New Zealand

Highlights A few indicators suggest that global growth will soon bottom. The bottoming process could prove volatile, but the duration of the slowdown suggests a V-shaped rather than U-shaped recovery. The dollar should weaken as higher-beta cyclical currencies rebound from deeply oversold levels. Sell the DXY index at 100. Aggressive short USD bets can be played via the NOK and SEK. The euro is also a natural beneficiary. Our favorite dollar-neutral bets include long AUD/CAD, SEK/NZD, GBP/JPY and short CAD/NOK. Feature The biggest question facing global investors is whether growth will pick up next year, and if so, what the durability of such a rebound will be. Any additional growth hiccups will cause the dollar to soar, and this week’s disappointing credit and industrial production numbers from China are a sober reminder that we are not out of the woods yet. Nevertheless, we believe a pickup in demand, especially emanating from outside the US, is forthcoming. This will favor more pro-cyclical currencies. Cyclical sectors of the equity market are already sniffing a growth rebound, and the dollar is off its peak for the year (Chart I-1). Historically, these have been good reflation indicators, especially when they are sending the same message. This is also a reminder to focus on where economic data will be six to 12 months from now rather than trade on yesterday’s news. Chart I-1The Dollar Tends To Weaken When Cyclicals Are Outperforming The Dollar Tends To Weaken When Cyclicals Are Outperforming The Dollar Tends To Weaken When Cyclicals Are Outperforming Policy shifts affect the economy with a lag, with a bottoming process that can be volatile and/or protracted. However, the duration of the current slowdown suggests we might be entering a V-shaped rather than U- or W-shaped recovery. Investors can track a few indicators to help calibrate the probability of the different scenarios playing out. The Message From Economic Variables There are a swath of economic variables one can follow to track the health of an economy, but we tend to focus on purchasing managers’ indices. This is because they are timely and have a good track record of confirming cyclical shifts in the economy. The problem is that for the most part, they tend to be coincident rather than leading indicators. Gauging the magnitude and duration of the cycle is also important to avoid false starts. The message is that the European manufacturing recession will be over by the first quarter of 2020.  In the US, financial conditions lead the ISM manufacturing index with a tight correlation (Chart I-2). Over the past 18 months, US bond yields have fallen. The historical precedent is that manufacturing activity should be reviving about now. The current reading is consistent with a rather explosive rise in the ISM manufacturing index, towards 60. Chart I-2The Drop In Bond Yields Is Consistent With An ISM Near 60 The Drop In Bond Yields Is Consistent With An ISM Near 60 The Drop In Bond Yields Is Consistent With An ISM Near 60 In Europe, the Sentix sentiment index, which surveys the balance of investors’ emotions between greed and fear, tends to be coincident. However, the ratio of the expectations component to the current situation, a second derivative measure of exuberance or capitulation, tends to lead changes in the PMI indices by six months (Chart I-3, top panel). Again, the message is that the European manufacturing recession will be over by the first quarter of 2020. Applying the same formula to the ZEW survey gives a similar message for Germany (Chart I-3, bottom panel). Even within the Japanese economy, which was heavily hit by the October consumption tax hike, some green shoots can still be uncovered. The expectations component of the Economy Watchers Survey, a comprehensive read across much of the smaller entrepreneurs that drive the local economy, is improving. This has nudged the difference between the expectations component and the current situation to the highest in 5 years. The message is corroborated by the economic surprise index (Chart I-4). Chart I-3A V-Shaped Recovery In European Manufacturing? A V-Shaped Recovery In European Manufacturing? A V-Shaped Recovery In European Manufacturing? Chart I-4Japan Green ##br##Shoots Japan Green Shoots Japan Green Shoots   Chinese credit growth was uninspiring in October, but the Caixin manufacturing PMI is now firmly above the 50 boom/bust level. More and more financial intermediation is being done through the bond market, and the drop in Chinese bond yields has eased financial conditions tremendously. This should encourage lending, which should lead to stronger economic activity, boosting demand for imports (Chart I-5). Rising Chinese imports will boost global growth. Chart I-5Chinese Imports Could Soon Rebound Chinese Imports Could Soon Rebound Chinese Imports Could Soon Rebound Bottom Line: For the most part, PMIs across many countries remain weak, but a few indicators are starting to point to an improvement next year. Given PMIs tend to be coincident, the most potent gains will be made by being early in the cycle. What Are Financial Markets Telling Us? The nascent upturn in our growth indicators is also coinciding with a positive signal from financial variables. Usually, when financial and economic data are in sync, the move in markets tends to be durable and powerful. Below are a few examples.  Usually, when financial and economic data are in sync, the move in markets tends to be durable and powerful.  Global cyclical stocks have started to outperform defensives, and the traditional negative correlation with the dollar appears to be holding (previously referenced Chart I-1). Correspondingly, flows into more cyclical ETF markets are accelerating. These are a small portion of overall FX flows, but the information coefficient is directionally quite good. The message is that in six months, EUR/USD will hit 1.16, GBP/USD will be at 1.4, AUD/USD at 0.75 and the USD/SEK at 8.5. Paradoxically, these are also closer to our own internal targets (Chart I-6). Chart I-6Inflows Into Cyclical ETFs Inflows Into Cyclical ETFs Inflows Into Cyclical ETFs The copper-to-gold, oil-to-gold, and CRB Raw Industrials-to-gold1 ratios often capture the transmission mechanism between easing liquidity conditions and higher growth. It is encouraging that these also tend to move in lockstep with US bond yields, another global growth barometer. The power of the signal is established when all three indicators peak or bottom at the same time, as is the case now (Chart I-7). The next confirmation will come with a clear breakout in these ratios. Chart I-7Global Growth Barometers Flashing Amber Global Growth Barometers Flashing Amber Global Growth Barometers Flashing Amber Correspondingly, in China, scrap steel prices have begun to rise faster than imported iron ore prices, suggesting an improving margin for steel producers. This is probably an indication that steel destocking has reached a nadir (Chart I-8). A renewed restocking cycle should benefit iron ore and other commodity imports and prices. In sympathy, the LMEX index appears to be making a tentative trough.  AUD/JPY breached the important technical level of 72 cents this year but has since recovered. The cross has failed to sustainably break below this level both during the euro area debt crisis in 2011-2012 and the China slowdown in 2015-2016. Again, it appears reflation is winning the tug-of-war. Given speculators are neutral the cross, it suggests that any move either way will be powerful and significant (Chart I-9). Chart I-8Bullish Bottom-Up Signals From Metals Bullish Bottom-Up Signals From Metals Bullish Bottom-Up Signals From Metals Chart I-9Breakdown Avoided For Now Breakdown Avoided For Now Breakdown Avoided For Now An improving liquidity environment will be especially favorable for carry trades. High-beta currencies such as the RUB/USD, ZAR/USD and BRL/USD have not yet broken down. These currencies are usually good at sniffing out a change in the investment landscape. The message so far is that the drop in US bond yields may have been sufficient to backstop any cascading selloff (Chart I-10). Chart I-10Carry Trades May Be Back In Style Soon Carry Trades May Be Back In Style Soon Carry Trades May Be Back In Style Soon Finally, bond yields across major markets are off their lows. Our strategy is to be selective as US dollar tailwinds shift to headwinds, by initially expressing tactical USD shorts via the more potent Norwegian krone and Swedish krona. We have discussed at length our rationale for picking these currency pairs,2 but the bottom line is that they are deeply oversold and have probably been the primary vehicles used to express US dollar long positions. Bottom Line: It is too early to tell if the dollar will retest its highs before ultimately cresting, because part of the move has been driven by risk aversion/political uncertainty. Our bias is that some sort of trade détente is sufficient to rejuvenate economic activity given part of the slowdown, especially vis-à-vis capex, has been driven by uncertainty. Meanwhile, lots of monetary ammunition has already been fired over the past year.  Notes On Australia And New Zealand This week, the Reserve Bank of New Zealand surprised markets by keeping rates on hold, a volte-face to its dovish surprise this summer. In retrospect, this makes sense. First, the RBNZ may be watching the same indicators as us, and as such is seeing an imminent turnaround in the global economy. Keeping some ammunition will allow for more room to ease down the road. Second, the weakness in the currency has probably done the heavy lifting in boosting exports and supporting domestic income. Finally, Australia and China are New Zealand’s biggest trading partners, and the trade war along with rising pork prices have allowed for a terms-of-trade boost for New Zealand’s agricultural exports (Chart I-11). Slowing migration will go a long way in eroding a meaningful supply of employment and domestic demand in New Zealand. We are positive on the kiwi but believe it will underperform its antipodean neighbor. First, the AUD/NZD is cheap on a real effective exchange rate basis (Chart I-12). Meanwhile, a more pronounced downturn in Aussie house prices has allowed some cleansing of sorts, bringing them further along the adjustment path relative to New Zealand. We are willing to overlook this week’s disappointment in Australia’s job numbers, given the unfortunate wildfires that are destroying businesses and homes. Fiscal stimulus will be forthcoming, and reconstruction efforts will go a long way to boosting domestic demand Chart I-11A Terms Of Trade Boost A Terms Of Trade Boost A Terms Of Trade Boost Chart I-12AUD/NZD Is Cheap AUD/NZD Is Cheap AUD/NZD Is Cheap Meanwhile, the RBNZ began a new mandate on April 1st that now includes full employment in addition to inflation targeting. But given the RBNZ has been unable to fulfill its price stability mandate over the past several years, it is hard to argue it will find a dual mandate any easier. Slowing migration will erode a meaningful supply of employment and domestic demand in New Zealand (Chart I-13). The final catalyst for the AUD/NZD cross will be a terms-of-trade shock (Chart I-14). Iron ore prices may face further downside, given supply from Brazil is back online, but China’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix. Given eliminating pollution is a strategic goal in China, this will be a multi-year tailwind Chart I-13Loss Of A Meaningful Tailwind For Employment Loss Of A Meaningful Tailwind For Employment Loss Of A Meaningful Tailwind For Employment Chart I-14Terms Of Trade Favors ##br##Aussie Terms Of Trade Favors Aussie Terms Of Trade Favors Aussie Bottom Line: Remain long AUD/NZD as a strategic position and SEK/NZD as a tactical position. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   Footnotes 1 The CRB Raw Industrials-to-gold ratio is not shown here because of the steep correction in iron ore prices, after a resolution to a supply disruption. That said, iron ore prices are up 28% this year, versus 14% for gold. 2 Please see page 24 for a summary of our recent reports. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been positive: The Michigan consumer sentiment index edged up to 95.7 from 95.5 in November. The NFIB business optimism index slightly increased to 102.4 from 101.8 in October. Headline inflation recorded modest growth to 1.8% year-on-year in October while core inflation fell to 2.3%. Headline and core producer prices both slowed to 1.1% and 1.6% year-on-year respectively in October. The housing market remains healthy, with mortgage applications up 9.6% for the week. The DXY index appreciated by 0.2% this week. During his testimony this week, Fed Chair Powell suggested the growth outlook for the US remained favorable, based on labor market trends. That said, Europe and EM probably have more scope to outperform amid a global growth recovery, which will be a headwind for the US dollar.  Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Preserving Capital During Riot Points - September 6, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been improving: The ZEW economic sentiment index rebounded to -1 from -23.5 in November. Industrial production contracted by 1.7% year-on-year in September, however it is better than the contraction of 2.8% in the previous month and the expectations of a 2.3% drop. The preliminary GDP report showed that growth increased to 1.2% year-on-year in Q3, up from 1.1% in the previous quarter. Impressively, Germany steered clear of a recession. The euro fell by 0.2% against the US dollar this week. We expect the euro to recover along with the gradual improvement in the data. Moreover, the increased issuance of euro-denominated debt suggests some inflows into European corporate bond markets. This will benefit the euro. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mixed: The trade surplus plunged to JPY 1 billion in September. The current account surplus narrowed to JPY 1.6 trillion from JPY 2.2 trillion. Machinery orders contracted by 2.9% month-on-month in September. On a yearly basis however, they grew by 5.1% year-on-year. Preliminary machine tool orders kept falling by 37.4% year-on-year in October. Preliminary annualized GDP growth slowed to 0.9% quarter-on-quarter in Q3. USD/JPY fell by 0.6% this week. Forward-looking data are showing more optimism on the domestic economy. This might prove that the damage from the tax hike is only a one-off effect. Continue to hold the yen, as both portfolio insurance, and a bet against more aggressive monetary stimulus from the BoJ. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been mostly negative: The total trade deficit (including EU) widened to £3.4 billion in September. Preliminary GDP growth slowed to 1% year-on-year in Q3, from 1.3% in the previous quarter. Industrial production contracted by 1.4% year-on-year in September. Average earnings kept growing by 3.6% year-on-year in September. Moreover, the ILO unemployment rate fell further to 3.8%. Headline inflation fell to 1.5% year-on-year in October, while core inflation remained at 1.7%. GBP/USD increased by 0.4% this week. Despite the recent small rally, the pound is still undervalued on a PPP basis. With a lower probability of a hard-Brexit, our bias remains that the pound has more upside and will converge towards its long-term fair value. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mixed: NAB business conditions and confidence both increased to 3 and 2 in October. Moreover, Westpac consumer confidence increased by 4.5% in November. The wage price index grew by 2.2% year-on-year in Q3. The labor market data was however disappointing, the unemployment rate slightly increased to 5.3% in October. There was a loss of 19K jobs in October, with 10K full-time and 9K part-time. AUD/USD fell by 1.3% this week, weighed down by the recent slide in iron ore prices and employment data. Given speculators are already very short the cross, this could be capitulation. We discuss Australia in this week’s front section. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been mostly negative: Inflation expectations fell slightly to 1.8% in Q4. The REINZ house price index grew by 1.1% month-on-month in October, down from 1.4% in the previous month. Migration into New Zealand continues to slow, with only 3440 newcomers in September. The New Zealand dollar rose by 0.6% against the US dollar this week. The main driver is that the RBNZ unexpectedly kept its interest rate unchanged at 1% this Wednesday. We are positive on the kiwi, but remain underweight against both the Australian dollar and the Swedish krona on valuation grounds. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The US Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been mostly negative: Housing starts fell by 20K to 202K in October. Building permits fell by 6.5% month-on-month in September. The unemployment rate was unchanged at 5.5% in October. There was a loss of 1.8K jobs in October. However, average hourly wages yearly growth accelerated to 4.4%. New house prices contracted by 0.1% year-on-year in September. The Canadian dollar fell by 0.4% against the US dollar this week, given broad US dollar strength. CAD has handsomely outperformed its G10 commodity counterparts and some measure of rotation is due. We are short CAD/NOK and long AUD/CAD. Report Links: Making Money With Petrocurrencies - November 8, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 Preserving Capital During Riot Points - September 6, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been negative: Producer and import prices contracted by 2.4% year-on-year in October. The Swiss franc has appreciated by 0.6%, and the latest PPI numbers suggest deflation is becoming more and more rampant. Our bias remains that the SNB is likely to soon weaponize its currency like other central banks. We have a limit buy on EUR/CHF at 1.06. Stay tuned. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been negative: Producer prices fell by 13.8% year-on-year in October. This can largely be explained by the petroleum sector. Headline inflation increased to 1.8% year-on-year from 1.5% in October. Core inflation was unchanged at 2.2% year-on-year. The mainland GDP growth was unchanged at 0.7% in Q3. The Norwegian krone fell by 0.8% this week. The weakness in the krone remains much more than is warranted by underlying economic conditions. Should the DXY hit 100, we will be aggressive buyers of the krone. Report Links: Making Money With Petrocurrencies - November 8, 2019 A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been positive: Headline inflation increased to 1.6% year-on-year from 1.5% in October. The unemployment rate fell to 6% from a downward-revised 6.6% in October. The Swedish krona depreciated by 0.3% against the US dollar this week. Statistics Sweden has revised down the unemployment rate for the period from July 2018 to September 2019, due to a flaw in data quality. This has dampened the credibility of the employment data in Sweden and its effect on the exchange rate. That said, we maintain a pro-cyclical stance and remain bullish on the Swedish krona.  Report Links: Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors. All of the Monitors are now below the zero line, indicating a growing need to ease global monetary policy (Chart of the Week). Central bankers have already gone down that path in several countries over the past few months (the U.S., the euro area, Australia and New Zealand), helping sustain the powerful 2019 rally in global bond markets. Feature With the global manufacturing & trade downturn now threatening to spill over into domestic demand in the major developed markets, policymakers will need to stay dovish to stave off recession. This will keep global bond yields at depressed levels in the near term, at least until widely-followed data like manufacturing PMIs stabilize and/or there is positive news on U.S.-China trade negotiations. Chart of the WeekStrong Pressures To Ease Global Monetary Policy Strong Pressures To Ease Global Monetary Policy Strong Pressures To Ease Global Monetary Policy Yields already discount a lot of bad economic news, however, and there is a ray of hope visible in the bottoming out of our global leading economic indicator. A sustainable bottom in global bond yields, though, will require some change in the current downward growth or inflation momentum highlighted in our Central Bank Monitors. Yields already discount a lot of bad economic news, however, and there is a ray of hope visible in the bottoming out of our global leading economic indicator. A sustainable bottom in global bond yields, though, will require some change in the current downward growth or inflation momentum highlighted in our Central Bank Monitors.  An Overview Of The BCA Central Bank Monitors* Chart 2Low Bond Yields Are Consistent With Our CB Monitors Low Bond Yields Are Consistent With Our CB Monitors Low Bond Yields Are Consistent With Our CB Monitors The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). All of the Monitors are currently pointing in a bond-bullish direction, making them less useful as a country allocation tool within global bond portfolios. With easing pressures most intense in the euro area, given that the ECB Monitor has the lowest reading, our recommended overweight stance on core euro area government bonds (hedged into U.S. dollars) remains well supported. In each BCA Central Bank Monitor Chartbook, we include a new chart for each country that we have not shown previously. In this edition, we show the components of the Monitors, grouped into those focusing on economic growth and inflation, plotted against our central bank discounters that indicate the amount of rate cuts/hikes priced into global Overnight Index Swap (OIS) curves. Fed Monitor: Signaling A Need For More Cuts Our Fed Monitor has fallen below the zero line (Chart 3A), indicating that the Fed’s summer rate cuts were justified with more easing still required. The Monitor, however, has not yet fallen to levels seen during U.S. recessions and is more consistent with the below-trend growth periods in 2016 and the late-1990s. The views of the FOMC on U.S. monetary policy are more deeply divided now than has been seen in many years. The doves can point to slumping global growth, persistent trade uncertainty, contracting capital spending and falling inflation expectations as reasons to continue cutting rates. The hawks can look at continued labor market tightness, elevated asset prices and realized inflation rates holding near the Fed’s 2% inflation target (Chart 3B) as reasons to keep monetary policy steady. That mixed picture can be seen in the components of our Fed Monitor, with the growth components showing the biggest pressure for more rate cuts compared to more stable readings from the inflation and financial components (Chart 3C). Chart 3AU.S.: Fed Monitor U.S.: Fed Monitor U.S.: Fed Monitor Chart 3BU.S. Realized Inflation Holding Firm U.S. Realized Inflation Holding Firm U.S. Realized Inflation Holding Firm Chart 3CGreatest Pressure For Fed Rate Cuts From Growth Components Of Our Fed Monitor Greatest Pressure For Fed Rate Cuts From Growth Components Of Our Fed Monitor Greatest Pressure For Fed Rate Cuts From Growth Components Of Our Fed Monitor The U.S. Treasury market may have gotten ahead of itself after the latest decline in yields, which looks stretched versus the Fed Monitor. The U.S. Treasury market may have gotten ahead of itself after the latest decline in yields, which looks stretched versus the Fed Monitor (Chart 3D). We still expect the Fed to deliver just one more rate cut at the FOMC meeting at the end of October, as the “hard” U.S. data is outpeforming the “soft” data like the weak ISM surveys. That leaves Treasury yields vulnerable to some rebound if global growth stabilizes, although that is conditional on no new breakdown of the U.S.-China trade negotiations – a factor that continues to weigh on U.S. business confidence. Chart 3DTreasury Yields More Than Fully Discount Fed Easing Pressures Treasury Yields More Than Fully Discount Fed Easing Pressures Treasury Yields More Than Fully Discount Fed Easing Pressures BoE Monitor: Easier Policy Needed Our Bank of England (BoE) Monitor, which was in the “tighter money required” zone from 2016-18, has been below the zero line since April of this year (Chart 4A). The market agrees with the message from the Monitor and is now pricing in -12bps of rate cuts over the next twelve months. The relentless uncertainty surrounding Brexit has triggered sharp downgrades of growth expectations and weakened business confidence, which the BoE is now factoring into its own projections. In the August Inflation Report, the BoE lowered its 2020 inflation forecast to below 2% - no surprise given the sharp fall in realized inflation that has already occurred even as economic growth has still not yet fallen substantially below trend (Chart 4B). Chart 4AU.K.: BoE Monitor U.K.: BoE Monitor U.K.: BoE Monitor Chart 4BFalling U.K. Inflation Opens The Door To A BoE Ease Falling U.K. Inflation Opens The Door To A BoE Ease Falling U.K. Inflation Opens The Door To A BoE Ease Still, weakening growth components have been the main driver of the BoE Monitor into rate cut territory (Chart 4C). While a strong jobs market is helping support consumer spending, the Brexit turmoil is having a lasting impact on future growth. Since the 2016 Brexit referendum, business confidence and real business investment have collapsed which, in turn, has hurt productivity growth, as we discussed in a Special Report last month.1 Chart 4CBrexit Uncertainty + Slumping Growth = Pressure For BoE Rate Cuts Brexit Uncertainty + Slumping Growth = Pressure For BoE Rate Cuts Brexit Uncertainty + Slumping Growth = Pressure For BoE Rate Cuts The uncertainty around Brexit dominates the economic outlook and any future BoE decisions. Our Geopolitical Strategy service anticipates that Brexit will be delayed beyond October 31st. As a result, uncertainty will continue to weigh on Gilt yields, even though yields have already fallen in line with our BoE Monitor (Chart 4D). We continue to recommend an overweight stance on U.K. Gilts. Chart 4DGilt Yields Have Fallen In Line With Our BoE Monitor Gilt Yields Have Fallen In Line With Our BoE Monitor Gilt Yields Have Fallen In Line With Our BoE Monitor ECB Monitor: Intense Pressure For Easier Monetary Policy Our European Central Bank (ECB) Monitor is now well below the zero line, signaling a strong need for easier monetary policy (Chart 5A). The global manufacturing downturn has hit the export-dependent economies of the euro area hard, with Germany now likely in a technical recession. Our European Central Bank (ECB) Monitor is now well below the zero line, signaling a strong need for easier monetary policy. Despite the weaker growth momentum, there remains far less spare capacity in the euro area economy than at any time since before the 2009 global recession (Chart 5B). This is keeping realized inflation in positive territory, in contrast to what was seen during the previous downturn in 2015-16. Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BEuro Area Inflation Is Subdued, Despite Tight Labor Markets Euro Area Inflation Is Subdued, Despite Tight Labor Markets Euro Area Inflation Is Subdued, Despite Tight Labor Markets The ECB has already responded to the weakening growth & inflation pressures, introducing a new TLTRO program back in March and then cutting the overnight deposit rate and restarting its Asset Purchase Program in September. The latest policy moves were reported to be more contentious, with the “hard money” northern euro area countries opposed to restarting bond purchases. The new incoming ECB President, Christine Lagarde, will likely have her hands full trying to gain consensus on any further easing measures from here, even as both the growth and inflation components of our ECB Monitor indicate that more stimulus is needed (Chart 5C). Chart 5CA Consistent Message On The Need For Future ECB Easing From Growth & Inflation A Consistent Message On The Need For Future ECB Easing From Growth & Inflation A Consistent Message On The Need For Future ECB Easing From Growth & Inflation The big decline in euro area bond yields, which has pushed large swaths of sovereign yields into negative territory, does not look particularly stretched relative to the plunge in the ECB Monitor (Chart 5D). Without signs that the global manufacturing downturn is ending, however, euro area yields will stay mired at current deeply depressed levels. We recommend a moderate overweight on core European government bonds, on a currency-hedged basis into U.S. dollars. Chart 5DBund Rally Looks In Line With The ECB Monitor Bund Rally Looks In Line With The ECB Monitor Bund Rally Looks In Line With The ECB Monitor BoJ Monitor: A Rate Cut On The Horizon? Our Bank of Japan (BoJ) Monitor has drifted slightly below the zero line into “rate cut required” territory (Chart 6A). Over the past few years, the BoJ’s monetary policy has remained unchanged for the most part and its messaging has grown less dovish, citing an expanding economy. However, recent Japanese economic data shows widespread deterioration in growth momentum, as the nation has been hit hard by the global manufacturing and trade recession. Yet even with weaker growth, Japan’s unemployment rate keeps hitting all-time lows. This has not helped boost inflation much, though, with Japan’s CPI inflation still struggling to reach even the 1% level (Chart 6B). Still, the latest leg lower in our BoJ Monitor has been driven by the growth, rather than inflation, components (Chart 6C). Chart 6AJapan: BoJ Monitor Japan: BoJ Monitor Japan: BoJ Monitor Chart 6BNo Spare Capacity In Japan, But Still No Inflation No Spare Capacity In Japan, But Still No Inflation No Spare Capacity In Japan, But Still No Inflation Weakening confidence has resulted in significant declines in both consumer spending and business investment. Due to the struggling domestic economy, it was expected that the Abe government would postpone the scheduled consumption tax hike, but it was finally initiated on October 1st. The timing could not be worse given the ongoing contraction in global manufacturing and trade activity that has clearly spilled over into Japan’s export and industrially-focused economy. Chart 6CThe Slumping Japanese Economy Could Use Some More BoJ Assistance The Slumping Japanese Economy Could Use Some More BoJ Assistance The Slumping Japanese Economy Could Use Some More BoJ Assistance The BoJ will likely try and deliver some sort of easing in the next few months, but its options are limited after years of already hyper-easy policy. A modest rate cut is likely all that will be delivered, on top of a continuation of the Yield Curve Control policy. That will be enough to keep JGB yields at depressed levels (Chart 6D), even if global yields were to begin climbing. Chart 6DJGB Yields Look Fairly Valued Vs The BoJ Monitor JGB Yields Look Fairly Valued Vs The BoJ Monitor JGB Yields Look Fairly Valued Vs The BoJ Monitor BoC Monitor: Rate Cuts Needed, But Will The BoC Deliver? The Bank of Canada (BoC) Monitor has been below zero since April of this year, indicating a need for easier monetary policy (Chart 7A). Although the BoC has maintained its policy rate at 1.75%, dovish Fed policy and softening domestic economic growth are making it harder for the BoC to continue sitting on its hands Although the Canadian labor market remains solid, household consumption has continued to weaken alongside falling consumer confidence. However, the inflation rate for both headline and core CPI measures is still hovering near the mid-point of BoC 1-3% target range (Chart 7B). Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BRising Inflation Making The BoC’s Job Harder Rising Inflation Making The BoC's Job Harder Rising Inflation Making The BoC's Job Harder At the moment, our BoC Monitor is more influenced by weaker growth components than stabilizing inflation components (Chart 7C). Similar mixed messages are also evident in other data. According to the latest BoC Business Outlook Survey, the overall outlook has edged up to the historical average,2 but real capex growth remains in negative territory and manufacturing new orders are still falling. In contrast, the Canadian labor market remains tight and both wage and price inflation are holding firm. Chart 7CBoC Growth & Inflation Components Signaling Moderate Pressure To Ease BoC Growth & Inflation Components Signaling Moderate Pressure To Rise BoC Growth & Inflation Components Signaling Moderate Pressure To Rise Canadian government bonds have rallied strongly this year, but the yield momentum has appeared to overshoot the decline in our BoC Monitor (Chart 7D). The Canadian OIS curve is discounting -27bps of rate cuts over the next twelve months, but the BoC is not signaling that they will ease. We upgraded our recommended stance on Canadian government bonds to neutral back in May, and we see no need to alter that view without further evidence of more deterioration in Canadian growth or inflation data.3 Chart 7DCanadian Bond Rally Looks A Bit Stretched Canadian Bond Rally Looks A Bit Stretched Canadian Bond Rally Looks A Bit Stretched RBA Monitor: Expect Another Cut The Reserve Bank of Australia (RBA) Monitor has been below the zero line since September 2018, indicating a need for easier monetary policy (Chart 8A). The RBA has already delivered on that signal this year, cutting the Cash Rate twice to an all-time low of 0.75%. Markets are still expecting more, with the Australian OIS curve discounting another -29bps of cuts over the next year, although most of those cuts are expected to occur within the next six months. The signal from our RBA Monitor suggests that Australian bond yields should remain under downward pressure, although the yield momentum has been excessive relative to the fall in the Monitor. Both headline and core CPI inflation remain below the RBA’s 2-3% target range (Chart 8B), and the central bank continues to lower its inflation forecasts, suggesting an entrenched dovish bias. Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BNo Inflation For The RBA To Worry About No Inflation For The RBA To Worry About No Inflation For The RBA To Worry About The latest downturn in our RBA Monitor is related to declines in both the inflation and growth components (Chart 8C). The weakness in the growth components is led by falling exports to Asia, in addition to the sharp drop in house prices in the major cities. The fall in the inflation components reflects both weak inflation expectations and spare capacity in labor markets. Chart 8CA Loud & Clear Message On The Need For RBA Easing A Loud & Clear Message On The Need For RBA Easing A Loud & Clear Message On The Need For RBA Easing The signal from our RBA Monitor suggests that Australian bond yields should remain under downward pressure, although the yield momentum has been excessive relative to the fall in the Monitor (Chart 8D). Australia’s economy will not begin to outperform again, however, until China’s current growth slump starts to bottom out, which is unlikely to occur until the first quarter of 2020 at the earliest. Thus, we expect the RBA to deliver another rate cut before the end of the year, justifying a continued overweight stance on Australian government bonds. Chart 8DA Lot Of Bad News Discounted In Australian Bond Yields A Lot Of Bad News Discounted In Australian Bond Yields A Lot Of Bad News Discounted In Australian Bond Yields RBNZ Monitor: More Easing To Come Our Reserve Bank of New Zealand (RBNZ) monitor remains well below zero, indicating that easier monetary policy is still required (Chart 9A). The central bank has already delivered two rate cuts this year: a -25bps cut in May and, more importantly, a shock rate cut of -50bps in August. Forward guidance remains dovish, with RBNZ Governor Adrian Orr signaling more easing is likely and even hinting at negative rates in the future. This rhetoric is reflected in the NZ OIS curve, which is pricing in a further -42bps of easing over the next twelve months. High inflation is not a constraint for the RBNZ. Both headline and core measures of inflation are currently at 1.7% (Chart 9B). As the RBNZ targets a 1-3% range over the medium term, the prospect of overshooting the 2% longer-term target will not restrict policymakers from acting as appropriate to boost growth. Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BNZ Inflation Creeping Higher NZ Inflation Creeping Higher NZ Inflation Creeping Higher Most of the pressure to ease has come from the continued deterioration in the growth component of our RBNZ Monitor (Chart 9C), reflecting weakness in manufacturing and consumption. The manufacturing PMI is currently in contractionary territory at 48.4, having fallen almost five points since February of this year. Annual growth in retail sales has been slowing for the past two years while consumer confidence is at 7-year lows. Chart 9CWeak Growth Is The Reason RBNZ Rate Cuts Are Needed Weak Growth Is The Reason RBNZ Rate Cuts Are Needed Weak Growth Is The Reason RBNZ Rate Cuts Are Needed We feel confident in reiterating our bullish recommendation on NZ government bonds versus U.S. and German sovereign debt. The RBNZ Monitor suggests that policy will stay dovish for some time, while NZ yields still offer a relatively attractive yield, unlike deeply overbought Treasuries and Bunds (Chart 9D). Chart 9DStill A Bullish Case For New Zealand Government Bonds Still A Bullish Case For New Zealand Government Bonds Still A Bullish Case For New Zealand Government Bonds Riksbank Monitor: Watching And Waiting Our Riksbank Monitor remains very slightly below zero and the market is currently priced for -4bps of rate cuts over the next year (Chart 10A). The Riksbank has decided to hold the Repo Rate constant at -0.25% while forecasting a hike towards the end of this year or the beginning of 2020. Given the policy environment, rate cuts remain unlikely. At most, the Riksbank can further delay rate hikes if the data continues to disappoint. The Riksbank noted in its September Monetary Policy Report that the unexpectedly weak development of the labor market indicates that resource utilization will normalize sooner than expected. This is reflected in Chart 10B, where the unemployment gap is now negative. Meanwhile, inflation readings are giving a mixed signal for the central bank. While the headline CPI measure has declined precipitously year-to-date, owing to the dramatic fall in oil prices, core inflation has continued to climb steadily. Chart 10ASweden: Riksbank Monitor Sweden: Riksbank Monitor Sweden: Riksbank Monitor Chart 10BMixed Messages From Swedish Inflation Mixed Messages From Swedish Inflation Mixed Messages From Swedish Inflation As a result, the inflation components of our Riksbank monitor - driven by a spike in the Citigroup Inflation Surprise Index, wage growth hooking upward and inflation expectations holding firm around 2% - are signaling the need for tighter monetary policy (Chart 10C). However, the growth components – led by weak exports, employment, and manufacturing data - are exerting pressure in the opposite direction. This is evident in the Swedish Manufacturing PMI, which tumbled from 51.8 to 46.3 in September, deep into contractionary territory. Chart 10CThere Is A Reason Why The Riksbank Has Been On Hold There Is A Reason Why The Riksbank Has Been On Hold There Is A Reason Why The Riksbank Has Been On Hold Keeping in mind the inflation constraint, it remains unlikely that the Riksbank will cut rates unless the economic data disappoints more significantly to the downside. This should help put a floor under Swedish bond yields in the near term (Chart 10D). Chart 10DSwedish Yields Have Fallen Too Far, Too Fast Swedish Yields Have Fallen Too Far, Too Fast Swedish Yields Have Fallen Too Far, Too Fast Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com   Shakti Sharma Research Associate shaktis@bcaresearch.com Footnotes * NOTE: All information in this report reflects our knowledge of global events as of Thursday, October 10. 1 Please see BCA Global Fixed Income Strategy Special Report “United Kingdom: Cyclical Slowdown Or Structural Malaise?” dated September 20, 2019, available at gfis.bcaresearch.com. 2https://www.bankofcanada.ca/2019/06/business-outlook-survey-summer-2019/ 3 Please see BCA Global Fixed Income Weekly Report, “Reconcilable Differences” dated May 8, 2019, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Central Bank Monitor Chartbook: Intensifying Pressure To Ease BCA Central Bank Monitor Chartbook: Intensifying Pressure To Ease Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, Please note that there will be no regular Weekly Report next week, as we take a summer break. Our regular publication will resume September 6th. Best regards, Chester Ntonifor, Vice President Foreign Exchange Strategy Highlights Our PPP models show the DXY index to be overvalued by 10-15%. Within the G10 universe, the cheapest currencies are the Swedish krona, the British pound, the Japanese yen and the Norwegian krone. Look to go short CHF/GBP on valuation grounds. Feature Regular readers of our publication will notice that we tend to adhere to very simple and time-tested ideas. One such is the concept of purchasing power parity (PPP). The beauty comes from its simplicity. If the price of a good in Sweden is rising faster than in South Africa, then the krona should depreciate versus the rand to equalize prices across both borders. Otherwise, the krona becomes incrementally expensive, relative to the rand. In practice, various models have shown PPP to be a very poor tool for managing currencies. One roadblock comes from measurement issues, since consumer price baskets tend to differ in composition from one country to the next. Second, there is less price discovery for services, than there is for tradable goods. For example, it is rather difficult to import a haircut from Mumbai into the U.S., and so arbitraging those prices away tends to be impractical. Tariffs, trade restrictions and transport costs also tend to dampen the explanatory power of PPP models, though those have had diminishing importance over time. In order to get closer to an apples-to-apples comparison across countries, we make two adjustments. First, we divide the consumer price index (CPI) baskets into five major groups. In most cases, this breakdown captures 90% of the national CPI basket: Food, restaurants and hotels Shelter Health, culture and recreation Energy and transportation Household goods The second adjustment is to run two regressions with the exchange rate as the dependent variable. The first regression (call it REG1) uses the relative price ratios of the five groups as independent variables. This allows us to observe the most influential price ratios that help explain variations in the exchange rate. The second regression (call it REG2) uses a weighted average combination of the five groups to form a synthetic relative price ratio. If for example, shelter is 33% in the U.S. CPI basket, but 19% in the Swedish CPI basket, relative shelter prices will represent 26% of the combined price ratio. This allows for a uniform cross-sectional comparison, compared to using the national CPI weights. The results were largely consistent: Both regressions were statistically significant, but more so for REG1. This makes intuitive sense, as the number of variables were higher in the first regression. The sign for household goods was negative for some countries. This could be due to some specter of multicollinearity, if the tradable goods price effect is captured in other categories. There is also the low value-to-weight ratio for many household goods such as refrigerators or air conditioners, which could make currency deviations from PPP persistent. The shelter sign was also negative for some countries, meaning rising shelter prices tended to be associated with an incrementally cheaper currency. This could be due to the Balassa-Samuelson effect. Rising incomes (one key determinant of rising house prices) usually reflect rising productivity levels, which tend to lift the fair value of the exchange rate. The results showed the U.S. dollar as overvalued, especially versus the Swedish krona, British pound and Norwegian krone. Commodity currencies were closer to fair value, and within the safe haven complex, the Japanese yen was more attractive than the Swiss franc. The euro was less undervalued than implied by the overvaluation in the DXY index. As a final note, PPP models are just an additional kit to our currency toolbox, and so should never be used in isolation, but in conjunction with other currency signals. This is just a first iteration in our PPP modelling work, which we intend to improve in the months to come. U.S. Dollar We reverse-engineered the fair value for the DXY index by aggregating the model results from its six constituents. This includes the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona, and the Swiss franc, using the corresponding DXY weights. The message from the synthetic model is clear: the U.S dollar is above its fair value, in line with our fundamental view (Chart 1). Chart 1The Dollar is Slightly Expensive The Dollar is Slightly Expensive The Dollar is Slightly Expensive Americans spent 35% of their income in 2018 on goods and 65% on services. Shelter remains the single largest consumption item for American households, which makes up 33% of the consumption basket. However, the relative importance of shelter is dwarfed by much more rampant rent and house price increases in other developed countries. Medical care accounts for 8.7% of the CPI basket, and is the highest in the developed world on a per capita basis. Total spending on health care accounts for almost 20% of nominal GDP. Since the 1980s, the CPI for medical care has risen fivefold, far outpacing many developed countries. This makes the dollar incrementally expensive.  Core CPI edged higher to 2.2% in July, driven by medical care and shelter. While above the Federal Reserve’s 2% target, the risks to inflation remain asymmetric to the downside. That will keep the Fed on a dovish path near-term, which should help close overvaluation in the dollar. Euro We had limited data for the euro area, and so our regression results were less robust. REG1 shows the euro as cheap, while REG2 is more ambiguous (Chart 2). In short, a PPP model for the euro had one of lowest explanatory powers within the G10 universe. Food, restaurants and hotels are the largest consumption item in the euro CPI basket. Looking at the details, food and non-alcoholic beverages account for 14%, alcohol and tobacco make up 4%, and restaurant and hotels account for about 10% (Table). Relative price trends have moved to undermine the fair value of the euro. Chart 2The Euro Is Slightly Cheap The Euro Is Slightly Cheap The Euro Is Slightly Cheap Euro Area CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Shelter’s weight in the euro area CPI basket currently stands at 16.7%, the smallest among G10 countries. Since 2012, relative house and rent prices in the euro area have been decreasing compared with that in the U.S. Rampant rent controls, especially in places like Germany have subdued housing CPI, and tempered the fair value of the euro. This makes sense to the extent that it represents a concomitant rise in the welfare state. It is well-known that the euro area is relatively open and so tradable goods prices are important for the fair value of the euro. Given that the epicenter of trade tensions is between the U.S. and China, this will act to boost the relative attractiveness of European goods, which will be a bullish underpinning for the euro. Inflation expectations have collapsed in the euro area. However, compared to the Federal Reserve, there is little the European Central Bank can do to boost inflation. This is relatively euro bullish. Once global growth eventually picks up, improved competitiveness in the periphery will allow for non-inflationary growth. Japanese Yen The yen benefits from being cheap, as well as being a safe-haven currency (Chart 3). The overarching theme for Japan is a falling (and rapidly aging) population, which means that deficient demand and falling prices are the norm. This makes the yen relatively attractive on a recurring basis. Most of the Heisei era in Japan has been characterized by deflation. Importantly, all categories in Japan have been in a relative price downtrend during this period (Table). Domestically, an aging population (that tends to be a large voting base), prefer falling prices. Meanwhile, the bursting of the asset bubble in the late 80s/early 90s led to a powerful deleveraging wave that undermined prices. Chart 3The Yen Is Quite Cheap The Yen Is Quite Cheap The Yen Is Quite Cheap Japan CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity The relative prices for most items have been decreasing, but culture and recreation inflation have experienced a meaningful rebound since 2013, largely due to a booming tourism industry in Japan.1 According to tourism statistics, the number of international visitors to Japan reached 31 million in 2018, almost five times the number ten years ago. But as long as the younger generation in Japan continues to save more and consume less, prices will remain under pressure. BoJ Governor Haruhiko Kuroda remains committed to achieving a 2% inflation target, but inflation expectations are falling to historical lows at a time when the BoJ is running out of policy bullets.2  That means inflation will likely lag that of other developed countries, lifting the fair value of the yen. British Pound Both regressions show the pound as undervalued. This supports our view that over the long term, the pound is a categorical buy (Chart 4). The consumption baskets in both the U.K. and the U.S. are roughly similar, which means traditional PPP models do a good job at capturing the true underlying picture of price differentials (Table). For example, OECD PPP models, based on national expenditure, show the pound as 15% undervalued. Chart 4The Pound Is Cheap The Pound Is Cheap The Pound Is Cheap U.K. CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Housing is the largest item in the consumption basket, with a total weight close to 30% (including housing electricity and water supply). The shelter consumer price index in the U.K. started to fall relative to the U.S. in 2016, which has lowered the fair-value of the pound (in the Balassa-Samuelson framework). That said, the fall in the pound has been much more deep and violent than suggested by domestic price fundamentals. For example, food restaurants and hotels are 10% cheaper in the U.K. compared to the U.S. over the last half decade. However, rather than appreciating 10%, the pound has plummeted by about 30%. Brexit will continue to dictate the ebb and flow of sterling gyrations, but the reality is that the pound should be higher on a fundamental basis. Meanwhile, a pick up in the global economy will benefit the pound. Going short CHF/GBP on valuation grounds is an attractive bet today. Australian Dollar As a commodity currency, PPP models are less useful for the Australian dollar than terms of trade, or even interest rate differentials. That said, the Aussie dollar is still relatively cheap versus the USD on a PPP basis (Chart 5). The key driver for value in the AUD has been a drop in the currency, relative to what price differentials will dictate. Food, restaurants and hotels comprise 23% of the Australian CPI basket, with the alcohol and tobacco category alone making up 7.4% (Table). Given food price differentials have been stable versus the U.S. in over a decade, Aussie citizens have not been particularly worse off. Chart 5The Aussie Is Slightly Cheap The Aussie Is Slightly Cheap The Aussie Is Slightly Cheap Australia CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Shelter accounts for almost a quarter percent of the basket. Relative shelter prices in Australia have been rising since the late 1990s, but started to soften in the past few years, on the back of macro prudential measures. Meanwhile, holiday travel and accommodation have a total weight of 6%, of which domestic travel makes up 2.9%, and international travel 3.1%. The overall cost of tourism in Australia has been falling relative to the U.S., boosting the fair value of the Aussie. In the 1980s, inflation in Australia averaged around 8.3% year-on-year. This made the Aussie incrementally expensive, creating grounds for a subsequent 50% devaluation from 1980 to 1986. Inflation targeting was finally introduced and has realigned Aussie prices with the rest of the world. Our bias is that the Aussie will be less driven by price differentials going forward, but more by RBA policy and terms of trade. New Zealand Dollar The New Zealand dollar is at fair value according to both models (Chart 6).  Like the aussie, the kiwi is less driven by price differentials and more by terms of trade. Food and shelter account for the largest share of the consumption basket, and relative prices have not been moving in favor of the kiwi (Table). So, while the kiwi was overvalued earlier this decade, the overvaluation gap has been mostly closed via a higher dollar. Chart 6The Kiwi Is At Fair Value The Kiwi Is At Fair Value The Kiwi Is At Fair Value New Zealand CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Relative shelter prices in New Zealand have been soaring in recent decades compared to the U.S. Higher immigration, foreign purchases and a commodity boom helped. However, in August 2018, the ban on foreign property purchases came into effect, which helped cool down the housing market. Like in Australia, the inflation rate in New Zealand reached 18% year-on-year in the early 1980s, and was subsequently addressed via inflation targeting. This has realigned New Zealand prices somewhat with the rest of the world. Our bias is that going forward, the kiwi will underperform the aussie, mainly because of a negative terms of trade shock. Canadian Dollar The loonie is currently trading below its fair value, according to both of our models (Chart 7).  Shelter remains the largest budget item for Canadian households (Table). The average Canadian household spent C$18,637 on shelter per year, around 29.2% of the total consumption in 2017.3 Interestingly, the shelter consumer price index does not fully capture skyrocketing house prices in Canada over the last decade. Since 2005, Canadian house prices relative to U.S. have doubled, according to OECD. On the contrary, the relative shelter CPI has trended downwards. These crosscurrents have dampened the explanatory power of the exchange rate. Chart 7The Loonie Is Slightly Cheap The Loonie Is Slightly Cheap The Loonie Is Slightly Cheap Canada CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Canadians are avid users of private transportation. The average spending on transportation accounted for 20% of total consumption, the second-largest expenditure item. Relative prices in this category have been rising, which has lowered the fair value of the exchange rate. Canada stands as the sixth largest energy producer in the world, but due to heavy taxation, Canadian consumers are paying more for gas prices than their U.S. neighbors. That said, terms of trade have been more important than PPP concerns for the loonie. In the near term, we believe energy prices (and the Western Canadian Select price spread) will continue to be important for the loonie. Swiss Franc USD/CHF is trading slightly below fair value, despite structural appreciation in the franc in recent years (Chart 8). The largest consumption item in Switzerland is the food, restaurants and hotels category (Table). The second item is shelter. Social services have a higher weight in the CPI basket, compared to other developed nations. This has been a huge driver of relative prices between Switzerland and the rest of the world, with falling relative prices boosting the fair value of the franc. Chart 8The Swiss Franc Is At Fair Value The Swiss Franc Is At Fair Value The Swiss Franc Is At Fair Value Switzerland CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Healthcare notably accounts for 15.5% in the total CPI basket, of which patient services makes up 11.5%. The Swiss healthcare system is a combination of public, subsidized private, and entirely private systems. It is mandatory for a Swiss resident to purchase basic health insurance, which covers a range of treatments. The insured person then pays the insurance premium plus part of the treatment costs. Finally, as a small open economy, tradable goods prices are important for Switzerland. Given high levels of specialization, terms-of-trade in Switzerland are soaring to record highs. This makes the franc a core holding in a currency portfolio. Norwegian Krone The Norwegian krone is undervalued according to both models (Chart 9). Food and shelter account for the largest share of the Norwegian CPI basket (Table). While the share of shelter is lower than in the U.S., other categories share similar weights, allowing traditional PPP models to be adequate for USD/NOK. One difference is that in terms of social services, only 0.2% of the expenditures are allocated to education, since all schools are free in Norway, including universities. Chart 9The Norwegian Krone Is Cheap The Norwegian Krone Is Cheap The Norwegian Krone Is Cheap Norway CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity As a large energy producer, Norwegians pay less for electricity, gas, and other fuels. Norway is also a heavy producer of renewable energy, notably hydropower. This makes the domestic energy basket less susceptible to the ebbs and flows of energy prices. Going forward, the path of energy prices will continue to dictate ebbs and flows in the krone. Meanwhile, long NOK positions also benefit from an attractive valuation starting point.  Swedish Krona The krona is the cheapest currency in our universe by a wide margin (Chart 10). This stems less from fluctuations in relative prices and more from negative rates that have hammered the exchange rate. Like many countries, food and shelter is the largest component of the consumption basket (Table). Transportation is also important. However, an important driver for undervaluation in the currency has been a drop in the relative price of social services. Chart 10The Swedish Krona Is Very Cheap The Swedish Krona Is Very Cheap The Swedish Krona Is Very Cheap Sweden CPI Weights A Fresh Look At Purchasing Power Parity A Fresh Look At Purchasing Power Parity Sweden experienced very high inflation rates in the 1980s, and since then, has been in a disinflationary regime. More recently, the inflation rate has edged down below the Riksbank’s target, mostly dragged down by recreation, culture, and healthcare. This makes Swedish real rates relatively attractive. We remain positive on the Swedish krona and believe that it will be one of the first to benefit, should global growth pick up.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com   Kelly Zhong, Research Analyst kellyz@bcaresearch.com Footnotes 1 We removed the shelter component in regression 1, since it was distorting results. 2 Please see Foreign Exchange Strategy Weekly Report, titled “Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much”, dated May 31, 2019, available at fes.bcaresearch.com 3 Please see “Survey of Household Spending, 2017,” Statistic Canada, December 12, 2018. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights A unified push among central banks to drop their currencies inevitably leads to lower interest rates, which eventually sows the seeds of a recovery. However, with prospects of a full-blown trade war in front view, fundamentals could be put to the wayside for longer, as markets keep the switch on risk aversion. The new round of tariffs could pin USD/CNY at about 7.3-7.4, given the impact from negative feedback loops. The breakdown in the AUD/JPY cross is precarious. Stay short USD/JPY, but focus on the crosses rather than on outright bets versus the dollar. The RBNZ’s dovish surprise was a positive catalyst for our AUD/NZD and SEK/NZD positions. Remain long. Feature Chart I-1Summer Blues Summer Blues Summer Blues Just as summer trading volumes are falling close to new lows, central banks appear to be weaponizing their exchange rates in a renewed currency war salvo. Both the Reserve Bank of India (RBI) and the Reserve Bank of New Zealand (RBNZ) surprised market participants this week by slashing rates by more than expected. In retrospect, the European Central Bank probably fired the first shot at its forum in Sintra, Portugal this June. ECB President Mario Draghi highlighted back then that if the inflation outlook failed to improve, the central bank had considerable headroom to launch a fresh expansion of its balance sheet. What has followed is a renewed wave of dovishness by global central banks, which should intensify, given the latest flare-up in the trade war. For currency strategy, this means fundamentals could be temporarily put to the wayside, as markets keep the switch on risk aversion (Chart I-1). This is because there is little visibility on either the political or the economic front. Our strategy remains three-fold: First, maintain tight stops on tactical positions. Second, we prefer trades at the crosses rather than versus the dollar, for now. Finally, maintain portfolio insurance by being short the USD/JPY. USD/CNY And The Economics Of Tariffs Chart I-2Sino-U.S. Trade Is Small Relative To Domestic Demand Sino-U.S. Trade Is Small Relative To Domestic Demand Sino-U.S. Trade Is Small Relative To Domestic Demand Standard theory suggests that exchange rates should move to equalize prices across any two countries. The question that naturally follows is by how much? The answer is that the exchange rate should move by exactly the same percentage point as the price change, everything else equal. If both countries produce homogeneous goods, then it is easy to see why, since there is perfect substitution. All demand will flow to one country, until its currency rises by enough to equalize prices across borders again. However, assume countries ‘A’ and ‘B’ produce heterogeneous goods (‘A’ being the U.S. in this case, and ‘B’ China). Then the loss of purchasing power in Country ‘A’ will lead to less demand for Country ‘B’’s goods. The former loses purchasing power because prices of imports have increased by the amount of the tariff. This means the latter’s currency will have to adjust downwards for the markets to clear. The decrease has to match the magnitude of the price increase, if there are no other outlets to liquidate Country ‘B’’s goods. This is obviously a very simplified version of the real world economy, but it highlights an important point that is central to the discussion: The currency move necessary to realign competitiveness will always be equal to, or less than, in percentage point terms, to the price increase. In the case where the entire production base is tradeable, it will be the former. But with a rise in the number of trading partners, a more complex export basket, import substitution, shipping costs, and many other factors that influence tradeable prices, the currency adjustment needed should be smaller. Since the onset of 2018, the U.S. has slapped various tariffs on China, the latest of which is 10% on $300 billion worth of Chinese goods. The U.S. currently imports $509 billion worth of goods from China, about 16% of its total imports. However, as a percentage of overall U.S. demand, this only represents 2.4% (Chart I-2). This suggests that at best, a 25% tariff on all Chinese imports will only lift import prices by 4% and consumer prices by much less. On the Chinese side of the equation, exports to the U.S. account for 18.4% of total exports, a ratio that has been falling since 2018. Therefore, a tariff of 25% should only lift export prices by 4.5%. The conclusion is that the yuan and the dollar only need to adjust by 4-5% to negate the impact of a 25% tariff. Part of the rise in the dollar and fall in the RMB has been due to tariffs, but it has mostly been due to the fact that global trade has been slowing. This brings us to an important point: Part of the rise in the dollar and fall in the RMB has been due to tariffs, but it has mostly been due to the fact that global trade has been slowing (Table I-1). The DXY index is up 10% since its 2018 trough, while the USD/CNY has risen by 12%. This is much more than economic theory would suggest. In quantity terms, the IMF estimated that a 20% import tariff from East Asia would lift the U.S. dollar’s REER by 5% over five years, while dropping output by 0.6% over the same timeframe.1 But if past is prologue, the new round of tariffs will pin USD/CNY at about 7.3-7.4, given the impact from negative feedback loops – mainly a slowing global economy and a slowing Chinese economy. Chart I- With no corresponding export subsidy for U.S. goods, however, the rise in the dollar makes exporters worse off. And with over 40% of S&P 500 sales coming from outside the U.S., this will make a meaningful dent in corporate profits. This is an important political impediment. Historically, trade wars are usually synonymous with recessions. As such, there are acute political constraints inching both sides towards an agreement. A Disorderly Breakdown Or Steady Depreciation? The RMB has been trading like a pro-cyclical currency, meaning it is becoming an important signaling mechanism for the evolution of the cycle. The USD/CNY has been moving tick-for-tick with emerging market equities, Asian currencies, and even some commodity prices (Chart I-3). It has also closely mirrored the broad trade-weighted dollar (Chart I-4). This has implications for developed market currencies, especially those tied to Chinese demand. Therefore, it will be important to see if the RMB has a disorderly breakdown towards 7.4 or if it stabilizes at higher levels. A few barometers will be key to watch: Chart I-3The Yuan Is Pro-cyclical The Yuan Is Pro-cyclical The Yuan Is Pro-cyclical Chart I-4Is The Dollar Headed Higher? Is The Dollar Headed Higher? Is The Dollar Headed Higher? In a world of rapidly falling yields, Chinese rates remain attractive. Historically, USD/CNY has moved in line with interest rate differentials between the U.S. and China. The current divergence is unsustainable (Chart I-5). Typically, offshore markets have had a good track record of anticipating depreciation in the yuan. Back in 2014, offshore markets started pricing in a rising USD/CNY rate, and maintained that view all the way through to 2018, when the yuan eventually bottomed. Right now, not much depreciation is being priced in (Chart I-6). The reason offshore markets in Hong Kong and elsewhere can be prescient is because more often than not, they are the destination for illicit flows out of China. Chart I-5The Chinese Bond Market Is Attractive The Chinese Bond Market Is Attractive The Chinese Bond Market Is Attractive Chart I-6Forward Markets Not Concerned As In 2015 Forward Markets Not Concerned As In 2015 Forward Markets Not Concerned As In 2015 Chinese money and credit growth, especially forward-looking liquidity indicators such as M2 relative to GDP, have bottomed. Historically, this led the cycle by a few months. The drop in Chinese bond yields is also reflationary, and should soon stimulate imports, especially if the improvement in exports continues (Chart I-7). Chinese government expenditures are likely to inflect higher, especially given acute weakness in the July manufacturing data. Again, this suggests stimulus this time around may be more fiscal than monetary (Chart I-8). In addition, the recent VAT cuts for manufacturing firms, a cut to social security contributions, and a pickup in infrastructure spending are all net positives. Chart I-7Trade War Extends Traditional Lags Trade War Extends Traditional Lags Trade War Extends Traditional Lags Chart I-8Government Spending Set To Increase Government Spending Set To Increase Government Spending Set To Increase The housing market remains healthy. A revival in the property market will support construction activity and investment. House prices have been rising to the tune of 10% year-on-year, and real estate stocks in China remain firm relative to the overall index. If house prices roll over, this will be a negative development (Chart I-9). The housing market remains healthy. A revival in the property market will support construction activity and investment. If house prices roll over, this will be a negative development. In terms of market dynamics, the AUD/JPY cross breached the important technical level of 72 cents, but has since recovered. This is important, since the cross failed to break below this level both during the euro area debt crisis in 2011-2012 and the China slowdown of 2015-2016. It will be especially important to see a clear breach to signal we are entering a deflationary bust (Chart I-10). Chart I-9China Housing Is Fine China Housing Is Fine China Housing Is Fine Chart I-10AUD/JPY Breakdown Is Precarious AUD/JPY Breakdown Is Precarious AUD/JPY Breakdown Is Precarious Bottom Line: We are watching a few key reflationary indicators to gauge whether it pays to be contrarian. The message is that it is not time yet, given the ramp-up in the trade war rhetoric.  Notes On The RBNZ Chart I-11AUD/NZD Is Cheap AUD/NZD Is Cheap AUD/NZD Is Cheap This week, the RBNZ surprised markets by cutting interest rates by 50 basis points to parity (expectations were for a 25-basis-point cut). From an external standpoint, this makes sense. Australia and China are New Zealand’s biggest trading partners, and have been easing policy much earlier. The RBNZ’s bet was that demand was probably going to recover by now. The latest salvo in the trade war probably dashed those hopes. Meanwhile, over the last 35 years, the AUD/NZD cross has spent more than 95% of the time over 1.06. With the AUD/NZD near record lows, the cross is cheap on a real effective exchange rate basis (meaning NZD is expensive) (Chart I-11).  This suggests that even though interest rates are aligning in both Australia and New Zealand, the Aussie should be 11% higher relative to the Kiwi because of the valuation starting point (Chart I-12). The market remains more dovish on Australia relative to New Zealand, in part due to a more accelerated downturn in house prices and a significant slowdown in China. The reality is that the downturn in Australia has allowed some cleansing of sorts, and brought it far along the adjustment path relative to New Zealand. Economic data in New Zealand are now converging to the downside relative to Australia (Chart I-13). Chart I-12Interest Rates Could Move In Favor Of AUD Interest Rates Could Move In Favor Of AUD Interest Rates Could Move In Favor Of AUD Chart I-13New Zealand Has More Economic Downside New Zealand Has More Economic Downside New Zealand Has More Economic Downside The RBNZ began a new mandate on April 1st to include full employment in addition to inflation targeting. But given that the RBNZ has been unable to fulfill its price stability mandate over the last several years, it is hard to argue it will find a dual mandate any easier. Business confidence is rapidly falling, and employment will soon follow suit (Chart I-14). Meanwhile, for an economy driven by agricultural exports, productivity gains will be hard to come by. Economic data in New Zealand are now converging to the downside relative to Australia. The final catalyst for the AUD/NZD cross will be a terms-of-trade shock which, at the moment, is turning in favor of the Aussie (Chart I-15). Iron ore prices may face further downside, given that supply from Brazil is back online, but China’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix. Since eliminating pollution is a strategic goal in China, this will be a multi-year tailwind. As the market becomes more liberalized and long-term contracts are revised to reflect higher spot prices, the Aussie will get a boost. Chart I-14Employment Growth Could Collapse In New Zealand Employment Growth Could Collapse In New Zealand Employment Growth Could Collapse In New Zealand Chart I-15Terms Of Trade Favors##br## Aussie Terms Of Trade Favors Aussie Terms Of Trade Favors Aussie Bottom Line: Remain long AUD/NZD as a strategic position and SEK/NZD as a tactical position. Housekeeping The stop on our short XAU/JPY position was triggered at 158,000 with a loss of -3.27%. This was a mean-reversion trade between two safe-havens, likely to work even if volatility remains elevated. Put it back on. Finally, lift the limit sell on EUR/GBP to 0.95.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Maurice Obstfeld, “Tariffs Do More Harm Than Good At Home,” IMFBlog, September 8, 2016. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been mostly positive: Labor market remains tight: Unemployment rate was steady at 3.7%; Participation rate increased to 63%; Average hourly earnings increased by 3.2% year-on-year; Nonfarm payrolls increased by 164 thousand. Initial jobless claims fell to 209 thousand last week. Trade balance narrowed slightly to $55.2 billion in June. Michigan sentiment index was unchanged at 98.4 in July. Markit composite and services PMI both increased to 52.6 and 53 respectively in July, while ISM non-manufacturing PMI fell to 53.7 in July. DXY index fell by 1% this week, erasing the gains following the Fed’s hawkish surprise last week. Weakness in the dollar given a ramp-up in trade war rhetoric suggest that dollar tailwinds are facing diminishing marginal returns. A few of our favorite dollar indicators, including the bond-to-gold ratio, are sending a warning signal. Report Links: Focusing On the Trees But Missing The Forest - August 2, 2019 Global Growth And The Dollar - July 19, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have continued to deteriorate: Producer price inflation fell to 0.7% year-on-year in June. Retail sales increased by 2.6% year-on-year in June, surprising to the upside. Markit composite PMI was unchanged at 51.5 in July, while services PMI fell slightly to 53.2. Sentix investor confidence fell further to -13.7 in August, the lowest since 2014. EUR/USD increased by 1% this week. In the most recent Economic Bulletin, the ECB highlighted the risk of a weaker Q2 global services PMI which might lead to a more broad-based deterioration in global growth. With negative interest rates and diminishing marginal returns to monetary policy, the euro area will be ever dependent on fiscal stimulus. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mixed: Composite PMI was unchanged at 51.2 in July, while services PMI fell to 51.8. Household spending yearly growth fell to 2.7% in June. That said, previous growth of 4% was too high relative to Japan’s potential. Wages increased by 0.4% year-on-year in June. Leading economic index and coincident index both fell to 93.3 and 100.4 respectively in June. The trade balance increased to ¥759.3 billion in June. Current account balance narrowed to ¥1,211 billion in June. USD/JPY fell by 0.9% this week. In the Summary of Opinions released this week, the BoJ concluded that the Japanese economy has been moderately expanding, a trend that is likely to continue in the second half. However, this may be too ambitious. As we go to press, Q2 GDP growth is still pending, and a marked slowdown could be a harbinger for a much softer second half, especially given renewed trade tensions. That said, the path to easier monetary policy will be lined by a stronger yen. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Battle Of The Central Banks - June 21, 2019 Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been mostly positive: Markit composite PMI increased to 50.7 in July. Services and construction components also increased to 51.4 and 45.3 respectively. Retail sales increased by 0.1% year-on-year in July. Halifax house prices contracted by 0.2% month-on-month in July. GBP/USD has been very volatile but returned flat this week. All eyes are on the new PM Boris Johnson and new Brexit developments. Our Geopolitical strategist is assigning 21% risk of a no-deal Brexit, and the probability would rise to 30% if negotiations with the EU fail. We believe that the pound could easily drop to 1.10-1.15 if there is no deal. That being said, we are looking to sell EUR/GBP at 0.94, given Europe will also absorb some collateral damage from a hard Brexit. Report Links: Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mostly positive: Producer price inflation increased to 2% year-on-year in Q2. Retail sales grew by 0.4% month-on-month in June. Both composite and services PMI increased to 52.1 and 52.3 respectively in July. Australian Industry Group (AiG) construction index fell to 39.1 in July. Exports grew by 1% month-on-month in June, while imports contracted by 4% month-on-month. This nudged the trade surplus to A$8 billion in June, a record. AUD/USD fell by 1.8% initially, then rebounded, returning flat this week. The RBA held interest rates unchanged at 1% on Tuesday, after cutting by 25 bps both in June and July. Long-term government bond yields declined to record-lows. Currency markets are currently focused on interest rate differentials. Once the focus shifts to other fundamentals as global interest rates converge, the Aussie dollar will get a boost. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been positive: Consumer confidence decreased by 5.1% month-on-month in July. On the labor market front, the participation rate was steady at 70.4% in Q2; Unemployment rate fell to 3.9%; Wages increased by 2.2% year-on-year in Q2. NZD/USD fell by 0.8% this week. RBNZ shocked the market with the half-percentage point rate cut this Wednesday, stating that a larger initial move would be best to meet the inflation and employment objectives in New Zealand. The RBNZ also lowered 2-year inflation expectations from 2.01% to 1.86% in Q3. Relative terms-of-trade favors our long AUD/NZD position. Stay with it. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been mostly positive: Imports and exports both fell to C$50.2 billion and C$50.3 billion in June. The trade balance thus narrowed to C$0.14 billion. Bloomberg Nanos confidence index increased to 58.6 last week. Ivey PMI increased to 54.2 in July. New housing price index contracted by 0.2% year-on-year in June. USD/CAD increased by 0.2% this week. The sudden oil prices drop has dragged down the Canadian dollar. WTI crude oil prices plunged by more than 10% during the past week, and Western Canadian Select crude oil spot prices fell by 14.5%. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been mostly negative: Headline and core consumer price inflation dropped to 0.3% and 0.4% year-on-year respectively in July. Manufacturing PMI fell to 44.7 in July. Consumer confidence fell to -8 in July. Real retail sales increased by 0.7% year-on-year in June. USD/CHF fell by 1.2% this week. The concerns over the global growth, an escalating trade war, a potential hard-Brexit, political tensions in the Middle East and East Asia continue to weigh on investors’ sentiment. VIX once again touched 24 following Trump’s tweet to threaten to impose 10% tariffs over $300 billion Chinese goods last Thursday. We continue to favor the safe-haven Swiss franc as a tactical portfolio hedge. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There is little data from Norway this week: Manufacturing production yearly growth fell from 5% in May to 3% in June. USD/NOK has been flat this week.  Next week, the Norges Bank is likely to reverse its well-telegraphed forward guidance of rate hikes, following global developments. With oil prices down, and a new trade war, they will stand pat in line with market expectations, but an interest rate cut cannot be ruled out. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been mixed: Industrial production contracted by 0.7% year-on-year in June. Services production yearly growth also fell to 1.3% in June. However, industrial orders increased by 7.5% year-on-year in June, the strongest since July 2018.  Budget balance widened to SEK 28.2 billion in July. USD/SEK fell by 0.9% this week. The upside surprise in industrial orders is mainly led by transport equipment. Mining and quarrying also rebounded to 9.3% compared with -7.8% in May. Our SEK/NZD position is now 0.4% in the money. The negative carry has been narrowed following RBNZ’s 50 bps rate cut. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Our intermediate-term timing models are not sending any strong signals at the moment. That means the balance of forces could tilt the greenback in either way, in what appears to be a stalemate for the U.S. dollar so far.  We are maintaining a pro-cyclical currency stance, but have a few portfolio hedges in the event we are caught offside in what could be a volatile summer. Stay long petrocurrencies versus the euro. Remain short USD/JPY. Also hold a short basket of gold bullion versus the yen. Feature Chart 1Major Peak In The Bond-To-Gold Ratio Major Peak In The Bond-To-Gold Ratio Major Peak In The Bond-To-Gold Ratio Regular readers of our publication are well aware that we have maintained a pro-cyclical stance over the past few months, a view that has been underpinned by a few tectonic forces moving against the U.S. dollar. The reality is that the DXY index has been stuck in a broad range of 96 to 98 for most of this year, failing to decisively breakout or breakdown in what has largely been an extremely frustrating stalemate for traders. Our rationale for a breakdown in the dollar was outlined in a Special Report 1 we penned in March, and the arguments still hold true today (Chart 1).    Over the next few weeks, we will be going back to the drawing board to see if and where we could be offside in this view. We start this week with a review of our intermediate-term timing models. Back in 2016, we developed a set of currency indicators to help global portfolio managers increase their Sharpe ratio in managing currency exposure. The idea was quite simple: For every developed-world country, there were three key variables that influenced the near-term path of its exchange rate versus the U.S. dollar. Interest Rate Differentials: Under the lens of interest rate parity, if one country is expected to have lower interest rates versus another one, the incumbent’s currency will fall today so as to gradually appreciate in the future and nullify the interest rate advantage. This sounds vaguely familiar for the U.S. dollar. Inflation Differentials:  Assuming no transactional costs, the price of sandals cannot be relatively high and rising in Mumbai versus Auckland. Either the Indian rupee needs to fall, the kiwi rise, or a combination of the two has to occur to equalize prices across borders. This concept originated from the School Of Salamanca in 16th century Spain, and still applies to this day in the form of Purchasing Power Parity (PPP). Risk factor: Exchange rates are not government bonds in that few treasury departments and central banks can guarantee a par value on them. Ergo, the ebb and flow of risk aversion will have an impact on the Norwegian krone as well as the yen. Gauging the balance of forces for this risk is important. For all countries, the variables are highly statistically significant and of the expected signs. These models help us understand in which direction fundamentals are pushing the currency. We hereto refer to these as Fundamental Intermediate-Term Models (FITM). Including the momentum variable helps fine-tune the models. Real rate differentials, junk spreads and commodity prices remain statistically significant and of the correct sign.  A final adjustment is one for momentum. Including a 52-week moving average for each cross helps fine-tune the models for trend. Real rate differentials, junk spreads and commodity prices remain statistically very significant and of the correct sign. They are therefore trend- and risk-appetite adjusted UIP-deviation models. These models are more useful as timing indicators on a three- to nine-month basis, as their error terms revert to zero much faster. We refer to these as Intermediate-Term Timing Models (ITTM). For the most part, our models have worked like a charm. On a risk-adjusted return basis, a dynamic hedging strategy based on our ITTMs has outperformed all static hedging strategies for all investors with six different home currencies since 2001.2 Even in the very long run of 41 years – from August 1976 – a simple momentum-based dynamic hedging strategy outperforms static ones for investors with five home currencies, with only the AUD portfolio being worse off. These results give us confidence to continue running these models as a sanity check for our ever-shifting currency biases. The U.S. Dollar Chart 2No Major Mispricing In The U.S. Dollar No Major Mispricing In The U.S. Dollar No Major Mispricing In The U.S. Dollar Chart 3More Upside Is Possible More Upside Is Possible More Upside Is Possible The approach for modelling the U.S. dollar was twofold. First, we estimated the fair value of each of the DXY constituents, and reconstructed an index based on DXY weights – a bottom-up fair-value DXY, if you will. Second, we ran our three variables against the DXY index. Averaging both approaches gave us similar results to begin with. The dollar is currently sitting in a neutral zone, with two opposing forces holding it in stalemate. The Federal Reserve’s dovish shift is moving real interest rate differentials against the dollar, but budding risk aversion judging from the combination of junk bond spreads and commodity prices are keeping the dollar bid. The call on the dollar will be critical for currency strategy, and our bias is that a breakdown is imminent based on the bond-to-gold ratio. That said, the breakdown will require the final pillars of dollar support to crack, which would come from a nascent rebound in global growth and/or an easing in the dollar liquidity shortage. We will be watching these developments like hawks. The Euro Chart 4No Major Mispricing In The Euro No Major Mispricing In The Euro No Major Mispricing In The Euro Chart 5EUR/USD Is Not Particularly Cheap EUR/USD Is Not Particularly Cheap EUR/USD Is Not Particularly Cheap The model results for the euro are the mirror image of the dollar, with no evidence of mispricing. What is interesting about the euro, however, is that the biggest buy signal was generated in 2015, and since then the fair value has exhibited a series of higher-lows and higher-highs. In short, it appears the euro has been in a low-conviction bull market since 2015. The Treasury-bund spread is the widest it has been in decades, and it is fair to say that some measure of mean reversion is due. The standard dilemma for the euro zone is that interest rates have always been too low for the most productive nation, Germany, but too expensive for others such as Spain and Italy. As such, the euro has typically been caught in a tug-of-war between a rising equilibrium rate of interest for Germany, but a very low neutral rate for the peripheral countries. The silver lining is that the European Central Bank has now finally lowered domestic interest rates and eased policy to the point where they are accommodative for almost all euro zone countries. The drop in the euro since 2018 has also eased financial conditions and made euro zone companies more competitive. This is a tailwind for European stocks. Fortunately for investors, European equities, especially those in the periphery, remain unloved, given they are trading at some of the cheapest cyclically adjusted price-to-earnings multiples in the developed world. Earlier this year, analysts began aggressively revising up their earnings estimates for euro zone equities relative to the U.S. If they are right, this could lead to powerful inflows into the euro over the next nine to 12 months.  The Japanese Yen Chart 6Rate Differentials Have Helped The Yen Rate Differentials Have Helped The Yen Rate Differentials Have Helped The Yen Chart 7JPY Is Slightly Expensive JPY Is Slightly Expensive JPY Is Slightly Expensive The yen’s fair value has benefitted tremendously from the plunge in global bond yields, which made rock-bottom Japanese rates relatively attractive from a momentum standpoint. That said, relatively subdued risk aversion has constrained upside in the fair value. The message from our ITTM is a moderate sell on the yen, which stands in contrast to our tactically short USD/JPY position. With the BoJ owning 46% of outstanding JGBs, about 75% of ETFs and almost 5% of JREITs, the supply side obviously puts a serious limitation on how much more stimulus the central bank can provide. Total annual asset purchases by the Bank of Japan are currently running at under ¥30 trillion, while JGB purchases are running at ¥20 trillion. This is a far cry from the central bank’s soft target of ¥80 trillion, and unlikely to change anytime soon, given 10-year government bond yields are six points away from the 20 basis-point floor. It looks like the end of the Heisei era has brought forward a well-known quandary for the central bank, which is that additional monetary policy options are hard to come by, since there have been diminishing economic returns to additional stimulus. This puts short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position.  The British Pound Chart 8Cable Is At Equilibrium Cable Is At Equilibrium Cable Is At Equilibrium Chart 9Political Risk Could Lead To An Undershoot Political Risk Could Lead To An Undershoot Political Risk Could Lead To An Undershoot The selloff in the pound since 2015 has been quick and violent, and triggered our stop loss at 1.25 this week. Interestingly, our ITTM does not show any mispricing in the pound’s fair value at the moment, suggesting momentum could shift either way rather quickly. For longer-term investors, there is fundamental support for holding the pound. For one, the pound is below where it was after the 2016 referendum results, yet more people are now in favor of staying in the union. Yes, incoming data in the U.K. has softened, but employment growth has been holding up very well, wages are inflecting higher and the average U.K. consumer appears in decent shape. This suggests that gilt yields should be higher than current levels, solely on the basis of domestic fundamentals. Our bulletin last week3 provided an ERM roadmap for the pound, and the conclusion is that we could be quite close to a floor. That said, valuation confirmation from our ITTM would have been a nice catalyst, which is not currently the case. As such, we are standing aside on the pound for now. The Canadian Dollar Chart 10Loonie Is Trading At A Discount Loonie Is Trading At A Discount Loonie Is Trading At A Discount Chart 11A Rise In Crude Oil Will Be Bullish A Rise In Crude Oil Will Be Bullish A Rise In Crude Oil Will Be Bullish USD/CAD is slightly overvalued from a fundamental perspective, but our ITTM is squarely sitting close to neutral. Going forward, movements in the Canadian dollar will be largely dictated by interest rate differentials and crude oil prices, which for now remain supportive. Canadian data has been firing on all cylinders of late, so it was no surprise that Bank of Canada Governor Stephen Poloz decided to keep interest rates on hold this week. Risks from the slowdown in global trade remain elevated, but easier monetary policy around the world should help. Developments in the oil patch should also be increasingly favorable as mandatory production curtailments in Alberta are eased. Notably, Canadian exports to the U.S. are near record highs. Housing developments have been uneven, with Halifax, Montreal and Ottawa seeing robust housing markets versus softer data elsewhere. That said, solid gains in labor income should sustain housing investment and growth. As for the loonie, the tailwinds remain favorable because 1) the Fed is expected to be more dovish over the next 12 months, which should tilt interest rate differentials in favor of the loonie, and 2) crude oil prices should remain well anchored in the near term on the back of geopolitical tensions, which will favor the loonie. The caveat is of course that global (and Canadian) growth bounces back by 2020 into 2021 as the BoC expects. The Swiss Franc Chart 12The Franc Value Is Fair The Franc Value Is Fair The Franc Value Is Fair Chart 13The Franc Has Been A Dormant Currency The Franc Has Been A Dormant Currency The Franc Has Been A Dormant Currency For most of the past decade, the Swiss franc has tended to be a dormant currency, interspersed by short bouts of intense volatility. That is reflected in the ITTM, which has not deviated much from zero over this time. The current message is that USD/CHF is slightly undervalued, a deviation that remains within the margin of error. A unifying theme for the franc is that it has tended to stage big moves near market riot points. That makes it attractive as a portfolio hedge, given no major evidence of mispricing today. With Swiss bond yields at already low levels, any downward pressure on global rates will boost the franc’s fair value. Meanwhile, Swiss prices are rising at a 0.6% annual rate, while U.S. prices are rising at a 1.6% clip, suggesting the franc is getting incrementally cheaper relative to its fair value. The message from Swiss National Bank Chair Thomas Jordan has been very clear: Interest rates could be lowered further, along with powerful intervention in the foreign exchange market, if necessary. This suggests that in the near term, the preference for the SNB is for a stable exchange rate. The issue is that market forces have occasionally dictated otherwise, especially during riot points. With the S&P 500 at record highs and corporate spreads both in the U.S. and euro area historically low, we may be approaching such a riot point soon, which will support the franc.  The Australian Dollar Chart 14AUD Trading Tightly With Fundamentals AUD Trading Tightly With Fundamentals AUD Trading Tightly With Fundamentals Chart 15No Major Mispricing In AUD No Major Mispricing In AUD No Major Mispricing In AUD Our ITTM for the Australian dollar sits notoriously close to fair value at most times, making opportunistic buys or sells in the Aussie rather difficult. The current message is that the AUD/USD is sitting squarely at fair value, meaning a move in either direction is fair game.  On the surface, most data points appear negative for the Aussie dollar. Typical reflation indicators such as commodity prices and industrial share prices are soft after a nascent upturn earlier this year. This suggests that so far, policy stimulus in China has not been sufficient to lift global growth, and/or the transmission mechanism towards higher growth is not working. That said, the latest Reserve Bank of Australia interest rate cut might be the ultimate insurance backstop needed to jumpstart the Australian economy. More importantly, fiscal policy is set to become decisively loose this year. The new government introduced income tax cuts this month. This is skewed towards lower-income households, meaning the fiscal multiplier may be larger than what the Australian economy is normally accustomed to. Infrastructure spending will also remain high, which will be very stimulative for growth in the short term. One bright spot for the Aussie dollar has been rising terms of trade. In recent months, both steel and iron ore prices have been soaring. Many commentators have attributed these increases to supply bottlenecks and/or seasonal demand. However, it is evident from both Chinese manufacturing data and the trend in prices that demand is also playing a role. We remain long AUD/USD with a tight stop at 68 cents.  The New Zealand Dollar Chart 16NZD Fair Value Has Been##br## Falling NZD Fair Value Has Been Falling NZD Fair Value Has Been Falling Chart 17NZD Cross Reflects Deteriorating Fundamentals NZD Cross Reflects Deteriorating Fundamentals NZD Cross Reflects Deteriorating Fundamentals Like the AUD, our ITTM for the NZD is sitting squarely at fair value. That said, we believe fundamentals are likely to shift against the NZD in the near-term. This warrants holding long AUD/NZD and SEK/NZD positions. Our bias is that failure to cut interest rates at the last policy meeting might have been a mistake by the Reserve Bank of New Zealand – one that will be reversed with more interest rate cuts down the line. Since 2015, the market has been significantly more dovish on Australia relative to New Zealand, in part due to a more accelerated downturn in house prices and a significant slowdown in China. The reality is that the downturn in Australia has allowed some cleansing of sorts, and brought it far along the adjustment path relative to New Zealand. We may now be entering a window where economic data in New Zealand converges to the downside relative to Australia, the catalyst being a foreign ban on domestic home purchases. The Norwegian Krone Chart 18NOK Is Cheap NOK Is Cheap NOK Is Cheap Chart 19A Rise In Crude Oil Will Be Bullish A Rise In Crude Oil Will Be Bullish A Rise In Crude Oil Will Be Bullish Our fundamental model for the Norwegian krone shows it as squarely undervalued. This favors long NOK positions, which we have implemented via multiple crosses in our bulletins. The Norges Bank is the most hawkish G10 central bank, which means interest rate differentials are likely to continue moving in favor of the krone. And with oil prices slated to rise towards year-end, this will also underpin NOK valuations. The Norwegian economy remains closely tied to oil, with the bottom in oil prices in 2016 having jumpstarted employment growth, business confidence and wage growth. With inflation near the central bank’s target and our expectation for oil prices to grind higher, we agree with the central bank’s assessment that the future path of interest rates is likely higher. Near $20/bbl, the discount between Western Canadian Select crude oil and Brent has narrowed, but remains wide. This has typically pinned the CAD/NOK lower. The NOK also tends to outperform the SEK when oil prices are rising, in addition to the benefit from a positive carry. The Swedish Krona Chart 20SEK Is Cheap SEK Is Cheap SEK Is Cheap Chart 21A Bounce In Global Growth Will Be Bullish A Bounce In Global Growth Will Be Bullish A Bounce In Global Growth Will Be Bullish Both our ITTM and FITM for the Swedish krona show the cross as cheap. Our high-conviction view is that the Swedish krona will be the biggest beneficiary from a rebound in global growth. For now, we are long SEK/NZD but are looking to add on to SEK positions once more evidence emerges that global growth has bottomed. The USD/SEK and NZD/SEK crosses tend to be highly correlated, since the SEK has a higher beta to global growth than the kiwi (Sweden exports 45% of its GDP versus 27% in New Zealand). On a relative basis, the Swedish economy appears to have bottomed relative to that of the U.S., making the SEK/NZD an attractive way to play USD downside. Meanwhile, the carry cost of being short NZD is lower compared to being short the U.S. dollar.    Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled "Tug Of War, With Gold As Umpire", dated March 29, 2019, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy / Global Asset Allocation Strategy Special Report titled, "Currency Hedging: Dynamic Or Static? – A Practical Guide For Global Equity Investors (Part II)", dated October 13, 2017, available at fes.bcaresearch.com and gaa.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Portfolio Tweaks Into Thin Summer Trading", dated July 5, 2019, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights It remains too early to put on fresh pro-cyclical trades, but the Federal Reserve’s dovish shift is a positive development at the margin. As the market fights a tug of war between weak fundamentals and easier monetary policy, bigger gains are likely to be made at the crosses rather than versus the dollar. Safe-haven currencies are also winners in the interim. Continue to hold short USD/JPY positions recommended last week. Watch the gold-to-bond ratio for cues on where the balance of forces are shifting, with a rising ratio negative for the dollar. Once investors eventually shift their focus towards the rising U.S. twin deficits, de-dollarization of the global economy and low expected returns for U.S. assets, the dollar will peak. New idea: Buy SEK/NZD for a trade. Feature Global markets have once again decided that the U.S. is due for rate cuts, and the Federal Reserve appears to be heeding their message. Both Fed Governor Lael Brainard and Fed Chair Jerome Powell have suggested that policy should be calibrated to address the downside risks posed by the trade war.   The question du jour is the path of the dollar if the Fed eventually does ease monetary policy. A slowing global economy on the back of deteriorating trade is positive for the greenback, since it is a counter-cyclical currency. A Fed rate cut will just be acknowledging the gravity of the slowdown. On the other hand, a dovish Fed knocks down U.S. interest rate expectations relative to the rest of the world. This has historically been bearish for the dollar, and positive for global growth. Our bias remains that the dollar will emerge a loser in this tug of war, especially if Beijing and Washington come to a trade agreement. However, for currency strategy, it is important to revisit our indicators to see where the balance of forces for the dollar lie. We do this via the lens of interest rate differentials, global growth, liquidity trends, and positioning. Expectations Versus Reality Markets are mostly wrong about Fed interest rate expectations, but do get it right from time to time. Since the 1990s, most Fed rate-cutting cycles were initially predicted in advance by the swaps market. Moreover, the current divergence between market expectations and policy action is as wide as before the Great Recession, and among the deepest in over three decades (Chart I-1). The fact that the Fed seldom cuts interest rates only once during a mid-cycle slowdown suggests expectations could diverge even further. Outside of recessions, falling rate expectations relative to policy action have historically been bearish for the dollar, and vice versa. This makes intuitive sense. As a reserve and counter-cyclical currency, the dollar has tended to rise during times of capital flight. However, if we are not on the cusp of a recession, then easier monetary policy by the Fed should improve global liquidity, which is bullish for higher-beta currencies and negative for the dollar. On this front, our discounter suggests rate cuts of about 80 basis points are penciled in by the swaps market over the next 12 months. This will put downward pressure on the dollar. It also helps that sentiment on the greenback remains relatively bullish, and speculators are very long the currency (Chart I-2). Chart I-1Big Divergences Are Rare Will The Market Be Wrong This Time? Will The Market Be Wrong This Time? Chart I-2Lots of Room For The Dollar To Fall Lots of Room For The Dollar To Fall Lots of Room For The Dollar To Fall     Chart I-3Relative Rates Moving Against The Dollar Relative Rates Moving Against The Dollar Relative Rates Moving Against The Dollar Relative interest rate differentials between the U.S. and the rest of the world continue to suggest that the greenback should be slightly higher. However, the Treasury market tends to be a global interest rate benchmark rather than specific to the U.S. With global growth in a downtrend and the Fed becoming relatively more dovish, U.S. interest rates are falling much faster than elsewhere and closing the interest-rate gap vis-à-vis the rest of the world. A peak in U.S. interest rates relative to its G10 peers has always been a bad omen for the greenback (Chart I-3). Market action following the Reserve Bank of Australia’s (RBA) interest rate cut this week is a case in point. The initial reaction was a knee-jerk rally in AUD/USD. Australian 10-year government bond yields are already 65 basis points below U.S. levels, the lowest since the 1980s. But the structural growth rate in Australia remains higher than in the U.S., suggesting there is a natural limit as to how low relative interest rates can go. We remain long AUD/USD, but are maintaining a tight stop at 68 cents should rising volatility nudge the market against us.1 Australian 10-year government bond yields are already 65 basis points below U.S. levels, the lowest since the 1980s. Bottom Line: Interest rate expectations between the rest of the world and the U.S. are already at very depressed levels. This suggests that unless the world economy tips into recession, rate differentials are likely to shift against the greenback. A dovish Fed could be the catalyst that triggers this convergence. Portfolio Flows The change in the U.S. tax code to allow for the repatriation of offshore cash helped the dollar in 2018, but not to the extent that might have been expected. On a rolling 12-month basis, the U.S. has repatriated about $400 billion in net assets, or close to 2% of GDP. Historically, this is a very huge sum that would have had the potential to set the greenback on fire – circa 10% higher. The issue today is that the tax break was a one-off, and net flows into the U.S. are now rolling over as the impact fades (Chart I-4). Historically, portfolio flows into the U.S. have been persistent, so it will be important to monitor how fast repatriation flows run off. The Fed’s tapering of asset purchases has been a net drain on dollar liquidity. In the meantime, foreign investors have been fleeing U.S. capital markets at one of the fastest paces in years. On a rolling 12-month total basis, the U.S. is seeing an exodus of about US$200 billion in equity from foreigners, the largest on record (Chart I-5). In aggregate, both foreign official and private long-term portfolio investment into the U.S. has been rolling over, with investor interest limited only to agency and corporate bonds. Foreigners are still net buyers of U.S. securities, but the downtrend in purchases in recent years is evident. Chart I-4Repatriation Flows Have Peaked Repatriation Flows Have Peaked Repatriation Flows Have Peaked Chart I-5Investors Stampeding Out Of U.S. Equities Investors Stampeding Out Of U.S. Equities Investors Stampeding Out Of U.S. Equities The one pillar of support for the dollar is falling liquidity (Chart I-6). Internationally, the Fed’s tapering of asset purchases has been a net drain on dollar liquidity, despite a widening U.S. current account deficit. The Fed’s balance sheet peaked a nudge above US$4.5 trillion in early 2015 and has been falling since. This has triggered a severe contraction in the U.S. monetary base, and has severely curtailed commercial banks’ excess reserves. However, with the Fed turning more dovish and its balance sheet runoff slated to end in September, dollar liquidity will likely improve at the margin. Chart I-6A Dollar Liquidity Squeeze A Dollar Liquidity Squeeze A Dollar Liquidity Squeeze Bottom Line: Currency markets continue to fight a tug of war between deteriorating global growth and easier monetary conditions. Our bias is that the dollar will emerge a loser. Falling interest rate differentials, portfolio outflows, soft relative growth and easing liquidity strains support this thesis. Another Dovish Shift By The ECB The European Central Bank (ECB) kept monetary policy unchanged following this week’s meeting, while highlighting that it will be on hold for longer – at least until mid-2020. The EUR/USD rallied on the news, suggesting the market expected a much more dovish ECB. Our bias is that with European long-term rates already at rock-bottom levels relative to the U.S., the currency market will continue to be disappointed by ECB policy actions for now. Economic surprises are rising in Sweden relative to New Zealand.    Terms for the new Targeted Longer-Term Refinancing Operation (TLTRO III – in other words, cheap loans), were announced at 10 basis points above the main refinancing rate. They can fall as low as 10 basis points above the deposit rate if banks meet certain lending standards. There was no mention of a tiered system for its marginal deposit facility, which would have alleviated some cash flow pressures for euro area banks. We remain of the view that TLTROs are a better policy tool than a tiered central bank deposit system. Chart I-7A Tentative Bottom In Euro Area Data A Tentative Bottom In Euro Area Data A Tentative Bottom In Euro Area Data In the case of a TLTRO, the ECB can effortlessly decentralize monetary policy, since liquidity gravitates towards the countries that need it the most. While a tiered system can allow a bank to offer higher rates and attract deposits, there is no guarantee that these deposits will find their way into new loans. It is also likely to benefit countries with the most excess liquidity. The euro’s bounce suggests that the ECB’s dovish shift is paradoxically bullish for the euro. If a central bank eases financing conditions at a time when growth is hitting a nadir, it is tough to argue that it is bearish for the currency. Meanwhile, fiscal policy is also set to be loosened. Swedish new orders-to-inventories lead euro area growth by about five months, and the recent uptick could be a harbinger of positive euro area data surprises ahead (Chart I-7). Bottom Line: European rates are further below equilibrium compared to the U.S., and the ECB’s dovish shift will help lift the euro area’s growth potential. Meanwhile, investors are currently too pessimistic on euro area growth prospects. Our bias is that the euro is close to a floor. Buy SEK/NZD For A Trade A few market indicators suggest there is a trading opportunity for the SEK/NZD cross: Since 2015, the cross has been trading into the apex of a tight wedge formation, defined by higher lows and lower highs. From a technical standpoint, the break above the 50-day moving average is bullish, suggesting the cross could gap higher outside its tight wedge (Chart I-8). Economic surprises are rising in Sweden relative to New Zealand. Going forward, this trend is likely to persist given that investor expectations toward the Swedish economy are very bearish (on the back of depressed sentiment towards the euro area). Relative economic surprises have a good track record of capturing short-term swings in the currency (Chart I-9). Chart I-8A Breakout Seems##br## Imminent A Breakout Seems Imminent A Breakout Seems Imminent Chart I-9Sweden Could Perform Better Than New Zealand Sweden Could Perform Better Than New Zealand Sweden Could Perform Better Than New Zealand Interest rates are moving in favor of the SEK/NZD cross. For almost two decades, relative interest rate differentials between Sweden and New Zealand have been a powerful driver of the exchange rate (Chart I-10). The housing downturn appears well advanced in Sweden relative to New Zealand. Rising relative house prices have historically been supportive of the cross (Chart I-11). The undervaluation of the krona has begun to mitigate the effects of negative interest rates, mainly a buildup of household leverage and an exodus of foreign direct investment. Chart I-10Relative Rates Favor SEK/NZD Relative Rates Favor SEK/NZD Relative Rates Favor SEK/NZD Chart I-11Swedish House Prices Could Stabilize Swedish House Prices Could Stabilize Swedish House Prices Could Stabilize The USD/SEK and NZD/SEK cross tend to be highly correlated, since the SEK has a higher beta to global growth than the kiwi (Sweden exports 45% of its GDP versus 27% in New Zealand). On a relative basis, the Swedish economy appears to have bottomed relative to that of the U.S., making the SEK/NZD an attractive way to play USD downside. Meanwhile, the carry cost of being short NZD is lower compared to being short the U.S. dollar. Housekeeping We recommended a short USD/JPY position last week, which is currently 1.3% in the money. Our conviction remains high that this could be the best performing trade over the next one-to-three months. For one, the cross has “underperformed” its safe-haven status. The AUD/JPY is back to its 2016 lows, suggesting the market is flirting with another riot point, but the USD/JPY is still well above 100. We expect the latter to eventually give way as currency volatility rises (Chart I-12). Chart i-12Hold Short USD/JPY Positions Hold Short USD/JPY Positions Hold Short USD/JPY Positions   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “A Contrarian View On The Australian Dollar,” dated May 24, 2019, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been negative: Headline and core PCE were both unchanged at 1.5% and 1.6% year-on-year, respectively. Personal income increased by 0.5% month-on-month in April. However, personal spending increased by only 0.3% month-on-month, lower than expected. Michigan consumer sentiment index fell to 100 in May. Markit composite PMI fell to 50.9 in May, with manufacturing and services PMIs both falling to 50.5 and 50.9, respectively. ISM manufacturing PMI fell to 52.1 in May, while non-manufacturing PMI increased to 56.9. MBA mortgage applications increased by 1.5% in May. The trade deficit fell from $51.9 billion to $50.8 billion in April. On the labor market front, initial and continuing jobless claims rose to 218 thousand and 1.682 million, respectively DXY index fell by 0.8% this week. Chairman Powell gave the opening remarks at the FedListens conference organized by the Chicago Fed this Tuesday, during which he stated that the Fed is closely monitoring trade developments, and will act to sustain the expansion. This signals the potential for rate cuts in the coming monetary policy meetings. Report Links: President Trump And The Dollar - May 9, 2019 Take Out Some Insurance - May 3, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been negative with inflation well below target: Markit manufacturing PMI in the euro area fell to 47.7 in May, as expected. Markit services and composite PMI increased to 52.9 and 51.8 respectively in May. Unemployment rate fell to 7.6% in April. Preliminary headline and core CPI both fell to 1.2% and 0.8% year-on-year respectively in May, dropping to the lowest levels in more than one year. Producer price inflation fell to 2.6% year-on-year in April. Retail sales growth fell to 1.5% year-on-year in April. Employment growth was unchanged at 1.3% year-on-year in Q1. EUR/USD increased by 0.8% this week. On Thursday, the ECB decided to leave interest rates unchanged. The Governing Council also expects the key rates to remain at current levels at least through the first half of 2020. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: Housing starts fell by 5.7% year-on-year in April. Construction orders fell by 19.9% year-on-year in April. Consumer confidence fell to 39.4 in May. Nikkei manufacturing PMI increased to 49.8 in May, while Markit services PMI fell to 51.7 in May. Capital spending was positive in Q1, rising 6.1% year-on-year versus expectations of 2.6%. USD/JPY fell by 0.6% this week. Our “Heads I Win, Tails I Don’t Lose Too Much” bet on a short USD/JPY position is currently 1.3% in the money since entered last Friday.                                                                                        Report Links: Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been mixed: Nationwide house prices grew by only 0.6% year-on-year in April. Mortgage approvals increased to 66.3 thousand in April. Money supply (M4) increased by 3% year-on-year in April. Markit manufacturing PMI fell to 49.4 in May, the lowest since 2016. Construction PMI also fell to 48.6, while services PMI increased to 51. GBP/USD increased by 0.5% this week. During Trump’s visit to U.K. this week, he said that U.S. companies should have market access to every sector of the British economy as part of any deal. The pound is likely to trade higher until political uncertainty is reintroduced in July, ahead of elections for a new Conservative leader. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mixed: Private sector credit increased by 3.7% year-on-year in April, slightly lower than expected. AiG performance of manufacturing index fell to 52.7 in May, while the services index increased to 52.5. The current account deficit narrowed to from A$6.3 billion to A$2.9 billion in Q1. Retail sales contracted by 0.1% month-on-month in April. GDP came in at 1.8% year-on-year in Q1, in line with expectations. Trade surplus fell to A$4.9 million in April. AUD/USD increased by 0.76% this week. The RBA cut interest rates by 25 bps to a record low of 1.25% on Tuesday, the first move since August 2016. Governor Philip Lowe emphasized that this decision is not due to deterioration in the Australian economy. Moreover, he believes that while the cut might reduce interest income for many, the effects will be fully passed to mortgage rates, thus lowering payments and boosting disposable income. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been mostly negative: Consumer confidence fell to 119.3 in May. Terms of trade increased by 1% in Q1. ANZ commodity price was unchanged in May. NZD/USD increased by 1.4% this week. The New Zealand dollar is benefitting from rising soft commodity prices, on the back of a poor U.S. planting season. However, we believe terms of trade over the longer term will be more favorable for Australia, compared to New Zealand. Hold strategic long AUD/NZD positions. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been mostly positive: Industrial product prices increased by 0.8% month-on-month in April. GDP growth increased by 1.4% year-on-year in Q1, above expectations.  Markit manufacturing PMI fell to 49.1 in May. Labor productivity increased by 0.3% quarter-on-quarter in Q1. The trade deficit narrowed to C$0.97 billion in April. Exports increased to C$50.7 billion, while imports fell to C$51.7 billion. USD/CAD fell by 1% this week. The latest downdraft in oil prices is likely to have a negative impact on the loonie. We remain short CAD/NOK as a play on better pricing for North Sea crude, versus WTI. Norway will also benefit more from a pickup in European growth.  Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been neutral: Real retail sales fell by 0.7% year-on-year in April, versus the consensus of -0.8%. Headline inflation fell from 0.7% to 0.6% year-on-year in May. Manufacturing PMI increased to 48.6 in May. USD/CHF fell by 1.1% this week. The franc will benefit from rising volatility as penned in our Special Report three weeks ago. Moreover, the franc is still cheap relative to its fair value. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There was little data out of Norway this week: Manufacturing PMI came in at 54.4 in May, from 54 in April. Current account surplus increased from NOK 47.3 billion to NOK 67.8 billion in Q1. USD/NOK fell by 0.6% this week. Our Commodity & Energy team continue to favor oil prices, but have revised down their forecasts from $77/bbl to $73/bbl for Brent this year and next. Despite the recent plunge in crude oil prices, rising inventories in the U.S. allow for OPEC production cuts, which will eventually be bullish. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been positive: Manufacturing PMI jumped to 53.1 in May, versus 50.9 in the previous month. Retail sales grew by 3.9% year-on-year in April. Industrial production increased by 3.3% year-on-year in April. Manufacturing new orders rose by 0.1% year-on-year in April.  Lastly, the current account surplus increased to SEK 63 billion in Q1.  USD/SEK fell by 0.6% this week. We like the Swedish krona as a potential reflation play and are going long SEK/NZD this week for a trade. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Central bankers appear to be in a rush to boost inflation expectations before the next economic downturn. This in practice should be stimulative for the global economy. Historically, currencies of small, open economies are typically the first to benefit from rebounding global growth. Ditto for those whose output gaps have fully closed. However, there appears to be a shift in the behavior of certain currency pairs in the current cycle. For example, the U.S. dollar has tended to perform better in a low-volatility environment in recent years, a shift from the past. Correspondingly, its safe-haven status may have been marginally eroded. The U.S. decision not to extend waivers on Iranian oil exports beyond the May 2 deadline is bullish for petrocurrencies such as the RUB and NOK. The Bank of Canada kept rates on hold but will be hard pressed to meet its inflation mandate before the next downturn. This suggests standing aside on USD/CAD. Rising net short positioning on the yen and Swiss franc is making them attractive from a contrarian standpoint. Place a limit-buy on CHF/NZD at 1.45. Feature Chart I-1Volatility Is Due For A Bounce Volatility Is Due For A Bounce Volatility Is Due For A Bounce The four most important financial variables that could give a near-complete snapshot of the world economy at any point in time are probably the level of the S&P 500, the U.S. 10-year Treasury yield, the trade-weighted dollar and a commodity bellwether, say, crude oil prices. Any permutation of these variables can identify what quadrant the world economy is operating in, with the two most important states being either boom or bust. Taking three of those variables today – the S&P 500 breaking to all-time highs, crude oil prices up 40% from their lows and U.S. 10-year Treasury yields off by almost 100 basis points from their October highs – it is hard to justify why the dollar has hardly budged, this week’s rally aside. Obviously, this is a very simplified view of an intricately complex world economy. But it highlights a point we have been making in recent bulletins: that extended periods of low currency volatility have been very unusual in the post-Bretton Woods world (Chart I-1). The typical narrative has been that as we enter a reflationary window, pro-cyclical currencies should outperform. The reason is simple enough: These economies are export-oriented and tied to the global cycle. So, a rising current account surplus as demand for their goods and services picks up provides underlying support for the currency. Should there be little slack in their domestic economies, this also raises the probability that the central bank tightens monetary policy to fend off future inflationary pressures. It does not hurt if these countries are also commodity producers, since rising terms of trade also provides an additional exchange-rate boost. The reality is that the world is not static, and some of these dynamics have been shifting. The evidence is in the counterfactual: At current levels, China’s credit injection should have lit a fire under pro-cyclical trades because they tend to work in real-time rather than with a lag. The foreign exchange market is one of the deepest and most liquid where new information tends to get digested and discounted instantaneously. As such, the lack of more pronounced strength in pro-cyclical currencies like the Australian, New Zealand and Canadian dollar exchange rates is genuine reason for concern and worth investigation. Why Is The Dollar Breaking Higher? Our Special Report1 on March 29th highlighted the fact that the dollar should be 5-10% higher simply based on measures of relative trends, and recent data corroborate this view. The growth differential between the U.S. and the rest of the world remains wide. Meanwhile, exports and industrial production from Southeast Asia continue to decelerate. Interbank rates in China are spiking higher, suggesting most of the monetary stimulus may have already been frontloaded. And on the earnings front, U.S. profit leadership also continues. It is unclear which of these catalysts was the actual trigger for dollar strength, since these have been in place for a while now, but confirmation from any and all of them was sufficient to reinvigorate the dollar bulls. That said, it is important to pay heed to shifting market forces, but it will be imprudent to change investment strategy on this week’s moves alone. Given these moves, a few observations are in order: Almost all currencies are already falling versus the U.S. dollar – a trend that has been in place for several months now (Chart I-2). This means most of the factors putting upward pressure on the dollar are well understood by the market. For example, global growth has been slowing for well over a year, based on the global PMI. Putting on fresh U.S. long positions is at risk of a washout from stale investors, just as it was back in 2015, a year after growth had peaked. Dollar technicals are also very unfavorable (Chart I-3). Speculators are holding near-record long positions, sentiment is stretched and our intermediate-term indicator is also flagging yellow. Over the past five years, confirmation from all three indicators has been followed by some period of U.S. dollar indigestion. This time should be no different. Chart I-2Is It Time To Initiate Fresh Dollar Longs? Is It Time To Initiate Fresh Dollar Longs? Is It Time To Initiate Fresh Dollar Longs? Chart I-3Dollar Technicals Are Unfavourable Dollar Technicals Are Unfavourable Dollar Technicals Are Unfavourable A breakout in the dollar along with rising equity markets suggests that the correlation is once again shifting. The dollar has tended to trade as a counter-cyclical currency for most of the time, with a negative correlation even to global equities (Chart I-4). Importantly, given current low levels of volatility and elevated equity market valuations, the dollar would have been a great insurance policy for any stock market correction. But with U.S. interest rates having risen significantly versus almost all G10 countries in recent years, the dollar has itself become the object of carry trades. This has also come with a good number of unhedged trades, as the rising exchange rate has lifted hedging costs (Table I-1). Chart I-4The Dollar Remains A 'Risk-Off' Currency The Dollar Remains A 'Risk-Off' Currency The Dollar Remains A 'Risk-Off' Currency Chart I- It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions. For one, safe-haven assets tend to be lower-yielding but also during episodes of capital flight, investors choose to repatriate capital to pay down debt, with creditor nations having the upper hand. And given U.S. investors have already been repatriating close to $400 billion in assets over the past 12 months, it is unlikely this pace persists (Chart I-5). The bottom line is that investors who believe that the U.S. dollar has become a high-beta currency should be prepared to stampede out the door on any rise in volatility. Our bias remains that the U.S. dollar will ultimately weaken, given that the forces driving it higher are mostly behind us. Meanwhile, currencies such as the Japanese yen or even Swiss franc that have been used to fund carry trades are very ripe for short-covering flows. Putting everything together suggests at minimum building portfolio hedges. It will be difficult for the dollar to act as both a safe-haven and carry currency. One such hedge is going long CHF/NZD. This trade has a high negative carry, so we do not intend to hold it for longer than three months. But speculative positioning and relative economic trends also support this cross for the time being (Chart I-6). We are placing a limit-buy at 1.45. Chart I-5How Much More Will Repatriation Flows Help? How Much More Will Repatriation Flows Help? How Much More Will Repatriation Flows Help? Chart I-6CHF/NZD Is An Attractive ##br##Hedge CHF/NZD Is An Attractive Hedge CHF/NZD Is An Attractive Hedge A Shifting Landscape If the dollar eventually weakens, let’s consider the premise that the most export-dependent economies should benefit more from a rebound in global growth, and by extension, their currencies should appreciate the most. Within the G10 universe, this will be notably the European currencies led by the Swiss franc, the Swedish Krona, the euro and the pound (Chart I-7). However, from the trough in the global Purchasing Managers’ Index (PMI) in December 2008 until the peak in April 2010, it was the commodity currencies that outperformed. During that time frame, the Swiss franc actually fell. It is well known that Switzerland’s persistent trade surplus over the decades has been a key factor behind structural appreciation in the currency. However, at any point in time, other nuances such as whether the rebound is China or commodities driven, the starting point for valuations or even interest rate differentials take center stage in explaining currency moves. The lesson is that investors have to become nimble with currency investment strategy. The lesson is that investors have to become nimble with currency investment strategy. For pro-cyclical currencies, there have been dramatic shifts in the export share of GDP for various countries, according to World Bank data. Most euro area countries have massively expanded their export share of GDP as they have gained ground in value-added products and services. Meanwhile, the export share in Australian GDP has been stuck at 20% for many years, while that in Norway, New Zealand and Canada has seen a huge drop, even since 2009 (Chart I-8). At first blush, this suggests diminishing marginal returns to their currencies from global growth. Chart I-7 Chart I-8A Shifting Export ##br##Landscape A Shifting Export Landscape A Shifting Export Landscape Take the example of New Zealand, where commodities are over 75% of exports. Since the 2000s, the government has been actively trying to redistribute growth from net exports to domestic demand. This has been mainly via the skilled workers program. The result has been a collapse in the export share of GDP from 36% to about 26%. This means that the New Zealand dollar, which has typically been a higher-beta play on global growth, is giving way to other currencies such as the euro and the Swedish krone (Chart I-4). In addition to this, while global growth might eventually recover, part of the widespread deterioration since the global financial crisis may be structural. If the overarching theme over slowing global trade is a global economy that is trying to lift its precautionary savings and spend less, then the world may not see the high rates of trade growth registered in the 1990s anytime soon. This is because at a lower rate of potential GDP growth, trade elasticities also tend to fall.2 There are many reasons for this, including less willingness among creditor nations to finance current account deficits, the paradox of thrift or just outright saturation in the turnover of trade. All of this dampens marginal returns toward all pro-cyclical currency trades. Chart I-9Trade Volatility Has Fallen Trade Volatility Has Fallen Trade Volatility Has Fallen The bottom line is that the overall magnitude and volatility of trade relative to GDP has fallen, at least until the recent China – U.S. trade spat (Chart I-9). This has had the effect of dampening the volatility of the corresponding mediums of trade exchanges. Part of this is clearly cyclical, but a part may be structural as well. If we embrace confirmation that the Chinese economy has bottomed, it will be important to monitor if this cycle plays out like those in the past. Notes On Petrocurrencies, And The BoC The U.S. has decided not to extend waivers on Iranian oil exports beyond the May 2 deadline. Supposedly, a coalition with both Saudi Arabia and the United Arab Emirates would ensure that oil markets remain adequately supplied, though Saudi Arabia has since signaled they are in no rush to raise production. Overall, this increases the bullish narrative for oil. First, the Iranian response to a shutoff in their exports could be unpredictable. The U.S. threat of driving Iranian oil exports to zero increases the geopolitical risk premium in prices, as full implementation pushes Iran to a wall, raising the odds of retaliation. Chart I-10Iran Is A Meaningful Oil Supplier Iran Is A Meaningful Oil Supplier Iran Is A Meaningful Oil Supplier Second, oil production is being curtailed at a time when Venezuelan output is rapidly falling, conflict in Libya is reviving and OPEC spare capacity remains tight. This could nudge the oil market dangerously close to a negative supply shock (Chart I-10). Meanwhile, there is the non-negligible risk of unplanned outages which have been rising in 2019, which is another source of risk for oil supply Oil futures have responded positively to the news, with both Brent and WTI making fresh 2019 highs. However, while initially reacting favorably, petrocurrencies such as the Canadian dollar, Russian ruble and Norwegian krone are selling off amid dollar strength. We think Brent will continue to trade at a premium to WCS crude. This bodes well for currencies tied to North Sea production. Hold short CAD/NOK and long NOK/SEK positions, despite the selloff this week. As for Canada, we are neutral on the loonie both short and medium term. The dovish shift by the BoC and looser fiscal policy are likely to be growth tailwinds. So is the rise in oil prices. However, there appears to be a genuine slowdown in the Canadian economy that is not yet fully reflected in economic forecasts.  The key drivers for the CAD/USD exchange rate are interest rate differentials with the U.S. (which we think will compress further) and energy prices (which we think Canada benefits less from due to the discount Canadian oil sells for, and persistent infrastructure problems). As such, we think domestic conditions will continue to knock down whatever benefit comes from rising oil prices (Chart I-11). Chart I-11CAD/USD Will Benefit From##br## Rising Terms Of Trade CAD/USD Will Benefit From Rising Terms Of Trade CAD/USD Will Benefit From Rising Terms Of Trade Chart I-12Can The BoC Hike Given ##br##This Backdrop? (1) Can The BoC Hike Given This Backdrop? (1) Can The BoC Hike Given This Backdrop? (1) On the consumer side, real retail sales are deflating at the worst pace since the financial crisis, and demand for housing loans is falling off (Chart I-12). This is unlikely to improve if house prices continue to roll over (Chart I-13). A study by the Reserve Bank of New Zealand shows that on average, the elasticity of consumption growth to house price changes is asymmetric with negative housing shocks, hurting consumption by more than the boost received from positive shocks. This asymmetry may be due to the fact that at very elevated debt levels, leveraged gains are used to pay down debt aggressively, whereas leveraged losses hit bottom lines directly. There appears to be a genuine slowdown in the Canadian economy that is not yet fully reflected in economic forecasts. On the corporate side of the equation, the latest Canadian Business Outlook Survey is very telling. Firms’ expectations for sales have softened significantly, as businesses in several sectors are less optimistic about demand. This is driven by uncertainty in the oil patch, weak housing and weak external conditions. This in turn, has led to a steep drop in plans to increase capex (Chart I-14). For external investors, the large stock of debt in the Canadian private sector and overvaluation in the housing market are likely to continue leading to equity outflows on a rate-of-change basis. Chart I-13Can The BoC Hike Given This Backdrop? (2) Can The BoC Hike Given This Backdrop? (2) Can The BoC Hike Given This Backdrop? (2) Chart I-14Can The BoC Hike Given This Backdrop? (3) Can The BoC Hike Given This Backdrop? (3) Can The BoC Hike Given This Backdrop? (3) Technically, USD/CAD failed to break below the upward sloping trendline drawn from its 2017 lows. The next resistance zone is the 1.36-1.38 level. Our bias is that this zone will prove to be formidable resistance. We continue to recommend investors short the CAD, mainly via the euro. Housekeeping Our limit-buy on AUD/USD was triggered at 0.70. Place tight stops at 0.68 until further evidence that global growth has bottomed. Our short USD/SEK position garnered losses this week. The RiksBank’s dovish shift surprised the market, and triggered panic selling as important technical levels were broken. With a manufacturing PMI at 52.8, inflation at 1.8% and wages growing near 3%, this is not exactly the symptoms of an economy that needs more stimulus. We recommend holding onto positions, but will respect our stop loss a few hundred pips away. Finally, the dovish shift by the Bank of Japan does not change our thinking on the yen. The resilience in the currency might indicate the pool of yen bears has been exhausted.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled “Tug Of War With Gold As Umpire,” dated March 29, 2019, available at fes.bcaresearch.com. 2 Cristina Constantinescu, Aaditya Mattoo, and Michele Ruta, “The Global Trade Slowdown: Cyclical Or Structural?” IMF working paper (2015). Currencies U.S. Dollar Chart II-1 USD Technicals 1 USD Technicals 1 Chart II-2 USD Technicals 2 USD Technicals 2 ​​​​​ Recent data in the U.S. suggest a weaker housing market: In March, building permits contracted by 1.7% month-on-month, falling to 1.27 million; housing starts decreased by 0.3% month-on-month, coming in at 1.14 million. March new home sales grew by 4.5% month-on-month, coming in at 0.69 million. However, existing home sales contracted by 4.9% month-on-month, falling to 5.21 million. The house price index grew by 0.3% month-on-month in February, in line with expectations. MBA mortgage applications decreased by 7.3% in April. The Chicago Fed National Activity index fell to -0.15 in March, underperforming expectations. Durable goods orders increased by 2.7% in March, surprising to the upside. DXY index appreciated by 1% this week, hitting the highest level since June 2017. While a more accommodative monetary policy stance has been taken in China, global growth momentum remains weak, which is a cause for concern. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 The Euro Chart II-3 EUR Technicals 1 EUR Technicals 1 Chart II-4 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area continue to soften: Italian business confidence and consumer confidence in March fell to 100.6 and 110.5, respectively. April preliminary consumer confidence in the euro area fell to -7.9, below expectations. German IFO business climate fell to 99.2 in April; expectations and current assessment fell to 95.2 and 103.3, respectively. French business confidence improved to 105, while business climate decreased to 101 in April. Italian trade balance came in at a larger surplus of 3.42 billion euro in April. EUR/USD depreciated by 1% this week. The incoming data from the euro area and globally have been weaker than expected. The recent ECB Economic Bulletin remains positive for the growth outlook going forward, stating that “the supportive financing conditions, favorable labor market dynamics and rising wage growth should continue to underpin the euro area expansion.” Report Links: Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 The Yen Chart II-5 JPY Technicals 1 JPY Technicals 1 Chart II-6 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: Headline inflation and core inflation were unchanged at 0.5% and 0.4% year-on-year in March, respectively. Machine tool orders in March contracted by -28.5% year-on-year. All industry activity index fell by 0.2% month-on-month in February, in line with expectations. USD/JPY surged initially by 0.4% ahead of BoJ’s rate decision, then fell sharply, returning flat this week. The BoJ has decided to keep the interest rate on hold at -0.1%. The shift to a calendar-based form of forward guidance is unlikely to be a game-changer on its own. Moreover, the BoJ expects the Japanese economy to pick up through 2021 supported by highly accommodative financial conditions and government spending, despite the weakness of global growth and scheduled consumption tax hike. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound Chart II-7 GBP Technicals 1 GBP Technicals 1 Chart II-8 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been positive: Public sector net borrowing increased to 0.84 billion pounds in March. In April, the CBI retailing reported sales increased to 13. The CBI business optimism came in at -16 in April, an improvement compared to the last reading of -23. GBP/USD fell by 1% this week, mostly affected by the U.S. dollar’s broad strength. The pound is likely to rebound once we see more signs confirming the strength in global growth, given Brexit has been kicked down the road. Report Links: Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 Australian Dollar Chart II-9 AUD Technicals 1 AUD Technicals 1 Chart II-10 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been negative: Headline inflation fell to 1.3% year-on-year in Q1, missing expectations. Trimmed mean inflation in Q1 fell to 1.6% year-on-year. AUD/USD fell by 2.3% this week, which triggered our limit buy order at 0.7 on Wednesday. Inflation is a lagging indicator. While the Q1 inflation number missed expectations, the Australian dollar is likely to bottom as Chinese stimulus plays out and global growth starts to pick up. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 New Zealand Dollar Chart II-11 NZD Technicals 1 NZD Technicals 1 Chart II-12 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been negative: Credit card spending contracted by 5.1% year-on-year in March, underperforming expectations. NZD/USD fell by 1.36% this week. We remain bearish on the New Zealand dollar due to the Achilles’ heel of an overvalued housing market. Moreover, the Kiwi is still expensive compared to its fair value. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13 CAD Technicals 1 CAD Technicals 1 Chart II-14 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been positive: Wholesale sales grew by 0.3% month-in-month in February, surprising to the upside. CFIB business barometer increased to 56.7 in April. USD/CAD surged by 0.95% this week. The Canadian dollar seems to be less responsive to the energy prices this week due to lots of concerns regarding the pipeline issue in Alberta. The Bank of Canada maintained its overnight interest rate target at 1.75% on Wednesday. In the April Monetary Policy Report, the BoC projects real GDP growth of 1.2% in 2019, and around 2% in 2020 and 2021. Given the current developments in household spending, energy investment, and trade conditions, a dovish stance by BoC is warranted. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swiss Franc Chart II-15 CHF Technicals 1 CHF Technicals 1 Chart II-16 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been mostly positive: Money supply M3 grew by 3.5% year-on-year in March, same as last month. ZEW survey expectations increased to -7.7 from the previous reading of -26.9. USD/CHF increased by 0.66% this week. While global growth is set to rebound, the uncertainties regarding geopolitical risks, trade conditions, and oil prices will weigh on the growth pace. We remain neutral on the Swiss franc against U.S. dollar, but acknowledge that the large short positioning is attractive from a contrarian standpoint. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Norwegian Krone Chart II-17 NOK Technicals 1 NOK Technicals 1 Chart II-18 NOK Technicals 2 NOK Technicals 2 There is no significant data from Norway this week. USD/NOK appreciated by 2.2% this week. We remain overweight the NOK based on our bullish outlook for oil. The Trump administration said they would not renew the waivers for Iranian oil exports, a move that roiled the energy market. The spike in oil prices will eventually benefit the Norwegian krone once global growth stabilizes. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swedish Krona Chart II-19 SEK Technicals 1 SEK Technicals 1 Chart II-20 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden suggest a more positive sentiment: Consumer confidence increased to 95.8 in April, surprising to the upside. Economic tendency survey increased to 102.7 in April. Moreover, the manufacturing confidence also improved to 108.4 in April. USD/SEK appreciated by 2.64% this week. The Riksbank has kept its interest rate unchanged at -0.25% this week, as widely expected. The dovish shift of central banks worldwide is likely to help the global economy, which will benefit the Swedish krona. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades