Germany

What's The Message From USTs Relative To Bunds? What's The Message From USTs Relative To Bunds? The drubbing in the US/EMU sovereign bond spread is cause for concern for the SPX’s slingshot recovery off the March 23 lows, especially given the tight positive correlation of these two series over the past three decades (top panel). Typically, higher relative yields attract capital to US shores and vice versa, and some of that capital inevitably leaks into US stocks. Moreover, theory would suggest that relative yields move with the ebb and flow of relative return on capital. Indeed, the bottom panel of the chart highlights such an empirical relationship. Currently, euro area return on assets is narrowing the gap with the US which usually happens in recessions. The persistent unresponsiveness in the 10-year UST yield near the zero line which stands closer to the ECB’s NIRP, likely spells short-term trouble for the SPX. Bottom Line: We remain cautious on the near-term prospects of the S&P 500 until the election uncertainty lifts in November.   

Highlights Butterflies & Yield Curve Models: With bond market volatility now back to the subdued levels seen prior to the COVID-19 market turbulence earlier in 2020, it is a good time to update our global yield curve valuation models to look for attractive butterfly trade ideas. Valuations: The models generally indicate that flattener trades offer better value across all countries. Our medium-term strategic bias, however, is towards steeper yield curves with policy rates on hold and depressed global inflation expectations likely to continue drifting higher over the latter half of the year. Yield Curve Trades: We are initiating the first set of yield curve trades within our rebooted Tactical Trade Overlay: going long a 7-year bullet vs. a 5-year/10-year barbell in the US; long a 2-year/30-year barbell vs. a 5-year bullet in France; long a 5-year/30-year barbell vs. a 10-year bullet in Italy; and long a 3-year/20-year barbell vs. a 10-year bullet in the UK. Feature In a Special Report published back in February of this year, we dusted off our model-based framework to find value in trades focused on the shape of government bond yield curves.1 By comparing the market-implied short-term interest rate expectations extracted from our curve models to our own macro views, we are able to come up with actionable buy or sell signals across the yield curve in nine developed markets: the US, Germany, France, Italy, Spain, the UK, Japan, Canada, and Australia. Table 1Most Attractive Butterfly Trades Global Yield Curve Trades: Netting Returns With Butterflies Global Yield Curve Trades: Netting Returns With Butterflies Given the extreme market turbulence around the time we published that report, as the full scope of the COVID-19 pandemic was becoming evident, we chose not to recommend any curve trades from our models until global volatility subsided to acceptable levels. The vigorous action from central banks to manipulate bond yields since then - quantitative easing, aggressive forward guidance, outright yield curve control in Japan and Australia, and other unconventional monetary policy measures - introduced another layer of difficulty in implementing successful curve trades using models estimated in more normal times. With global bond market volatility now back down to pre-COVID levels, we feel that the time is right to use our curve models to help identify opportunities. Specifically, we are implementing new recommended yield curve trades in the US, France, Italy, and the UK. Table 1 shows the most attractive butterfly trades across all the markets covered in this analysis. Note that three of the four trades we are initiating include very long-dated bonds where yields are less susceptible to direct central bank influence. The only exception is our US long 7-year bullet vs. 5-year/10-year barbell trade, the reasoning for which we outline later in this report. Three of the four trades we are initiating include very long-dated bonds where yields are less susceptible to direct central bank influence. The only exception is our US long 7-year bullet vs. 5-year/10-year barbell trade. Before delving into our analysis proper, a quick note: in the interest of brevity, we will limit ourselves to a simple explanation of butterfly strategies and our yield curve models in this report. For those interested in a deeper explanation of the curve modeling framework, please refer to our February 25, 2020 Special Report. A Recap On Butterflies And An Update On Our Yield Curve Models A butterfly fixed income strategy involves two main components: a barbell (a weighted combination of long-term and short-term bonds) and a bullet (a medium-term bond that sits within the yield curve segment selected in the barbell). To implement a butterfly strategy, a bond investor would go long (short) the barbell while simultaneously going short (long) the bullet. By weighting the combination of the long- and short-term bonds in the butterfly such that the weighted sum of their duration equals the duration of the medium-term bond in the bullet, we achieve immunization to parallel shifts in the yield curve. At the same time, due to the relatively higher duration of the longer-term component of the butterfly, we get exposure to specific changes in the slope of the yield curve. In general, the barbell will outperform the bullet in a flattening yield curve environment, and vice-versa. Chart of the WeekButterfly Spreads & Yield Curves Butterfly Spreads & Yield Curves Butterfly Spreads & Yield Curves To actually decide how, and on which parts of the yield curve, to implement our butterfly strategies, we make use of our yield curve models. These models rely on the positive relationship typically observed between the butterfly spread and the slope of the yield curve. When the curve steepens, the butterfly spread widens, and vice-versa (Chart of the Week). This has to do with mean reversion: as the curve steepens, it increases the odds that the curve will flatten in the future since it cannot steepen indefinitely. Consequently, investors will ask for greater compensation to enter a curve steepener trade when the curve is already steepening. As a result, we can create simplified models of the yield curve by regressing any butterfly spread on its corresponding curve slope. Deviations from these fair value models indicate which butterfly strategies are cheap or expensive. However, the model output does not by itself constitute a buy or sell signal and must be integrated with our macro view on the slope of the curve. For example, a butterfly strategy with an expensive bullet implies that there is already a certain amount of steepening discounted in the yield curve. If the yield curve flattens, or even steepens by an amount smaller than what is discounted in the yield curve over the investment horizon, the barbell will outperform, as expected. However, if we see more steepening than is discounted in the yield curve, the bullet will outperform, even though it was already at relatively expensive levels. Therefore, it is crucial to integrate our macro view on how much the curve will steepen or flatten over the investment horizon into our curve trade selection framework. In recent reports, we have emphasized our high-conviction view that global inflation expectations will drift higher in the coming months, driven by reflationary fiscal and monetary policy and a continued rebound in global commodity prices (most notably, oil).2 However, a rise in inflation expectations does not necessarily translate to a “one-to-one” rise in nominal yields if it is offset by a compression in real bond yields. To disentangle this, we look at the 3-year rolling betas of nominal 10-year government bond yields to the corresponding 10-year breakeven inflation rates using inflation-linked bonds (Chart 2). The data suggest a currently weaker relationship between inflation expectations and nominal yields, with all betas well below their post-crisis maxima. Our overall macro bias is towards a global steepening in yield curves, but given our strong belief in a rebound in inflation expectations, we would be more willing to enter steepener trades in higher-beta regions such as Germany, Canada, the US, and Australia where it is more likely that a rise in inflation expectations will translate to higher nominal yields. Conversely, we are less hesitant to enter flatteners in the lower-beta regions such as the UK, France, Italy, and Japan. Chart 2The Link Between Nominal Yields And Inflation Expectations Has Weakened Global Yield Curve Trades: Netting Returns With Butterflies Global Yield Curve Trades: Netting Returns With Butterflies When we said earlier this year that we were “dusting off” our yield curve models, that was not just a figure of speech. The models date back originally to 2002, meaning that they are old enough to vote—perhaps even for a popular rapper. Even though we have been refining and updating it along the way, one of our concerns was that this model was estimated for a pre-crisis sample period before near-zero rates became ubiquitous in developed markets. Our overall macro bias is towards a global steepening in yield curves, but given our strong belief in a rebound in inflation expectations, we would be more willing to enter steepener trades in higher-beta regions such as Germany, Canada, the US, and Australia. To test that the curve relationships within our models are maintained when global central banks are pinning policy rates near 0%, we have re-estimated all the regressions for the post-financial crisis period from 2009 to 2017 when most central banks kept rates near the zero bound. Chart 3 shows the results for the representative 2-year, 5-year and 10-year portions of the yield curve. On the whole, the coefficients are weaker but still positive with the exception of Japan, where many years of zero rates and quantitative easing have caused the 2-year/5-year/10-year butterfly spread to become largely unmoored from the 2-year/10-year slope. Chart 3Looking For Structural Shifts In Our Yield Curve Models Global Yield Curve Trades: Netting Returns With Butterflies Global Yield Curve Trades: Netting Returns With Butterflies Therefore, we still see value in our curve modeling approach, even in the current environment where central banks are likely to be on hold for a period measured in years, not months. Bottom Line: Butterfly strategies are an effective way to position for changes in the slope of the yield curve without exposure to shifts in the curve. Our current strategic bias is to expect steepening of developed market yield curves through rising longer-term inflation expectations, but our global yield curve models indicate better value in most flattening trades. Thus, we need to be extremely selective in recommending trades based on the results of our yield curve models. Yield Curve Models And Trades By Region In the remaining pages of this report, we present the current read-outs from of our yield curve models for each of the major developed markets. More specifically, we provide the deviations from fair value for different combinations of bullets and barbells and highlight the most attractive butterfly strategy. The deviations from fair value shown in Tables 2-10 are standardized to facilitate comparisons between the different butterfly combinations. In addition, for each country we provide a quick assessment of the performance of these butterfly strategies over time by applying a simple mechanical trading rule. Every month, we enter the most attractive butterfly strategy, i.e. the one with the highest absolute standardized deviation from its model fair value. The overall message from the models is that barbells appear attractive relative to bullets across all the countries shown. However, we will only initiate trades in cases where the model output and our macro outlook complement each other. US Looking solely at our model output, US Treasury curve flatteners appear most attractive, with the long 3-year/30-year barbell vs. 5-year bullet trade displaying the greatest deviation from fair value with a residual of -1.55 (Table 2). However, we are inclined to agree with our colleagues at BCA Research US Bond Strategy on how to interpret Treasury curve valuation in the current environment. They argue that even though steepeners in the US are currently expensive, valuations can become even more overstretched with the Fed signaling no rate increases for at least the next two years and the market priced for an extended period of near-zero rates.3 Table 2US: Butterfly Strategy Valuation: Standardized Residuals Global Yield Curve Trades: Netting Returns With Butterflies Global Yield Curve Trades: Netting Returns With Butterflies Our fundamental bias is towards US Treasury curve steepening, with the Fed locking down the front end of the curve and rising inflation expectations putting upward pressure on longer-term yields. Thus, we are entering into the long 7-year bullet vs. 5/10 barbell trade which has a small but positive model residual of +0.17. That represents a better valuation starting point than the other US butterfly spreads, and is therefore a more efficient and profitable way to position for steepeners becoming even more expensive going forward. As highlighted earlier, nominal yields in the US are also more sensitive to rising inflation expectations—another reason to enter into a curve steepener. The specific securities used to execute this trade, as well as the weights for the barbell component used to the make both legs of the trade duration-equivalent, can be found on Page 27 within our Tactical Trade Overlay table. Nominal yields in the US are also more sensitive to rising inflation expectations—another reason to enter into a curve steepener.  The 7-year bullet appears just 1bp cheap according to our model and would only underperform its counterpart given a flattening in the 5-year/10-year Treasury slope greater than 22bps, which we believe is unlikely given the reasons outlined above (Chart 4A). Chart 4AUS 5/7/10 Spread Fair Value Model US 5/7/10 Spread Fair Value Model US 5/7/10 Spread Fair Value Model Chart 4BUS Butterfly Strategy Performance US Butterfly Strategy Performance US Butterfly Strategy Performance Following the mechanical trading rule has delivered steady returns with only a few periods of negative year-over-year returns (Chart 4B). Germany The most attractively valued butterfly combination on the German yield curve is going long the 1-year/30-year barbell and shorting the 5-year bullet, which is almost one standard deviation above its model-implied fair value, with a standardized residual of -0.97 (Table 3). Table 3Germany: Butterfly Strategy Valuation: Standardized Residuals Global Yield Curve Trades: Netting Returns With Butterflies Global Yield Curve Trades: Netting Returns With Butterflies The 5-year bullet appears 29bps expensive according to our model and would only outperform its counterpart given a steepening in the 1-year/30-year German curve slope greater than 50bps (Chart 5A). Chart 5AGermany 1/5/30 Spread Fair Value Model Germany 1/5/30 Spread Fair Value Model Germany 1/5/30 Spread Fair Value Model Chart 5BGermany Butterfly Strategy Performance Germany Butterfly Strategy Performance Germany Butterfly Strategy Performance Following the mechanical trading rule has been quite profitable, delivering consistently positive year-over-year returns for all but the initial period of our sample (Chart 5B). France The most attractively valued butterfly combination on the French OAT yield curve is going long the 2-year/30-year barbell and shorting the 5-year bullet (Table 4). This combination is a little less than one standard deviation over its model-implied fair value with a standardized residual of -0.84. Nominal yields in France are also relatively less correlated with inflation expectations, which makes this a prime candidate for a flattener trade. The specific securities used to execute this trade, as well as the weights for the barbell component used to the make both legs of the trade duration-equivalent, can be found on Page 27 within our Tactical Trade Overlay table. Table 4France: Butterfly Strategy Valuation: Standardized Residuals Global Yield Curve Trades: Netting Returns With Butterflies Global Yield Curve Trades: Netting Returns With Butterflies The 5-year bullet appears 21bps expensive according to our model and would only outperform its counterpart given a steepening in the 2-year/30-year French curve slope greater than 48bps (Chart 6A). Chart 6AFrance 2/5/30 Spread Fair Value Model France 2/5/30 Spread Fair Value Model France 2/5/30 Spread Fair Value Model Chart 6BFrance Butterfly Strategy Performance France Butterfly Strategy Performance France Butterfly Strategy Performance As with Germany, following the mechanical trading rule in the French OAT market has also been profitable, with only three periods of negative year-over-year returns in our sample period (Chart 6B). Italy And Spain In Italy, the most attractively valued butterfly combination is going long the 5-year/30-year barbell and shorting the 10-year bullet – a combination with a standardized residual of -0.79 (Table 5). In Spain, going long the 3-year/30-year barbell and short the 5-year bullet seems most attractive with a standardized residual of -0.83 (Table 6). Of the two peripheral euro area countries, we are choosing to put on a trade in the relatively larger and more liquid Italian government bond market. As with France, Italian nominal yields also display a relatively low beta to inflation breakevens. The specific securities used to execute this trade, as well as the weights for the barbell component used to the make both legs of the trade duration-equivalent, can be found on Page 27 within our Tactical Trade Overlay table. Table 5Italy: Butterfly Strategy Valuation: Standardized Residuals Global Yield Curve Trades: Netting Returns With Butterflies Global Yield Curve Trades: Netting Returns With Butterflies Table 6Spain: Butterfly Strategy Valuation: Standardized Residuals Global Yield Curve Trades: Netting Returns With Butterflies Global Yield Curve Trades: Netting Returns With Butterflies In Italy, the 10-year bullet appears 22bps expensive according to our model and would only outperform its counterpart given a steepening in the 5-year/30-year Italian curve slope greater than 153bps (Chart 7A). Following the mechanical trading rule in Italy has yielded strong excess returns, with only one very short period of negative year-over-year returns in our sample period (Chart 7B).  As with Italy, following the mechanical trading rule in Spain has yielded some of the strongest excess returns on a cumulative and year-over-year basis. Chart 7AItaly 5/10/30 Spread Fair Value Model Italy 5/10/30 Spread Fair Value Model Italy 5/10/30 Spread Fair Value Model Chart 7BItaly Butterfly Strategy Performance Italy Butterfly Strategy Performance Italy Butterfly Strategy Performance In Spain, the 5-year bullet appears 14bps expensive according to our model and would only outperform its counterpart given a steepening in the 3-year/30-year Spanish curve slope greater than 47bps (Chart 8A). As with Italy, following the mechanical trading rule in Spain has yielded some of the strongest excess returns on a cumulative and year-over-year basis (Chart 8B). Chart 8ASpain 3/5/30 Spread Fair Value Model Spain 3/5/30 Spread Fair Value Model Spain 3/5/30 Spread Fair Value Model Chart 8BSpain Butterfly Strategy Performance Spain Butterfly Strategy Performance Spain Butterfly Strategy Performance UK On the UK Gilt yield curve, the most attractive butterfly combination is holding a 3-year/20-year barbell versus a 10-year bullet, which currently displays a standardized residual of -1.08 (Table 7). As with France and Italy, not only is this flattener trade attractively valued, the UK is also one of the countries where inflation breakevens are relatively less correlated with nominal yields, making this another excellent candidate for our Tactical Trade Overlay. The specific securities used to execute this trade, as well as the weights for the barbell component used to the make both legs of the trade duration-equivalent, can be found on Page 27. Table 7UK: Butterfly Strategy Valuation: Standardized Residuals Global Yield Curve Trades: Netting Returns With Butterflies Global Yield Curve Trades: Netting Returns With Butterflies The 10-year bullet appears 13bps expensive according to our model and would only outperform its counterpart given a steepening in the 3-year/20-year Gilt curve slope greater than 52bps (Chart 9A). Chart 9AUK 3/10/20 Spread Fair Value Model UK 3/10/20 Spread Fair Value Model UK 3/10/20 Spread Fair Value Model Chart 9BUK Butterfly Strategy Performance UK Butterfly Strategy Performance UK Butterfly Strategy Performance Following the mechanical trading rule in the UK has produced consistent returns on a year-over-year basis (Chart 9B). Canada The most attractively valued butterfly combination on the Canadian yield curve is favoring the 5-year/30-year barbell versus the 7-year bullet, which currently displays a standardized residual of -1.41 (Table 8). Table 8Canada: Butterfly Strategy Valuation: Standardized Residuals Global Yield Curve Trades: Netting Returns With Butterflies Global Yield Curve Trades: Netting Returns With Butterflies The 7-year bullet appears 7bps expensive according to our model and would only outperform its counterpart given a steepening in the 5-year/30-year Canadian curve slope greater than 42bps (Chart 10A). Chart 10ACanada 5/7/30 Spread Fair Value Model Canada 5/7/30 Spread Fair Value Model Canada 5/7/30 Spread Fair Value Model Chart 10BCanada Butterfly Strategy Performance Canada Butterfly Strategy Performance Canada Butterfly Strategy Performance Following the mechanical trading rule in Canada has historically been a good strategy, but we do note two periods of minor losses in 2013 and 2019 (Chart 10B). Japan The most attractively valued butterfly combination on the JGB yield curve is the 5-year/20-year barbell versus the 7-year bullet, which currently has a standardized residual of -1.03 (Table 9). As we noted earlier, however, valuations in the JGB market are likely distorted due to the Bank of Japan’s long-running programs of quantitative easing, zero policy rates and Yield Curve Control that aims to keep the 10-year JGB yield around 0%. Table 9Japan: Butterfly Strategy Valuation: Standardized Residuals Global Yield Curve Trades: Netting Returns With Butterflies Global Yield Curve Trades: Netting Returns With Butterflies The 7-year bullet appears 6bps expensive according to our model and would only outperform its counterpart given a steepening in the 5-year/20-year Japan curve slope greater than 23bps (Chart 11A). Following our mechanical trading rule has produced decent returns, especially given the dormant nature of the JGB market, with only a couple minor periods without positive year-over-year returns. Chart 11AJapan 5/7/20 Spread Fair Value Model Japan 5/7/20 Spread Fair Value Model Japan 5/7/20 Spread Fair Value Model Chart 11BJapan Butterfly Strategy Performance Japan Butterfly Strategy Performance Japan Butterfly Strategy Performance Following our mechanical trading rule has produced decent returns, especially given the dormant nature of the JGB market, with only a couple minor periods without positive year-over-year returns (Chart 11B). Australia The most attractively valued butterfly combination on the Australian yield curve is going long the 2-year/10-year barbell versus the 7-year bullet, displaying a standardized residual of -1.73 (Table 10). Table 10Australia: Butterfly Strategy Valuation: Standardized Residuals Global Yield Curve Trades: Netting Returns With Butterflies Global Yield Curve Trades: Netting Returns With Butterflies The 7-year bullet appears 15bps expensive according to our model and would only outperform its counterpart given a steepening in the 2-year/10-year Australian curve slope greater than 101bps (Chart 12A). Chart 12AAustralia 2/7/10 Spread Fair Value Model Australia 2/7/10 Spread Fair Value Model Australia 2/7/10 Spread Fair Value Model Chart 12BAustralia Butterfly Strategy Performance Australia Butterfly Strategy Performance Australia Butterfly Strategy Performance Compared to the other markets in our analysis, following the mechanical trading rule in Australia has not produced stellar returns (Chart 12B). However, excess returns on a year-over-year basis have been positive barring two periods.   Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Special Report, "Global Yield Curve Trades: Follow The Butterflies", dated February 25, 2020, available at gfis.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresearch.com. 3 Please see BCA Research US Bond Strategy Weekly Report, "Take A Look At High-Yield Technology Bonds", dated June 23, 2020, available at usbs.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Yield Curve Trades: Netting Returns With Butterflies Global Yield Curve Trades: Netting Returns With Butterflies ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights German bunds and Swiss bonds are no longer haven assets. The haven assets are the Swiss franc, Japanese yen, and US T-bonds. Gold is less effective as a haven asset. During this year’s coronavirus crash, the gold price fell by -7 percent. As such, our haven asset of choice for a further demand shock would be the 30-year T-bond, whose price rose by 10 percent during the crash. Technology and healthcare are the two sectors most likely to contain haven equities. Fractal trade: long Polish zloty versus euro. German Bunds And Swiss Bonds Are No Longer Haven Assets Chart of the WeekGold Is Tracking The US 30-Year T-Bond Price... But The T-Bond Is The Better Haven Asset Gold Is Tracking The US 30-Year T-Bond Price... But The T-Bond Is The Better Haven Asset Gold Is Tracking The US 30-Year T-Bond Price... But The T-Bond Is The Better Haven Asset European investors have been left defenceless. German bunds and Swiss bonds used to be the safest of haven assets. You used to be able to bet your bottom dollar – or euro or Swiss franc for that matter – that the bond prices would rally during a demand shock. Not in 2020. When the global economy and stock markets collapsed from mid-February through mid-March, the DAX slumped by -39 percent. Yet the German 10-year bund price, rather than rallying, fell by -2 percent, while the Swiss 10-year bond price fell by -4 percent.1  The lower limit to bond yields is around -1 percent. The reason is that German and Swiss bond yields are close to the practical lower limit to yields, which we believe is around -1 percent (Chart I-2). This means that German and Swiss bond prices cannot rise much, though they can theoretically fall a lot. Chart I-2German And Swiss Bond Yields Are Near Their Practical Lower Bound German And Swiss Bond Yields Are Near Their Practical Lower Bound German And Swiss Bond Yields Are Near Their Practical Lower Bound The behaviour of German bunds and Swiss bonds during the current crisis contrasts with previous episodes of market stress when their yields were unconstrained by the -1 percent lower limit. During the heat of the euro debt crisis in 2011, the 10-year bund price rallied by 12 percent. Likewise, during the frenzy of the global financial crisis in 2008, the 10-year bund price rallied by 7 percent (Chart I-3 - Chart I-5). Chart I-3German And Swiss Bonds Protected Investors During The 2008 Crash German And Swiss Bonds Protected Investors During The 2008 Crash German And Swiss Bonds Protected Investors During The 2008 Crash Chart I-4German And Swiss Bonds Protected Investors During The 2011 Crash German And Swiss Bonds Protected Investors During The 2011 Crash German And Swiss Bonds Protected Investors During The 2011 Crash Chart I-5German And Swiss Bonds Did Not Protect Investors During The 2020 Crash German And Swiss Bonds Did Not Protect Investors During The 2020 Crash German And Swiss Bonds Did Not Protect Investors During The 2020 Crash The defencelessness of European investors can also be illustrated via a ‘balanced’ 25:75 portfolio containing the DAX and 10-year German bund. The balanced portfolio theory is that a large weighting to bonds should counterbalance a sharp sell-off in equities, thereby protecting the overall portfolio. The theory worked well… until now. In this year’s coronavirus crisis, the 25:75 DAX/bund portfolio suffered a loss of -13 percent. This is substantially worse than the loss of -2 percent during the euro debt crisis in 2011, and the loss of -7 percent during the global financial crisis in 2008 (Chart I-6 - Chart I-8). Chart I-6A 25:75 DAX:Bund Portfolio Lost 7 Percent During The 2008 Crash A 25:75 DAX:Bund Portfolio Lost 7 Percent During The 2008 Crash A 25:75 DAX:Bund Portfolio Lost 7 Percent During The 2008 Crash Chart I-7A 25:75 DAX:Bund Portfolio Lost 2 Percent During The 2011 Crash A 25:75 DAX:Bund Portfolio Lost 2 Percent During The 2011 Crash A 25:75 DAX:Bund Portfolio Lost 2 Percent During The 2011 Crash Chart I-8A 25:75 DAX:Bund Portfolio Lost 13 Percent During The 2020 Crash A 25:75 DAX:Bund Portfolio Lost 13 Percent During The 2020 Crash A 25:75 DAX:Bund Portfolio Lost 13 Percent During The 2020 Crash What Are The Haven Assets? The lower limit to the policy interest rate – and therefore bond yields – is around -1 percent, because -1 percent counterbalances the storage costs of holding physical cash or other stores of value. If banks passed a deeply negative policy rate to their depositors, the depositors would flee into other stores of value. But if banks did not pass a deeply negative policy rate to their depositors, it would wipe out the banks’ net interest (profit) margin. Either way, a deeply negative policy rate would destroy the banking system. German and Swiss bond prices cannot rise much. German and Swiss bond yields are close to the -1 percent lower limit, meaning that the bond prices are close to their upper limit. Begging the question: what are the haven assets whose prices will rise and protect long-only investors when economic demand slumps? We can think of three. The Swiss franc. The Japanese yen (Chart I-9). US T-bonds. Chart I-9The Swiss Franc And Japanese Yen Are Haven Assets The Swiss Franc And Japanese Yen Are Haven Assets The Swiss Franc And Japanese Yen Are Haven Assets During the coronavirus crash, the 10-year T-bond price rallied by 4 percent while the 30-year T-bond price rallied by 10 percent (Chart I-10). Compared with German bund and Swiss bond yields, US T-bond yields were – and still are – further from the -1 percent lower limit. The good news is that long-dated T-bonds can still protect investors during a demand shock, although be warned that the extent of protection diminishes as yields get closer to the lower limit. Chart I-10Long-Dated US T-Bonds Are Haven Assets Long-Dated US T-Bonds Are Haven Assets Long-Dated US T-Bonds Are Haven Assets What about gold? As gold has a zero yield, it becomes relatively more attractive to own as the yield on other haven assets declines and turns negative. In fact, through the last three years, the gold price has been nothing more than a proxy for the US 30-year T-bond price (Chart of the Week). But gold is an inferior haven asset. During the coronavirus crash, the gold price fell by -7 percent, meaning it did not offer the protection that T-bonds offered. As such, our haven asset of choice for a further demand shock would not be gold. It would be the 30-year T-bond. What Are The Haven Equities? Many investors still use (root mean squared) volatility as a metric of investment risk. There’s a big problem with this. Volatility treats price upside the same as price downside. This is unrealistic. Nobody minds the price upside, they only care about the downside! Hence, a truer metric of risk is the potential for short-term losses versus gains. This truer measure of risk is known as negative asymmetry, or negative skew. In the twilight zone of ultra-low bond yields, bond prices take on this unattractive negative skew. As German bunds and Swiss bonds have taught us this year, bond prices can suffer losses, but they cannot offer gains. This means that bonds become riskier investments relative to other long-duration investments such as equities whose own negative skew remains relatively stable. The upshot is that the prospective return offered by equities must collapse. This is because both components of the equity return – the bond yield plus the equity risk premium – shrink simultaneously.  Equity valuations rise as an exponential function of inverted bond yields. Given that valuation is just the inverse of prospective return, the effect is that equity valuations rise as an exponential function of inverted bond yields. Chart I-11 illustrates this exponentiality by showing that technology equity multiples have tightly tracked the inverted bond yield plotted on a logarithmic scale. Chart I-11Technology Valuations Are Exponentially Sensitive To The (Inverted) Bond Yield Technology Valuations Are Exponentially Sensitive To The (Inverted) Bond Yield Technology Valuations Are Exponentially Sensitive To The (Inverted) Bond Yield Unfortunately, not all equities will benefit from this powerful dynamic. Equities must meet two crucial conditions to justify this exponential re-rating. One condition is that their sales and profits must be relatively resilient in the face of the current coronavirus induced demand shock. And they should not be at risk of a structural discontinuity, as is likely for say airlines, leisure and many other old-fashioned cyclicals. A second condition is that their cashflows must be weighted further into the future, so that their ‘net present values’ are much more geared to the decline in bond yields. Equities that meet these two conditions are likely to benefit the most from the ongoing era of ultra-low bond yields. And the two equity sectors that appear the biggest beneficiaries are technology and healthcare. In the coronavirus world, these two sectors will likely contain the haven equities. Stay structurally overweight technology and healthcare. Fractal Trading System* This week’s recommended trade is to go long the Polish zloty versus the euro. The profit-target and symmetrical stop-loss are set at 2 percent. Most of the other open trades are flat, though long Australian 30-year bonds versus US 30-year T-bonds and Euro area personal products versus healthcare are comfortably in profit.  The rolling 1-year win ratio now stands at 61 percent. Chart I-12PLN/EUR PLN/EUR PLN/EUR When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 From February 19 through March 18, 2020. 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Highlights Global stimulus efforts are sufficient thus far, but more will need to be done, especially by Europe and emerging markets. Hiccups will not be well-received by financial markets. The net public wealth of countries helps put debt constraints into perspective in a world of zero and negative interest rates. Insufficient fiscal policy is a bigger risk for Europe in the near term than any Germany-mandated withdrawal of ECB quantitative easing. European states remain locked in a geopolitical predicament that prevents them from abandoning each other despite serious differences over fiscal policy, which will persist. We are tactically long defensive plays and safe havens. Stay long JPY-EUR. Feature This week we focus on two questions: Will global stimulus be enough to fill the gap in demand? And will Germany impose a hard limit on European stimulus efforts? Our answers are yes to the first and no to the second. It is impossible for governments to replace private activity indefinitely, but the resumption of private activity is inevitable one way or another. Governments are continuing to provide massive fiscal and monetary support. The near term is cloudy, however, due to the mismatch between uncertain economic reopening and increasing impediments to new stimulus. Weak spots in the global fiscal stimulus efforts arise in Europe and emerging markets excluding China. Europe, at least, is a temporary catch – as Germany has no choice but to help the rest of the EU prop up aggregate demand. But fiscal policy is a greater near-term risk to peripheral European assets than any cessation of monetary support from the ECB. Will Global Stimulus Be Enough? Yes, Eventually Chart 1 shows the latest update of our global fiscal stimulus chart comparing the size of today’s stimulus to the 2008-10 period. Countries that make up 92% of global GDP are providing about 8% of global GDP in fiscal stimulus. Full calculations can be found in the Appendix. Chart 1US Still Leads In Fiscal Stimulus Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? The chief difference between our calculation and that of others is that we include government loans while excluding government loan guarantees. If a government gives a loan to a business or household, funds are transferred to the receiver’s deposits and can be spent to make necessary purchases or pay fixed costs. A loan guarantee, by contrast, is helpful but does not involve a transfer of funds. Our colleague Jonathan LaBerge, has recently written a Special Report analyzing the size of global fiscal stimulus. He provides an alternative calculation in Chart 2, which focuses on “above the line” measures, i.e. only measures affecting government revenues and expenditures. Government loans, guarantees, and other “below the line” measures are left aside in this conservative definition of stimulus. Chart 2Japan Leads In IMF “Above The Line” Account Of Stimulus Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? Chart 3 shows the discrepancies between Jonathan’s version and our own – they are not very large. The major differences are Japan, China, Germany, Italy, and South Africa. Of these only Germany, Japan, and China are significant.1 Chart 3Geopolitical Strategy Estimates Accord Less Stimulus To Japan, More To Germany And China, Than IMF Does Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? In Japan’s case, we include the stimulus measures that Japan passed at the end of 2019 because even though they were not passed in response to the pandemic, they will take affect at the same time as those that were. We do not include private sector complements to government action, which Japan includes in its account, since private responses are hard to predict and we do not include them for other countries. In China’s case, official estimates underrate the easing of credit policy. Credit is a quasi-fiscal function in China since the Communist Party controls the banks. With a large credit expansion the overall stimulus impact will be larger than expected, as long as borrowers still want to borrow. Data thus far this year suggests that they do, if only to cover expenses and debt payments. Our assessment that China’s stimulus will reach about 10% of GDP follows BCA Research’s China Investment Strategy. The UK and especially Italy, Spain, and France are falling short in their stimulus efforts … Is global stimulus “enough” to plug the gap in demand? Chart 4 shows our colleague Jonathan’s narrower definition of stimulus compared with estimates of the drop in demand from social lockdowns and spillover effects. It assumes a fiscal multiplier of 1.1. The result suggests that the US, China, and Australia are clearly doing enough; Germany, Japan, and Canada are arguably doing enough; other countries including Italy, France, and Spain will likely have to do more. Chart 4Which Countries Have Plugged The Gap In Demand So Far? Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? The latest news confirms this assessment. The US Congress is negotiating another phase of stimulus that will provide a second round of direct payments to households, a third infusion of small business loans, and a large bailout of state and local governments. The current total is $2 trillion, and so far this year these totals are only revised upward. This tendency stems from the political setup: Trump needs to stimulate for the election, GOP senators’ fates ultimately hinge on Trump, while the House Democrats cannot withhold stimulus merely to undermine the Republicans. Similarly, there can be little doubt that China and Japan will provide more stimulus to maintain full employment – their different political systems have always demanded it. We are more concerned about Europe. The UK and especially Italy, Spain, and France are falling short in their stimulus efforts, with the last three ranging from 2%-4% of GDP, according to Chart 4 above. They will add more stimulus, but might they still fall short of what is needed? Assuming that the ECB will provide adequate liquidity, and that low bond yields for a long time will enable debts to be serviced, these countries can service their debts for some time. But what then is the constraint? From a long-term point of view, the UK and peripheral European nations have relatively fewer national assets to weigh against their well-known liabilities. They are closer to their constraints in issuing debt, even if those constraints are nearly impossible to establish and years away from being hit. This is apparent from the IMF’s data series on net public wealth, i.e. total public sector assets and liabilities (Chart 5A). These data, from 2016, are a bit stale, but they are still useful because they take account of assets like natural resources, real estate, state-owned companies, and pension plans that retain value over the long run. It does no good to refer to the large debt loads of countries without considering the vast holdings that they command. By the same token, at some point the debt loads look formidable even relative to these huge realms. Chart 5ANet Public Wealth: A Fuller Picture Of The Debt Story Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? These data tend to underrate the sustainability of developed markets, which are highly indebted but have reserve currencies, safe haven status, and large, liquid credit markets. They overrate the sustainability of emerging markets, with large resource wealth and low-debt, but vulnerable currencies and credit markets. This is not only true for emerging markets with the most negative net worth, like Brazil, or with unsustainable fiscal policies, like Turkey and South Africa. China would look a lot worse in net public wealth, if this could be calculated, than it does on the general government ledger (Chart 5B), due to the liabilities of its state-owned enterprises and local governments. It would look more like the US or Japan in net public wealth – yet without a reserve currency. Chart 5BNet Government Debt: Flatters EM, Not DM Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? Nevertheless the European states have a problem that the other developed markets do not have: the Euro Area’s “constitutional” order is still unsettled. Questions are continually arising about whether countries’ liabilities are backstopped by a single currency authority and the entire assets of the Euro Area. These questions will tend to be settled in favor of European integration. But treaty battles in the context of upcoming elections – in the Netherlands, Germany, France, and likely Italy and Spain – will provide persistent volatility. Bottom Line: Fiscal stimulus passed thus far is only “sufficient” in a few economies; it is insufficient in southern Europe and emerging markets. Uncertainty about the pandemic, and the pace of economic reopening and normalization, combined with any hiccups in providing adequate stimulus will create near-term volatility. Will Germany Halt Quantitative Easing? No, Not Ultimately The questions about Europe highlighted above have come to the fore with the reemergence of the “German question,” which in today’s context means Germany’s and northern Europe’s willingness to conduct fiscal policy to help rebalance the Euro Area and monetary policy to ease conditions for heavily indebted, low productivity southern Europe. We have little doubt that Germany will provide more than its current 10.3% of GDP fiscal stimulus given that it has explicitly stated that state lender KfW has no limit on the amount of loans it can provide to small businesses. This accounts for the difference between our fiscal stimulus estimate and the IMF’s, but the fullest count, including “below the line” measures, would amount to nearly 35% of GDP. A sea change in the German attitude toward fiscal policy has occurred, which we have tracked in reports over the years. This shift gives permission for other European states to loosen their belts as well. We also have little doubt that German leaders will ultimately accept the ECB’s need to take desperate measures to backstop the European financial system: The “dirty little secret” of the Euro Area is that debt is already mutualized through the Target 2 banking imbalance, worth 1.5 trillion euros (Chart 6). As our Chief European Investment Strategist Dhaval Joshi has argued, Germany, as the largest shareholder in the ECB, holds a large quantity of Italian bonds, and Italians have deposited the proceeds of these bond purchases in German banks. All of this is denominated in euros. If Italy redenominates into lira, it can make bond payments in lira and the ECB and Germany will suffer capital losses. Germany would then face Italians withdrawing their deposits from German banks that would still be denominated in euros (or the deutschmark). The cause of this predicament is the ECB’s quantitative easing program (Chart 7). Chart 6Europe’s Gordian Knot Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? Thus Chancellor Angela Merkel’s shift in tone to become more supportive of joint debt issuance belies the fact that European debt is already mutualized through the Gordian knot of Target2 imbalances. This is a politically unpalatable reality for Germans, but they generally accept it because it is in Germany’s national interest to maintain the monetary union and broader European integration. Chart 7Quantitative Easing Puts Germans On Hook For Italy Quantitative Easing Puts Germans On Hook For Italy Quantitative Easing Puts Germans On Hook For Italy However, the market may need reassurances about “the German question” from time to time, as EU institutional evolution is ongoing. Financial markets did not sell off on the German court’s ruling on May 5, which ostensibly gave the Bundesbank three months before withdrawing from the ECB’s quantitative easing program. Since the sovereign debt crisis, investors have come to recognize that there is more undergirding European integration than mere German preference. Namely, geopolitics – which we have outlined many times, originally in a 2011 Special Report. European nations cannot compete globally without banding together, and Germany is not powerful enough to go it alone. Still, there will be more consequences from this week’s ruling. At issue is the budgetary sovereignty of the European member states as well as Article 123 of the Treaty of Europe, which holds that neither the ECB nor the national central banks of member states can directly purchase public debts. The latter is a prohibition on the monetary financing of deficits. It became controversial in the wake of Mario Draghi’s 2012 declaration that the ECB would do “whatever it takes” to preserve the euro and the ECB’s 2015 Public Sector Purchase Program (PSPP) quantitative easing program, which the European Court of Justice deemed legal on December 11, 2018. The controversy is now implicitly shifting to the new Pandemic Emergency Purchase Program. The other principle concerned is that of “proportionality,” which requires that EU entities not take actions beyond what is necessary to achieve treaty objectives. If the ECB acted without regard to the limits of its mandate, the fiscal supremacy of the states, and the broader economic and fiscal consequences of QE, then its actions would violate the principle of proportionality and would require adjustment by EU authorities or non-participation from member state authorities. The German court did not attempt to overrule or invalidate the European court’s decision in favor of QE, or QE as a whole. Rather, it held that this ruling was not “comprehensible,” hence requiring an independent German ruling, and that the larger question of whether QE violates the prohibition against debt monetization is “not ascertainable.” The reason is that the ECB did not explain its actions adequately and the European Court of Justice did not demand an explanation. Presumably once this is done more decisive determinations can be made. Essentially the German court is demanding “documentation” by the ECB Governing Council that it weighed its monetary decisions against larger economic and fiscal consequences. So will the Bundesbank withdraw from the ECB’s QE operations in three months? Highly unlikely! The ECB, whether directly or indirectly, will provide an assessment of the proportionality of its actions to the Bundesbank and the German court will probably conclude, with limitations, that the ECB’s actions were largely within its mandate. If not, however, markets will plunge. Then the Bundestag or the Bundesbank will have to intervene to ensure that Germany does not in fact withdraw support from the ECB. European nations cannot compete globally without banding together, and Germany is not powerful enough to go it alone. How can we be sure? German opinion. Chancellor Merkel and her ruling Christian Democrats have not suffered this year so far from launching a wartime fiscal expansion and backing the ECB and EU institutions in their emergency actions. On the contrary, they have received one of the biggest bounces in popular opinion polls of any western leaders over the course of the global pandemic. While the bounce will deflate once the acute crisis subsides, this polling signals more than the average rally around the flag (Chart 8). Merkel’s approval rating started to rise when her party embraced more expansive fiscal policy in late 2019 in reaction to malaise revealed in the 2017 election. Germany’s handling of today’s crisis, both the pandemic and the expansive fiscal policy, has put the ruling party in the lead for the 2021 elections (Chart 9). Chart 8Germans See Popular Opinion ‘Bounce’ Amid COVID Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? Chart 9Merkel's CDU Revives Amid Global Crisis Merkel's CDU Revives Amid Global Crisis Merkel's CDU Revives Amid Global Crisis Chart 10Germans Support Euro, But Lean On ECB Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? Moreover Germans are enthusiastically in support of the euro and the EU relative to their peers – which makes sense because Germany has been the greatest beneficiary of European integration (Chart 10). The ECB, by contrast, does not have strong support – and is losing altitude. But a crisis provoked by the court and centered on the ECB would quickly become a crisis about the euro and European project as a whole. Opinion has broken in this direction despite Merkel’s and Germany’s many compromises over the years. Remember that Merkel’s capitulation to the Mediterranean states on the European Council in June 2011, which paved the way for Draghi’s famous dictum, was initially seen as a failure by her to defend German interests. Merkel and her party have also recovered from the hit they took when she insisted that Germany take in a huge influx of Syrian refugees in 2015. German popular opinion is relevant when discussing the judicial system and rule of law. No court can ignore popular opinion entirely, no matter how independent and austere, because every court ultimately needs public opinion to maintain its credibility. The European Court’s decision is final, as long as Germany remains committed to the EU. Yet German sovereignty still gives German institutions a say. If the German court persists in attempting to block Bundesbank participation in QE, the result will be a bond market riot that pushes up peripheral debt funding costs. This would eventually risk forcing peripheral states out of the Euro Area, which is against German interests. It is very unlikely things will go so far. Rather, the court will back down after receiving due attention and having its legitimate concerns addressed. The imperatives of European integration are as powerful today as they were in 2011. True, other court challenges will open up against the ECB, particularly the PEPP. But bear in mind that it will be even easier to show that ECB actions are proportional – that broader economic consequences have been weighed – in the case of the pandemic relief emergency than with respect to PSPP prior to COVID. Today it is households and small businesses that need protection from an act of God, not banks and bureaucracies that need protection from the consequences of their excesses. As for the size and duration of QE, the court will try to force some limitations to be acknowledged given the risk to fiscal sovereignty. In this sense, the ECB faces a new constraint, albeit one that we doubt will prove relevant in the near term. Ultimately, the consequence of imposing some limits on central bank policy is to restore authority to member state budgets and European fiscal coordination. In the short term, emergency provision can be provided via the European Stability Mechanism (ESM), whose lending conditions can be relaxed, and by the ECB’s Outright Monetary Transactions (OMT), which can buy bonds amid a market riot. But beyond the immediate crisis the clash over fiscal policy will persist because at some point countries will have to climb down from their extraordinary stimulus and the attempt to restore limits will be contentious. Germany has already made a huge shift in a more fiscally accommodative direction. Italy, Spain, and France are currently not providing enough, but they will add more. Future governments might demand more than even today’s more dovish Germany is willing to accept. Down the road, if these states do not provide more stimulus, then their recoveries will be weaker and political malaise will get worse. An anti-establishment outcome is already likely in Italy in the coming year or two, due to the ability of the League to capitalize on post-COVID voter anger. The big question after that is France in 2022. Macron’s approval rating is holding up, we expect him to win, but his bounce amid the pandemic is not remarkable. From our point of view the peripheral states have a license to spend, so spend they will. But then fiscal conflicts will revive later. Bottom Line: The German constitutional court is not going to try to force the Bundesbank to withdraw from QE, but it is attempting to lay a foundation for the imposition of at least some limits on this policy. The risk to European assets in the short run is not on the monetary side but the fiscal side. Over the long run, the “German question” will never be settled. But the imperatives of European integration are as powerful today as they were in 2011. Each new crisis exposes the weakness of the peripheral states, their need for European institutions. It also exposes Germany’s need to accommodate them when they form a united front. Investment Takeaways Financial markets have no clarity on economic reopening in the face of the virus or how governments will respond to resurgent outbreaks or a second wave in the fall. Taking into consideration the initial shock of the lockdowns plus spillover effects, the cumulative impact to annual GDP rises to 6%-8% by the end of this year for major economies. If another lockdown occurs, the level of GDP would be 10-12% lower at the end of the year depending on the region. This bare risk suggests that global equities face a relapse in the near term. Eventually economic reopening will proceed, as the working age population will demand it. But the path between here and there is rocky and any hiccups in providing stimulus will create even more volatility. Globally, we continue to argue that political and geopolitical risks are rising across the board as the pandemic and recession evolve into a struggle among nations to maintain security amid vulnerabilities and distract from their problems at home. Rumors that China is about to declare an air defense identification zone (ADIZ) in the South China Sea are unverified but we have long expected this to occur and tensions and at least some saber-rattling would ensue. We also expect the US to surprise the market with punitive tech and trade measures against China in the near term and to upgrade relations with Taiwan. We remain long JPY-EUR on a tactical 0-3 month horizon. We are converting our tactical long S&P consumer staples, which is up 6%, to a relative trade against the broad market. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Appendix Table 1The Global Fiscal Stimulus Response To COVID-19 Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? Footnotes 1 In the case of Italy, we assume that parliament will pass the latest proposed increase in stimulus from 1.4% to 3.1% of GDP. In the case of South Africa, we expect the IMF to include these measures soon. Germany is discussed below.