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Your feedback is important to us. Please take our client survey today. Highlights US Election & Duration: We estimate that there is an 80% probability of a US election result that will give a lift to US Treasury yields via increased fiscal stimulus. Those are strong enough odds to justify a move to a below-benchmark cyclical US duration stance on a 6-12 month horizon. US Treasuries: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Country Allocation: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to Canada and Australia. Stay neutral on the UK given the near-term uncertainties over the final Brexit outcome. Feature With the US presidential election just two weeks away, public opinion polls continue to show that Joe Biden is the favorite to win the White House. However, the odds of a “Blue Sweep” - combining a Biden victory with the Democratic Party winning control of both the US Senate and House of Representatives - have increased since the end of September according to online prediction markets. US Treasury yields have also moved higher over that same period (Chart II-1), which we interpret as the bond market becoming more sensitive to the likelihood of a major increase in US government spending under single-party Democratic control. Chart II-1A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish Table II-1A Comparison Of The Candidates' Budget Proposals November 2020 November 2020 According to a recent analysis done by the Committee for a Responsible Federal Budget, President Trump’s formal policy proposals would increase US federal debt by $4.95 trillion between 2021 and 2030, while Biden’s plan would increase the debt by $5.60 trillion (Table II-1).1 While those are both massive fiscal stimulus plans, there is a stark difference in the policy mix of their proposals that matters for the future path of US bond yields. Under Biden, spending is projected to increase by a cumulative $11.1 trillion, partially offset by $5.8 trillion in revenue increases and savings with the former vice-president calling for tax hikes on corporations and high-income earners. On the other hand, Trump’s plan includes $5.45 trillion of spending increases and tax cuts over the next decade, offset by $0.75 trillion in savings. Conclusion: Biden would increase spending by over twice that of a re-elected Trump, with much of that spending expected to be front-loaded in the early part of his first term. Outright spending is more reflationary than tax cuts because it puts more money in the pockets of consumers (spenders) relative to producers (savers). The Biden plan would be more stimulating for overall activity even if the increase in debt is about the same. Chart II-2The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative Another analysis of the Biden and Trump platforms was conducted by Moody’s in September, based on estimates of how much of each candidate’s promises could be successfully implemented under different combinations of White House and Congressional control.2 The stimulus figures were run through the Moody’s US economic model, which is similar to the budget scoring model of the US Congressional Budget Office, to produce a year-by-year path for the US economy over the next decade (Chart II-2). Moody’s concluded that the US economy would return to full employment in the second half of 2022 under a President Biden – especially if the Democrats win the Senate - compared to the first half of 2024 under a re-elected President Trump. Such a rapid closing of the deep US output gap that opened up because of the COVID-19 recession would likely trigger a reassessment of the Fed’s current highly dovish policy stance. At the moment, the US overnight index swap (OIS) curve discounts one full 25bp Fed hike by late 2023/early 2024, and two full hikes by late 2024/early 2025 (Chart II-3). This pricing of the future path of interest rates has occurred even with the Fed promising to keep the funds rate anchored near 0% until at least the end of 2023. The likelihood of some form of increased fiscal spending after the election will cause the bond market to challenge the Fed’s current forward guidance even more, putting upward pressure on Treasury yields. Chart II-3US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff Our colleagues at BCA Geopolitical Strategy see a Blue Sweep as the most likely outcome of the US election, although their forecasting models suggest that the race for control of the Senate will be much closer than the Biden vs Trump battle (there is little chance that control of the House of Representatives would switch back to the Republicans).3 Their scenarios for each of the White House/Senate combinations, along with their own estimated probability for each, are the following: Biden wins in a Democratic sweep: BCA probability = 27%. The US economy will benefit from higher odds of unfettered fiscal stimulus in 2021, although financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. Government bond yields should rise on the generally reflationary agenda. Trump wins with a Republican Senate: BCA probability = 23%. In this status quo scenario, a re-elected President Trump would still face opposition from House Democrats on most domestic economic issues, forcing him to tilt towards more protectionist foreign and trade policies in his second term. Fiscal stimulus would be easy to agree, though not as large as under a Democratic sweep. US Treasury yields would rise, but would later prove volatile due to the risk to the cyclical recovery from a global trade war, as Trump’s tariffs will not be limited to China and could even affect the European Union. Biden wins with the Senate staying Republican: BCA probability = 28%. This is ultimately the most positive outcome for financial markets - reduced odds of a full-blown trade war with China, combined with no new tax hikes. Bond yields would drift upward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators. The first such battle would start right after the election. Treasuries would remain well bid until financial market pressures forced a Senate compromise with the new president sometime in H1 2021. Trump wins with a Democratic Senate: BCA probability = 22%. This is the least likely scenario but one that could produce a big positive fiscal impulse. Trump is a big spender and will veto tax hikes, but will approve populist spending on areas where he agrees. The Democratic Senate would not resist Trump’s tough stance on China, however, thus keeping the risk of US-China trade skirmishes elevated. This is neutral-to-bearish for US Treasuries, depending on the size of any bipartisan stimulus measures and Trump’s trade actions. The key takeaway is that the combined probability of scenarios that will put upward pressure on US Treasury yields is 72%, versus a 28% probability of a more bond-neutral outcome. That is a bond-bearish skew worth positioning for by reducing US duration exposure now, ahead of the November 3 election. Of this 72%, 45 percentage points come from scenarios in which President Trump would remain in power. Hence his trade wars would eventually undercut his reflationary fiscal policy. This would become the key risk to the short duration view after the initial market response. Bottom Line: The most likely scenarios for the US election will give a cyclical lift to US Treasury yields via increased fiscal stimulus. This justifies a move to a below-benchmark US duration stance on a 6-12 month horizon. If Trump is re-elected, the timing of Trump’s likely return to using broad-based tariffs will have to be monitored closely. A Moderate Bear Market While our anticipated Blue Sweep election outcome will lead to a large amount of fiscal spending in 2021 and beyond, we anticipate only a modest increase in bond yields during the next 6-12 months. In terms of strategy, our recommended reduction in portfolio duration reflects the fact that fiscal largesse meaningfully reduces the risk of another significant downleg in bond yields and strengthens our conviction in a moderate bear market scenario for bonds. This does raise the question of how large an increase in US Treasury yields we expect during the next 6-12 months. We turn to this question now. Chart II-4Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart II-4). For one thing, the Fed was much more eager to tighten policy in 2016 than it is today, and it did deliver a rate hike one month after the Republicans won the House, Senate and White House (Chart II-4, bottom panel). This time around, the Fed has made it clear that it will wait until inflation is running above its 2% target before lifting rates off the zero bound and will not respond directly to expectations for greater fiscal stimulus. Second, 2016’s election result was mostly unanticipated. This led to a dramatic adjustment in market prices once the results came in. The PredictIt betting market odds of a “Red Sweep” by the Republicans in 2016 were only 16% the night before the election. As of today, the betting markets are priced for a 58% chance of a Blue Sweep in 2020. Unlike in 2016, bonds are presumably already partially priced for the most bond-bearish election outcome. A Slow Return To Equilibrium To more directly answer the question of how high bond yields can rise, survey estimates of the long-run (or equilibrium) federal funds rate provide a useful starting point. In a world where the economy is growing at an above-trend pace and inflation is expected to move towards the Fed’s target, it is logical for long-maturity Treasury yields to settle near estimates of the long-run fed funds rate. Indeed, this theory is borne out empirically. During the last two periods of robust global economic growth (2017/18 & 2013/14), the 5-year/5-year forward Treasury yield peaked around levels consistent with long-run fed funds rate estimates (Chart II-5). As of today, the median estimates of the long-run fed funds rate from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers are 2% and 2.25%, respectively. In other words, a complete re-convergence to these equilibrium levels would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. We expect this re-convergence to play out eventually, but probably not within the next 6-12 months. In both prior periods when the 5-year/5-year forward Treasury yield reached these equilibrium levels, the Fed’s reaction function was much more hawkish. The Fed was hiking rates throughout 2017 & 2018 (Chart II-5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart II-5, bottom panel). The Fed’s new dovish messaging will ensure that the market reacts less quickly this time around. Also, continued curve steepening will mean that the 5-year/5-year forward yield’s 80 – 100 bps of upside will translate into significantly less upside for the benchmark 10-year yield. The 10-year yield and 5-year/5-year forward yield peaked at similar levels in 2017/18 when the Fed was lifting rates and the yield curve was flat (Chart II-6). But, the 10-year peaked far below the 5-year/5-year yield in 2013/14 when the Fed stayed on hold and the curve steepened. Chart II-5How High For Treasury Yields? How High For Treasury Yields? How High For Treasury Yields? Chart II-6Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y   The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart II-6, bottom panel).4 TIPS Versus Nominals We have seen that a full re-convergence to “equilibrium” implies 80 – 100 bps of upside in the 5-year/5-year forward nominal Treasury yield. Bringing TIPS into the equation, we have also observed that long-maturity (5-year/5-year forward and 10-year) TIPS breakeven inflation rates tend to settle into a range of 2.3 – 2.5 percent when inflation is well-anchored and close to the Fed’s target (Chart II-7). The additional fiscal stimulus that will follow a Blue Sweep election makes it much more likely that the economic recovery will stay on course, leading to an eventual return of inflation to target and of long-maturity TIPS breakeven inflation rates to a 2.3 – 2.5 percent range. However, as with nominal yields, this re-convergence will be a long process whose pace will be dictated by the actual inflation data. To underscore that point, consider that our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate – a model that is driven by trends in the actual inflation data – has the 10-year breakeven rate as close to fair value (Chart II-8).5 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart II-7Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Chart II-8Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed   All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart II-8, bottom panel).6 Chart II-9Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners Two More Curve Trades In addition to moving to below-benchmark duration, maintaining nominal yield curve steepeners and staying overweight TIPS versus nominal Treasuries, there are two additional trades that investors should consider in order to profit from the reflationary economic environment. The first is inflation curve flatteners. The cost of short-maturity inflation protection is below the cost of long-maturity inflation protection, meaning that it has further to run as inflation returns to the Fed’s target (Chart II-9). In addition, if the Fed eventually succeeds in achieving a temporary overshoot of its inflation target, then we should expect the inflation curve to invert. Real yield curve steepeners are in some ways the mirror image of inflation curve flatteners. Assuming no change in nominal yields, the real yield curve will steepen as the inflation curve flattens. But what makes real yield curve steepeners look even more attractive is that increases in nominal yields during the next 6-12 months will be concentrated in long-maturities. This will impart even more steepening pressure to the real yield curve. Investors should continue to hold inflation curve flatteners and real yield curve steepeners. Bottom Line: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Government Bonds: Reduce Exposure To US Treasuries The mildly bearish case for US Treasuries that we have laid out above not only matters for our recommended duration stance, but also for our suggested country allocation within global government bond portfolios. Simply put, the risk of rising bond yields is much higher in the US than elsewhere, both for the immediate post-election period but also over the medium-term. Thus, the immediate obvious portfolio decision is to downgrade US Treasuries to underweight. The move higher in US Treasury yields that we expect is strictly related to spillovers from likely US fiscal stimulus. While other countries in the developed world are contemplating the need for additional fiscal measures, particularly in Europe where there is a renewed surge in coronavirus infections and growing economic restrictions, no country is facing as sharp a policy choice as the US with its upcoming election. We can say with a fair degree of certainty that the US will have a relatively more stimulative fiscal policy stance than other developed economies over at least the next couple of years. This implies a higher relative growth trajectory for the US that hurts Treasuries more on the margin than non-US government debt. In addition, the likely path of relative monetary policy responses are more bearish for US Treasuries. As described above, the scope of the US stimulus will cause bond investors to further question the Fed’s commitment to keeping the funds rate unchanged for the next few years. That also applies to the Fed’s other policy tools, like asset purchases. The Fed is far less likely to continue buying US Treasuries at the same aggressive pace it has for the past eight months if there is less need for monetary stimulus because of more fiscal stimulus. Chart II-10The Fed Will Gladly Trade Less QE For More Fiscal Stimulus November 2020 November 2020 According to the IMF, the Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued (Chart II-10). If US Treasury yields are rising because of improving US growth expectations, fueled by fiscal stimulus, the Fed will likely tolerate such a move and buy an even lower share of Treasuries issued – particularly if the higher bond yields do not cause a selloff in US equity markets that can tighten financial conditions and threaten the growth outlook. The fact that US equities have ignored the rise in Treasury yields seen since the end of September may be a sign that both bond and stock investors are starting to focus on a faster trajectory for US growth. In terms of country allocation, beyond downgrading US Treasuries to underweight, we recommend upgrading exposure to countries that are less sensitive to changes in US Treasury yields (i.e. countries with a lower yield beta to changes in US yields). In Chart II-11, we show the rolling beta of changes in 10-year government bond yields outside the US to changes in 10-year US Treasury yields. This is a variation of the “global yield beta” concept that we have discussed in the BCA Research bond publications in recent years. Here, we modify the idea to look at which countries are more or less correlated to US yields, specifically. A few points stand out from the chart: Chart II-11Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields All countries have a “US yield beta” of less than 1, suggesting that Treasuries are a consistent outperformer when US yields fall and vice versa. This suggests moving to underweight the US when US yields are rising is typically a winning strategy in a portfolio context. The list of higher beta countries includes Canada, Australia, New Zealand, the UK and Germany; although Canada stands out as having the highest yield beta in this group. The list of lower beta countries includes France, Italy, Spain, and Japan. In Chart II-12, we show what we call the “upside yield beta” that is estimated only using data for periods when Treasury yields are rising. This gives a sense of which countries are more likely to outperform or underperform during a period of rising Treasury yields, as we expect to unfold after the election. From this perspective, the “safer” lower US upside yield beta group includes the UK, France, Germany and Japan. The riskier higher US upside yield beta group includes Canada, Australia, New Zealand, Italy and Spain. Chart II-12Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Spain and Italy are less likely to behave like typical high-beta countries as US yields rise, however, because the ECB is likely to remain an aggressive buyer of their government bonds as part of their asset purchase programs over the next 6-12 months. We also do not recommend trading UK Gilts off their yield beta to US Treasuries in the immediate future, given the uncertainties over the negotiations over a final Brexit deal. Both sets of US yield betas suggest higher-beta Canada, Australia and New Zealand are more at risk of relative underperformance versus lower-beta France, Germany and Japan. In terms of government bond country allocation, we recommend reducing exposure to the former group and increasing allocations to the latter group. Bottom Line: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields, especially those with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to “higher-beta” Canada and Australia.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 2 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 3 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 4 For more details on this recommended steepener trade please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 5 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 6 For a detailed look at the implications of the Fed’s policy shift please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com

Highlights US Election & Duration: We estimate that there is an 80% probability of a US election result that will give a lift to US Treasury yields via increased fiscal stimulus. Those are strong enough odds to justify a move to a below-benchmark cyclical US duration stance on a 6-12 month horizon. US Treasuries: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Country Allocation: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to Canada and Australia. Stay neutral on the UK given the near-term uncertainties over the final Brexit outcome. Feature With the US presidential election just two weeks away, public opinion polls continue to show that Joe Biden is the favorite to win the White House. However, the odds of a “Blue Sweep” - combining a Biden victory with the Democratic Party winning control of both the US Senate and House of Representatives - have increased since the end of September according to online prediction markets. US Treasury yields have also moved higher over that same period (Chart 1), which we interpret as the bond market becoming more sensitive to the likelihood of a major increase in US government spending under single-party Democratic control. Chart 1A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish According to a recent analysis done by the Committee for a Responsible Federal Budget, President Trump’s formal policy proposals would increase US federal debt by $4.95 trillion between 2021 and 2030, while Biden’s plan would increase the debt by $5.60 trillion (Table 1).1 While those are both massive fiscal stimulus plans, there is a stark difference in the policy mix of their proposals that matters for the future path of US bond yields. Table 1A Comparison Of The Candidates' Budget Proposals Beware The Bond-Bearish Blue Sweep Beware The Bond-Bearish Blue Sweep Under Biden, spending is projected to increase by a cumulative $11.1 trillion, partially offset by $5.8 trillion in revenue increases and savings with the former vice-president calling for tax hikes on corporations and high-income earners. On the other hand, Trump’s plan includes $5.45 trillion of spending increases and tax cuts over the next decade, offset by $0.75 trillion in savings. Conclusion: Biden would increase spending by over twice that of a re-elected Trump, with much of that spending expected to be front-loaded in the early part of his first term. Outright spending is more reflationary than tax cuts because it puts more money in the pockets of consumers (spenders) relative to producers (savers). The Biden plan would be more stimulating for overall activity even if the increase in debt is about the same. Another analysis of the Biden and Trump platforms was conducted by Moody’s in September, based on estimates of how much of each candidate’s promises could be successfully implemented under different combinations of White House and Congressional control.2 The stimulus figures were run through the Moody’s US economic model, which is similar to the budget scoring model of the US Congressional Budget Office, to produce a year-by-year path for the US economy over the next decade (Chart 2). Chart 2The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative Moody’s concluded that the US economy would return to full employment in the second half of 2022 under a President Biden – especially if the Democrats win the Senate - compared to the first half of 2024 under a re-elected President Trump. Such a rapid closing of the deep US output gap that opened up because of the COVID-19 recession would likely trigger a reassessment of the Fed’s current highly dovish policy stance. The US output gap would close more rapidly under a President Biden, likely triggering a reassessment of the Fed’s current highly dovish policy stance.  At the moment, the US overnight index swap (OIS) curve discounts one full 25bp Fed hike by late 2023/early 2024, and two full hikes by late 2024/early 2025 (Chart 3). This pricing of the future path of interest rates has occurred even with the Fed promising to keep the funds rate anchored near 0% until at least the end of 2023. The likelihood of some form of increased fiscal spending after the election will cause the bond market to challenge the Fed’s current forward guidance even more, putting upward pressure on Treasury yields. Chart 3US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff Our colleagues at BCA Geopolitical Strategy see a Blue Sweep as the most likely outcome of the US election, although their forecasting models suggest that the race for control of the Senate will be much closer than the Biden vs Trump battle (there is little chance that control of the House of Representatives would switch back to the Republicans).3 Their scenarios for each of the White House/Senate combinations, along with their own estimated probability for each, are the following: Biden wins in a Democratic sweep: BCA probability = 45%. The US economy will benefit from higher odds of unfettered fiscal stimulus in 2021, although financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. Government bond yields should rise on the generally reflationary agenda. Trump wins with a Republican Senate: BCA probability = 30%. In this status quo scenario, a re-elected President Trump would still face opposition from House Democrats on most domestic economic issues, forcing him to tilt towards more protectionist foreign and trade policies in his second term. Fiscal stimulus would be easy to agree, though not as large as under a Democratic sweep. US Treasury yields would rise, but would later prove volatile due to the risk to the cyclical recovery from a global trade war, as Trump’s tariffs will not be limited to China and could even affect the European Union. Biden wins with the Senate staying Republican: BCA probability = 20%. This is ultimately the most positive outcome for financial markets - reduced odds of a full-blown trade war with China, combined with no new tax hikes. Bond yields would drift upward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators. The first such battle would start right after the election. Treasuries would remain well bid until financial market pressures forced a Senate compromise with the new president sometime in H1 2021. Trump wins with a Democratic Senate: BCA probability = 5%. This is the least likely scenario but one that could produce a big positive fiscal impulse. Trump is a big spender and will veto tax hikes, but will approve populist spending on areas where he agrees. The Democratic Senate would not resist Trump’s tough stance on China, however, thus keeping the risk of US-China trade skirmishes elevated. This is neutral-to-bearish for US Treasuries, depending on the size of any bipartisan stimulus measures and Trump’s trade actions. The key takeaway is that the combined probability of scenarios that will put upward pressure on US Treasury yields is 80%, versus a 20% probability of a more bond-neutral outcome. That is a bond-bearish skew worth positioning for by reducing US duration exposure now, ahead of the November 3 election. Of this 80%, 35 percentage points come from scenarios in which President Trump would remain in power. Hence his trade wars would eventually undercut his reflationary fiscal policy. This would become the key risk to the short duration view after the initial market response. Bottom Line: The most likely scenarios for the US election will give a cyclical lift to US Treasury yields via increased fiscal stimulus. This justifies a move to a below-benchmark US duration stance on a 6-12 month horizon. If Trump is re-elected, the timing of Trump’s likely return to using broad-based tariffs will have to be monitored closely. A Moderate Bear Market Chart 4Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 While our anticipated Blue Sweep election outcome will lead to a large amount of fiscal spending in 2021 and beyond, we anticipate only a modest increase in bond yields during the next 6-12 months. In terms of strategy, our recommended reduction in portfolio duration reflects the fact that fiscal largesse meaningfully reduces the risk of another significant downleg in bond yields and strengthens our conviction in a moderate bear market scenario for bonds. This does raise the question of how large an increase in US Treasury yields we expect during the next 6-12 months. We turn to this question now. Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart 4). For one thing, the Fed was much more eager to tighten policy in 2016 than it is today, and it did deliver a rate hike one month after the Republicans won the House, Senate and White House (Chart 4, bottom panel). This time around, the Fed has made it clear that it will wait until inflation is running above its 2% target before lifting rates off the zero bound and will not respond directly to expectations for greater fiscal stimulus. A complete re-convergence to long-run fed funds rate estimates would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. Second, 2016’s election result was mostly unanticipated. This led to a dramatic adjustment in market prices once the results came in. The PredictIt betting market odds of a “Red Sweep” by the Republicans in 2016 were only 16% the night before the election. As of today, the betting markets are priced for a 58% chance of a Blue Sweep in 2020. Unlike in 2016, bonds are presumably already partially priced for the most bond-bearish election outcome. A Slow Return To Equilibrium To more directly answer the question of how high bond yields can rise, survey estimates of the long-run (or equilibrium) federal funds rate provide a useful starting point. In a world where the economy is growing at an above-trend pace and inflation is expected to move towards the Fed’s target, it is logical for long-maturity Treasury yields to settle near estimates of the long-run fed funds rate. Indeed, this theory is borne out empirically. During the last two periods of robust global economic growth (2017/18 & 2013/14), the 5-year/5-year forward Treasury yield peaked around levels consistent with long-run fed funds rate estimates (Chart 5). As of today, the median estimates of the long-run fed funds rate from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers are 2% and 2.25%, respectively. In other words, a complete re-convergence to these equilibrium levels would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. We expect this re-convergence to play out eventually, but probably not within the next 6-12 months. In both prior periods when the 5-year/5-year forward Treasury yield reached these equilibrium levels, the Fed’s reaction function was much more hawkish. The Fed was hiking rates throughout 2017 & 2018 (Chart 5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart 5, bottom panel). The Fed’s new dovish messaging will ensure that the market reacts less quickly this time around. Also, continued curve steepening will mean that the 5-year/5-year forward yield’s 80 – 100 bps of upside will translate into significantly less upside for the benchmark 10-year yield. The 10-year yield and 5-year/5-year forward yield peaked at similar levels in 2017/18 when the Fed was lifting rates and the yield curve was flat (Chart 6). But, the 10-year peaked far below the 5-year/5-year yield in 2013/14 when the Fed stayed on hold and the curve steepened. Chart 5How High For Treasury Yields? How High For Treasury Yields? How High For Treasury Yields? Chart 6Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart 6, bottom panel).4 TIPS Versus Nominals We have seen that a full re-convergence to “equilibrium” implies 80 – 100 bps of upside in the 5-year/5-year forward nominal Treasury yield. Bringing TIPS into the equation, we have also observed that long-maturity (5-year/5-year forward and 10-year) TIPS breakeven inflation rates tend to settle into a range of 2.3 – 2.5 percent when inflation is well-anchored and close to the Fed’s target (Chart 7). The additional fiscal stimulus that will follow a Blue Sweep election makes it much more likely that the economic recovery will stay on course, leading to an eventual return of inflation to target and of long-maturity TIPS breakeven inflation rates to a 2.3 – 2.5 percent range. However, as with nominal yields, this re-convergence will be a long process whose pace will be dictated by the actual inflation data. To underscore that point, consider that our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate – a model that is driven by trends in the actual inflation data – has the 10-year breakeven rate as close to fair value (Chart 8).5 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart 7Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Chart 8Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart 8, bottom panel).6 Two More Curve Trades Chart 9Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners In addition to moving to below-benchmark duration, maintaining nominal yield curve steepeners and staying overweight TIPS versus nominal Treasuries, there are two additional trades that investors should consider in order to profit from the reflationary economic environment. The first is inflation curve flatteners. The cost of short-maturity inflation protection is below the cost of long-maturity inflation protection, meaning that it has further to run as inflation returns to the Fed’s target (Chart 9). In addition, if the Fed eventually succeeds in achieving a temporary overshoot of its inflation target, then we should expect the inflation curve to invert. Real yield curve steepeners are in some ways the mirror image of inflation curve flatteners. Assuming no change in nominal yields, the real yield curve will steepen as the inflation curve flattens. But what makes real yield curve steepeners look even more attractive is that increases in nominal yields during the next 6-12 months will be concentrated in long-maturities. This will impart even more steepening pressure to the real yield curve. Investors should continue to hold inflation curve flatteners and real yield curve steepeners. Bottom Line: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Government Bonds: Reduce Exposure To US Treasuries The mildly bearish case for US Treasuries that we have laid out above not only matters for our recommended duration stance, but also for our suggested country allocation within global government bond portfolios. Simply put, the risk of rising bond yields is much higher in the US than elsewhere, both for the immediate post-election period but also over the medium-term. Thus, the immediate obvious portfolio decision is to downgrade US Treasuries to underweight. The move higher in US Treasury yields that we expect is strictly related to spillovers from likely US fiscal stimulus. While other countries in the developed world are contemplating the need for additional fiscal measures, particularly in Europe where there is a renewed surge in coronavirus infections and growing economic restrictions, no country is facing as sharp a policy choice as the US with its upcoming election. The Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued. We can say with a fair degree of certainty that the US will have a relatively more stimulative fiscal policy stance than other developed economies over at least the next couple of years. This implies a higher relative growth trajectory for the US that hurts Treasuries more on the margin than non-US government debt. Chart 10The Fed Will Gladly Trade Less QE For More Fiscal Stimulus Beware The Bond-Bearish Blue Sweep Beware The Bond-Bearish Blue Sweep In addition, the likely path of relative monetary policy responses are more bearish for US Treasuries. As described above, the scope of the US stimulus will cause bond investors to further question the Fed’s commitment to keeping the funds rate unchanged for the next few years. That also applies to the Fed’s other policy tools, like asset purchases. The Fed is far less likely to continue buying US Treasuries at the same aggressive pace it has for the past eight months if there is less need for monetary stimulus because of more fiscal stimulus. According to the IMF, the Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued (Chart 10). If US Treasury yields are rising because of improving US growth expectations, fueled by fiscal stimulus, the Fed will likely tolerate such a move and buy an even lower share of Treasuries issued – particularly if the higher bond yields do not cause a selloff in US equity markets that can tighten financial conditions and threaten the growth outlook. The fact that US equities have ignored the rise in Treasury yields seen since the end of September may be a sign that both bond and stock investors are starting to focus on a faster trajectory for US growth. In terms of country allocation, beyond downgrading US Treasuries to underweight, we recommend upgrading exposure to countries that are less sensitive to changes in US Treasury yields (i.e. countries with a lower yield beta to changes in US yields). In Chart 11, we show the rolling beta of changes in 10-year government bond yields outside the US to changes in 10-year US Treasury yields. This is a variation of the “global yield beta” concept that we have discussed in the BCA Research bond publications in recent years. Here, we modify the idea to look at which countries are more or less correlated to US yields, specifically. A few points stand out from the chart: Chart 11Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields All countries have a “US yield beta” of less than 1, suggesting that Treasuries are a consistent outperformer when US yields fall and vice versa. This suggests moving to underweight the US when US yields are rising is typically a winning strategy in a portfolio context. The list of higher beta countries includes Canada, Australia, New Zealand, the UK and Germany; although Canada stands out as having the highest yield beta in this group. The list of lower beta countries includes France, Italy, Spain, and Japan. In Chart 12, we show what we call the “upside yield beta” that is estimated only using data for periods when Treasury yields are rising. This gives a sense of which countries are more likely to outperform or underperform during a period of rising Treasury yields, as we expect to unfold after the election. From this perspective, the “safer” lower US upside yield beta group includes the UK, France, Germany and Japan. The riskier higher US upside yield beta group includes Canada, Australia, New Zealand, Italy and Spain. Chart 12Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Spain and Italy are less likely to behave like typical high-beta countries as US yields rise, however, because the ECB is likely to remain an aggressive buyer of their government bonds as part of their asset purchase programs over the next 6-12 months. We also do not recommend trading UK Gilts off their yield beta to US Treasuries in the immediate future, given the uncertainties over the negotiations over a final Brexit deal. Both sets of US yield betas suggest higher-beta Canada, Australia and New Zealand are more at risk of relative underperformance versus lower-beta France, Germany and Japan. In terms of government bond country allocation, we recommend reducing exposure to the former group and increasing allocations to the latter group. Bottom Line: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields, especially those with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to “higher-beta” Canada and Australia.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 2 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 3 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 4 For more details on this recommended steepener trade please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 5 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 6 For a detailed look at the implications of the Fed’s policy shift please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com

Highlights We remain bearish on the US dollar over the next 12 months. The best vehicle to express this view continues to be the Scandinavian currencies (NOK and SEK). Precious metals remain a buy so long as the dollar faces downside. However, we remain more bullish on silver than gold. Go short the gold/silver ratio (GSR) again at 75. At the crosses, our favorite trade is short NZD against other cyclical currency pairs. These include the CAD, AUD, and SEK. Sterling is selling off as we anticipated, but our timing was offside. That said, the pound is cheap. We will go long cable if it falls below 1.25. Short EUR/GBP at current levels. The Swiss franc will continue to appreciate versus the USD, but will lag behind the euro. EUR/CHF will touch 1.15. We prefer the JPY to the CHF as a currency portfolio hedge. We argued last week that Prime Minster Shinzo Abe’s resignation does not change the yen’s outlook. Feature Our trade basket this year has been centered on a dollar-bearish theme. Since the top in the DXY index on March 19th, we have been expressing this view via various vehicles, most of which have been very profitable. Our favorites have been the Scandinavian currencies, silver, and the AUD, either at the crosses or against the US dollar. So far, these are among the best-performing trades in the G10 currency world (Chart I-1). Chart I-1A Currency Report Card Revisiting Our High-Conviction Trades Revisiting Our High-Conviction Trades Going into the final leg of 2020, the key question is which currency pairs will provide the most upside. In this report, we revisit the rationale behind our high-conviction trades. The Case For Scandinavian Currencies A review of Q2 GDP across the G10 reveals which countries have been doing relatively better during the pandemic. Norway emerges as the economy that had the best quarter-on-quarter annualized growth (Chart I-2). Swedish growth held up very well in Q1 and even the drop in Q2 still puts it well ahead of the US, the euro area, and the UK. As small, open economies which are very sensitive to global growth conditions, this is a very impressive feat for Sweden and Norway. Part of the reason for this is that over the years, the drop in their currencies, both against the US dollar and euro, has made them very competitive. Chart I-2A Currency Report Card A Currency Report Card A Currency Report Card Norway benefited from a few things during the pandemic. First, as a major oil exporter, the sharp fall in the NOK helped cushion the domestic economy against the crash in crude prices. Second, the handling of the pandemic was swift and rigorous, and this has almost completely purged the number of new infections in Norway. Third, aggressive monetary and fiscal stimulus (zero rates, quantitative easing, and the first budget deficit in 40 years) has set the economy on a recovery path. As a result, consumption is rebounding smartly and the Norges Bank expects mainland GDP to touch pre-crisis levels by 2023. Already, real retail sales have exploded higher (Chart I-3). Should global growth continue to rebound, a reversal in pessimism towards energy stocks (and value stocks in general) could see investors reprice the Norwegian stock market (and krone) sharply higher (Chart I-4). Chart I-3Norwegian Consumption Has##br##Recovered Norwegian Consumption Has Recovered Norwegian Consumption Has Recovered Chart I-4A Bounce In Oil & Gas Stocks Will Help The Krone A Bounce In Oil & Gas Stocks Will Help The Krone A Bounce In Oil & Gas Stocks Will Help The Krone In the case of Sweden, the sharp rebound in the manufacturing PMI also suggests the industrial base is recovering. This will also coincide with a solid bounce in exports, cementing Sweden’s rise in relative competitiveness and its exit from the pandemic-induced recession (Chart I-5). The Riksbank’s resource utilization indicator has stabilized, suggesting deflationary pressures are abating. Meanwhile, home prices are on the cusp of a recovery, which should help boost consumer confidence and support consumption. With our models showing the Swedish krona as undervalued by 19% versus the USD, there is much room for currency appreciation before financial conditions tighten significantly. Should global growth continue to rebound, a reversal in pessimism towards energy stocks could see investors reprice the Norwegian stock market (and krone) sharply higher. The bottom line is that both Norway and Sweden are well poised to benefit from a global economic recovery, with much undervalued currencies that will bolster their basic balances. We expect both the SEK and NOK to be the best performers versus the USD in the coming year (Chart I-6).  Chart I-5The Swedish Economy Is On The Mend The Swedish Economy Is On The Mend The Swedish Economy Is On The Mend Chart I-6The Scandinavian Currencies Remain Cheap The Scandinavian Currencies Remain Cheap The Scandinavian Currencies Remain Cheap Stay Long Precious Metals, Especially Silver In a world of ample liquidity and a falling US dollar, gold and precious metals are bound to benefit. This is especially the case on the back of a central bank that is trying to asymmetrically generate inflation. Gold has a long-standing relationship with negative interest rates, though the correlation has shifted over time. The intuition behind falling real rates and rising gold prices is that low rates reduce the opportunity cost of holding non-income-generating assets such as gold. But more importantly, the correlation is between the rise in gold prices and the level of real interest rates, meaning as long as the latter stays negative, it is sufficient to sustain the gold bull market (Chart I-7). Gold tends to be a “Giffen good,” meaning demand increases as prices rise. This can be seen in the tight correlation between our financial demand indicator (proxied by open futures interest on the Comex and ETF holdings, Chart I-8) and gold prices. The conclusion is that, just like the US dollar, gold tends to be a momentum asset, where higher prices beget more demand – at least until the catalyst of easy money and negative rates vanishes Chart I-7Gold Prices And Real Yields Gold Prices And Real Yields Gold Prices And Real Yields Chart I-8Gold Is A Giffen Good Gold Is A Giffen Good Gold Is A Giffen Good There is reason to believe that the bull market in gold might be sustained for longer this time around. The reason is that central banks have become important (and price-insensitive) buyers. Foreign central banks have been amassing almost all of the gold annual output in recent years. It is remarkable that for most of the dollar bull market this past decade, the world’s major central banks (and biggest holders of US Treasurys) have seen rather stable exchange rates relative to the gold price (Chart I-9). This suggests that gold price risks could be asymmetric to the upside. A fall in prices encourages accumulation by EM central banks as a way to diversify out of their dollar reserves, while a rise in prices encourages financial demand and boosts the value of gold foreign exchange reserves. While we like gold, more value can be found in silver (and even platinum) prices, which have lagged the run up in gold. While we like gold, more value can be found in silver (and even platinum) prices, which have lagged the run up in gold. During precious metals bull markets, prices tend to move in sequence, starting with gold, then silver. Meanwhile, the gold/silver ratio (GSR) tends to track the US dollar (Chart I-10), since silver tends to rise and fall more explosively than gold. Part of the reason is that the silver market is thinner and more volatile. Silver’s rising industrial use has also led to competition with investment demand in recent years. Chart I-9Central Banks Will Put A Floor Under Gold Prices Central Banks Will Put A Floor Under Gold Prices Central Banks Will Put A Floor Under Gold Prices Chart I-10Silver Should Outperform Gold As The Dollar Falls Silver Should Outperform Gold As The Dollar Falls Silver Should Outperform Gold As The Dollar Falls The next important technical level for silver will be the 2012 highs near $35/oz. After this, silver could take out its 2011 highs that were close to $50/oz, just as gold did. Globally, the world produces much more gold than silver, with a supply ratio that is 7:1. Meanwhile, the price ratio between gold and silver is near 70:1. Back in the 1800s, Isaac Newton concluded that the appropriate ratio was 15.5:1. We initially shorted the GSR at 100 and eventually took 25% profits when our rolling stop was triggered. We recommend putting a limit sell at 75. More speculative investors can buy silver outright. Stay Short NZD At The Crosses, Especially Versus The CAD Chart I-11Stay Long CAD/NZD Stay Long CAD/NZD Stay Long CAD/NZD In our currency portfolio, trades at the crosses are equally important as versus the USD in terms of adding alpha. Over the past year, we have successfully been playing the short side of the kiwi trade. We closed our long SEK/NZD trade for a profit of 7.8% on March 20, and our long AUD/NZD trade for a profit of 5.2% on June 26. Today, we remain bullish on the CAD/NZD as an exploitable trading opportunity. First, the New Zealand stock market is the most defensive in the G10, while Canadian bourses are heavy in cyclical stocks. Should value start to outperform growth, this will favor the CAD/NZD cross. Second, immigration was an important source of labor for New Zealand, and COVID-19 has eaten into this dividend for the economy. As such, the neutral rate of interest is bound to head lower. And finally, in the commodity space, our bias is that energy will fare better than agriculture, boosting Canada’s relative terms of trade. At the Bank of Canada’s meeting this past Wednesday, the tone was slightly optimistic as it kept rates on hold. Recent data has been rather strong in Canada, especially in housing and goods consumption. This allows for the possibility of the BoC tapering asset purchases faster than the market expects, as argued by my colleague Mathieu Savary. This arbitrage is already being reflected in real interest rates, where they offer a premium of 180 basis points in Canada relative to New Zealand (Chart I-11). What To Do About Sterling? Trade negotiations between the UK and EU are once again hitting a brick wall. The key issue is around Northern Ireland. Ireland wants to remain bound to the EU’s customs and trade regime. The UK is seeking an amendment to be able to intervene, if there is “inconsistency or incompatibility with international or domestic law.” In short, it allows for UK discretion in the movement of goods to and from Northern Ireland, as well as state aid to Northern Ireland. The EU argues this is a clear breach of the treaty agreed to last year.    We remain bullish on the CAD/NZD as an exploitable trading opportunity. As negotiations go on, our base case is that a deal will eventually be reached. This is because neither side wants the worst-case scenario, namely, a no-deal Brexit. Should no deal be reached, the sharp rise in the trade-weighted euro will be exacerbated by a drop in the pound. This is deflationary for the euro area. And while the drop in the pound could be beneficial to the UK in the longer term, it will be very destabilizing since the UK is highly dependent on capital flows. Our roadmap for sterling is as follows: Historically, odds of a “hard” Brexit have usually been associated with cable near 1.20. This occurred after the UK referendum in 2016 and after Prime Minister Boris Johnson was elected with a mandate to take the UK out of the EU (Chart I-12). Intuitively, this suggests that maximum pessimism on the pound, driven by Brexit fears, pins cable at around 1.20. A “weak” deal cobbled together at the eleventh hour will still benefit cable. Depending on the details, 1.35-1.40 for cable will be within striking distance. In the case where both the UK and EU come to a “perfect” agreement, the pound could be 20%-25% higher. The real effective exchange rate for the pound is now lower than where it was after the UK exited the ERM in 1992, with a drawdown that has been similar in size. A good deal should cause the pound to overshoot the mid-point of its historical real effective exchange rate range (Chart I-13). Chart I-12GBP Has Historically Bottomed At 1.20 GBP Has Historically Bottomed At 1.20 GBP Has Historically Bottomed At 1.20 Chart I-13The Pound Is Cheap The Pound Is Cheap The Pound Is Cheap The pound is also cheap versus the euro, and we expect the EUR/GBP to start facing significant headwinds near 0.92. It is remarkable that UK data continues to outperform both the US and euro area (Chart I-14). As such, cable should be bought on weakness. Tactically, we would be buyers of the pound in the 1.24-1.25 zone, and our limit sell on EUR/GBP was triggered yesterday at 0.92.   Chart I-14The UK Economy Is Improving The UK Economy Is Improving The UK Economy Is Improving Thoughts On The ECB The main takeaways from the European Central Bank (ECB) conference were threefold. First, data in the euro area was better than the ECB expected. Second, the ECB did not give any hints on its policy review or extend forward guidance. Keeping policy easy until inflation is up to, but still below, 2% appears more hawkish than the Federal Reserve, which is now trying to asymmetrically generate inflation. And finally, the ECB said they are monitoring the exchange rate, but fell short of providing any hints that they will actively lean against the currency. The euro took off, both against the dollar and other European currencies. We outlined in last week’s report why we do not believe the euro can fall much from current levels. These include the common currency being cheap and having a large share of exports in the eurozone. A Few Words On The CHF Finally, a few clients have asked what happens to the Swiss franc in an environment where the euro is rising (and the dollar is falling). Our bias is that the Swiss National Bank lets a rising EUR/CHF ease financial conditions in Switzerland, and even leans into it. The Swiss National Bank has been stepping up its pace of intervention since EUR/CHF touched 1.05 this year and will continue to do so (Chart I-15). Unfortunately, there is not much it can do about a falling USD/CHF. This suggests the franc will fall against the euro, but not so much against the dollar. In a world where global yields eventually converge to zero, holding the Swiss franc is an attractive hedge. Chart I-15USD Weakness Will Be A Headache For The SNB USD Weakness Will Be A Headache For The SNB USD Weakness Will Be A Headache For The SNB   Chester Ntonifor Foreign Exchange Strategist chestern@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 from the US have been positive: On the labor market front, nonfarm payrolls fell to 1371K from 1734K in August. The average hourly earnings increased by 4.7% year-on-year. The unemployment rate declined from 10.2% to 8.4%. Initial jobless claims increased by 884K for the week ending on September 4th.  Finally, the NFIB business optimism index increased from 98.8 to 100.2 in August. The DXY index initially rose to a 4-week high of 93.6 earlier this week with positive data releases, then fell back to 93. Our bias is that while the dollar has been rebounding since the beginning of the month, the rally could prove to be a healthy counter-trend move in the long-term dollar bear market. Report Links: Addressing Client Questions - September 4, 2020 A Simple Framework For Currencies - July 17, 2020 DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 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 from the euro area have been mixed: The Sentix investor confidence increased from -13.4 to -8 in September. GDP plunged by 11.8% quarter-on-quarter in Q1, or 14.7% year-on-year.  The euro declined by 0.5% against the US dollar this week. The ECB decided to keep its interest rate and PEPP program unchanged on this Thursday. President Christine Lagarde sounded quite hawkish in the press conference, saying that incoming data since the last monetary policy meeting suggest “a strong rebound in activity broadly in line with previous expectations.” We continue to favor the euro against the US dollar. Report Links: Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 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 from Japan have been mixed: The coincident index increased from 74.4 to 76.2 in July. The leading economic index also climbed up from 83.8 to 86.9 in July. The current account balance widened from ¥167 billion to ¥1,468 billion in July. GDP plunged by 7.9% quarter-on-quarter in Q2, or 28.1% on an annualized basis. Preliminary machine tool orders continued to fall by 23.3% year-on-year in August. Overall household spending contracted by 7.6% year-on-year in July. The Japanese yen appreciated by 0.2% against the US dollar this week. The expansion in Japan’s current account balance is mainly driven by the decline in domestic demand. Exports fell by 19.2% year-on-year in July while imports slumped at a faster pace by 22.3%. This suggests that deflationary forces are returning to Japan, which will boost real rates and buffet the yen. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 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 from the UK have been mostly positive: Retail sales continued to increase, rising by 4.7% year-on-year in August, following a 4.3% increase the previous month. Halifax house prices increased by 5.2% year-on-year for the 3 months to August. The Markit construction PMI declined from 58.1 to 54.6 in August. The British pound extended its sell-off this week, depreciating by 2.5% against the US dollar, making it the worst-performing G10 currency. Under ongoing trade negotiations, the possibility of a no-deal Brexit is now putting more downward pressure on the pound after the summer rally. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 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 from Australia have been mixed: The AiG services performance index fell from 44 to 42.5 in August. The NAB business confidence increased from -14 to -8 in August while the business conditions index fell from 0 to -6. The Australian dollar appreciated by 0.4% against the US dollar this week. Spending fell sharply during the pandemic, pushing Australia’s savings rate to 19.8% from 6%. Until consumer spending returns in earnest, the RBA is unlikely to raise rates, which puts a cap on how far the AUD can rise. The good news is that household balance sheets are being mended, which reduces macroeconomic risk. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 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 from New Zealand have been mixed: Manufacturing sales plunged by 12.2% quarter-on-quarter in Q2. The preliminary ANZ business confidence index increased from -41.8% to -26% in September. The ANZ activity outlook index also ticked up from -17.5% to -9.9%. The New Zealand dollar fell initially against the US dollar, then recovered, returning flat this week. The ANZ New Zealand Business Outlook shows that most activity indicators have increased to the highest levels since the beginning of the pandemic but are still well below pre-COVID-19 levels. We like the New Zealand dollar against the US dollar but believe that it will underperform against other pro-cyclical currencies including the Australian dollar and the Canadian dollar. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 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 from Canada have been positive: On the labor market front, the unemployment rate declined from 10.9% to 10.2% in August. The participation rate increased from 64.3% to 64.6%. Average hourly wages surged by 6% year-on-year in August. Housing starts increased by 6.9% month-on-month to 262.4K in August, the highest reading since 2007. The Canadian dollar depreciated by 0.3% against the US dollar this week. The Bank of Canada maintained its target rate at 0.25% on Wednesday. It is also continuing large-scale asset purchases of at least C$5 billion per week of government bonds. Moreover, the Bank suggested that the bounce-back in activity in Q3 was better than expected, which bodes well for the loonie. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 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 from Switzerland have been mixed: FX reserves continued to increase from CHF 847 billion to CHF 848 billion in August. The unemployment rate remained unchanged at 3.4% in August. The Swiss franc appreciated by 1% against the US dollar this week. The SNB Chairman Thomas Jordan said that “stronger currency market interventions relieve over-valuation pressure on the Swiss franc and protect the Swiss economy”. Recent dollar weakness could be another headache for the SNB, accelerating SNB’s currency intervention. While we like the franc as a safe-haven hedge with high real rates, the upside potential is likely to be more gradual as the SNB leans against it. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 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 from Norway have been positive: Manufacturing output increased by 1.8% month-on-month in July. Headline consumer price inflation ticked up from 1.3% to 1.7% year-on-year in August. Core inflation continued rising to 3.7% year-on-year from 3.5% the previous month. The Norwegian krone depreciated by 0.5% against the US dollar this week. The increase in headline inflation was mainly driven by furnishings and household equipment (10%), communications (4.9%) and food (3.7%). However, the Norwegian krone is still tremendously undervalued against the US dollar according to our models. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 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 from Sweden have been mostly positive: The current account surplus fell to SEK 63.2 billion in Q2 from SEK 75.5 billion in Q1. However, this compares favorably to a surplus of SEK 34.7 billion the same quarter last year. Manufacturing new orders continued to fall by 6.4% year-on-year in July. This is an improvement compared to the 13.1% contraction the previous month. Headline consumer prices inflation increased from 0.5% to 0.8% year-on-year in August. Core inflation also climbed up from 0.5% to 0.7% year-on-year. The Swedish krona appreciated by 0.5% against the US dollar this week. We continue to favor the Swedish krona amid global economy recovery. Moreover, our PPP model shows that the krona is still undervalued by 19% against the US dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

To all clients, Next week, in lieu of publishing a regular report, I will be hosting a webcast on September 15th at 10 am EDT, discussing our latest views on global fixed income markets.  Sign up details for the Webcast will arrive in your inboxes later this week.   Best regards, Robert Robis, Chief Fixed Income Strategist   Feature Much of the global rebound in economic activity, and recovery in equity and credit markets, seen since the COVID-19 shock earlier this year can be attributed to historic levels of monetary and fiscal stimulus. However, the effective transmission of various monetary policy measures such as liquidity injections and refinancing operations, and by extension a sustained global recovery, is dependent on the continued smooth flow of credit from lenders to borrowers. As such, the tightening in bank lending standards seen across developed markets in the second quarter of 2020 could imperil the recovery if banks remain cautious with borrowers (Chart 1). Chart 1Credit Standards Across Developed Markets Introducing The GFIS Global Credit Conditions Chartbook Introducing The GFIS Global Credit Conditions Chartbook This week, we are introducing the BCA Research Global Fixed Income Strategy (GFIS) Global Credit Conditions Chartbook—a review of central bank surveys of bank lending standards and loan demand.  We will be publishing this chartbook on an occasional basis going forward to help inform our fixed income investment recommendations. Where it is relevant to our analysis, we will also make special note of the one-off questions asked in some of these surveys that are germane to the economic situation at hand. Where To Find The Bank Lending Surveys A number of central banks publish regular surveys of bank lending conditions in their domestic economies. The surveys, and the details on how they are conducted, can be found on the websites of the central banks: US Federal Reserve:  https://www.federalreserve.gov/data/sloos.htm European Central Bank: https://www.ecb.europa.eu/stats/ecb_surveys/bank_lending_survey/html/index.en.html Bank of England: https://www.bankofengland.co.uk/credit-conditions-survey/ Bank of Japan: https://www.boj.or.jp/en/statistics/dl/loan/loos/index.htm/ Bank of Canada: https://www.bankofcanada.ca/publications/slos/ Reserve Bank of New Zealand: https://www.rbnz.govt.nz/statistics/c60-credit-conditions-survey US Chart 2US Credit Conditions US Credit Conditions US Credit Conditions Overall credit standards for US businesses, measured as an average of standards faced by small, medium and large firms, tightened dramatically in Q2/2020 (Chart 2). Unsurprisingly, gloomier economic outlooks, reduced risk tolerance, and worsening industry-specific problems were the top reasons cited by US banks for tightening standards. US banks reported that commercial and industrial (C&I) loan demand from all firms also weakened in Q2, owing to a decrease in customers’ inventory financing and fixed investment needs. This suggests that the surge in actual C&I loan growth data during the spring was fueled by companies drawing down credit lines to survive the lack of cash flow during the COVID-19 lockdowns and should soon peak. Standards for consumer loans tightened significantly in Q2, as well. A continuation of this trend would pose a major risk to the US economic recovery, given the still fragile state of US consumer confidence. Business lending standards typically lead US high-yield corporate bond default rates by about one year, suggesting that defaults will continue to climb over the next few quarters (Chart 2, top panel). Tightening US junk bond spreads have ignored the rising trend in defaults and now provide no compensation for the likely amount of future default losses, suggesting poor value in the overall US high-yield market (Chart 3). Turning to the real estate market, lending standards have tightened significantly for both commercial and residential mortgage loans (Chart 4). In a special question asked in the Q2 survey, US banks indicated that lending standards for both those categories are at the tighter end of the range that has prevailed since 2005. Business lending standards typically lead US high-yield corporate bond default rates by about one year, suggesting that defaults will continue to climb over the next few quarters. Chart 3US Junk Spreads Do Not Compensate For Default Risk US Junk Spreads Do Not Compensate For Default Risk US Junk Spreads Do Not Compensate For Default Risk Chart 4The White Picket Fence Is Looking Out Of Reach The White Picket Fence Is Looking Out Of Reach The White Picket Fence Is Looking Out Of Reach Euro Area Italy is seeing the greater benefit from ECB support, however, with loan growth now at a new cyclical high. Chart 5Euro Area Credit Conditions Euro Area Credit Conditions Euro Area Credit Conditions In contrast to the US, credit standards actually eased slightly in the euro area in Q2/2020 (Chart 5). Banks reported increased perceptions of overall risk from a worsening economic outlook, but that was more than offset by the massive liquidity and loan guarantee programs that were part of the policy response to the COVID-19 recession. Going forward, banks expect lending standards to tighten as the maximum impact of those policies begins to fade. Credit demand from firms rose in Q2, driven by acute liquidity needs during the COVID-19 lockdowns. At the same time, demand for longer-term financing for capital expenditure was very depressed. Banks expect credit demand to normalize in Q3, as easing lockdown restrictions dampen the immediate need for liquidity. Credit demand from euro area households plummeted in Q2. Banks reported that plunging consumer confidence was the leading cause of decline in credit demand, followed closely by reduced spending on durable goods. Consumer confidence has already rebounded and banks expect demand to follow suit, as economies re-open and spending opportunities return. Chart 6HY Spreads In The Euro Area Are Unattractive HY Spreads In The Euro Area Are Unattractive HY Spreads In The Euro Area Are Unattractive As with the US, we expect that tighter credit standards to firms will drive up euro area high-yield default rates. Current euro area high-yield spreads offer little compensation for the coming increase in default losses, suggesting a similar poor valuation backdrop to US junk bonds (Chart 6). Looking at the four major euro area economies, credit standards eased across the board in Q2, with the largest moves seen in Italy and Spain (Chart 7). The ECB’s liquidity operations have helped support lending in those countries, each with a take-up from long-term refinancing operations (LTROs) equal to around 14% of total bank lending (Chart 8). Italy is seeing the greater benefit from ECB support, however, with loan growth now at a new cyclical high and Spanish banks projecting a much sharper tightening of lending standards in Q3 relative to Italian banks.   Chart 7Loan Growth Accelerating Across Most Of The Euro Area Loan Growth Accelerating Across Most Of The Euro Area Loan Growth Accelerating Across Most Of The Euro Area Chart 8Italy & Spain Taking Full Advantage Of LTROs Italy & Spain Taking Full Advantage Of LTROs Italy & Spain Taking Full Advantage Of LTROs UK For consumers, UK banks are projecting loan demand to improve in Q3, although that will require a sharper rebound in consumer confidence than has been seen to date. Chart 9UK Credit Conditions UK Credit Conditions UK Credit Conditions In the UK, corporate credit standards eased significantly in Q2 2020 thanks to the massive liquidity support programs provided by the UK government (Chart 9). Lenders reported a larger proportion of loan application approvals from all business sizes, with the greatest improvements seen in small businesses and medium-sized private non-financial corporations (PNFCs). However, lenders indicated that average credit quality on new PNFC borrowing facilities had actually declined, with default rates increasing, for all sizes of borrowers. This divergence between increased lending and declining borrower creditworthiness attests to the impact of the UK’s substantial liquidity provisions in response to the COVID-19 shock.   The credit demand side mirrors the supply story with a massive spike in Q2 2020. In contrast to euro area counterparts, UK businesses reportedly borrowed primarily to facilitate balance sheet restructuring. However, as with the euro area, the story for Q3 is much more bearish. Banks are projecting credit standards to turn more restrictive as stimulus programs run out and borrowers rein in credit demand. Going forward, decreasing risk appetite of UK banks will likely contribute to a tightening in lending standards. For consumers, UK banks are projecting loan demand to improve in Q3, although that will require a sharper rebound in consumer confidence than has been seen to date. UK banks surprisingly reported that the average credit quality of new consumer loans improved in Q2, suggesting that consumer loan demand could rebound strongly in Q3 as lockdown restrictions fade.   Japan Perversely, the latest improvement in Japanese business optimism could translate to lower business loan demand going forward. Chart 10Japan Credit Conditions Japan Credit Conditions Japan Credit Conditions Before the pandemic hit, credit standards in Japan were in a structural tightening trend for both firms and households (Chart 10). Fiscal authorities have taken a number of measures to ease conditions for businesses, including low interest rate loan programs and guarantees for large businesses as well as small and medium-sized enterprises, which has translated into the easiest credit standards for Japanese firms since 2005. The correlation between business loan demand and business conditions is not as clear-cut in Japan compared to other countries. Japanese firms tend to borrow more when the economic outlook is poor, indicating that loans are being used to meet emergency funding or restructuring needs rather than being put towards capital expenditure or inventory financing. Perversely, the latest improvement in Japanese business optimism could translate to lower business loan demand going forward. However, the consumer picture is a bit more conventional—consumer loan demand and confidence tend to track quite closely. While consumer confidence has yet to stage a convincing rebound, it has clearly bottomed. The more positive projections for consumer loan demand from the Japan bank lending survey seem to confirm this message.  Canada And New Zealand In Canada, business lending standards tightened in Q2/2020 as loan growth slowed (Chart 11). Although loan growth is far from contracting on a year-on-year basis, further tightening in conditions could pose an obstacle to Canadian recovery. On the mortgage side, the Canadian government has been active in easing pressures for lenders by relaxing loan-to-value requirements for mortgage insurance, making it easier for them to collateralize and sell their assets to the Canadian Mortgage and Housing Corporation (CMHC). Although this has yet to translate to the standards faced by borrowers, residential mortgage growth remains buoyant. In New Zealand, credit standards for firms (including both corporates and SMEs) tightened significantly in Q2 (Chart 12). Many banks expect to apply tighter lending standards to borrowers in industries most impacted by the pandemic, such as tourism, accommodation, and construction. Demand for credit from firms was driven by working capital needs while capital expenditure funding demands fell drastically. Chart 11Canada Credit Conditions Canada Credit Conditions Canada Credit Conditions Chart 12New Zealand Credit Conditions New Zealand Credit Conditions New Zealand Credit Conditions   On the consumer side, residential mortgage standards increased somewhat, and banks expect to perform more due diligence on income and job security. The hit to credit demand was broad-based across credit card, secured, and unsecured lending and coincided with a sharp fall in loan demand.     Shakti Sharma Research Associate ShaktiS@bcaresearch.com ​​​​​​​​​​​​​​Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Introducing The GFIS Global Credit Conditions Chartbook Introducing The GFIS Global Credit Conditions Chartbook ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Negative Rates: The persistence of the COVID-19 pandemic is intensifying pressure on policymakers in many countries to provide more stimulus. The odds that a new central bank will join the negative policy interest rate club are increasing. UK vs. New Zealand: Recent comments from Bank of England and Reserve Bank of New Zealand officials have hinted at the possibility of a shift to negative policy rates, should conditions warrant. The odds are greater for such a move in New Zealand. Go long 10-year New Zealand government bonds versus 10-year UK Gilts (currency-hedged into GBP) on tactical (0-6 months) basis. Feature Policymakers around the world are, once again, under increasing pressure to contemplate new responses to the COVID-19 pandemic, which continues to rage through much of the US and emerging world and is flaring up again across Europe. Additional fiscal policy measures will likely be necessary, but it is increasingly politically difficult in many countries to ramp up government support measures – or even extend existing programs - after the massive increase in deficits and debt undertaken this past spring. Chart of the WeekA Bull Market In Negative-Yielding Debt A Bull Market In Negative-Yielding Debt A Bull Market In Negative-Yielding Debt An inadequate fiscal response will put even more pressure on monetary policy to give a boost to virus-stricken economies. Yet fresh options there are even more limited. Policy rates are already near 0% in all developed nations, with central banks promising to keep them there for at least the next couple of years. Central banks are also rapidly expanding their balance sheets to buy up assets via quantitative easing programs. A move to sub-0% policy rates may be the next option for central banks not already there like the ECB and the Bank of Japan. Although it remains questionable how much more stimulus monetary policy could hope to deliver. Government bond yields are at or near historic lows in most countries, while equity and credit markets continue to enjoy a spectacular recovery from the rout in February and March. The stock of global negative-yielding debt has risen to $16 trillion, according to Bloomberg, which remains close to the highs seen over the past few years (Chart of the Week). So who will be the next central bank to cross that bridge into negative rate territory? US Federal Reserve Chairman Jerome Powell, Bank of Canada Governor Tiff Macklem and Reserve Bank of Australia Governor Philip Lowe have all publicly dismissed the need for negative rates in their economies. Recent comments from Bank of England (BoE) Governor Andrew Bailey and Reserve Bank of New Zealand (RBNZ) Governor Adrian Orr, however, have suggested that negative rates could be a future policy choice, if needed. New Zealand looks like the more likely candidate to go to negative rates sometime in the next 3-6 months. Markets are increasingly discounting those outcomes. The UK Gilt yield curve is trading below 0% out to the 6-year maturity, while New Zealand nominal government bond yields are trading at or below a mere 0.3% out to 7-years (and where real yields on inflation-linked bonds have recently turned negative). Of the two, New Zealand looks like the more likely candidate to go to negative rates sometime in the next 3-6 months. A Negative Rates Checklist For The UK & New Zealand In a Special Report we published back in May, we looked back at the decisions that drove the move to negative policy rates by the ECB, Bank of Japan, Swiss National Bank and the Riksbank, with a goal of determining if such an outcome could happen elsewhere.1 We were motivated by the growing market chatter suggesting that the Fed would eventually be forced to cut the fed funds rate to sub-0% territory to fight the deep COVID-19 recession. Chart 2The Fundamental Case For Negative Rates The Fundamental Case For Negative Rates The Fundamental Case For Negative Rates We concluded in that report that such a move was unlikely, but could occur if there was a contraction in US credit growth and/or a spike in the US dollar to new cyclical highs, both outcomes that would result in a major drop in US inflation expectations. Such moves preceded the shift to negative rates in those other countries during 2014-16, as a way to lower borrowing costs and weaken currencies. Since that May report, the US dollar has depreciated and US credit growth has continued to expand amid very stimulative financial conditions, thus the odds of the Fed having to cut the funds rate below 0% are very low. The Fed is far more likely to dovishly alter its forward guidance, or even institute yield curve control to cap US Treasury yields, to deliver additional monetary easing, if necessary. (NOTE: next week, we will be discussing the Fed’s next possible policy moves, and the potential impact on financial markets, in a Special Report jointly published with our colleagues at BCA Research US Bond Strategy). The pressure to consider negative interest rates in the non-negative rate developed market countries remains strong, however, after the major increase in unemployment rates and sharp falls in inflation seen earlier this year (Chart 2). Putting current levels of both into a simple Taylor Rule formula suggests that the “appropriate” level of nominal policy rates is currently negative in the US and Canada, mainly because of the double-digit unemployment rates in those countries. Taylor Rules for the UK and New Zealand remain slightly positive, however, at 0.2% and 0.9%, respectively. Yet the forecasts for inflation and unemployment from the BoE and RBNZ suggest a diverging dynamic between the two over the next couple of years. The BoE is forecasting a very sharp recovery from the 2020 recession, with the UK unemployment rate projected to fall back to 4.7% by 2022 from the surge to 7.5% this year. At the same time, the RBNZ’s forecasts are more cautious, with the New Zealand unemployment rate expected to fall to only 6.1% in 2022 from the projected 8.1% peak at the end of this year. Thus, the implied Taylor Rules using those forecasts suggest a need for negative rates in New Zealand, but a rising path for UK policy rates over the next two years (Chart 3). Clearly, markets are taking the RBNZ’s open talk about negative interest rates to heart, while remaining skeptical that the BoE’s optimistic path for the post-virus UK economy will come to fruition. Despite the diverging trajectory in policy rates implied by the two central banks’ forecasts, markets are pricing in a more similar path for rates. Forward overnight index swap (OIS) rates are discounting slightly negative rates in the UK and New Zealand to the end of 2022 (Chart 4). Clearly, markets are taking the RBNZ’s open talk about negative interest rates to heart, while remaining skeptical that the BoE’s optimistic path for the post-virus UK economy will come to fruition. Chart 3Mapping Central Bank Projections Into The Taylor Rule Mapping Central Bank Projections Into The Taylor Rule Mapping Central Bank Projections Into The Taylor Rule Chart 4Markets Pricing Slightly Negative Rates In The UK & NZ Markets Pricing Slightly Negative Rates In The UK & NZ Markets Pricing Slightly Negative Rates In The UK & NZ The individual cases of the UK and New Zealand as current candidates for negative interest rates can help derive a list of factors to monitor to determine if negative rates would be a more likely policy outcome for any central bank. Based on our read of recent comments from BoE and RBNZ officials, combined with our assessment of what took place in other countries that moved to negative rates in the past, we would include the following in any Negative Rates Checklist: Policymaker perceptions on the effective lower bound (ELB) on policy rates For central bankers, the ELB (or “reversal rate”) is defined as the policy rate below which additional rate cuts are deemed counterproductive to stimulating the economy. For example, cutting rates too low could limit the ability of the banking system to earn interest income, thus hindering banks’ appetite to make new loans. Chart 5Could The Effective Lower Bound Be Negative In the UK & NZ? Could The Effective Lower Bound Be Negative In the UK & NZ? Could The Effective Lower Bound Be Negative In the UK & NZ? For most central banks, the belief is that the ELB is at or just above 0%. It is possible that because of a structural shift, a central bank could deem the ELB to be negative in that particular economy. That could be because of a sharp deterioration in trend economic growth or a rapid rise in debt or a belief that the banking system was strong enough to handle the income shock of negative rates. Currently, potential GDP growth rate estimates have been marked down in both the UK and New Zealand because of the 2020 COVID-19 recession (Chart 5). In New Zealand, taking the average of the RBNZ’s real GDP growth forecasts for the next three years as a proxy for trend growth suggests that trend growth is now around 1.2%, similar to the reduced estimates of UK potential GDP growth. In terms of debt levels, the ratio of total public and private non-financial debt to GDP is close to 400% in the UK, which is far greater than the 126% level of that same ratio in New Zealand. In terms of banking system health, banks in both countries are well capitalized. The Tier 1 capital ratio of the major UK banks is 14.5%, while the similar figure in New Zealand is 13.5%; both figures are provided by the BoE and RBNZ, respectively. Stress tests run by the central banks in recent months indicate that capital levels will remain adequate even after the likely hit from loan losses due to the severity of the 2020 economic downturn. Our assessment is that both the BoE and RBNZ can claim that the ELB is in fact below zero, based on the slow pace of trend economic growth in both. In the case of the UK, high debt levels also suggest that policy rates may have to go below 0% to generate any stimulus to growth via new borrowing activity. In both countries, the central banks can claim that the banking system can handle a period of negative rates, if policymakers go down that road to boost economic growth. Economic confidence is depressed An extended period of weak economic activity and depressed confidence can trigger a need to move to negative policy rates if rates were already at 0%. Currently, UK economic confidence is in tatters after the -20% decline in real GDP seen in the second quarter of 2020. The GfK consumer confidence index remains at recessionary low levels, while the BoE Agents’ survey of UK firms shows a collapse in plans for investment and hiring over the next year (Chart 6). Chart 6A Severe Hit To UK Growth & Confidence A Severe Hit To UK Growth & Confidence A Severe Hit To UK Growth & Confidence New Zealand, the economy contracted -1.6% in the first quarter of the year with consensus forecasts calling for a -20% collapse in the second quarter. Yet economic confidence is surprisingly resilient. The Westpac survey of consumer confidence is falling, but the July reading was still above typical recessionary lows (Chart 7). The ANZ survey of business investing and hiring intentions has been surprisingly upbeat of late, rebounding from the April trough but still below pre-virus levels. Our assessment here is that the BoE has a stronger case for moving to negative rates, based on the deeper collapse in confidence in the UK compared to New Zealand. Inflation expectations are too low If inflation expectations remain too low once rates have hit 0%, then inflation-targeting central banks must consider more extraordinary options to revive inflation expectations. That could take the form of extended forward guidance on future interest rate moves, expanding the size and scope of quantitative easing programs, or cutting policy rates into negative territory. Currently, inflation expectations remain elevated in the UK. 5-year CPI swaps, 5-years forward, are now at 3.6%, while the Citigroup/YouGov survey of household inflation expectations 5-10 years out sits at 3.3% (Chart 8). In New Zealand, the RBNZ inflation survey shows inflation expectations have fallen into the bottom half of the central bank’s 1-3% target band. Chart 7Only A Very Modest Downturn In NZ Only A Very Modest Downturn In NZ Only A Very Modest Downturn In NZ Chart 8Inflation Expectations Are Much Lower In NZ Inflation Expectations Are Much Lower In NZ Inflation Expectations Are Much Lower In NZ Our assessment here is that only the RBNZ can argue for a move to negative rates because of weak inflation expectations. Our assessment here is that only the RBNZ can argue for a move to negative rates because of weak inflation expectations. Financial conditions turning more restrictive Chart 9The News Is Mixed On UK & NZ Financial Conditions The News Is Mixed On UK & NZ Financial Conditions The News Is Mixed On UK & NZ Financial Conditions Another reason why a central bank could try negative rates is if asset prices were trading at depressed levels even after policy rates were at 0%. The current signals on financial conditions in the UK and New Zealand are generally stimulative, but more so in the latter. Currently, the MSCI equity index for New Zealand is nearing the all-time high reached in 1987, while the equivalent UK equity index is languishing near the lows of the past decade (Chart 9). The New Zealand dollar and British pound have both bounced off the cyclical lows seen earlier this year (more on that later). The annual growth rates of nominal house prices have started to pick up in both countries, but with a faster pace in New Zealand. Finally, corporate credit spreads have narrowed sharply since the end of the first quarter in both countries, with New Zealand spreads actually falling below the pre-virus levels seen this year. Our assessment here is that financial conditions in both countries remain generally stimulative, but more so in New Zealand. Neither central bank can point to restrictive financial conditions as a reason to move to negative rates. Signs of impairment of the transmission of policy interest rates to actual borrowing costs If bank lending growth was weakening and/or borrowing rates remained high relative to policy rates, this could be a sign that negative policy rates are necessary to induce greater loan demand by lowering borrowing costs. Chart 10NZ Lenders Are Not Passing On RBNZ Rate Cuts NZ Lenders Are Not Passing On RBNZ Rate Cuts NZ Lenders Are Not Passing On RBNZ Rate Cuts Currently, the annual growth rate of bank lending is slowing in New Zealand, but remains positive at 4.5% (Chart 10). Loan growth in the UK is now a much more robust 7.4%, but some of that growth is due to UK companies drawing down lines of credit with their banks to survive during the COVID-19 lockdowns. A bigger issue is the lack of the full pass-through of the RBNZ’s recent cuts into borrowing rates, especially for home loans. The spread between 5-year fixed mortgage rates and the RBNZ cash rate is now an elevated 387bps, while the equivalent spread in the UK is much lower at 160bps. Our assessment here is that only the RBNZ can argue that an impaired transmission of policy rate cuts to actual borrowing rates could justify a move to negative rates. Scope For Currency Depreciation For any central bank, a benefit of a negative interest rate policy is that it can trigger more stimulus via a weaker currency. This can help boost economic growth by making exports more competitive, while also helping lift inflation by raising the cost of imports. On the growth side, a weaker currency would be somewhat more helpful for New Zealand where exports are 19% of GDP, compared to 16% in the UK. (Chart 11). That is an important distinction, as there is greater scope for the New Zealand dollar (NZD) to depreciate if the RBNZ went to negative rates than for the British pound (GBP) to weaken if the BoE did the same. Chart 11A New Experiment? Negative Rates With A Current Account Deficit A New Experiment? Negative Rates With A Current Account Deficit A New Experiment? Negative Rates With A Current Account Deficit Chart 12BoE Does Not Need To Go Negative To Weaken The Pound BoE Does Not Need To Go Negative To Weaken The Pound BoE Does Not Need To Go Negative To Weaken The Pound Perhaps the most interesting feature of this entire negative rates discussion is that, for the first time in the “negative rates era”, central banks of countries with current account deficits are considering pushing policy rates below 0%. For the first time in the “negative rates era”, central banks of countries with current account deficits are considering pushing policy rates below 0%. The UK and New Zealand both have similarly sized current account deficits, equal to -3.3% and -2.7% of GDP, respectively (middle panel). At the same time, both countries have net foreign direct investment surpluses roughly equal to those current account deficits, leaving their basic balances around 0 (bottom panel). In other words, both countries currently attract enough long-term foreign direct investment inflows to “fund” their current account deficits. Foreign investors may be less willing to continue buying as many New Zealand or UK financial assets if either country went to a negative interest rate to intentionally weaken the currency, as the RBNZ has publicly stated would be a desired outcome of such a move. Chart 13RBNZ Could Go Negative To Weaken The Kiwi RBNZ Could Go Negative To Weaken The Kiwi RBNZ Could Go Negative To Weaken The Kiwi Our colleagues at BCA Foreign Exchange Strategy estimate that, on purchasing power parity (PPP) basis, the GBP/USD exchange rate is now -20% below its long-run fair value (Chart 12). The level of the currency is also broadly in line with the current level of interest rate differentials between the UK and the US (bottom panel). In other words, the GBP is already cheap and additional rate cuts would have limited impact in driving the currency lower. It is a different story for NZD/USD, which is fairly valued on a PPP basis but remains elevated relative to New Zealand-US interest rate differentials (Chart 13). Therefore, our assessment is that only the RBNZ can credibly generate meaningful currency weakness from a move to negative rates. Summing it all up Based on the elements of our Negative Rates Checklist, we deem it more likely for the RBNZ to go negative than the BoE. In the UK, there is less evidence pointing to a significantly impaired credit channel that could be remedied by negative rates, inflation expectations are elevated, and the pound is already at undervalued levels. In New Zealand, previous RBNZ rate cuts have not fully flowed through into bank lending rates, inflation expectations are low, and the New Zealand dollar is at fair value (and, therefore, has room to become cheaper via negative rates). Based on the elements of our Negative Rates Checklist, we deem it more likely for the RBNZ to go negative than the BoE. Bottom Line: The persistence of the COVID-19 pandemic is intensifying pressure on policymakers in many countries to provide more stimulus. The odds that a new central bank will join the negative policy interest rate club are increasing. Recent comments from Bank of England and Reserve Bank of New Zealand officials have hinted at the possibility of a shift to negative policy rates, should conditions warrant. The odds are greater for such a move in New Zealand. A Negative Rates Trade Idea: Go Long New Zealand Government Bonds Vs. UK Gilts Chart 14Go Long 10yr NZ Govt. Bonds Vs 10yr UK Gilts Go Long 10yr NZ Govt. Bonds Vs 10yr UK Gilts Go Long 10yr NZ Govt. Bonds Vs 10yr UK Gilts Based on our analysis above, we are adding a new cross-country spread trade to our Tactical Overlay Trades list on page 18: going long 10-year New Zealand government bonds versus 10-year UK Gilts on a currency-hedged basis (i.e. hedging the NZD exposure into GBP). The trade is to be implemented using on-the-run cash bonds. The current unhedged NZ-UK 10-year yield spread is +36bps, but even on a hedged basis (using 3-month currency forwards) the yield differential is still positive at +23bps (Chart 14). We are targeting zero for the unhedged spread, to be realized sometime within the six months. We like this trade because it can win not only from a decline in New Zealand bond yields if the RBNZ goes to negative rates (as we think is increasingly likely), but also from a potential rise in Gilt yields if the BoE defies market pricing and does not go to negative rates. If both countries keep rates on hold, then the trade will earn a small positive spread over the current meagre level of Gilt yields.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Special Report, "Negative Rates: Coming Soon To A Bond Market Near You?", dated May 20, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Assessing The Leading Candidates To Join The Negative Rate Club Assessing The Leading Candidates To Join The Negative Rate Club Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear clients, This week we are sending you a Research Note on balance of payments across the G10, authored by my colleague Kelly Zhong. With unprecedented monetary and fiscal stimulus, balance-of-payment dynamics will become an even more important driver of currencies over the next few years. That said, while the US current account is in deficit, the short dollar narrative is beginning to capture investor imagination, suggesting the call is rapidly becoming consensus. We are in the consensus camp, but are going short GBP today, as a bet on a short-term reversal. As for cable, the recent rally has gotten ahead of potential volatility in the coming months, even though it is cheap. Finally, we are lowering our target on the short gold/silver trade to 65, but tightening the stop-loss to 75. I hope you find the report insightful. Chester Ntonifor, Vice President Foreign Exchange Strategy Highlights COVID-19 has turned the world upside down this year, and severely impaired global trade. Global trade values plunged by 5% quarter-on-quarter in the first quarter, and are forecasted to have slumped by 27% in the second quarter. Most countries have also seen negative foreign direct investment (FDI) growth in the first few months of 2020. Global FDI inflows are forecasted to fall by 40% this year and drop by an additional 5-10% next. While all countries have been hit by COVID-19, the economic damage appears particularly pronounced in countries heavily reliant on foreign funding. Feature COVID-19 has turned the world upside down in 2020. The global economy headed into recession following a decade-long expansion. While many economies are starting to ease restriction measures, the possibility of a second wave remains a big downside risk to the global economy. If history is any guide, the Spanish flu during the early 1900s came in three waves, the second of which brought the most severe damage. Undoubtedly, international trade has been under severe pressure this year. Global trade volumes plunged by 5% in the first quarter, and are expected to be down 27% in the second quarter from their levels in the final three months of 2019. Moreover, the path of recovery remains uncertain as the pandemic continues to disrupt global supply chains and weaken consumer confidence. According to the United Nations Conference on Trade and Development (UNCTAD), it may take until late 2021/early 2022 for global trade to recover to pre-pandemic levels (Chart 1). As reinvested earnings make up more than half of total FDI, squeezed earnings this year will have a direct impact on FDI in the aftermath of COVID-19.  Global FDI inflows rebounded in 2019, reaching a total of $1.5 trillion, as the effect of the 2017 US tax reforms waned and US repatriation declined. This year, however, most countries have seen negative FDI growth rates in the first few months in 2020. According to UNCTAD, global FDI inflows are forecast to plunge by 40%, bringing total FDI inflows below the US$1 trillion level for the first time since 2005 (Chart 2). Unfortunately, as reinvested earnings make up more than half of total FDI, squeezed earnings this year will have a direct impact on FDI in the aftermath of COVID-19. Typically, FDI flows bottom only six to 18 months after the end of a recession. FDI inflows are forecast to decline further by another 5-10% in 2021. Chart 1Steep Decline In Trade Volumes In 1H'20 Steep Decline In Trade Volumes In 1H'20 Steep Decline In Trade Volumes In 1H'20 Chart 2Global FDI Projected To Fall Through 2021 Global FDI Projected To Fall Through 2021 Global FDI Projected To Fall Through 2021 While all economies have been hit by COVID-19, the impact varies by region. Emerging market countries, particularly those linked to commodities and manufacturing-intensive industries, appear to be have been hit harder by the crisis. This makes sense, given trade is much more volatile than services or consumption. Chart 3 shows that while exports make up less than 30% of GDP in the US, they amount to over 130% of GDP in Thailand and Malaysia, and over 300% of GDP in Singapore and Hong Kong. Chart 3Reliance On Trade Differ Across Countries Balance Of Payments Beyond COVID-19 Balance Of Payments Beyond COVID-19 Going forward, the recoveries might be uneven as well. Prior to COVID-19, global trade flows were already facing many challenges, including trade disputes, geopolitical tensions and rising protectionism. COVID-19 may have just supercharged two megatrends: Technology and Innovation: The pool of investments concentrated on exploiting raw materials and cheap labor is shrinking, while those promoting technology and ESG are becoming crucial. De-globalization: Policymakers in many countries are promoting more regulation and intervention, especially in key industries related to national security and health care. This suggests COVID-19 might represent a tipping point, making balance of payments all the more important for currencies, as investors become more discerning between countries and sectors with a high return on capital and those without. The euro area, Switzerland, Australia and Sweden sport the best basic balance surpluses.  In this report, we look at the balance-of-payment dynamics in the G10. The most important measure for us is the basic balance, which takes the sum of the current account and net long-term capital inflows. Our rationale is that these tend to measure the underlying competitiveness of a currency more accurately than other balance of payment measures. On this basis, the euro area, Switzerland, Australia and Sweden sport the best basic balance surpluses. The US is the worst (Chart 4). Below, we visit some of key drivers behind these trends. Chart 4Basic Balances Across G10 Balance Of Payments Beyond COVID-19 Balance Of Payments Beyond COVID-19 United States Chart 5US Balance Of Payments US Balance Of Payments US Balance Of Payments The US basic balance is deteriorating again (Chart 5). The key driver has been a decline in foreign direct investment. If this trend continues, this could further undermine the US currency. The US remains the world’s largest FDI recipient, attracting US$261 billion in 2019, which is almost double the size of FDI inflows into the second largest FDI recipient – China – with US$141 billion of inflows last year. However, cross-border flows have since fallen off a cliff after the waning effect of the one-time tax dividend introduced at the end of 2017. The lack of mega-M&A deals has also been a contributing factor. The trends in the trade balance have been flat, despite a push by the Trump Administration to reduce the US trade deficit and rejuvenate the US economy. The most recent second-quarter data show a deterioration from -2.3% of GDP to -2.8%. The trade deficit with China did drop by 21% to $345 billion in 2019, however, US companies quickly found alternatives from countries that are not affected by newly imposed tariffs, particularly from Southeast Asia: The US trade deficit with Vietnam jumped by 30%, or $16.3 billion, in 2019. More recently, exports have plunged much faster than imports, further widening the US trade deficit. On portfolio flows, the most recent TIC data show that US Treasurys continued to be shunned by foreigners in May. In short, the US balance-of-payment dynamics are consistent with our bearish dollar view. Euro Area Chart 6Euro Area Balance Of Payments Euro Area Balance Of Payments Euro Area Balance Of Payments A rising basic balance surplus has been one of the key pillars underpinning a bullish euro thesis. Of course, an apex in globalization will hurt this thesis, but the starting point for the euro area is much better than many of its trading partners. The trade surplus in the euro area was not spared from COVID-19 – it plunged to €9.4 billion in May from €20.7 billion the same month last year, as the pandemic hit global demand and disrupted supply chains. Exports tumbled by 29.5% year-on-year to €143.3 billion while imports declined by 26.7% to €133.9 billion. Even in this dire scenario, the trade surplus still remains a “healthy” 1.8% of GDP, buffeting the current account (Chart 6). Foreign direct investment inflows have regained some ground in recent years, with the improvement accelerating in recent months. FDI inflows surged by 18% in 2019, reaching US$429 billion. Outflows also rose by 13% in 2019, led by a large increase in investment by multinationals based in the Netherlands and Germany. Going forward, FDI is sure to drop, but this will not be a European-centric problem. Portfolio flows have started to reverse, but have not been the key driver of the basic balance. This is because ever since the European Central Bank introduced negative interest rates in 2014, portfolio outflows have been persisted. This also makes sense since Europeans need to recycle their excess savings abroad. In sum, despite the headwinds to global trade and investment, the basic balance remains at a healthy 2.9% of GDP, which bodes well for the euro. Japan Chart 7Japan Balance Of Payments Japan Balance Of Payments Japan Balance Of Payments A key pillar for the basic balance in Japan has been the current account balance, which has been buffeted over the years by income receipts from Japan’s large investment positions abroad. Going forward, this could make the yen very attractive in a world less reliant on global trade. Japanese exports tumbled by 26.2% year-on-year in June, led by lower sales in transport equipment, motor vehicles and manufactured goods. However, the slowing export trend was well in place before the pandemic. Exports had been declining for 18 consecutive months before COVID-19 dealt the final blow. Imports also fell by 14% year-on-year in June, led by lower energy prices. On the service side of the income equation, foreign visitors to Japan dropped by 99.9% from over 2.5 million in January to less than 2,000 in May. That equates to about 2% of the Japanese population. Despite all this, Japan still sports a healthy current account surplus, at 4% of GDP (Chart 7). In 2019, Japan remained the largest investor in the world, heavily recycling its current account surplus. FDI outflows from Japanese multinationals surged by 58% to a record US$227 billion, including US$104 billion in cross-border M&A deals. Notable mentions include Takeda acquiring Shire (Ireland) for US$60 billion, and SoftBank Group acquiring a stake in WeWork (the US) for US$6 billion. In terms of portfolio investments, foreign bond purchases have eased of late as global interest rates approach zero. Higher real rates are now being found in safe-haven currencies like the Swiss franc and the Japanese yen, which is supportive for the yen. Overall, the basic balance in Japan is at nil, in perfect balance between domestic savings and external investments. United Kingdom Chart 8UK Balance Of Payments UK Balance Of Payments UK Balance Of Payments The key development in the UK’s balance-of-payment dynamics is that a cheap pound combined with the pandemic appear to have stemmed the decline in the trade balance. The UK has run a current account deficit each year since 1983. This has kept the basic balance mostly negative (Chart 8). That could change if the marginal improvement in trade is durable and meaningful. The current account deficit further widened to £21.1 billion, or 3.8% of GDP, in the first quarter, of which the goods trade balance was more volatile than usual. Since May, the goods trade balance has been slowly recovering to £2.8 billion, but has been offset by the services trade deficit. The primary income deficit also widened in the first quarter as offshore businesses rushed to preserve cash buffers. Foreign direct investment in the UK has been improving of late, currently sitting at 3.7% of GDP. This is encouraging, given the steep post-Brexit drop. Going forward, we continue to favor the British pound over the long term due to its cheap valuation. However, we are going short today, as a play on a tactical dollar bounce. More on this next week.       Canada Chart 9Canada Balance Of Payments Canada Balance Of Payments Canada Balance Of Payments The Canadian basic balance has been flat for over a decade, as the persistent current account deficit has continuously been financed by FDI inflows and portfolio investment (Chart 9). This is a vote of confidence by investors over longer-term returns on Canadian assets. Canada is one of the largest exporters of crude oil, meaning the fall in resource prices generated a big dent in export incomes. However, the country is slowly on a recovery path. Exports increased 6.7% month-on-month in May, helping narrow the trade deficit to C$0.7 billion. More importantly, a positive net international investment position means that positive income flows into Canada are buffeting the current account balance. In 2019, Canada was the 10th largest FDI recipient in the world, with FDI inflows increasing to US$50 billion. Today, the basic balance stands at a surplus of 1% of GDP.               Australia Chart 10Australia Balance Of Payments Australia Balance Of Payments Australia Balance Of Payments Australia’s trade balance has been rapidly improving since the 2016 bottom, and has been the primary driver of an improving basic balance. While exports fell as the pandemic hit a nadir, imports fell more deeply. This allowed the trade surplus to widen in the first six months of the year compared to last year. Australia has long had a current account deficit, as import requirements to help drive investment opportunities were not met by domestic savings. With those projects now bearing fruit, the funding requirement has greatly eased. This has buffeted the current account balance, which turned positive for the first time last year following a 35-year-long deficit, and continues to rocket higher (Chart 10). Going forward, Australia’s trade balance and current account balance are likely to continue increasing as Australia has a comparative advantage in exports of resources, especially LNG, which is consistent with the ESG megatrend. Australia is also introducing major reforms to its foreign investment framework to protect national interests and local assets from acquisitions. Meanwhile, net portfolio investment remains negative, suggesting the current account surplus is being recycled abroad. In short, we believe the Aussie dollar has a large amount of running room, based on its healthy basic balance surplus of 4% of GDP. New Zealand Chart 11New Zealand Balance Of Payments New Zealand Balance Of Payments New Zealand Balance Of Payments Compared to its antipodean neighbour, the New Zealand basic balance has been flat for many years, but has seen recent improvement (Chart 11). The trade balance was boosted by goods exports, which were up NZ$261 million, while imports were down NZ$352 million in the first quarter of this year. The rise in goods exports was led by an increase in fruit (mainly kiwifruit), milk, powder, butter and cheese. More recently, due to the ease of lockdown measures, exports increased by 2.2% year-on-year in June while imports marginally rose by 0.2%, further enhancing New Zealand’s trade balance. The primary income deficit widened to NZ$2.2 billion in the first quarter due to less earnings on foreign investment. Moreover, the secondary income deficit also widened, driven by a smaller inflow of non-resident withholding tax. Despite this, the current account deficit narrowed to NZ$1.6 billion in the first quarter, or 2% of GDP, the smallest deficit since 2016.  New Zealand received $5.4 billion in FDI flows in 2019, rising from only $2 billion in 2018. Most FDI inflows arrived from Canada, Australia, Hong Kong and Japan. Impressively, according to the World Bank’s 2020 Doing Business Report, New Zealand ranked first out of 190 countries due to its openness and business-friendly economy, low levels of corruption, good protection of property rights, political stability and favorable tax policies. Portfolio investment inflows also increased by NZ$11.8 billion.  The improvement in the backdrop of New Zealand’s basic balance will allow it to outperform the US dollar. As a tactical trade, however, we are short the kiwi versus the CAD. The basis is that relative terms of trade favor the CAD for now. Switzerland Chart 12Switzerland Balance Of Payments Switzerland Balance Of Payments Switzerland Balance Of Payments Switzerland’s basic balance is almost always in surplus, driven by a structural uptrend in the trade balance (Chart 12). This has allowed the trade-weighted Swiss franc to outperform on a structural basis. We expect this trend to continue. As a country consistently running high surpluses, Switzerland also tends to invest more in foreign assets. Over the years, these smart investments have helped buffet the current account. Overall, in the first three months of this year, the current account balance stood at CHF 17.4 billion, or 11.2% of GDP. In terms of the net international investment position, both stocks of assets and liabilities fell by CHF 110 billion and CHF 42 billion, respectively in the first quarter, due to falling equity prices globally. The net international investment position fell by CHF 67 billion to CHF 745 billion in the January-March period. That said, Switzerland continued to deploy capital abroad in the first quarter, which should help buffet the current account going forward. The positive balance-of-payment backdrop has created a headache for the Swiss National Bank. As such, the SNB will likely continue to intervene in the foreign exchange markets to calm appreciation in the franc. We believe the franc will continue to outperform the USD in the near term, but underperform the euro.  Norway Chart 13Norway Balance Of Payments Norway Balance Of Payments Norway Balance Of Payments Norway has a very open economy, with trade representing over 70% of GDP, and it has been hit quite hard by COVID-19 this year. The trade surplus started to plunge sharply due to falling energy prices at the beginning of the lockdown (Chart 13). More recently, Norway posted its first trade deficit in May since last September, which carried over to June, as exports fell more than imports. Thanks to increases in income receipts from abroad, the current account balance remained flat at NOK 66.1 billion in the first quarter. With persistent current account surpluses, Norway has long been a capital exporter. However, the FDI outflow and inflow gap is gradually closing. In 2019, net FDI was -3.5% of GDP. In the first quarter of this year, it was -3.3%. Portfolio outflows have also softened over the years, as the current account balance has narrowed. There was, however, a trend change in the first three months of this year - Norway’s purchases of foreign bonds, surged as investors switched to safer assets. Ultimately, we remain NOK bulls due to its cheap valuation. As economies gradually reopen and ease lockdown measures, the recovery in energy prices will push the Norwegian krone back toward its fair value.     Sweden Chart 14Sweden Balance Of Payments Sweden Balance Of Payments Sweden Balance Of Payments Sweden maintained its trade surplus with the rest of the world throughout the first few months of 2020 (Chart 14). Imports fell more than exports amid the pandemic. The goods trade balance almost doubled from the fourth quarter of 2019 to SEK 68.8 billion in the first quarter of 2020. The primary income surplus also increased by SEK 10 billion to SEK 42.2, further strengthening the current account and bringing the total current account surplus to SEK 80.6 billion, or 4% of GDP. Both FDI inflows and outflows have been increasing in Sweden, but the net number was slightly negative. In the first quarter of 2020, FDI inflows rose by SEK 51.6 billion while FDI outflows increased by SEK 100.6 billion. In terms of portfolio investment, Swedish investors reduced their portfolio investment abroad by SEK 141 billion in the first quarter, while foreigners decreased their portfolio investment in Sweden by SEK 45.8 billion. In conclusion, the Swedish krona remains one of our favorite longs due to its increasing basic balance surplus (4% of GDP) and its cheap valuation. We are long the Nordic basket (NOK and SEK) against both the euro and the US dollar. Kelly Zhong Research Analyst kellyz@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes   Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The underperformance of value versus growth has been a reason behind the dollar bull market rather than a consequence of it. The rationale is that the catalyst for any sector to outperform is return on capital rather than the cost of capital. The outperformance of health care and technology has been on the back of rising profits, rather than just investor exuberance and/or low bond yields. Cyclical currencies with a high concentration of value sectors have tracked the relative performance of their representative bourses. A reversal will require value sectors to start outperforming on a sustainable basis. It is encouraging that leadership changes in equity markets occur more often than not. Historically, these tend to take place every decade. Bombed-out valuations suggest some deep-value sectors have become sufficiently cheap to compensate for a pessimistic profit scenario. An outperformance of value versus growth will favor cyclical currencies. We are long a basket of petrocurrencies, the SEK, and GBP. We are also short USD/JPY as portfolio insurance (and as a play on the cyclical Japanese market). Feature The usual market narrative is that for non-US stocks to outperform, the dollar has to decline. This also applies to value stocks that have a higher weighting outside the US, compared to growth stocks. At the center of this premise is that the dollar is a reserve currency. As a result, three reasons emblem the view. First, a fall in the dollar eases financing costs for non-US corporations borrowing in dollars. Second, commodities tend to do well when the dollar declines, benefiting emerging market and commodity-producing countries. And finally, a lower dollar boosts the common-currency returns for US-based investors, leading to more capital deployment in offshore markets. On the surface, this makes sense. But digging deeper into the thesis, it appears that a lower US dollar is a necessary but not sufficient condition for non-US (or value) stocks to outperform. The reason is that profit growth (the ultimate driver of stock prices) is more contingent on productivity gains rather than translation effects. As such, the value-versus-growth debate is important, not only for the sectors involved, but for currency strategy as well. A Two-Decade Postmortem Chart I-1Value/Growth Turns Before The Dollar Value/Growth Turns Before The Dollar Value/Growth Turns Before The Dollar Chart I-1 plots the MSCI global value index versus its growth counterpart, superimposed against the US dollar. Two trends become apparent: The relative performance of value versus growth typically bottoms or peaks ahead of turns in the US dollar. The relationship between the value/growth ratio and the US dollar is not always in sync. There was a period of decoupling after the financial crisis, and, more recently, in 2015-2016. This was also the case in the ‘80s and around the Asian crisis in the late ‘90s. Flows tend to gravitate to capital markets with the highest expected returns, and this is certainly the case when value or growth style tilts are concerned. This is important for currency strategy, since sector composition can drive a country’s equity returns. Meanwhile, both equity and currency relative performances tend to be in sync (Chart I-2A and Chart I-2B). Chart I-2ACurrencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance Chart I-2BCurrencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance According to the MSCI classification, information technology and health care are the biggest components of the growth index – a whopping 49%. This is in stark contrast to financials and industrials, which make up 33% of the value index. Not surprisingly, currencies with a heavy value weighting in their domestic bourses (Table I-1) have suffered indiscriminately compared to their growth counterparts, over the last decade. Table I-1Sector Weights Across G10 Currencies And The Value-Versus-Growth Debate Currencies And The Value-Versus-Growth Debate Take the US and Switzerland, which have the highest equity concentration in traditional growth sectors, at over 60%. Both the US dollar and Swiss franc have held up remarkably well in trade-weighted terms since the onset of the dollar bull market (Chart I-3). Likewise, it would have been a miracle for petrocurrencies (CAD, NOK and AUD) to hold up amid the recent underperformance in energy and financials. Chart I-3Style Tilt Drives Currency Performance Style Tilt Drives Currency Performance Style Tilt Drives Currency Performance This suggests that at minimum, the underperformance of value versus growth has been a reason for the dollar bull market rather than a consequence of it. Chicken And Egg Problem? What about the narrative that a decline in the dollar greases the engine of non-US stocks? Yes, but not entirely. It is certainly the case that most global trade and financing is conducted in US dollars, and so a fall in the US dollar (commensurate with lower interest rates) leads to easier global financial conditions. As Chart I-4 clearly illustrates, corporate spreads abroad have been tightly correlated to dollar volatility. A lower dollar also eases repayment costs for non-US borrowers. Chart I-4The Dollar And Funding Stresses The Dollar And Funding Stresses The Dollar And Funding Stresses A lower dollar also boosts resource prices through the numeraire effect (Chart I-5). Meanwhile, rising commodity prices flatter industries tied to the resource value chain such as industrials, materials, and energy. Second-round economic effects also buffet other cyclical industries such as retail and hospitality, which help boost the domestic equity index. That said, the rally in commodities, value stocks, and emerging market share prices in 2016-2017 occurred despite a dollar that was flat-to-higher – so the causality versus effect link is not always trivial. Part of the reason is that, over the past few years, both emerging market and other non-US corporates have diversified their sources of debt funding. Euro- and yen-denominated debt have been surging (Chart I-6), which has kept their cost of capital low, even as the dollar has risen. Chart I-5Tied To The Hip Tied To The Hip Tied To The Hip Chart I-6Lots Of Non-US Debt Lots Of Non-US Debt Lots Of Non-US Debt It is also important to note that in commodity bull markets, prices tend to rise in all currencies, including domestically (Chart I-7). This is crucial for sector outperformance since the translation effect for profits will otherwise be negative, given local-currency fixed and variable costs. This suggests that demand is the driving force behind bull markets in commodity prices and cyclical stocks, rather than a lower greenback. Chart I-7Commodity Bull Markets In Different Currencies Commodity Bull Markets In Different Currencies Commodity Bull Markets In Different Currencies This demand has come in the form of Chinese stimulus. Chart I-8 shows a close correlation between excess liquidity in China (a measure of the centripetal force from Chinese credit) and resource share valuations. Ergo, a key barometer for value to outperform growth is that Chinese demand picks up, plugging the hole in exactly the sectors that have borne the brunt of deleveraging in recent years. Chart I-8China And Commodities China And Commodities China And Commodities A look at corporate balance sheets and income statements corroborates this view. Growth has outperformed value on the back of a re-rating, but also on profitability. Chart I-9A and Chart I-9B rank G10 equity bourses on the basis of return on equity and their corresponding price-to-book ratios. Not surprisingly, the winners of the last decade have had the biggest returns on equity, as was the case for the winners during the prior decade. Chart I-9AMarkets Bid Up High Returns To Capital Markets Bid Up High Returns To Capital Markets Bid Up High Returns To Capital Chart I-9BMarkets Bid Up High Returns To Capital Markets Bid Up High Returns To Capital Markets Bid Up High Returns To Capital As such, the catalyst for any sector to outperform is return on capital rather than the cost of capital. Structural Shift? There is some evidence that the underperformance of value versus growth could be structural. For one, being a value manager seems to be following the fate of telephone switchboard operators in the early 1900s. Perhaps the advent of computer trading systems has systematically eroded the value premium. As such it is becoming more and more difficult, even for the most skillful value managers, to beat their own index. An inability for value sectors to outperform will be a key risk to a dollar-bearish view. Work done on our in-house Equity Trading Strategy platform corroborates this view. Since about 2014, a long/short strategy based on the best value stocks relative to the worst in terms of a swath of fundamental valuation metrics has been flat compared to a more blended strategy (Chart I-10). According to our quantitative specialists, the best value can be found in European countries such as Sweden, Denmark, the Netherlands, and Germany (Chart I-11). Surprisingly, their proprietary value model rate Switzerland and New Zealand quite highly, despite a clear defensive bias in these equity markets. Unsurprisingly, some of the countries that have had the weakest currencies in the last decade such as Sweden and the Eurozone members have highly favored value sectors. Chart I-10A Dearth Of Value Managers A Dearth Of Value Managers A Dearth Of Value Managers Chart I-11Lots Of Value Outside The US Currencies And The Value-Versus-Growth Debate Currencies And The Value-Versus-Growth Debate Going forward, a few things could change. One of the primary reasons why growth has outperformed value has been the drop in bond yields, which has increased the appeal of companies with low payout ratios and much more backdated cash flows (Chart I-12). But as countries from Japan to Australia implement yield-curve controls at the zero bound, the capitalized dividend from low yields is bound to be exhausted. Meanwhile, any rise in yields will favor deep-value sectors like banks (due to rising net interest margins) and commodities (due to inflation protection). Chart I-12A Lower Discount Favors Long-Duration Assets A Lower Discount Favors Long-Duration Assets A Lower Discount Favors Long-Duration Assets Second, falling global trade and the proliferation of Environmental, Social and Governance (ESG) investing has hammered traditional industries such as energy and autos. Part of this trend is structural, but there is also a cyclical component. For the auto industry in particular, auto sales are strongly (inversely) correlated to the unemployment rate, and as more economies reopen, car sales should pick up. Meanwhile, traditional auto and energy companies are stepping up their electric vehicle and alternative energy strategies, meaning the first-mover advantage for the avant-gardes like Tesla and Nikola could be eroded. Finally, valuation tends to be a key catalyst near recessions. Given that over the years, one of the more consistent drivers of long-term equity returns has been the valuation starting point, this favors non-US stocks (Chart I-13A, Chart I-13B, Chart I-13C, Chart I-13D). Not surprisingly, the currencies that are the most undervalued in our models1 also have cheap equity markets. Even if one focuses solely on growth sectors such as technology and health care, non-US companies are still more attractive, according to our Equity Trading Strategy platform (Chart I-14). This suggests some measure of convergence is due. Chart I-13AProspective Returns Higher Outside The US Prospective Returns Higher Outside The US Prospective Returns Higher Outside The US Chart I-13BProspective Returns Higher Outside The US Prospective Returns Higher Outside The US Prospective Returns Higher Outside The US Chart I-13CProspective Returns Higher Outside The US Prospective Returns Higher Outside The US Prospective Returns Higher Outside The US Chart I-13DProspective Returns Higher Outside The US Prospective Returns Higher Outside The US Prospective Returns Higher Outside The US Currencies And The Value-Versus-Growth Debate Currencies And The Value-Versus-Growth Debate Chart I-14Attractive Growth Stocks Outside The US Currencies And The Value-Versus-Growth Debate Currencies And The Value-Versus-Growth Debate It is encouraging that leadership changes in equity markets occur more often than not. Historically, these tend to occur every decade. Bombed-out valuations suggest some deep-value sectors have become sufficiently cheap to compensate for a pessimistic profit scenario. Portfolio Construction Chart I-15CAD/NZD And Relative Stocks CAD/NZD And Relative Stocks CAD/NZD And Relative Stocks An outperformance of value versus growth will favor cyclical currencies. The catalyst will have to be improving return on capital from value sectors, but the valuation starting point is already quite compelling. Meanwhile, even traditional growth sectors are still cheaper outside the US. We are already selectively long a basket of petrocurrencies, the SEK, and GBP. We are also short USD/JPY as portfolio insurance (and as a play on the cyclical Japanese market). Should value stocks gain more widespread appeal, we will add the Eurozone and emerging market currencies to this basket. Elsewhere, a tactical trading opportunity has also opened up to go short the NZD/CAD cross. Little known is that the New Zealand stock market is the most defensive in the world (previously referenced in Table I-1). This has helped keep the New Zealand dollar higher than would have otherwise been the case. Should value start to outperform growth, this will favor the CAD/NZD cross (Chart I-15). While we commend Prime Minister Jacinda Ardern’s efforts to limit the spread of COVID-19 in New Zealand, the economy will soon start to bump against supply-side constraints. More specifically, COVID-19 has accentuated the immigration cliff in New Zealand, an important hit to the labor dividend for the economy (Chart I-16). As such, the neutral rate of interest is bound to head lower. Chart I-16A Top For NZD/CAD? A Top For NZD/CAD? A Top For NZD/CAD? This is in stark contrast to Canada, where the current government was pro-immigration even before widespread lockdowns. Meanwhile, in the commodity space, our bias is that energy will fare better than agriculture, boosting relative Canadian terms of trade. Go short NZD/CAD for a trade.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report , "Updating Our Intermediate-Term Models", dated July 3, 2020. 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 robust: The ISM non-manufacturing PMI jumped from 45.4 to 57.1 in June, with the new orders component surging from 41.9 to 61.6 and the employment component at 43.1 versus 31.8 earlier. JOLTS job openings increased from 5 million to 5.4 million in May. Initial jobless claims fell from 1413K to 1314K for the week ended July 3rd. The DXY index fell by 1% this week, alongside the outperformance of non-US equities, particularly emerging market stocks. Recent data have shown budding signs of a recovery as many countries gradually reopen their economies. As a counter-cyclical currency, this has pressured the dollar. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 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 mostly positive: The Markit services PMI increased from 47.3 to 48.3 in June. The Sentix investor confidence index rebounded from -24.8 to -18.2 in July. Retail sales fell by 5.1% year-on-year in May. However, this is a 17.8% increase on a month-on-month basis.  The euro increased by 0.6% against the US dollar this week. While recent data have been promising, the Summer 2020 Economic Forecast released by the European Union sounded quite pessimistic this week. The Summer Forecast projects that the euro area will contract by 8.7% in 2020 and grow by 6.1% in 2021, much worse than the spring forecast. That said, a mild second wave could trigger the European Union to revise these estimates higher. Meanwhile, the ECB remains committed to lowering the cost of capital for Eurozone countries. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 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 mostly negative: The current account balance surged from ¥262.7 billion to ¥1176.8 billion in May, as imports fell faster than exports. The preliminary coincident index fell from 80.1 to 74.6 in May, while the leading economic index increased from 77.7 to 79.3. Machinery orders fell by 16.3% year-on-year in May, following a 17.7% decrease the previous month. Moreover, preliminary machine tool orders in June continued to fall by 32% year-on-year. USD/JPY fell by 0.5% this week. The June Eco Watchers Survey released this Wednesday shows that the current conditions index increased sharply from 15.5 to 38.8. Moreover, the outlook index rose to 44 in June from 36.5 the previous month. The Survey sounded cautiously optimistic and indicated that while COVID-19 continues to be a downside risk, activities are starting to pick up in recent months. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 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 positive: The Markit services PMI ticked up marginally from 47 to 47.1 in June. The construction PMI surged from 28.9 to 55.3. Halifax house prices increased by 2.5% year-on-year in June. The British pound jumped by 1.3% against the US dollar this week. The Bank of England chief economist, Andy Haldane, has warned about second, third or even fourth wave of COVID-19 infections. However, he also acknowledged that the UK economy has received a boost since restaurants and bars have reopened. We remain bullish on the pound as an undervalued currency, but are monitoring Brexit developments closely as they continue to add more volatility to trading patterns. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 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 negative: The AiG services performance index was flat at 31.5 in June. Home loans fell by 7.6% month-on-month in May, following a 4.4% decline the previous month. The Australian dollar rose by 0.6% against the US dollar this week. On Tuesday, the RBA held its interest rate unchanged at 0.25%, as widely expected. The Bank sounded optimistic about the recovery and the government’s effective measures to contain the virus. That said, with Melbourne returning into lockdown, a dose of skepticism is warranted. We continue to favor the Australian dollar as a key barometer for procyclical trades, but domestic factors could be a risk to this view. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 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: The ANZ preliminary business confidence index recovered from -34.4 to -29.8 in July. The New Zealand dollar rose by 0.9% against the US dollar this week. The Q2 NZIER Quarterly Survey of Business Opinion (QSBO) indicated that economic activities plunged sharply in Q2. According to the survey, a net 63% of businesses expect conditions to deteriorate, compared with 70% in the previous survey. While confidence has picked up slightly, business sentiment remains downbeat with less intensions to invest and hire, particularly in the subdued construction sector. As such, a tactical opportunity is opening for short NZD trades at the crosses. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 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 positive: The Ivey PMI surged from 39.1 to 58.2 in June. The Markit manufacturing PMI also increased from 40.6 to 47.8 in June. Bloomberg Nanos confidence increased from 46 to 46.2 for the week ended July 3rd. Housing starts picked up from 195.5K in May to 211.7K in June. The Canadian dollar appreciated by 0.5% against the US dollar this week. The BoC Business Outlook Survey was released this week and survey results suggest that “business sentiment is strongly negative in all regions and sectors” due falling energy prices. Most firms believe that production could pick up quickly but sales might take longer to recover. That said, both interest rate differentials and recovering oil prices are bullish for the Canadian dollar for now.  Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses 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 positive: FX reserves increased from CHF 817 billion to CHF 850 billion in June. The unemployment rate declined from 3.4% to 3.2% in June. Total sight deposits increased from CHF 683 billion to CHF 687 billion for the week ended July 3rd. The Swiss franc appreciated by 0.7% against the US dollar this week. The Swiss franc has been quite resilient recently despite the rebound in risk sentiment since the March lows. The expensive franc remains a headache for the SNB and the Swiss economy. We are looking to go long EUR/CHF at 1.055. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 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: Manufacturing output fell by 3% month-on-month in May. The Norwegian krone surged by 1.3% against the US dollar this week. We remain bullish on the krone due to its cheap valuation and signs of a recovery in energy prices. Our Nordic Basket is now around 10% in the money and we also went long a petrocurrency basket including the Norwegian krone last week. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 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 negative: Industrial production fell by 15.5% year-on-year in May. Manufacturing new orders plunged by 18.4% year-on-year in May. The Swedish krona surged by 1.3% against the US dollar this week. Like the Norwegian krone, the Swedish krona is tremendously undervalued and remains one of our favorite G10 currencies at the moment. As a small open economy, Sweden relies heavily on exports and imports. While global trade was hit hard during COVID-19, signs of stabilization bode well for the Swedish krona. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Our intermediate-term timing models suggest the US dollar is broadly overvalued.  We are maintaining a modest procyclical currency stance (long NOK, GBP and SEK), but also have a portfolio hedge (short USD/JPY). Go long a basket of petrocurrencies versus the euro. Stay short the gold/silver ratio. Feature Our fundamental intermediate-term timing models (FITM) are one of the toolkits we use in currency management. These simple models enable us to time shifts in developed-market currencies using two key variables. Real Interest Rate Differentials: G10 currencies tend to move with their real rate differentials. Under interest rate parity, if one country is expected to have high interest rates versus another, its currency will rise today so as to gradually depreciate in the future and nullify the interest rate advantage. Risk factor: The ebb and flow of risk aversion affects the path of currencies, as it does their domestic capital markets. Procyclical currencies tend to perform better during risk-on periods. We use high-yield spreads and/or commodity prices as a gauge for risk. 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 currencies we look at. These models are more useful as timing indicators on a three-to-nine month basis, as their error terms revert to zero quickly. For the most part, our models have worked like a charm. On a risk adjusted-return basis, a dynamic hedging strategy based on our models has outperformed all static hedging strategies for all investors with six different home currencies since 2001.1  The US Dollar Chart I-1USD Is Overvalued By 4.4% USD Is Overvalued By 4.4% USD Is Overvalued By 4.4% The dollar is a sell, according to the model, with a fair value that is falling much faster than the DXY index itself. Going forward, the Federal Reserve’s dovish stance should keep real interest rate differentials moving against the dollar. This will especially be the case if the authorities move to some form of yield curve control. The wildcard is how risk aversion gyrates as we navigate the volatile summer months, especially given rising geopolitical tensions and the potential for an equity market correction (Chart I-1). One of the factors holding up the dollar is that US domestic growth has been relatively strong, with the Citigroup economic surprise index at the highest level since the inception of the series. For the dollar to decline meaningfully, these positive surprises will need to be repeated abroad. On the data front this week, pending home sales rose 44.3% month-on-month in May, following a 21.8% decline the previous month. House prices are rebounding, to the tune of 4%. The ISM manufacturing index broke out to 52.6 in June from 43.1 the prior month. Job gains for the month of June came in at 4.8 million versus expectations of 3.23 million, pushing the unemployment rate down to 11.1%. These strong numbers provide a high hurdle that non-US growth will need to overcome in order for dollar weakness to continue. The Euro Chart I-2EUR/USD Is Undervalued By 3.8% EUR/USD Is Undervalued By 3.8% EUR/USD Is Undervalued By 3.8% The euro is not excessively undervalued versus the US dollar (Chart I-2). Usually, strong buy signals for the euro have been triggered at a discount of about 10% or so relative to the greenback. That said, the euro can still bounce towards 1.16, or about 3%-4% higher, to bring it back to fair value. The biggest catalyst for the euro remains that interest rate differentials with the US are quite wide and can continue to mean revert. The Treasury-bund spread peaked at 2.8%, and has since lost around 1.7%. Yet, a gap of 100 basis points remains wide by historical standards. On the data front, the CPI numbers from the euro area this week were quite instructive. German inflation came in at +0.8% versus a decline of -0.3% in Spain. In a general sense, inflation in Germany has been outperforming that in the periphery for a few months now, which is a sea-change from the historical trend in eurozone inflation, where both the core and periphery have seen CPI tied at the hip. If rising competitiveness in the periphery is a key driver, then the fair value of the Spanish “peseta” is rapidly catching up to that of the German “Deutsche mark,” which is positive for the euro. The Yen Chart I-3USD/JPY Is Overvalued By 10.3% USD/JPY Is Overvalued By 10.3% USD/JPY Is Overvalued By 10.3% The yen’s fair value has benefited tremendously from the plunge in global bond yields, making rock-bottom Japanese rates relatively attractive from a momentum standpoint (Chart I-3). This has pushed the yen to undervalued levels, supporting our tactically short USD/JPY position. The data out of Japan this week suggest that deflationary forces remain quite strong, which will continue to boost real rates and support the yen. The jobs-to-applicants ratio, a key barometer of labor market health, plunged to 1.20 in May from a cycle high of 1.63. Industrial production fell 25.9% year-on-year in May, the worst since the financial crisis. Meanwhile, the second quarter all-important Tankan survey suggests small businesses will continue to bear the brunt of the economic slowdown.  With most of the increase in the Bank of Japan’s balance sheet coming from USD swaps with the Fed rather than asset purchases, it suggests little ammunition or appetite for more stimulus. Fiscal policy remains the wild card that could help lift domestic demand.   The British Pound Chart I-4GBP/USD Is Undervalued By 5.9% GBP/USD Is Undervalued By 5.9% GBP/USD Is Undervalued By 5.9% Our model shows the pound as only slightly undervalued, putting our long cable position at risk. The drop in UK real rates since the Brexit referendum has prevented our model from flagging the pound as being much cheaper. Given the potential for added volatility this summer, we are looking to book modest profits on long cable (Chart I-4). Data out of the UK remains grim. Mortgage approvals fell to 9.3K in May, well below expectations. Consumer credit is falling much faster than during the depths of the financial crisis, suggesting all the BoE’s liquidity measures are still not filtering down to certain pockets of the economy. Meanwhile, the trend in the trade balance suggests that the pound has not yet started to reflate the economy.   The Canadian Dollar Chart I-5USD/CAD Is Overvalued By 8.1% USD/CAD Is Overvalued By 8.1% USD/CAD Is Overvalued By 8.1% The Canadian dollar is undervalued by about 8% (Chart I-5). Going forward, movements in the Canadian dollar will be largely dictated by interest rate differentials and crude oil prices, which remain supportive for now. We are going long a petrocurrency basket today, one that includes the Canadian dollar. Canadian data have been slowly improving, with housing starts up 20.2% month-on-month in May and existing home sales up 56.9% month-on-month. House prices have also remained resilient. More importantly, foreign investors have used the plunge in oil prices to deploy some fresh capital into Canadian assets. International security transactions in April stood at C$49 billion, the highest on record, and will likely continue to improve as oil prices recover.   The Swiss Franc Chart I-6USD/CHF Is Undervalued By 20.6% USD/CHF Is Undervalued By 20.6% USD/CHF Is Undervalued By 20.6% Our models suggest the Swiss franc is tactically at risk (Chart I-6). The main reason is that the franc has remained strong, despite the pickup in risk sentiment since March. Even if strength in the franc is sniffing market turbulence ahead, the yen remains a better and cheaper hedge. The Swiss National Bank continues to intervene in the foreign exchange market, but this week’s data shows that growth in sight deposits is rolling over. This is happening at a time when the economy remains weak. The June PMI came in at 41.9, well below expectations. Deflation has returned to Switzerland, with the CPI print for June at -1.3%, in line with the May number. While this is boosting real rates, the strength in the franc is an unnecessary headache for the SNB, especially against the euro.    The Australian Dollar Chart I-7AUD/USD Is Undervalued By 7.3% AUD/USD Is Undervalued By 7.3% AUD/USD Is Undervalued By 7.3% Despite the 20% rally in the Aussie dollar since March, it still remains 7%-8% cheap, according to our FITM (Chart I-7). Typical reflation indicators such as commodity prices and industrial share prices are showing nascent upturns. This suggests that so far, policy stimulus in China has been sufficient to lift commodity demand. Meanwhile, 10-year Aussie government bonds sport a positive spread vis-à-vis 10-year Treasurys. Recent data in Australia have been holding up. The private sector is slowly releveraging, the CBA manufacturing PMI went to 51.2 in June, and the trade balance continues to sport a healthy surplus, at A$8 billion for the month of May. Meanwhile, LNG is a long-term winner from China’s shift away from coal and will continue to benefit Australian terms of trade. We are currently in an LNG glut due to Covid-19, but should electricity generation in China, Japan, and other Asean countries recover to pre-crisis peaks, this will ease the glut. The New Zealand Dollar Chart I-8NZD/USD Is Overvalued By 4.9% NZD/USD Is Overvalued By 4.9% NZD/USD Is Overvalued By 4.9% Unlike the AUD, our FITM for the NZD is in expensive territory. This favors long positions in AUD/NZD (Chart I-8). The New Zealand economy will certainly benefit from having put Covid-19 mostly behind it. Both the ANZ business confidence and activity outlook indices continue to rebound strongly from their lows, with the final print for June released this week. However, the hit to tourism will still impact national income. Meanwhile, the adjustment to housing, especially given the ban to foreign purchases, will continue to constrain domestic spending, relative to its antipodean neighbor. In terms of trading, long CAD/NZD and AUD/NZD remain attractive positions. The Norwegian Krone Chart I-9USD/NOK Is Overvalued By 16.9% USD/NOK Is Overvalued By 16.9% USD/NOK Is Overvalued By 16.9% 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 (Chart I-9). The Norwegian economy remains closely tied to oil, and the negative oil print in April probably marked a structural bottom in prices. With inflation near the central bank’s target and our expectation for oil prices to grind higher, the Norwegian currency will likely fare better than a lot of its G10 peers. In terms of data, the unemployment rate ticked higher in April, but at 4.8%, it remains much lower than other developed economies. Our bet is that once the global economy stabilizes, the Norges Bank might find itself ahead of the pack, in any hiking cycle. The Swedish Krona Chart I-10USD/SEK Is Overvalued By 10.6% USD/SEK Is Overvalued By 10.6% USD/SEK Is Overvalued By 10.6% Like its Scandinavian counterpart, the Swedish krona is also quite cheap and is one of our favorite longs at the moment (Chart I-10). Meanwhile, since the Fed extended its USD swap lines, SEK has lagged the bounce in AUD, NZD, and NOK, suggesting some measure of catch up is due. The export-driven Swedish economy was hit hard by Covid-19, despite no widespread lockdowns being implemented. As such, the Riksbank expanded its QE program this week, boosting asset purchases from SEK 300 billion to SEK 500 billion, until June 2021. In September, it will start purchasing corporate bonds in addition to government, municipal, and mortgage bonds. While the repo rate was left unchanged at zero, interest rates on the standing loan facility were slashed 10 basis points and on weekly extraordinary loans by 20 basis points. These measures should provide sufficient liquidity to allow Sweden to recover as economies open up across the globe.     Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 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.   Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades