Policy

Highlights Since 2008, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent before needing to take a breather… and then reverse course. The current vulnerability to further tightening emanates from stock markets and risk spreads. Through the next couple of years U.S. long bonds will strongly outperform German bunds… …and USD/EUR will trend lower. Since October 2017, no stock market rally or sell-off has lasted more than three months. Overweight equities tactically, but don’t get too comfortable. The broad stock market will remain trendless, but offer excellent tactical opportunities in both directions. Feature More than a decade has passed since the Global Financial Crisis. Yet through the past ten years, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent before needing to take a breather… and then swiftly reverse course. 2019 is a pivotal year for monetary policy because it will answer a fundamental question: will the 2 percent limit for monetary tightening that has held since 2008 continue to hold, or finally break? (Chart of the Week). The answer will have a huge bearing on European investment strategy for equities, bonds and currencies. Chart of the WeekSince 2008, The Limit For Sequential Rate Hikes Has Been 2 Percent... So Far A History Of Policy Reversals Swedish interest rates peaked near 5 percent in 2008 before collapsing to the zero bound in the financial crisis. But when the Riksbank started its so-called ‘policy normalisation’ in 2010, the interest rate could only reach 2 percent before the central bank had to backtrack; Norway could manage just 1 percent of tightening before its volte-face. Admittedly, Sweden and Norway were caught in the maelstrom of the euro debt crisis in 2011-12. But on the other side of the world and relatively immune to the crisis in Europe, New Zealand could achieve a tightening of only 1 percent; Korea could manage just 1.25 percent (Chart I-2); the Reserve Bank of Australia marched interest rates up by 1.75 percent before taking a breather… and then marched them down again.   Chart I-2Since 2008, The Limit For Sequential Rate Hikes Has Been 2 Percent The Federal Reserve has sequentially raised interest rates by 2 percent, and guess what? It has just decided to take a breather! Last week, Chairman Jay Powell was asked the question as plainly as possible: is the next move in interest rates as likely to be up as down? And his answer: “we don’t have a strong prior… we will patiently wait and let the data clarify.”1 There is no requirement at BCA for strategists to agree. In fact, the opposite is true in that we encourage independent thinking and diverse ways of looking at the world. BCA’s house view is that the Fed will resume its sequential hiking later in the year. But I believe this takes a too rosy view on the global financial system’s capacity to tolerate further tightening. The Vulnerability Is In Stock Markets And Risk Spreads   Monetary policy operates on an economy by adjusting its financial conditions: its bond yields, credit availability, currency, stock market, and risk spreads. And the neutral monetary policy stance – the so-called ‘neutral real interest rate’ – is the policy stance consistent with the economy growing at trend. In the past, a simple rule of thumb was that real rates, over time, should approximate to the real growth in the economy. But some studies argue that the neutral real rate may now be close to zero. All the Fed has done is bring the real interest rate out of negative territory to barely above zero. Yet its recent hikes have been blamed for extreme volatility in stock markets and risk spreads. Last week, Powell acknowledged that if there is a sustained change in financial conditions through any one or more of its components then “that has to play into our thinking.” Furthermore, “the policy stance is now in the range of the Committee’s estimates of neutral… and when you get to that (neutral) range we have to put aside our own priors and let the data speak to us.” All of which raises a salutary observation from my colleague Martin Barnes, BCA Chief Economist: if a real interest rate that is barely above zero is enough to trigger extreme market volatility and threaten the economic expansion, then the system is much more vulnerable than generally assumed.2  Martin has hit the nail on the head. At the current level of tightening, the system is much more vulnerable than generally assumed. But the vulnerable components of financial conditions are not bond yields, credit availability, or currency; the vulnerability emanates from stock markets and risk spreads, and specifically their potential for extreme volatility. Previous reports have focused on the source of this vulnerability. To recap, at low yields, bond prices develop the same unattractive negative asymmetry as equities. Therefore, an extended period of ultra-low interest rates removes the need for an equity risk premium, and justifies sharply higher valuations for equities and other risk-assets. But when the 10-year global bond yield rises back to around 2 percent, the process viciously reverses: bond prices lose their negative asymmetry, re-requiring an equity risk premium and sharply lower valuations for risk-assets.3 Put simply, when interest rates rise from low levels they undermine the support for elevated risk-asset valuations in a viciously non-linear way. The consequent plunge in risk-asset prices aggressively tightens financial conditions and thereby sets an unusually low ceiling for nominal interest rates and bond yields. This dynamic proved to be the major feature of the financial market landscape in 2018 and will loom large in 2019 too. It also solves the riddle as to why the neutral real rate may now be close to zero. An unusually low ceiling for the nominal interest rate combined with inflation hovering around 2 percent, translates into a neutral real interest rate that is not much higher than zero. The Investment Implications When the Riksbank paused after its near 2 percent of hiking, it proved to be a good structural entry point for Swedish long bonds, and a good structural exit point for the Swedish krona (Chart I-3 and Chart I-4). Likewise, when the Reserve Bank of Australia paused after its near 2 percent of hiking, it was an excellent moment to buy Australian long bonds and to sell the Australian dollar (Chart I-5 and Chart I-6). Chart I-3When The Riksbank Paused, It Was A Good Structural Entry Point In To Swedish Bonds... Chart I-4...And A Good Structural Exit Point Out Of The Swedish Krona Chart I-5When The RBA Paused, It Was A Good Structural Entry Point In To Australian Bonds... Chart I-6...And A Good Structural Exit Point Out Of The Australian Dollar Will the the 2 percent limit for monetary tightening that has held since 2008 continue to hold? If, as we expect, the answer is yes the implication is that through the next couple of years U.S. long bonds will strongly outperform German bunds. Over the same time frame, USD/EUR will trend lower (Chart I-7 and Chart I-8).  Chart I-7A Good Structural Entry Point In To Long T-Bonds/Short Bunds Chart I-8A Good Structural Exit Point Out Of USD/EUR Finally, as regards the broad stock market, a quick glance at the MSCI all country world index shows a striking feature. Since October 2017, no rally or sell-off has lasted more than three months (Chart I-9). Given the current highly non-linear relationship between equities and bond yields, this pattern is set to continue. Chart I-9Since October 2017, No Rally Or Sell-Off Has Lasted More Than Three Months In essence, the broad stock market will remain trendless, but offer excellent tactical opportunities in both directions. The current stance is tactically long, but don’t get too comfortable! Fractal Trading System* The sharp recent rally in government bonds has hit a point where tight liquidity conditions could trigger a temporary reversal. Accordingly, the 65-day trade is to go short 30-year T-bonds, setting a profit target at 3 percent with a symmetrical stop-loss. All of the five other open positions are in healthy profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.   Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com  * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnotes 1 The Federal Reserve has raised the federal funds rate by a total of 2.25 percent comprising an isolated 0.25 percent hike at the end of 2015 and a sequential 2 percent hike from December 2016 through December 2018. 2 Please see the BCA Special Report “A Grumpy View Of The Outlook” January 28, 2019 available at www.bcaresearch.com 3 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance”, October 25, 2018 available at eis.bcaresearch.com  Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Highlights So What? The late-cycle rally faces non-trivial political hurdles. Why? The rally is based on a too-sanguine view of the Fed, China, and the trade war. Other issues – like Brexit and the U.S. border showdown – are also problematic. Venezuela still has the potential to push oil prices sharply upwards. Feature All is well. Global equities are on the path of recovery, as should be the case at the end of an economic cycle. The U.S. S&P 500 has gained 16% since the bottom on December 24, with healthy technicals suggesting a breakout is ahead (Chart 1). The S&P 500 may be entering one of its typical late-cycle rallies, which tend to be the second best-performing decile of a bull market (Chart 2).1 Meanwhile, emerging market equities and currencies are outperforming developed market peers (Chart 3), a reversal from 2018 Chart 1Late Cycle Rally Ahead?   Chart 3...As Does Current Global Outperformance Typically, global risk assets outperform American risk assets at the end of an economic cycle. While institutional investors can use these rallies to lighten the load ahead of a recession, most investors cannot afford to miss such a rally. As such, BCA (and others) are calling for investors to play what is expected to be a yearlong rally in global risk assets and the S&P 500. Our view at BCA Geopolitical Strategy is more cautious, perhaps because it is informed by a methodological bias rooted in geopolitics. We believe that the reversal in U.S. outperformance relative to global risk assets rests on three pillars: The Federal Reserve remains dovish throughout 2019; China begins a major reflationary effort;  The U.S.-China tariff truce results in a trade deal. In addition, a consensus is emerging that a “no deal” Brexit will not occur, that U.S. polarization cannot get worse, and that President Trump eschews foreign interventionism. While we hold a nuanced view on each of these assertions, the mix is far less bullish than investors may think. We see a witches’ brew of factors that is murky at best and bearish at worst. The Three Pillars Of The Bullish View Before we turn to geopolitics, let us examine the three pillars underpinning the bullish view. Our colleague Peter Berezin, BCA’s Chief Global Strategist, remains bullish on the U.S. economy and expects the Fed to resume hiking rates by mid-year.2 The Conference Board’s Leading Credit Index remains in expansionary territory (Chart 4). While business capex intention surveys have come off their highs, they still point to robust spending plans over the next few quarters (Chart 5). Chart 4Little Sign Of A Looming Credit Crunch Chart 5Capex Plans Still Solid It is no surprise that the BCA Fed Monitor continues to suggest that “tighter monetary policy is required” (Chart 6). This is a far cry from 2016, when our indicator was in deeply “tightening” territory and the Fed paused for 12 months. If we compare 2019 to 2016, it is difficult to see how the market expectation of 4.72 bps of rate cuts will occur over the next 12 months (Chart 7). Of the three components that make up the BCA Fed Monitor, only the financial conditions have fallen into “easing required” territory (Chart 8), and they are already shifting back to “tightening required” territory with the stock market rally underway (Chart 9). Chart 6A Hawkish Fed Is Needed Chart 8BCA Fed Monitor Calls For Tighter Policy Chart 9Financial Conditions Starting To Ease In addition, in 2016 the Fed was not contracting its balance sheet. Today it is doing so, although the pace has moderated. As such, the Fed’s rate hike pause is occurring amidst an ongoing effort to normalize monetary policy and to transfer rate risks back to the private sector. By chance, this is also occurring at a time when the Treasury Department must issue more debt to cover a larger deficit, a process that could significantly pull U.S. rates higher and, by extension, yields on assets further down the risk curve. This would be a particular problem for global risk assets given the exposure of several EM economies to dollar-denominated debt.  The bottom line for investors is that a rate hike pause is not a pause in the overall hawkish policy of the U.S. Fed, which acts as a global central bank. The fall in the amount of dollars available for the international financial system acts as a brake on growth. Over the past 10 years, each time money supply growth fell below the loan uptake of the U.S. corporate sector, BCA’s Global Industrial Activity Nowcast, BCA’s Global Leading Economic Indicator, Korean exports, and global export prices all deteriorated considerably (Chart 10). Chart 10Deteriorating Excess Liquidity Hurts Global Growth Our muted view on Chinese reflation is unnecessary to repeat here. There is no doubt that Chinese policymakers are stimulating the economy, but the question is whether they are willing to pull the credit lever as aggressively as they have done in the past (Chart 11).So far, all of the evidence we have reviewed point to a cautious effort to stabilize growth, not reflate the entire planetary economy as Beijing did in 2016. If our BCA House View on the Fed is correct, a tepid Chinese effort to stimulate the domestic economy will fall short of lighting the flame of a global risk rally in 2019. Chart 11Compare Any Stimulus To Previous Efforts The BCA China Play Index, which in the past has tracked EM vs. DM equity outperformance, is sending mixed signals today (Chart 12). Enthusiasm for global risk assets has not been confirmed by the most China-sensitive plays. Chart 12Mixed Signals From China-Sensitive Plays Finally, there is the trade truce that should produce a trade deal. The logic is clear: President Trump sets aside the political constraints working against a deal and focuses on ensuring that he wins 2020 by avoiding a recession. The near bear market in the S&P 500 was a game changer that focused the White House on averting any further downside to markets and the economy from the trade war. But if the current rally proves that the selloff in December was a temporary pullback, the White House may be emboldened to play hard-to-get with China. After all, the electorate is generally supportive of getting tough on China (Chart 13) and there is no demand from either Trump voters or Democrats for a quick deal. The Fed pause and lower oil prices also give Trump some space to push negotiations a bit harder. Already there are leaks from the negotiations that the U.S. is asking for a lot from China, which could prolong the talks. This includes genuine structural changes to the economic relationship that would address long-standing U.S. concerns of forced technology transfers, intellectual property theft, and foreign investor access to the Chinese domestic market. It also includes U.S. demands that these changes be verifiable and enforceable. China is likely to balk at some of the U.S. demands, particularly if the U.S. is indeed pushing for regular reviews of China’s progress, a condition that implicitly creates a hierarchy between the two economies and would thus represent a loss of face for Beijing.3 Table 1 presents our latest expectations of where the U.S. and China will be on March 1. We assign only 10% each to “black and white” outcomes, a “Grand Compromise” and “No deal, with major escalation.” The remaining 80% is divided between “mushy” outcomes, including a 25% probability that negotiations simply continue. Table 1Updated U.S.-China Trade War Probabilities How would the market react to such uncertain outcomes? We think that almost anything other than a “Grand Compromise” would be greeted with limited relief, if not outright market correction. A vaguely positive meeting between Presidents Trump and Xi, and a memorandum of understanding, would not remove long-term risks in the relationship, especially if the parallel “tech war” is not resolved. On top of the ongoing U.S.-China negotiations, there is one remaining trade issue that investors should keep in mind: auto tariffs. The Section 232 investigation into whether auto imports are a national security threat is ongoing and U.S. authorities are expected to present their conclusions on February 17. We fear that the Trump administration could still stage a surprise and impose tariffs on auto imports. This is because the just-concluded NAFTA deal likely raised the cost of vehicle production within the trade bloc, necessitating import tariffs in order for the deal to make sense from President Trump’s set of political priorities. An extended truce with China could provide the opportunity. The Trump administration may not have the stomach for a long-term trade war with Europe, but the timing of this decision could upset the market’s perception of Trump’s commitment to free trade once again. Bottom Line: The conventional narrative is that global markets are experiencing a late-cycle rally, one that is worth playing given its usual duration and amplitude. This view rests on three pillars: that the Fed has backed off from tightening, that China is stimulating in earnest, and that the trade deal will produce a definitive outcome. We fear that all three pillars are shaky. First, the Fed is not easing. Its balance sheet contraction process, which is ongoing, is a form of tightening. And the U.S. economy remains healthy. As such, the expectation of a 12-month Fed pause is overly optimistic. Second, China is stimulating, but only tepidly. Third, “black and white,” definitive outcomes are unlikely in the U.S.-China negotiations. In fact, more protectionism could be around the corner if U.S.-China tech issues continue to flare or if the U.S. announces the conclusion of its investigation into auto imports. Geopolitical Factors To Monitor Aside from shaky pillars, markets will also have to contend with several uncertain geopolitical processes this year. While we are not necessarily bearish on each one, we are concerned that the collective investment community is overly bullish. Take Brexit. We agree with the conventional view that the chances of a no-deal Brexit outcome are below 10%. Political betting markets have only priced in an actual exit on March 29, which is in ink in British legislation, at just above 30% (Chart 14). Chart 14Online Betters Expect A Brexit Delay The problem is not with the conventional view but with its timing. While Prime Minister Theresa May will ultimately be forced to extend the Article 50 deadline, it may take a lot of brinkmanship and eleventh hour negotiations to do so. Getting from here – collective bullishness – to there – an actual extension of Article 50 – may require a downturn in GBP/USD or other U.K. assets. Furthermore, several scenarios could produce a downturn in GBP/USD (Diagram 1). For example, the Labour Party remains neck-and-neck with the Tories in the polls, despite being led by the most left-leaning leader since the 1970s. Although a new election that produces a Labour government would likely reduce the odds of Brexit eventually occurring, it would raise the odds of Corbyn pursuing unorthodox economic policy while also trying to negotiate his own version of Brexit with the EU. Diagram 1Brexit: The Path To Salvation Remains Fraught With Dangers The point is that it is tough to recommend that investors close their eyes and buy GBP/USD, no matter how cheap the currency may look, unless one has a very long time horizon and a high threshold for pain. The second issue where we take a more nuanced position is the ongoing U.S. executive-legislative standoff over the border. The government shutdown is only on pause until February 15. The House Democrats are demanding that a solution be found by Friday, February 8 if it is to be voted on in time. Meanwhile President Trump’s popularity is in the doldrums (Chart 15). His supporters note that President Reagan was even less popular at this point in his term, but that is because unemployment hit 10.4% in January 1983 (Chart 16). The grave risk for President Trump is that he is as unpopular as Reagan, even though unemployment is at 4% and the U.S. economy is on fire. Chart 15President Trump Is Unpopular... Chart 16...And It Can't Be Blamed On Unemployment As such, the real risk is not another shutdown, but rather political dysfunction in Congress that imperils the legislative process. The current two-year budget deal, which raised spending levels in January 2018, is set to expire when the FY2019 ends. Democrats and Trump have to come to an agreement to avert the “stimulus cliff” expected in 2020 (Chart 17). If they cannot conclude the border issue and the FY2019 appropriations, then Trump may declare a national emergency (or act unilaterally in other ways) and spark a new conflict with the courts. He could also threaten not to raise the debt ceiling in spring or summer. This is not an atmosphere in which a FY2020 deal looks very easy. Chart 17Stimulus Cliff Ahead Ultimately, we expect Democrats to succumb to the pressure from their voters for more spending. But a total failure to cooperate is a risk. Furthermore, the greatest political risk in the U.S. is that the 2020 election will not be contested on the same issues as in 2016: trade and immigration. Instead, income inequality is rearing its head, as Democratic candidates jostle for attention and as they test various messages on focus groups. If income inequality catches fire as the issue of 2020, we will know it soon. And it may begin to impact the markets as Democrats begin to campaign on, for instance, reversing President Trump’s income tax cuts. While the market may ignore headline election risks for some time, we do not think that non-financial corporates can do the same. Any hint that President Trump’s pro-business policies will be reversed could send shivers down the spines of CEOs and negatively impact capex intentions, hurting the real economy well before the next election. Finally, there is the issue of foreign policy. President Trump has abandoned his maximum pressure tactic on Iran and has begun withdrawing the remaining troops in the Middle East. These trends are likely to continue in 2019 as President Trump focuses on China and lesser issues like Venezuela. There is one important area of alignment between him and the defense and intelligence community, notwithstanding recent scuffles: less focus on the Middle East means more focus on Asia and specifically China. However, President Trump is facing a dilemma. Despite an extraordinary economic performance, his popularity remains in the doldrums. When faced with similar situations in the past, presidents far more orthodox than Trump have sought relevance abroad, by means of military interventions. A convenient opportunity has presented itself in Venezuela, where a revolution against Chavismo could give the U.S. an opening to intervene. On paper, we see how such a scenario could look appealing for a quick, and relatively painless, intervention. The problem is that it could also get messy and, in the analysis of BCA’s Commodity & Energy Strategy, raise oil prices to nearly $100 per barrel by mid-year if a total loss of Venezuelan production ensues (Chart 18). This is a non-negligible risk. Chart 18A Venezuela Collapse Could Send Brent Crude Prices Toward $100/Bbl Bottom Line: Geopolitical risks still abound. We are not alarmist. However, there is little reason to believe that Brexit, U.S. polarization, U.S.-China tensions, or a potential U.S. intervention in Venezuela will end painlessly for the market. An unpopular U.S. president is seeking to remain relevant and a global populist wave is continuing to create unorthodox and anti-establishment policy prescriptions. Given that the current rally is supported by three shaky pillars, any one of these geopolitical risks could catalyze a relapse, the history of late-cycle rallies be damned.   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      Please see BCA U.S. Investment Strategy Weekly Report, “Late-Cycle Blues,” dated October 29, 2018, available at usis.bcaresearch.com. 2      Please see BCA Global Investment Strategy Weekly Report, “Patient Jay,” dated January 18, 2019, available at gis.bcaresearch.com. 3      Please see Reuters, “Exclusive: U.S. demands regular review of China trade reform,” dated January 18, 2019, available at reuters.com.   Geopolitical Calendar

Highlights Fed Policy: The Fed’s move to a more dovish posture is positive for global risk assets in the near-term. This is setting up for a revival of volatility later in 2019, however, with U.S. growth unlikely to slow enough to justify a continuation of the Fed’s dovish stance. With the market now discounting no change in Fed policy rates over the next year, the risks for U.S. Treasury yields are now tilted to the upside. ECB Policy: Growth has slowed in Europe, but the ECB is limited in its ability to ease policy further given tight labor markets and rising wage growth. Policy rates will stay on hold over at least the next year. U.S. & European Duration: Keep global duration exposure below benchmark, with a more defensive stance on U.S. Treasuries over German Bunds given that the Treasury-Bund spread has overshot to the downside. Feature “In fact, our policy works through changing financial conditions, so it’s sort of the essence of what we do” – Federal Reserve Chairman Jerome Powell Have central bankers now turned TOO dovish? That is a question that will be answered in the coming weeks and months after the Federal Reserve and European Central Bank (ECB) signaled a more cautious outlook on growth and inflation. Both central banks cited common causes for the increased caution, such as financial market instability related to geopolitical uncertainty (U.S.-China trade tensions, Brexit, the U.S. government shutdown). Importantly, neither the Fed nor ECB expressed conviction that monetary policy settings were now too restrictive. The sharp selloff in global stock and credit markets at the end of 2018 did tighten financial conditions which, in and of itself, should result in slower growth on either side of the Atlantic in the first half of 2019 (Chart of the Week). Yet we do not expect a move to a below-trend pace of growth that would trigger rising unemployment and weaker inflation pressures. Chart of the WeekFed Too Dovish, ECB Not Dovish Enough The shift to a more dovish posture by the Fed and ECB has already induced some easing of financial conditions to help support growth in the U.S. and Europe until the uncertainties over geopolitics and the Chinese economy are resolved. This appears to be providing more stimulus to economies that may not necessarily need it. That is a risk that policymakers have decided to take to protect against the downside tail risks to economic growth and confidence from global uncertainty. In terms of fixed income markets, more dovish policymakers have created a pro-risk backdrop that will support the outperformance of corporate bonds versus government debt over the next 3-6 months. Without a deeper slowdown of global growth beyond what is currently expected, however, this will only be a temporary respite as central banks revert back to fighting inflation pressures instead of calming financial markets. The result will be a return to monetary tightening and higher bond yields, although that is a far more likely scenario in the U.S. than in Europe over the next 6-12 months given the relative signals from our Central Bank Monitors (bottom panel). Fed Outlook – A Temporary Dovish Turn, Nothing More The quote at the beginning of this report was taken from Fed Chair Powell’s press conference after last week’s FOMC meeting, in response to a question on how the Fed thinks about financial conditions. We can think of no cleaner way to explain the Fed’s understanding of how its monetary policy actions get transmitted to the real economy. By inducing changes in financial asset values (equity prices, corporate bond yields, the value of the U.S. dollar) through adjustments in the fed funds rate – and perceptions about its forward path – the Fed is able to impact the cost of financing across much of the U.S. economy. The goal is either to slow or stimulate growth, as needed, to allow the Fed to reach its dual mandate of maximizing employment while keeping inflation stable. Viewed from this perspective, the Fed’s “dovish” turn last week was a necessary step to not only stabilize financial markets, but to induce a pro-growth rally in risk assets that had sold off too aggressively. On that front, the Fed can say “Mission Accomplished”. Year-to-date, the S&P 500 is up 8% while U.S. investment grade and high-yield corporate bond spreads have fallen by 26bps and 110bps, respectively. The U.S. dollar is also down 1.6% since the start of the year, providing further stimulus to the U.S. economy. U.S. Treasury yields, which had fallen thanks to lower real and inflation components, have also helped ease financial conditions. Real yields have declined as the market has moved to price out all Fed rate hikes for 2019 in response to some signs of cooling U.S. growth (i.e. housing) and the big fall in asset prices. At the same time, inflation expectations have drifted lower as markets now expect the plunge in oil prices seen in 2018 to filter though more broadly into lower realized inflation (Chart 2). Chart 2Too Much Pessimism In UST Yields The ability for yields to decline further is now limited, however, with U.S. economic growth likely to continue at an above-trend pace in the next few quarters, based on the readings from reliable indicators. The ISM Manufacturing index rebounded to 56.6 in January, still well above the 50 level indicating an expanding U.S. economy, even after the decline that began last September. Within the sub-components of the index, the New Orders series also rose last month by 6.9 points, suggesting that the bounce in the overall ISM series could persist. The 10yr UST yield broadly tracks the ISM Manufacturing index (Chart 3), with the post-crisis relationship indicating that the bond yield will have difficulty falling below 2.5% if the ISM remains above 55. Chart 3U.S. Treasuries Vulnerable To Better U.S. Data U.S. economic data continues to broadly meet expectations, and the momentum in U.S. Treasury yields has overshot to the downside versus data surprises (bottom panel). Admittedly, there have been far fewer data releases of late because of the U.S. government shutdown last month. Yet even if the bulk of the unreleased data was weak, Treasury yields at current levels already seem to be discounting very soft growth. Forward-looking indicators of growth - the Conference Board leading economic indicator and BCA’s U.S. employment and capital spending models – are all pointing to the U.S. economy continuing to expand at a solid, above-trend pace in the coming months (Chart 4). Chart 4No Signs Pointing To Slower U.S. Growth The U.S. labor market remains tight, as evidenced by continued low unemployment and solid growth in wage measures like Average Hourly Earnings and the Wages and Salaries component of the Employment Cost Index (Chart 5). At the same time, readings from leading inflation indicators like the New York Fed’s Underlying Inflation Gauge remain elevated (bottom panel). The combined message is that U.S. core inflation rates will remain surprisingly sticky in the coming months, even given the lagged impact of last year’s drop in oil prices. Chart 5Persistent U.S. Inflation Pressures Many have made the case that the current cycle looks a lot like the Fed’s 2016 pause on policy tightening, which ended up lasting one full year after the December 2015 initial post-QE rate hike. Back then, the Fed’s more dovish posture helped generate easier financial conditions through a weaker U.S. dollar, tighter U.S. corporate credit spreads and higher U.S. equity values. U.S. Treasury yields fell sharply as the market aggressively covered a large bearish tilt towards U.S. interest rates while removing all rate hikes that were discounted for 2016 (Chart 6). There is one major difference between then and now, however – the U.S. economy is growing at a much faster pace, with far less spare capacity (bottom panel). Chart 6This Is NOT A Repeat Of 2016 When looking at all the U.S. data objectively, we conclude that the Fed’s latest dovish turn will not last anywhere near as long as the 2016 episode. The current easing of U.S. (and global) financial conditions alongside still-solid U.S. growth will eventually set up a return to the Fed rate hiking cycle, at a time when no interest rate increases are discounted in U.S. money markets. This supports our current recommendation to be tactically overweight U.S. corporate debt versus U.S. Treasuries on a 3-6 month horizon, during this window when the Fed is deliberately easing financial conditions by being overly dovish. On a more medium term 6-12 month horizon, however, we are maintaining a below-benchmark stance on U.S. duration exposure. The only way Treasury yields can move lower from here is if a Fed rate cutting cycle starts to be discounted – a highly unlikely scenario given the signals from leading growth and inflation indicators. Bottom Line: The Fed’s move to a more dovish posture is positive for global risk assets in the near-term. This is setting up for a revival of volatility later in 2019, however, with U.S. growth unlikely to slow enough to prevent inflation pressures from surfacing. With the market now discounting a stand-pat Fed over the next year, with minimal expected inflation, the risks for U.S. Treasury yields are now tilted to the upside. ECB Outlook – Firmly Neutral The euro area is currently facing a fairly significant growth slowdown. The manufacturing PMI has fallen for 13 consecutive months and now sits just above the 50 line indicating expanding growth. The OECD’s leading economic indicator (LEI) has also declined over that same period. Both indicators are now back to levels last seen prior to the 2009 and 2012 recessions (Chart 7). Chart 7Euro Area LEI and PMI Overstating The Downturn? Yet at the same time, surveys of business and consumer confidence from the European Commission suggest that the current downturn is nothing like those previous slumps. Even the Commission’s indicator of exporter order books (bottom panel) suggests that things do not appear as bad as indicated by the PMI and LEI. So where does the truth lie about the euro area economy? When looking at the hard data on exports (using the IMF’s Direction of Trade statistical database that includes both goods and services), it is obvious that there was a sharp slowing of euro area exports last year (Chart 8). Slumping Chinese demand was a major reason for that slowdown, but exports to the rest of the world also took a major hit. For the more export-intensive economies of Europe, last year’s global growth deceleration was a major punch to the gut. Chart 8European Export Shock Should Bottom Out Later In 2019 Looking ahead, there is still likely to be some pain coming from weaker export demand in the first half of 2019. The Chinese credit impulse (measured as a 12-month change in Total Social Financing as a % of GDP) is still negative, while our global LEI measure continues to drift lower. However, there are some tentative signs that things may be stabilizing. The shorter 6-month China credit impulse has hooked up (the “x’ in the top panel of Chart 8). Our diffusion index of countries within our global LEI – itself a leading indicator of the global LEI – has also begun to move higher, meaning there are fewer countries within the euro area with falling LEIs. While it is still too early to draw firm conclusions, there is a chance that euro area export growth will bottom out by mid-year. This is especially true if a U.S.-China trade detente is soon reached and Chinese policymakers deliver some additional growth stimulus measures, which is BCA’s base case scenario. ECB President Mario Draghi noted last week that a stabilization of global trade tensions would reduce much of the perceived uncertainty within the euro area economy. The U.S.-China trade spat has not been the only thing weighing on euro area growth, though. In our framework for analyzing the ECB’s policy decisions, we look at how broad-based are the trends in growth and inflation within the euro area to determine the next likely move on monetary policy. The way we do that is by looking at diffusion indices of economic data, constructed using figures from as many euro area countries as possible, given data availability. We show those diffusion indices for real GDP growth, manufacturing PMIs, headline inflation and core inflation in the euro area in Chart 9. Chart 9No Pressure On The ECB To Adjust Interest Rates The diffusion indices show that the vast majority of euro area countries are now suffering slowing real GDP growth and falling PMIs, with levels seen during recessions. Yet the actual pullbacks in real GDP growth and the PMIs have been shallower than those past episodes. It is as if today, all countries are suffering a slump, but no deep downturn. This is consistent with the ECB’s belief that Europe has suffered a bunch of one-off triggers for slowing growth – cutbacks in German auto production related to new emission standards, large-scale French street protests, the Italian fiscal policy debate with the EU, slowing exports from global trade tensions – but no broad-based decline that can be attributed to, or solved by, monetary policy. This is especially true with the diffusion index for core euro area inflation which now rising, suggesting that core inflation could remain surprisingly sticky in the coming months. The diffusion indices for euro area labor markets provide additional information as to why the ECB has not shifted to an even more dovish stance, despite the signs of weaker growth. Not only is the overall euro area unemployment rate now below the OECD’s estimate of the full employment NAIRU, the vast majority of countries within the euro area are at full employment (Chart 10). That diffusion index correlates strongly with a traditional Taylor Rule estimate of the equilibrium ECB policy rate, and suggests that the ECB should be raising rates right now. That can also be seen in the diffusion index for wage growth (bottom panel), which shows that the majority of euro area countries are seeing higher wage inflation. Chart 10Tightening Labor Markets In Europe Given the readings on the core inflation and labor market related diffusion indices, the current backdrop is not one where the ECB should be shifting to a more dovish posture. Yet when looking at market-based measures of inflation expectations like CPI swaps, investors clearly do not believe that the ECB’s optimistic inflation forecasts will be achieved over the next two years – typically a sign of policy settings that appear too tight (Chart 11). Chart 11Bund Yields Will Stay Subdued Without More Euro Area Inflation It will require some signs of euro area growth reacceleration, and maybe some upside surprises on core inflation and wage growth, before inflation expectations (and Bund yields) begin rising again. Those are unlikely to become visible until at least the latter half of 2019, and the ECB is likely to keep policy rates unchanged over the balance of the year. Given our relative views on the Fed and ECB, we see the scope for the yield spread between the benchmark 10-year U.S. Treasury and German Bund to widen from current levels. That spread is wide on a long-term basis because of the relative policy stance of the two central banks, with the current 255bps gap roughly equal to the gap between the fed funds rate and ECB refi rate. Yet the momentum of that spread is closely correlated to the difference in the data surprise indices for the U.S. and euro area, and a divergence has opened up between those two measures on the back of better U.S. growth (Chart 12). Chart 12UST-Bund Spread Has Overshot To Downside With the forward curves currently pricing in some additional tightening of the Treasury-Bund spread, betting on some renewed spread widening is a positive carry trade that also makes sense on a fundamental basis. Bottom Line: Growth has slowed in Europe, but the ECB is limited in its ability to ease policy further given tight labor markets and rising wage growth. Policy rates will stay on hold over at least the next year.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns