US Dollar

Highlights The vaccine promises an eventual return to “normal” life – just as Americans voted to “return to normalcy.” Markets are cheering and hinting at an eventual rotation into value stocks. The contested US election can still cause volatility even though Trump is highly unlikely to change the result. The fiscal stimulus cliff is still a risk to the normalcy rally in the short run. But gridlock is the best political outcome over the coming 12-24 months. Stay strategically long global stocks over bonds. Tactically maintain safe-haven positions, add risk gradually, and stay short China/Taiwan. Feature The news of Pfizer’s success in developing a COVID-19 vaccine galvanized financial markets this week. America’s leading public health official Anthony Fauci also predicted that Moderna’s vaccine candidate would be similarly effective. It will take time to distribute these vaccines but the world can look toward economic recovery next year. Stocks rallied, bonds sold off, and value outperformed growth on the back of the news (Charts 1A and 1B). Chart 1ABiden: Return To Normalcy Biden: Return To Normalcy Biden: Return To Normalcy Chart 1BVaccine: Return To Normalcy Vaccine: Return To Normalcy Vaccine: Return To Normalcy The vaccine announcement super-charged the “return to normalcy” rally that followed the US election. The election’s likeliest policy outcome is that President Elect Joe Biden will not raise sweeping tariffs while Republican senators will not raise taxes next year, the best-case scenario for markets. This is genuinely positive news. The benefits are very clear over the next 12 months. But the risks are also very clear over the next three months: the virus will remain a problem until the vaccine is widely distributed, the US is in the midst of a contested election that could still cause negative surprises, the Republican senators are less likely to agree to fiscal relief, and President Trump will take aggressive actions to cement his legacy during the “lame duck” period of his last 68 days in office. The takeaway is that the US dollar will see a near-term, counter-trend rally and developed markets will outperform emerging markets for a while longer. We are only gradually adding risk to our strategic portfolio as we keep dry powder and maintain tactical safe-haven trades. Is The Election Over Or Not? Yes, most likely the election is over. But our definitive guide to contested US elections will teach any reader to be sensitive to the tail risks. The counting of ballots is not finished and the Electoral College does not vote until December 14. First, it is still possible that President Trump could pull off a victory in Georgia, which will now recount ballots by hand. Biden’s margin of victory of 14,045 votes is not so large there as to make it impossible that Trump would come back with a win (though history suggests recounts only change hundreds, not thousands, of votes). Trump is also narrowing the gap in Arizona, where counting continues, though the latest reports suggest he is still falling short of the roughly 60% share of late ballots that he needs to close the 11,635 vote gap and win the state. Second, there is a 50/50 chance that the Supreme Court will rule that Pennsylvania must stick to the statutory November 3 deadline, i.e. not accept mail-in ballots that arrived in the three days after that date. While the high court would prefer to let Pennsylvania settle its own affairs, this case is of the sort that the court could feel compelled to weigh in. The constitution is crystal clear that legislatures, not courts, decide how a state’s electors are chosen. Such a ruling probably would not reverse Biden’s projected victory in Pennsylvania. Trump is currently trailing Biden by 53,980 votes in this state. State officials say that the ballots that arrived late amount to only 7,800 and would not be able to change the outcome.1 This may be understating the risk but it is probably accurate in the main. Table 1 shows the share of mail-in votes that arrived late in this year’s primary elections. The share was 1.07% in Pennsylvania and up to 3% in other states. Applying the high water mark of 3% to the November 3 general election mail-in ballots, it is possible that 77,187 votes arrived late and would be excluded by a Supreme Court ruling. However, 85% of those ballots would have to have gone to Biden in order for Trump to come out the winner. This is far-fetched. Table 1Share Of Ballots Arriving Late In Primary Election Extrapolated To General Election The "Normalcy" Rally The "Normalcy" Rally It is also unlikely that Republican legislatures will take matters into their own hands and defy the election boards of their state by nominating their own slate of Republican electors – a scenario we entertained in our definitive guide. If Biden leads the statewide vote, then a state legislature would be politically suicidal to appoint the state’s electors to vote for Trump. It would invite a popular backlash. In the case of Pennsylvania, Republican leaders of the lower and upper chambers have explicitly denied any willingness or ability to choose electors other than those entailed by the popular vote. Thus the 1876 “Stolen Election” scenario is extremely unlikely in this critical state. It is just as unlikely in Arizona, Nevada, or Georgia.2 Nevertheless, if President Trump wins in Georgia or gets a favorable Supreme Court verdict, investors will have to increase the probability that the election result will be overturned, which currently stands at 16% (Chart 2). This will cause a bout of volatility even if it changes nothing in the end. If somehow Trump pulls off a Rutherford B. Hayes and overturn the result, markets should sell off. Yes, Trump is an exclusively commercial and reflationary president, but his election on a constitutional technicality would create nearly unprecedented social and political instability in the United States and it would presage major instability globally. Chinese, European, and Canadian assets would be hardest hit (Chart 3). Chart 2Trump’s Tiny Chance Of Reversing Election The "Normalcy" Rally The "Normalcy" Rally Otherwise Trump and the Republicans are trying to do four things with their litigation: (1) probing for weaknesses that can delay or change the Electoral College math (2) conducting due diligence in case fraud really did tip over one of the states (3) saving face for President Trump and his allies, who otherwise would be exposed as failures (4) keeping their base motivated for the showdown in Georgia on January 5, which will determine control of the Senate. Chart 3Trump's Loss Favors Euro, Renminbi, Loonie Trump's Loss Favors Euro, Renminbi, Loonie Trump's Loss Favors Euro, Renminbi, Loonie In Georgia, opinion polls show Republican David Perdue slightly leading Democrat Jon Ossoff, in keeping with his superior showing on November 3. However, Republican Kelly Loeffler is trailing Democrat Raphael Warnock (Charts 4A and 4B). Last week we argued that the odds of Democrats winning both races stood around 20%. If anything this view is generous – given that Perdue already beat Ossoff, and Warnock will continue to suffer attacks for associating with Fidel Castro – but it is in line with online betting markets (Chart 5). Chart 4AVoters Split On Georgia Senate Runoffs The "Normalcy" Rally The "Normalcy" Rally Chart 4BVoters Split On Georgia Senate Runoffs The "Normalcy" Rally The "Normalcy" Rally Chart 5Democrats Have ~20% Chance To Win Senate The "Normalcy" Rally The "Normalcy" Rally Investors should plan on the US government being gridlocked unless something occurs that fundamentally changes the Georgia race. Gridlock is positive, so if Trump’s election disputes keep the Republican political base spirited for the Georgia runoffs, then Trump’s activities have an ironic upside for markets. That is, as long as he doesn’t succeed in overturning the election result and the flames of discontent do not break out into a significant violent incident. Other fears about the transition period are less concerning. Several clients have asked us what should happen if President Elect Biden came down with COVID-19 or were otherwise incapacitated. The answer is that Vice President Elect Kamala Harris would take his place, as she now has popular consent to do exactly that. Prior to the Electoral College voting on December 14, the Democratic National Committee would have to nominate a candidate to replace Biden, almost certainly Harris. After December 14, the regular succession would apply under the twentieth amendment and Harris would automatically fill Biden’s shoes. Harris is only slightly more negative for equities than Biden: her regulatory pen would be more anti-business, but like Biden her main policies depend entirely on control of the senate. Bottom Line: It ain’t over till it’s over. The big picture is positive for risk assets but a surprise from ongoing election disputes or the unusually rocky transition of power would trigger a new bout of volatility. Stay long Japanese yen and health stocks on a tactical time frame. Trump’s Lame Duck Risk An investor in the Wild West has often criticized us for arguing that Trump would become a “war president” as he became a political lame duck at home. This war president view did pay off with Iran in January 2020, but otherwise the criticism is valid (see Trump’s Abraham Accords). Now Trump is almost certainly a lame duck so we will find out what he intends to do when unshackled from election concerns. Stay long Japanese yen and health stocks on a tactical time frame.  Since losing the election, Trump has fired Defense Secretary Mark Esper, several defense officials have resigned, and CIA Director Gina Haspel is rumored to be next on the chopping block. Most of the officials to depart had broken with the president over the course of the election year, so he may just be dishing out punishment now that the campaign is over. But it is possible that Trump is planning a series of final actions to cement his legacy and that these officials were removed because they got in the way. Chart 6Trump's Lame Duck Risk To China And Taiwan Strait Trump's Lame Duck Risk To China And Taiwan Strait Trump's Lame Duck Risk To China And Taiwan Strait First, there is no doubt that Trump is already tightening sanctions on China and Iran. China was the origin of the coronavirus pandemic and Trump has called for reparations, which could mean more tariff hikes. His outstanding legacy in US history will be his insistence that the US confront China. We are fully prepared for this outcome and remain short the renminbi and Taiwanese equities, despite their strong performance year-to-date (Chart 6). Trump could also raise tariffs on Europe. However, investors should be used to tariffs and sanctions by now. The impact would be fleeting and the next administration could reverse it. In the case of the renminbi, or any tariffs that weigh on the euro, investors should buy on the dips. By contrast, there are some conceivable actions – we are speculating – that would be extremely destabilizing and possibly irreversible. These would include: Extending diplomatic recognition to Taiwan, potentially provoking a war with China. Sending aircraft carriers into the Taiwan Strait, like Bill Clinton did during the Third Taiwan Strait Crisis, to shore up US deterrence. Launching surgical strikes against Iran’s ballistic missile and nuclear facilities or critical infrastructure. A prominent official has already denied that Trump intends anything of the sort. Launching surgical strikes against North Korea’s ballistic missile and nuclear facilities. No sign of this, but Kim Jong Un did enhance his capabilities after his meetings with Trump, thus embarrassing the president on a major foreign policy initiative ahead of the election. Providing intelligence and assistance to US allies like Israel who may seek to sabotage or attack Iran now or in future to prevent it from acquiring nuclear weapons. Withdrawing US troops from Germany or South Korea – which is much more consequential than hasty withdrawals from Afghanistan or Syria, which Trump clearly intends. War actions are largely infeasible. The bureaucracy would refuse to implement them. Assuming the Department of Defense would slow-walk any attempts to reduce troops in important regions like Germany or Korea, it would almost certainly avoid instigating a war. Withdrawing troops from Afghanistan or Syria is manageable, and fitting with Trump’s legacy, but it would not be disruptive for financial markets. A diplomatic upgrade or a show of force to demonstrate the American commitment to defend Taiwan is possible and highly disruptive for global financial markets. The critical risk may come from US allies or partners that are threatened by the impending Biden administration and have a window of opportunity to act with full American support while Trump still inhabits the Oval Office. The likeliest candidate would be Israel and Saudi Arabia on the Iranian nuclear program. Trump’s onetime national security advisor, H. R. McMaster, has already warned that Israel could act on the “Begin Doctrine,” which calls for targeted preventive strikes against hostile nuclear capabilities.3 Even here, Israel is unlikely to jeopardize its critical security relationship with the United States, so any actions would be limited, but they could still bring a major increase in regional tensions. Saudi Arabia can do little on its own but President Trump could willingly or unwilling encourage provocative actions. Chart 7Big Tech Is Not Priced For Surprises Big Tech Is Not Priced For Surprises Big Tech Is Not Priced For Surprises Any number of incidents or provocations could occur in this risky interregnum between Trump and Biden. Some suggest Trump will release a treasure trove of documents to discredit Washington and the Deep State. If that is all that occurs, then investors will be able to give a sigh of relief, as revelations of government intrigue would have to be truly consequential for future events in order to cause a notable market impact. Last-minute executive orders on regulating domestic industries are just as likely to shock markets as any international moves. We speculate that Big Tech is in Trump’s sights for censoring his comments during the election. In the wake of the Supreme Court’s decision in Department of Homeland Security versus Regents of the University of California, the Trump administration is positively incentivized to issue a flurry of executive orders and write them in a way that makes them hard for the Biden administration to rescind them.4 Tech is priced for perfection, despite ruffles due to the vaccine this week, and investors expect Biden-Harris to maintain Obama’s alliance with Silicon Valley, not least because Biden has named executives from Facebook and Apple to his transition team and is considering putting former Google chief Eric Schmidt in charge of a Big Tech task force (Chart 7).5 Ultimately we have no idea what the Trump administration will do in its final two months. A lot of Trump’s attention will be focused on contesting the election. Drastic or reckless decisions will likely be obstructed by the bureaucracy. But the president still retains immense powers and there are executive orders that are legitimate and would benefit the US’s long-term interests even if disruptive for financial markets – and these would be harder for officials to disobey. Trump is an anti-establishment player who intends to shake up Washington, stay involved in politics, and cement his legacy. There is a reason for investors to take political risk seriously rather than to assume that the transition to a more market-friendly administration will be smooth. Bottom Line: Stay long gold on geopolitical risk, despite the potential for a counter-trend rise in the US dollar. We are neutral tech: polarization and fiscal risks are positive for tech shares but reopening and Trump lame duck risks are negative. Biden’s Cabinet Picks This “lame duck Trump” risk explains why we are not overly concerned about Biden’s cabinet picks. Insofar as Biden’s choices affect the market at all, they will confirm the “return to normalcy” theme and hence will be market-friendly. Take for example Biden’s just-announced chief of staff, Ronald Klain, who was chief of staff when Biden served as vice president from 2009- 16. The current transition is obstructed by election disputes, as occurred in November-December of 2000, but the cabinet picks are not likely to bring negative surprises. Already Biden has announced a coronavirus advisory board, a bipartisan transition team, and is pondering other picks, some of which will be known by Thanksgiving. None of the choices are in the least disruptive or radical – and most are acceptable to Wall Street. Biden will pick experts and technocrats who are known from his political career, the Obama administration, the Clinton administration, the Democratic Party, and academia. The market will invariably approve of establishment nominations after four years of anti-establishment picks and spontaneous firings. Since the Senate will remain in Republican hands, the cabinet members will have to be centrist enough to be confirmed. While Biden will inevitably nominate a few progressives, they will either fail in the Senate or take up marginal posts. Stay long gold on Trump “lame duck” geopolitical risks. Biden may have the opportunity to appoint three or even four members to the Federal Reserve’s board of governors. The Trump administration failed to fill two seats, while Fed Chair Jerome Powell’s term will expire in February 2022 (Diagram 1). If Biden appoints Lael Brainard to another post, such as Treasury Secretary, he will have a fourth space to fill. Diagram 1Biden Could Have Three-To-Four Fed Picks The "Normalcy" Rally The "Normalcy" Rally Chart 8Facing Gridlock, Biden Will Re-Regulate The "Normalcy" Rally The "Normalcy" Rally The implication will be a further entrenchment of dovish policy, with greater attention to new concerns that fall outside of traditional monetary policy such as climate change and racial inequality. The Fed has already committed to pursuing “maximum employment,” refraining from rate hikes till the end of 2023, and targeting average inflation – all a major boon to the Biden administration as it attempts to revive the economy. What is negative for markets is that Biden will re-regulate the economy – after Trump’s deregulatory shock – and that this will bring about political risks for small business and key industries like health, financials, and energy (Chart 8). Biden has little other option given that his legislative agenda will be largely stymied. Nevertheless, the sectors most likely to be heavily impacted are attractively valued and stand to benefit from economic normalization if not from Biden’s version of normalcy. Bottom Line: Stay long health and energy. Yes, Gridlock Is Best For Markets Some clients have asked us about our view that gridlocked government is truly the best for financial markets. Wouldn’t Democrats winning control of the Senate in Georgia be better, as it would usher in greater political certainty and larger fiscal spending? We have addressed this issue in previous reports so we will be brief. First, yes, gridlock has higher returns than single-party sweep governments on average over the past 120 years (Chart 9). Clearly the normalcy rally can go higher, but it is equally clear that it will get caught by surprise when the political reality hits home.  Second, however, the stock market’s annual returns are roughly average under single-party sweeps during this period (Chart 10). Chart 9Gridlock Best For Markets The "Normalcy" Rally The "Normalcy" Rally Chart 10Single-Party Sweeps Generate Average Annual Returns The "Normalcy" Rally The "Normalcy" Rally So while investors can cheer gridlock, it is not as if they should sell everything if Democrats do win control of the Senate on January 5. Chart 11Sweeps As Good As Gridlock Over 70 Years The "Normalcy" Rally The "Normalcy" Rally Indeed, looking at the period after World War II, sweep governments have witnessed average annual returns that are the same or slightly better than under gridlock (Chart 11). Whereas limiting the study to the post-Reagan era, gridlocks are clearly favored. If greater fiscal resources are needed then gridlock will quickly become a market risk rather than an opportunity. It is notable that over the past 120 years, there is not an example of a Democratic president presiding over a Republican senate and a Democratic House. There was only one case of the inverse – a Republican President, a Democratic senate, and a Republican House – which occurred in 2001-02 and coincided with a bear market. In fact, this episode should be classified as a Republican sweep, as in Table 2, since a sweep was the result of the 2000 election and the context of the key market-relevant legislation in 2001.6 Table 2Average Annual Equity Returns And Gridlock Government The "Normalcy" Rally The "Normalcy" Rally Chart 12Market Predicted Gridlock In 2020 Market Predicted Gridlock In 2020 Market Predicted Gridlock In 2020 In 2020 the stock market clearly anticipated a gridlocked outcome – the market’s performance matches with the historical profile of divided government (Chart 12). We argued that this was the best case for the market because it meant neither right-wing populism nor left-wing socialism. But we also highlighted that any relief rally on election results (reduced uncertainty) would be cut short by the major near-term implication of gridlock: a delay of fiscal support for the economy in the near term. This was the only deflationary scenario on offer in this election. Hence bad news in winter 2020-21 would precede the good news over the entire 2020-22 period. This is still largely our view, but we admit that the vaccine announcement erodes near-term risk aversion even further. There is little substance to the discussion of whether Americans will take the vaccine or not. Evidence shows that Americans are no less likely to take vaccines than other developed country citizens – assuming they are demonstrated to be safe and effective (Chart 13). Chart 13Yes, Americans Take Vaccines The "Normalcy" Rally The "Normalcy" Rally So gridlock looks even better now than it did previously. Yet we still think the near-term fiscal risks will hit markets sometime soon. Senate Republicans have been emboldened by the fact that their relative hawkishness paid off in the election on November 3. If they would not capitulate to House Speaker Nancy Pelosi prior to the election, they are even less likely to do so after gaining seats in the House, retaining the Senate, and crying foul over the presidential election. McConnell could agree to a $500 billion deal before Christmas – or not. There is no clear basis for optimism. A government shutdown is even possible if the continuing resolution expires on December 12. If the economic data turns sour and/or markets sell off dramatically then the Republicans will be forced to agree to a bigger deal, but as things stand they are not forced to do anything. And that presents a downside risk to the normalcy rally. Investment Takeaways Today’s post-election environment is comparable to the period after 2010, when a new business cycle was beginning and a new President Barack Obama had to face down Republican fiscal hawks in the House of Representatives. Today’s GOP senators may prove somewhat more cooperative with President Elect Biden, but that remains to be seen. Given how tight the election was, Republicans have an incentive to obstruct, slow down the economic recovery, and contest the 2022 midterms and 2024 election on the back of another slow-burn recovery. It worked last time. The debt ceiling crises of 2011 and 2012-13 were different than the fiscal stimulus cliff that Washington faces today but the market implications are similar. At the climax of brinkmanship between the president and the senate, treasuries will rally, the dollar will rally, stocks will fall, and emerging markets will underperform (Charts 14A and 14B). Today there is a greater limit on how far the dollar will rise and how far treasury yields will fall, but a fiscal impasse will still drive flows into these assets. Chart 14AObama’s Debt Ceiling Crises… Obama's Debt Ceiling Crises... Obama's Debt Ceiling Crises... Chart 14B… Presage Biden’s Fiscal Cliffs ... Presage Biden's Fiscal Cliffs ... Presage Biden's Fiscal Cliffs ​​​​​​​This is what we expect over the next three months. The fact that President Trump could bring negative surprises only enhances this expectation. Therefore we are only gradually adding risk to our strategic portfolio and maintaining tactically defensive positions. Clearly the normalcy rally can go higher, but it is equally clear to us that it will get caught by surprise when the political reality hits home. Since this could be anytime over the next two months, we are only gradually adding new risk. We would not deny that the outlook is brighter over the 12-24-month periods due to the vaccine and election results.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Chris Matthews, "Alleging fraud, GOP seeks to overturn election results in Michigan, Pennsylvania," MarketWatch, November 10, 2020, marketwatch.com. 2 See Senator Jake Corman and Representative Kerry Benninghoff, "Pennsylvania lawmakers have no role to play in deciding the presidential election," Centre Daily, October 19, 2020, centredailly.com. As for the 1876 “Stolen Election,” the initial election results suggested that Democrat Samuel Tilden had won 184 electoral votes while Republican Rutherford B. Hayes had won 165. The amount needed for a majority in the Electoral College at the time was 185, so Tilden fell one vote short while Hayes fell 20 votes short. After partisan litigation, actions by state legislatures, an intervention by the US House of Representatives, and a grand political compromise, Hayes won with 185 votes. 3 See Charles Creitz, "McMaster warns Biden on Iran deal: Don't resurrect 'political disaster masquerading as a diplomatic triumph,’" Fox News, November 12, 2020, foxnews.com. 4 In this ruling, which was decided on a 5-4 split with Chief Justice John Roberts siding with liberal justices, the Supreme Court denied the Trump administration’s effort to overturn the Obama administration’s policy known as Deferred Action on Childhood Arrivals (DACA), which stopped the US from deporting illegal immigrants who came to the US as children. The majority opinion argued that the Trump administration had merely asserted, not demonstrated, that the Obama administration’s executive orders were unconstitutional. In doing so, it established a precedent by which the court can determine whether one president’s executive orders should overrule another’s. While future administrations may follow better procedures in attempting to revoke their predecessors’ orders, this decision likely incentivizes the Trump administration to try to issue decrees that will be difficult to revoke. See John Yoo, "How the Supreme Court’s DACA decision harms the Constitution, the presidency, Congress, and the country," American Enterprise Institute, June 22, 2020, aei.org. 5 See Kiran Stacey, “What can Silicon Valley expect from Joe Biden?” Financial Times, November 8, 2020, ft.com. 6 The election produced a Republican sweep, with a 50-50 balance in the Senate, that led to the Bush tax cuts in May 2001. The business cycle was ending, however. In June, Democrats took the senate majority when Republican Senator Jim Jeffords of Vermont became an independent and began caucusing with Democrats. In September terrorists attacked the World Trade Center causing a market collapse.

Highlights Biden’s chances of winning the US election are rising, but it is still unsettled and could bring negative surprises to financial markets. The fiscal cliff will not subside immediately as the Senate Republicans have been vindicated for their fiscally hawkish approach. We doubt Democrats will win both Senate seats in Georgia to restore the lost “Democratic Sweep” scenario that offered maximum policy reflation. President Trump’s lame duck period, if he loses, lasts for three months and could bring negative surprises on China, the Taiwan Strait, Big Tech, Iran, or North Korea. The US remains at “peak polarization,” though we expect a growing national consensus over the long haul. Go long a basket of Trans-Pacific Partnership countries on a strategic time horizon to capitalize on what we believe will be Biden’s pro-trade-ex-China policy. Feature Chart 1Market Response To US Election Market Response To US Election Market Response To US Election The US presidential election remains undecided despite former Vice President Joe Biden’s increasing likelihood of victory. Votes will be recounted in several states while one potential tipping-point state, Pennsylvania, could easily swing on a Supreme Court decision. The Senate is likely to remain in Republican hands, though there is still a ~20% chance that it will flip if Democrats win both of the likely Georgia runoff elections on January 5. Thus our base case is the same as in our final forecast: Biden plus a Republican Senate. Financial markets first rallied and have now paused (Chart 1). The pause makes sense to us. Ultimately the best-case scenario of this election was always Biden plus a Republican Senate – neither tariffs nor taxes would increase. But this same scenario also always posed the highest risk of near-term fiscal tightening that would undermine the US recovery and global reflation trade. GOP Senators will insist on a smaller fiscal relief bill and may wait too long to enact it. Below we discuss these dynamics and why we maintain a tactically defensive position amid this contested election. We will not go full risk-on until the critical short-run risks subside: the contested election, the fiscal impasse, Trump’s “lame duck” executive orders, and the international response. Biden Not Yet President-Elect Biden is leading the vote tally in Arizona, Georgia, Michigan, Nevada, Pennsylvania, and Wisconsin as we go to press. To all appearances he has reclaimed the “Blue Wall” (MI, PA, WI) and made inroads in the Sun Belt (AZ, GA). We will not go full risk-on until the critical short-run risks subside. Map 1 shows tentative election results. Unsettled states are colored lightly while settled states are solid red or blue. This map points to a Biden victory even if Georgia and Pennsylvania slip back to Trump. The President would need to reclaim the latter two and one other state to reach 270 Electoral College votes. Map 1US 2020 Election Results (Tentative) Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Chart 2 shows the final prediction of our quantitative model. While our model predicted a Trump victory at 51% odds, we subjectively capped Trump’s odds at 45% because we disagreed that Trump would win Michigan.1 We did not do the same for our Senate model as the results matched with our subjective judgment that Republicans would keep control. Chart 2Our Presidential Quant Model Versus Actual Results Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Investors cannot yet conclude that the contested election risks have abated. If Biden wins only AZ, NV, MI, and WI, then he will end up with 270 Electoral College votes. This is the minimal vote needed for a victory. It is legitimate, but it means that a net of one faithless elector, or a disqualified elector, could throw the nation into a historic and nearly unprecedented crisis. If the Electoral College becomes indecisive for any reason, the House of Representatives will decide the election. Each state will get one vote. The results of the election suggest Republicans have four-to-ten seat majority of state delegations in the House (Table 1). Trump would win. Polarization and unrest would explode. Not for nothing did we brand this election cycle “Civil War Lite.” Table 1State Delegations In US House Of Representatives Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization The greater the margin of victory in the Electoral College, the less vulnerable the nation is to indecision in the college, or to a result decided in the courts. The Republicans have a strong case in Pennsylvania that votes that arrived after November 3 should not be counted. It is not clear if the Supreme Court will revisit the case, having left it unresolved prior to the election. If Pennsylvania’s 20 electoral votes become the fulcrum of the election, and the Supreme Court rules to exclude votes received after November 3, and if Trump thereby wins the count, a national crisis will erupt. This is not high probability at the moment because Biden can afford to lose Pennsylvania if he wins Nevada or Georgia. But the history of contested elections teaches that investors should not rush to conclusions. Senate Gridlock Will Survive Georgia Runoffs The most likely balance of power is a Democratic president with a Republican Senate and Democratic House, i.e. gridlock. Chart 3 shows the likely balance of power in Congress. Democrats would need to win both runoff elections in Georgia to win 50 seats, which would give them a de facto majority if Biden wins, since Vice President Kamala Harris would become President of the Senate and break any tie votes there. They are unlikely to do so. Chart 3AGridlock In US Government Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Chart 3BGridlock In US Government Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Why do we doubt that Democrats will win both Georgia seats, given that Trump is now falling short in the statewide presidential vote? First, Republicans tend to do well in runoffs as Georgia is a conservative-leaning state (Chart 4). Second, the Republican vote was greater than the Democratic vote in both Senate elections, though falling short of 50%. Third, exit polls show that voters leaned Republican in the suburbs and were mostly concerned about the economy, not the coronavirus. Fourth, also clear from exit polls, Republican voters will be more motivated to retain control of the Senate with Trump out, while Democratic voters will be less motivated with Biden in (Chart 5). Voter turnout will drop in the special election as usual. Neither Trump nor the presidency will be on the ballot on January 5. Still, it is possible for Democrats to win both seats and hence de facto control of the Senate. We would say the odds are roughly 20% (0.5 x 0.4 = 0.2). Chart 4GOP Does Well In Georgia Runoffs Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Chart 5Georgia 2020 Election Results (So Far) Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization If Democrats pulled off two victories in Georgia, the “Blue Sweep” scenario would be reaffirmed and several legislative proposals that had a 0% chance of passage in a Republican Senate would become at least possible. Certainly taxes would go up – the Democrats would be able to use the reconciliation process to push through reforms to the health care system paid for by partially repealing the Trump Tax Cut and Jobs Act. They would also be able to pass legislation that is popular with moderate Democrats who would then hold the balance in the Senate. The Green New Deal would become possible, if highly improbable. There would be a small chance of removing the filibuster in an exigency, but a vanishingly small chance of other radical structural changes, like creating new seats on the Supreme Court or granting statehood to Washington DC and Puerto Rico. A 50-50 count in the Senate, with Harris breaking the tie, would produce a larger increase in the budget deficit than otherwise. Stocks would have to discount the tax hike but they would recover quickly on the prospect of combined monetary and fiscal ultra-dovishness. Fiscal Impasse Prolonged Biden plus a Republican Senate is positive for the US corporate earnings outlook over the 24 months between now and the 2022 midterm election. It is also positive for the global earnings outlook over the four-year period due to the drastically reduced odds of a global trade war. But it is negative in the near term because it will result in a smaller and delayed fiscal relief package – and sooner than later the market will need a signal that the government will not pull the rug out from under the recovery. Biden plus a GOP Senate is negative in the near term due to fiscal risks but positive beyond that. True, the US economy continues to bounce back rapidly, which is why the Republicans performed so well in this election despite a recession, a pandemic, and a failure to pass another round of stimulus beforehand. In October the unemployment rate fell to 6.9%. Yet previous rounds of fiscal support are drying up. The job market is showing some signs of underlying weakness and these will worsen as long as benefits run out and COVID-19 cases discourage economic activity (Chart 6). Personal income has dropped off from its peak when the first round of stimulus was passed in March. Without the dole it will relapse (Chart 7). Chart 6US Job Market Weakening Sans Stimulus US Job Market Weakening Sans Stimulus US Job Market Weakening Sans Stimulus Chart 7US Personal Income Will Drop Sans Stimulus US Personal Income Will Drop Sans Stimulus US Personal Income Will Drop Sans Stimulus Will Senate Republicans agree to a fiscal deal in the “lame duck” session before the new Congress sits on January 3? We have no basis for a high-conviction view. They might agree to a deal in the range of $500 billion to $1 trillion, but only if the Democrats come down to these levels in the talks. Senate Majority Leader Mitch McConnell is one of the big winners of the election. He held his seat and likely maintained Republican control of the Senate without capitulating to House Speaker Nancy Pelosi’s demands of a $3 trillion-plus relief bill. He wagered that Republicans would do better with voters if they concentrated on reopening the economy (and confirming Amy Coney Barrett to the Supreme Court) while limiting any fiscal bill to targeted COVID response measures. He drew a hawkish line against broad-based social spending and bailouts for state and local governments. The gambit appears to have worked. House Democrats, far from gaining seats, lost five. We would not be surprised if Pelosi were replaced as speaker in 2021. Her plan backfired so badly that if Trump had stayed on message in his campaign, he might even have won. The implication is that unless Pelosi comes down to McConnell’s number, the fiscal impasse will extend into January and February. The American public approves of fiscal relief, but that did not force McConnell’s hand earlier, as the economy was recovering regardless (Table 2). Unless the economy slumps or financial markets selloff drastically, he will likely insist on a skinny deal that includes liability protections for businesses while minimizing bailouts for indebted blue states. Table 2Americans Support Fiscal Stimulus Package Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Hence investors are likely to get bad news before good news on the US fiscal front. And if other bad news arises, the absence of fiscal support will be sorely felt. This motivates our tactically defensive posture until the fiscal impasse is resolved. Peak Polarization Polarization is at peak levels in the US and the election result suggests it will remain elevated. Whichever party wins will win with a narrow margin. There is simply no commanding mandate for either party, as has been the case this century, so the struggle will continue (Chart 8). Chart 8Polarization Will Continue With Narrow Margins Of Victory Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Of course, polarization may subside temporarily, assuming Trump loses. At least under Biden the Electoral College vote will coincide with the popular vote, improving popular consent. Biden will have a lower disapproval rating, probably throughout his term. High disapproval tends to coincide with crises in modern US history, but in 2021, after the dust clears from this election, the country may catch its breath (Chart 9). Chart 9Presidential Disapproval Will Fall Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Much will depend on whether the presumed Biden administration is willing to sideline the left-wing of the Democratic Party to court the median voter. Exit polling in the swing states strongly suggests that the Biden administration won the election (if indeed it did) by improving Democratic support among the majority white population, non-college educated voters, and senior citizens, all groups that delivered Trump the victory in 2016. The Democrats had mixed results among ethnic minorities and suburban voters. Their biggest liability was their focus on issues other than the economy (Chart 10). Chart 10Exit Polls Say Focus On Bread And Butter Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Over the coming decade we think the combination of (1) cold war with China and (2) generational change on fiscal policy will produce a new national consensus. But we are not there yet. The contested election is not guaranteed to end amicably. If Trump wins on a technicality, the country will erupt into mass protests; if he loses and keeps crying stolen election, isolated domestic terrorist incidents are entirely possible. Moreover the battle over the 2020 census and redistricting process will be fierce. Democrats will be hungry to take the Senate in 2022, failing Georgia in January, to achieve major legislative objectives while Biden is in office. And the 2024 election will be vulnerable to the fact that Biden may have to bow out due to old age, depriving the Democrats of an incumbent advantage. The bottom line is that Republicans outperformed and will not be inclined to help the Biden administration start off on strong footing. The implication is the fiscal battle will extend into the New Year unless a stock market selloff forces Republicans to compromise. Fiscal cliffs will be a recurring theme until at least the 2022 election. A deflationary tail risk will persist. Obama’s Legacy Secured? The sole significance of a gridlocked Biden presidency will lie in regulatory affairs, foreign policy, and trade policy. These are the policy areas where presidents have unilateral authority and Biden can act without the Senate’s approval. In this context, Biden’s sole focus will be to consolidate the legacy of the Barack Obama administration, in which he served. 1. Obamacare (ACA): Republicans failed to repeal and replace this bill despite a red sweep in 2016. Biden’s election ensures that Obamacare will be implemented, if not expanded, as he will have the power to enforce the law at the executive level. The risk is that the conservative-leaning Supreme Court could strike it down. Based on past experience, the health care sector will benefit from the drop in uncertainty once the court’s decision is known (Chart 11). For investors the lesson of the past four election cycles is that Obamacare is here to stay, but Americans will not adopt a single-payer system until 2025 at the earliest conceivable date. We are long health equipment and see this outcome as beneficial to the health sector in general, particularly health insurance companies. Big Pharma, however, will suffer from bipartisan populist pressures to cap prices. 2. Iran Nuclear Deal (JCPA): Biden will seek to restore Obama’s signature foreign policy accomplishment, the Joint Comprehensive Plan of Action, i.e. the Iran nuclear deal of 2015. The purpose of the deal was to establish a modus vivendi in the Middle East so that the US could “pivot to Asia” and focus its energy on the existential strategic challenge posed by China. Biden will stick with this plan. The Iranians also want to restore the deal but will play hard to get at first. Israel and Saudi Arabia could act to thwart Iran and tie Biden’s hands in the final three months of Trump’s presidency while they have unmitigated American backing. Chart 11Obamacare Preserved Obamacare Preserved Obamacare Preserved The implication is that Iranian oil production will return to oil markets (Chart 12), but that conflict could cause production outages, and Saudi Arabia could increase production to seize market share. Hence price volatility is the outcome, which makes sense amid fiscal risks and COVID risks to demand as well. 3. The Trans-Pacific Partnership (CPTPP): Biden claims he will “renegotiate” the Trans-Pacific Partnership, which was the Obama administration’s key trade initiative. The idea was to group like-minded Pacific Rim countries into an advanced trade deal that addressed services, the digital economy, labor and environmental standards, and pointedly excluded China. Trump withdrew from the deal out of pique despite the fact that it served the purpose of diversifying the American supply chain away from China. The impact of rejoining is miniscule from an economic point of view (Chart 13), but it will be a boon for small emerging markets like Mexico, Chile, Vietnam, and Malaysia. Chart 12Restoring The Iran Nuclear Deal Restoring The Iran Nuclear Deal Restoring The Iran Nuclear Deal Chart 13Rejoining The Trans-Pacific Partnership Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization The bigger takeaway is that Biden will continue the US grand strategic shift toward confronting China, which will be a headwind toward Chinese manufacturing and a tailwind for India, Latin America, Southeast Asia. The US will cultivate relations with the Association of Southeast Asian Nations (ASEAN) as a more coherent economic bloc and a manufacturing counterweight to China (Chart 14). A lame duck Trump will  attempt to cement his legacy by targeting China/Taiwan, Iran, North Korea, or Big Tech. When it comes to on-shoring, Biden’s focus will be reducing dependency on China and improving the US’s supply security in sensitive areas like health and defense. Trade and strategic tensions with China will persist, but a global trade war is not in the cards. Manufacturing economies ex-China stand to benefit. 4. The Paris Climate Accord: Biden will not be able to pass his own version of the Green New Deal without the Senate, so investor excitement over a government-backed surge in green investment will subside for the time being (Chart 15). He will also moderate his stance on the energy sector after his pledge to phase out oil and gas nearly cost him the election. He was never likely to ban fracking comprehensively anyway. Chart 14ASEAN's Moment ASEAN's Moment ASEAN's Moment Biden will be able to rejoin the international Paris Agreement and reverse President Trump’s deregulation of the energy sector. He will re-regulate the economy to lift clean air, water, environment, and sustainability standards. This is a headwind for the energy sector, but stocks are already heavily discounted and congressional gridlock is a positive surprise. Chart 15Returning To The Paris Climate Accord Returning To The Paris Climate Accord Returning To The Paris Climate Accord There may be some room for compromise with Senate Republicans when it comes to renewables in a likely infrastructure package next year. Post-Trump Republicans may also be interested in Biden’s idea of a “carbon adjustment fee” on imports, which is another way of saying tariffs on Chinese-made goods. Like the health care sector, the election is tentatively positive for US energy stocks – especially once fiscal risks are surmounted. Investment Takeaways Chart 16Lame Duck Trump Risk: Taiwan Strait Civil War Lite And Peak Polarization Civil War Lite And Peak Polarization Three near-term risks prevent us from taking a tactically risk-on investment stance. First, the contested election, which could still throw up surprises. Second, the fiscal stimulus impasse, which could persist into January or February and will reduce the market’s margin of safety in the event of other negative surprises. Third, a lame duck Trump will attempt to cement his legacy via executive orders. He could target China/Taiwan, Iran, North Korea, or even Big Tech. On China, Trump is already tightening export controls on China and selling a large arms package to Taiwan (Chart 16). The lame duck period of any presidency is a useful time for the US to advance strategic objectives. Trump will also blame China and the coronavirus for his defeat. He could seek reparations for the virus, restrictions on Chinese manufacturing and immigration to the US, export controls or sanctions on tech companies, secondary sanctions over Iran or North Korea, delisting of Chinese companies listed in the US, sanctions over human rights violations in China’s autonomous regions, or travel bans on Communist Party members. During these three months, Big Tech will face crosswinds – risks from Trump, but opportunities from gridlock. Polarization has helped support US equity and tech outperformance over the past decade. Frequent hold-ups over the budget in Congress weigh on growth and inflation expectations, thus favoring growth stocks and tech. Internal divisions have prompted the US to lash out abroad, increasing risks to international stocks and driving safe-haven demand into the dollar and tech. More broadly the second wave of the pandemic is a boon for tech earnings and Biden will restore the Obama administration’s alliance with Silicon Valley. But tech is already priced for perfection and this favorable trend will be cut short when COVID restrictions ease and Biden works out a compromise with the Senate GOP over stimulus and the budget (Chart 17). Beyond these near-term risks, we have a constructive outlook for risk assets over the next 12 months. Chart 17Biden, Peak Polarization, And Big Tech Biden, Peak Polarization, And Big Tech Biden, Peak Polarization, And Big Tech Chart 18Global Stocks, Cyclicals Benefit When US Fiscal Impasse Resolved Global Stocks, Cyclicals Benefit When US Fiscal Impasse Resolved Global Stocks, Cyclicals Benefit When US Fiscal Impasse Resolved Insofar as Biden seeks to restore US commitment to global free trade, and more stable and cooperative relations with allies and partners ex-China, global policy uncertainty should fall relative to the United States. Once near-term fiscal hurdles are cleared, the dollar’s strength can subside and global stocks and global cyclicals can start to outperform (Chart 18). Chart 19Trump An Exclusively Commercial President Trump An Exclusively Commercial President Trump An Exclusively Commercial President We also favor stocks over bonds on a strategic horizon. Trump was an exclusively commercial president whose approval rating had a tight correlation with the stock-to-bond ratio (Chart 19). A surge in stocks would help power Trump’s approval. This relationship is not standard across presidents. But it does make sense during periods of policy change that affect earnings. Trump’s tax cuts are the best example. Equities outpaced bonds in anticipation of tax cuts in 2017. Trump’s approval rating recovered once the bill was passed. President Obama’s approval rating also correlated somewhat with the stock-to-bond ratio during the critical fiscal cliff negotiations under gridlock from 2010-12. Once Biden works out a compromise with GOP Senators, bond yields will rise and stocks will power upward. The takeaway from these points is that volatility can remain elevated over the next 0-3 months (Chart 20). We would not expect it to go as high as in 2000, when the dotcom bubble burst, but Trump’s lame duck maneuvers against China could generate a massive selloff. But this cannot be ruled out. Indeed, Trump’s constraints have almost entirely fallen away regardless of whether he loses or wins. Investors should take a phased and conservative approach to adding risk in the near term. The outlook will brighten up when the president is known, a fiscal deal is reached, and President Trump’s legacy as the Man Who Confronted China is complete. Chart 20Volatility Will Stay Elevated In Short Run Volatility Will Stay Elevated In Short Run Volatility Will Stay Elevated In Short Run Chart 21Go Long Trans-Pacific Partnership Go Long Trans-Pacific Partnership Go Long Trans-Pacific Partnership Given our view that Biden will be hawkish on China, especially amid gridlock at home, we are maintaining our short CNY-USD trade. We also recommend buying a basket of Trans-Pacific Partnership bourses, weighted by global stock market capitalization, on a strategic time-frame to capture what we expect will be Biden’s pro-trade-ex-China policy (Chart 21). Finally, to capture the views expressed above regarding Biden’s likely market impacts, over the short and long run, we will go long US health care relative to the broad market on a tactical basis and long US energy on a strategic basis.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 As things stand, the model overrated the Republicans in Arizona and Georgia as well, though really Georgia looks to be the only state Democrats won that the model gave high odds of staying Republican. If we had used the level rather than the range of Trump’s approval rating – or if we had neglected opinion polling altogether – the model would have called a Biden win.

Highlights We agree with the market consensus that the long-term dollar outlook is bearish, but caution against chasing the dollar lower in the short term. While the election results remain uncertain, currency markets also continue to ignore risks of a no-deal Brexit and significant escalation in Covid-19 infections. As such, pro-cyclical currencies remain vulnerable to a countertrend reversal, especially as the greenback remains oversold. The Japanese yen stands as a viable portfolio hedge. For longer-term currency investors, a more robust portfolio of US and Chinese paper and precious metals should do better than a pro-cyclical basket. The Bank of England delivered significant stimulus this week. As we argue below, EUR/GBP remains a sell, but we will wait to buy sterling at 1.25. Look to rebuy a basket of Scandinavian currencies versus the USD and EUR at a trailing trigger point of -2%. New trade idea: Go long EUR/CHF. Feature The US election outcome has taken many investors by surprise. Going into election night, former Vice President Joe Biden was widely expected to win in a “blue wave.” This implied that the former Vice President wins the White House while Democrats gain control of the Senate and retain the House. This was not the BCA view. What has become evident is that similar to 2016, the polls have been offside. What we now know is that Republicans will likely keep control of the Senate. In short, the real prospect of a contested election and/or political gridlock in Washington is coming to fruition. President Donald Trump has been telegraphing that he views the results as fraudulent, triggered by some news agencies calling Arizona a Democratic win on Wednesday before all votes were counted. Some legal action is now becoming a real possibility, with Trump threatening to take matters to the Supreme Court and already filing lawsuits contesting the results in Michigan, Georgia and Pennsylvania. Democratic legal teams are surely preparing for retaliation. Cleaner risk-on/risk-off currency measures such as the AUD/JPY exchange rate were tracking 10-year Treasury yields tick-for-tick. The dollar price action has been consistent with our forecast of additional volatility, with wild swings in both the AUD/JPY exchange rate and the Chinese RMB. However, the direction of the DXY has been surprising, simply on the basis that the dollar is seasonally strong in November and, since the Great Financial crisis, the dollar has tended to rally into year-end (Chart I-1). In fact, given the political “certainty” going into elections, one would have expected the dollar to soar on Wednesday on a safe-haven bid. Chart I-1The Dollar Move This Week Was Unusual The Dollar Move This Week Was Unusual The Dollar Move This Week Was Unusual Chart I-2The Market Made A Shift The Dollar Conundrum And Protection The Dollar Conundrum And Protection Cleaner risk-on/risk-off currency measures such as the AUD/JPY exchange rate were tracking 10-year Treasury yields tick-for-tick, consistent with a safe-haven bid, as the election was becoming uncertain. Once it became clear that fiscal gridlock would be a reality, the market focus shifted from fiscal policy to the prospect that the Federal Reserve is likely to deliver additional stimulus (Chart I-2). US real rates have fallen relative to its trading partners. This is also consistent with the surge in technology equities and positive market action.  In a recent piece, we also argued that historically, the dollar has not really benefitted from uncertainty when the US is the source of political risk (Chart I-3). We had been, however, cautioning investors against other tail risks that we expect to continue to dominate the FX market narrative: Brexit and the new wave of Covid-19 infections.1  As such, even as the US election uncertainty gets resolved, markets remain vulnerable, and the dollar could still benefit from safe-haven flows. As we have argued, it will be a countertrend bounce rather than a renewed bull market. Chart I-3US Policy Uncertainty And The Dollar US Policy Uncertainty And The Dollar US Policy Uncertainty And The Dollar An Election “Post-Mortem” It is impossible to tell for sure when we will know the definitive election results, as the political theater is likely to continue in the coming days. What is clear is that the polls were widely offside in this election (Chart I-4). Chart I-4The Polls Were Offside The Dollar Conundrum And Protection The Dollar Conundrum And Protection Nevada will continue to accept ballots until November 10 and North Carolina until November 12 if they are postmarked by election day. A decision will have to be made in Pennsylvania, where Trump is still ahead in the polls, if ballots received after November 3 will be valid. As our geopolitical strategists argue,2 it would not be surprising if the Supreme Court ruled that ballots received after election day cannot be accepted, as the original deadline was changed to November 6 by a lower court decision. The two likely outcomes as we go to press are a GOP Senate and Democratic House, with either Biden or Trump in the White House. Betting markets are pricing in the former outcome. Our contention is that both are neutral-to-dollar bullish. Chart I-5The Dollar And Real Yields The Dollar And Real Yields The Dollar And Real Yields Democratic leaders have been more aggressive in their demands for a greater government role in the economy. What is clear is that Senate Republicans will block very aggressive stimulus, but will still agree to some spending. However, smaller stimulus may be offset by policies favorable for markets, such as lower taxes3 and lower regulation, remaining in place. This is a bullish outcome for the dollar since on the one hand, US equities continue to enjoy a higher rate of return, and on the other hand, real bond yields are likely to be higher with less-than-expected fiscal stimulus.  Should Trump win the White House, the biggest risk down the road is a renewed trade war, not only with China but even with Europe. This was evident in RMB overnight trading, as Trump started to positively surprise in the polls with Florida. Economically, a trade war will lift the price of foreign goods and services. Foreign currencies should depreciate, as demand for their goods adjusts lower to a higher tariff. This will boost the dollar. That said, it is possible that market focus has rapidly shifted from the government to the Fed. For one, foreign policy is unlikely to be the focus in the near term, given the immediate need for fiscal stimulus and a pandemic. Meanwhile, US real rates have been falling relative to its trading partners this week (Chart I-5). Ten-year TIPS yields have also declined relative to similar real rates in Germany or the UK. In short, the bond market may be pricing in that the Fed will offset any decline in inflation expectations by more stimulus later. For now, they remain on hold. The Real Risk To Dollar Short Positions What is becoming clear to market participants is that the US Treasury market continues to maintain its safe-haven properties. This was evident both in the March drawdown and in recent trading sessions. So, the big risk to dollar short positions is economic uncertainty that drives inflows into the US dollar. Chart I-6Japan Has Been Buying Treasurys Japan Has Been Buying Treasurys Japan Has Been Buying Treasurys Chart I-7Capital Outflows From Japan Capital Outflows From Japan Capital Outflows From Japan Chart I-6 shows that Japanese investors and officials have remained very active buyers of US Treasurys, despite real rates being higher in Japan. This partly explains why the yen has not been a particularly potent safe haven compared to the dollar this year. In a nutshell, the huge pool of Japanese external assets has not been repatriated home during times of market stress. Japan is the biggest holder of US Treasurys in the world, and looking at portfolio investment, it remains deeply negative in 2020. In short, income receipts have been rapidly re-invested abroad (Chart I-7). Japanese investors and officials have remained very active buyers of US Treasurys, despite real rates being higher in Japan. Overall, the Japanese yen still remains a safe-haven asset. The yen did outperform from the September drawdown in markets, and has proven to be a better hedge than the Swiss franc or the US dollar over the longer term (Chart I-8). Chart I-8The Yen Remains The Perfect Hedge The Yen Remains The Perfect Hedge The Yen Remains The Perfect Hedge Chart I-9An Explosion In Covid-19 Cases An Explosion In Covid-19 Cases An Explosion In Covid-19 Cases The need for a portfolio hedge is particularly important, since the US presidential elections are not the only source of uncertainty. As we approach the winter season in the northern hemisphere, a new wave of infections is taking hold. Norway and Switzerland, small countries that were able to manage infection rates over the summer, are seeing a resurgence in cases. Even Sweden, where infection rates had dropped significantly, is going through a very severe second wave (Chart I-9). In the case of Sweden, this is seriously questioning the theory of “herd immunity,” since the economy never really shut down. The key variable for the dollar will be global and relative growth. For much of the summer months, the US was under siege from a second wave while the Eurozone and many other countries were well into their reopening phases. Now the reverse is happening, where the reacceleration in cases is somewhat faster outside the US, triggering temporary lockdowns. If this threatens the improvement in relative economic growth between G10 economies and the US, this could catalyze a dollar rally (Chart I-10). Chart I-10The Dollar And Relative Growth The Dollar And Relative Growth The Dollar And Relative Growth Our longer-term bias remains that the potential economic impact from Covid-19 is likely to be much less than what many economies endured for the first half of 2020. The virus is less deadly, as mortality rates across many countries have come down, and there is a potential for a vaccine soon. As global economies recover, the dollar will decline, with portfolio rotation into cheaper markets. That may be the story for 2021. As we argued last week, the market remains due for a reset in the short term, which should benefit the dollar. The BoE, Brexit And The Case For The Pound As both the pandemic and US election risks remain at the fore of investors’ concerns, Brexit uncertainty continues to brew in the background. UK Prime Minister Boris Johnson has been forced to relock the economy as the number of new cases surge. At the same time, negotiations between the EU and the UK continue in their stop-and-go pattern. Both sides failed to reach an agreement this week, and talks should resume on Sunday or Monday. More importantly, key issues such as the treatment of Northern Ireland remain unresolved, with political bickering over other concerns such as fishing access rights, “level playing field” conditions for businesses and energy cooperation. The Bank of England decided today to front-run the impending economic slowdown by aggressively increasing its target for government bond purchases by £150 billion to £875 billion. This was bigger than expected. The target for corporate bond purchases stays at £20 billion. This will balloon the BoE’s balance sheet to over 40% of GDP. This will be at par with the Fed, but still lower than the European Central Bank or the Bank of Japan. With lower estimates for Q3 GDP growth and a double-dip recession baked in the cake for Q4, additional stimulus was warranted. The BoE also expects UK GDP to only return to pre-pandemic levels in 2022, rather than 2021. The reaction in the gilt market was muted, with rates back to yesterday’s levels, and the pound was slightly up on broad-based dollar weakness. Such action is warranted, given the already very low levels of UK interest rates, especially relative to the US. And with the Fed effectively signaling unlimited quantitative easing, the efficacy of other central bank actions on relative monetary policy trends has dramatically fallen. We saw the same reaction from the Aussie dollar earlier this week, even though the Reserve Bank of Australia cut interest rates and expanded its QE program. The UK budget deficit has tended to move in lockstep with central bank purchases.  Domestically, the shift by the BoE was important. The UK budget deficit has tended to move in lockstep with central bank purchases (Chart I-11). When domestic demand is low, the right policy is for government to step in and prevent a negative feedback loop of falling prices, rising real rates and higher savings. We, therefore, commend the Chancellor of the Exchequer, Rishi Sunak's, push to extend the furlough scheme and relief to businesses until the end of next March. This should cushion the blow from the lockdown on the economy. The important takeaway is that the BoE’s QE program opens the door for more fiscal stimulus, since the government can issue debt that will be purchased by the central bank. And given the UK borrows in its own currency, this is not a threat to the pound, especially given extremely low financing costs (Chart I-12) and the lack of inflationary pressures in the UK. In fact, this is a key distinction from the prior warfare episodes, where soaring deficits were met with higher inflation that pushed up interest rates and triggered massive devaluations in the currency. Today, the problem is deficient rather than excess demand. Chart I-11UK Debt And Central Bank QE UK Debt And Central Bank QE UK Debt And Central Bank QE Chart I-12Cheap Debt Financing Costs Cheap Debt Financing Costs Cheap Debt Financing Costs The key risk for the pound, therefore, remains a “no-deal” Brexit. This possibility is probably higher with a Trump presidency, since former Vice President Joe Biden has opposed Brexit. This limits the potential for a favorable trade deal with the US, should Democrats gain control of the White House. On the positive side, we have noted before that the pound is in an “ugly contest” with all fiat currencies. For example, even though speculators are short the pound today, positioning is much less extreme than in 2016 or 2019, when the Brexit referendum and the election of Prime Minister Johnson led to “maximum pessimism” on cable. Moreover, the pound is cheap. The cheapness of a currency can be measured by the trade balance, since a cheap currency will stimulate exports while imports will be relatively expensive. On this metric, the UK trade balance has violently swung to near balance (Chart I-13).  Chart I-13The UK Trade Balance Is Improving The UK Trade Balance Is Improving The UK Trade Balance Is Improving As a strategy, we are short EUR/GBP for now as a play on cable strength. Interest rates still favor the UK relative to Germany or France, and the dollar could receive a bid over the next one-to-three months, as we have argued above. We also have a limit-buy on GBP/USD at 1.25. In terms of targets, cable will be between 1.35-1.40 over the next six months. In an optimistic scenario, the pound could go 20-25% higher. Concluding Thoughts We continue to advocate for a prudent strategy when trading foreign exchange markets over the next few weeks: Hold some portfolio protection. Our preferred vehicle is the Japanese yen, as argued above. Longer-term, as the dollar declines, the Chinese yuan will benefit. The Chinese bond market could be becoming the safe-haven in Asia. A basket of Chinese bonds and silver has provided less volatility than procyclical currencies (Chart I-14). Focus on trades at the crosses. An interesting divergence has opened between EUR/CHF and EUR/USD. Either the euro is too high or the franc is too high (Chart I-15). Given more pervasive deflation in Switzerland, our bias is the latter. Go long EUR/CHF for a trade. Buy Scandinavian currencies if they drop another 2% versus an equal weighted basket of the euro and USD. Go short the gold/silver ratio at 80. Chart I-14An Alternative To US Treasurys An Alternative To US Treasurys An Alternative To US Treasurys Chart I-15Buy EUR/CHF Buy EUR/CHF Buy EUR/CHF   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, "Tail Risks In FX Markets," dated October 2, 2020. 2 Please see Geopolitical Strategy Special Report, "Gridlock," dated November 4, 2020. 3 Our Chief Strategist, Peter Berezin, argues that the Trump tax cuts could become permanent. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data from the US have been mostly positive: The ISM Manufacturing PMI increased from 55.4 to 59.3 in October, while the ISM Services PMI declined from 57.8 to 56.6. Headline PCE increased by 1.4% year-on-year in September. Nonfarm productivity increased by 4.9% quarter-on-quarter in Q3. Initial jobless claims increased by 751K for the week ending on October 30. The DXY index fell by 1.5% this week. The Fed stood on hold as widely expected, but the dollar still witnessed tremendous volatility this week. While we believe that the US dollar will depreciate in the long term, especially in the post-COVID world, we do see near-term volatilities amid the election and rising COVID numbers. Report Links: The Dollar In A Market Reset - October 30, 2020 A Few Market Observations -  October 23, 2020 Does The US Save Too Much Or Too Little? - October 16, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area have been positive: GDP recovered by 12.7% quarter-on-quarter in Q3, well above the 9.4% expansion as expected. Headline inflation was unchanged at -0.3% year-on-year in Q3. Core inflation was also unchanged at 0.2% year-on-year. The unemployment rate was unchanged at 8.3% in September. PPI fell by 2.4% year-on-year in September. Retail sales increased by 2.2% year-on-year in September.  The euro increased by 0.7% against the US dollar this week. Rising COVID cases in Europe and re-implemented lockdown measures continue to spur worries for the recovery. In a speech on Wednesday, ECB Board Member Isabel Schnabel said that further monetary policy support is required to safeguard favorable financial conditions and underpin economic activity. Report Links: Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mostly negative: Construction orders fell by 10.6% year-on-year in September. Housing starts dropped by 9.9% year-on-year in September. The Jibun Bank Services PMI increased from 46.9 to 47.7 in October. The Japanese yen appreciated by 1% against the US dollar this week amid market volatilities. The BoJ meeting minutes released this week showed divergences among BoJ members. While most members agree that maintaining the existing monetary policy should be sufficient in current conditions, other members mentioned it would be necessary to reconsider the strategy towards achieving price targets. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data from the UK have been positive: Nationwide housing prices increased by 5.8% year-on-year in October. The British pound increased by 0.8% against the US dollar this week. On Thursday, the BoE kept key interest rates unchanged at 0.1%. However, the Bank increased its bond-buying program by another £150 billion, much larger than expected, bringing the total amount to £895 billion. The increased stimulus plan will help weather further deterioration as the crisis continues to strike the UK’s services sector. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data from Australia have been positive: Building permits increased by 8.8% year-on-year in September. Exports continued to grow by 3.9% month-on-month in September, while imports fell by 5.9% month-on-month. The trade balance jumped to A$5.6 billion in September from A$2.6 billion in the previous month. The Australian dollar surged by nearly 3% against the US dollar this week. The RBA lowered its interest rate from 0.25% to 0.1% this week to provide further support for job creation and economic recovery. Moreover, the Bank will increase the size of its QE program by purchasing A$100 billion of government bonds over the next six months. Accommodative policies, lower COVID cases and elevated current account surplus all underpin the Aussie dollar. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data from New Zealand have been mixed: Building permits increased by 3.6% month-on-month in September. The participation rate marginally increased from 69.9% to 70.1% in Q3, while the unemployment rate ticked up from 4% to 5.3% in Q3. The ANZ Activity Outlook Index was little changed at 4.6% in November. The New Zealand dollar increased by 1.5% against the US dollar this week. The latest ANZ Business Outlook report showed that New Zealand’s business outlook data remained stable. Investment intentions dropped, while employment intentions increased. Following the RBA’s action this week, the RBNZ is likely to carry out more stimulus in its policy meeting next week. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data from Canada have been positive: GDP increased by 1.2% month-on-month in August. Exports marginally increased from C$44.9 billion to C$45.5 billion in September, led by higher exports of lumber and aircraft. Imports also slightly increased from C$48.1 billion to C$48.8 billion, mainly on higher crude oil imports. The Canadian dollar increased by 2.4% against the US dollar this week. On a quarter-on-quarter basis, Canada’s exports were up 26.9% in the third quarter, showing a strong recovery over the summer. However, it’s still down 7.5% compared with the same quarter last year. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data from Switzerland have been mostly positive: Real retail sales increased by 0.3% year-on-year in September. The KOF Leading Indicator declined from 110.1 to 106.6 in October. Headline inflation increased from -0.8% to -0.6% year-on-year in October. The Swiss franc appreciated by 1.2% against the US dollar this week. The recent SECO survey showed no further recovery of consumer sentiment since the summer. As downside risks continue to loom, the SNB is likely to fight appreciation in the franc. Go long EUR/CHF as trade. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There have been no significant data from Norway this week. The Norwegian krone soared by 4% this week, recouping the recent loss. On Thursday, the Norges Bank kept its key interest rate on hold at a record low 0%, as expected, and said that they would maintain policy accommodative until they see clear signs of a recovery. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data from Sweden have been mixed: Manufacturing PMI increased from 55.9 to 58.2 in October. Industrial production declined by 2.6% year-on-year in September. Manufacturing new orders fell by 0.3% year-on-year in September. The Swedish krona increased by 2.8% against the US dollar this week. Statistics Sweden showed that GDP increased by 4.3% quarter-on-quarter in the third quarter in 2020, following an 8% drop in the second quarter. Exports and imports have recovered close to pre-pandemic levels. The labor market has also shown strength. The services industry, however, is still negatively affected by the crisis, although they make up a relatively smaller share in the GDP. Kelly Zhong Research Analyst Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Our base case of a Biden win with a GOP Senate may come to pass. But the US election is not over yet. Trump still has a chance of victory by winning Pennsylvania and one other state. If the vote count does not settle the outcome clearly this week, a full-fledged contested election will emerge that may not be settled until just before December 14 (or even January). Risk-off sentiment will prevail in the interim, given the importance of the executive-legislative configuration for the pandemic response and the fiscal policy outlook. What we know is that Republicans kept the Senate, in line with our final forecast last week. This means gridlock is assured – which is positive for US stocks beyond near-term fiscal risks. Stay long JPY-USD, short CNY-USD, long stocks over bonds, long health care equipment, and long infrastructure plays. Keep dry powder for the presidential outcome, as global trade hangs in the balance. Feature The US presidential election is unsettled as we go to press, but we know that Republicans will keep control of the Senate and hence that American government will be divided or “gridlocked” for the next two years. As things stand, Democrats picked up two senate seats, Arizona and Colorado, but fell short everywhere else. They may even have lost a seat in Michigan. This leaves the balance of power at ~52-48 in favor of Republicans – which is one seat better than our final 51-49 forecast in their favor (Chart 1).1 Chart 1Our Senate Election Model Correctly Predicted Republican Control Gridlock Gridlock Table 1Gridlock Is Inevitable Regardless Of Presidential Outcome Gridlock Gridlock Gridlock is the inevitable consequence. If President Trump pulls off a victory in any two of the upper Midwestern states (Michigan, Pennsylvania, Wisconsin), then he will still face a Democrat-controlled House of Representatives. If former Vice President Joe Biden pulls off a victory in two of these states, then he will face a Republican controlled Senate (Table 1). Chart 2Gridlock More Favorable Than Sweep For Wall Street, But Fiscal Risks Abound In Short Run Gridlock More Favorable Than Sweep For Wall Street, But Fiscal Risks Abound In Short Run Gridlock More Favorable Than Sweep For Wall Street, But Fiscal Risks Abound In Short Run Historically gridlock offers more upside for the S&P 500 than a single-party sweep (Chart 2), and we agree with this expectation when it comes to the long-run impact of this election. However, we have also warned against the fiscal risks of a Biden win with a Republican Senate in the short run. The status quo Trump gridlock is reflationary at first but later problematic due to trade war. The Biden gridlock is deflationary at first but the best outcome for investors over the long run. Consider the following: Trump with Senate Republicans: Trump is a spendthrift and he and his party joined the House Democrats in blowing out the budget deficit from 2018-20. Trump’s victory will force House Speaker Nancy Pelosi to concede to a Republican-drafted ~$1-$1.5 trillion new COVID-19 fiscal relief bill right away. For the second term, Trump will push an infrastructure bill, border security, and make his tax cuts permanent. The fiscal thrust in 2021 will be flat-to-up. The budget deficit will probably end up somewhere between the Republican “high spending” scenario and the Democratic “low spending” scenario in our budget deficit projections (Chart 3). This is positive for US growth and especially corporate earnings, but it comes with a catch: Trump will be emboldened in his trade wars, which could expand beyond China to Europe or others. Tariffs and currency depreciation will weigh on global growth. Still, Trump’s second term will occur in the early stages of the business cycle and the Fed is committed not to hike rates until 2023, so the overall picture is reflationary.   Chart 3Trump Gridlock Reflationary, Biden Gridlock Deflationary Over Short Run Gridlock Gridlock Biden with Senate Republicans: Since Senate Republicans did not capitulate to large Democratic spending demands prior to the election, when their seats were at risk, they will have less incentive to do so afterwards when the president hails from the opposing party. The only way they will agree to a new fiscal stimulus in the “lame duck” session (November-December) is if the Democrats concede to their skinny proposals for the time being. But Democrats will probably insist on their demands having made electoral gains. In this case, either financial markets will sell off, forcing Republicans to capitulate, or investors will have to wait until early 2021 to receive a new fiscal bill that is uncertain in size and timing. The first battle of Biden’s presidency will be with the GOP Senate. The Republican “low spending” scenario in Chart 3 is most likely. It is not realistic that Congress will allow the baseline scenario, in which the budget deficit contracts by ~7.4% of GDP. Republican senators today are not the Tea Party House Republicans of 2010, who were rabid fiscal hawks. Still, uncertainty will weigh heavily and markets will have to fall before GOP senators wake up to the underlying risk to the economic recovery. The consolation is that beyond this 3-6 month period of negative sentiment and deflationary fiscal risk, the outlook will be fairly positive. Biden will not use broad-based unilateral tariffs the way Trump did, with the possible exception of China later in his term. And the Republican Senate will not agree to tax hikes at any point, making taxes a concern for 2023 or thereafter. This is the best of both worlds for US business sentiment and the corporate earnings outlook over the two-year period. Risk-off sentiment will prevail until the election is decided. This could be in a couple of days if the vote count is clear in Michigan, Pennsylvania, and Wisconsin. Or it could extend until just before December 14, when the Electoral College votes, if the litigation and court rulings in these critical states drag on, which we discuss below. The reason risk-off sentiment will prevail is that the US economy is burning through its remaining stimulus funds rapidly, the fiscal trajectory is unclear until the presidency is decided, Europe is going into partial lockdowns over the pandemic, and a Biden victory would imply more US lockdowns. Diagram 1 outlines the macro and market implications as we see them, depending on the presidential outcome. We never took the view that a Democratic sweep of White House and Senate would be the best outcome for the overall investment outlook, though we conceded that it was the most reflationary and bullish in the short term. But now this point is moot. Investors will have to wait another two years at minimum for the full smorgasbord of Democratic spending proposals to have a chance at passage. Diagram 1Gridlock Rules Out Massive Fiscal Boost Gridlock Gridlock Bottom Line: The presidency is indeterminate as we go to press. What is clear is that Republicans retained the Senate. Therefore gridlock will prevail. This is generally market positive, though a Biden win would weigh on risk assets in the near term until financial markets force Republican senators to capitulate to a new fiscal bill. A Controversial Election Or A Contested Election? The critical battleground states are undecided as we go to press. Trump needs to win any two of Michigan, Pennsylvania, and Wisconsin to retain the White House. The vote count will last through Wednesday and possibly beyond. The Republican and Democratic legal teams are preparing for trench warfare. Major legal challenges are highly likely and will delay the final outcome into December or even January. The first thing is to finish counting the absentee and mail-in ballots. Georgia, Michigan, Wisconsin, and Arizona are not accepting ballots after election day, so they will finish counting soon. Then all that remains is to see if any legal disputes arise that prevent the Electoral College members from being settled in these states, which is still possible. For example, Wisconsin is within a percentage point. Nevada will accept ballots by November 10 and North Carolina by November 12 as long as they are postmarked by election day. It is likely but not certain that Democrats will keep Nevada (~75% counted) while Republicans will keep North Carolina (~100% counted). Thus Pennsylvania poses the biggest risk of a contested result – and this was anticipated. The deadline to receive mailed ballots is Friday, November 6, but a legal dispute is already underway as to whether the original November 3 deadline should be reinstated.2 We will not pretend to predict the final court verdict on Pennsylvania, but it would not be surprising at all if the Supreme Court ruled that ballots received after election day cannot be accepted. The constitution grants state legislatures the sole power of choosing a state’s electors. Each state passes its own election laws. The Pennsylvania state legislature clearly stated that ballots must be returned by election day. It was a court decision that extended the deadline. The Supreme Court could easily determine that a lower court does not have the power to change the deadline. But nobody will know until the court rules. The fact that Trump appointed several of the judges has little bearing on their decisions because they serve lifetime appointments. Once election disputes rise above state vote-counting to the federal level, Trump gets a lifeline. First, the two-seat conservative leaning on the Supreme Court should produce strict readings of the law that could favor his bid. Second, the GOP’s victory in the Senate means that Democrats cannot unilaterally settle disputed electoral votes in their own favor at the joint session of Congress on January 6, which they could have done with a united Congress. Third, the Republicans are likely to have maintained a one or two-state majority of state delegations in the House of Representatives (based on results as we go to press), which means that Trump would win if the candidates failed to reach a 270-vote majority on the Electoral College or tied at 269. Note that an Electoral College tie is a distinct possibility in this election. Right now, if Trump loses in Michigan and Wisconsin, but wins Pennsylvania, and nothing else changes, then an Electoral College tie could result at 269-269 electoral votes.3 Polls … And Exit Polls Before condemning the entire profession of opinion pollsters to death it will be important to receive the verified results of the election and compare them with the final polling averages. It is clear that Trump was widely underrated yet again, but it is not yet clear that this was primarily or exclusively the fault of pollsters. Right now Trump is down by 1.8% in the nationwide popular vote, whereas he lagged by 7.2% in the average of the national polls and 2.3% in the battleground average on election day. This is a big 5.4% gap in the national poll, but in the battleground poll it is a minor 0.5% polling gap and as such merely confirms what many observers knew, that the battleground polls were the ones that really mattered due to the Electoral College. Trump’s battleground support average was 46.6% and his approval rating was 45.9% on election day, which respectively is 1.8% and 2.5% below his tentative share of the national vote at 48.4%. These gaps are within the average 3% margin of error – and normally sitting presidents outperform their polling by around 1%. State opinion polling had huge errors like the national poll. Charts 4 and 4B shows the final election polling in the critical swing states along with a “T” or “B” to mark Trump’s and Biden’s tentative vote share as we go to press. Swing state polls showed Trump staging a major rally in the final weeks of the campaign, which is what prompted us to upgrade his odds to 45%. Neither major pundits nor the mainstream media paid enough attention to this shift. Several prominent outlets denied that there was any real tightening in the polls even in late October. Chart 4APundits Overlooked Trump’s Rally In Swing State Polls In Final Weeks Pundits Overlooked Trump's Rally In Swing State Polls In Final Weeks Pundits Overlooked Trump's Rally In Swing State Polls In Final Weeks Chart 4BPundits Overlooked Trump’s Rally In Swing State Polls In Final Weeks Pundits Overlooked Trump's Rally In Swing State Polls In Final Weeks Pundits Overlooked Trump's Rally In Swing State Polls In Final Weeks What this demonstrates to us is the power of momentum in opinion polling, especially in the final week before an election when people’s attitudes harden and they bare more of their true opinions. It does not tell us that opinion polling is dead. What about the exit polls? Biden cut into Trump’s lead in key demographic groups just as the Democratic Party machinery anticipated, but it is not clear if it was enough to win the election. Trump lost ground and Democrats gained ground, relative to 2016, with white voters, old folks, and non-college-educated voters. But Trump improved his support among blacks and Hispanics, a signal point that gives the lie to much of this year’s media hype (Charts 5A and 5B). Chart 5ADemocrats Gained Ground With White, Elderly, And Non-College-Educated Voters; GOP Gained Among Blacks And Hispanics Gridlock Gridlock Chart 5BDemocrats Gained Ground With White, Elderly, And Non-College-Educated Voters; GOP Gained Among Blacks And Hispanics Gridlock Gridlock By far voters cared most about the issues, not personalities, and the biggest issue was the economy (35% of voters versus 20% on racial inequality and 17% on the coronavirus, which was apparently overrated as an issue by Democrats). The economic focus is the only explanation for Trump’s outperformance – the law and order narrative was less popular. Trump’s vote share may end up exactly equal to the number of respondents who said the economy was “good” or “excellent” (48%). Otherwise Trump’s base is well known: it consists predominantly of white people, rural people, those in the Midwest and South, those who have been fairly successful in income, and those who think America needs a “strong leader” more than a unifier with good judgment who seems to care about the average person. If Trump is defeated, the clear implication is that he failed to expand his base. If he wins, the clear implication is that Democrats suffered in the key regions for their aggressive approach to COVID lockdowns, their condoning of lawlessness, and their divisive handling of racial inequality and police brutality. With such a close vote for the White House, sweeping narratives are questionable. It is not clear yet whether liberalism or nationalism won, and at any rate the margin was thin. What is clear is that Democrats substantially disappointed in the Senate and they might even have failed to gain the White House. Given that this year witnessed a recession, pandemic, and widespread social unrest – well-attested historical signs that point to the failure of the incumbent party and recession – Democrats apparently failed to capitalize. National exit polls suggest the fault lay in their relative neglect of bread and butter in favor of the coronavirus or left-wing social theory. This is true not so much in the House of Representatives but in the presidential and senate races. If Trump wins – especially through a contested election – then US political polarization will rise due to the continued divergence of popular opinion and the constitutional system. “Peak polarization” will last another four years at least. But if Trump loses, given that Republicans held the Senate, there is room for compromise that would reduce polarization. But it is too early to say. Investment Takeaways Trade and foreign policy hinge on the presidency. Trump is favored in several of the key states at the moment and he is especially favored in a contested election process, but it is too soon to make investment recommendations on the executive branch other than that US equity outperformance is likely to continue on both of the scenarios at hand. Table 2Earnings Shock From Partial Repeal Of Trump Tax Cuts Has Been Averted Gridlock Gridlock For now we recommend investors stay long JPY-USD, short CNY-USD, long health care equipment, and overweight stocks relative to bonds. On the Senate, the key takeaway is that Biden and the Democrats will not be able to raise taxes. This is a big benefit to the sectors that faced the greatest earnings shock from a partial repeal of Trump’s Tax Cuts and Jobs Act – namely real estate, tech, health care, utilities, consumer discretionary, and financials (Table 2). A simple play on these sectoral benefits courtesy of Anastasios Avgeriou, our US equity strategist, would be to go long small caps versus large caps, i.e. S&P 600 relative to the S&P 500, but wait till the fiscal hurdle is cleared. The BCA infrastructure basket should benefit regardless, as infrastructure is one of the few areas of bipartisan agreement, especially amid a large output gap.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 We upgraded the Republicans to favored status last week based on our quantitative Senate election model, which showed a 51% chance that Republicans would maintain control, with 51-49 votes. Our presidential model also showed Trump winning with a 51% chance, but we subjectively capped his odds at 45% due to our doubts about his ability to win Michigan given Biden’s 4% lead in head-to-head public opinion polls there. 2 It is possible that Nevada’s November 10 deadline or North Carolina’s November 12 deadline could become relevant, but we doubt it. 3 Precise Electoral College outcomes cannot be predicted due to faithless electors, i.e. electoral college members who vote differently than required based on their state’s popular vote. In 2016 there were seven faithless electors and in 2020 there could be several and they could make the difference. Material punishments may not prevent an elector from making a conscientious decision to stray from his or her state’s results in an election viewed as having historic importance.

Your feedback is important to us. Please take our client survey today. Highlights The long-term outlook for the dollar is bearish, but fresh shorts could be offside over the next one to three months. An uptick in US political uncertainty adds to our bullish dollar view over the next month. Stay short USD/JPY as a core holding for now. Beyond the near term, the Scandinavian currencies are best positioned for outperformance over the next 12 months. Silver is selling off relative to gold. Being long silver is a long-term bet that will pay handsome returns, but stand aside for now. Feature November is seasonally a good month for the dollar, and this year could well prove no exception (Chart I-1). Just a few days ago, the market consensus was that the dollar would decline irrespective of who sits in the Oval Office next year. A few days later and the market woke up to the realization that such a “heads I win, tails I win” bet rarely pans out smoothly. We have been very sympathetic to a dollar-bearish view over the long term, but as we highlighted last week, a few indicators have not passed our smell test, setting up the potential for a knee-jerk dollar rally. To add to this thesis, the rise in the greenback this week (and bloodbath in financial markets) has eerie historical echoes with the recent past. Remarkably, since the 2009 global financial crisis and the ensuing 2011 dollar bull market, the greenback has tended to stage its most powerful rallies into year-end. Chart I-2 shows that even after adjusting for the dollar uptrend over the last decade, November to January have proven to be very good months for dollar-long positions. This was particularly notable in 2009, 2011, 2014 and 2017 (Chart I-3). Chart I-1The Dollar Loves November The Dollar In A Market Reset The Dollar In A Market Reset Chart I-2The Dollar Since GFC The Dollar Since GFC The Dollar Since GFC Chart I-3The Dollar Is Oversold The Dollar Is Oversold The Dollar Is Oversold We are no technical experts, but could this time be different, especially given so many uncertainties clouding the investment outlook? And if so, what are other catalysts for a dollar bounce, other than those penned in report last week? What Could Be Different? Chart I-4The Dollar Rally Occurs In Two Phases The Dollar Rally Occurs In Two Phases The Dollar Rally Occurs In Two Phases Crises are rarely solved with one silver bullet. Historians can try to justify this over the last several centuries, but for the dollar call, it is instructive to simply re-examine the significant events we have lived through since the Great Financial Crisis. Enter 2008. The dollar rally occurred in two phases. The first phase prompted the US authorities to act by dropping interest rates, which dampened the rally and stimulated reflation. When the crisis proved bigger than the authorities expected, indiscriminate liquidation by financial market participants eventually prompted more action (Chart I-4). To be specific, the US first introduced swap lines with a select few central banks in December 2007 in response to the dollar crisis following the collapse of the housing market. These swap lines allowed foreign central banks to draw on dollar liquidity directly from the Federal Reserve and use this to provide credit to domestic concerns. However, from March to October 2008, the dollar soared by about 25%, since the swap lines did not include emerging markets. This prompted the Fed to expand its swap lines to include more developed-market participants and some emerging market countries. When the crisis proved bigger than the authorities expected, indiscriminate liquidation by financial market participants eventually prompted more action.  If we consider the situation today, we can all agree that the nature of the crisis is quite different from 2008, but the severity is as important, if not greater. However, similar to 2008, the Fed only has swap lines with 14 central banks. Moreover, the six-month original window is expiring. Granted, cross-currency basis swaps do not suggest any imminent danger (Chart I-5). Nevertheless, emerging market countries like South Africa, Turkey, India, Indonesia, and Russia do not have direct access to dollar liquidity from the Fed and are at risk to torpedo the dollar decline. Chart I-5No Funding Stresses For Now No Funding Stresses For Now No Funding Stresses For Now In short, many emerging market central banks do not have swap agreements with the US. These are countries with huge dollar liabilities that could continue to see their currencies fall, pushing up the aggregate dollar index. Developed market commodity currencies tend to be highly correlated with emerging market currencies, so this dynamic is very important for the US dollar call (Chart I-6). Meanwhile, there is a huge pool within the financial architecture unable to access funding through central bank swap lines. To be exact, around 60% of outstanding foreign exchange swaps/forwards are among non-bank financial and other institutions. Hedge funds are included in this group, and they entail a lot more credit risk than any central bank would be willing to bear. Then there is the Fed’s FIMA facility. This is a temporary repo facility for foreign and international monetary authorities (FIMA) that allows account holders to temporarily exchange their Treasury securities held with the Fed for US dollars. However, the pool of Treasury securities available to swap for US dollars has shrunk significantly. This has been on the back of slowing global trade and conscious diversification of reserves by offshore concerns (Chart I-7). Chart I-6EM And DM Currencies EM And DM Currencies EM And DM Currencies Chart I-7A Smaller Pool Of Treasurys To Sell A Smaller Pool Of Treasurys To Sell A Smaller Pool Of Treasurys To Sell The bottom line is that there is a window between a crisis and action by the Fed that could exacerbate the knee-jerk rally in the US dollar, as we have been highlighting in recent weeks. For now, there remains ample room for foreign central banks to draw on dollar liquidity (Chart I-8). As such, the dollar bounce will be an opportunity to establish fresh short positions rather than signal a renewed bull market. Chart I-8Ample Swap Liquidity Ample Swap Liquidity Ample Swap Liquidity Currency Positions US Dollar: A temporary dip in inflation expectations in the US will boost real rates and encourage flows back into US fixed-income assets. The drop in oil prices, which has been moving neck in neck with US inflation expectations, corroborates this view (Chart I-9). The DXY could easily touch 96 before consolidating gains. Chart I-9US Inflation Expectations Could Drop US Inflation Expectations Could Drop US Inflation Expectations Could Drop Euro: It remains unclear the disbursement of the funds from the pandemic emergency purchase program (PEPP). In the meantime, the European Central Bank stood pat today, confirming the narrative that Europe might be out of monetary bullets and fiscal policy is needed to revive animal spirits. This could cause air pocket for EUR/USD, which could touch 1.15 before rebounding. Yen: The yen is a perfect “heads I win, tails I don’t lose much bet.” Japan is one of the few countries offering positive real rates (Chart I-10). Switzerland also falls in that category. In a world that can temporarily dip into deflation, one might prefer to be in US dollars, but the yen and Swiss franc will also hold up nicely. Chart I-10Only In Japan And Switzerland The Dollar In A Market Reset The Dollar In A Market Reset Loonie: Our colleagues at the Daily Insights summarized the Bank Of Canada’s actions this week as technical and not fundamental (Chart I-11). With no real change in monetary policy, Canadian asset prices will remain dominated by global trends. The CAD has cyclical upside versus the USD, as we wrote about, but the current period of market tumult should push the loonie lower in the coming month or two. Chart I-11Canada Versus US Canada Versus US Canada Versus US Scandinavian currencies: The NOK and SEK have borne the brunt of the dollar decline so far and will bounce the most once reflation is back in play. We have a limit buy order on Nordic currencies should they decline further (Chart I-12). Chart I-12Dollar Seasonality The Dollar In A Market Reset The Dollar In A Market Reset Relative Value: Focus on relative value at the crosses rather than outright dollar bets. We are short the NZD/CAD, CAD/NOK and EUR/GBP as plays on relative fundamentals. EUR/GBP remains at risk of a significant selloff if we get a Brexit deal. Oil currencies: Remain long petrocurrencies versus the euro, but we are looking to use the tactical bounce in the dollar to shift to USD shorts. Silver: Short-term investors should stand aside on silver for now. The bullish thesis remains intact but volatility will rise in the short term.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data from the US have been positive: GDP recovered by 33.1% quarter-on-quarter on an annualized basis in Q3. The Markit Manufacturing PMI marginally increased from 53.2 to 53.3 in October. The services PMI also increased, from 54.6 to 56. The Chicago Fed National Activity Index declined from 1.11 to 0.27 in September. Initial jobless claims increased by 751K for the week ending on October 23rd. The DXY index increased by 1% this week alongside the equity market correction, impacted by the looming US elections and increasing number of COVID-19 cases. Our Geopolitical strategists have upgraded Trump’s odds of winning from 35% to 45%, though major opinion polls still favor a Biden victory. Our bias is that a Biden win will likely increase fiscal stimulus and decrease economic and trade policy uncertainties, which is bearish for the US dollar. Report Links: A Few Market Observations - October 23, 2020 Does The US Save Too Much Or Too Little? - October 16, 2020 Tail Risks In FX Markets - October 2, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area have been mixed: The Markit Manufacturing PMI increased from 53.7 to 54.4 in October. However, the Services PMI declined from 48 to 46.2.  M3 money supply surged by 10.4% year-on-year in September. The Economic Sentiment Indicator was unchanged at 90.9 in October. The euro plunged by 1.4% against the US dollar this week. On Thursday, the ECB held its key interest rate unchanged at -0.5% despite re-imposed lockdown measures against surging COVID cases in Europe. However, it also hinted that there could be additional policy action and more stimulus in December should conditions worsen. Report Links: Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data from Japan have been positive: The Jibun Manufacturing PMI increased from 47.7 to 48 in October. The Coincident Index rose from 78.3 to 79.2 in August. The Leading Economic Index also ticked up from 86.7 to 88.4. Retail trade fell by 8.7% year-on-year in September.  The Japanese yen depreciated by 0.3% against the US dollar this week amid market volatilities. With relatively higher real interest rates, a current account surplus and cheaper valuation, the Japanese yen is our favorite safe-haven currency. We continue to recommend holding the Japanese yen as a portfolio hedge for surfing election and COVID waves. On a separate note, the BoJ kept its interest rate on hold this Thursday. The Bank also weakened its economic forecast for this year but upgraded the economic recovery outlook. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data from the UK have been mixed: Retail sales increased by 4.7% year-on-year in September. The Markit Manufacturing PMI declined from 54.1 to 53.3 in October. The services PMI fell from 56.1 to 52.3 in October. The British pound plunged by 1.5% against the US dollar this week amid broad USD strength. The latest PMI releases saw a steeper decline in the services industry. As UK’s services account for more than half of total economic output, it suggests that the pound is more exposed to second infection risks than other manufacturing-oriented economies. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data from Australia have been positive: Imports fell by 1% month-on-month in September. Exports, however, increased by 3% month-on-month. The trade surplus widened from A$2.6 billion to A$5.1 billion. Headline CPI increased by 0.7% year-on-year in Q3, up from -0.3% the previous quarter. The Australian dollar fell by 1.5% against the US dollar this week. The pickup in inflation eased the RBA’s pressure to further ease monetary policy further. The expansion in the trade account surplus also bodes well for the Australian dollar in a reflationary environment. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data from New Zealand have been negative:  Exports fell from NZ$4.4 billion to NZ$4 billion in September while imports expanded from NZ$4.7 billion to NZ$5 billion. The trade deficit therefore widened from NZ$282 million to NZ$1,013 million. The ANZ Business Confidence Index rose to -15.7 from -28.5 in October. The New Zealand dollar fell by 1.2% against the US dollar this week. The ANZ Activity Outlook Report said that “there was a mix of ups and downs” in recent developments and warned against higher economic and unemployment risks once the cushioning impact of the wage subsidy fades. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data from Canada have been positive: Building permits increased by 17% month-on-month in September. The Canadian dollar plunged by 1.7% against the US dollar this week. Crude oil prices dropped by 12% this week amid worries about the second infection wave and prolonged travel restrictions, which represent a headwind for the Canadian dollar. On Wednesday, the Bank of Canada announced that it would keep interest rates on hold at 0.25% and maintain such low policy rates until the inflation objective is achieved. Moreover, the Bank is recalibrating the QE program to shift purchases towards longer-term bonds, which have a more direct influence on the borrowing rates for household and businesses. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data from Switzerland have been negative: The ZEW Expectations Index plunged from 26.2 to 2.3 in October. Total sight deposits increased from CHF 705.1 billion to CHF 706.9 billion for the week ending on October 23rd. While the Swiss franc depreciated by 1% against the US dollar this week, it increased by 0.5% against the euro, which brings it close to our limit buy price of 1.06. An expensive currency is likely to impede growth for a small open economy like Switzerland, suggesting the SNB will step up its currency intervention. Prepare to go long EUR/CHF.  Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data from Norway have been positive: Retail sales increased by 0.3% month-on-month in September. The Norwegian krone plunged by 3.4% against the US dollar this week, making it the worst performing G10 currency. Despite recent market volatilities, we continue to favor the Norwegian krone in the long run based on its cheap valuation and a brighter energy outlook in the post-vaccine world. We are looking to rebuy the Nordic currencies on weakness. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data from Sweden have been positive: The trade balance shifted from a deficit of SEK 2.1 billion to a surplus of SEK 2.6 billion in September. Consumer confidence increased from 88.4 to 90 in October. Retail sales increased by 3.9% year-on-year in September. PPI fell by 4.2% year-on-year in September. The Swedish krona decreased by 1.9% against the US dollar this week. While COVID cases have been resurging in Sweden, Sweden’s services is lower, as a % of GDP, than other major euro area countries and therefore less exposed to the risk of a second wave. We continue to recommend the Swedish krona from a cyclical perspective. Kelly Zhong Research Analyst Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Your feedback is important to us. Please take our client survey today. Highlights Mounting populism has created a structural tailwind behind inflation. The risk that inflation accelerates quickly is greater than the market appreciates. Monetary dynamics strongly influence consumer prices when inflation is stationary. The Federal Reserve’s back-door monetization of debt is inflationary. Financial assets do not embed a sufficiently large risk premium against higher inflation. The long-term, real returns of equities are likely to be poor. Small cap stocks and commodities offer cheap protection against higher inflation. Feature The equity market is extremely vulnerable to positive inflation surprises. The expectation of an extended period of low interest rates and extraordinarily easy monetary policy is the crucial justification for the S&P 500’s exceptionally elevated multiples. Anything that could threaten this policy set up would create a danger for stocks. Whether the mean of inflation in a given period is stationary will determine the influence that money has on inflation. The problem for the S&P 500 is that investors assign a much-too-small probability to the inflation risk, especially as structural and political forces point to an elevated chance that inflation will reach 3% to 5% within the next 10 years. There is also a non-trivial probability that inflation begins rising significantly faster than the market anticipates, even if it is not BCA Research’s base case. The dichotomy between the low odds of a quick turnaround in inflation embedded in financial asset prices and the inflationary threat created by monetary and fiscal choices is too large. It will force market participants to assign a greater inflation risk premium in bonds and stocks to protect against this eventuality. This process could precipitate painful corrections in both bond and equity prices. The good news is that inflation protection remains cheap. Three Stages Of Inflation The staggering recent increase in money supply and the extraordinary fiscal stimulus rolled out this year raise two questions: Are we exiting the recent period of low and stable inflation that has prevailed? Is inflation becoming a threat to financial asset prices? Major turning points in inflation provide context to assess the risk of an impending threat of increased inflation. From a statistical perspective, three phases in inflation dynamics have defined the past 100 years (Chart I-1): Chart I-1Three Stages Of Inflation Three Stages Of Inflation Three Stages Of Inflation 1922 to 1965: Inflation gyrated violently from as low as -12.1% to as high as 11.9% in response to various shocks such as the Great Depression or World War II. Nonetheless, inflation’s mean was stationary or trendless. 1965 to 1998: A period of great upheaval when inflation trended strongly, moving up until 1980 and then down until 1998. 1998 to present: Inflation has been stable, flatlining between 0.6% and 2.9%. Chart I-2More Often Than Not, Money Matters More Often Than Not, Money Matters More Often Than Not, Money Matters Empirically speaking, whether the mean of inflation in a given period is stationary will determine the influence that money has on inflation. The era of stationary inflation from 1922 to 1965 saw M2 closely correlated with changes in US consumer prices, but the link was severed from 1965 to 1998 when inflation trended strongly (Chart I-2, top and bottom panel). When inflation stabilized again from 1998 to 2020, M2 growth again explained gyrations in consumer prices (Chart I-2, bottom panel). Why did inflation behave differently from 1965 to 1998 compared with other episodes in the past 100 years? The defining factor of the pre-1965 era was an adherence to the gold standard. The gold standard created a hard anchor on prices because its rigidity made monetary policy credible, which produced stable inflation expectations. The velocity of money was also steady. Consequently, using the Fisher formulation of the equation of exchange (Price*Output = Money*Velocity or PY=MV), inflation became a direct derivative of the money supply. Various shocks such as a war or a depression would impact the rate of expansion of money, leading to a nearly linear effect on prices. When we examine unstable inflation from 1965 to 1998, it helps if we split the period into two subsamples: 1965 to 1977 and 1977 to 1998. The first interval generated accelerating inflation due to a multitude of factors. In the mid-1960s, slack in the US economy disappeared while demand became excessive as a result of the federal government’s increased spending from The Great Society programs and the Vietnam War. Additionally, by 1965, the gold standard was under attack. The US current account disappeared between 1965 and 1969. Worried by the deteriorating US balance of payment dynamics, French President De Gaulle sent his navy to repatriate France’s gold at the New York Fed. Other countries followed suit. The continued pressure on the US balance of payments, along with the need for easier monetary policy following the 1970 recession, lead to the 1971 Smithsonian Agreement whereby President Nixon unpegged the dollar from gold, effectively killing the gold standard. Any semblance of monetary rectitude disappeared and inflation expectations began to drift up. The oil shock of 1973 fueled the inflationary dynamics and pushed inflation higher through the rest of the decade. The developments outside of monetary policy reinforced downward pressure on inflation expectations created by the Fed’s orthodoxy. The second interval began in 1977, three years before inflation peaked. This date marks the implementation of the Federal Reserve Reform Act, which modified the Fed’s mandate from only targeting full employment to full employment and stable inflation. At first, the Act had little practical impact until Paul Volker became Fed chair in 1979 and began to combat inflation. Prior to 1977, the unemployment rate was below NAIRU (the unemployment rate consistent with full employment) most of the time, the economy overheated and ultimately, inflation trended up (Chart I-3). However, since 1977, the unemployment rate has mostly been above NAIRU and the labor market has predominantly experienced excess slack. Consequently, inflation expectations re-anchored to the downside and realized inflation collapsed. Chart I-3The Effect Of The Federal Reserve Reform Act Of 1977 The Effect Of The Federal Reserve Reform Act Of 1977 The Effect Of The Federal Reserve Reform Act Of 1977 Chart I-4The Monetarist Fed: 1977 to 1998 The Monetarist Fed: 1977 to 1998 The Monetarist Fed: 1977 to 1998 The relationship between short rates and money supply provides another way to appreciate the change in monetary policy after 1977. The Fed opted for a monetarist approach (officially and unofficially) when it had to combat high realized and expected inflation. During most of the past 100 years, money supply changes and short rates were either negatively correlated or not linked at all (Chart I-4, top and second panel); however, they began to move together from 1979 to 1998 (Chart I-4, bottom panel). The Fed boosted rates to preempt the inflationary impact of faster money supply expansion, which curtailed the link between prices and M2. Between 1977 and 1998, major structural forces also pushed down inflation and severed the bond between money supply and CPI. Starting with President Reagan, a period of aggressive deregulation and union-busting increased competition and removed some pricing power from labor.1 Most importantly, the rapid widening in globalization resulted in international trade representing an ever-climbing portion of global GDP. By adding more people to the global network of supply chains, globalization further entrenched the loss of workers’ pricing power, which caused wages to lag productivity and decline as a share of national income (Chart I-5). The developments outside of monetary policy reinforced downward pressure on inflation expectations created by the Fed’s orthodoxy. In the final phase from 1998 to 2020, the stabilization of inflation reunited prices and money supply. Inflation flattened due to several factors. By 1998, 70% of the global population lived in a capitalist system (compared to market shares only 28% in 1977). Thus, most of the expansion of the global labor supply was completed. China entered the WTO only in 2001, but it had been exerting its deflationary influence for many years by stealing market share away from newly industrialized Asian economies. Additionally, following the Asian Crisis of 1997, many Asian economies (including China and Japan) elected to build large dollar FX reserves to contain their currencies versus the USD, and subsidize economic activity. This process created some stability in global goods prices and slowed the USD’s depreciation started in 2002. In response to these influences, inflation expectations stabilized in the late 1990s, creating an anchor for realized inflation (Chart I-6). Thanks to this steadiness in inflation expectations, the Phillips curve (the inverse link between wages and the unemployment rate) flattened. The economy entered a feedback loop where consistent inflation rates begat stable wages, which in turn created more stability in aggregate prices. Fluctuations in the rate of inflation became directly linked to changes in the output gap and thus, variations in demand. Importantly, the flat Phillips curve and the well-anchored inflation expectations freed the Fed to maintain easier policy during expansions and allow money supply to expand in line with money demand. Chart I-5Expanding Globalization Robbed Labor Of Its Bargaining Power Expanding Globalization Robbed Labor Of Its Bargaining Power Expanding Globalization Robbed Labor Of Its Bargaining Power Chart I-6The Anchoring Of Inflation Expectations The Anchoring Of Inflation Expectations The Anchoring Of Inflation Expectations   Bottom Line: The correlation between inflation and M2 growth since 1998 is as relevant as it was from 1922 to 1965. What The Future Holds Structurally, inflation will likely trend higher. The Median Voter Theory (MVT), developed by Anthony Downs and upheld by our Geopolitical Strategy service as the key constraint on global and US policymakers, is at the heart of our position. Over the past 40 years, income and wealth inequalities have soared worldwide, especially in the US and the UK, which have both embraced ‘laissez-faire’ capitalism enthusiastically. Moreover, these countries also suffer from pronounced levels of intergenerational social immobility.2 The effect of these aforementioned trends has become so pervasive that life expectancy for a large swath of the US population is decreasing (Chart I-7). The shift by median voters to the left on economic matters will force greater fiscal profligacy and regulatory rigidity. This policy mix will add a secular drift to inflation. In response to widening inequalities, voter preferences have shifted to the left on economic matters and toward populism. Brexit and the election of President Trump both fit this pattern because they represent the repudiation of the prevalent neoliberal discourse that pushed toward more globalization, more immigration and more deregulation. Moreover, voters in the UK and the US increasingly doubt the benefits of free trade (Chart I-8). Chart I-7Inequalities Are Physically Hurting Many US Voters November 2020 November 2020 Chart I-8Free Trade Is Out… November 2020 November 2020   Attitudes toward the government’s role in the economy have also changed. Voters in the US are much more open than they were 10 or 20 years ago to a greater involvement of the public sector in the economy. Additionally, support toward socialism has become more widespread among various demographic groups (Chart I-9). The MVT posits that politicians who want to access or remain in power must cater to voter preferences. Hence, when compared with the Great Financial Crisis, the swift fiscal policy easing that accompanied the COVID-19 recession illustrates the understanding by politicians that spending is popular, especially in times of crisis (Chart I-10). Chart I-9…But State Intervention Is In November 2020 November 2020 Chart I-10Politicians Deliver What Voters Want November 2020 November 2020   Greater government spending and larger fiscal deficits are used to achieve faster nominal growth. When the output gap is negative, public spending helps the economy and may even increase national savings. However, if profligacy continues after the economy has reached full employment, it generates excess demand relative to aggregate supply and puts downward pressure on the national savings rate. This is inflationary. To redistribute income toward the middle class, populists aim to diminish competition in the economy. They reregulate the economy, which indirectly protects workers. They also limit global trade flows as much as possible. Free trade is good for the economy, but it puts downward pressure on the price of goods relative to services. Therefore, to remain competitive domestic goods producers must compress their labor costs, which either hurts wages for middle-class workers or destroys the number of manufacturing jobs with high wages. Undoing this process raises labor costs and undermines a major deflationary influence on the economy. Tax policy is another tool to force a redistribution of income and wealth toward the middle class. We should expect increased taxes on higher-income households. This process puts more money in the pockets of a middle class whose marginal propensity to consume is around 95% to 99% compared with 50% to 60% for households at the top of the income distribution. Re-shuffling the composition of national income toward the middle class will boost demand and puts upward pressure on consumer prices. Central banks are not immune to the preference of the median voter. As we showed earlier, the Fed Reform Act of 1977 had a meaningful impact on inflation, but only after Volcker took the helm of the FOMC. Given the damages wrought by high inflation in the 1970s, the median voter wanted to see less inflation, which enabled Volcker’s hawkish shift. As Marko Papic argued in a recent BCA Research webcast,3 a minority of voters (and policymakers) remember the pain created by inflation, but everyone is aware of the difficulties created by low nominal growth. Moreover, the Fed is still a creature of Congress and the median voter’s preferences greatly affect the legislative body’s decisions. Consequently, the Fed’s policy stance will likely become structurally looser in response to indirect voter pressure. Inflation accelerates when the Fed expands money supply faster than the federal government sucks in liquidity via its deficit. The Fed’s recent adoption of an average inflation mandate fits within this paradigm. According to its new strategy, the Fed will start tightening policy after the unemployment gap has closed and inflation is above 2%. This is reminiscent of the model prior to 1977 (when full employment conditions were paramount), which generated a significant inflation upside. Bottom Line: The shift by median voters to the left on economic matters will force greater fiscal profligacy and regulatory rigidity. It will also contribute to a more dovish bias by central banks. This policy mix will add a secular drift to inflation. What About Now? Markets may be failing to recognize the risk that inflation will rise sooner rather than later. Low yields, subpar inflation expectations, dovish central bank pricing and the valuation premium of growth relative to value stocks already reflect the strong deflationary force created by a deeply negative output gap. Thus, a quicker-than-expected recovery in inflation threatens the financial markets. Our structural inflation view is not the source of this danger. The hidden, near-term inflationary risk arises because we are still in an environment where broad money matters because inflation remains stationary. M2 is expanding at 23.7%, its fastest rate on record. If relationships of the past 20-plus years hold, then this is a warning sign for inflation. The catalyst to crystalize the structural inflationary pressures created by economic populism may be the loose monetary and fiscal conditions caused by the COVID-19 recession. Chart I-11The Real Near-term Inflation Risk The Real Near-term Inflation Risk The Real Near-term Inflation Risk This view may seem simplistic in light of the current large output gap, but when fiscal policy is included in the assessment, the picture becomes clearer. Since 1998, the gap between the expansion of M2 and the issuance of debt to the public by the federal government has explained inflation better than broad money alone (Chart I-11). Inflation accelerates when the Fed expands money supply faster than the federal government sucks in liquidity via its deficit. However, inflation decelerates when the Fed expands the money supply slower than the public sector pulls in private funds. In other words, if the Fed eases monetary conditions enough to finance the deficit, then debt monetization occurs, the private sector is not crowded out and demand gets a massive boost. This point is crucial and feeds the stronger economic recovery compared with the one post-GFC. In 2009 and 2010, the private sector was deleveraging and commercial banks were retrenching their lending. Neither the demand for nor the supply of credit was ample. Therefore, the Fed’s rapid balance sheet expansion had a limited impact on broad money. Instead, it skewed the composition of M2 toward commercial bank excess reserves at the Fed and away from private-sector deposits. Broad money was not rising quickly enough to fully finance the government and real interest rates did not fall as far as they should have. The economy suffered. A virtuous cycle has emerged, one which creates more inflation risks than are priced in. Nowadays, broad money responds much better to the Fed’s intervention because the balance sheets of the nonfinancial private sector are much healthier than in 2008 and deleveraging is absent. This mitigates the tightening credit standards of commercial banks. As Chart I-12 illustrates, household net worth is more robust than it was 12 years ago, debt-servicing costs account for a much narrower slice of disposable income and the government’s aggressive actions have bolstered household finances. Moreover, the majority of job losses have been concentrated in low-income jobs, thus, above-average earners have kept their incomes. Under these conditions, households have taken advantage of record low mortgage rates to purchase real estate, which is contributing to growth in the residential sector (Chart I-13, top two panels). Meanwhile, the rapid rebound in businesses’ capex intentions (which even small firms exhibit) and in core capital goods orders indicates that animal spirits are much more vigorous than anyone expected this past spring (Chart I-13, bottom two panels). At that time, the dominant narrative posited that firms were tapping their credit lines to set aside cash. Chart I-12Robust Household Balance Sheets = No Liquidity Trap Robust Household Balance Sheets = No Liquidity Trap Robust Household Balance Sheets = No Liquidity Trap Chart I-13Housing And Capex Are In The Driver's Seat Housing And Capex Are In The Driver's Seat Housing And Capex Are In The Driver's Seat   Chart I-14Unlike In 2008/09, Real Rates Have Collapsed Unlike In 2008/09, Real Rates Have Collapsed Unlike In 2008/09, Real Rates Have Collapsed Thanks to these more favorable balance sheet dynamics, the Fed’s injection of liquidity is boosting M2 enough to finance the Treasury’s issuance. Hence, real interest rates are much lower than in 2009/10 even if the economy is recovering much more quickly (Chart I-14). Policymakers are not crowding out the private sector. A virtuous cycle has emerged, one which creates more inflation risks than are priced in. A counterargument is that technology is too deflationary for the above dynamics to matter. The reality is that technology is always a deflationary force. The expansion of the capital stock has always been about providing each worker with access to newer and better technology to boost productivity. The current low level of productivity gains suggests that the dominant discourse exaggerates the economic advances from new technologies. Thus, inflation stationarity and the interplay between monetary and fiscal policy still matters to CPI. Investors should monitor factors that would indicate if the upside risk to near-term inflation described above is morphing into reality. Doing so would seriously damage financial asset prices made vulnerable to higher inflation by prohibitive valuations. We propose tracking the following variables: The household savings rate. If savings normalize faster because consumer confidence firms, then spending will accelerate, profits will rise more quickly and money will expand further, all of which will bring back inflation sooner. A Blue Sweep in the US presidential election. If the Democrats take control of both the executive and legislative branches, then they will expand stimulating policies that will bolster demand. This, too, would boost profits and broad money supply, which would be inflationary. The velocity of money. An increase in money velocity, which remains depressed, would accentuate the impact of rapid money growth. It would also suggest that animal spirits are strengthening, which will further encourage economic transactions. A weak dollar. The dollar is set to weaken because of savings dynamics and the global recovery. A runaway decline in the USD would indicate that the interplay between monetary and fiscal policy is debasing money, unleashing an inflationary spiral.  Bottom Line: The probability that inflation returns quickly is much more meaningful than financial markets appreciate because of the interplay between money growth, fiscal deficits and robust private-sector balance sheets. This dissonance will create a substantial risk for asset prices next year. Investment Implications The most important implication of the analysis above is that investors should consider inflation protection in all asset classes. However, this protection is cheap to acquire because investors are focusing on deflation, not inflation. Chart I-15Inflation Protection Remains Cheap Inflation Protection Remains Cheap Inflation Protection Remains Cheap Bonds Our bond strategists recently moved to a below-benchmark duration in fixed-income portfolios in light of the economic recovery and the increasing probability of a Blue Wave on November 3, an argument highlighted in the Section II Special Report written by our colleagues Rob Robis and Ryan Swift. The Fed’s new average-inflation target, coupled with the global economic recovery, should put upward pressure on inflation breakeven rates, which are still well below 2.3%-2.5% normally associated with stable inflation near 2% (Chart I-15). The underestimated upward risk to inflation further favors climbing yields. Beyond lifting inflation breakeven rates, this risk would also raise inflation uncertainty, which warrants a greater term premium and a steeper yield curve (Chart I-16). Additionally, higher inflation would occur lockstep with declining savings. The recent surge in excess savings was a primary driver of the collapse in yields; its reversal would push up long-term interest rates (Chart I-17). Chart I-16Rising Inflation Uncertainty Will Steepen The Yield Curve Rising Inflation Uncertainty Will Steepen The Yield Curve Rising Inflation Uncertainty Will Steepen The Yield Curve Chart I-17Excess Savings Will Fall And Yields Will Rise Excess Savings Will Fall And Yields Will Rise Excess Savings Will Fall And Yields Will Rise   The Dollar The US dollar is the major currency most exposed to growing populism because of the extraordinary income inequalities observed in the US. Moreover, a generous combined monetary and fiscal policy setting in the US has eroded the dollar’s appeal as the country’s trade deficit widens (it normally narrows during a recession) in response to pronounced national dissaving (Chart I-18, left panel). Furthermore, US broad money growth stands far above that of other major economies (Chart I-18, right panel). Compared with other major central banks, the Fed is more guilty of financing the public-sector’s debt binge. Debt monetization creates a real risk to a stable USD. Chart I-18AFalling Savings And The Fed's Generosity Will Tank The Greenback November 2020 November 2020 Chart I-18BFalling Savings And The Fed’s Generosity Will Tank The Greenback November 2020 November 2020   The expanding global recovery creates an additional problem for the countercyclical dollar. China’s role is particularly important in this regard as the nation’s domestic economic activity will improve further in response to the lagged impact of a rapid climb in total social financing (Chart I-19, top panel). Sturdy Chinese demand results in climbing global industrial production, which will hurt the greenback. Likewise, China’s healthy recovery has lifted interest rate differentials in favor of the yuan (Chart I-19, bottom panel). A strong CNY flatters China’s purchasing power abroad and diminishes deflationary pressures around the world. This combination should stimulate the global manufacturing sector, which benefits foreign economies more than it does the US.  Investors should consider inflation protection in all asset classes. Equities BCA Research still prefers global equities to bonds on a cyclical basis. The early innings of a pickup in inflation would solidify this bias. Our Adjusted Equity Risk Premium, which accounts for the expected growth rate of earnings and the non-stationarity of the traditional ERP, shows a solid valuation cushion in favor of stocks (Chart I-20). Moreover, forward earnings for the S&P 500 have upside, judging by the gap between the Backlog of Orders and the Customer Inventories components of the ISM Manufacturing survey (Chart I-21). Chart I-19China's Robust Growth Hurts The Dollar China's Robust Growth Hurts The Dollar China's Robust Growth Hurts The Dollar Chart I-20The Adjusted ERP Still Favors Stocks The Adjusted ERP Still Favors Stocks The Adjusted ERP Still Favors Stocks   We also continue to overweight cyclical sectors over defensive ones. The existence of greater inflation risk than the market believes confirms this view. Cyclicals would outperform if investors priced in quicker inflation because they would also bid down the dollar and push up inflation breakeven rates (Chart I-22). These relationships exist because industrials and materials enjoy greater pricing power in an inflationary environment and financials would benefit from a steeper yield curve. An outperformance of deep cyclicals relative to defensive equities should result in an underperformance of US shares relative to the rest of the world. Chart I-21Earnings Revisions Have Upside Earnings Revisions Have Upside Earnings Revisions Have Upside Chart I-22Deep Cyclicals Will Like The Brand New World Deep Cyclicals Will Like The Brand New World Deep Cyclicals Will Like The Brand New World   The long-term outlook for real stock returns is poor, despite a positive six- to nine-month view. Higher inflation will force a greater upside in yields. However, the current extraordinary market multiples can only be justified if one believes that yields will stay depressed for many more years. Thus, inflation would likely prompt a de-rating of equities. Furthermore, our structural inflation view rests on the imposition of populist economic policies. A move backward in globalization and redistributionist policies would lift the share of wages in national income, which would compress extraordinarily wide profit margins (Chart I-23). Therefore, real long-term profits will probably suffer. Paradoxically, nominal stock prices may still eke out positive nominal gains, but that will be a consequence of the money illusion created by higher inflation. Chart I-23Populism Threatens Profit Margins Populism Threatens Profit Margins Populism Threatens Profit Margins BCA Research still prefers global equities to bonds on a cyclical basis. Investors should continue to overweight equities versus bonds, despite pronounced hurdles to long-term, real returns in stocks. Historically, periods of transition from low inflation to higher inflation have allowed stocks to outperform bonds, even if equities generate negative real returns (Table I-1). The exceptionally low real yields and thin inflation protection offered by government bonds increases the likelihood that history will be repeated. Table I-1Rising Inflation: Equities Beat Bonds November 2020 November 2020 A size bias may offer some protection against higher inflation both in the near and long term. We have been positive on small cap equities since September and our US Equity Strategy service upgraded the Russell 2000 to overweight this week.4 A bump in railroad freight volumes augurs well for the domestic economy to which small caps are very sensitive. Additionally, stronger railroad freight volumes also indicate net rating upgrades for junk bonds, which decreases the riskiness of a highly levered small cap sector (Chart I-24). Moreover, small cap stocks are positively linked to major trends produced by higher inflation, such as a weaker dollar and higher commodity prices (Chart I-25). Small firms also enjoy rising consumer confidence, a variable targeted by populist politicians (Chart I-26). Therefore, the potential for a re-rating of the Russell 2000 relative to the S&P 500 is elevated, especially if investors reassess the likelihood of higher inflation.  Chart I-24Small-Cap Stocks Are Set To Shine Small-Cap Stocks Are Set To Shine Small-Cap Stocks Are Set To Shine Chart I-25Small-Cap Will Enjoy Higher Inflation... Small-Cap Will Enjoy Higher Inflation... Small-Cap Will Enjoy Higher Inflation... Chart I-26...And Populists ...And Populists ...And Populists Commodities BCA Research remains positive on the prices of natural resources on a cyclical basis even if there is more risk of a near-term correction for this asset class. Commodities are highly sensitive to a global industrial cycle that offers significant upside and to China in particular. Moreover, commodities are high-beta plays on a weaker dollar and higher inflation expectations (Chart I-27). Natural resources will benefit from economic populism because it lifts demand for cyclical spending. Moreover, commodities are natural hedges against the risk of higher inflation. In this context, it makes sense to allocate more funds to resource stocks to protect an equity portfolio against inflation. Investors worried about the near-term outlook for commodities should rotate out of copper into crude. Copper has withstood the COVID-19 shock much better than Brent despite the strong cyclicality of both natural resources. Following this move, net speculative positions and sentiment measures for copper are toward the top of their ranges of the past 15 years. Meanwhile, the opposite is true for oil. Since 2005, increases in the Brent-to-copper ratio have followed declines to the current levels in the relative Composite Sentiment Indicator (Chart I-28), which includes sentiment and positioning measures for both commodities. Chart I-27Commodities Remain Efficient Inflation Hedges Commodities Remain Efficient Inflation Hedges Commodities Remain Efficient Inflation Hedges Chart I-28A Contrarian Tactical Trade: Buy Brent / Sell Copper A Contrarian Tactical Trade: Buy Brent / Sell Copper A Contrarian Tactical Trade: Buy Brent / Sell Copper   Fundamentals also point in that direction. After collapsing in recent months, global inventories of copper are beginning to climb relative to Brent. Moreover, oil production has dropped significantly relative to copper. Oil demand fell even more dramatically than that of copper, but the gap between production and demand growth is moving in favor of crude. Real long-term profits will probably suffer. This trade is agnostic to the direction of the business cycle. Copper prices embed a much more optimistic take toward global economic activity than Brent. Therefore, copper is more vulnerable to a negative economic upset than oil and less likely to benefit from a positive economic surprise. Mathieu Savary Vice President The Bank Credit Analyst October 29, 2020 Next Report: November 30, 2020   II. Beware The Bond-Bearish Blue Sweep US Election & Duration: We estimate that there is an 72% probability of a US election result that will give a lift to US Treasury yields via increased fiscal stimulus. Those are strong enough odds to justify a move to a below-benchmark cyclical US duration stance on a 6-12 month horizon. US Treasuries: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Country Allocation: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to Canada and Australia. Stay neutral on the UK given the near-term uncertainties over the final Brexit outcome. With the US presidential election just two weeks away, public opinion polls continue to show that Joe Biden is the favorite to win the White House. However, the odds of a “Blue Sweep” - combining a Biden victory with the Democratic Party winning control of both the US Senate and House of Representatives - have increased since the end of September according to online prediction markets. US Treasury yields have also moved higher over that same period (Chart II-1), which we interpret as the bond market becoming more sensitive to the likelihood of a major increase in US government spending under single-party Democratic control. Chart II-1A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish Table II-1A Comparison Of The Candidates' Budget Proposals November 2020 November 2020 According to a recent analysis done by the Committee for a Responsible Federal Budget, President Trump’s formal policy proposals would increase US federal debt by $4.95 trillion between 2021 and 2030, while Biden’s plan would increase the debt by $5.60 trillion (Table II-1).5 While those are both massive fiscal stimulus plans, there is a stark difference in the policy mix of their proposals that matters for the future path of US bond yields. Under Biden, spending is projected to increase by a cumulative $11.1 trillion, partially offset by $5.8 trillion in revenue increases and savings with the former vice-president calling for tax hikes on corporations and high-income earners. On the other hand, Trump’s plan includes $5.45 trillion of spending increases and tax cuts over the next decade, offset by $0.75 trillion in savings. Conclusion: Biden would increase spending by over twice that of a re-elected Trump, with much of that spending expected to be front-loaded in the early part of his first term. Outright spending is more reflationary than tax cuts because it puts more money in the pockets of consumers (spenders) relative to producers (savers). The Biden plan would be more stimulating for overall activity even if the increase in debt is about the same. Chart II-2The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative Another analysis of the Biden and Trump platforms was conducted by Moody’s in September, based on estimates of how much of each candidate’s promises could be successfully implemented under different combinations of White House and Congressional control.6 The stimulus figures were run through the Moody’s US economic model, which is similar to the budget scoring model of the US Congressional Budget Office, to produce a year-by-year path for the US economy over the next decade (Chart II-2). Moody’s concluded that the US economy would return to full employment in the second half of 2022 under a President Biden – especially if the Democrats win the Senate - compared to the first half of 2024 under a re-elected President Trump. Such a rapid closing of the deep US output gap that opened up because of the COVID-19 recession would likely trigger a reassessment of the Fed’s current highly dovish policy stance. At the moment, the US overnight index swap (OIS) curve discounts one full 25bp Fed hike by late 2023/early 2024, and two full hikes by late 2024/early 2025 (Chart II-3). This pricing of the future path of interest rates has occurred even with the Fed promising to keep the funds rate anchored near 0% until at least the end of 2023. The likelihood of some form of increased fiscal spending after the election will cause the bond market to challenge the Fed’s current forward guidance even more, putting upward pressure on Treasury yields. Chart II-3US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff Our colleagues at BCA Geopolitical Strategy see a Blue Sweep as the most likely outcome of the US election, although their forecasting models suggest that the race for control of the Senate will be much closer than the Biden vs Trump battle (there is little chance that control of the House of Representatives would switch back to the Republicans).7 Their scenarios for each of the White House/Senate combinations, along with their own estimated probability for each, are the following: Biden wins in a Democratic sweep: BCA probability = 27%. The US economy will benefit from higher odds of unfettered fiscal stimulus in 2021, although financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. Government bond yields should rise on the generally reflationary agenda. Trump wins with a Republican Senate: BCA probability = 23%. In this status quo scenario, a re-elected President Trump would still face opposition from House Democrats on most domestic economic issues, forcing him to tilt towards more protectionist foreign and trade policies in his second term. Fiscal stimulus would be easy to agree, though not as large as under a Democratic sweep. US Treasury yields would rise, but would later prove volatile due to the risk to the cyclical recovery from a global trade war, as Trump’s tariffs will not be limited to China and could even affect the European Union. Biden wins with the Senate staying Republican: BCA probability = 28%. This is ultimately the most positive outcome for financial markets - reduced odds of a full-blown trade war with China, combined with no new tax hikes. Bond yields would drift upward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators. The first such battle would start right after the election. Treasuries would remain well bid until financial market pressures forced a Senate compromise with the new president sometime in H1 2021. Trump wins with a Democratic Senate: BCA probability = 22%. This is the least likely scenario but one that could produce a big positive fiscal impulse. Trump is a big spender and will veto tax hikes, but will approve populist spending on areas where he agrees. The Democratic Senate would not resist Trump’s tough stance on China, however, thus keeping the risk of US-China trade skirmishes elevated. This is neutral-to-bearish for US Treasuries, depending on the size of any bipartisan stimulus measures and Trump’s trade actions. The key takeaway is that the combined probability of scenarios that will put upward pressure on US Treasury yields is 72%, versus a 28% probability of a more bond-neutral outcome. That is a bond-bearish skew worth positioning for by reducing US duration exposure now, ahead of the November 3 election. Of this 72%, 45 percentage points come from scenarios in which President Trump would remain in power. Hence his trade wars would eventually undercut his reflationary fiscal policy. This would become the key risk to the short duration view after the initial market response. Bottom Line: The most likely scenarios for the US election will give a cyclical lift to US Treasury yields via increased fiscal stimulus. This justifies a move to a below-benchmark US duration stance on a 6-12 month horizon. If Trump is re-elected, the timing of Trump’s likely return to using broad-based tariffs will have to be monitored closely. A Moderate Bear Market While our anticipated Blue Sweep election outcome will lead to a large amount of fiscal spending in 2021 and beyond, we anticipate only a modest increase in bond yields during the next 6-12 months. In terms of strategy, our recommended reduction in portfolio duration reflects the fact that fiscal largesse meaningfully reduces the risk of another significant downleg in bond yields and strengthens our conviction in a moderate bear market scenario for bonds. This does raise the question of how large an increase in US Treasury yields we expect during the next 6-12 months. We turn to this question now. Chart II-4Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart II-4). For one thing, the Fed was much more eager to tighten policy in 2016 than it is today, and it did deliver a rate hike one month after the Republicans won the House, Senate and White House (Chart II-4, bottom panel). This time around, the Fed has made it clear that it will wait until inflation is running above its 2% target before lifting rates off the zero bound and will not respond directly to expectations for greater fiscal stimulus. Second, 2016’s election result was mostly unanticipated. This led to a dramatic adjustment in market prices once the results came in. The PredictIt betting market odds of a “Red Sweep” by the Republicans in 2016 were only 16% the night before the election. As of today, the betting markets are priced for a 58% chance of a Blue Sweep in 2020. Unlike in 2016, bonds are presumably already partially priced for the most bond-bearish election outcome. A Slow Return To Equilibrium To more directly answer the question of how high bond yields can rise, survey estimates of the long-run (or equilibrium) federal funds rate provide a useful starting point. In a world where the economy is growing at an above-trend pace and inflation is expected to move towards the Fed’s target, it is logical for long-maturity Treasury yields to settle near estimates of the long-run fed funds rate. Indeed, this theory is borne out empirically. During the last two periods of robust global economic growth (2017/18 & 2013/14), the 5-year/5-year forward Treasury yield peaked around levels consistent with long-run fed funds rate estimates (Chart II-5). As of today, the median estimates of the long-run fed funds rate from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers are 2% and 2.25%, respectively. In other words, a complete re-convergence to these equilibrium levels would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. We expect this re-convergence to play out eventually, but probably not within the next 6-12 months. In both prior periods when the 5-year/5-year forward Treasury yield reached these equilibrium levels, the Fed’s reaction function was much more hawkish. The Fed was hiking rates throughout 2017 & 2018 (Chart II-5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart II-5, bottom panel). The Fed’s new dovish messaging will ensure that the market reacts less quickly this time around. Also, continued curve steepening will mean that the 5-year/5-year forward yield’s 80 – 100 bps of upside will translate into significantly less upside for the benchmark 10-year yield. The 10-year yield and 5-year/5-year forward yield peaked at similar levels in 2017/18 when the Fed was lifting rates and the yield curve was flat (Chart II-6). But, the 10-year peaked far below the 5-year/5-year yield in 2013/14 when the Fed stayed on hold and the curve steepened. Chart II-5How High For Treasury Yields? How High For Treasury Yields? How High For Treasury Yields? Chart II-6Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y   The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart II-6, bottom panel).8 TIPS Versus Nominals We have seen that a full re-convergence to “equilibrium” implies 80 – 100 bps of upside in the 5-year/5-year forward nominal Treasury yield. Bringing TIPS into the equation, we have also observed that long-maturity (5-year/5-year forward and 10-year) TIPS breakeven inflation rates tend to settle into a range of 2.3 – 2.5 percent when inflation is well-anchored and close to the Fed’s target (Chart II-7). The additional fiscal stimulus that will follow a Blue Sweep election makes it much more likely that the economic recovery will stay on course, leading to an eventual return of inflation to target and of long-maturity TIPS breakeven inflation rates to a 2.3 – 2.5 percent range. However, as with nominal yields, this re-convergence will be a long process whose pace will be dictated by the actual inflation data. To underscore that point, consider that our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate – a model that is driven by trends in the actual inflation data – has the 10-year breakeven rate as close to fair value (Chart II-8).9 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart II-7Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Chart II-8Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed   All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart II-8, bottom panel).10 Chart II-9Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners Two More Curve Trades In addition to moving to below-benchmark duration, maintaining nominal yield curve steepeners and staying overweight TIPS versus nominal Treasuries, there are two additional trades that investors should consider in order to profit from the reflationary economic environment. The first is inflation curve flatteners. The cost of short-maturity inflation protection is below the cost of long-maturity inflation protection, meaning that it has further to run as inflation returns to the Fed’s target (Chart II-9). In addition, if the Fed eventually succeeds in achieving a temporary overshoot of its inflation target, then we should expect the inflation curve to invert. Real yield curve steepeners are in some ways the mirror image of inflation curve flatteners. Assuming no change in nominal yields, the real yield curve will steepen as the inflation curve flattens. But what makes real yield curve steepeners look even more attractive is that increases in nominal yields during the next 6-12 months will be concentrated in long-maturities. This will impart even more steepening pressure to the real yield curve. Investors should continue to hold inflation curve flatteners and real yield curve steepeners. Bottom Line: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Government Bonds: Reduce Exposure To US Treasuries The mildly bearish case for US Treasuries that we have laid out above not only matters for our recommended duration stance, but also for our suggested country allocation within global government bond portfolios. Simply put, the risk of rising bond yields is much higher in the US than elsewhere, both for the immediate post-election period but also over the medium-term. Thus, the immediate obvious portfolio decision is to downgrade US Treasuries to underweight. The move higher in US Treasury yields that we expect is strictly related to spillovers from likely US fiscal stimulus. While other countries in the developed world are contemplating the need for additional fiscal measures, particularly in Europe where there is a renewed surge in coronavirus infections and growing economic restrictions, no country is facing as sharp a policy choice as the US with its upcoming election. We can say with a fair degree of certainty that the US will have a relatively more stimulative fiscal policy stance than other developed economies over at least the next couple of years. This implies a higher relative growth trajectory for the US that hurts Treasuries more on the margin than non-US government debt. In addition, the likely path of relative monetary policy responses are more bearish for US Treasuries. As described above, the scope of the US stimulus will cause bond investors to further question the Fed’s commitment to keeping the funds rate unchanged for the next few years. That also applies to the Fed’s other policy tools, like asset purchases. The Fed is far less likely to continue buying US Treasuries at the same aggressive pace it has for the past eight months if there is less need for monetary stimulus because of more fiscal stimulus. Chart II-10The Fed Will Gladly Trade Less QE For More Fiscal Stimulus November 2020 November 2020 According to the IMF, the Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued (Chart II-10). If US Treasury yields are rising because of improving US growth expectations, fueled by fiscal stimulus, the Fed will likely tolerate such a move and buy an even lower share of Treasuries issued – particularly if the higher bond yields do not cause a selloff in US equity markets that can tighten financial conditions and threaten the growth outlook. The fact that US equities have ignored the rise in Treasury yields seen since the end of September may be a sign that both bond and stock investors are starting to focus on a faster trajectory for US growth. In terms of country allocation, beyond downgrading US Treasuries to underweight, we recommend upgrading exposure to countries that are less sensitive to changes in US Treasury yields (i.e. countries with a lower yield beta to changes in US yields). In Chart II-11, we show the rolling beta of changes in 10-year government bond yields outside the US to changes in 10-year US Treasury yields. This is a variation of the “global yield beta” concept that we have discussed in the BCA Research bond publications in recent years. Here, we modify the idea to look at which countries are more or less correlated to US yields, specifically. A few points stand out from the chart: Chart II-11Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields All countries have a “US yield beta” of less than 1, suggesting that Treasuries are a consistent outperformer when US yields fall and vice versa. This suggests moving to underweight the US when US yields are rising is typically a winning strategy in a portfolio context. The list of higher beta countries includes Canada, Australia, New Zealand, the UK and Germany; although Canada stands out as having the highest yield beta in this group. The list of lower beta countries includes France, Italy, Spain, and Japan. In Chart II-12, we show what we call the “upside yield beta” that is estimated only using data for periods when Treasury yields are rising. This gives a sense of which countries are more likely to outperform or underperform during a period of rising Treasury yields, as we expect to unfold after the election. From this perspective, the “safer” lower US upside yield beta group includes the UK, France, Germany and Japan. The riskier higher US upside yield beta group includes Canada, Australia, New Zealand, Italy and Spain. Chart II-12Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Spain and Italy are less likely to behave like typical high-beta countries as US yields rise, however, because the ECB is likely to remain an aggressive buyer of their government bonds as part of their asset purchase programs over the next 6-12 months. We also do not recommend trading UK Gilts off their yield beta to US Treasuries in the immediate future, given the uncertainties over the negotiations over a final Brexit deal. Both sets of US yield betas suggest higher-beta Canada, Australia and New Zealand are more at risk of relative underperformance versus lower-beta France, Germany and Japan. In terms of government bond country allocation, we recommend reducing exposure to the former group and increasing allocations to the latter group. Bottom Line: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields, especially those with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to “higher-beta” Canada and Australia.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com III. Indicators And Reference Charts The S&P 500 is experiencing its second correction in the past two months. The market looks even more fragile than it did in September. COVID-19 is heating up fast enough that lockdowns are re-emerging globally, the odds of an imminent fiscal deal have cratered to a near-zero chance, and investors are paying more attention to the growing risk of gridlock in Washington where a Biden Presidency and a Republican Senate majority would result in temporary fiscal paralysis. In this context, the decline in the momentum of the BCA Monetary Indicator, the elevated reading of our Speculation Indicator and the overvaluation of the stock market create the perfect cocktail for a dangerous few weeks. The longer we live in uncertainty regarding the elections’ result, the worse the market will fare. Short-term indicators confirm that equities are likely to remain under downward pressure in the coming weeks. Both the proportion of NYSE stocks above their 30-week and 10-week moving averages are still deteriorating after forming negative divergences with the S&P 500. They are also nowhere near levels consistent with a solid floor under the market. Moreover, our Intermediate Equity Indicator and the S&P 500 as a deviation from its 200-day moving average have rolled-over after reaching extremely overbought levels. Finally, both the poor performance of EM stocks as well as the underperformance of the Baltic Dry index and global chemical stocks relative to bond prices and the VIX indicate that cyclical assets could suffer from a wave of growth disappointment. Despite these short-term headwinds, the main pillar supporting the rally remains intact: global monetary conditions are highly accommodative. Moreover, the economic and financial risks created by the tepidity of fiscal support in recent months is self-limiting. As the economy progressively teeters toward a second leg of the recession, the pressure will rise for policymakers to spend generously once again to support their nations. Our cyclical indicators confirm the positive backdrop for stocks. Our Monetary Indicator remains at the top of its pre-COVID-19 distribution, which will put a natural floor under stocks, even if its recent deterioration is consistent with a market correction. Moreover, our Revealed Preference Indicator continues to flash a buy signal for stocks. Additionally, the BCA Composite Sentiment Indicator stands toward the middle of its historical distribution and the VIX has not hit the extremely compressed levels that normally precede major cyclical tops in the S&P 500. When weighing the short-term negative forces against the cyclical positives, we expect the S&P 500 to find a floor between 3000 and 3100. At this level, the froth highlighted by our Speculation Indicator will have dissipated.  The bond market’s dynamics are interesting. Despite the violent sell-off in equities, Treasury yields are not declining much. Bonds are too expensive and with short-term rates near their lower bound, Treasurys are losing their ability to hedge equity risk in portfolios. Moreover, the bond market seems to understand that any recession will encourage additional fiscal profligacy, which puts a floor under yields. These dynamics suggest that once equities stabilize, yields could start rising meaningfully. Finally, the dollar continues its sideways correction. However, as risk aversion rises and global growth deteriorates, the dollar is likely to catch further upside in the near term, especially as it has not fully worked out this summer’s oversold conditions. Moreover, the dollar is a momentum currency. Thus, once its start to turn around, its rally is likely to be more powerful than most expect, which will put additional downward pressures on commodity prices. Consequently, it is too early to start selling the USD again or to bottom fish natural resources. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see The Bank Credit Analyst Special Report "Labor Strikes Back," dated February 27, 2020, available at bca.bcaresearch.com 2 High odds of staying in the income decile of your parents. 3 Please see Geopolitical Strategy Webcast "Geopolitical Alpha In 2020-21," dated October 21, 2020. Marko also recently published a book "Geopolitical Alpha." 4 Please see US Equity Strategy Weekly Report "Vigilantes Gone Missing?" dated October 26, 2020, available at uses.bcaresearch.com 5 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 6 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 7 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 8 For more details on this recommended steepener trade please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 9 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 10 For a detailed look at the implications of the Fed’s policy shift please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com

Highlights Most sentiment and technical indicators suggest the dollar is undergoing a countertrend bounce rather than entering a new bull market. However, the internal dynamics of financial markets remain short-term constructive for the DXY. The DXY could rise to 96 before working off oversold conditions. Stay short USD/JPY as a core holding. Look to rebuy a basket of Scandinavian currencies versus the USD and EUR at a trigger point of -2%. Go long sterling if it drops to 1.25. Remain short EUR/GBP. Feature Chart I-1The Dollar Is A Counter-Cyclical Currency The Dollar Is A Counter-Cyclical Currency The Dollar Is A Counter-Cyclical Currency The world remains dominated by the reflation trade. The equity market downdraft this past March and the subsequent recovery since April has been a mirror image of the rise and fall of the dollar (Chart I-1). This suggests that at a minimum, the Federal Reserve’s actions and Washington’s policy decisions have served as important pillars in the global economic recovery. A falling dollar tends to reflate the global economy, so it is important to gauge whether the recent bounce is technical in nature or at risk of a more meaningful increase. From an investment perspective, the economic outlook as we enter the final stretch of 2020 is as uncertain as ever. Factors such as the potential for renewed lockdowns, a fiscal cliff in the US, political uncertainty due to Brexit, and the possibility of a contested US election all make for a very complex decision tree. As investors try to decipher the end game, we turn to the internal dynamics of financial markets for a more sober view. Sentiment and technical indicators make up an important component of our currency framework, and are usually good at gauging important shifts in financial markets. Given market action over the past few weeks, we are reviewing a few of these key indicators to help guide currency strategy into year-end and beyond. The Signal From Currency Markets The message from our currency market indicators suggests a technical bounce in the dollar rather than a renewed bear market. The exchange rate that best signals whether we are in a reflationary/deflationary environment is the AUD/JPY rate.  Chart I-2DXY Is Testing Strong Resistance The Message From Dollar Sentiment And Technical Indicators The Message From Dollar Sentiment And Technical Indicators From a broad perspective, the DXY index was oversold, having broken below key support levels this year. More recently, the bounce in the DXY index has brought it a nudge above the upward-sloping trend line, which had defined the bull market since the 2011 lows (Chart I-2). A significant bounce from current levels will be worrisome. More likely, the dollar will churn near current levels before resuming its downtrend. In other words, we expect that, going forward, this upward-sloped line will act as powerful overhead resistance. The exchange rate that best signals whether we are in a reflationary/deflationary environment is the AUD/JPY rate (Chart I-3). Since the Great Recession, the yen has been the best performer during equity drawdowns, while the Aussie has been the worst. As a result, the AUD/JPY cross has consistently bottomed at the key support zone of 72-74. This defensive line notably held during the European debt crisis, China’s industrial recession, and the global trade war. The frontier was clearly breached during the March drawdown this year, but we have since re-entered the safe zone (Chart I-4). Going forward, a break below 72 will be worrisome. Looking at the intra-day charts, we see a clear pattern of lower highs and lower lows since the September 10th peak. That said, speculators are still short the cross, suggesting that the level of complacency going into the February equity market drawdown is not there today (Chart I-4, bottom panel). Chart I-3The Reflation Trade The Reflation Trade The Reflation Trade Chart I-4AUD/JPY: Watch The 72-24 Zone AUD/JPY: Watch The 72-24 Zone AUD/JPY: Watch The 72-24 Zone   High-beta carry currencies such as the RUB, ZAR, MXN, and BRL have been rather weak, even if they are still holding above their lows. These currencies are usually good at sniffing out a change in the investment landscape, specifically one becoming fertile for carry trades. Carry trades usually do well when US yields are low and the global growth environment is improving (Chart I-5). The message so far is that the drop in U.S. bond yields may not have been sufficient to make these currencies attractive again. This is confirmed by the performance of the Deutsche Bank carry ETF, DBV, which has been struggling to recover amid very low rates (Chart I-6). Chart I-5Carry Trades Are Lagging Carry Trades Are Lagging Carry Trades Are Lagging Chart I-6Carry Trade ETFs Have Underperformed Carry Trade ETFs Have Underperformed Carry Trade ETFs Have Underperformed Speculators are very short the dollar. Whenever the percentage of leveraged funds and overall speculators that are short the dollar is at or below 20%, a meaningful rally ensues (Chart I-7). However, because the dollar is a momentum currency, reversion-to-the-mean strategies work in the short term but not so much longer term. The dollar advance/decline line remains well below its 200-day moving average. Meanwhile, there is a death-cross formation between the 200-day and 400-day moving averages. This is a very bearish technical profile (Chart I-8). We cannot rule out rallies toward the 200-day moving average, but for now we remain well below this danger zone. Chart I-7Rising Number Of Dollar Bears Rising Number Of Dollar Bears Rising Number Of Dollar Bears Chart I-8A Cyclical Bear Market A Cyclical Bear Market A Cyclical Bear Market Finally, currency volatility is rising from very depressed levels. Usually, low currency volatility is a sign of complacency among traders and investors, while higher volatility signals a more balanced and healthy market rotation. Over the last three episodes where volatility rose from these oversold levels, the dollar soared and pro-cyclical currencies suffered severe losses. For example, the most significant episodes were 1997-1998, 2007-2008, and 2014-2015 (Chart I-9). The one difference this time around is that the dollar is expensive, while it was very cheap during previous riot points. This argues for a technical bounce, rather than a renewed bull market. Chart I-9Currency Volatility Has Spiked Currency Volatility Has Spiked Currency Volatility Has Spiked In a nutshell, the message from technical indicators is that the bounce in the dollar was to be expected. However, we are monitoring a few worrisome developments. First, the consensus is overwhelmingly bearish on the dollar, which could make this bounce advance much further than most expect. Second, spikes in volatility, especially as the equity market corrects, are traditionally dollar bullish. The Signal From Commodity Markets Commodity prices hold a special place as FX market indicators, since they are both driven by final demand and financial speculation. Over the years, we have found that the internal dynamics of commodity prices usually send key signals for underlying FX market trends. Overall, the signals are also mixed: The copper-to-gold ratio has bottomed and is heading higher from deeply oversold levels. Together with the stabilization in government bond yields, it signifies that the liquidity-to-growth transmission mechanism might be working. This is usually dollar bearish, as rising global growth leads to capital outflows from the US (Chart I-10). The Gold/Silver ratio (GSR) tends to track the US dollar, and its recent rebound is worrisome (Chart I-11). The GSR provides important information on the battleground between easing financial conditions and a pickup in economic (or manufacturing) activity. Gold benefits from plentiful liquidity and very low real rates, while silver benefits from rising industrial demand. Therefore, the GSR rallies during periods of financial stress that forces policymakers to act, and peaks as we exit a recession into a recovery. Chart I-10The Copper/Gold Ratio Leads The Dollar The Copper/Gold Ratio Leads The Dollar The Copper/Gold Ratio Leads The Dollar Chart I-11The Gold/Silver Ratio Is Rebounding The Gold/Silver Ratio Is Rebounding The Gold/Silver Ratio Is Rebounding We had a limit-sell order on the GSR at 75 that was triggered this week, putting our position offside by 7%. The key driver of GSR price action over the next few weeks will be silver prices. The next important technical level for silver is the $18-to-$20-per-ounce zone. This has acted as a strong overhead resistance since 2015, which should now provide strong downside support. If silver is able to stabilize around this level, it will indicate that the precious metals bull market remains intact. We eventually expect the GSR to drop toward 50. The Signal From Fixed-Income Markets The fixed-income market is a very powerful sentiment barometer for the dollar. Both cross-border flows and global allocation to FX reserves provide important information about investor preferences for the dollar. Below, we go through the indicators that we track frequently and which constitute an integral part of our framework. The bond-to-gold ratio is an important signal for the dollar, since both US Treasurys and gold are competing assets. Chart I-12Gold And Treasurys Are Competing Assets Gold And Treasurys Are Competing Assets Gold And Treasurys Are Competing Assets The bond-to-gold ratio is an important signal for the dollar, since both US Treasurys and gold are safe-haven assets and thus, by definition are competing assets (Chart I-12). As the Fed continues to increase the supply of bonds, the ratio of the US bond ETF (TLT)-to-gold (GLD) will be an important proxy for investor sentiment on the dollar (Chart I-13). For now, the ratio is sitting on the key 0.94 support zone. Remarkably, the ratio of the total return in US government bonds-to-gold prices has tracked the dollar pretty well since the end of the Bretton Woods system in the early ‘70s (Chart I-14). This makes it both a good short-term and long-term barometer. Chart I-13Watch The Bond-To-Gold Ratio Watch The Bond-To-Gold Ratio Watch The Bond-To-Gold Ratio Chart I-14Competing Assets And The Dollar Competing Assets And The Dollar Competing Assets And The Dollar Inflows into US government bonds are falling sharply, while those into gold are rising sharply (Chart I-15). With interest rates near zero and real rates deeply negative, this pattern is likely to continue in the near future. This should pressure the bond-to-gold ratio lower.   It is remarkable that in recent days investors have begun pricing even more negative real rates in the US compared to other G10 countries (Chart I-16). Again, should this materialize, this will send gold prices higher and cause further erosion in foreign bond purchases. Chart I-15Gold And USD Inflows Diverge Gold And USD Inflows Diverge Gold And USD Inflows Diverge Gold And USD Inflows Diverge Gold And USD Inflows Diverge Chart I-16Real Rate Expectations Are Relapsing Real Rate Expectations Are Relapsing Real Rate Expectations Are Relapsing Overall, the signal from fixed-income markets remain US dollar bearish.  The Signal From Equity Markets Equity market indicators continue to flag that the rally in the dollar has a bit further to go, but should remain a counter-trend bounce.  Currencies tend to move in sync with the relative performance of their equity bourses.  Chart I-17Cyclicals Have Outperformed Defensives Cyclicals Have Outperformed Defensives Cyclicals Have Outperformed Defensives Cyclical stocks have been underperforming defensive ones of late, but the pattern of higher lows in place since the March bottom continues to persist (Chart I-17). The dollar tends to weaken when cyclical stocks are outperforming defensive ones. This is because non-US equity markets have a much higher concentration of cyclical stocks in their bourses. Thus, whenever cyclical sectors are outperforming defensives, it is a clear sign that the marginal dollar is rotating outside of the US. Correspondingly, currencies tend to move in sync with the relative performance of their equity bourses (Chart I-18A and I-18B). So far, non-US equity markets have relapsed relative to the US, but are not yet breaking down. Earnings revisions continue to head higher across all markets. Bottom-up analysts are usually too optimistic about the level of earnings, but are generally spot on about their direction. That said, higher earnings revisions have been concentrated in the US so far, and will need to improve in other markets for the dollar bear market to resume (Chart I-19). Chart I-18ACurrencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance Chart I-18BCurrencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance Chart I-19V-Shape Recoveries In Earnings Revisions V-Shape Recoveries In Earnings Revisions V-Shape Recoveries In Earnings Revisions In a nutshell, corrections in equity markets are usually a healthy reset for the bull market to resume, but the character of this particular selloff is worth monitoring. Cyclical and value stocks that are already at historically bombed-out levels have started to underperform. This is usually dollar bullish. Whether the correction ensues or the bull market resumes, it will require a change in equity market leadership from defensives to cyclicals for the dollar bear market to resume. Investment Implications It is very difficult to gauge whether the current market shakeout will last just a few more weeks or continue into year-end. Given such a lack of clarity, our strategy is as follows: Stay long safe-haven currencies. Our preferred vehicle is the Japanese yen, which sports an attractive real rate relative to the US. Focus on relative value at the crosses rather than outright dollar bets. We are short the NZD/CAD and EUR/GBP as a play on relative fundamentals. Stick with them. We already have limit orders on a few currencies, and are adding the Nordic currency basket to this list if it drops another 2%. We initially took profits on this trade last week, when our stop loss was triggered. As Scandinavian currencies continue to fall, they are becoming more compelling buys. Chart I-20Place Stops On Short GSR At 85 Place Stops On Short GSR At 85 Place Stops On Short GSR At 85 We have been long petrocurrencies versus the euro, and the drop in the EUR/USD has helped hedge that trade against market volatility. That said our stop-loss of -5% was triggered amid market volatility. We are reinstating this trade today, and will be looking to rotate into USD shorts once there is more clarity on the economic front. Our short gold/long silver trade was triggered at 75, putting the position offside. For risk management purposes, we are implementing a tight stop at 85 (Chart I-20).   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies US Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data from the US have been mixed: The current account deficit widened from $111.5 billion to $170.5 billion in Q2. The preliminary Markit Manufacturing PMI increased from 53.1 to 53.5 in September while the services PMI declined from 55 to 54.6. The Michigan Consumer Sentiment Index increased from 74.1 to 78.9 in September. Existing home sales increased by 2.4% month-on-month in August. Initial jobless claims increased by 840K for the week ending on September 19. The DXY index appreciated by 1.8% this week amid an equity market correction. While the risk-off sentiment provides a positive backdrop for the US dollar, rising twin deficits and unfavorable real rates both suggest a weaker dollar in the long term. Meanwhile, any incoming positive news on the vaccine will support cyclical currencies against the US dollar.   Report Links: Addressing Client Questions - September 4, 2020 A Simple Framework For Currencies - July 17, 2020 DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020   The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area have been mostly generally constructive: The current account surplus narrowed from €20.7 billion to €16.6 billion on a seasonally-adjusted basis in July. While the preliminary Markit Manufacturing PMI increased from 51.7 to 53.7 in September, the services PMI dropped from 50.5 to 47.6. Consumer confidence marginally increased from -14.7 to -13.9 in September. The German Ifo Business Climate index rose to 93.4 in September. The expectations component has broken above pre-pandemic levels. The euro declined by 1.6% this week against the US dollar. The ECB Economic Bulletin released this Thursday warned that the unemployment rate will continue to rise in the euro area as current figures are skewed by job subsides. The ECB also sees little upside in demand for consumer goods and repeated that it is ready to further adjust its policies to support the economy and boost inflation.   Report Links: Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019   The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data from Japan have been positive: The manufacturing PMI was largely unchanged at 47.3 in September. The services PMI ticked up from 45 to 45.6. The All Industry Activity Index increased by 1.3% month-on-month in July. The Japanese yen depreciated by 1% against the US dollar this week. The latest BoJ Monetary Policy Meeting Minutes released on Thursday expects economic activity to pick up in the second half of 2020 through pent-up demand and supported by accommodative monetary policies, but it also warned about a slower recovery in the event of an upturn in COVID cases. Moreover, the Minutes said that core inflation is likely to be negative in Japan for now. Japan’s higher real rates make the yen an attractive safe-haven hedge.   Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020   British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data from the UK have been mixed: The Markit Manufacturing PMI declined from 55.2 to 54.3 in September. The services PMI also dropped from 58.8 to 55.1. Retail sales increased by 2.8% year-on-year in August. House prices increased by 5% year-on-year in September. The British pound plunged by 1.9% against the US dollar this week amid broad USD strength. Besides global synchronized risks, the internal risk from Brexit uncertainties still poses a big threat to the British pound. That said, the pound is still undervalued at current levels and its year-to-date performance lags behind those of other risky G10 currencies. The pound is poised to rebound with positive vaccine and Brexit news.   Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019   Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data from Australia have been mostly positive: The manufacturing PMI increased from 53.6 to 55.5 in September. The services PMI also ticked up from 49 to 50. The ANZ Consumer Confidence index increased from 92.4 to 93.5 for the week ending on September 20. Retail sales declined by 4.2% month-on-month in August. The Australian dollar dropped by 4% against the US dollar this week, only slightly above the pre-crisis level. We continue to favor the Australian dollar due to lower domestic COVID cases and effective measures for containing the virus. Moreover, China’s data continues to surprise to the upside, which bodes well for the Australian dollar.    Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019   New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data from New Zealand have been negative: Exports declined from NZ$5 billion to NZ$4.4 billion in August, while imports increased from NZ$4.6 billion to NZ$4.8 billion. The trade balance shifted from a positive NZ$447 million to a deficit of NZ$353 million. The New Zealand dollar plunged by 3.8% against the US dollar this week. On Wednesday, the RBNZ held its interest rate at 0.25%, but warned that the economy needs further support and implied further easing. The rising possibility of negative interest rates in New Zealand would hurt the kiwi especially against the Aussie dollar. Moreover, New Zealand’s services trade surplus evaporated as tourism continues to suffer. We will go long AUD/NZD at 1.05.   Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019   Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data from Canada have been positive: Retail sales increased by 1.1% month-on-month in August. New housing prices increased by 2.1% year-on-year in August. Bloomberg Nanos Confidence edged up from 52.9 to 53.1 for the week ending on September 18. The Canadian dollar fell by 1.2% against the US dollar this week. Both retail sales and the housing market have been quite resilient so far, providing support for the Canadian dollar. We are long the Canadian dollar against the New Zealand dollar. Stay with it.   Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020   Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There have been scant data from Switzerland this week: Total sight deposit declined from CHF 704.1 billion to CHF 703.9 billion for the week ending on September 18. The Swiss franc fell by 1.4% against the US dollar this week. On Thursday, the SNB kept its interest rate unchanged at -0.75% and warned of a longer coronavirus impact on economic activity. We like the Swiss franc as a safe-haven hedge especially during a second COVID-19 wave. Moreover, if the October US Treasury Report lists Switzerland as a currency manipulator, it will limit downward pressure on the Swiss franc against the US dollar.     Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020   Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There is no significant data from Norway this week. The Norwegian krone dropped by 2.8% against the US dollar this week. The Norges Bank held its key policy interest rate on hold at a record low 0% on Thursday, as widely expected, and said no rate hike is likely within two years. That said, with core inflation at 3.7% year-on-year in August, it’s unlikely that the Norges Bank will further lower rates into negative territory. Our NOK/USD and NOK/EUR trades from the long Nordic basket were stopped out last week with profits of 18.4% and 9.5%, respectively. We continue to like the Norwegian krone in the long term.   Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 ​​​​​​​ Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 There is no significant data from Sweden this week. The Swedish krona fell by 3.2% against the US dollar this week. On Tuesday, the Riksbank kept its interest rate unchanged at 0% and implied that the rate will likely remain unchanged at least through late 2023. However, the Bank is also ready to further lower the repo rate if necessary. The Swedish krona remains one of our favorite procyclical currencies among the G10 universe supported by its cheap valuation.   Kelly Zhong Research Analyst   Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 ​​​​​​​​​​​​​​ Footnotes Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The dollar is on the verge of a significant breakdown. If the DXY punches through 94, it will likely mark the beginning of a structural bear market. The most recent catalyst – fiscal support in the euro zone – has been good news on the “anti-dollar” front. Agreement on the EU recovery fund has underscored a powerful centripetal force for the euro. Because it is a reserve currency, a breakdown in the dollar will amplify the global liquidity surge. This will lead to a self-reinforcing spiral of better global growth, and a weaker dollar. Our long Scandinavian currency basket and long silver versus gold positions have benefitted tremendously from the shift in sentiment. Stick with them. While our technical indicators are flagging the dollar as oversold, any bounce from current levels should be shorted.  Our FX model remains dollar bearish, and is recommending shorting the DXY for the month of August. Feature Chart I-1On A Precipice The Great FX Rotation The Great FX Rotation The DXY index is punching below key support levels and on the verge of a significant multi-year decline. Up until March, the dollar was trading in a narrow band (Chart I-1). With that support now breached, the next key test for the DXY index will be the 93-94 zone, defined by the upward-sloping trend line, in place since the 2011 lows. As the breakdown becomes more broad-based, especially vis-a-vis emerging market currencies, this will cement the transition from easing financial conditions to improving global growth. Our trade basket has benefitted significantly from the shift in market sentiment, especially being long the NOK, the SEK and silver relative to gold. As Chart I-2 shows, while gold and the safe-haven currencies remain this year’s frontrunners, the more industrial metals such as silver and platinum will likely take over the baton by year end. Within the G10 universe, cyclical currencies such as the Australian dollar and the Norwegian krone are now in the technical definition of a bull market. Such a rotation usually signals a genuine and potentially meaningful breakdown in the dollar. Chart I-2The Great FX Rotation The Great FX Rotation The Great FX Rotation Our trade basket has benefitted significantly from the shift in market sentiment, especially being long the NOK, the SEK and silver relative to gold.  Technical indicators suggest the dollar is likely to consolidate losses in the weeks ahead. Our intermediate-term indicator is in the lower decile of its range, and speculators are very short the cross (see US dollar section on page 14). That said, any bounce should be used as an opportunity to establish fresh short positions, contrary to the “buy-on-the-dip” strategy that has worked well over the last decade.  DXY Breakdown: What Has Changed? US dollar weakness has been driven by three interrelated factors: Non-US economies that were initially hit by COVID-19 are well into their reopening phases. Meanwhile, new infections in the US are proving rather sticky. As a result, economic momentum is higher outside the US. This partly explains why the euro is outperforming both the US dollar and the yen (Chart I-3). Money velocity is rising faster outside the US, suggesting animal spirits are being rekindled at a faster pace abroad (Chart I-4). This is evident in capital flows, where some non-US markets have started to outperform. In the classical equation MV=PQ,1 a rise in M has historically been accompanied by a collapse in V, suggesting the economy remained in a liquidity trap. With the fiscal spending spigots now open almost everywhere, a rise in both M and V will be explosive for nominal output. Chart I-3Positive COVID-19 Trends For Europe Positive COVID-19 Trends For Europe Positive COVID-19 Trends For Europe Chart I-4Money Velocity Outside The US Money Velocity Outside The US Money Velocity Outside The US There was significant progress towards a European fiscal union this week, with leaders agreeing to a €750 billion recovery fund. Assuming the agreement is ratified, this will underscore a powerful centripetal force for the common-currency union. As the “anti-dollar,” this is positive for the euro (and negative for the greenback). More on this later. The US economy had been relatively resilient compared to the rest of the world, at least until late. This was in part driven by a late start to state-wide shutdowns. With various US municipalities and states now reversing reopening plans, economic activity abroad is now improving relative to the US. Chart I-5 shows the economic surprise index between the Eurozone and the US is inflecting sharply higher from very depressed levels. Historically, this has usually put a floor under the euro. Similarly, G10 PMIs have bottomed relative to the US. These trends should continue in the months ahead. Chart I-5EUR/USD And Relative Growth EUR/USD And Relative Growth EUR/USD And Relative Growth How High Can EUR/USD Rise? Agreement on the EU recovery fund was a historic event, not due to the size of the package but because of revealed preferences toward euro membership. For over two decades, the standard dilemma plaguing the euro area was that centralized monetary policy was never a panacea for desynchronized business cycles.2 The lack of fiscal transfers between member nations amplified this problem. With Italian and Spanish bond yields now collapsing towards those in the core, liquidity is flowing to where it is most needed, significantly curtailing euro break-up risk. The key components of the agreement are €360 billion in the form of loans and €390 billion in the form of grants. The money will be borrowed via bonds issued by the European Commission, with maturities of three to 30 years. Repayment will not be due until 2027. The most important component of the deal, the grants, is a de facto fiscal transfer. Going forward, the next catalyst for euro strength must be growth differentials between the euro zone and the US. This will translate into an improvement in the equilibrium rate of interest between the two blocs (Chart I-6). This is quite plausible in a post-COVID-19 world. As a relatively closed economy, the US has tended to have a higher services component to GDP. However, the service sector has been hit much harder by the pandemic due to social distancing measures that will likely remain in place for a while. A more drawn-out services recovery raises the prospect that countries geared more towards manufacturing, such as Europe, Japan and China, could experience better growth (Chart I-7). Chart I-6EUR/USD And The Neutral Rate EUR/USD And The Neutral Rate EUR/USD And The Neutral Rate Chart I-7Service Industries Could Stay Weak For A While Service Industries Could Stay Weak For A While Service Industries Could Stay Weak For A While Chart I-8The European Periphery Is Competitive Again The European Periphery Is Competitive Again The European Periphery Is Competitive Again Internally within the euro zone, a powerful adjustment has already occurred. Unit labor costs in Greece, Ireland, Portugal and Spain are well off their peak. This has effectively eliminated the competitiveness gap with the core that had accumulated over the previous two decades (Chart I-8). Italy remains saddled with a rigid and less-productive workforce, but overall adjustments have still come a long way in plugging a key fissure undermining the common-currency area. The euro tends to be largely driven by pro-cyclical flows. Fortunately for investors, European equities, especially those in the periphery, remain unloved, given they are trading at very cheap multiples. Part of the reason is that most Eurozone bourses are heavy in cyclical stocks that are well into a 10-year relative bear market.3  A re-rating of cyclical stocks, especially banks and energy, relative to defensives could be the catalyst that carries the next leg of the euro rally. This could push the EUR/USD towards 1.20. As higher-beta, the Scandinavian currencies will also benefit. For now, most analysts remain very pessimistic about European profits relative to those in the US, but that could change if the dollar enters a structural bear market (Chart I-9). Chart I-9Relative Profit Revisions Lead EUR/USD Relative Profit Revisions Lead EUR/USD Relative Profit Revisions Lead EUR/USD Cyclical Or Structural Move? If the DXY punches through 94, it will likely mark the beginning of a structural bear market.  If the DXY punches through 94, it will likely mark the beginning of a structural bear market. The dollar tends to run in long cycles, driven by fundamentals but also confidence. In our report last week, we suggested three indicators for gauging a shift in confidence. The total return of US bonds versus gold: Gold and US Treasurys are competing assets (Chart I-10), with the dollar being the key arbiter, as we argued last week. The TLT/GLD ratio has dropped from over 1.16 to 0.96, putting it at the precipice of bear-market territory. The USD/CNY exchange rate: Tensions are flaring up between the US and China, with the latest being the US government’s closure of China’s Houston consulate. Yet USD/CNY is still holding around 7. As the key arbiter between the dollar and emerging market currencies, a firm yuan limits upward pressure on the greenback. The gold-to-silver ratio (GSR): This correlates well with the dollar, and has absolutely collapsed (Chart I-11). Given similar moves in gold versus copper and oil, it is fair to assume that the global economy is not in a liquidity trap. Chart I-10Gold And Treasurys Are Competing Assets Gold And Treasurys Are Competing Assets Gold And Treasurys Are Competing Assets Chart I-11The Gold-To-Silver Ratio Has Collapsed The Gold-To-Silver Ratio Has Collapsed The Gold-To-Silver Ratio Has Collapsed The more important point is that there is a nascent, concerted push by both institutional investors and central banks to diversify out of dollar assets: The S&P 500 usually moves inversely to gold, but both have been moving in sync since the March lows (Chart I-12). This suggests investors have been using gold rather than US bonds to hedge their equity long positions. The dollar proved to be the best safe-haven asset during the March drawdown. With the Federal Reserve having flooded the system with dollars, gold (and precious metals) are the next logical choice. Since 2014, central banks have been aggressively diversifying out of their dollar holdings. This is not only evident in the official TIC data that continues to show foreign officials are selling Treasurys, but within IMF reserve data well. Part of these flows have gone into other currencies, especially the yen, but a huge portion has been to gold (Chart I-13). This has been driven by emerging market countries such as Russia and China, the same concerns in the middle of geopolitical confrontations with the US. Chart I-12Gold And The S&P 500 Are Moving Together Gold And The S&P 500 Are Moving Together Gold And The S&P 500 Are Moving Together Chart I-13Central Banks Are Loading Their Gold Vaults Central Banks Are Loading Their Gold Vaults Central Banks Are Loading Their Gold Vaults Within our service (and together with our Commodity & Energy colleagues), we have been highlighting that precious metals will be a huge beneficiary from the Fed’s reflationary efforts, even though they are overbought. As a hedged bet, we have been long silver versus gold, a trade that continues to perform well.   As the gold trade becomes crowded and demand for diversification from fiat money remains strong, silver and platinum could be the outperformers.  Chart 14 shows that precious metals such as silver and platinum are much cheaper from a historical perspective. As the gold trade becomes crowded and demand for diversification from fiat money remains strong, silver and platinum could be the outperformers. Chart I-14Silver And Platinum Remain Relatively Cheap Silver And Platinum Remain Relatively Cheap Silver And Platinum Remain Relatively Cheap In a nutshell, remain long silver, SEK, NOK and petrocurrencies. Currency traders can also add platinum to the list. These top picks will continue to benefit from global reflation, dollar weakness and a breakout in the euro. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   Currencies US Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been positive: Existing home sales surged by 20.7% in June compared with May, the highest monthly gain on record. This followed a strong increase in building permits and housing starts last week. The University of Michigan consumer sentiment declined from 78.1 to 73.2 in July, while the Chicago Fed national activity index ticked up from 3.5 to 4.1 in June. Initial jobless claims increased by 1416K for the week ended July 17th, higher than the 1307K increase the previous week. The DXY index continued to edge lower, falling by 1% this week. Our bias is that the US dollar is likely to begin a long depreciation should the global economy continue to rebound.   Report Links: A Simple Framework For Currencies - July 17, 2020 DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020   The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been mixed: The current account surplus narrowed from €14.4 billion to €7.95 billion in May. Headline inflation was flat at 0.3% year-on-year in June. Core inflation also remained at 0.8% year-on-year in June. Preliminary consumer confidence marginally fell from -14.7 to -15 in July. The euro appreciated by 1.4% against the US dollar this week, climbing to the highest level in almost two years, alongside European equities. The catalyst was the €750 billion rescue fund (around 5.5% of EU GDP) announced this Tuesday. The fact that member countries reached an agreement is encouraging for the sustainability of the euro.   Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019   The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mostly negative: The trade deficit narrowed from ¥601 billion to ¥424 billion in June. Exports fell by 26.2% year-on-year while imports fell by 14.4% In June. National headline CPI remained flat at 0.1% year-on-year in June, while core inflation was also unchanged at 0.4%. The Jibun Bank manufacturing PMI increased from 40.1 to 42.6 in July. The Japanese yen rose by 0.2% against the US dollar this week. In the monthly report released this Wednesday, Japan’s Cabinet Office reported improvement in 6 out of 14 economic categories, including consumer spending, exports, production and public investment. However, capital spending, corporate profits and employment remain weak due to the pandemic. That said, we are long the Japanese yen as a  safe-haven hedge.   Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020   British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been positive: The Rightmove house price index rose by 3.7% year-on-year in July, up from 2.1% the previous month. CBI industrial trends survey orders recovered from -58% to -46% in July. The British pound appreciated by 1.6% against the US dollar this week. Near-term volatility around Brexit negotiations is a negative for the pound, but it is cheap and unloved.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019   Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mixed: Retail sales rose by 2.4% month-on-month in June, following 16.9% increase the previous month. NAB business confidence fell to -15 from -12 in Q2. The Australian dollar jumped by 2.3% against the US dollar this week. The recent RBA meeting minutes suggested that there is no need to adjust its policy measures in the current environment and reiterated that negative interest rates remain “extraordinarily unlikely”.   Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019   New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 There was scant data from New Zealand this week: The New Zealand business index surged from 37.5 to 54.1 in June. The New Zealand dollar rose by 1.8% against the US dollar this week. Following weak inflation data last week , the Westpac Economic Bulletin suggests consumer prices will remain subdued on weakened demand. This raises the prospect of further stimulus from the RBNZ.   Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019   Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been positive: Retail sales increased by 18.7% month-on-month in May. Auto sales were particularly strong. The new house price index increased by 1.3% year-on-year in June.  The Teranet/National Bank house price index rose by 5.9%. Headline inflation increased from -0.4% to 0.7% year-on-year in June, as oil prices recovered. Core inflation also rose from 1.6% to 1.8% year-on-year in June. The Canadian dollar rose by 1.3% against the US dollar this week. The inflation data were stronger than expected, led by gas, food and shelter prices. Going forward, a recovery in energy prices will be important for the performance of the CAD. In general, we like petrocurrencies.   Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been positive: The trade balance widened marginally from CHF 2.7 billion to CHF 2.8 billion in June. Exports rose by 6.9% month-on-month while imports jumped by 7.3%. Total sight deposits continued to increase from CHF 688.6 billion to CHF 691.5 billion for the week ended July 17th. The Swiss franc appreciated by 1.3% against the US dollar this week. Switzerland has seen a trade recovery in recent months. Notably, luxury goods exports like Swiss watches increased by 58.9% month-on-month in June, though well below pre-COVID-19 levels.   Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020   Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been positive: Exports and imports both improved in June, especially with rebounding oil prices. The trade surplus widened from NOK2.7 billion to NOK3.2 billion. The Norwegian krone appreciated by 1.3% against the US dollar this week. Our Commodity & Energy team holds the view that global fiscal stimulus to combat COVID-19 will support global oil demand. Moreover, both OPEC and the US are likely to continue production cuts. Their bias is that oil prices will continue to grind higher, which is bullish for the Norwegian krone. Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been negative: The unemployment rate rose to 9.8% in June, up from 9% the previous month and 7.2% the same month last year. The Swedish krona surged by 2% against the US dollar this week. The latest Labor Force Survey released this week showed that the labor market in Sweden continues to deteriorate. In June, employment fell by 148,000. Average hours worked per week fell by 8.4%. That said, the Swedish krona remains cheap and will benefit from a global economic recovery.   Footnotes 1Where M = money supply, V = velocity of money, P = price level and Q = output. 2Please see Foreign Exchange Strategy Weekly Report, "EUR/USD And The Neutral Rate Of Interest", dated June 14, 2019. 3Please see Foreign Exchange Strategy Special Report, "Currencies And The Value-Vs Growth Debate", dated July 10, 2020.   Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Should the DXY fail to breach below 92 in the coming months, momentum will be a risk to our short dollar positions. Another risk is valuation. The trade-weighted dollar is expensive, but not overly so. It is not especially expensive versus the euro and some commodity currencies. A post-COVID-19 world in which global economies become more closed could also hurt short dollar positions. Maintain a barbell strategy, being long a basket of the cheapest currencies (SEK and NOK) together with some safe havens (JPY). This should insulate portfolios over what could become a more volatile summer. Feature Chart I-1The Dollar And Markets The Dollar And Markets The Dollar And Markets The breakdown in the dollar since March is still facing some skepticism, even internally at BCA. As a reserve currency, the dollar tends to do well during periods of heightened uncertainty. With a clear risk of a second COVID-19 infection wave, and with equity markets up strongly from their lows, odds are that volatility could rise in the near term. Renewed geopolitical tensions between China and the US as well as the upcoming US presidential election are also sources of risk. Historically, the dollar has tended to rise with both increasing equity and geopolitical risk premia (Chart I-1). The key question is whether any near-term bounce in the dollar is technical in nature, or represents the resumption of the bull market. While the dollar is a countercyclical currency, it has also been in a bull market since 2011, notwithstanding the growth upcycles that took place during that period. Through a series of technical, valuation, and macroeconomic charts, we will explore the key risks to our dollar-bearish view as well as potential signposts to see if we are spot on in our thinking. The Long-Term Technical Profile Is Bullish Chart I-2The Dollar And Cycles The Dollar And Cycles The Dollar And Cycles The dollar is a momentum currency, and so tends to move in long cycles. Moreover, in recent history, these cycles have tended to last around eight to 10 years, coinciding with the NBER definition of business cycles. The dollar bear market of the 1980s entered its capitulation phase with the 1990s recession. Similarly, the dollar bull market of the late ‘90s ended with the 2001 recession. The Great Recession in 2008 and subsequently cascading crises from the Eurozone to Japan in 2010-2011 ended the bear market run in the dollar from 2001. If the past is prologue, then the pandemic recession of 2020 may also be signaling an end to the dollar’s decade-long bull run. There is also an economic reason for the decade-long run in dollar cycles. This is the time it usually takes to build and subsequently unwind imbalances in the US economy. In a closed economy, savings must equal investment. However, in open economies, investors usually require a cheaper exchange rate (or higher interest rates) to fund rising deficits, just as they require a higher IRR to fund projects with risky cash flows. This has been the story for the US dollar since the 1980s (Chart I-2). Of course, dollar transition phases can be quite volatile, and the risk to this view is that the dollar bear story could be one for 2022 rather than 2020. However, it is also noteworthy that dollar tops are generally V-shaped, while bottoms are more saucer-shaped. The reason is that the Federal Reserve is usually at the center of a dollar peak, in its decisiveness to ease monetary conditions quite aggressively. At bottoms, the dollar is typically already sufficiently cheap that it does not pose headwinds to the US economy. The pandemic recession of 2020 may also be signaling an end to the dollar’s decade-long bull run. If the DXY can easily break through  the 92-94 zone, this will technically end the bull market in place since 2011, as the powerful upward-sloping channel, in place since then, will be breached (Chart I-3). On the sentiment side of things, conditions remain bullish, which is positive from a contrarian perspective. Professional forecasters often tend to be  adaptive, with a Bloomberg survey expecting the DXY to be flat by year end, but hitting 92 only in 2022 (Chart I-4). More importantly, they tend to miss important turning points in the greenback. Chart I-3A Technical Profile For DXY A Technical Profile For DXY A Technical Profile For DXY Chart I-4The Dollar And Forecasters The Dollar And Forecasters The Dollar And Forecasters The Dollar Is Not Overly Expensive The valuation picture for the dollar is more nuanced, and is our biggest source of risk. The dollar is clearly expensive versus currencies such as the Swedish krona and Norwegian krone, but on a trade-weighted basis, the dollar is only one standard deviation above our fair-value model. This still makes the dollar pricey, but not to the extent of previous peaks, that have tended to occur around two standard deviations above fair value (Chart I-5). Our long-term fair value model has two critical inputs – the productivity gap between the US and its trading partners as well as real bond yield differentials. Rising productivity ensures a country can pursue non-inflationary growth. This lifts the neutral rate of interest in the country, raising the long-term fair value of its exchange rate. The Bloomberg survey expects the DXY to be flat by year end, but hitting 92 only in 2022. Since 2010, the productivity gap between the US and its trading partners has been flat, but there is reason to believe this gap will start to roll over. For one, fiscal largesse could crowd out private investment. But more importantly, as my colleague Ellen JingYuan He of BCA’s Emerging Market Strategy reckons, productivity gains in countries like China could start to pick up as it becomes a world leader in innovation (Chart I-6). This will allow real bond yields outside the US to remain high. Chart I-5The Dollar Is Expensive The Dollar Is Expensive The Dollar Is Expensive Chart I-6US Relative Productivity May Decline US Relative Productivity May Decline US Relative Productivity May Decline The key point is that valuation alone is not a sufficient catalyst for dollar short positions, which is a risk to the view. This is especially the case versus commodity currencies and the euro. That said, there are still some currencies trading below or near two standard deviations from their mean relative to the US dollar. This includes the NOK, SEK, and to a certain extent the GBP (Chart I-7). We remain long these currencies in our portfolio. Chart I-7ASome G10 Currencies Are Very Cheap Some G10 Currencies Are Very Cheap Some G10 Currencies Are Very Cheap Chart I-7BSome G10 Currencies Are Very Cheap Some G10 Currencies Are Very Cheap Some G10 Currencies Are Very Cheap   Post COVID-19 Behavior Could Be Dollar Bullish A post COVID-19 world in which global economies become more closed could hurt the bearish dollar view. This is because when global growth is rebounding, more cyclical economies benefit from this growth dividend, and as such capital tends to gravitate to their respective economies. This is aptly illustrated with consumption being a much larger share of GDP in the US compared to exports (Chart I-8). A move towards more domestic production will hurt the capital flows that have tended to dictate the dollar’s countercyclical nature. A post COVID-19 world in which global economies become more closed could hurt the bearish dollar view.  Chart I-9 shows that dollar strength throughout most of March can be partly  explained by the relative resilience of the US economy, in part driven by a late start to state-wide shutdowns. With economies outside the US now reopening, PMIs abroad have recovered at a faster pace. Once the initial snapback phase has been established, differentiation among economies will then begin Chart I-8The US Economy Will Benefit From De-Globalization The US Economy Will Benefit From De-Globalization The US Economy Will Benefit From De-Globalization Chart I-9Relative Growth And ##br##The Dollar Relative Growth And The Dollar Relative Growth And The Dollar More importantly, in a post COVID-19 world, “platform” companies that can virtually leverage their technology and expertise across borders are replacing “brick and mortar” businesses that need both shipping lanes and ports to remain open. For example, will demand for autos ever recover to pre-crisis levels, when one can video conference rather than drive for two hours to the office? In general terms, if deep value stocks cannot find a way to improve their return on capital, flows into these markets (heavily represented outside the US), will dwindle. This will be a key risk to the dollar bearish view (Chart I-10).   Chart I-10Deep Value And The Dollar Deep Value And The Dollar Deep Value And The Dollar That said, manufacturing renaissances do happen. Asia, for example, remains at the core of both robotic and semiconductor manufacturing, which are redefining the production landscape. And over the long term, valuations do matter – and the starting point for US equities is unfavorable. Strategy And Housekeeping We continue to recommend a barbell strategy. Hold a basket of the cheapest currencies such as the NOK, SEK, and the GBP, along with some safe havens. Our list of trades is printed on page 9. We were stopped out of our short gold/silver position and are reinstating that trade today. While gold does better than silver during market riots, the ratio is 100:1, which is the most overvalued it has been in over a century. Once retail participation gains hold of cheap silver prices, which usually occurs during latter parts of precious metal bull markets, the move could be explosive. We remain long the pound, but are respecting our stop on our short EUR/GBP position that was triggered last week. Valuation supports the pound but politics will increase near-term volatility. We are raising our limit sell to 0.92, which has provided tremendous resistance since the referendum in 2016. Finally, the correction in energy prices is providing an interesting entry point for both the NOK/SEK cross and petrocurrencies. We remain oil bulls on the back of a pickup in global demand. This should lead to the outperformance of energy stocks, benefiting inflows into the CAD, NOK, RUB, MXN, and COP.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been mostly positive: The Markit manufacturing PMI rebounded to 49.6 from 39.8 in June. The services PMI and composite PMI both increased to 46.7 and 46.8, respectively. The Chicago Fed National Activity index increased from -17.89 to 2.61 in May. Existing home sales fell by 9.7% month-on-month in May. However, new home sales surged by 16.6% month-on-month. Initial jobless claims increased by 1480K for the week ended June 19th, higher than the expected 1300K. The DXY index increased by 0.34% this week. Recent data have shown some improvement in the economy, supported by the reopening and Fed’s unprecedented relief measures. We remain cautiously bearish on the US dollar. Please refer to our front section this week for a checklist of risks to the bearish dollar view. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been mostly positive: The Markit manufacturing PMI increased from 39.4 to 46.9 in June. The services PMI increased to 47.3 from 30.5 and the composite PMI ticked up from 31.9 to 47.5. The current account surplus shrank from €27.4 billion to €14.4 billion in April. Consumer confidence slightly improved from -18.8 to -14.7 in June. The euro fell by 0.5% against the US dollar this week. The ECB decided to offer euro loans against collateral to central banks outside the euro area during the pandemic. Besides, the Eurosystem repo facility for central banks (EUREP) will remain available until the end of June 2021. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: The manufacturing PMI fell from 38.4 to 37.8 in June. The coincident index fell from 81.5 to 80.1 in April, while the leading economic index ticked up from 76.2 to 77.7. The All Industry Activity Index fell by 6.4% month-on-month in April. The Japanese yen depreciated by 0.5% against the US dollar this week. The BoJ Summary of Opinions released this week pointed out that Japan’s economy has been in an extremely severe downturn and the recovery is likely to be longer and slower. Moreover, the BoJ has expressed concerns that Japan might slip back into deflation. We are long the yen as portfolio insurance. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been positive: The Markit manufacturing PMI increased from 40.7 to 50.1 in June. The services PMI also soared from 29 to 47. Retail sales fell by 13.1% year-on-year in May. However, it increased by 12% compared to the previous month.  The British pound fell by 0.7% this week. Last week, the MPC voted unanimously to keep the current rate unchanged at 0.1%. The Committee also voted by a majority of 8-1 for the Bank to increase government bond purchases by another £100 billion, bringing the total purchases to £745 billion. However, governor Andrew Bailey also indicated in a Bloomberg Opinion article on Monday that the Bank might take measures to reduce the BoE’s swollen balance sheet, indicating the £100 billion might be the last should conditions improve. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been positive: The manufacturing PMI increased from 44 to 49.8 in June. The services PMI soared from 26.9 to 53.2, bringing the composite PMI up to 52.6 in June. The Australian dollar initially rose against the US dollar, then fell, returning flat this week. During an online panel discussion this week, the RBA Governor Lowe warned about the long-lasting impact of the COVID-19. More importantly, he said that at the current level close to 0.7, the Australian dollar is not overvalued against the US dollar, even though a lower currency would support exports and push the inflation back to target. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been negative: Exports declined by 6.1% year-on-year to NZ$5.4 billion in May, mainly due to lower sales in logs, fish, machinery and equipment. In contrast, exports of dairy products increased by 4.5% year-on-year. Imports slumped by 25.6% year-on-year, led by lower purchases of vehicles and petroleum products. The trade surplus fell to NZ$ 1.25 billion in May from NZ$ 1.34 billion in April. However, this compares favorably with a trade deficit of NZ$ 175 million in the same month last year. The New Zealand dollar fell by 0.6% against the US dollar this week. On Wednesday, the RBNZ held its interest rate unchanged at 0.25% as widely expected and maintained its current pace of QE. However, the Bank sounded quite dovish and indicted that it is ready to further ease policy whenever needed. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been positive: Preliminary data shows that retail sales rebounded by 19.1% month-on-month in May, following a 26.4% decrease the previous month. The Canadian dollar depreciated by 0.7% against the US dollar this week. In his first speech as Bank of Canada Governor this week, Tiff Macklem warned that the recovery might be longer than expected, and indicated that the Bank needs a quick response and targeted containment to fight possible future waves of COVID-19 and another round of a broad-based shutdown. Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been positive: The ZEW expectations index rose from 31.3 to 48.7 in June. Money supply (M3) surged by 2.5% year-on-year in May. Total sight deposits increased to CHF 680.1 billion from CHF 679.5 billion for the week ended June 19th. The Swiss franc appreciated by 0.2% against the US dollar this week. The SNB Quarterly Bulletin in Q2 was released this week and it showed that while government loans have been helpful to support the economy, the declines in profit margins were exceptionally severe. Moreover, a further appreciation of the Swiss franc remains a downside risk for a small open economy like Switzerland. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been negative: The unemployment rate increased to 4.2% in April from 3.6% the previous month. The Norwegian krone fell by 1% against the US dollar this week, along with lower oil prices. Last week, the Norges Bank left its interest rate unchanged at 0% and signaled that the rates are set to remain at current levels over the next few years. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been positive: Consumer confidence increased from 77.7 to 84 in June. The Swedish krona appreciated by 1.2% against the US dollar this week. As one of the few countries without strict lockdown measures, Sweden’s business sectors are showing budding signs of recovery in May and June, according to a company survey by the central bank. However, most companies believe that the recovery would take at least 9 months or longer. On another note, the Riksbank has been testing its digital currency e-krona and might be the first central bank to implement the wide use of digital currency. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The dollar is likely to churn on recent weakness before a cyclical bear market fully unfolds. The reason is that the economic landscape remains fraught with uncertainty, both politically and economically. We continue to recommend a barbell strategy. Hold a basket of the cheapest currencies such as the NOK, SEK, and GBP along with some safe havens. Watch the performance of cyclicals versus defensives and non-US markets versus the S&P 500 as important barometers for dollar downside. The EUR/USD could touch 1.16, while still staying in the confines of a structural bear market. Our FX model is more aggressive, and is recommending shorting the DXY for the month of June. Feature Chart I-1The Dollar Tries To Break Down DXY: False Breakdown Or Cyclical Bear Market? DXY: False Breakdown Or Cyclical Bear Market? The DXY index is punching below key support levels in an attempt to reverse the cyclical bull market in place since 2011. Our technical roadmap has been the upward-sloping channel, in place since 2018 (Chart I-1). At 96.77, the DXY index is already several ticks below the lower bound of this channel. As the breakdown becomes more broad based, especially vis-à-vis the euro, this will cement the transition from easing financial conditions to improving global growth. Cyclical currencies such as the Australian dollar and the Norwegian krone have already bounced powerfully from their March lows and have now entered the technical definition of a bull market (Chart I-2). For example, from a low of 55 cents, the Aussie is now trading at 69 cents, up 25%. As long-term dollar bears, our portfolio has benefited tremendously from this shift in market sentiment.1  Chart I-2A Report Card On Currency Performance DXY: False Breakdown Or Cyclical Bear Market? DXY: False Breakdown Or Cyclical Bear Market? The key question for new investors is whether the move in the dollar represents a false breakdown or the beginning of a cyclical bear market. To answer this, we are reviewing key charts and indicators to explain dollar weakness and help gauge whether it pays to enter new short positions. Explaining Dollar Weakness US dollar weakness has been driven by three interrelated factors: Non-US economies that were initially hit by COVID-19 are reopening faster. As a result, economic momentum is higher outside the US. The rise in economic momentum is supporting money velocity outside the US. In other words, animal spirits are being rekindled at a faster pace abroad. In the classical equation MV=PQ,2 a rise in both M and V can be explosive for nominal output. Higher money velocity outside the US has started to attract capital inflows. This is beginning to show up in the outperformance of non-US markets. With economies outside the US now reopening, PMIs abroad have recovered at a faster pace.  Chart I-3 shows that dollar strength throughout most of March can be partly explained by the relative resilience of the US economy, in part driven by a late start to state-wide shutdowns. This was exacerbated by a dollar liquidity shortage, as demand for US dollars abroad surged. With economies outside the US now reopening, PMIs abroad have recovered at a faster pace. As Chart I-2 illustrates, developed market currencies have fared in pecking order of the easing in lockdown measures, with the AUD outperforming the CAD, and the SEK outperforming the EUR. Prior to the onset of COVID-19, there was a pretty tight correlation between global services relative to manufacturing activity and the dollar (Chart I-4). As a relatively closed economy, the US tended to benefit when services output had the upper hand. This time around, the service sector has been hit much harder due to social distancing measures in place, but it is also likely to have a more drawn-out recovery. For example, visits to theme parks or restaurants are unlikely to retrace back to their pre-crisis peaks anytime soon. However, construction activity, especially geared towards infrastructure or residential housing, may bounce back sooner. Chart I-3A Strong Recovery Outside The US A Strong Recovery Outside The US A Strong Recovery Outside The US Chart I-4USD And Manufacturing Vs Services USD And Manufacturing Vs Services USD And Manufacturing Vs Services The key message is that global manufacturing activity so far is holding up better than services, and activity is picking up faster abroad. This has historically been good news for procyclical currencies. Money Velocity And The Dollar There is increasing evidence that money velocity is being supported outside the US. For global manufacturing activity to recover, it requires a rise in animal spirits to begin to capitalize on very generous financing conditions. In this respect, there is increasing evidence that money velocity is being supported outside the US. In the euro area, the velocity of money in Germany has stopped falling relative to the US. This is a marked change from anything we have seen since the European debt crisis. More importantly, the ebb and flow of ‘V’ in Germany relative to the US has mirrored the relative path of interest rates (Chart I-5). Global industrial activity remains quite subdued, but it appears that sentiment among German investors is very upbeat for the post-COVID recovery. This has usually been a good barometer for the improvement in PMIs (Chart I-6). Granted, the improvement in relative V has been driven mostly by the collapse in US money velocity. But what matters for currencies are relative trends. Once economic activity enters a full-fledged recovery, we expect US output to be hampered by the rise in the dollar over the past 18 months, while cyclical economies will be buffeted by much-cheapened currencies. This raises the prospect of much more pronounced economic vigor outside the US. Chart I-5Money Velocity Support In Europe Money Velocity Support In Europe Money Velocity Support In Europe Chart I-6Euro Area Sentiment Is Improving Euro Area Sentiment Is Improving Euro Area Sentiment Is Improving The ratio of the velocity of money between the US and China has tended to track the gold/silver ratio (GSR) with a tight fit (Chart I-7). A falling ratio signifies that the number of times money is changing hands in China outpaces the number in the US. This also tends to coincide with a pickup in manufacturing activity, for the simple reason that silver has more industrial uses than gold. Therefore, the recent collapse in the GSR is prescient.   Soft data confirms this trend. Both the Caixin and NBS manufacturing PMI are outperforming that in the US, and are likely to keep doing so in the coming months (Chart I-8). Chart I-7Money Velocity Support In China? Money Velocity Support In China? Money Velocity Support In China? Chart I-8Wide Gap Between Chinese And US Output Wide Gap Between Chinese And US Output Wide Gap Between Chinese And US Output It is important to note that while there has been some disconnect between the performance of the economy and stock prices, no such dichotomy exists in currency markets. The ratio of cyclical currencies relative to defensive ones tends to track the global PMI directionally. While this ratio is below its 2008 lows, the global PMI has bottomed at higher levels (Chart I-9). The difference can probably be explained by the fact that either domestic investors (especially retail) have been the dominant buyers of equities, and/or institutional investors have been hedging currency risk. It is true that the bounce in AUD/CHF (or other procyclical pairs) from the lows has brought it closer to technically stretched levels, and some measure of indigestion is overdue. That said, this mainly reflects mean reversion from deeply oversold levels (Chart I-10). If manufacturing activity can keep improving, and the velocity of money outside the US can pick up, this will revive capital flows into these markets, which will lead to more pronounced breakouts. Given the huge uncertainty surrounding these forecasts, we believe the risk to the greenback is currently balanced. Chart I-9Equity And Currency Markets Have Diverged Equity And Currency Markets Have Diverged Equity And Currency Markets Have Diverged Chart I-10Still Oversold Still Oversold Still Oversold Capital Flows As An Indicator The nascent upturn in a few growth indicators is also coinciding with a positive signal from equity markets. Global cyclical stocks have started to outperform defensives in recent weeks, as flows into more cyclical ETF markets are accelerating (Chart I-11). Chart I-11Inflows Into Cyclical ETFs Inflows Into Cyclical ETFs Inflows Into Cyclical ETFs Chart I-12Inflows Into US Assets Are Picking Up Inflows Into US Assets Are Picking Up Inflows Into US Assets Are Picking Up The S&P 500 has been the best performing market for a few years now, so a crucial part of the dollar call lies in international equity markets outperforming the US. Indeed, the latest data show that as recent as March, net foreign inflows into US equity markets were quite strong (Chart I-12). This might explain why the S&P 500 continued to outperform during the March drawdown. In a nutshell, the outperformance of more cyclical currencies will require confirmation of a breakout in their relative equity market performance. This applies to the euro area, commodity-producing countries, and other emerging and developed market currencies (Charts I-13A and I-13B). The catalyst will have to be rising relative returns on capital outside the US, but the starting point is also extremely attractive valuations. Chart I-13ANascent Bounce In Cyclicals Versus Defensives Nascent Bounce In Cyclicals Versus Defensives Nascent Bounce In Cyclicals Versus Defensives Chart I-13BNascent Bounce In Cyclicals Versus Defensives Nascent Bounce In Cyclicals Versus Defensives Nascent Bounce In Cyclicals Versus Defensives We recently penned a report titled “Cycles And The US Dollar,” which showed empirically that US valuations have more than fully capitalized future earning streams, especially vis-à-vis their G10 peers. That said, before a cyclical bear market can fully unfold, we are watching two key indicators for dollar downside: As the Fed continues to dilute existing bond shareholders, the ratio of the US bond ETF (TLT) to gold (GLD) will be an important proxy for investor sentiment. One of the functions of money is as a store of value, and gold remains a viable threat to the dollar (and Treasurys) in this regard. A falling ratio will suggest private investors are dumping their bond holdings in exchange for harder assets such as precious metals. Recent inflows into the GLD ETF may be signaling such a shift (Chart I-14), but it will take a clean break in this ratio below 0.95 to solidify the trend. As geopolitical tensions between US and China mount, the USD/CNY exchange rate will become the key arbiter between two dollars: one versus emerging markets and the other versus developed markets. So far, USD/CNY is holding close to cyclical highs, but a break above will put Asian currencies at risk. This will have negative implications for developed-market commodity currencies (Chart I-15). Chart I-14Gold And USD Inflows Diverge Gold And USD Inflows Diverge Gold And USD Inflows Diverge Chart I-15Tied To The Hip Tied To The Hip Tied To The Hip EUR, GBP And Housekeeping We continue to recommend a barbell strategy. Hold a basket of the cheapest currencies such as the NOK, SEK, and the GBP along with some safe havens. Being short the gold/silver ratio is also a good way to play an eventual economic recovery, with the benefit of a tremendous valuation cushion. The market certainly applauded the European Central Bank’s addition of €600 billion in bond purchases, given the fall in peripheral bond spreads. The euro also bounced on the back of two factors: Chart I-16QE And EUR/USD QE And EUR/USD QE And EUR/USD Even with additional stimulus, the balance sheet impulse of the Fed is still larger than that of the ECB (Chart I-16). Historically, this has favored long EUR/USD positions. The compression in peripheral spreads should boost European growth as it lowers the cost of capital for countries such as Spain and Italy. This improves debt dynamics and encourages the productive deployment of capital. Technically, the EUR/USD can rally towards 1.16 while remaining within the confines of a structural bear market (Chart I-17). Beyond this point, it will be imperative for European growth dynamics to take over the baton to support a much higher exchange rate. As we mentioned earlier, the velocity of money in Germany has stopped falling relative to the US, but relative improvement is not yet enough to warrant structural positions in EUR/USD. Our FX model is more aggressive, and is recommending shorting the DXY for the month of June. Our FX model is more aggressive, and is recommending shorting the DXY for the month of June. Since the 1980s, this three-factor model has outperformed the DXY index by a significant margin (Chart I-18). Chart I-17EUR/USD Could Touch 1.16 EUR/USD Could Touch 1.16 EUR/USD Could Touch 1.16 Chart I-18The Model Is Short DXY In June The Model Is Short DXY In June The Model Is Short DXY In June Finally, our limit-sell on EUR/GBP was triggered at 0.90 last week. While valuation favors a short position, the ramp-up in Brexit tensions is a key risk to this trade. As such, we are placing tight stops at 0.905.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies US Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been negative: Headline PCE fell from 1.3% to 0.5% year-on-year in April. Core PCE also declined from 1.7% to 1%. Personal income surged by 10.5% month-on-month in April, while personal spending decreased by 13.6%, implying a higher savings rate. Total vehicle sales increased from 8.6 million to 11 million in May. Factory orders fell by 13% month-on-month in April. The trade deficit widened from $42.3 billion to $49.4 billion in April. Initial jobless claims increased by 1877K for the week ended May 29th. The DXY index fell by 1.1% this week, reflecting cautiously positive sentiment as many countries started to ease lockdown measures.   Report Links: Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Dollar Funding Crisis - March 19, 2020   The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been negative: Headline inflation fell from 0.3% to 0.1% year-on-year in May, while core inflation was unchanged at 0.9%. The unemployment rate increased from 7.1% to 7.3% in April. The Markit manufacturing PMI slightly fell from 39.5 to 39.4 in May, while the services PMI increased from 28.7 to 30.5. Retail sales plunged by 19.6% year-on-year in April, following an 8.8% decline the previous month. EUR/USD appreciated by 1.4% this week. On Thursday, the ECB kept key interest rates unchanged, while announcing a further 600 billion euros increase of its PEPP facility, taking the total to 1.35 trillion euros. There was also an extension of the program till June 2021.   Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019   The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mostly negative: Construction orders plunged by 14.3% year-on-year in April. Housing starts fell by 12.9% year-on-year in April. Capital spending increased by 4.3% quarter-on-quarter in Q1. The monetary base surged by 3.9% year-on-year in May. The manufacturing PMI was unchanged at 38.4 in May, while the services PMI increased from 21.5 to 26.5. The Japanese yen fell by 1.3% against the US dollar this week. Japan lifted its nationwide state of emergency last week, however, the economy is still in deep recession as COVID-19 continues to disrupt global supply chains.   Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020   British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been mixed: The Markit manufacturing PMI slightly increased from 40.6 to 40.7 in May. The services PMI also ticked up from 27.8 to 29. Nationwide housing prices fell by 1.7% month-on-month in May. Money supply (M4) surged by 9.5% year-on-year in April. Mortgage approvals increased by 15.8K in April, down from 56K the previous month. GBP/USD increased by 1.7% this week. The Bank of England urged banks to step up no-deal Brexit plans this week, implying that there might have been a shift in the BoE’s assumptions about the outcome of ongoing talks between the UK and the European Union. That being said, we remain bullish on the pound from a valuation perspective, but are tightening our stop loss this week.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019   Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mixed: The manufacturing index increased from 35.8 to 41.6 in May. The current account surplus increased from A$1 billion to A$8.4 billion in Q1. However, more recent trade data was less encouraging. Imports plunged by 9.8% month on month in April while exports slumped by 11.3%. The trade surplus narrowed from A$10.6 billion to A$8.8 billion. GDP grew by 1.4% year-on-year in Q1. On a quarterly basis, it fell by 0.3% compared with the last quarter in 2019.  Building permits increased by 5.7% year-on-year in April. AUD/USD appreciated remarkably by 4.5% this week. On Tuesday, the RBA kept its interest rate unchanged at 0.25%. Moreover, the RBA sounds cautiously positive in its rate statement, saying that “it is possible that the depth of the downturn will be less than earlier expected.”   Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019   New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been negative: Terms of trade fell by 0.7% quarter-on-quarter in Q1, down from a 2.8% increase the previous quarter. It is the first fall since Q4 2018. Building permits fell by 6.5% month-on-month in April, following a 21.7% monthly decrease in March. NZD/USD increased by 4% this week. The fall in terms of trade was led by the decline in meat prices, including lamb and beef, from record levels at the end of 2019. Forestry product prices also fell by 3.4% quarterly in Q1. On a positive note, New Zealand is prepared to ease lockdown measures as there has been no new cases reported for nearly two weeks.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019   Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been negative: GDP plunged by 8.2% quarter-on-quarter in Q1. The Markit manufacturing PMI increased from 33 to 40.6 in May. Labor productivity increased by 3.4% quarterly in Q1. Imports fell from C$48 billion to C$36 billion in April. Exports also declined from C$46 billion to C$33 billion. The trade deficit widened from C$1.5 billion to C$3.3 billion.  The Canadian dollar rose by 2.2% this week, alongside oil prices. On Wednesday, the BoC kept interest rates unchanged at 0.25%. It also decided to scale back the frequency of some market operations as financing conditions have improved.   Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses   Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been negative: KOF leading indicator fell from 59.7 to 53.2 in May. Real retail sales plunged by 20% year-on-year in April, following a 5.8% decrease the previous month. The manufacturing PMI increased from 40.7 to 42.1 in May. GDP declined by 1.3% year-on-year in Q1. On a quarter-on-quarter basis, GDP fell by 2.6% compared with Q4 2019.  Headline consumer prices kept falling by 1.3% year-on-year in May. The Swiss franc rose by 0.5% against the US dollar this week. The 2.6% quarterly decline in Switzerland’s GDP has been the most severe since 1980, mostly led by hotels and restaurants which suffered a 23.4% fall. In addition, the consistent decline in consumer prices might lead the SNB to further step up FX intervention.   Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020   Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There has been scant data from Norway this week: The current account surplus increased from NOK 25 billion to NOK 66 billion in Q1. The Norwegian krone appreciated by 3.5% against the US dollar this week. Statistics Norway’s recent balance of payments report shows that the balance of goods and services surged to NOK 27 billion in Q1. Balance of income and current transfers also increased from NOK 1.9 billion to NOK 38.9 billion. Our Nordic basket against the euro and the US dollar is now 10% in the money.   Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020   Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been negative: GDP increased by 0.4% year-on-year in Q1, down from 0.5% the previous quarter. The trade surplus increased from SEK 5.2 billion to SEK 7.6 billion in April. The manufacturing PMI increased from 36.4 to 39.2 in May. Industrial production plunged by 16.6% year-on-year in April. Manufacturing new orders also declined by 20.7% year-on-year. The Swedish krona increased by 2.5% against the US dollar this week. Sweden’s GDP grew modestly in Q1, which is better than most of its European counterparts, following its decision not to impose a full lockdown to contain the virus.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019   Footnotes 1Please see our table of trades below. 2Where M = money supply, V = velocity of money, P = price level and Q = output.   Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades