Policy
Highlights The Fed will shrink its balance and is determined to raise rates. Implications of synchronized global growth and global NAIRU. Consumers are upbeat and ready to spend. What's the signal from record high consumer expectations for equities? Feature Risk assets and Treasury yields rose up to and after last week's Fed meeting, but late-week saber-rattling by North Korea left most asset classes little changed on the week. The U.S. economic data released last week continued to be impacted by Hurricanes Harvey and Irma, but the Fed notes that the storms are "unlikely to materially alter the course of the national economy beyond the next few months". The backdrop has turned more bearish for bonds even before the Fed's recommitment last week to raising rates gradually and shrinking its balance sheet. The Fed's hawkish stance short term and dovish stance long term will allow risk assets to outperform Treasury bonds and cash, but a sudden move higher in inflation would challenge that view. FOMC: Short Term Hawkish... The Fed sent a hawkish short-term signal on the outlook for monetary policy at its meeting last week. The vast majority of FOMC members, 12 out of 16, expect to raise rates again by December (Chart 1). A 0.2% downward revision to the Fed's 2017 core PCE inflation forecast was offset by an equal 0.2% upward revision to its GDP growth forecast. Moreover, Fed Chair Janet Yellen downplayed this year's soft inflation figures and stressed that inflation expectations remain "reasonably well anchored". Although the relationship may have weakened somewhat recently, the Fed is loath to throw the Phillips curve model into the dust bin just yet. The unemployment rate forecasts were lowered from 4.2% to 4.1% for 2018 and 2019, while the Fed kept its NAIRU estimate at 4.6%. The tightening labor market is expected to place upward pressure on wage inflation and push PCE inflation to the 2% target by 2019. Chart 1Market Expects A Hike In December Incoming data on actual inflation and inflation expectations will determine whether the Fed will be able to pull the trigger in December. Further softness in the core PCE inflation and CPI will raise doubts as to whether the inflation undershoot is indeed transitory. And especially worrisome will be a decline in inflation expectations. It is noteworthy that 10-year inflation breakevens fell nearly 4bps immediately following yesterday's FOMC announcement. At 1.85%, 10-year breakevens are already running below the 2.4-2.5% range that is consistent with the Fed's 2% target for PCE inflation. Any further decline in breakevens will call into question the Fed's view that inflation expectations remain well anchored. Further, with the decline in inflation expectations, the 2/10-year yield curve flattened following the Fed's announcement. This is could be considered a sign of a slight lowering in growth expectations. Finally, there was little surprise on the Fed's balance sheet announcement. For now, the Fed is committed to slowly unwinding its bond holdings. Janet Yellen said that the Fed will only resume full reinvestment of maturing bonds after it had cut the policy rate back to the zero bound. In other words, the Fed funds rate is now the primary tool to set monetary policy. The odds of another Fed rate hike by year-end have certainly increased (Chart 1). This need not upset risk assets if the incoming data justify higher rates. Only a policy error, where the Fed hikes rates even as inflation expectations decline and the yield curve flattens, will trigger a sizeable pullback in risk assets. This is not our baseline scenario. Softness in inflation and inflation expectations will force the Fed to back down. ...But Long Term Dovish Although the Fed signaled a greater probability of an interest rate hike in the near-term, it lowered the long-run outlook for policy rates. First, the median FOMC member now expects only two rate increases in 2019, down from three in the June forecast (not shown). Second, the estimate for the terminal rate was lowered to 2.75% from 3.0% (Chart 2, panel 4). With the long-run inflation target being 2% (Chart 2, panel 3), this means that the FOMC collectively believes the long-term neutral real Fed funds rate to be just 0.75%. Currently, the Laubach-Williams estimate of the neutral real Fed funds rate is near zero (Chart 3). Therefore, the FOMC sees it rising only modestly from current levels over the coming years. Chart 2The FOMC's "Long Run" Forecasts Since 2012 Chart 3Neutral Real Rate Near Zero For any given term premium, a lower short-term interest rate path will mean a lower 10-year yield. If estimates for the terminal policy rate outside the U.S. remain unchanged, the Fed's lower projection will mean narrower interest rate differentials, reducing the relative attractiveness of the dollar. As for equities, a lower estimate for the long-run policy rate would be a wash if it also reflected a lower estimate for long-term GDP growth. However, the Fed kept its longer run real GDP growth estimate unchanged at 1.8% (Chart 2, panel 1). If that proves accurate, lower interest rates and a weaker dollar will be more supportive for U.S. equities over the long-term. Notably, the Fed did not adjust its view of NAIRU, keeping it at 4.6%, where it has been since April (Chart 2, panel 2). Bottom Line: In terms of investment implications, the lower estimate of the long-run neutral rate is supportive for 10-year Treasuries, negative for the dollar and positive for equities. Stay overweight stocks versus bonds and short duration. Don't Downplay NAIRU Synchronous global growth remains in place in 2017 and will persist into 2018, but this growth alone may not be enough to push up inflation. BCA's OECD Real GDP Diffusion Index is at 100% after it dipped to 14% during the financial crisis. The index was also above 90% from 1994 through 1998, and then again from 2001 through 2007. Moreover, the OECD expects that GDP growth will climb above zero in all the member countries in BCA's diffusion index again in 2018. The broad-based global GDP growth has historically been associated with a rising stock-to-bond ratio, rising global trade flows, a narrowing output gap and accelerating industrial production (Chart 4). However, there is no consistent pattern on the dollar, the unemployment rate, or core inflation. Chart 5 shows that during prior periods of robust global growth, equities beat bonds, the U.S. output gap tightened and industrial production increased. U.S. exports tend to contribute more to GDP growth during these phases, but not in a uniform way. Meantime, the Fed has both raised and lowered rates during these periods. Chart 4Widespread##BR##Global Growth... Chart 5... Supports Risk Assets,##BR##Trade And A Narrower Output Gap Nonetheless, while the dollar jumped in the 1990s when BCA's OECD growth index was above 90%, it fell from 2001 to 2007, and it's performance since 2015 has been mixed. The unemployment rate declined in the mid-to-late 1990s, but initially rose in the 2001-2007 period and has dropped since 2010. The Fed both raised and lowered rates during the previous episodes, but has only boosted rates in the current phase. Core inflation slowed in the 1990s when 90% of countries saw positive GDP growth, but accelerated in the early 2000s. Since 2015, core inflation has both climbed and decelerated. What will trigger higher inflation if more than 90% of the globe is experiencing positive economic growth? BCA's Global Fixed Income Strategy service notes that1 67% of OECD nations have unemployment rates under the organization's assessment of "global NAIRU", a level not seen since before the Great Recession when inflation expanded in both the goods and service sectors (Chart 6). However, the link between inflation and NAIRU waned during and just after the 2007-2009 recession and only reconnected lately. The implication for investors is that there is a global NAIRU level (or global output gap), which is more important in determining worldwide inflation rates than individual country NAIRU measures. Chart 6The NAIRU Concept Is Not Dead Yet Bottom Line: Surging global growth is a precondition for higher inflation, but sustained improvement in the labor market is needed to drive up inflation and prompt more action from the Fed. Investors may be downplaying the NAIRU concept at a time when it is finally set to bite. If that is the case, inflation expectations around the world are too low, although it will take some evidence of faster realized inflation (especially in the U.S. and Europe) before the markets begin to discount that view in bond yields. Stay underweight duration. Flow Of Funds Update On Consumer And Corporate Health The latest readings on the health of household and corporate balance sheets from the Fed's flow of funds accounts reinforce BCA's stance that consumer spending will provide strong support for the U.S. economy through 2017 and 2018. Household net worth continues to rise and is well above average at this point in a long expansion (Chart 7). The total wealth effect for consumer spending is still lagging prior cycles, but remains supportive. Debt-to-income ratios are at multi-decade lows. The ongoing repair of consumer balance sheets has led to an all-time high in FICO scores (Chart 7, panel 4). Last week's U.S. flow of funds report also allows us to update BCA's Corporate Health Monitor (CHM) (Chart 8). The level of the CHM improved slightly between Q1 and Q2, but the overall level still suggests corporate balance sheets are deteriorating. The progress in Q2 was broadbased, as all the components improved, notably the net leverage component. Profit growth surged while debt moved up modestly in Q2, modestly reducing leverage. The Monitor has been a reliable indicator of the trend in corporate bond spreads. The upswing in the CHM in Q2 - and particularly the dip in leverage - supports our corporate bond overweight. On the consumer front, while the recent weakness in vehicle sales and overall retail sales are noteworthy, they do not signal the end of the business cycle. We found2 that a peak in vehicle sales leads the end of the economic cycle by two years. Moreover, Hurricane Harvey weighed on August's retail sales report and Irma will have the same impact on September's sales.3 Instead, the backdrop for consumer spending remains strong. For example, the most recent Fed Senior Loan Officer's Survey suggests that the banking sector is willing to lend to households and that consumers are open to borrowing, although household demand for loans has weakened in recent quarters (Chart 9). Chart 7Support For The Consumer##BR##Remains In Place Chart 8Improved A Bit In Q2##BR##But Still Deteriorating Chart 9Senior Loan Officers##BR##Survey Still Supportive In addition, consumer spending intentions remain in an uptrend and the decade-high readings on "plans to buy" a house and a car are telling (Chart 10, panels 1 and 2). Overall measures of consumer confidence remain at 16-year peaks (Chart 10, panel 3). Furthermore, the sturdy labor market, modest wage growth and low inflation are all factors that support a solid pace of real income growth, which reinforces the spending backdrop (Chart 10, panel 4). Student loan debt increased again in Q2 and investors are concerned by the risks posed by the upswing. The Bank Credit Analyst covered the topic in a comprehensive report in November 2016.4 The key message was that student debt is a modest drag on economic growth, but is not a threat to U.S. government finances and does not represent the next subprime crisis. Nearly a year later, BCA's conclusions remain unchanged. A recent report5 by the Federal Reserve Bank of New York provides data on student loans through Q2 2017. The report noted that while student debt levels were little changed between Q1 and Q2 2017, they are up $85B from a year ago and at record highs (Chart 11). Although student loan delinquencies ticked higher in Q2, and remain elevated by historical standards, they have moved sideways in recent years. We will continue to monitor all types of consumer indebtedness as we assess hazards in the U.S. economy. Student loans are only a mild economic headwind and do not represent a source of systemic financial risk. Chart 10Consumers Upbeat And Ready To Spend Chart 11Student Loan Debt Is Elevated Bottom Line: The consumer - a key driver of the U.S. economy and corporate earnings - will provide a solid backdrop for the economy through 2017 and beyond. This climate will allow the Fed to boost rates one more time this year and begin paring its balance sheet starting next month. The solid underpinnings for the consumer will sustain corporate earnings growth and, ultimately, higher stock prices. However, favorable consumer attitudes toward U.S. equity prices are a mild concern. Signals From Stock Sentiment Surveys Record U.S. consumer optimism - as measured by the University of Michigan (UM) - on forward stock returns does not necessarily signal a market top. On the other hand, it supports BCA's view that investors be prudent with risk allocations. Respondents to the UM Survey of Consumers assign a 65% probability that the U.S. stock market will move higher in the next 12 months, surpassing the previous zenith in mid-2004. Interestingly, before the 2014 high (60%), the top reading was in mid-2007 (62%), only three months prior to the October 2007 equity market peak. A cursory look at Chart 12, panel 1 shows that peaks on this metric line up with those in equities. We view it another way. Investors should not assume that stocks are peaking based on the UM data. The bottom panel of Chart 12 shows that at just 5.6%, the annual change in the percentage of respondents who expect stocks to move higher in the next 12 months is not at an extreme. The 12-month change was as high as 18% in early 2004 and again in March 2010. Stock returns in the 12 months after these peaks in sentiment were lower than in the 12 months prior. However, we are not yet in the danger zone based on this indicator. Furthermore, BCA's Investor Sentiment Composite Index (not shown) is not at an extreme, although it is at the top end of its bull market range. We expect the stock-to-bond ratio to move higher in the next 6-to-12 months, despite the elevated readings on households' expected return on stocks. Our position is driven more by our bearish stance on Treasury bond prices than on an overly bullish call on equity returns. Chart 13 illustrates this point across three time horizons given our view of fair value on the 10-year Treasury yield (2.67%).6 Our analysis assumes a 2% annualized dividend yield on the S&P 500. Panel 1 shows the ratio between now and year end will remain positive if U.S. equities dip by 5%. Looking ahead 6 and 12 months (Panels 2 and 3), the S&P 500 will have to drop by between 5% and 10% to signal a localized peak in the stock-to-bond ratio. Chart 12Consumers' Expectations For Equity Returns Are Elevated Chart 13Scenarios For Stock-To-Bond Ratio Bottom Line: Despite heightened consumer sentiment toward equities, we expect the stock-to-bond ratio to move higher in the next 6 to 12 months. Nonetheless, investors should be prudent with risk assets, paring back any maximum overweight positions and holding some safe-haven assets within diversified portfolios. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No.", September 12, 2017. Available at gfis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "Disconnected," September 11, 2017. Available at usis.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Shelter From The Storm, "September 5, 2017. Available at usis.bcaresearch.com. 4 Please see The Bank Credit Analyst Special Report, "Student Loan Blues: Can't Replay What I Borrowed", November 2016. Available at bca.bcaresearch.com. 5 https://www.newyorkfed.org/medialibrary/interactives/householdcredit/data/pdf/HHDC_2017Q2.pdf 6 Please see BCA's U.S. Bond Strategy Portfolio Allocation Summary, "The Cyclical Sweet Spot Rolls On," September 5, 2017. Available at usbs.bcaresearch.com.
Highlights This week's FOMC statement telegraphed another rate hike in December and three more hikes in 2018. The ability of the Fed to deliver on these hikes will depend on whether inflation picks up. We think it will. Stronger GDP growth will push the unemployment rate below 4% next year, the threshold at which the Phillips curve becomes quite steep. The often-cited reasons for why the Phillips curve has become defunct - well-anchored inflation expectations, decreased union bargaining power, a more globalized economy, and technological trends - are less convincing than they appear. Underweight long-term government bonds and overweight equities for the next 12 months. Look to reduce risk exposure late next year. The beleaguered dollar could catch a bid over the coming months. We are closing our long Brent oil trade for a gain of 13.8%. Feature The Fed Delivers A "Hawkish Hold" Going into this week's FOMC meeting, there was some speculation among market participants that the Fed would signal a reluctance to raise rates in December and reduce the number of rate hikes planned for next year. In the end, that didn't happen. Twelve of the sixteen participants indicated that they expected the fed funds rate to rise in December, exactly the same number as in June. The Fed downplayed the effects of the hurricanes, noting that they would not "materially alter" medium-term growth prospects. The median number of rate hikes planned for next year also remained at three. The FOMC kept the long-term estimate of unemployment at 4.6%, despite trimming the forecast for end-2018 unemployment rate from 4.2% to 4.1%. The only substantive dovish changes to the dots came in the form of a cut in the number of hikes planned for 2019 from three to two, and a reduction in the terminal rate from 3% to 2.75%. Not surprisingly, the somewhat hawkish tone of the FOMC statement caused the implied odds of a December rate hike to jump from about one-in-two to two-in-three. The dollar also rallied, with the euro falling a full big figure against the greenback immediately following the release of the statement. Don't Write Off The Phillips Curve Just Yet Last week's higher-than-expected inflation print undoubtedly increased the Fed's willingness to keep raising rates. Nevertheless, despite the tentative rebound in inflation, core CPI inflation is down 0.6 percentage points since January on a year-over-year basis, while core PCE inflation is down 0.5 points over the same period. The failure of inflation to accelerate in response to diminished economic slack has convinced many people that the Fed will not be able to continue scaling back monetary stimulus. It has also prompted numerous commentators to pen obituaries for the so-called Phillips curve. Named after New Zealand economist William Phillips, the curve predicts that falling unemployment will lead to rising inflation. It is certainly true that the Phillips curve has become flatter over the past few decades (Chart 1). However, we think that it is premature to write it off as a useful tool for predicting inflation. This is because the Phillips curve tends to become much steeper once the economy reaches full employment. As we have discussed in the past, a variety of measures suggest that the U.S. is approaching this "kink" in the curve (Chart 2).1 Chart 1The Phillips Curve Has Gotten Flatter Chart 2U.S. Economy At Full Employment The idea that the Phillips curve steepens at low levels of unemployment is very intuitive: If excess capacity is high to begin with, a modest decline in slack will still leave many workers idle. In such a setting, inflation is unlikely to rise. However, once the output gap is fully closed, any further decline in slack will cause bottlenecks to emerge, pushing wages and prices higher. The empirical evidence supports this conclusion. Chart 3 shows that U.S. wage growth has tended to accelerate once the unemployment rate falls into the range of 4%-to-5%. Chart 3U.S. Wage Growth Accelerates Once The Unemployment Rate Falls To Low Levels The Absence Of Evidence Is Not Evidence Of Absence The past three U.S. business-cycle expansions never reached the stage where the economy had the chance to fully overheat. The 1982-90 cycle was cut short by the spiraling effects of the Savings & Loan crisis, while the 2001-2007 cycle was short-circuited by the housing bust. The closest the economy came to boiling over was during the 1990s expansion. However, that cycle was also prematurely terminated by the dotcom bust and the adverse knock-on effect this had on business investment spending. Moreover, the late 1990s expansion occurred against the backdrop of a soaring dollar, turmoil in emerging markets, and plummeting commodity prices. These external deflationary forces arguably overwhelmed the inflationary impulse stemming from an overheated domestic economy. The tendency of financial imbalances to metamorphize into full-blown recessions before inflation has had a chance to take off means that the U.S. has spent the past 30 years on the flat side of the Phillips curve. One can see this point analytically: Between 1964 and 1980, the unemployment rate was below the Fed's estimate of NAIRU 79% of the time, compared to only 29% of the time since 1980. It is thus no wonder that the Phillips curve looks dead - it has not been given a chance to come alive. This makes us sceptical of studies such as the recent one by the Philadelphia Fed which purported to show that the Phillips curve is no longer useful for forecasting inflation.2 The Kinky Sixties We argued several weeks ago that the next recession could resemble the "classic recessions" of the post-war era, which were caused by the Fed's decision to raise rates aggressively after realizing it was behind the curve in normalizing monetary policy.3 The 1960s provides a useful lesson in that regard. Just like today, inflation hovered below 2% during the first half of that decade, even though unemployment was trending downward over this period. To most observers back then, the Phillips curve would have also appeared defunct. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 4). The kink in the Phillips curve had been reached. Inflation ultimately made its way to 6% in 1970, four years before the first oil shock struck. One might challenge the 1960s comparison on four grounds: First, inflation expectations are allegedly better anchored today; Second, trade unions play a much smaller role in the wage bargaining process; Third, globalization has purportedly made both product and labour markets much more competitive than they were back then, thus severely limiting the scope of firms to raise prices and wages; Fourth, the deflationary impact of new technologies such as robotics and online commerce has become more pervasive. We think all four of these explanations leave much to be desired. As far as inflation expectations are concerned, it is certainly true that central banks did not pursue explicit inflation targets during the 1960s. However, this does not mean that inflation expectations were necessarily poorly anchored. Ten-year Treasury yields averaged 4.1% in the first half of the sixties, well below the 6.6% pace of nominal GDP growth. Investors back then were clearly quite relaxed about inflation risk. This is not that surprising, given that the U.S. had not seen a period of sustained inflation since the Civil War. A decline in unionization rates is also often cited as a reason for why the Phillips curve may be flatter today. The problem with this argument is that it is very U.S.-centric. For example, while the U.S. has experienced a pronounced drop in unionization rates since the 1960s, Canada has not (Chart 5). Yet, the sensitivity of inflation to economic fluctuations has fallen in both countries by roughly the same magnitude. Likewise, the increased use of inflation-linked wage contracts in the 1970s appears mainly to have been a response to rising inflation rather than the cause of it (Chart 6). Chart 4Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Chart 5Inflation Fell In Canada Despite A High Unionization Rate Chart 6Wage Indexation Was Mainly A Response To Rising Inflation Globalization And The Phillips Curve The extent to which globalization has flattened the Phillips curve remains the subject of intense debate. The empirical evidence is mixed, with most studies leaning towards the conclusion that globalization has had only a limited impact on the slope of the curve in large economies such as the U.S. This makes perfect sense, considering that the import share in U.S. personal consumption stands at less than 15%.4 Supporting this conclusion is the fact that wage growth appears to be just as sensitive to changes in the unemployment rate in industries that are highly exposed to trade as those which face little import competition. Upon deeper inspection, many of the arguments for why globalization has led to a flatter Phillips curve are really arguments for why globalization has limited the degree of movement along the Phillips curve. In a highly globalized world, a decline in slack in one country - unless matched by reduced slack in other countries - will lead to higher interest rates in that country and a stronger currency. A stronger currency, in turn, will choke off growth, preventing the unemployment rate from falling as much as it otherwise would. Clearly, such a sequence of events has not applied to the U.S. dollar since the start of the year. This suggests that the unemployment rate will either keep falling towards the steeper part of the Phillips curve, or the Fed will be forced to turn more hawkish. The Effects Of Technology What about the possibility that technological advances have led to a flatter Phillips curve? The problem here is that the data do not fit the story. As my colleague Mark McClellan has pointed out, almost all of the decline in inflation since the Great Recession has occurred in categories of the CPI - such as energy, food, and rent - that have little to do with e-commerce (Table 1).5 Also keep in mind that while online sales have grown rapidly during the past two decades, they still account for only 8.9% of total retail sales and less than 5% of the U.S. Consumer Price Index. Amazon's recent growth has actually lagged behind what Walmart experienced during its heyday (Chart 7). Table 1Comparison Of Pre- And Post-Lehman Inflation Rates Chart 7Amazon Vs. Walmart: Who's More Deflationary? The proliferation of big-box retailers pushed up productivity growth in the retail sector to 3.9% between 1992 and 2007. Productivity growth in this sector has fallen to 2.1% since then. This undercuts the notion that the explosion in e-commerce has produced major efficiency gains for the broader economy, thus contributing to deflationary pressures.6 Investment Conclusions U.S. inflation is likely to trend higher over the coming months as a variety of one-off factors that depressed inflation earlier this year fall out of the equation. The effects of the hurricanes complicate the picture, but history suggests that both inflation and growth tend to renormalize fairly quickly after such disasters. Hence, the markets will look through any near-term noise in the data, focusing instead on the cyclical growth outlook, which remains reasonably upbeat. Chart 8 shows that fluctuations in the ISM manufacturing index have often predicted changes in inflation. The current level of the ISM implies that core inflation will rebound to about 2% by the second half of next year. Risk assets are unlikely to suffer if inflation rises towards the Fed's target against the backdrop of stronger growth. However, if inflation moves above the Fed's target due to brewing supply bottlenecks, the Fed will have little choice but to pick up the pace of rate hikes. This could unsettle markets and sow the seeds for the next recession, which we tentatively expect to occur in the second half of 2019. What should investors do? Right now, none of our leading indicators are warning of an imminent economic downturn (Chart 9). Thus, we continue to recommend a cyclically overweight position in equities. However, we would not fault longer-term investors for starting to take money off the table, especially in light of today's lofty valuations. Chart 8ISM Has Often Predicted Changes In Inflation Chart 9No Warnings Of An Imminent Downturn The Fed is likely to raise rates in December and three or four more times in 2018. We are positioned for this by being short the December 2018 Fed funds futures contract, a trade that has gained 22 basis points so far. Considering that the market is pricing in only 42 basis points of hikes between now and the end of next year, there is plenty of juice left in this trade. A more aggressive-than-expected Fed could give the beleaguered dollar a much-needed lift. We see EUR/USD falling back to 1.15 by the end of the year and USD/JPY moving to 115. We are less bearish towards the British pound and the Swedish krona. Our short EUR/GBP and long SEK/CHF trades are up 2.6% and 5.4%, respectively, since we initiated them. Finally, we are closing our long December 2017 Brent oil futures contract for a gain of 13.8%. We still see modest upside for oil prices, and are expressing this view by being long the Canadian dollar and Russian ruble against the euro. Both currency trade recommendations remain in the money. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017; and "What's the Matter With Wages?" dated August 11, 2017. 2 Michael Dotsey, Shigeru Fujita, and Tom Stark, "Do Phillips Curves Conditionally help To Forecast Inflation?"Federal Reserve Bank of Philadelphia, Working Paper no. 17-26 (August 2017). 3 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery To Retro-Recession?" dated August 18, 2017. 4 Galina Hale and Bart Hobijn, "The U.S. Content of "Made in China"," FRBSF Economic Letter 2011-25 (August 8, 2011). 5 Please see The Bank Credit Analyst, "Did Amazon Kill The Phillips Curve?" dated August 31, 2017. 6 Ironically, if technological change has made the Phillips curve more flat, it may be because it has reduced competition rather than fostered it. The shift to a digital economy has allowed more companies to dominate their markets by virtue of network and scale effects. The expansion of such "winner-take-all markets" helps explain why industry concentration has risen over the past few decades, boosting profit margins in the process. A recent NBER working paper by Jan De Loecker and Jan Eeckhout found that the average U.S. publicly-listed firm set prices 67% above marginal costs in 2014 compared to 30% in 1990 and 18% in 1980. Economic theory suggests that firms with significant market power will tend to raise prices by less than highly competitive firms in response to costs increases. This would make the Phillips curve more flat. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights A major investment theme for the coming years will be the resynchronization of developed economy monetary policies. Expect substantial further convergence between U.S. T-bond yields and both German bund yields and Swedish bond yields. This yield convergence necessarily supports the currency crosses EUR/USD and SEK/USD. Underweight U.K. consumer services versus the FTSE100. Overweight German consumer services versus the DAX. The September 24 German election and October 1 proposed referendum on Catalan independence are not major catalysts for the financial markets. Feature A major investment theme for the coming years will be the resynchronization of developed economy monetary policies. As monetary policy resynchronizes, it will become clear that the extreme desynchronization of monetary policies over the past few years was the great anomaly (Chart of the Week and Chart I-2). This anomaly reached its peak in 2014 when policies at the ECB and the Federal Reserve moved in diametrically opposite directions. The ECB signalled the start of its quantitative easing just as the Fed began to end its own. Chart of the WeekThe Desynchronization Of Monetary##br## Policy Was An Anomaly Chart I-2The Desynchronization Of Monetary##br## Policy Was An Anomaly Why Did Monetary Policy Desynchronize? The extreme desynchronization of monetary policy would not have happened if it was just about economics. On the basis of the hard economic data, the ECB could have emulated the unconventional policies of the Fed, BoJ and BoE years before it eventually did in 2015. If it had, ECB policy would have been much more synchronized with the other major central banks. However, unconventional monetary policy wasn't, and isn't, just about economics. The ECB faced, and still faces, much tougher political and technical hurdles than other central banks. The euro area does not have one government, it has 19. The ECB had to convince sceptical core euro area governments that zero and negative interest rate policy and bond buying were not just a bailout for the periphery, especially with the euro debt crisis so fresh in the mind. Likewise, the euro area does not have one sovereign bond, it has 19. To design and implement an asset purchase program in the euro area is much more complicated than in the U.S., Japan or the U.K. But by mid-2014 it had become clear that each wave of unconventional monetary easing - through its impact on exchange rates - had allowed other major economies to 'steal' some inflation from the euro area (Chart I-3). With the ECB still undershooting its inflation mandate, it was becoming a dereliction of duty for the ECB not to do what the Fed, BoJ and BoE had already done several years earlier. As the saying goes, it is better for a reputation to fail conventionally, than to succeed unconventionally. Chart I-3Currency Depreciations "Steal" Inflation From Other Economies Why Will Monetary Policy Resynchronize? Three years and several trillion euros later, the ECB can feel it has had a fair crack at unconventional easing (Chart I-4). At the same time, the central bank must contend with fresh political and technical hurdles. How many more German bunds can it realistically buy without irking Germany's policymakers? Chart I-4The ECB Has Had A Fair Crack At QE The ECB is also aware that ultra-loose monetary policy - by compressing banks' net interest margins - endangers banks' fragile profitability. This impairs the bank credit channel which is the mainstay of private sector credit intermediation in the euro area.1 Meanwhile, the euro area's configuration of solid economic growth, solid job growth and subdued inflation is common to most large developed economies (the exception is the U.K. which we explain below). Putting all of this together, the theme for the coming years has to be monetary policy resynchronization, one way or the other. One way is that the more hawkish central banks will become less hawkish, as subdued inflation limits the scope for monetary policy tightening. The other way is that the more dovish central banks will become less dovish as the benefits of ultra-accommodation diminish and the costs rise. Or, both ways will happen together. Nowhere are negative bond yields more absurd and more inappropriate than in Sweden (Chart I-5). In just three years the economy has grown 12% and house prices have surged 50%. Furthermore, unlike in other parts of Europe, the housing market in Sweden did not suffer a meaningful setback in either 2008 or 2011. Yet Sweden's negative interest rate policy means that it stills pays people to borrow and further bid up house prices. If anywhere is at risk of a bubble from ultra-accommodative monetary policy, Sweden must be it. For bond yield spreads and currencies - which are relative trades - it doesn't really matter how the resynchronization of monetary policies occurs. We expect substantial further convergence between U.S. T-bond yields and both German bund yields and Swedish bond yields. And this yield convergence necessarily supports the currency crosses EUR/USD and SEK/USD (Chart I-6). Chart 5A Negative Bond Yield ##br##In Sweden Is Absurd Chart I-6If The Swedish Bond Yield Shortfall ##br##Compresses, The Krona Will Rally The Myth Of The Beneficial Currency Devaluation Sharp depreciations in a currency result in an economy 'stealing' inflation from its major trading partners. Chart I-7 and Chart I-8 suggest that absent the post Brexit vote slump in the pound, the gap between U.K. and euro area inflation would be almost 1% less than it is. Chart I-7The Weaker Pound Lifted ##br##U.K. Headline Inflation... Chart I-8...And U.K. ##br##Core Inflation So the Brexit vote explains why the U.K. is one of the few major economies where inflation is running well north of 2%. Unfortunately for U.K. households, nominal wage inflation has not followed price inflation higher. Which means that the pound's weakness has choked households' real incomes. Against this, textbook economic theory says that a currency devaluation should make a country's exports more competitive and thereby boost the net export contribution to economic growth. But in the textbook the only thing that is supposed to change is the exchange rate. The textbook assumes that the country's trading framework with its partners remains unchanged. In the case of the U.K. leaving the EU, this assumption clearly does not apply, mitigating the concept of the 'beneficial currency devaluation'. A lot of the benefits of the textbook devaluation come because firms can trade in markets that were previously unprofitable to them. This process requires investment - for example, in marketing and distribution. If Brexit means that many of those markets are no longer available, or come with tariffs, then firms will hold off making the necessary investments - unless the currency devaluation is massive. But in this case, the corresponding surge in inflation and choke on households' real incomes would also be massive. We also hear the myth of the beneficial currency devaluation applied to the weaker members of the euro area. As in, why don't these countries just break free from the euro, and devalue their way to prosperity? The simple answer is that if they left the euro, they would also risk losing access to the largest single market in the world - defeating the whole purpose of the beneficial currency devaluation! A Tale Of Two Consumers Chart I-9A Good Pair Trade: Long German Consumer ##br##Services, Short U.K. Consumer Services For the time being, hawkish comments from the BoE have given the pound a boost. But U.K. consumer spending now faces one of two headwinds. If the BoE follows through with a rate hike, household borrowing is likely to fade as a driver of spending. Alternatively, if the BoE backs off from its threat, the pound will once again weaken, push up inflation and weigh on real incomes. So for the time being, stay underweight U.K. consumer services versus the FTSE100. In Germany, the opposite logic applies. Stay overweight German consumer services versus the DAX. Euro strength helps German consumers in as much as it reduces the prices of imported food and energy. But for German exporters, the strong euro hurts the translation of their multi-currency international profits back into local currency terms. A good pair trade is to be long German consumer services, short U.K. consumer services (Chart I-9). Finally, regarding two upcoming political events - the September 24 German election and the October 1 proposed referendum on Catalan independence, we do not see either as a major catalyst for the financial markets. In the case of the German election, it is because no likely outcome is especially malign (or benign). In the case of the Catalan referendum, it is because it will be hard to draw any meaningful conclusion from the result, given that Madrid has ruled the referendum illegal - and many 'unionists' are unlikely to participate. Please note that there is no Weekly Report scheduled for next week as I will be at our New York Conference. I hope to see some of you there. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 In the euro area, small and medium sized companies tend to access credit through banks rather than through the bond market. Fractal Trading Model This week, we note an excessive underperformance of U.K. personal and household goods (dominated by BAT, Unilever, Reckitt Benckiser) versus U.K. food and beverages (dominated by Diageo and Associated British Foods). Go long U.K. personal and household goods versus U.K. food and beverages with a profit target / stop loss of 4.5%. In other trades, short nickel / long silver hit its 8% profit target, while short MSCI China / long MSCI EM hit its 2.5% stop loss. This leaves three open trades. 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. * 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 Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions 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##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Duration: The bond market is quick to react to any signs that inflation might put in a bottom, but Treasuries are still not priced for a resumption of inflation's modest cyclical uptrend. Remain at below-benchmark duration and short the July 2018 fed funds futures contract. Fed Balance Sheet: The Fed will announce the run-off of its balance sheet at tomorrow's FOMC meeting. This decision has implications for Treasury issuance and how monetary policy will be conducted in the future, but we do not envision a large impact on yields. Investors should remain focussed on changes in the expected path of the fed funds rate to assess the outlook for Treasury yields. Feature Yields bounced back strongly last week, driven by a combination of easing flight-to-safety flows and a reasonably strong August CPI report. Even so, the bond market remains priced for an environment where inflation will never return to the Fed's 2% target, no matter the pace of economic growth. It should therefore not be shocking that yields are quick to spring higher on any evidence that core inflation might re-gain its cyclical uptrend (Chart 1). As we have previously written,1 we anticipate that core inflation will soon respond to above-trend growth and resume its modest cyclical uptrend. It is therefore worth considering whether last week's August CPI report represents a step in that direction or whether it should be written off as an outlier. After digging into the report's details we conclude that while it was probably stronger than we should expect going forward, it also suggests that core inflation is poised to put in a bottom. A Bottom In Core Inflation? Month-over-month core CPI increased 0.248% in August, an annualized pace of 3.02%, and the annualized 3-month rate of change rose back above the 12-month growth rate (Chart 2). This often signals a near-term trend reversal. Chart 1Very Sensitive To Inflation Chart 2Core Inflation By Major Component Shelter inflation jumped higher in August from 3.18% year-over-year to 3.30%. But our model suggests that this uptrend will not persist (Chart 2, panel 2). Notably, the increase in shelter inflation was concentrated in the Houston/Galveston/Brazoria area and as such reflects the one-off impact of Hurricane Harvey. The bottom line is that the positive August number should be considered an outlier. The underlying trend remains one of decelerating shelter inflation. Chart 3Ignore CPI Medical Care In contrast, year-over-year core goods prices decelerated in August, but this deceleration is equally unsustainable. The recent depreciation of the U.S. dollar and surge in non-oil import prices suggest that core goods inflation is poised to increase (Chart 2, panel 3). We expect accelerating core goods prices to offset decelerating shelter prices during the next few months. In the longer-run, neither shelter nor core goods will be sustainable drivers of inflation. Shelter has already rolled over, and core goods inflation will do the same once the dollar reverses its downtrend. For overall core inflation to sustainably return to the Fed's 2% target, core services inflation (excluding shelter and medical care) must be the main source of price pressure. Historically, this component of inflation is the most tightly linked to wage growth (Chart 2, bottom panel), and it has fallen precipitously so far this year. In August, however, year-over-year core services inflation (excluding shelter and medical care) ticked higher from 1.18% to 1.40%. While this is a positive sign, we will need to see further strength in this component to be certain that the downtrend in core inflation has turned. Some pundits have pointed to the steep decline in medical care CPI inflation as an additional deflationary force, but this is a red herring (Chart 3). In the CPI basket, medical care includes only consumers' out of pocket healthcare expenses. It does not include spending by the government on households' behalf, which is included in the Fed's target PCE inflation measure. Unlike CPI medical care, PCE medical care inflation has seen only a mild downturn and should move higher in August based on the most recent PPI numbers (Chart 3, panel 3). The bottom line is that the downtrend in CPI medical care inflation represents nothing more than a convergence between CPI and PCE inflation. Since the Fed targets PCE inflation, falling CPI medical care inflation can be safely ignored. The Fed's Reaction The Fed has already sent a strong signal that there will be no rate hike at this week's meeting, but that it will announce the run-off of its balance sheet (see next section). Our view has been that if inflation shows some signs of rebounding, the Fed will deliver another rate hike in December. The market appears to have taken a similar view and, on the strength of last week's CPI report, is now discounting a 51% chance of another rate hike this year. Last week's CPI report was probably strong enough to ensure that the median FOMC forecast will still call for one more hike this year when the revised forecasts are released tomorrow. However, we suspect that stronger inflation will need to persist for the next few months in order for that hike to be delivered on time. The reading from our Fed Monitor2 underscores how close a call another rate hike is at the moment (Chart 4). The monitor remains in "tighter money required" territory, but only faintly so. Notably, the economic growth and financial conditions components of the monitor both suggest that higher rates are required, but the inflation component remains below zero. This supports the notion that any sign of stronger inflation makes the case for further rate hikes a slam dunk. Chart 4A Close Call For The Fed Bottom Line: The bond market is quick to react to any signs that inflation might put in a bottom, but Treasuries are still not priced for a resumption of inflation's modest cyclical uptrend. Remain at below-benchmark duration and short the July 2018 fed funds futures contract. Five Questions About The Fed's Balance Sheet As was mentioned above, the Fed appears set to announce that it will cease the reinvestment of its bond holdings, meaning that its balance sheet will finally start to shrink. In all likelihood this announcement will come in tomorrow's FOMC statement. To recap, here is what we already know about how the plan will proceed: The Fed will cease the reinvestment of Treasuries and MBS at the same time. For the first three months the Fed will allow a maximum of $6 billion in Treasuries and $4 billion in MBS to run off each month. These caps will increase in steps of $6 billion and $4 billion, respectively, every three months until they level off at $30 billion per month for Treasuries and $20 billion per month for MBS. Question 1: How Long Will It Take? To answer this question we must first recall that the Fed does not target a specific level of assets on its balance sheet. Rather, it is the amount of bank reserves in the system (a liability on the Fed's balance sheet) that is the crucial variable for the economy. Bank reserves are the single biggest liability on the Fed's balance sheet, but the amount of currency in circulation is the second biggest. As of last Wednesday, bank reserves totaled $2.4 trillion and currency in circulation totaled $1.6 trillion. The amount of currency in circulation also increases as the economy grows. This means that during normal times the Fed must increase its asset holdings in line with the amount of outstanding currency just to keep the level of bank reserves constant. In other words, even if the Fed allows bank reserves to fall all the way to zero, it will still carry a larger balance sheet than it did prior to the start of QE because of the rising amount of currency in circulation. We have received no official guidance on the level of bank reserves the Fed will target for the end of the run-off process. However, New York Fed President William Dudley recently recommended that this level should be higher than during the pre-QE period. Together, as a rough starting point, we have suggested that the necessary amount of excess reserves could be in a range of $400 billion to $1 trillion. Coupled with uncertainty about the likely growth in other factors, such as currency outstanding, this implies a normalized balance sheet size of, perhaps, $2.4 trillion to $3.5 trillion in the early 2020s.3 In our estimates we have assumed that bank reserves will level-off once they reach $650 billion, considerably above levels maintained prior to the financial crisis. Bank reserves averaged $20 billion between 2000 and 2007. There are two main reasons why the Fed will favor a higher level of reserves. The first was also stated in President Dudley's speech: Having managed the System Open Market Account during the financial crisis - a period during which the demand for reserves was very volatile - I very much favor a floor-type system. It is much easier to manage on a day-to-day basis. A "floor system" means that the Fed controls the overnight rate by paying interest on excess reserves and conducting reverse repos with the securities on its balance sheet. This is the system currently in use, and it requires a glut of reserves in the banking system. Prior to the financial crisis, the Fed used a "corridor system" to control interest rates. This system required the Fed to transact in the interbank market to manage interest rates, and it required a dearth of reserves.4 The second reason is that the demand for safe short-maturity investment vehicles has been steadily increasing for at least the past fifteen years, largely due to rising cash balances on corporate balance sheets. Prior to the financial crisis this demand was intermediated through the repo market, but now that repo has mostly gone away, that cash is sitting on deposit at the Fed in the form of reserves (Chart 5). With all this demand, if the Fed tries to remove too many reserves from the banking system it could have difficulty keeping a floor under interest rates. That is, unless some other investment vehicle is supplied to mop up the rising demand for safety. In this regard, T-bills would be the most likely candidate, and fortunately, with T-bills at multi-decade lows as a percentage of the outstanding funding mix (Chart 6), there is ample room for the Treasury to increase bill supply. In short, the secular uptrend in demand for safe short-maturity financial assets means that going forward either: (i) the Fed will have to maintain a greater level of reserves in the banking system, (ii) the Treasury will have to increase the supply of T-bills, or (iii) some combination of the two. With all that in mind, let's answer the initial question of how long the Fed will allow its balance sheet to shrink. Our projections are shown in Chart 7, and make the following assumptions: Chart 5Rising Demand For Safe Short-Dated Assets Chart 6T-Bill Issuance Has Room To Rise Chart 7Fed Balance Sheet Projections Balance sheet run-off begins October 1, 2017 Bank reserves level-off at $650 billion. At that point, the Fed will continue to allow MBS to run off its balance sheet, but will start buying Treasuries to keep reserves stable. MBS will run off at a pace of $15 billion per month, before considering the caps.5 Currency in circulation will grow at a pace of 4.5% per year. Under these assumptions, we estimate that bank reserves will reach the target level of $650 billion in June 2021. At that point, the Fed's securities holdings will total $2.9 trillion - down from the current $4.3 trillion - and the Fed will have to start buying Treasuries to keep reserves stable and compensate for the continued run-off of MBS. Question 2: What Does This Mean For Bond Supply? To compensate for balance sheet run-off, The Treasury will have to increase issuance by $217 billion in 2018, $249 billion in 2019 and $182 billion in 2020 (Chart 8). Then, in 2021 and beyond, the Fed will once again start removing Treasury supply from the market as it stabilizes reserve balances. We estimate that an extra $150 billion of MBS supply will also hit the market in 2018, but we will save a discussion of the impact on MBS spreads for a future report. Chart 8Fed Starts Buying Again In 2021 The form in which this extra issuance will reach the marketplace is a question for the Treasury department. Officially, the Treasury has said: Treasury will likely respond to the additional borrowing needs associated with SOMA redemptions by increasing both Treasury bill and Treasury nominal coupon auction sizes, beginning with bills and then coupons, as appropriate.6 But the Treasury Borrowing Advisory Committee has recommended both that the Treasury increase the proportion of T-bills in its funding mix and increase the size of future coupon auctions, starting as early as next quarter. We expect these recommendations will be heeded. Question 3: Who Will Buy All These Bonds? A full breakdown of Treasury demand from different financial market actors is beyond the scope of this report. However, there is one sector that will need to greatly increase its holdings of Treasury securities as reserves are drained. That is the banking sector. The relatively new Liquidity Coverage Ratio (LCR) mandates that banks hold high-quality liquid assets (HQLA) in an amount sufficient to cover net cash outflows during a stressed 30-day period. HQLAs consist of Level 1 assets and Level 2 assets. Level 1 assets are bank reserves and Treasury securities, Level 2 assets are other riskier securities such as Agency MBS. A haircut is applied to level 2 assets for the purposes of calculating HQLA. Based on disclosures from the eight U.S. Systemically Important Financial Institutions (SIFIs), we calculate that HQLAs total about $2.4 trillion from those 8 banks alone (Table 1). If we assume that required HQLAs increase at a pace of about 4% per year (in line with expected growth in deposits), then that represents close to $100 billion of baseline Treasury demand next year and in 2019. This demand will also have to increase to compensate for the draining of reserves from the system (Chart 9). Table 1Liquidity Coverage Ratios For The 8 U.S. SIFIs Chart 9Bank Balance Sheets Loaded With Reserves At least at present, the eight largest U.S. banks do not have much of a buffer above the 100% mandated LCR. This means they will have to be active buyers of securities in order to compensate for lost reserves and keep their ratios stable. Question 4: What Will Be The Market Impact? It has been our long-standing view that the bulk of the impact on Treasury yields from Federal Reserve asset purchases can be attributed to signaling about the future path of short rates. In fact, throughout the entire QE period, there remained a strong positive correlation between long-maturity real Treasury yields and the number of rate hikes expected during the next 24 months (Chart 10). Chart 10Real Yields Driven By Rate Expectations Even theoretically, as Michael Woodford explained in his seminal Jackson Hole address from 2012,7 there is little reason to expect that central bank asset purchases exert an impact on bond yields beyond signaling about the future path of interest rates: In the representative-household theory, the market price of any asset should be determined by the present value of the random returns to which it is a claim, [...]. Insofar as a mere re-shuffling of assets between the central bank and the private sector should not change the real quantity of resources available for consumption in each state of the world, [...] the market price of one unit of a given asset should not change [...]. A more thorough empirical examination also suggests that the "signaling channel" explains most of the reaction in long-maturity Treasury yields to announcements about Fed asset purchases. We looked at a sample of dates where the Fed either made or teased an announcement related to its asset purchases, and then looked at how different financial markets reacted to those announcements. Chart 11 shows changes in the 10-year Treasury yield on the days in our sample versus changes in our 24-month fed funds discounter - the expected number of rate hikes during the next 24 months as discounted in the overnight index swap (OIS) curve. The chart shows a very strong linear relationship between changes in the 10-year Treasury yield and in expected rate hikes on those days. Chart 1110-Year Treasury Yield Vs. 24-Month Fed Funds Disc Chart 12 uses the same sample of dates, but this time looks at the change in the 10-year Treasury yield versus the change in the 10-year OIS rate. The pay-off on overnight index swaps is directly tied to the level of the fed funds rate. Therefore, if Fed asset purchases exert some impact on Treasuries above and beyond sending a signal about the future path of the fed funds rate, we should expect that impact to show up in Treasury yields but not in OIS rates. However, Chart 12 shows that changes in the 10-year Treasury yield and in the 10-year OIS rate remained tightly linked throughout our sample. Chart 1210-Year Treasury Yield Vs. 10-Year OIS Rate* Following Announcements Related##br## To Federal Reserve Asset Purchases Why is it important that the impact of Fed asset purchases on Treasury yields was mostly about signaling? It is because the Fed is following a "subordination strategy" with respect to the wind-down of its balance sheet. It plans to provide us with the schedule of balance sheet run-off in advance, and then leave that schedule un-touched regardless of economic developments. Put differently, it will respond to deteriorating economic conditions by cutting the fed funds rate before it alters the pace of balance sheet run off. In essence, the link between the Fed's balance sheet and signals about the path of the fed funds rate has been severed. As long as the "subordination strategy" is strictly enforced, we should not expect much of an impact on long-maturity Treasury yields from the unwinding of the Fed's balance sheet. Question 5: Are There Any Other Potential Market Impacts? Where Fed asset purchases essentially removed Treasuries (and MBS) from the market and replaced them with bank reserves (cash), the running down of the Fed's balance sheet will reverse this swap. Supplying securities into the market and removing cash. Some have argued that this removal of cash could lead to an appreciation of the U.S. dollar. In particular, Zoltan Pozsar of Credit Suisse has observed a correlation between U.S. bank reserves and FX basis swap spreads.8 There is also a strong correlation between FX swap spreads and the U.S. dollar (Chart 13). Chart 13Basis Swaps, Reserves And The Dollar One possible chain of events is that as the Fed drains cash from the market, there will be less liquidity in the FX swap market. Basis swap spreads will widen as a result, and this will cause the dollar to appreciate. In this framework, the unwinding of the Fed's balance sheet will put upward pressure on the U.S. dollar. However, it is also possible that the chain of causation runs in the other direction. The BIS has proposed a model9 where a stronger dollar weakens the capital positions of bank balance sheets. This causes them to back away from providing liquidity to the FX swap market, leading to wider basis swap spreads. In this model, a strong dollar leads to wider basis swap spreads and not the reverse. If this is the correct direction of causation, then we should not expect any impact on the dollar from the unwinding of the Fed's balance sheet. At the moment it is impossible to tell which of the above two theories are correct. All we can do is monitor the correlation between reserves, FX basis swap spreads and the dollar going forward. Bottom Line: The Fed will announce the run-off of its balance sheet at tomorrow's FOMC meeting. This decision has implications for Treasury issuance and how monetary policy will be conducted in the future, but we do not envision a large impact on yields. Investors should remain focussed on changes in the expected path of the fed funds rate to assess the outlook for Treasury yields. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Open Mouth Operations", dated September 2, 2017, available at usbs.bcaresearch.com 2 For further details on the monitor please see U.S. Bond Strategy Weekly Report, "Buy The Back-Up In Junk Spreads", dated March 14, 017, available at usbs.bcaresearch.com 3 https://www.newyorkfed.org/newsevents/speeches/2017/dud170907 4 For a detailed description of the differences between a floor and corridor system please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet", dated February 28, 2017, available at usbs.bcaresearch.com 5 For simplicity we assume a constant pace of $1 billion MBS refinancing every month. This is somewhat below recent averages to account for the likelihood that interest rates will rise. 6 https://www.treasury.gov/press-center/press-releases/Pages/current_PolicyPressRelease.aspx 7 http://www.columbia.edu/~mw2230/JHole2012final.pdf 8 https://ftalphaville.ft.com/2017/04/13/2187317/where-would-you-prefer-your-balance-sheet-banks-or-the-federal-reserve/ 9 http://www.bis.org/publ/work592.pdf Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Fed vs. BoE: U.S. inflation data is stabilizing, while financial conditions continue to ease. The market is underestimating the potential for the Fed to hike rates again, perhaps as soon as December. At the same time, markets have priced in too many rate hikes in the U.K., with the Bank of England's growth and inflation forecasts unlikely to be realized. USTs vs. Gilts: Maintain an overall below-benchmark portfolio duration tilt, while keeping an underweight stance on U.S. Treasuries and a neutral bias towards Gilts. Look to upgrade Gilts on any additional spread widening versus Treasuries or core Europe. Duration Checklists: An update of our Duration Checklists shows that the backdrop for growth, inflation and investor risk appetite remains bearish for U.S. Treasuries and German Bunds. Maintain below-benchmark duration exposure to both markets on a medium-term basis. Feature Inflation: Waking Up In The U.S., Peaking Out In The U.K. The bull market in risk assets remains powerful. Investors have shrugged off the worries about U.S. hurricanes and geopolitical tensions and have returned to focusing on the global growth and inflation backdrop. The fact that the S&P 500 could close at a new all-time high just above 2500 last Friday, shortly after another North Korean missile launch and a terrorist attack on the London Underground, speaks volumes about the renewed confidence (or is it hubris?) of investors. For bond markets, two events stood out - the firming read on August U.S. CPI inflation data and the surprisingly hawkish commentary from the Bank of England (BoE). We advise that investors pay more attention to the former and fade the latter. The U.S. inflation data is far more important, as it showed a decent rise in core inflation after five months of very weak prints (Chart of the Week). Chart of the WeekUSTs At Risk From A Rebound In Inflation A rebound in inflation is critical to our call for U.S. bond yields to rise over the next 6-12 months, as it would bring Fed rate hikes back into play. Right now, there is still a significant gap between market expectations for the fed funds rate by the end of 2018 and the current FOMC projection ("dot"). If the latest inflation data is the beginning of a sustained period of faster monthly price increases, then there is room for investors to reprice their expectations for both inflation and the funds rate (bottom two panels). There is a risk that the median FOMC rate projection for next year comes down a bit when the new "dots" are released after this week's FOMC meeting. Although with market-based inflation expectations firming, and survey-based measures holding steady near the Fed's 2% target amid easing financial conditions, the FOMC may choose to hold steady and wait to see if the August inflation data is the beginning of a trend - especially with the Fed set to announce the timing and details of the reduction of its balance sheet at this week's meeting. Downgrading interest rate expectations while also starting the unwind of the balance sheet could send a confusing message to markets. At the same time, any shift to a more hawkish or less dovish message from the Fed would be taken negatively by the Treasury market. The experience of Gilts last week is a warning sign about how unprepared investors are for a change in tone from central bankers. The language in the statement released after last week's BoE Monetary Policy Committee (MPC) meeting suggested that a rate hike may come within the next few months if U.K. economic growth evolves along the lines of the MPC's forecasts. That was enough to trigger a bear-flattening move in the Gilt curve, with the markets quickly pricing in one full additional rate hike by the BoE over the next year (Chart 2, second panel). A similar move could happen if the Fed were to send any new hawkish signals, although that is unlikely to occur at this week's FOMC meeting. We see a greater potential for the Fed's forecasts to be realized than the BoE's over the next year. Financial conditions have eased and leading indicators are still pointing to a reacceleration in U.S. growth in the coming months. The impact of the hurricanes in Texas and Florida will be a drag on growth in the 3rd quarter of this year, but this will not be enough to materially impact the Fed's growth forecasts for 2018. Meanwhile, the inflationary backdrop for the U.S. may finally be bottoming out, for a few reasons: 1. Our CPI diffusion index rising back above the 50 line in August (Chart 3, top panel), although additional gains will be necessary to herald a more sustained rise in core inflation. Chart 2Markets Have Bet Heavily##BR##On Central Bank Inaction Chart 3U.S. Inflation##BR##Stabilizing? 2. The U.S. labor market continues to tighten, with the gap between the "jobs plentiful" minus "jobs hard to get" indices from the Conference Board's consumer confidence survey widening to the widest level since 2001 (2nd panel), putting upward pressure on wage growth. 3. One of the biggest sources of the surprising downturn in core inflation seen in 2017, the plunge in wireless phone prices back in the spring, has fully stabilized (3rd panel). That decline alone represented a drag on the rate of inflation for core CPI services (excluding shelter) of 1.2 percentage points (bottom panel), and on overall core CPI inflation of around 35bps - ½ of the total decline in core CPI inflation since January. As the impact of that collapse in wireless charges falls out of the inflation data in the coming months, the drag on core CPI will fade. There is now a much better chance for the Fed's inflation forecasts to be realized next year, especially once the impact of a weaker dollar (and higher energy prices) is taken into account. While some of the doves on the FOMC may downgrade their inflation forecasts this week, a major reduction is unlikely in the absence of signs of a weakening U.S. labor market or renewed strength in the U.S. dollar. The U.S. backdrop contrasts sharply with what is going on in the U.K. While the labor market is even tighter there than in the U.S., the current upturn in U.K. inflation has also occurred alongside a sharp depreciation of the Pound since the 2016 Brexit vote (Chart 4). The currency has stabilized over the course of this year, with the year-over-year change in the BoE's trade-weighted index now nearly flat (bottom panel). Against this backdrop, inflation is more likely to peak out than reaccelerate from current levels. A similar argument can be made for the U.K. economy. Leading economic indicators have rolled over, while actual real GDP growth has decelerated (Chart 5, 3rd panel). Consumer confidence has steadily declined as the currency-driven inflation increase has eroded real income growth. This has created a very odd divergence between falling confidence and an increased market expectation for BoE rate hikes over the next year, which typically move in unison (bottom panel). Add in the ongoing uncertainties over Brexit that continue to weigh on business confidence and investment spending, and it is far more likely that the U.K. economy will lag versus the BoE's forecasts. Chart 4Currency Impact On U.K. Inflation Is Fading Chart 5Why Should The BoE Hike? For now, we are maintaining our recommended neutral allocation on Gilts in our model bond portfolio. Although we would view any additional widening in yield spreads between Gilts and U.S. Treasuries and core European yields as an opportunity to move to overweight. Simply put, the odds are far greater that the Fed's economic and inflation forecasts for the next year will be realized than those of the BoE, suggesting that there is more upside risk for yields in Treasuries than Gilts. Bottom Line: U.S. inflation data is stabilizing, while financial conditions continue to ease. The market is underestimating the potential for the Fed to hike rates again, perhaps as soon as December. At the same time, markets have priced in too many rate hikes in the U.K., with the Bank of England's growth and inflation forecasts unlikely to be realized. Maintain an overall below-benchmark portfolio duration tilt, while keeping an underweight stance on U.S. Treasuries and a neutral bias towards Gilts. Look to upgrade Gilts on any additional spread widening versus Treasuries or core Europe. Duration Checklist Update Back in February of this year, we introduced a list of indicators we need to monitor to determine if our recommended defensive duration stance on U.S. Treasuries and German Bunds was still warranted.1 These "Duration Checklists" combined data on overall global growth, as well as U.S. and Euro Area economic activity, inflation, investor risk-seeking behavior and technical positioning on government bonds. At the time, the Checklists were almost unanimous in pointing to a period of rising bond yields based on an improving growth profile and slowly rising inflation pressures. We updated the Checklists in May and, for the most part, the majority of the indicators were still flagging more upward pressures on yields, although some series on global growth and inflation had softened.2 With the benefit of hindsight, we now know that these factors - especially the pullback in U.S. inflation pressures - were enough to trigger a significant bond rally. With the U.S. inflation downdraft now in the process of stabilizing, as discussed earlier, this is now a good opportunity to revisit our Duration Checklists to assess the current backdrop for bond yields. The broad conclusion is that the majority of the indicators are still pointing to higher bond yields in the months ahead (Table 1). Table 1A Bearish Message From Our Duration Checklists Global economic activity indicators are mixed, but may be bottoming. The global leading economic indicator (LEI) continues to rise, heralding a continuation of the current economic uptrend (Chart 6). The breadth of that advance, however, is fading with our LEI diffusion index having fallen below the 50 line, meaning that there are more countries with a falling LEI. The global ZEW indicator of investor sentiment is also trending downward, another factor weighing on yields. The near-term dynamics on growth are starting to shift more bearishly for bonds, however, with the global data surprise index rising and the latest read on our Global Credit Impulse indicator ticking upward. We are giving a "check" to 3 of the 5 global growth elements in our Duration Checklists (LEI, data surprises, Credit Impulse), which represents a bond-bearish shift from the last update of the Checklists in May when only the LEI warranted a "check". Domestic economic growth in the U.S. and Euro Area is solid. Manufacturing PMIs in both the U.S. (the ISM index) and Europe are rising, as is consumer and business confidence (Charts 7 & 8). The latter is not surprising given the strong growth in corporate profits on both sides of the Atlantic that our models expect will continue. This bodes well for future growth momentum, as firms will not be forced to retrench on hiring and investment spending to protect profitability. We are giving a "check" to all domestic growth components of our Duration Checklists, highlighting that the economic backdrop remains bond bearish. Chart 6Yields Are Exposed To##BR##Improving Global Growth Chart 7A Solid U.S.##BR##Economic Expansion Chart 8European Growth Momentum##BR##Is Bearish For Bunds Realized inflation has dipped, but the worst looks to be over. In our Checklists, we include measures on energy prices, labor market tightness and wage inflation as the primary inflation indicators to monitor. On that front, the story still looks fairly benign for U.S. inflation given the dip in wage inflation measures like Average Hourly Earnings growth and the Atlanta Fed Wage Tracker (Chart 9). The unemployment gap (unemployment rate vs. NAIRU) is still negative, and other wage measures like the wage & salaries component Employment Cost Index are steadily expanding, suggesting that the underlying wage dynamics in the U.S. may not be as slow as indicated by Average Hourly Earnings. In the Euro Area, wage growth has accelerated above 2%, occurring alongside a grinding increase in core inflation and an unemployment gap that is almost fully closed (Chart 10). Meanwhile, the downward momentum in the growth of energy prices - denominated in both dollars and euros - has bottomed out after the sharp decline since the beginning of the year, although the rebound has been tepid so far (top panel of Charts 9 & 10). Chart 9Not Much Inflationary##BR##Pressures On UST Yields Chart 10Core Inflation & Wages Are##BR##Grinding Higher In Europe The most significant divergences between the regions exist within the inflation elements of our Checklists. For wage growth, we are giving an "x" to the U.S. but a "check" to Europe. For the unemployment gap, we are giving a "check" to both regions. For energy prices, however, we are not giving any indication (a "?") until we see more decisive evidence of a sustained acceleration that is pressuring headline inflation rates even higher. Both the Fed and ECB are biased to remove monetary accommodation. The Fed is in the midst of a rate-hiking cycle that began in late 2015, and is now about to begin the long process of shrinking its swollen balance sheet. The ECB has been slowly preparing the market for a shift to a slower pace of asset purchases, although rate hikes are still at least a couple of years away. For both central banks, we are giving a "check" for having a more hawkish/less dovish policy bias that is not bullish for bonds. Investors remain in risk-seeking mode. The way that we interpret investor risk aversion in the Checklists is if growth-sensitive risk assets like equities and corporate credit are rallying, then this is bearish for government bonds. The logic here is that private investor demand for Treasuries and Bunds is diminished when risk assets are rallying, as long as equities are not stretched to a point where the risks of a correction are elevated (i.e. indices trading 10% above their 200-day moving average). Also, the easing of financial conditions stemming from rallying stock and credit markets is a boost to growth that central banks will likely respond to by becoming less accommodative. From that perspective, the persistent bull markets in equities and corporate credit on both sides of the Atlantic are bearish for Treasuries (Chart 11) and Bunds (Chart 12). With stocks not looking stretched versus the medium-term trend and with volatility remaining low, all the related elements of our Checklists earn a "check". Chart 11Still A Pro-Risk Bias##BR##Among U.S. Investors Chart 12Still A Pro-Risk Bias##BR##Among Euro Area Investors Bond yields do not look stretched to the upside from a technical perspective. The Treasury sell-off from the 2017 peak back in March has pushed the 10-year yield back below its 200-day moving average, while also boosting the 6-month total return into positive territory (Chart 13). There is also a persistent net long position in 10-year Treasury futures (bottom panel). Add it all up and the technical backdrop for Treasuries is stretched in a way pointing to greater near-term risks of higher yields. In Europe, momentum measures all look neutral (Chart 14) and are no impediment to rising yields. We give all technical elements of our Duration Checklists a "check". Chart 13UST Rally Since March##BR##Is Looking Stretched Chart 14Neutral Technical##BR##Backdrop For Bunds Net-net, the Checklists show that the majority of indicators are still pointing to a bond-bearish backdrop. The only bond-bullish factors are the soft inflation readings in the U.S. although that may be in the process of shifting, as discussed earlier. There is not a major difference in the number of checkmarks for both the U.S. and Euro Area Checklists, thus we see no reason to favor either market from a relative perspective - there is pressure for both Treasury and Bund yields to rise. Thus, we are maintaining our recommended below-benchmark medium-term duration stance in both the U.S. and core Europe within hedged global bond portfolios. Chart 15UST Yields Have More Near-Term Upside From a shorter-term tactical perspective, however, we see more upside for Treasury yields vs Bunds with U.S. economic data surprising to the upside at a faster pace than in Europe (Chart 15). Throw in the potential for U.S. inflation to also rise above depressed expectations and a wider Treasury-Bund spread - a trade that we currently have in our Tactical Overlay portfolio and which goes against the tightening currently priced into the forwards - is the more likely outcome in the next few months. Bottom Line: An update of our Duration Checklists shows that the backdrop for growth, inflation and investor risk appetite remains bearish for U.S. Treasuries and German Bunds. Maintain below-benchmark duration exposure to both markets on a medium-term basis. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15th 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, "Fade The "Trump Fade"", dated May 23rd 2017, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Finally, an upside surprise on inflation. Recent significant developments reinforce BCA's bullish view on crude oil. Investors should consider the Monthly Report on personal income and spending, and not the quarterly GDP data, to gauge hurricanes' impact on economy. While the Fed will consider impact of Harvey and Irma, policy will ultimately be made on health of underlying economy. Feature Chart 1Rally For Risk Assets##BR##A Week Before The FOMC Risk assets and oil prices rose last week along with Treasury yields ahead of this week's FOMC meeting. Both the S&P 500 and the Dow hit new highs last week as the dollar moved lower. The stock-to-bond ratio also climbed, approaching the highs it reached earlier this year (Chart 1). All of this occurred amid an absence of any meaningful news on corporate earnings, aside from Apple's launch of the latest iPhone. Q3 earnings season is still a month away. Our base case projects stocks outperforming cash and bonds over the next 6-12 months, but in early September we recommended that clients be prudent, pare back any overweight positions and hold some safe-haven assets within diversified portfolios. The most significant movement in assets prices last week came in the U.S. Treasury market. Aided by hints of some progress on tax cuts in Washington less damage than initially feared from Hurricane Irma's impact on Florida, and despite another rocket launch by North Korea, the 10-year Treasury yield moved from near 2.0% in the first week of September to 2.20% on September 15. BCA's U.S. Bond Strategy service notes1 that bond markets are priced as though the link between growth and inflation is broken. We expect they will be proven wrong as inflation regains its uptrend during the next few months. Finally A Surprise On Inflation Chart 2Does One Month Make A Trend? After five months of downside surprises, U.S. core CPI met expectations in August. It is still too soon say that this is enough for the Fed to raise rates again this year. To get a better sense of the underlying trends, we like to break core CPI into three sub-groups: shelter, core goods and core services ex-shelter and medical care. Shelter, which accounts for over 40% of core CPI, rose 0.4% m/m in August. This was the biggest contributor to core CPI during the month. Our shelter model suggests that this strength is unlikely to persist. On the flip-side, core goods prices (25% of core CPI) fell 0.1% m/m. Given the weakness in the dollar, core goods prices should soon begin to rise. To some degree, a slowdown in shelter and a pick-up in core goods could offset each other over the coming months (Chart 2). Therefore, a sustained pick-up in overall core inflation requires an upturn in core services ex-shelter and medical. This sub-component of core CPI is the most tightly correlated with wage inflation. There was a slight tick higher in annual core services ex-shelter and medical inflation in August. However, it is still near a 25-year low of just 1.1%. Bottom Line: Following five months of persistent downside surprises, the 0.2% m/m increase in core CPI during August was a welcomed change for the Fed. However, one month does not make a trend and Fed will need to see more evidence of inflation turning the corner before raising interest rates again. Any rise in oil prices would also give inflation a lift, although it would affect the headline more than the core inflation rate. Bullish Oil Supply And Demand Recent significant developments reinforce BCA's bullish view on crude oil. The International Energy Agency (IEA) revised its forecasts for global oil demand. Oil consumption will be 100,000 bpd higher this year than the IEA's previous projection. Furthermore, renewed turmoil in Libya curbed production by 300,000 bpd from a 4-year high of more than 1 million bpd. BCA's Commodity & Energy Strategy service states that while predicting OPEC compliance is tricky, little to no cheating will occur. At worst, Saudi Arabia will step in and curtail production if Libya and/or Iraq begins to pump oil above quota. Finally, the Energy Information Administration (EIA) in the U.S. lowered its estimated shale oil output by 200,000 bpd for this year's third quarter. The decreased estimation confirms BCA's assertion that the EIA has overestimated the pace of the shale production response during 2017. Chart 3Drawdown In Global Oil##BR##Inventories Is Underway Taken together, these factors will help to improve the global net demand/supply balance by 600,000 bpd, if the current situation remains unchanged. As a result, global oil inventories will continue to be drawn down (Chart 3). Severe weather in the U.S. has temporarily distorted the energy markets. Crack spreads have widened in the U.S. as product inventories have declined along with Brent - WTI spreads. Nonetheless, BCA's commodity strategists remain bullish on crude oil, forecasting a rise in WTI to over $55/bbl and Brent to $60/bbl by year-end. Looking to next year, crude prices could go higher with an extension of the OPEC/Russian production cuts beyond March 2018 and continued strong growth in global oil demand. A sudden jump in the U.S. dollar could risk BCA's bullish view. Bottom Line: There is a disagreement between the market's view of the fundamentals of the global oil balance, which is guided by the EIA data, and BCA's view that is driven by the OPEC 2.0 framework.2 Oil prices could spike higher if the market adheres to the OPEC framework. BCA's Equity Trading Strategy service recommends an overweight to the S&P 500 Energy Sector and initiated an overweight in the Oil and Gas Refining and Marketing sub-group on September 11, 2017.3 Hurricane Redux Turning to the U.S. hurricane destruction, history shows that natural disasters have only a passing effect on the U.S. economy, the financial markets and the Fed.4 Ultimately, the macro environment in place before the storm will reassert itself. Nonetheless, it may be a few months before investors determine the long-term impact of the storms on Houston, Florida and nearby southern states. The U.S. data gathering agencies (BEA, BLS and Census) have processes to ensure that the storm's sway is reflected in the economic data. In the past, all three have produced post-disaster evaluations and will likely release the same type of information in the months ahead. Most of the storms' effects will be felt in the September data, but have already affected the initial claims data for the last week in August and the first week of September. The storms will also buffet the Q3 GDP (due out in late October). However, GDP data may not provide a comprehensive picture; GDP is not directly affected by natural disaster losses involving property, plants, equipment and structures. However, GDP can take a direct hit from the loss of productive capacity linked to a storm. The BEA notes that "while GDP may be affected by the actions that consumers, businesses, and governments take in response to a disaster, these responses are generally not separately identifiable, and they may be spread out over a long period of time." Investors should consider the monthly report on personal income and spending, and even more, the regional accounts by state, and not the quarterly GDP data, for details on the storms' economic fallout. Only hurricanes Katrina and Rita warranted a mention in the Q3 2005 GDP release, and none of the other major storms since that time have been noted by the agency. On the other hand, the personal income and spending reports released after all the major hurricanes since 2005 have provided key specifics on incomes. For example, the BEA stated that "work interruptions" linked to Hurricane Sandy reduced wages by $18 billion in October 2012 when the storm hit the northeastern U.S. The Bureau of Economic Analysis (BEA) also tends to note a storm's influence on other primary income categories including personal rental incomes, proprietors' incomes, and other current transfer receipts (i.e. insurance payments received). Table 1Total Federal Spending And Total Economic Damage For Selected Hurricanes, 2000 To 2015 A 2016 Congressional Budget Office (CBO) report found that federal spending after major hurricanes can add as much as 0.6% to GDP growth (Table 1). CBO notes that most of the economic impact is in the first year after a storm, with most of those expenditures helping victims to obtain food and shelter, fund search and rescue operations, and protect critical infrastructure. Federal outlays for public infrastructure occur after the first year and provide a much smaller lift to GDP (Chart 4). Chart 4Federal Government Outlays For Hurricane Relief The severe weather in the U.S. has raised the odds that the Trump administration and Congress will make progress on fiscal policy this fall. We think that the outlines of a tax bill will emerge in the next month or so, and while the probability of passing legislation this year is still low, BCA's Geopolitical Strategy service expects the market to react when it sees the bill. The implication for investors is that the President Trump trades (Chart 5) that have unwound since the start of the year may soon become profitable again. The recent agreement between Trump and the Democrats to extend the debt ceiling and avoid a government shutdown support our stance. Chart 5Trump Trades Making A Comeback? Bottom Line: The hurricanes may have a bearing on the economic data for the next few months. Investors should closely monitor the input data to GDP, but not GDP itself. However, we do not anticipate that any economic disruptions from the storms will have a meaningful influence on near-term Fed monetary policy. Disasters And The Fed The hurricanes will probably play a supporting role in the Fed's outlook on the economy, inflation and labor market at this week's meeting. The FOMC statement will mention the storms and Fed Chair Yellen may include them in her opening remarks. Moreover, the news conference will provide another opportunity to discuss the issue. For example, the FOMC statement released in mid-December 2012, six weeks after Sandy, stated that "economic activity and employment have continued to expand at a moderate pace in recent months, apart from weather-related disruptions". Fed staff noted that manufacturing production was held down by Sandy and that household spending, notably vehicle sales, declined in October due to the storm (Table 2). Similarly, the wrath of Hurricanes Katrina and Rita was noted in FOMC statements and minutes in the fall and early winter of 2005. For example, in the statement released at the meeting after Katrina hit in August 2005, the FOMC observed: "The widespread devastation in the Gulf region, the associated dislocation of economic activity, and the boost to energy prices imply that spending, production, and employment will be set back in the near term." Fed policymakers made similar observations in the aftermath of other natural and man-made disasters in the past 25 years (Table 2). Table 2FOMC Reaction To Disasters, Natural And Man Made Bottom Line: Fed officials will consider the disruptions to the economy and economic data caused by Hurricanes Harvey and Irma, but ultimately make policy decisions based on the underlying strength of the economy, labor market and inflation. FOMC Preview The FOMC will initiate shrinking its balance sheet at this week's meeting, but neither BCA nor the market anticipate that the Fed will bump up rates. Moreover, the Fed will need more evidence that inflation, inflation expectations and/or inflation surprise has turned higher before resuming its rate hike regime. Furthermore, there is still a significant disconnect between the market and the Fed concerning rates for the next 12 months, and how that gap closes could be crucial for the financial markets, especially the bond market. At 43 basis points, the gap between the June dot plots and the market on the Fed funds rate in the next 12 months remains near its widest level of the year. The market is currently predicting only 30 bps in increases in the next 12 months. However, an uptick in inflation could quickly change that view (Chart 6). Despite the disagreement on rates, the Fed and the market are mostly aligned on the economy, the labor market and inflation, at least in 2017. For the first time, the FOMC will provide projections for 2020 at this week's meeting. At 4.4% in August, the unemployment rate is a mere tenth above the Fed's end-2017 forecast, but it is 0.2% below the central bank's latest estimate of full employment (4.6%). The Fed's measure of full employment has declined in recent years and we would not be shocked to see a drop again this week. The consensus outlook for the unemployment rate matches the Fed's path through the end of 2018 (Chart 7 and Chart 8). Chart 6Big Disagreement Between The Fed ##br##And The Market On Rates Chart 7The Fed Vs. The Market Chart 8The FOMC's "Long Run"##BR##Forecasts Since 2012 The economy is on pace this year to grow at the Fed's 2.2% projection but is running above the FOMCs long-run calculation of 1.8%, which is the low point since the Fed started publishing these long-run projections in 2009. The consensus forecast for GDP in 2018 and 2019 is slightly above the upper end of the Fed's range set in June (Chart 7 and Chart 8). The Fed and the market are relatively close on inflation this year, but there is still a wide gap in 2018 and beyond. In June, the Fed lowered its inflation forecast for 2017 to 1.6% from 1.9% in March. PCE inflation is at only 1.4% (year-to-date in 2017), so there is not much disagreement in this regard. The market does not agree with the Fed's view that inflation will return to 2.0%, and this is a key reason why the 10-year Treasury yield recently touched a new post-election low at 2.0%, although geopolitical tensions also played a role. The central bank's view of inflation in the long run has not deviated from 2.0% since 2012. Bloomberg consensus estimates for core inflation for this year and next are below the low end of the Fed's forecast range (Chart 7 and Chart 8). Market participants and some Fed officials are still concerned that the traditional Phillips curve model may be broken and that inflation may never accelerate even with an unemployment rate that is below the Fed's estimate of full employment. (Please see a BCA Special Report, "Did Amazon Kill The Phillips Curve?").5 Who Will Be The Next Fed Chair? As some investors consider the Fed's next policy move, others are taking a longer view and thinking about Fed Chair Yellen's replacement. Yellen's term as Chair will end in February 2018, and the markets have not yet shown any concerns about her potential replacement. Until last month, the frontrunner to replace Yellen was Gary Cohn, the Chairman of President Trump's National Economic Committee; his appointment would conform to some historical precedents but violate others.6 Several new names have emerged as possible Fed nominees as Cohn fell out of favor in the White House in early September. Kevin Warsh, Glen Hubbard and John Taylor, are all high-profile economists with links to the GOP, but Warsh stands out because he served on Trump's Strategic and Policy forum before it disbanded in August, and was a Fed Governor in the early 2000s (Table 3). Hubbard, who is currently an academic, was President George W. Bush's chief economist. However, he has not worked with Trump and has no Fed experience. John Taylor is well known in monetary policy circles, but has no Fed or government background, nor has he served with Trump. Taylor advocates for rules-based monetary policy.7 Another possible name, Larry Lindsey, an advisor to George W. Bush's campaign in 2000, a Fed Governor in the 1990s, and worked in the Reagan White House but he has no connection to Trump. He has recently spoken in favor of the House tax plan. Table 3Characteristics Of Fed Chairs Since 1970 The other two names under consideration - Richard Davis and John Allison - may have difficulty winning confirmations by the Senate. Both men were CEOs at major banks although neither have directly served Trump, nor been at the Fed or in government. Allison, a former president of the Libertarian Cato Institute, has argued that the Fed should be abolished and blamed the Fed for the financial crisis. The timing of Trump's announcement on Yellen's replacement may be critical. As a reminder, names floated by the Obama White House in the summer of 2013 were mainly rejected by the markets. Yellen's official announcement came in early October 2013. In August 2009, President Obama reappointed Bernanke for a second four-year term. Bernanke was initially nominated to be Fed Chair by George W. Bush in October 2005. If the appointment comes in October and the nominee is perceived to be hawkish, the risk is that markets may begin to price in the regime change sometime in the next few months. As we noted in the sections above, there is already a wide discrepancy between the Fed and the market over the pace and timing of rate hikes in the coming year. BCA's fair value model for the 10-year Treasury yield (based on Global PMI and dollar sentiment) currently places fair value at 2.67%.8 Moreover, our 3-factor version of the model (which includes the Global Economic Policy Uncertainty Index), puts fair value slightly higher at 2.68%. Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. Bottom Line: Markets will be increasingly concerned in the next six weeks about the next Fed Chair and his or her policies. While the reappointment of Fed Chair Yellen for another term would please the markets, several other possible successors would not. We anticipate that the President will make a choice within the next month. Taking a longer view, the next Fed chair will oversee the policy response to the next recession and its aftermath. Investors should understand how the next Chair views the Fed's role in the business cycle. Economy Focus: Some Good News From The Quarterly Services Survey Even with the increasingly dominant role of the service sector's contribution to the economy (~69% of GDP), most of the high-frequency data are related to the manufacturing sector (~12% of GDP) (Chart 9, top panel). However, the Quarterly Services Survey (QSS), initiated in 2003-2004 by the Bureau of Economic Analysis (BEA), measures the services sector of the economy, including companies of all sizes (small- and medium-sized). It produces the most timely revenue data, on a quarterly basis, within the flourishing service sector. The dataset is used primarily by the BEA to estimate a more accurate picture of the national accounts, notably personal consumption and the intellectual property segment of private fixed investment. The survey is also essential for FOMC policymakers as it is very useful to track current economic performance. Even more, during the financial crisis, the BEA "aggressively responded to policymakers' needs for data on financial services". The QSS is a significant source of revisions to real GDP, as about 42% of the quarterly estimates of PCE for services is now based on QSS data. The "key services statistics" include information services; health care services; professional, scientific, and technical services; administrative and support and waste management and remediation services (Chart 9). For the first half of 2017, upward revisions to second and third estimates to real GDP stemmed from revisions to PCE services and nonresidential fixed investment, namely: health care services, financial & insurance services and intellectual property products (specifically software) and other services accounted for by cellular telephone services. The most recent QSS for 2017Q2 showed U.S. selected services total revenue rising by 3.2% over the last quarter and 6.2% over the last four quarters (in nominal terms and non-seasonally adjusted data only available). The strongest growth came from revenues of Other Services (9.4% QoQ% and 18.4% YoY) followed by Arts, Entertainment & Recreation and Administration, Support & Waste Management. Sales in Finance & Insurance and Health Care & Social Assistance, which make up about 50% of total service revenues, are advancing at a sturdy pace, as is revenue in Information services (Chart 9). Chart 9Growth For Service Sector##BR##Industries Is Broad-Based Chart 10QSS Survey Heralds Some##BR##Upward Revision To Real GDP Bottom Line: Given that the majority of service industries from the QSS sample survey continue to show upward momentum, perhaps we will see some upward revision to real consumer spending for services for the third estimate of real GDP next week (Chart 10). We continue to expect U.S. GDP growth to match or exceed the Fed's modest target for 2017. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA U.S. Bond Strategy Weekly Report "Open Mouth Operations", published September 12, 2017. Available at usbs.bcaresearch.com. 2 Please see BCA Commodity & Energy Strategy Weekly Report "Hurricane Recovery Obscures OPEC 2.0's Forward Guidance", published September 14, 2017. Available at ces.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report "Still Goldilocks", published September 11, 2017. Available at uses.bcaresearch.com. 4 Please see BCA U.S. Investment Strategy Weekly Report "Shelter From The Storm", published September 5, 2017. Available at usis.bcaresearch.com. 5 Please see The Bank Credit Analyst Special Report "Did Amazon Kill The Phillips Curve?", published August 31, 2017. Available at bca.bcaresearch.com. 6 Please see BCA U.S. Investment Strategy Weekly Report "Global Monetary Policy Recalibration", published July 17, 2017. Available at usis.bcaresearch.com. 7 Please see BCA U.S. Investment Strategy Weekly Report "Trump And The Fed", published March 6, 2017. Available at usis.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report "The Cyclical Sweet Spot Rolls On", published September 5, 2017. Available at usbs.bcaresearch.com.