. Amidst currency market volatility, EUR/CHF broke below parity. The SNB views currency strength as a virtue in today’s paradigm. As such, it has halted currency interventions, evident through the decline in sight deposits. Markets are pricing in another 50bps hike in September. Inflation continued to accelerate above projections in June. Headline and core CPI were up 3.4% and 1.9% year on year respectively, lower than other G10 countries but high enough to keep the SNB on alert. Inflation remains largely driven by the prices of imported goods which strengthens the case for a strong franc. The labor market is also tight, with unemployment at 2.2% in May. The outlook for the Swiss economy remains positive for the rest of the year, albeit with some signs of slowing activity emerging. The manufacturing PMI at 59.1 and the KOF leading indicator at 96.8 were both down to multi-month lows in June. The trade surplus in May was down to CHF 2bn. The franc is undervalued against the dollar and can serve as a good hedge for spikes in global volatility.  Norwegian Krone: Improving The Current Account Chart 11NOK Has Decoupled From Oil Prices NOK Has Decoupled From Oil Prices NOK Has Decoupled From Oil Prices The NOK is down 13.2% YTD and down 6.2% over the last month. Against the euro, the NOK is down 2.4% YTD and 1.3% in over the past month. In June, the Norges Bank raised the policy rate from 0.75% to 1.25%, 25bps higher than broadly anticipated. The rate path was also revised sharply higher and now corresponds to a 25bps hike at each meeting until the rate steadies at around 3% next summer. Governor Ida Wolden Bache left the door open for more half-point hikes but also highlighted the potential risk of overtightening, suggesting a balanced approach. Inflation in Norway is surprising to the upside. In May, CPI came in at 5.7% and 3.4% for core, signaling that price increases are becoming more broad-based. The labor market remains tight. The unemployment rate dipped to 1.7% in June, the lowest reading since 2008. Wages are projected to grow 3.9% this year. Together with a positive output gap, and a weak currency, both domestic and imported inflation could remain sticky for a while. Economic activity remains healthy in Norway. The manufacturing PMI went up to 56.4 in June, private consumption is robust, and business investment is expected to increase around 8% this year. Petroleum investments are also expected to pick up markedly in the years ahead, spurred by elevated energy prices and tax incentives. Recent natural gas production hikes, approved by the government, will further contribute to the healthy trade surplus. The strike started by union workers this week threatened to halt a significant portion of Norway’s oil and natural gas output. However, a resolution was found rather quickly. Despite record energy prices, the krone is one of the worst-performing majors this year. Pronounced global risk-off sentiment in the first half weighed on the currency. Despite potential challenges in the near term, Norway’s trade balance will remain a major tailwind this year. Shorting EUR/NOK on rallies looks attractive.  Swedish Krona: Tracking The Euro Lower Chart 12The SEK Is At Capitulation Lows The SEK Is At Capitulation Lows The SEK Is At Capitulation Lows The SEK is down 14.2% year-to-date and 7.1% over the last month. Inflation is becoming a problem in Sweden. In May, the CPIF increased 7.2% year on year, while the core measure was up 5.4%. In response, the Riksbank raised the policy rate by 50bps to 0.75% at its June meeting. The Riksbank sees the policy rate at around 1.75% by year-end, implying 50bps hikes at the remaining two meetings this year. The bank also announced a faster run-off in its balance sheet. We had anticipated the hawkish pivot by the Riksbank in early June, but that has not helped the Swedish krona much. Like Europe, the Swedish economy is being held hostage by external shocks, the global slowdown and an energy crisis. Signs of economic slowdown are becoming more pronounced. The Riksbank’s GDP forecast for 2022 was revised down by 1% to 1.8% and cut in half to 0.7% for 2023. Industrial production and new order data also point to a cooling in economic activity. Manufacturing and services PMIs remain expansionary zone but are falling rapidly. Notably, export orders have been hovering around the 50 boom/bust line over the last few months. Housing market is also vulnerable, with the Riksbank projecting a more-than-10% decline in prices by next year. That said, the SEK is below the 2020 lows suggesting these risks are well priced in. We are buyers of SEK on weakness.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Artem Sakhbiev Research Associate artem.sakhbiev@bcaresearch.com Thierry Matin Research Associate thierry.matin@bcaresearch.com   Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary Does Powell Need To Channel His Inner Volcker? Does Powell Need To Channel His Inner Volcker? Economic growth is now a casualty, and not a driver, of monetary policy choices. Inflation is dictating where central banks are taking interest rates. Our baseline view remains that core US inflation will cool by enough on its own without the need for the Fed to deliver a policy-induced recession. However, the odds of the latter have increased after the upside surprise in the May US CPI report. The ECB has been dragged into the same morass as other major central banks – tightening policy because of soaring inflation, despite broad-based signs of sluggish economic growth. We still see the pricing of cumulative rate hikes in the euro area as being too aggressive, even after last week’s clear announcement from the ECB that a string of future rate hikes was coming. With the ECB also announcing an end to its QE program, but offering no details on a replacement, markets have been given the green light to push Italian yields/spreads higher (and the euro lower) until there is an ECB response to market fragmentation in European sovereign debt. Bottom Line: The Fed is still more likely than the ECB to follow through on rate hikes discounted in US and European interest rate curves - position for renewed widening of the Treasury-Bund spread. Italian bond yields will remain under upward pressure until the contours of an ECB plan to stabilize Peripheral Spreads alongside rate hikes are revealed – tactically position for a wider BTP-Bund spread. Central Bankers Cannot Worry About Growth … Or Your Investment Portfolio The US consumer price index (CPI) report for May was yet another bond-bearish shock in a year full of them. With US headline US inflation hitting an 41-year high of 8.6%, the Treasury market adjusted bond yields upward to reflect both higher inflation expectations and even more aggressive Fed tightening. Coming only a day after the June European Central Bank (ECB) meeting that provided guidance that a series of rate hikes would begin in July, that could include a 50bp hike at the September meeting, financial markets worldwide moved to price in the risk that policy-induced recessions were the only way to bring down soaring global inflation. The result: global bond yields soared to new highs for the year, while risk assets of all shapes and sizes were hammered. We have our doubts that today’s class of policymakers – especially the Fed - has the stomach to repeat the actions of former Fed Chair Paul Volcker, who famously pushed US interest rates above the double-digit inflation rates of the late 1970s to engineer a deep recession to crush inflation. The starting point of the current tightening cycle is even further behind the curve than during the Volcker era, in terms of “realized” real interest rates, with the 10-year US Treasury yield now over five percentage points below headline US CPI inflation (Chart 1). Related Report  Global Fixed Income StrategyAssessing The Risks To Our Main Views Central bankers are now faced with the no-win scenario of pushing nominal policy rates higher to chase soaring inflation in a bid to maintain inflation fighting credibility, regardless of the spillover effects on financial market stability or economic growth expectations. More worryingly, the rate hikes needed to establish that credibility are not only becoming more frequent but larger. 50bps has become the “standard” size for developed market rate hikes. The Fed may have upped the ante with the 75bp hike at yesterday's FOMC meeting. Such is the reality of a funds rate still only at 1.75% but with US inflation pushing toward 9%. The timing of the latest hawkish shifts from the Fed, ECB and others is surprising, looking purely from a growth perspective. The OECD leading economic indicators for the US, euro area and China are slowing, alongside depressed consumer confidence and deteriorating business sentiment (Chart 2). Similar readings are evident in comparable measures in other major economies, both in developed and emerging economies. This would normally be the type of backdrop that would entice central banks to consider easing monetary policy - IF inflation was subdued, which is clearly not the case today. Chart 1Does Powell Need To Channel His Inner Volcker? Does Powell Need To Channel His Inner Volcker? Does Powell Need To Channel His Inner Volcker? In fact, high inflation is the reason why economic sentiment has worsened. Chart 2Worrying Signs For Global Growth Worrying Signs For Global Growth Worrying Signs For Global Growth ​​​​​​ Consumers see income growth that is lagging inflation, especially for everyday items like gasoline and food. Businesses are seeing input costs rising, especially for labor in an environment of tight job markets. Inflation has become broad-based, across goods, services and wages. This is true for countries that are more advanced in their monetary tightening cycles - the US, Canada and the UK - where inflation rates are remarkably similar (Chart 3). But it is also now true in countries with lower (but still accelerating) inflation rates and where central banks have been slower to tighten monetary conditions, like the euro area and Australia (Chart 4). Chart 3Inflation Turning More 'Domestic' (Services / Wages) Here Inflation Turning More 'Domestic' (Services / Wages) Here Inflation Turning More 'Domestic' (Services / Wages) Here ​​​​​​ Chart 4Still No Major Services/Wage Inflation Overshoots Here Still No Major Services/Wage Inflation Overshoots Here Still No Major Services/Wage Inflation Overshoots Here ​​​​​​ For the Fed, assessing the underlying momentum of US inflation, and setting monetary policy accordingly, has become a bit trickier. While headline inflation continues to accelerate in response to rising energy and food prices, core inflation ticked lower in both April and May and now sits at 6.1%, down from 6.5% in March. Longer-term survey-based measures of inflation expectations have been moving steadily higher, with the University of Michigan 5-10 year consumer inflation expectations survey now up to a 14-year high of 3.3% (Chart 5). Yet longer-term market-based inflation expectations have been more stable, with the 10-year TIPS breakeven now at 2.66%, down from the late April peak of 3.02%. There are also some mixed signals visible within the US inflation data. Core goods CPI inflation clocked in at 8.5% in May, down from the recent peak of 12.4% in February 2022, while core services CPI inflation accelerated to a 14-year high of 5.2% in May (Chart 6). A similar divergence can be seen when looking at the Atlanta Fed’s measures of “sticky” and “flexible” price inflation. Core flexible CPI inflation – measuring prices that adjust more rapidly – has fallen from a peak of 19% to 12.3% in May. At the same time, core sticky CPI inflation for prices that are slower to adjust sped up to an 31-year high of 5% in May. Chart 5Some Mixed Inflation Messages For The Fed Some Mixed Inflation Messages For The Fed Some Mixed Inflation Messages For The Fed ​​​​​​ Chart 6US Inflation Will Eventually Be Lower, But 'Stickier' US Inflation Will Eventually Be Lower, But 'Stickier' US Inflation Will Eventually Be Lower, But 'Stickier' ​​​​​​ Chart 7Stick With UST-Bund Spread Widening Trades Stick With UST-Bund Spread Widening Trades Stick With UST-Bund Spread Widening Trades In terms of the Fed’s next policy moves, the acceleration of core services (and sticky) inflation means underlying inflation momentum remains strong enough to make it difficult for the Fed to tighten by less than markets are discounting over the next year. Yet the deceleration of core goods (and flexible) inflation, if it continues, can lead to an eventual peak in overall US inflation. This would ease pressure on the Fed to tighten policy more aggressively than markets are expecting to slam the brakes on US economic growth. For nervous markets worried about Fed-induced recession risks, the clear peak in US inflation that we had been expecting has likely been pushed out further into the latter half of 2022. Thus, a significant fall in US Treasury yields that would provide relief to stressed risk assets is unlikely in the near term. Our preferred way to play that upward pressure on US Treasury yields is through an underweight stance on US Treasuries in global bond portfolios, rather than a below-benchmark duration stance. That is particularly true versus German Bunds - the 10-year UST-Bund yield spread is now well below the fair value level from our fundamental valuation model (Chart 7). Bottom Line: It is not clear that the Fed needs to “pull a Volcker” and generate a policy-induced recession to cool off US inflation. However, the Fed is far more likely to hike rates in line with market expectations than the ECB over the next 6-12 months. Stay underweight US Treasuries versus core Europe in global bond portfolios. The ECB Takes The Patient Off Life Support The ECB is finally coming to grips with surging European inflation. At last week’s policy meeting, the ECB Governing Council voted to end new bond buying via the Asset Purchase Program, while also signaling that a 25bp rate hike was on the way in July, with more hikes to follow – perhaps as much as 50bps in September if inflation remains elevated. Chart 8Markets Pricing In A Highly Aggressive ECB Markets Pricing In A Highly Aggressive ECB Markets Pricing In A Highly Aggressive ECB The central bank provided a new set of quarterly economic projections that, unsurprisingly, included significant upward revisions to the inflation forecasts. The 2022 headline HICP inflation forecast was bumped from 5.1% to 6.8%, the 2023 forecast from 2.1% to 3.5% and the 2024 forecast was nudged higher from 1.9% to 2.1%. The projections for core HICP inflation were also increased to 3.3% for 2022, 2.8% for 2023 and 2.3% for 2024. The central bank now expects euro area inflation to stay above its 2% inflation target throughout its forecast period – even with a 20% decline in oil prices, and 36% fall in natural gas prices, built into the projection between 2022 and 2024. A move towards tighter monetary policy has been heralded by our ECB Monitor, which remains elevated largely due to its inflation component (Chart 8). By contrast, the growth component of the Monitor has rolled over and is now at levels consistent with unchanged monetary policy. Yet in the current environment of very elevated inflation, concerns about the economy are taking a back seat to maintaining the ECB’s inflation-fighting credibility. In the relatively young history of the ECB, dating back to the inception of the euro in 1998, there have only been three true hiking cycles that involved multiple interest rate increases: 2000, 2006-08 and 2011. In each case, both growth and inflation were accelerating in a broad-based way across the majority of euro area countries. Today, inflation is surging, with the headline HICP inflation rate hitting 8.1% in May, while core inflation (ex energy and food) is a more subdued but still high 4.4%. Economic growth is decelerating, however, with leading economic indicators now slowing in a majority of euro area countries (Chart 9). Chart 9Coming Up: An Unusual ECB Tightening Cycle That Ignores Growth Coming Up: An Unusual ECB Tightening Cycle That Ignores Growth Coming Up: An Unusual ECB Tightening Cycle That Ignores Growth The ECB’s updated economic growth forecasts were downgraded for this year and next, with real GDP growth now expected to reach 2.8% in 2022 and 2.1% in both 2023 and 2024. Cutting growth forecasts for the current year was inevitable given the uncertainties stemming from the Ukraine war and soaring European energy prices. However, the projected growth rates do seem optimistic in the face of deeply depressed readings on economic sentiment from reliable measures like the ZEW index or the European Commission consumer confidence index, both of which have fallen sharply to levels last seen during the 2020 pandemic shock (Chart 10). Demand for European exports is also sluggish, particularly exports to China which are now flat in year-over-year terms. A similar pattern can be seen in the ECB’s inflation forecasts, which seem too optimistic in projecting lower wage growth and core inflation through 2024, even with the euro area unemployment rate forecasted to stay below 7% - under the OECD’s full employment estimate of 7.7% over the same period (Chart 11). Chart 10Overly Optimistic ECB Growth Forecasts Overly Optimistic ECB Growth Forecasts Overly Optimistic ECB Growth Forecasts ​​​​​​ Chart 11Overly Optimistic ECB Inflation Forecasts? Overly Optimistic ECB Inflation Forecasts? Overly Optimistic ECB Inflation Forecasts? ​​​​​​ The ECB is facing the same communications problem as other central banks at the moment. There is a fear of forecasting a major growth slowdown that would scare financial markets, even though that is a necessary condition to help bring down elevated inflation. At the same time, projections of a big decline in inflation that would limit the need for economy-crushing monetary tightening are not credible in the current environment of historically elevated headline inflation with very low unemployment rates. Interest rate markets understand the bind that the ECB finds itself in, and have moved to price in a very rapid jump in policy rates over the next 1-2 years. The 1-month OIS rate, 2-years forward is now at 2.5%, a high level compared to estimates of the neutral ECB policy rate, which lies between 1-1.5%. Core European bond yields have moved up alongside those rising rate expectations, with the 10-year German bund yield now at 1.64%, a far cry from the -0.18% yield at the start of 2022. Additional German yield increases will prove to be more difficult in the months ahead. There has already been a major upward adjustment in the inflation expectations component of yields, with the 10-year euro CPI swap rate now up to 2.6% compared to 2% at the start of this year (Chart 12). Importantly, those inflation expectations have stabilized of late, even in the face of high oil prices. Meanwhile, real bond yields, while still negative, have also moved up substantially and are now back to levels that prevailed before the ECB introduced negative policy rates in 2014 (bottom panel). With so much bond-bearish news now priced into core European bond yields, additional yield increases from here would require a more fundamental driver – an upward repricing of terminal interest rate expectations. On that note, the German yield curve is signaling that the terminal rate in the euro area is not much above 1.75%, as that is where bond yield forwards have converged to for both long and short maturity bonds (Chart 13). Chart 12How Much Higher Can Bund Yields Realistically Go? How Much Higher Can Bund Yields Realistically Go? How Much Higher Can Bund Yields Realistically Go? ​​​​​​ Chart 13Markets Signaling A 1.75% Terminal Rate Markets Signaling A 1.75% Terminal Rate Markets Signaling A 1.75% Terminal Rate Given our view that the neutral rate in Europe is, at best, no more than 1.5%, ECB rate hikes much beyond that level would likely invert a Bund curve that is priced for only a 1.75% terminal rate. An inverted Bund curve would also raise the odds that Europe enters a policy-induced recession – turning a bond bearish outcome into a bond bullish one. Even with the relatively aggressive policy expectations priced into European bond yields, it is still too soon to raise European duration exposure with inflation still accelerating. We prefer maintaining a neutral duration stance until there is a clear peak in realized European inflation – an outcome that would also favor a shift into Bund curve steepeners as the markets price out rate hikes and, potentially, begin to discount future rate cuts. Does The ECB Even Have A Plan For Italian Debt? The ECB seems to have a clear near-term plan on the timing, and even the potential size, of rate hikes. There is far less clarity on how it will deal with stabilizing sovereign bond yields post-APP in the countries that benefitted from ECB asset purchases, most notably Italy. By offering no details on a replacement to APP buying of riskier European debt at last week’s policy meeting, markets were given the green light to test the ECB’s resolve by pushing Italian bond yields higher (and the euro lower). Volatility in both markets will continue until there is a credible ECB response to so-called “market fragmentation” in European sovereign debt (i.e. higher yields and wider spreads versus Bunds in the Periphery). With the benchmark 10-year Italian BTP yield pushing above 4%, the ECB tried to calm markets yesterday by announcing an emergency meeting of the Governing Council to discuss “anti-fragmentation” policy options. The announcement triggered a relief rally in BTP prices, likely fueled by short covering. But the ECB statement was again light on concrete details, only noting that: a)     reinvestments from maturing bonds from the now-completed Pandemic Emergency Purchase Program (PEPP) could be used “flexibly” to support stressed parts of the European bond market b)     the timeline for ECB researchers to prepare proposals for a “new anti-fragmentation instrument” would be accelerated. We expect the ECB to eventually produce a credible bond buying plan to support Peripheral European bond markets – but only after an “iterative” trial-and-error process where trial balloon proposals are floated and skeptical financial markets respond. Chart 14Stay Cautious On Italian Government Bonds Stay Cautious On Italian Government Bonds Stay Cautious On Italian Government Bonds There is almost certainly some serious horse trading going on within the ECB Governing Council, with inflation hawks demanding more rate hikes in exchange for their support of new plans to deal with market fragmentation. Details such as the size of any new program, the conditions under which it would be activated, and country purchase limits (if any) will need to be ironed out. Internal ECB debates will prolong that trial-and-error process with financial markets, keeping yield/spread/FX volatility elevated in the short-term. On a strategic (6-18 month) time horizon, we see a neutral allocation to Italy in global bond portfolios as appropriate, given the tradeoff between increasingly attractive yields and the uncertain timing of effective ECB market stabilization proposals. On a more tactical horizon (0-6 months), we expect Italian yields and spreads versus Germany to remain under upward pressure until a viable anti-fragmentation program is announced (Chart 14). To play for that move, we are introducing a new position in our Tactical Overlay Trade portfolio, selling 10-year Italy futures and buying 10-year German Bund futures. The details of the new trade, including the specific futures contracts and weightings for the two legs of the trade to make it duration-neutral, can be found in the Tactical Trade table on page 18. As we monitor and discuss this trade in future reports, we will refer to the well-followed 10-year Italy-Germany spread (currently 225bps) to determine targets and stop levels of this bond futures spread trade. We are setting a stop-out on this trade if the 10-year Italy-Germany spread has a one-day close below 200bps, while targeting a potential widening to 275-300bps (the 2018 peak in that spread). Bottom Line: The ECB’s lack of conviction on designing a plan to support Peripheral bond markets during the upcoming period of interest rate hikes will keep upward pressure on Peripheral yields/spreads over the next few months.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark Volcker's Ghost Volcker's Ghost The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Volcker's Ghost Volcker's Ghost Tactical Overlay Trades

Executive Summary ECB & Inflation: Whatever It Takes? Pricey Industrials Pricey Industrials Inflation is the European Central Bank’s single focus. This single-mindedness heightens the risks to Euro Area growth, especially because wider peripheral spreads do not seem to worry the ECB yet. Italian spreads will widen further, which will contribute to weaker financials, especially in the periphery. The money market curve already prices in the path of the ECB; the upside in Bund yields is therefore capped. Cyclical assets, including stocks, are vulnerable to the confluence of weaker growth and tighter monetary policy. Industrials are fragile. Downgrade to neutral for now. German industrials will outperform Italian industrials.     Bottom Line: The ECB will do whatever it takes to slow inflation, which will further hurt an already brittle European economy. This backdrop threatens European stocks and peripheral bonds. Downgrade industrials to neutral and go long German / short Italian industrials. Feature Last week, the European Central Bank’s Governing Council sided with the hawks. The doves have capitulated. This development creates mounting risks this summer for European assets, especially when global growth is slowing. Worryingly, the ECB has given speculators the green light to widen peripheral and credit spreads in the near term. Cyclical assets remain at risk. We are downgrading industrials and financials. Hawkish Chart 1Higher Inflation Forecast = Hawkish ECB Don’t Fight The ECB Don’t Fight The ECB The ECB’s forward guidance proved more hawkish than anticipated by the market, as highlighted by the 16bps increase in the implied rate of the December 22 Euribor contract following the press conference. The ECB also refused to sooth investors’ nerves regarding fragmentation risk in the periphery. A large part of the ECB move was already anticipated. The ECB will lift its three interest rate benchmarks by 25bps at its July meeting. It also increased its headline inflation forecasts to 6.8% from 5.1% in 2022, to 3.5% from 2.1% in 2023, and most importantly, it raised its long-term HICP forecast to 2.1% from 1.9% (Chart 1). The ECB now expects medium-term inflation to be above its 2% target. The true hawkish shock came in response to the higher-than-target medium-term inflation forecast. By September, if the 2024 inflation forecast does not fall back below 2%, then a 50bps hike that month will be inevitable. The whole interest rate curve moved up in response to that guidance. The most concerning part of the statement was the lack of clarity about the fragmentation fighting tool. The ECB specified that it will re-invest the principal of its holdings under the APP and PEPP until 2024, at least. However, the program to prevent stress in peripheral bond markets was not revealed and was presented as an eventuality to be deployed only if market conditions deteriorate further. Investors may therefore assume that the ECB is still comfortable with Italian bond yields above 3.5% and high-yield spreads of 464bps (Chart 2). Ultimately, the ECB’s single-minded focus is inflation, even though it is mostly an imported shock. The ECB cares little for the effect of its actions on growth. It will therefore remain very hawkish until it sees enough evidence that the medium-term inflation outlook will fall back below 2%. Before the ECB can tabulate a decline in the inflation outlook, the following developments must take place: The economy must slow in order to extinguish domestic inflationary pressures. The labor market, to which President Christine Lagarde referred often in the press conference, must cool. Specifically, the very elevated number of vacancies must decline relative to the low number of unemployed persons (Chart 3). A weaker economy will cause this shift. Energy inflation must recede to choke secondary effects on prices. Chart 2Tight But Not Tight Enough For The Hawks Tight But Not Tight Enough For The Hawks Tight But Not Tight Enough For The Hawks Chart 3The Labor Market Must Cool The Labor Market Must Cool The Labor Market Must Cool The good news is that the decline in commodity inflation is already underway. Last week, we argued that if energy prices remain at their current levels, (or if Brent experiences the additional upside anticipated by BCA’s Commodity and Energy strategists), then energy inflation will decelerate significantly. Already, the inflationary impact of commodities is dissipating (Chart 4). European growth has not slowed enough to hurt the labor market, but it will decline further. Real disposable income is falling, and the manufacturing sector is decelerating globally. Moreover, European terms of trade are tumbling, which hurts the Euro Area’s growth outlook, especially compared to the US where the terms of trade are improving (Chart 5). Chart 4Dwindling Commodity Impulse Dwindling Commodity Impulse Dwindling Commodity Impulse Chart 5Europe's Terms-of-Trade Problem Europe's Terms-of-Trade Problem Europe's Terms-of-Trade Problem The European periphery, especially Italy, faces particularly acute problems. We argued two months ago that Italian yields of 4.5% would not cause a sovereign debt crisis if economic activity were strong. As we go to press, Italian yields stand at 3.7%, or higher than those in Canada and Australia. Yet, Italy suffers from poor demographic and productivity trends; its neutral rate of interest is lower than that of both Canada and Australia. Moreover, Canada and Australia today enjoy robust terms-of-trades. Meanwhile, Italy is among the European economies most hurt by surging energy prices. Consequently, a vicious circle of higher yields and lower growth is likely to develop. Chart 6The BTP-EUR/USD Valse The BTP-EUR/USD Valse The BTP-EUR/USD Valse Italy’s economic problems imply that investors will continue to push Italian spreads higher until the ECB provides a clear signal of support for BTPs, which could happen after spreads reach 300bps over German 10-year yields. Italy’s weakness is a major handicap for the monetary union as well. The higher Italian spreads widen, the weaker the euro will be (Chart 6). However, a depreciating euro is inflationary, which invites higher rates for the Euro Area and tighter financial conditions. The great paradox is that, if the ECB were more pro-active about the fragmentation risk, it could fight inflation with less danger to the economy and thus, the Eurozone could achieve higher rates down the road. Weaknesses in global and European growth, risks of higher Italian and peripheral spreads, and an ECB solely focused on inflation will harm European risk assets further. Specifically, credit spreads will widen more and cyclical stocks will remain vulnerable. Within cyclical stocks, Italian and Spanish financials are the most exposed to the fragmentation threat in Euro Area bond markets. We have held an overweight recommendation on industrial equities. We maintain a positive long-term bias toward this sector, but a neutral stance is warranted in the near term. Finally, Bund yields have limited upside from here. The curve already anticipates 146bps of tightening by the end of this year and 241bps by June 2023. The ECB is unlikely to increase rates more than is anticipated, which caps German yields. Instead, the ECB is likely to undershoot the €STR curve pricing if it increases interest rates once a quarter after the September 50bps hike. Bottom Line: Don’t fight the ECB. The Governing Council is single-mindedly focused on fighting inflation. Growth must slow significantly to cool the labor market and allow the ECB to cut back its medium-term inflation forecast to 2%. Therefore, European assets will remain under stress in the coming months as global growth deteriorates. Italian and peripheral spreads are particularly vulnerable, which will also weigh on financials because of Spanish and Italian banks. Chart 7Pricey Industrials Pricey Industrials Pricey Industrials Neutral On Industrials Industrials stocks have outperformed other cyclicals and have moved in line with the Euro Area broad market. However, relative forward EPS have not tracked prices; industrials are now expensive and vulnerable to shocks (Chart 7). The increase in the relative valuations of industrials reflects their robust pricing power. Normally, the economic weakness pinpointed by the Global Growth Expectations component from the ZEW Survey results in falling valuations for industrials, since it is a growth-sensitive sector (Chart 8). However, this year, the earnings multiples of industrials relative to the broad market have followed inflation higher (Chart 8, bottom panel). This paradox reflects the strong pricing power of the industrial sector, which allows these firms to pass on a greater share of their increasing input-costs and protect their profits (Chart 9). Chart 8Ignore Growth, Loving Inflation Ignore Growth, Loving Inflation Ignore Growth, Loving Inflation Chart 9Pricing Power Is The Savior Pricing Power Is The Savior Pricing Power Is The Savior The ability of industrials to weather a growth slowdown is diminishing: European inflation will peak in response to the decline in commodity inflation (see Chart 4, on page 4). Already, the waning inflation of metal prices is consistent with lower relative multiples for industrials (Chart 10) Last week, we argued that global PMIs have greater downside because of the tightening in global financial conditions. Weaker global manufacturing activity hurts the relative performance of industrials. Capex in advanced economies is likely to drop in the coming quarters. US capex intentions are rapidly slowing, which has hurt European industrials. European capex intentions have so far withstood this headwind; however, the outlook is worsening. European final domestic demand is weakening, and European inventories are growing rapidly (Chart 11). Capex is a form of derived demand; the challenges to European growth translate into downside for investment. Chart 10The Commodity Paradox The Commodity Paradox The Commodity Paradox Chart 11The Inventory Buildup Threat The Inventory Buildup Threat The Inventory Buildup Threat The Euro Area Composite Leading Economic Indicator is already contracting and will fall further. The ECB’s focus on inflation and its neglect of financial conditions will drag the LEI lower. Moreover, central banks across the world are also tightening policy, which will filter through to weaken global and Europe LEIs. A declining LEI hurts industrials (Chart 12). The relative performance of European industrials is positively correlated to that of US industrials (Chart 13). BCA’s Global Asset Allocation has recently downgraded industrials to neutral from overweight. Chart 12Weaker LEIs Spell Trouble Weaker LEIs Spell Trouble Weaker LEIs Spell Trouble Chart 13Where the US Goes, So Does Europe Where the US Goes, So Does Europe Where the US Goes, So Does Europe Despite these risks, we are reluctant to go underweight industrials because financials are more exposed to the ECB’s neglect of financial conditions. Moreover, the headwinds against the industrial complex are temporary, especially when it comes to China. Chinese authorities have greatly stimulated their economy, and Beijing is softening its stance on the tech sector. A loosening of the regulatory crackdown would revive animal spirits and credit demand. Moreover, the aerospace and defense industry, which is a large component of the industrial sector, still offers attractive prospects. Instead, we express our concerns for industrials via the following pair trade: Long German industrials / short Italian Industrials. This is a relative value trade. German industrials have underperformed their relative earnings, while Italian ones have moved significantly ahead of their earning power. Thus, German industrials are very cheap and oversold relative to their southern neighbors (Chart 14). Interestingly, this derating took place despite the widening in Italian government bond spreads, which normally explains this price ratio well (Chart 15). This disconnect presents a trading opportunity. Chart 14A Relative Value Trade A Relative Value Trade A Relative Value Trade Chart 15An Unusual Disconnect An Unusual Disconnect An Unusual Disconnect Chart 16German Industrials And Growth Expectations German Industrials And Growth Expectations German Industrials And Growth Expectations While global growth has yet to bottom, the performance of German relative to Italian industrials fluctuates along growth expectations (Chart 16). Germany seats earlier in the global supply chain than Italy. The Global Growth Expectations component from the ZEW Survey is extremely depressed and approaching levels where a rebound would be imminent. German industrials suffer more from the energy crunch than Italian ones. They will therefore benefit more from the decline in energy inflation. Historically, German industrials outperform Italian ones when commodity prices rise, but this relationship normally reflects the strong global demand that often lifts natural resource prices (Chart 17). Today, commodities are skyrocketing because of supply constraints, not strong demand. Therefore, they are hurting rather than mimicking growth. This inversion in the relationship between the performance of German compared to Italian industrials and natural resources prices is particularly evident when looking at European energy prices (Chart 18). Consequently, once the constraint from commodities and global supply chains ebb, German industrials will outshine their Italian counterparts. Chart 17Commodities: From Friends To Foes Commodities: From Friends To Foes Commodities: From Friends To Foes Chart 18Energy: From Friend To Foe Energy: From Friend To Foe Energy: From Friend To Foe German industrials suffer when stagflation fears expand (Chart 19). The ECB’s focus on inflation will assuage the apprehension of entrenched inflation in Europe. The recent improvement in our European Stagflation Sentiment Proxy will continue to the advantage of German industrials. Additionally, a firm ECB stance will push European inflation expectations lower, which will help German industrials compared to their Italian competitors (Chart 20). Chart 19Stagflation Hurts Germany More Stagflation Hurts Germany More Stagflation Hurts Germany More Chart 20The ECB"s Inflation Focus Helps German Industrials The ECB"s Inflation Focus Helps German Industrials The ECB"s Inflation Focus Helps German Industrials German PMIs are improving relative to Italian ones. The trend in Germany’s industrial activity compared to that of Italy dictates the evolution of industrials relative performance between the two countries (Chart 21). The tightening in financial conditions in Italy due to both wider BTP spreads and their negative impact on the Italian banking sector will accentuate the outperformance of Germany’s manufacturing sector. German industrials are more sensitive than Italian ones to the gyrations of the Chinese economy. BCA’s Geopolitical Strategy service anticipates an improvement in China’s economy for the next 18 months or so in response to previous stimuli and the easing regulatory burden. The close link between the performance of German industrials relative to Italian ones and the yuan’s exchange rate indicates that a stabilizing Chinese economy will undo most of the valuation premium of Italian industrials (Chart 22). An improvement in China’s economy will also lift its marginal propensity to consume (which the spread between the growth rate of M1 and M2 approximates). A rebound in Chinese marginal propensity to consume will boost comparative rates of returns in favor of Germany (Chart 22, bottom panel). Chart 21Relative Growth Matters Relative Growth Matters Relative Growth Matters Chart 22The China Factor The China Factor The China Factor Bottom Line: Industrials have become expensive relative to the rest of the market, but they are still too exposed to the global economy’s downside risk. This tug-of-war warrants a downgrade to neutral for now. Going long German industrials / short Italian industrials is an attractive pair trade within the sector. German industrials are cheap and they will benefit from both the ECB’s policy tightening and the upcoming decline in European inflation. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades

Executive Summary Is Relative Inflation Peaking In The US? Is Relative Inflation Peaking In The US Is Relative Inflation Peaking In The US The dollar has likely peaked in the near term. An unwinding of speculative bets, based on structurally higher inflation in the US, is the key driver (Feature Chart). Our theme of central bank convergence continues to play out. Rates in the euro area are headed higher. The next bet for higher rates is in Japan. The key for picking currency winners will be global growth barometers. The US dollar embeds a huge safety premium that will be eroded as we get more clarity on global growth and inflation. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Short DXY 104.80 2022-05-13 2.22   Bottom Line: We are short the DXY index as of 104.8. We recommend sticking with this position. Feature The dollar very much remains well bid (Chart 1). But the macroeconomic environment that has helped the dollar is likely to reverse. As inflation in the US cools, especially relative to other DM economies, the policy divergence between the US and other economies will move in the opposite direction (Chart 2 and Chart 3).  Chart 1Long Dollar Positions Still Profitable Month In Review: Recession Risk Month In Review: Recession Risk Chart 2Is Relative Inflation Peaking In The US Is Relative Inflation Peaking In The US Is Relative Inflation Peaking In The US Chart 3The Dollar And Interest Rates The Dollar And Interest Rates The Dollar And Interest Rates Last month, we posited that interest rate differentials played a key role in pushing the dollar higher but have not been the sole factor. The safe-haven premium in the DXY is around 8-10%. That premium will remain if growth concerns are at the forefront of investors’ minds but will evaporate otherwise. Over the last few weeks, we have had a few surprises from central banks, notably the ECB and the RBA. In this Month-In-Review, we go over our current currency thinking, and implications for portfolio strategy. US Dollar: Peak Hawkishness? Chart 4Is Inflation Peaking In The US Is Inflation Peaking In The US Is Inflation Peaking In The US The dollar DXY index is up 7.4% year to date. However, over the last month, there has been a big reversal in the dollar, down 1.5% month-to-date. As a momentum currency, technical forces are moving against the greenback. Incoming data for the US remains robust, but a peak in inflation expectations, that will temper the pace of Fed interest rate hikes, has been driving dollar momentum. Headline CPI is expected to come in at 8.3% in May, while the core measure should decelerate to 5.9%. It is possible that these numbers surprise to the downside. For example, used car prices, an important contribution to US CPI, are rolling over sharply (panel 2). Overall, supply-side price pressures appear to be easing (panel 3). The US added 390K jobs in May, so the employment report remains robust. Encouragingly, the participation rate is also picking up. This suggests the US can absorb more willing workers before we see additional upward pressure in wage growth. We are closely watching the Atlanta Fed wage growth tracker (panel 4). The ISM manufacturing index had a solid print of 56.1 in May, but the prices paid index dipped from 84.6 to 82.2. As we highlighted above, these developments have sapped market expectations for aggressive interest rate increases in the US relative to other G10 countries. Speculative froth in the dollar is also unwinding (panel 5). We went short the DXY index at 104.8, with a stop loss at 107. We recommend sticking with this position.  The Euro: A European Soft Landing? Chart 5The Euro Has Priced A Recession The Euro Has Priced A Recession The Euro Has Priced A Recession The euro is down 6.6% year-to-date. Over the last month, the euro is up 0.7%. The ECB cemented the fact that interest rates are headed higher this week. With a mandate of taming inflation, the central bank faces a tough job of reigning in price pressures, while engineering a soft landing in the economy. From the perspective of the euro, it is our view that most of the downside risks to this scenario have been priced in, while upside surprises have not (panel 1). Incoming data from the euro area has been improving. The Sentix Investor Confidence index ticked up in June. Energy prices remain high, but momentum has been softening. The ZEW expectations survey also delivered an upside surprise in May. The key point from an FX perspective is that the euro has already priced a recession in the European economy, but no prospect of a soft landing. That is positive from a contrarian perspective. With HICP inflation at 8.1% (panel 2), emergency monetary settings are no longer required, and the ECB should lift rates. As we suggested last month, a “least regrets” approach will gently nudge rates higher to address inflationary pressures but pay attention to cyclical sectors of the economy (panel 3). It is important to remember that interest rates in the eurozone are still at -0.5%. Related Report  Foreign Exchange StrategyMonth In-Review: A Hefty Safe-Haven Premium In The Dollar We remain long EUR/GBP on the prospect that the ECB could better engineer a soft landing, compared to the BoE. We also remain sellers of the EUR/JPY cross. In a risk-off environment, EUR/JPY will collapse. In a Goldilocks scenario, the cross has already priced in a much stronger global economy (panel 4). This is also a perfect hedge for a pro-cyclical currency positioning. The Japanese Yen: Back To Carry Trades Chart 6The Yen Will Soon Bottom The Yen Will Soon Bottom The Yen Will Soon Bottom The Japanese yen is down 14.3% year-to-date, the worst performing G10 currency this year. Over the last month, the yen is down 2.9%. The yen is a classic case of the risks of fighting the trend in currency markets (panel 1). That said we remain buyers, rather than sellers, on weakness. The drivers of the yen have been very clear and absolute. First, rising interest rates abroad, as we saw this week, have put selling pressure on the JPY (panel 2), given the BoJ will maintain yield curve control. Second, the pickup in energy prices continues to deflate the Japanese trade balance. These are negative shocks that are likely to continue inflicting pain on yen long positions in the near term. From a contrarian perspective, there is solace for yen bulls. First, it is the cheapest G10 currency according to our PPP models. It also happens to be one of the most heavily shorted currencies, according to CFTC data (panel 4). In terms of data, there have also been positive surprises over the last month. The Eco Watcher’s Survey surprised to the upside. PMIs have rebounded above 50. Inflation is above the 2% target and should keep rising. Machinery orders are picking up. The Bank of Japan is likely to stay dovish next week but that is largely priced in. Meanwhile, the BoJ will have no choice but to pivot if inflationary pressures prove stronger than they anticipate, and/or the output gap in Japan closes much faster as demand recovers. We have no active position on the yen right now but will be buyers on weakness.  British Pound: Sterling And A Policy Mistake Chart 7Cable Is At Risk Near Term Cable Is At Risk Near Term Cable Is At Risk Near Term The pound is down 7.6% year to date. Over the last month, the pound is up by 1.3%. We wrote a report on sterling last week. In our view, sterling faces headwinds in the near term but is likely to be a profitable long position for investors with a more structural view. First, the deterioration in the UK’s trade balance is cyclical and not structural. Fuels constitute 11% of UK imports so higher energy prices are affecting the balance of trade. This will soon reverse. Second, goods imports have picked up, but it is encouraging that a huge share has been machinery and transport equipment. Inflation remains a problem in England, with CPI at 9%. In our view, while sterling is pricing in a policy mistake by the BoE – tightening too fast into a slowing economy, our bias is that the BoE can engineer a soft landing for the economy. Only one-third of the rise in UK inflation has been driven by demand-side pull, with the balance related to supply-side factors. The latter have been the usual suspects – rising energy costs, supply shortages, and even legacies of the Brexit shock (Chart 10). These could ease going forward. We are currently long EUR/GBP. This cross still heavily underprices the risks to the UK economy in the near term. However, if recession fears ease, our suspicion is that cable is poised for a coiled spring rebound.  Canadian Dollar: The BoC Will Stay Hawkish Chart 8CAD Should Benefit From Terms Of Trade CAD Should Benefit From Terms Of Trade CAD Should Benefit From Terms Of Trade The CAD is down 0.6% year to date. Over the last month, it is up 2.4%. The CAD has been the best performing G10 currency this year after the DXY, and the key drivers of loonie strength will persist. First, the CAD will benefit from a terms-of-trade boost, given it is trading at a discount to prevailing oil prices. Second, the BoC will stay hawkish, having hiked interest rates by 50 bps last month, and telegraphing more tightening going forward. Economic data out of Canada suggests tighter monetary policy is warranted. Both headline and core inflation remain strong, with headline inflation at 6.8% in April. The common, trim, and median inflation prints were at 3.2%, 5.1%, and 4.4%, respectively, well above the BoC’s target. This continues to suggest inflationary pressures in Canada are broad based (panel 2). House prices are rolling over so the wealth effect could temper hawkishness from the BoC. However, recent speeches from policy officials have highlighted a need to tame housing price pressures in Canada (panel 4). We remain buyers of the CAD on a lower dollar but are monitoring risks from a tightening in financial conditions.     New Zealand Dollar: Will Weaken At The Crosses Chart 9The RBNZ Is Trying To Engineer A Soft Landing The RBNZ Is Trying To Engineer A Soft Landing The RBNZ Is Trying To Engineer A Soft Landing The NZD is down 6.6% this year. Over the last month, the kiwi is down 1.0%. The RBNZ hiked interest rates by 50 bps in May, taking the overnight rate to 2%. This seems to be having the intended effect, with house price inflation rolling over as mortgage rates adjust higher. This “least regrets” approach is likely to continue in the short term. The labor market is extremely tight, with a shortage of high skilled labor given immigration has slowed. This is leading to substantial wage increases. As such, the RBNZ has been increasing guidance for annual CPI inflation, and therefore, interest rates, raising its overnight projection for June 2023 to 3.9% from 2.8%. There is reason to believe the RBNZ will tone down its hawkish rhetoric. For one, terms of trade are softening. Dairy prices, circa 20% of exports, are down 1% this month after reaching a 10-year high in May. A domestic slowdown is also likely to nudge the RBNZ toward more accommodation. In a nutshell, the kiwi has upside versus the dollar, but will underperform at the crosses.        Australian Dollar: Our Top Pick Against The Dollar Chart 10The RBA Will Continue To Hike The RBA Will Continue To Hike The RBA Will Continue To Hike The Australian dollar is down 2.3% year to date. Over the last month, the AUD is up 2%. The Reserve Bank of Australia raised interest rates by 50 bps this week, a surprise to markets, but in line with the hawkish tone telegraphed in prior meetings. Inflation in Australia is surprising to the upside. Meanwhile, unemployment remains well below NAIRU. As a result, an exit from emergency monetary settings makes sense. The key will be whether the RBA can engineer a soft landing in the Aussie economy. Job gains remain robust, and both the unemployment rate and the participation rate are at healthy levels. Terms of trade are holding up, and wage gains are improving. Home prices are rolling over, but it is a welcome development as the RBA is trying to calibrate financial conditions. We are long the AUD as of 72 cents. The big concern for this trade is China, and the potential for renewed lockdowns that will hurt the external balance. As such, we expect this trade to be volatile near-term, but pay off over a longer horizon.        Swiss Franc: A Safe Haven Chart 11The SNB Will Stay Constructive On The Franc The SNB Will Stay Constructive On The Franc The SNB Will Stay Constructive On The Franc The Swiss franc is down 7% year-to-date, but up versus the dollar over the last month. Swiss economic conditions have been rather resilient. GDP expanded by 0.5% in Q1, slightly above expectations, while industrial production also rose 2.4% in the same period. In April, Switzerland’s trade surplus widened to CHF 3.8bn, boosted by demand for machinery and chemicals. In May, the KOF leading indicator clocked 96.8 and the manufacturing PMI stood at 60, a slowdown month-on-month but still a very healthy reading. Inflation is surprising to the upside in Switzerland. Headline and core CPI growth came in at 2.9% and 1.7% year-on-year in May, respectively. Recently, several SNB board members have voiced the primacy of price stability and preparedness to hike rates if inflation becomes broad based. This has helped support the franc. The market now expects SNB to follow the ECB in removing the NIRP starting in September. But it is always good to remember that the Swiss franc is a defensive currency, so a path to policy normalization still presents upside for EUR/CHF. In our trading book, we are short CHF/SEK, but will take profits if Thomas Jordan proves to be more of an inflationary hawk.   Norwegian Krone: Bullish On A 12-to-18 Month Horizon Chart 12The Norges Bank Will Stay Hawkish Month In Review: Recession Risk Month In Review: Recession Risk NOK is down 8.1% year to date and up 1.5% over the last month. In the three months through March, Norway’s GDP contracted by 1% quarter on quarter, led by drops in private consumption (1.5%), government spending (1.4%), and exports (3.5%). The decline largely reflects restriction measures imposed at the start of the year. That said, economic growth is rebounding and GDP growth will be around 3% in the next 12 months. Meanwhile, the trade surplus remains very healthy at 92.6bn NOK. As a result, the current account surplus hit at an all-time high of 341bn NOK in Q1. From a broader perspective, incoming numbers in Norway reflect a slowdown in global growth. Consumer confidence dropped to the lowest levels since 2016. The manufacturing PMI fell sharply to 54.9 in May, the lowest reading in over a year. Industrial production also decreased by 0.5% month-on-month in April. That said, the labor market continues to tighten. The unemployment rate fell to 1.7% in May, significantly below Norge Bank’s 2% projection. Renewed immigration might help alleviate some of the labor market tightness, but the strength in employment trends is very evident. As a result, our bias is that the committee will stick to its quarterly 25bps hikes, but upside surprises to this baseline are non-trivial. Terms of trade are a tailwind for Norway. In particular, NOK/SEK can be an attractive bet on a 12-month horizon, should oil prices remain firm.  Swedish Krona: Into A Capitulation Phase Chart 13More Hawkish Surprises From The Riksbank More Hawkish Surprises From The Riksbank More Hawkish Surprises From The Riksbank The SEK is down 8.7% year to date and up 1.6% over the last month.  Sweden sits right at the crosshairs of the Russia-Ukraine conflict. As a result, inflation remains a problem with CPIF at 6.4%, year-over-year in April, above updated projections from Riksbank. The issue is that there are rising risks that inflation will not be transitory, raising the prospect of a policy surprise from the Riksbank. The OIS curve is now pricing in a 1.75% policy rate by year-end. In our view, this will be a baseline scenario. The critical point is whether the Riksbank is on the verge of making a policy mistake. Economic growth is slowing. Swedish GDP contracted by 0.8% in Q1 from the previous quarter. However, if policymakers are overly fixated on inflation, the prospect of grinding the Swedish economy to a halt becomes a rising risk. Major rounds of collective wage negotiations early next year, affecting as much of as 40% of total labor force, is a risk to monitor. There is already some evidence of a slowdown in economic activity. Consumers reported the lowest level of confidence since the Global Financial Crisis. PMIs remain resilient, well above 50 but the risk is to the downside. Should the Chinese credit impulse bottom and supply constraints ease, economic activity will pick up in the second half of the year, but the risk of downside surprises are worth monitoring. The bottom line is that SEK has already priced in much of the negative news and remains undervalued in our models. We are short CHF/SEK on these grounds, a position 1.5% in the money.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Listen to a short summary of this report.       Executive Summary Chinese Stocks Are Relatively Cheap Chinese Stocks Are Relatively Cheap Chinese Stocks Are Relatively Cheap The Chinese economy faces a trifecta of economic woes: 1) The threat of renewed Covid lockdowns; 2) Cooling export demand; 3) A floundering housing market. Trying to reflate the Chinese housing bubble would only damage the long-term prospects of China’s economy. A much better option would be to adopt measures that boost disposable income. Not only would this help offset the drag from slowing export growth and a negative housing wealth effect, but it would also take some of the sting out of China’s zero-Covid policy. With the Twentieth Party Congress slated for later this year, the political incentive to shower the economy with cash will only intensify. Chinese equities are trading at only 10-times forward earnings and about 1-times sales. A significant upward rating for equity valuations is likely if the government adopts broad-based income-support measures. Go long the iShares MSCI China ETF ($MCHI) as a tactical trade. Bottom Line: China faces a number of economic woes, but these are fully discounted by the market. What has not been discounted is a broad-based stimulus program focused on income-support measures.   Dear Client, I will be visiting clients in Saudi Arabia, Bahrain, and Abu Dhabi next week. No doubt, the outlook for oil prices will feature heavily in my discussions. I will brief you on any insights I learn in my report on June 17. In the meantime, I am pleased to announce that Matt Gertken, BCA’s Chief Geopolitical Strategist, will be the guest author of next week’s Global Investment Strategy report. Best regards, Peter Berezin Chief Global Strategist Triple Threat The Chinese economy faces a trifecta of economic woes: 1) The threat of renewed Covid lockdowns; 2) Cooling export demand; 3) A floundering housing market. Let us discuss each problem in turn.   Problem #1: China’s Zero-Covid Policy in the Age of Omicron Chart 1China’s Lockdown Index Remains Elevated China: A Trifecta Of Economic Woes China: A Trifecta Of Economic Woes China was able to successfully suppress the virus in the first two years of the pandemic. However, the emergence of the Omicron strain is challenging the government’s commitment to its zero-Covid policy. The BA.2 subvariant of Omicron is 50% more contagious than the original Omicron strain and about 4-times more contagious than the Delta strain. While 89% of China’s population has been fully vaccinated, the number drops off to 82% for those above the age of 60. And those who are vaccinated have been inoculated with vaccines that appear to be largely ineffective against Omicron. Keeping a virus as contagious as measles at bay in a population with little natural or artificial immunity is exceedingly difficult. While the authorities are starting to relax restrictions in Shanghai, China’s Effective Lockdown Index remains at elevated levels (Chart 1). A number of domestically designed mRNA vaccines are in phase 3 trials. However, it is not clear how effective they will be. Shanghai-based Fosun Pharma has inked a deal to distribute 100 million doses of Pfizer’s vaccine, but so far neither it nor Moderna’s vaccine have been approved for use. Our working assumption is that China will authorize the distribution of western-made mRNA vaccines later this year if its own offerings prove ineffectual. The Chinese government has already signed a deal to manufacture a generic version of Pfizer’s Paxlovid, which has been shown to cut the risk of hospitalization by 90% if taken within five days of the onset of symptoms. In the meantime, the authorities will continue to play whack-a-mole with Covid. Investors should expect more lockdowns during the remainder of the year.   Problem #2: Weaker Export Growth China’s export growth slowed sharply in April, with manufacturing production contracting at the fastest rate since data collection began. Activity appears to have rebounded somewhat in May, but the new export orders components of both the official and private-sector manufacturing PMIs still remain below 50 (Chart 2). Part of the export slowdown is attributable to lockdown restrictions. However, weaker external demand is also a culprit, as evidenced by the fact that Korean export growth — a bellwether for global trade — has decelerated (Chart 3).  Chart 2China’s Export Growth Has Rolled Over China's Export Growth Has Rolled Over China's Export Growth Has Rolled Over Chart 3Softer Export Growth Is Not A China-Specific Phenomenon Softer Export Growth Is Not A China-Specific Phenomenon Softer Export Growth Is Not A China-Specific Phenomenon Spending in developed economies is shifting from manufactured goods to services. Retail inventories in the US are now well above their pre-pandemic trend, suggesting that the demand for Chinese-made goods will remain subdued over the coming months (Chart 4). The surge in commodity prices is only adding to Chinese manufacturer woes. Input prices rose 10% faster than manufacturing output prices over the past 12 months. This is squeezing profit margins (Chart 5). Chart 4Well-Stocked Shelves In The US Bode Poorly For Chinese Export Demand Well-Stocked Shelves In The US Bode Poorly For Chinese Export Demand Well-Stocked Shelves In The US Bode Poorly For Chinese Export Demand Chart 5Surging Input Costs Are Weighing On The Profits Of Chinese Commodity Users Surging Input Costs Are Weighing On The Profits Of Chinese Commodity Users Surging Input Costs Are Weighing On The Profits Of Chinese Commodity Users A modest depreciation in the currency would help the Chinese export sector. However, after weakening from 6.37 in April to 6.79 in mid-May, USD/CNY has moved back to 6.66 on the back of the recent selloff in the US dollar. Chart 6The RMB Tends To Weaken When EUR/USD Is Rising The RMB Tends To Weaken When EUR/USD Is Rising The RMB Tends To Weaken When EUR/USD Is Rising We expect the dollar to weaken further over the next 12 months as the Fed tempers its hawkish rhetoric in response to falling inflation. Chart 6 shows that the trade-weighted RMB typically strengthens when EUR/USD is rising. Chester Ntonifor, BCA’s Chief Currency Strategist, expects EUR/USD to reach 1.16 by the end of the year.   Problem #3: Flagging Property Market Chinese housing sales, starts, and completions all contracted in April (Chart 7). New home prices dipped 0.2% on a month-over-month basis, and are up just 0.7% from a year earlier, the smallest gain since 2015. The percentage of households planning to buy a home is near record lows (Chart 8). Chart 7The Chinese Property Market Has Been Cooling The Chinese Property Market Has Been Cooling The Chinese Property Market Has Been Cooling Chart 8Intentions To Buy A House Have Declined Intentions To Buy A House Have Declined Intentions To Buy A House Have Declined China’s property developers are in dire straits. Corporate bonds for the sector are, on average, trading at 48 cents on the dollar (Chart 9). Goldman Sachs estimates that the default rate for property developers will reach 32% in 2022, up from their earlier estimate of 19%. The government is trying to prop up housing demand. The PBoC lowered the 5-year loan prime rate by 15 bps on May 20th, the largest such cut since 2019. The authorities have dropped the floor mortgage rate to a 14-year low of 4.25%. They have also taken steps to make it easier for property developers to issue domestic bonds. BCA’s China strategists believe these measures will foster a modest rebound in the property market in the second half of this year. However, they do not anticipate a robust recovery – of the sort experienced following the initial wave of the pandemic – due to the government’s continued adherence to the “three red lines” policy.1 China is building too many homes. While residential investment as a share GDP has been trending lower, it is still very high in relation to other countries. China’s working-age population is now shrinking, which suggests that housing demand will contract over the coming years (Chart 10). Chart 9Chinese Property Developer Bonds Are Trading At Distressed Levels Chinese Property Developer Bonds Are Trading At Distressed Levels Chinese Property Developer Bonds Are Trading At Distressed Levels Chart 10Shrinking Working-Age Population Implies Less Demand For Housing Shrinking Working-Age Population Implies Less Demand For Housing Shrinking Working-Age Population Implies Less Demand For Housing Chinese real estate prices are amongst the highest anywhere. The five biggest cities in the world with the lowest rental yields are all in China (Chart 11). The entire Chinese housing stock is worth nearly $100 trillion, making it the largest asset class in the world. As such, a decline in Chinese home prices would generate a sizable negative wealth effect. Chart 11Chinese Real Estate Is Expensive China: A Trifecta Of Economic Woes China: A Trifecta Of Economic Woes A Silver Bullet? Trying to reflate the Chinese housing bubble would only damage the long-term prospects of China’s economy. Luckily, one does not need to fill a leaky bucket through the same hole the water escaped. As long as there is enough demand throughout the economy, workers who lose their jobs in declining sectors will eventually find new jobs in other sectors. China needs to reorient its economy away from its historic reliance on investment and exports towards consumption. The easiest way to do that is to adopt measures that boost disposable income, which has slowed of late (Chart 12). Not only would this help offset the drag from slowing export growth and a negative housing wealth effect, but it would also take some of the sting out of China’s zero-Covid policy. The authorities have not talked much about pursuing large-scale income-support measures of the kind adopted by many developed economies during the pandemic. As a result, market participants have largely dismissed this possibility. Yet, with the Twentieth Party Congress slated for later this year, the political incentive to shower the economy with cash will only intensify. Chinese equities are trading at only 10-times forward earnings and about 1-times sales (Chart 13). A significant upward rating for equity valuations is likely if the government adopts broad-based income-support measures. As we saw in the US and elsewhere, stimulus cash has a habit of flowing into the stock market; and with real estate in the doldrums, equities may become the asset class of choice for many Chinese investors. With that in mind, we are going long the iShares MSCI China ETF ($MCHI) as a tactical trade. Chart 12Disposable Income Growth Has Been Trending Lower Disposable Income Growth Has Been Trending Lower Disposable Income Growth Has Been Trending Lower Chart 13Chinese Stocks Are Relatively Cheap Chinese Stocks Are Relatively Cheap Chinese Stocks Are Relatively Cheap At a global level, a floundering Chinese property market would have been a cause for grave concern in the past, as it would have represented a major deflationary shock. Times have changed, however. The problem now is too much inflation, rather than too little. To the extent that reduced Chinese investment injects more savings into the global economy and knocks down commodity prices, this would be welcomed by most investors. China’s economy may be heading for a “beautiful slowdown.” Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn Twitter   Footnotes   1      The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. View Matrix China: A Trifecta Of Economic Woes China: A Trifecta Of Economic Woes Special Trade Recommendations Current MacroQuant Model Scores China: A Trifecta Of Economic Woes China: A Trifecta Of Economic Woes

Executive Summary Villains Still Lurking Villains Still Lurking Villains Still Lurking European assets and the euro already discount a significant worsening of Europe’s economic outlook. If the global economic situation were to stabilize, then European assets would be a buy at current levels. However, there remain very large risks lurking over the outlook. First, a further deterioration in energy flows between Russia and the EU is a major threat to the European economic outlook. Second, the ECB delivering the seven rate hikes priced in the June 2023 Euribor contract would be painful for the European economy. Third, further selloff in the US equity market could translate into more pain for European equities. And fourth, the weakness in the Chinese economy and aggressive monetary tightening in the broader EM space outside China are additional risks. These risks loom large enough, so that investors should avoid bottom-fishing the market. Wait until greater clarity emerges or valuations improve further. Bottom Line: Don’t be a hero. European assets and the euro are probably in the process of bottoming. However, the probability of a very significant additional decline is large enough that investors should continue to emphasize capital preservation over return maximization. Also, continue to favor defensives over cyclical assets.      After declining nearly 8% since its January 2021 peak, the euro is down another 7% so far this year. Meanwhile, the Dow Jones Euro STOXX 50, which has plunged 17% since its January 5, 2022 apex, or 22% in US dollar terms, trades at 11.2 times 2023 earnings estimates. At these valuations, European assets already discount a major growth slump in Europe. Is it time to buy European assets, to favor cyclicals versus defensives, and to buy the euro? At face value, the answer is “yes,” but uncertainty abounds, which means that capital preservation remains paramount. As a result, we recommend investors avoid bottom-fishing European assets. They should wait for a safer entry point, rather than trying to pick through the market trough. Plenty Of Risks Four main risks cast a long shadow on the performance of European assets: The evolution of the energy crisis, the potential for an ECB policy mistake, the threat of a worsening US selloff, and the instability in EM. The Energy Crisis It’s official: Sweden and Finland are applying to join NATO. Turkey’s objection will create delays in the process, but it will not stop it. Turkey needs protection against Russia, and it needs help to support the lira. Turkey’s acquiescence, therefore, will be bought. What is genuinely surprising is Russia’s silence. President Putin threatened to flex Russia’s military muscles if Sweden and Finland were to abandon their neutrality. Yet, he now has “no problem” with their bid to join the alliance. We are skeptical, especially as the EU is aiming to ban Russian oil imports by the end of the year. Based on these observations, we continue to see a further deterioration in energy flows between Russia and the EU as a major threat to the European economic outlook. It is far from a guaranteed outcome, but its probability is elevated enough (more than 30%) and so impactful that any investment strategy must account for it. Chart 1Rebuilding Nat Gas Stocks Is A Must Don’t Be A Hero Don’t Be A Hero Chart 2Low-Income Households Are At Risk Don’t Be A Hero Don’t Be A Hero Moreover, European nations continue to pay a premium for their energy and are trying to rebuild their natural gas inventory ahead of winter (Chart 1). Thus, the energy market continues to carry a significant recession risk for the Eurozone. Lower-income households already spend a substantial portion of their income on utilities and transportation costs, and their consumption is highly sensitive to the evolution of energy prices (Chart 2). A Policy Mistake We consider a rate hike in July a policy mistake, but it would be a true error if the ECB ratified the pricing currently embedded in the €STR curve (Chart 3). Why would a rate hike constitute a policy mistake? The EU’s inflation spike is not a reflection of strong domestic demand. It reflects foreign factors over which the ECB has no control. Energy prices drive European inflation and are passing-through to core CPI (Chart 4). Yet, wage growth remains tepid at 2.6%. Hiking rates will not bring about the additional energy supply Europe needs to tame inflation. Chart 3Too Far Too Fast Too Far Too Fast Too Far Too Fast Chart 4European Inflation Is Energy inflation European Inflation Is Energy inflation European Inflation Is Energy inflation Chart 5The US Is Lifting Prices Around The World The US Is Lifting Prices Around The World The US Is Lifting Prices Around The World Even the analysis of the ECB is conflicted. On May 11, Executive Board Member Isabel Schnabel highlighted the need for an imminent interest rate hike, yet she also underscored the global nature of the current inflation outbreak. Goods prices in Europe not only reflect higher input costs, but they also bear the imprint of the excess demand in the US, which is lifting the price of goods prices around the world (Chart 5). However, an ECB rate hike will do little to tame US demand for manufactured goods. In the monetary policy realm, only aggressive tightening by the Fed will have the desired effect, which will trickle down to lower European inflation. Thus, European interest rate hikes will accentuate consumption weaknesses already visible across the region more than they will slow inflation. While a few rate hikes will not have a major impact, the seven rate hikes priced in the June 2023 Euribor contract would be disastrous as long as Europe is hamstrung by the current relative price shock. We remain long this contract. Worsening US Equity Selloff Investors seem to be waking up to the reality that US consumers are facing the same difficult predicament as European consumers: rising energy and food prices and contracting real incomes. The recent earnings call by Walmart was a shock that caused an 8% drubbing for consumer staples and a 7% fall in consumer discretionary equities. Until US inflation clearly peaks, investors will have to evaluate how much deeper the pain for consumers may run. Moreover, since consumers have begun to cut their discretionary spending in response to strained budgets, the ability of firms to pass on rising input costs is dwindling. Hence, investors will have to handicap the risks to margins as well. Chart 6Fed Put Not Exercised Fed Put Not Exercised Fed Put Not Exercised US inflation also impacts the Fed’s outlook. Until inflation has decelerated for a few months, the Fed will remain comfortable with tighter financial conditions. This means that the strike price of the so-called Fed put is inversely proportional to inflation, especially since FCIs are far from tight (Chart 6). As a result, inflation or energy prices must soften before the Fed can begin to send comforting signals to the market. Chart 7Where Walmart Goes, So Does The Market? Where Walmart Goes, So Does The Market? Where Walmart Goes, So Does The Market? The US market has cheapened significantly, and a floor should be close; but the risks remain considerable. A very smart investor with whom we regularly chat highlighted that we have not yet seen a full-fledged liquidation. Only once energy stocks have also been purged will the necessary condition for a bottom be met (since only then will all the speculative activity have been cleared). In fact, the recent poor performance of Walmart highlights the risk that the S&P 500 could suffer one last down leg to 3500, since over the past 12 years, WMT often leads the SPX (Chart 7). Another 300 points decline in the US benchmark could translate into significant selling pressure in the Euro STOXX, because it sports an elevated beta. EM Instability EM are still facing ample risks, which could easily dislodge the prospects of European firms servicing these economies. As a result, EM constitute another major threat for European equities. Chart 8Less COVID In Shanghai and Jilin Less COVID In Shanghai and Jilin Less COVID In Shanghai and Jilin The outlook for China remains fraught with risks. National COVID cases are declining as a result of the collapse in cases in the Shanghai and Jilin provinces (Chart 8). However, Omicron is spreading around the nation, with broadening lockdowns in Beijing and Tianjin. The one certainty is that the Chinese Communist Party remains wedded to its zero-COVID policy. Considering the size of the country and how contagious the various Omicron variants are, rolling lockdowns and their deleterious impact on activity are here to stay. China therefore remains a source of downside risk for global goods demand. Unemployment is surging, and the PMIs are extremely weak, suggesting a contraction in GDP is coming. Moreover, households continue to deleverage (Chart 9). The CNY’s weakness confirms the risks to earnings growth in Europe, and the yield spread between China and the US points to further downside in the RMB (Chart 10, top panel). Interestingly, the weakness of the yen could also drag the CNY lower because of competitive pressures. Chester Ntonifor, BCA’s Chief Foreign Exchange strategist recommends investors sell CNY/JPY. Historically, a depreciating CNY/JPY portends weakness in European stock prices (Chart 10, bottom panel). Chart 9Chinese Growth Problems Chinese Growth Problems Chinese Growth Problems Chart 10A Weaker CNY Augurs Poorly For European Stocks A Weaker CNY Augurs Poorly For European Stocks A Weaker CNY Augurs Poorly For European Stocks The broader EM space outside of China is also a source of risk. EM countries are tightening monetary policy, which is slowing economic activity in nations already exposed to declining Chinese imports. Additionally, as Arthur Budaghyan shows, the strength in the dollar is tightening EM financial conditions and invites further increases in EM policy rates because of the inflationary impact of depreciating currencies.  An additional tightening in EM financial conditions in response to this toxic mix will invite greater downside for European equities (Chart 11). Bottom Line: European equities already reflect enough of a valuation cushion to compensate for a significant slowdown in European growth. However, ample risks to global growth still lurk in the background. If these risks materialize, European stocks could selloff another 15% or so. Moreover, the overvaluation of cyclical stocks relative to defensive ones has now been purged, but China’s economic weakness remains a major handicap (Chart 12). Consequently, don’t be hero: avoid bottom-fishing European assets, especially cyclical ones. Chart 11Brewing EM Troubles Brewing EM Troubles Brewing EM Troubles Chart 12Cyclicals At Risk From China Cyclicals At Risk From China Cyclicals At Risk From China Is it Time to Buy the Euro? After falling below 1.04, EUR/USD has rebounded to 1.055. Is it time to buy the euro? The euro now embeds a large discount that reflects fears of a recession and stagflation in the Eurozone. A purchasing power parity model developed by BCA’s Foreign Exchange Strategy team that accounts for the differences in consumption baskets in Europe and the US shows that EUR/USD is trading at its deepest discount to fair value since 2001. Moreover, BCA’s Intermediate-term timing model, which is based on an augmented interest rate parity framework, confirms that EUR/USD is cheap. Additionally, BCA’s Intermediate-Term Technical Indicator is massively oversold (Chart 13). For the euro to bottom durably, the dollar needs to reverse its rally. The combination of net speculative positions on the DXY and BCA’s Dollar Capitulation Index point to elevated chances of an imminent peak (Chart 14). Chart 13The Euro's Large Risk Premium The Euro's Large Risk Premium The Euro's Large Risk Premium Chart 14The Over Extended Dollar The Over Extended Dollar The Over Extended Dollar Despite this backdrop, three of the aforementioned risks to European stocks translate into threats to the euro: A Russian energy embargo would cause a much more severe European recession. Two weeks ago, we highlighted a Bundesbank study which showed that such a cutoff would curtail German growth by 5% point for 2022.  We also highlighted that this shock would cause a temporary but significant increase in inflation. This combination would be poisonous for the euro, and it carries a roughly 30% probability. A policy mistake in the Euro Area would cause a period of significant spread widening in the periphery. Such shocks often prompt a widening in the breakup risk-premium for the euro. This risk premium pushes EUR/USD lower. Chart 15Chinese Assets Matter To The Euro Chinese Assets Matter To The Euro Chinese Assets Matter To The Euro Chinese growth problems often hurt the euro as well as European stocks. A fall in the Chinese stock-to-bond ratio often leads to a weaker EUR/USD, since both variables are correlated to Chinese economic activity. Additionally, a depreciating CNY is also synonymous with a softer euro because a declining renminbi hurts European exporters (Chart 15). Further weaknesses in the S&P 500 no longer guarantee a fall in EUR/USD. Investors are worried about the US equity outlook because they are extrapolating the impact on consumers of rising energy and food prices. They are applying the template of what is going on in Europe to US households, which means that they are pricing in a convergence of US growth toward European growth (barring the three additional shocks highlighted in the bullet points above). Related Report  European Investment StrategyIs UK Stagflation Priced In? Bottom Line: From a technical and valuation perspective, the rebound in the euro that began this week could last longer. However, several exceptional risks could prevent this bounce from morphing into a durable rally. The significant odds of a Russian energy embargo stand at the top of the list of concerns, but so does the possibility of a policy mistake in Europe as well China’s problems. Thus, even if the euro is bottoming, don’t be a hero and wait on a safer entry point to focus on capital preservation. In fact, BCA’s Foreign Strategy team is now selling EUR/JPY. Within a European context, a short GBP/CHF position is attractive as a portfolio hedge. The Swiss National Bank seems more tolerant of a higher CHF as a vehicle to tame growing inflationary pressures, while the UK faces significant risks.    Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Listen to a short summary of this report.     Executive Summary The Dollar Likes Volatility The Dollar Likes Volatility The Dollar Likes Volatility Uncertainty about Fed policy has supercharged volatility in bond markets, and correspondingly, USD demand (Feature chart). A well-telegraphed path of interest rates will deflate the volatility “bubble” in Treasury markets and erode the USD safety premium. The dollar has also already priced in a very aggressive path for US interest rates. The onus is on the Fed to deliver on these expectations. Our theme of playing central bank convergence – by fading excessive hawkishness or dovishness by any one central bank – continues to play out. Our latest candidate: short EUR/JPY. The Russia-Ukraine conflict, and ensuing volatility in oil markets, is providing some trading opportunities. One of those is that “good” oil will continue to trade at a premium to “bad” oil. Go long a basket of CAD and NOK versus the RUB. TRADES* INITIATION DATE INCEPTION LEVEL TARGET RATE STOP LOSS PERCENT RETURNS SPOT CARRY** TOTAL Short DXY 2022-05-12 104.8 95 107       Short EUR/JPY 2022-05-12 133.278 120 137       Bottom Line: We recommended shorting the DXY index on April 8th at 102, with a tight stop at 104. That stop-loss was triggered this week. We are reinitiating this trade this week at 104.8, in line with our cyclical view that the dollar faces downside on a 12–18 month horizon.       Multiple factors tend to drive the dollar: Real interest rate differentials, growth divergences, portfolio flows into both public and private capital markets, or even safe-haven demand. Across both developed and emerging market currency pairs, the dollar has been strong (Chart 1), but what has been the key driver of these inflows? For most of this year, interest rate differentials have played a key role in pushing the dollar higher. That said, they have not been the complete story. Chart 2 shows that the dollar has very much overshot market expectations of Fed interest rate policy, relative to other central banks. That premium has been around 8%-10% in the DXY index. In real terms, the overshoot has been even higher. Chart 1The Dollar Has Been King Month In-Review: A Hefty Safe-Haven Premium In The Dollar Month In-Review: A Hefty Safe-Haven Premium In The Dollar Chart 2The Fed And The Dollar The Fed And The Dollar The Fed And The Dollar Chart 3The Dollar Likes Volatility The Dollar Likes Volatility The Dollar Likes Volatility A key source of this safe-haven premium has been rising volatility, specifically in the bond market. For most of the last two years, the dollar has tracked the MOVE index, a volatility measure of US Treasurys (Chart 3). Uncertainty about the path of US interest rates, and the corresponding rise in dollar hedging costs, have ushered in a wave of “naked” foreign buyers – owning USTs without a corresponding dollar hedge. Foreign purchases of US Treasurys are surging. Speculators have also expressed bearish bets on the euro, yen, and even sterling via the dollar. There is a case to be made that some of these bullish dollar bets will be unwound in the next few months, even if marginally. For example, the market expects rates to be 248 bps and 313 bps higher in the US by year end, respectively, compared to the euro area and Japan (Chart 4). This might be exaggerated. The real GDP growth and inflation differential between the eurozone and the US is 0.1% and 0.8%, respectively, for 2022. The difference in the neutral rate could be as low as 1.25%. This suggests that a simplified Taylor-rule framework will prescribe a policy rate differential of only 1.7% (1.25 + 0.5(0.8+0.1)). In a global growth slowdown, US inflation will come in much lower, which will allow the Fed to ratchet back interest rate expectations. Should growth accelerate, however, then growth differentials between open economies and the US will widen, narrowing the policy divergence we have been experiencing. The safe-haven premium in the dollar has also been visible in the equity market. One striking feature of the correction has been the inability for US equities to outperform, as they usually do, during a market riot point. The carnage in technology stocks has been absolute, and the tech-heavy US equity market continues to struggle against its global peers. As such, there has been a break in the historically strong relationship between the dollar and the outperformance of the US equity market (Chart 5). Chart 4Pricing In The Euro And Yen In Line With Rates Pricing In The Euro And Yen In Line With Rates Pricing In The Euro And Yen In Line With Rates Chart 5The Dollar Has Overshot The Relative Performance Of US Equities The Dollar Has Overshot The Relative Performance Of US Equities The Dollar Has Overshot The Relative Performance Of US Equities As US equity markets were surging throughout 2021, investors started accumulating dollars as a hedge against equity market capitulation, which explained the tight correlation between the put/call ratio and the USD (Chart 6). As the carry on the dollar has risen, and puts have become more expensive, our suspicion is that the greenback has become a preferred hedge. Chart 6Dollar Hedges Against A Drawdown In The S&P Dollar Hedges Against A Drawdown In The S&P Dollar Hedges Against A Drawdown In The S&P As we have highlighted in past reports, the dollar continues to face a tug of war. Higher interest rates undermine the US equity market leadership, while lower rates will reverse the record high speculative positioning in the dollar. Given recent market action, the path of US bond yields will be critical for the dollar outlook. Cresting inflation could pressure bond yields lower. As a strategy, we recommended shorting the DXY index on April 8th at 102, with a tight stop 104. That stop-loss was triggered this week. We are reinitiating this trade at 104.8, in line with our cyclical view that the dollar faces downside on a 12–18-month horizon. As usual, this week’s Month In Review report goes over our take on the latest G10 data releases and the implications for currency strategy both in the near term and longer term.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   US Dollar: Inflation Will Be Key Chart 7How Sustainable Is The Breakout? How Sustainable Is The Breakout How Sustainable Is The Breakout The dollar DXY index is up 9% year-to-date, hitting multi-year highs (panel 1). The Fed increased interest rates by 50bps this month. In our view, the Fed will continue to calibrate monetary policy based on data, and the key releases continue to surprise to the upside. Headline CPI came in at 8.3% in April, while the core measure was at 6.2%. Both were higher than expected. Importantly, the month-on-month rate for core was 0.6%, much higher than a run rate of 0.2% that will be consistent with the Fed’s target of inflation (panel 2). It is important to note that used car prices have had an important contribution to US CPI. Airfares had an abnormally large contribution to US CPI for the month of April. As these prices crest, along with other supply-driven costs, inflation could meaningfully roll over in the coming months (panel 3). The job’s report was robust, but there was disappointment in the participation rate that fell from 62.4% to 62.2%. This suggests there might be more labor slack in the US than a 3.6% unemployment rate suggests. Wages continue to inflect higher. The Atlanta Fed Wage Growth Tracker currently sits at 6% (panel 4). These developments continue to underpin market expectations for aggressive interest rate increases. The market now expects the Fed to raise rates to 2.5% by December 2022. Speculators are also very long the dollar. Three factors could unhinge market expectations. First, inflation could come crashing back down to earth which will unwind some of the rate hikes priced in the very near term. That would hurt the dollar. Second, growth could pick up outside the US, especially in economies with lots of pent-up demand like Japan. Third, financial conditions could ease, which will help revive animal spirits. In conclusion, our 3-month view on the dollar remains neutral, but our 12-18-month assessment is to sell the dollar. We are reinitiating our short DXY position today with a stop-loss at 106.  Euro: A Recession Is Priced Chart 8Go Short EUR/JPY Go Short EUR/JPY Go Short EUR/JPY The euro has broken below 1.05 and the whisper circulating in markets is that parity is within striking distance. EUR/USD is down 8.7% year-to-date. We have avoided trading the euro against the dollar and have mostly focused on the crosses – long EUR/GBP, and this week, we are selling EUR/JPY. The euro is in a perfect tug of war: Rising inflation is threatening the credibility of the ECB while there is the risk of slowing growth tipping the euro area into a recession. In our view, the euro has already priced in the latter, much more than potentially higher rates in the eurozone. The ZEW sentiment index, a gauge of European growth prospects, is at COVID-19 lows, along with EUR/USD (panel 1). My colleague, Mathieu Savary, constructed a stagflation index for Europe which perfectly encapsulates the ECB’s quandary. A growing cohort of ECB members are supporting a July rate hike. On the surface, the ECB has the lowest rate in the G10 (outside of Switzerland). With HICP inflation at 7.5% (panel 2), emergency monetary settings are no longer required. A “least regrets” approach suggests gently nudging rates higher to address inflationary pressures. House prices in Germany and Italy are rising at their fastest pace in over a decade, much more than wage inflation (panel 3). The key for the ECB will be to telegraph that policy remains extremely accommodative. It is hard to envision that hiking rates from -0.5% to -0.25% will trigger a European recession, but the ECB will need to balance that outcome with the possibility that inflation crests and real rates rise in Europe. In our trading books, we are long EUR/GBP as a play on policy convergence between the ECB and the BoE. This week, we are playing the same theme via shorting EUR/JPY. In a risk-off environment, EUR/JPY should fall. In an economic boom, the cross has already priced in a stronger euro, relative to the yen (panel 4). We are neutral on the euro over a 3-month horizon but are buyers over 12-18 months.  Japanese Yen: A Mean-Reversion Play Chart 9A Capitulation In The Yen? A Capitulation In The Yen? A Capitulation In The Yen? The Japanese yen is down 10.5% year-to-date, one of the worst performing G10 currency this year. In retrospect, a chart formation since 1990 suggests that we witnessed a classic liquidation phase that could only be arrested by an exhaustion in selling pressure, or a shift in fundamentals (panel 1). The two key drivers of yen weakness are the rise in US yields (panel 2) and the higher cost of energy imports. As today’s price move suggests, any reversal in these key variables will lead to a selloff in USD/JPY – falling bond yields and/or lower energy prices. We have been timidly long the yen, via a short CHF position. Today we are introducing a short EUR/JPY trade as well. What has been remarkable in the last month is the improvement in Japanese economic fundamentals, as the country slowly emergences from the latest COVID-19 wave: Both the outlook and current situation components of the Eco Watchers Survey improved in April. This is a survey of small and medium-sized businesses, very sensitive to domestic conditions. PMIs in Japan are improving on both the manufacturing and service fronts. The Tokyo CPI surprised to the upside, with the headline figure at 2.5%. Historically, the earlier release of the Tokyo CPI has been a reliable gauge for nationwide inflation. Importantly, the release was much below BoJ forecasts. Inflation in Japan could surprise to the upside (panel 3). Employment numbers remain robust. The unemployment rate fell to 2.6% in March, and the jobs-to-applicants ratio rose to 1.22. The Bank of Japan has stayed dovish, reinforcing yield curve control in its April 27 meeting, with strong forward guidance. That said, the BoJ will have no choice but to pivot if inflationary pressures prove stronger than they anticipate, and/or the output gap in Japan closes much faster as demand recovers. Related Report  Foreign Exchange StrategyWhat To Do About The Yen? We were stopped out of our short USD/JPY position at 128. In retrospect, USD/JPY rallied above 131 and is finally falling back down to earth. We are already in the money on our short CHF/JPY position, from our last in-depth report on the yen. This week, we recommend shorting EUR/JPY.  British Pound: A Volte-Face By The BoE Chart 10The Pound Is Being Traded As High Beta The Pound Is Being Traded As High Beta The Pound Is Being Traded As High Beta The pound is down 9.8% year-to-date. While the Bank of England raised rates to 1% this month, they also expect the economy to temporarily dip into recession this year. This week’s disappointing GDP release confirmed the BoE’s fears. In short, pricing in the SONIA curve for BoE rate hikes remains aggressive. The Bank of England has been one of the more proactive central banks, yet the currency has been performing akin to an inflation crisis in emerging markets (panel 1). Inflation continues to soar in the UK with headline CPI now at 6.2% (panel 2). According to the BoE’s projections, inflation will rise to around 10% this year before peaking, well above previous forecasts of 8%. Together with tighter fiscal policy, the combination will be a hit to consumer sentiment. While the BOE must contain inflationary pressures (in accordance with their mandate), the risks of a policy mistake have risen, akin to the eurozone. Labor market conditions appear tight on the surface (panel 3), but our prognosis is that the UK needs less labor regulation, especially towards areas in the economy where labor shortages are acute and are pressuring wages higher. That is unlikely to change in the near term. As such, the current stance of tight monetary and fiscal policy will stomp out any budding economic green shoots. We are currently short sterling, via a long EUR position. In our view, the EUR/GBP cross still heavily underprices the risks to the UK economy in the near term. Given that the pound is very sensitive to global financial conditions (panel 1), it could rebound if recession fears ease, but our suspicion is that it will still underperform the euro.  Canadian Dollar: The BoC Will Stay Hawkish Chart 11The CAD Will Stay Resilient The CAD Will Stay Resilient The CAD Will Stay Resilient The CAD is down 3% year-to-date. The key driver of the CAD remains the outlook for monetary policy and the path of energy prices (panel 1). In the near term, oil prices will stay volatile, but the CAD has not priced in the fact that the BoC is matching the Fed during this interest rate cycle, and/or the rise in energy prices. Together with the NOK, we are going long the CAD versus the RUB today. As we expected, the Bank of Canada raised interest rates by 50bps to 1% at the April 13 meeting. Since then, all the measures the BoC looks at to calibrate monetary policy are continuing to suggest more tightening in monetary policy. Both headline and core inflation came in strong, with headline inflation at 6.7% in March. The common, trim, and median inflation prints were at 2.8%, 4.7%, and 3.8%, respectively, well above the BoC’s target. This continues to suggest inflationary pressures in Canada are broad- based (panel 2). The employment report in April disappointed market consensus, but employment in Canada is back above pre-pandemic levels, and the unemployment rate fell to 5.2%, close to estimates of NAIRU. This suggests the BoC’s path for monetary policy will not be altered (panel 3). House price inflation seems to be moderating across many cities, which argues that monetary policy is having the intended effect, but price increases remain well above nominal income growth (panel 4). Speculators are slightly long the CAD, a risky stance over the next three months. That said, we are buyers of CAD over a 12-to-18-month horizon.  New Zealand Dollar: Positive Catalysts, But Fairly Valued Chart 12Real NZ Rates Need To Stabilize Real NZ Rates Need To Stabilize Real NZ Rates Need To Stabilize The NZD is down 8.7% year-to-date. The RBNZ remains the most hawkish central bank in the G10. They further raised interest rates to 1.5% on April 13. Given a strict mandate on inflation, together with house price considerations, long bond yields have accepted that the RBNZ will be steadfast in tightening policy and hit 3.8% this month. This will help stabilize real yields are rising (panel 1). Underlying data suggests that the “least regrets” approach by the RBNZ makes sense – in a nutshell, tighten policy as fast as economically possible, to get ahead of the inflation curve. CPI continues to accelerate, hitting 6.9% year-on-year in Q1, from 5.9% the previous quarter (panel 2). House price inflation is rolling over from very elevated levels (panel 3). This suggests that monetary policy is having the intended effect of dampening demand.  A weak NZD could sustain imported inflation, but a hawkish central bank cushions this risk.   The RBNZ is forecasting a 2.8% overnight rate for June 2023. The OIS curve suggests that market expectations are much higher. This fits with our view that the market had been overpricing higher interest rates in New Zealand, especially relative to other countries. We already took profits on our long AUD/NZD trade and continue to expect the NZD to underperform at the crosses, even if it rises versus the dollar.  Australian Dollar: Our Top Pick Against The Dollar Chart 13The AUD Has A Terms Of Trade Tailwind The AUD Has A Terms Of Trade Tailwind The AUD Has A Terms Of Trade Tailwind The Australian dollar is down 5.5% year-to-date. The Reserve Bank of Australia raised interest rates by 15bps on its May 3rd meeting, in line with the hawkish tone telegraphed at the prior meeting. The two critical measures that the RBA is focusing on, inflation and wages, have been improving. That said, we had expected the RBA to wait for fresh wage data, out next week, before calibrating monetary policy. The key point is that emergency monetary settings are no longer required in Australia. Home prices remain robust, the unemployment rate has fallen to a cycle low of 4% in and inflationary pressures remain persistent.  Headline CPI was at 5.1% year-on-year in Q1. The trimmed-mean and weighted- median CPI print came in at 3.7% and 3.2%, respectively, above the upper bound of the RBA’s 2%-3% target range. The external environment is one area of concern for the AUD. The trade balance continues to soar, but China’s zero COVID-19 policy is a risk to Australian exports. On the flip side, many speculators are now short the Aussie, which is bullish from a contrarian perspective. We are long the AUD as of 72 cents, expecting this trade to be volatile in the near term, but to pay off over a longer horizon.  Swiss Franc: The Yen Is A Better Hedge Chart 14Swiss Inflation Will Fall Swiss Inflation Will Fall Swiss Inflation Will Fall Year-to-date, CHF is down 9% against USD and flat against the EUR.  The Swiss economy continues to perform well and remains relatively insulated from the inflation dynamics taking place in the rest of the G10. In April, headline CPI inched higher to 2.5% and core CPI to 1.5% year-over-year (panel 2), while the unemployment rate was down to 2.3%. The KOF indicator was also above expectations at 101.7. At 62.5, the manufacturing PMI is still well in the expansionary zone. In other data, retail sales were up 0.8% month-on-month in March and the trade surplus was down to CHF 1.8bn, likely due to the elevated exchange rate versus the euro. Since then, the franc has given up all its gains against the euro. Several SNB board members have recently spoken about the beneficial role of a strong franc in helping to control inflation (panel 4). That said, it is unclear whether the SNB, known for rampant currency interventions, will be as welcoming to a highly valued franc should inflation roll over. Switzerland’s trade surplus as a share of GDP has been persistently increasing since the early 2000s. An expensive currency would not be positive for economic growth. In fact, SNB sight deposits, have been on the rise recently. Last week, these deposits posted the largest one-week increase in two years. In a world where inflation starts to roll over, the SNB will be more dovish. In this environment, EUR/CHF can see more upside.  Norwegian Krone: Bullish On A 12-to-18 Month Horizon Chart 15NOK Has Upside Month In-Review: A Hefty Safe-Haven Premium In The Dollar Month In-Review: A Hefty Safe-Haven Premium In The Dollar The NOK is down 10.7% against the USD this year. This is a remarkable development amidst higher real rates in Norway (panel 1). The Norges Bank is one of the most predictable central banks. It is set to deliver quarterly 25bps hikes through the end of 2023 to a total of 2.5%. In April, headline CPI rose 5.4% and the measure excluding energy was up 2.6% (panel 2). Although slightly above the latest projections, these figures are unlikely to make the bank deviate from its projected rate path. Economic activity is recovering steadily since the removal of pandemic-related restrictions in February. Household consumption and retail sales grew 4.3% and 3.3% month-over-month, respectively, in March. The manufacturing PMI broke above the 60 level in April, while industrial production was up 2.2% on the month in March. Registered unemployment fell under 2% in April, below pre-pandemic levels. This is helping boost wages (panel 3). Norway’s trade balance continued to break all-time highs with a NOK 138bn surplus in March. Elevated energy prices and the transition away from Russian energy should be a significant tailwind for the Norwegian economy. Oil companies planned to increase investment even before the invasion, and recent developments will likely induce more capex. NOK has significantly underperformed in the last month largely due to broad risk-off sentiment. Once markets stabilize, the krone should strengthen over the next 12–18 months. Given the relatively “safer” nature of Norwegian oil, we are initiating a long NOK/RUB trade today, along with a long CAD leg.  Swedish Krona: Into A Capitulation Phase Chart 16SEK Has Upside SEK Has Upside SEK Has Upside The SEK is down 10.8% versus the dollar this year. In a major policy U-turn, the Riksbank raised rates by 25bps during its last meeting, after inflation came in above expectations at 6.1% on the year in March. The Bank also announced a faster pace of balance-sheet reduction, as well as expecting two-to-three more hikes before the end of the year. Just like the euro area, Sweden is within firing range of tensions between Russia and Ukraine (panel 1). Swedish GDP contracted 0.4% from the previous quarter. Global uncertainty and rising prices are weighing on consumer confidence, reflected in subdued retail sales and household consumption in March. The manufacturing PMI remains robust at 55 but is falling quite rapidly, as are real rates (panel 2). As a small open economy, Sweden needs external demand to recover. On a positive note, orders remain very strong and an easing of lockdowns in China should contribute to growth in manufacturing and goods exports later this year. It is also encouraging that Sweden’s trade surplus rose to 4.7bn SEK in March.  The krona remains vulnerable to both a growth contraction in Europe as well as geopolitical risk, especially as Finland might join NATO, sparring retaliation from Russia. That said, the negative news is likely already priced in. SEK should benefit from growth normalization and a pick-up in the Chinese credit impulse in the second half of the year. As a way to benefit from this dynamic, we are short CHF/SEK, but short USD/SEK positions will be warranted later this year.  Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Artem Sakhbiev Research Associate artem.sakhbiev@bcaresearch.com   Footnotes Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary