Economy
Results from the May New York Fed Empire State Manufacturing Survey sent a warning about the state of the US manufacturing sector. The General Business Conditions index collapsed 36.2 points to -11.6, far below expectations of a more muted deterioration to…
Japanese machine tool orders are an excellent gauge of the state of the global manufacturing and trade cycle. On the surface, the double-digit year-on-year pace of expansion in April suggests that underlying macroeconomic conditions are resilient. However,…
Listen to a short summary of this report. Executive Summary The Dollar Likes Volatility Uncertainty about Fed policy has supercharged volatility in bond markets, and correspondingly, USD demand (Feature chart). A well-telegraphed path of interest rates will deflate the volatility “bubble” in Treasury markets and erode the USD safety premium. The dollar has also already priced in a very aggressive path for US interest rates. The onus is on the Fed to deliver on these expectations. Our theme of playing central bank convergence – by fading excessive hawkishness or dovishness by any one central bank – continues to play out. Our latest candidate: short EUR/JPY. The Russia-Ukraine conflict, and ensuing volatility in oil markets, is providing some trading opportunities. One of those is that “good” oil will continue to trade at a premium to “bad” oil. Go long a basket of CAD and NOK versus the RUB. TRADES* INITIATION DATE INCEPTION LEVEL TARGET RATE STOP LOSS PERCENT RETURNS SPOT CARRY** TOTAL Short DXY 2022-05-12 104.8 95 107 Short EUR/JPY 2022-05-12 133.278 120 137 Bottom Line: We recommended shorting the DXY index on April 8th at 102, with a tight stop at 104. That stop-loss was triggered this week. We are reinitiating this trade this week at 104.8, in line with our cyclical view that the dollar faces downside on a 12–18 month horizon. Multiple factors tend to drive the dollar: Real interest rate differentials, growth divergences, portfolio flows into both public and private capital markets, or even safe-haven demand. Across both developed and emerging market currency pairs, the dollar has been strong (Chart 1), but what has been the key driver of these inflows? For most of this year, interest rate differentials have played a key role in pushing the dollar higher. That said, they have not been the complete story. Chart 2 shows that the dollar has very much overshot market expectations of Fed interest rate policy, relative to other central banks. That premium has been around 8%-10% in the DXY index. In real terms, the overshoot has been even higher. Chart 1The Dollar Has Been King Chart 2The Fed And The Dollar Chart 3The Dollar Likes Volatility A key source of this safe-haven premium has been rising volatility, specifically in the bond market. For most of the last two years, the dollar has tracked the MOVE index, a volatility measure of US Treasurys (Chart 3). Uncertainty about the path of US interest rates, and the corresponding rise in dollar hedging costs, have ushered in a wave of “naked” foreign buyers – owning USTs without a corresponding dollar hedge. Foreign purchases of US Treasurys are surging. Speculators have also expressed bearish bets on the euro, yen, and even sterling via the dollar. There is a case to be made that some of these bullish dollar bets will be unwound in the next few months, even if marginally. For example, the market expects rates to be 248 bps and 313 bps higher in the US by year end, respectively, compared to the euro area and Japan (Chart 4). This might be exaggerated. The real GDP growth and inflation differential between the eurozone and the US is 0.1% and 0.8%, respectively, for 2022. The difference in the neutral rate could be as low as 1.25%. This suggests that a simplified Taylor-rule framework will prescribe a policy rate differential of only 1.7% (1.25 + 0.5(0.8+0.1)). In a global growth slowdown, US inflation will come in much lower, which will allow the Fed to ratchet back interest rate expectations. Should growth accelerate, however, then growth differentials between open economies and the US will widen, narrowing the policy divergence we have been experiencing. The safe-haven premium in the dollar has also been visible in the equity market. One striking feature of the correction has been the inability for US equities to outperform, as they usually do, during a market riot point. The carnage in technology stocks has been absolute, and the tech-heavy US equity market continues to struggle against its global peers. As such, there has been a break in the historically strong relationship between the dollar and the outperformance of the US equity market (Chart 5). Chart 4Pricing In The Euro And Yen In Line With Rates Chart 5The Dollar Has Overshot The Relative Performance Of US Equities As US equity markets were surging throughout 2021, investors started accumulating dollars as a hedge against equity market capitulation, which explained the tight correlation between the put/call ratio and the USD (Chart 6). As the carry on the dollar has risen, and puts have become more expensive, our suspicion is that the greenback has become a preferred hedge. Chart 6Dollar Hedges Against A Drawdown In The S&P As we have highlighted in past reports, the dollar continues to face a tug of war. Higher interest rates undermine the US equity market leadership, while lower rates will reverse the record high speculative positioning in the dollar. Given recent market action, the path of US bond yields will be critical for the dollar outlook. Cresting inflation could pressure bond yields lower. As a strategy, we recommended shorting the DXY index on April 8th at 102, with a tight stop 104. That stop-loss was triggered this week. We are reinitiating this trade at 104.8, in line with our cyclical view that the dollar faces downside on a 12–18-month horizon. As usual, this week’s Month In Review report goes over our take on the latest G10 data releases and the implications for currency strategy both in the near term and longer term. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com US Dollar: Inflation Will Be Key Chart 7How Sustainable Is The Breakout? The dollar DXY index is up 9% year-to-date, hitting multi-year highs (panel 1). The Fed increased interest rates by 50bps this month. In our view, the Fed will continue to calibrate monetary policy based on data, and the key releases continue to surprise to the upside. Headline CPI came in at 8.3% in April, while the core measure was at 6.2%. Both were higher than expected. Importantly, the month-on-month rate for core was 0.6%, much higher than a run rate of 0.2% that will be consistent with the Fed’s target of inflation (panel 2). It is important to note that used car prices have had an important contribution to US CPI. Airfares had an abnormally large contribution to US CPI for the month of April. As these prices crest, along with other supply-driven costs, inflation could meaningfully roll over in the coming months (panel 3). The job’s report was robust, but there was disappointment in the participation rate that fell from 62.4% to 62.2%. This suggests there might be more labor slack in the US than a 3.6% unemployment rate suggests. Wages continue to inflect higher. The Atlanta Fed Wage Growth Tracker currently sits at 6% (panel 4). These developments continue to underpin market expectations for aggressive interest rate increases. The market now expects the Fed to raise rates to 2.5% by December 2022. Speculators are also very long the dollar. Three factors could unhinge market expectations. First, inflation could come crashing back down to earth which will unwind some of the rate hikes priced in the very near term. That would hurt the dollar. Second, growth could pick up outside the US, especially in economies with lots of pent-up demand like Japan. Third, financial conditions could ease, which will help revive animal spirits. In conclusion, our 3-month view on the dollar remains neutral, but our 12-18-month assessment is to sell the dollar. We are reinitiating our short DXY position today with a stop-loss at 106. Euro: A Recession Is Priced Chart 8Go Short EUR/JPY The euro has broken below 1.05 and the whisper circulating in markets is that parity is within striking distance. EUR/USD is down 8.7% year-to-date. We have avoided trading the euro against the dollar and have mostly focused on the crosses – long EUR/GBP, and this week, we are selling EUR/JPY. The euro is in a perfect tug of war: Rising inflation is threatening the credibility of the ECB while there is the risk of slowing growth tipping the euro area into a recession. In our view, the euro has already priced in the latter, much more than potentially higher rates in the eurozone. The ZEW sentiment index, a gauge of European growth prospects, is at COVID-19 lows, along with EUR/USD (panel 1). My colleague, Mathieu Savary, constructed a stagflation index for Europe which perfectly encapsulates the ECB’s quandary. A growing cohort of ECB members are supporting a July rate hike. On the surface, the ECB has the lowest rate in the G10 (outside of Switzerland). With HICP inflation at 7.5% (panel 2), emergency monetary settings are no longer required. A “least regrets” approach suggests gently nudging rates higher to address inflationary pressures. House prices in Germany and Italy are rising at their fastest pace in over a decade, much more than wage inflation (panel 3). The key for the ECB will be to telegraph that policy remains extremely accommodative. It is hard to envision that hiking rates from -0.5% to -0.25% will trigger a European recession, but the ECB will need to balance that outcome with the possibility that inflation crests and real rates rise in Europe. In our trading books, we are long EUR/GBP as a play on policy convergence between the ECB and the BoE. This week, we are playing the same theme via shorting EUR/JPY. In a risk-off environment, EUR/JPY should fall. In an economic boom, the cross has already priced in a stronger euro, relative to the yen (panel 4). We are neutral on the euro over a 3-month horizon but are buyers over 12-18 months. Japanese Yen: A Mean-Reversion Play Chart 9A Capitulation In The Yen? The Japanese yen is down 10.5% year-to-date, one of the worst performing G10 currency this year. In retrospect, a chart formation since 1990 suggests that we witnessed a classic liquidation phase that could only be arrested by an exhaustion in selling pressure, or a shift in fundamentals (panel 1). The two key drivers of yen weakness are the rise in US yields (panel 2) and the higher cost of energy imports. As today’s price move suggests, any reversal in these key variables will lead to a selloff in USD/JPY – falling bond yields and/or lower energy prices. We have been timidly long the yen, via a short CHF position. Today we are introducing a short EUR/JPY trade as well. What has been remarkable in the last month is the improvement in Japanese economic fundamentals, as the country slowly emergences from the latest COVID-19 wave: Both the outlook and current situation components of the Eco Watchers Survey improved in April. This is a survey of small and medium-sized businesses, very sensitive to domestic conditions. PMIs in Japan are improving on both the manufacturing and service fronts. The Tokyo CPI surprised to the upside, with the headline figure at 2.5%. Historically, the earlier release of the Tokyo CPI has been a reliable gauge for nationwide inflation. Importantly, the release was much below BoJ forecasts. Inflation in Japan could surprise to the upside (panel 3). Employment numbers remain robust. The unemployment rate fell to 2.6% in March, and the jobs-to-applicants ratio rose to 1.22. The Bank of Japan has stayed dovish, reinforcing yield curve control in its April 27 meeting, with strong forward guidance. That said, the BoJ will have no choice but to pivot if inflationary pressures prove stronger than they anticipate, and/or the output gap in Japan closes much faster as demand recovers. Related Report Foreign Exchange StrategyWhat To Do About The Yen? We were stopped out of our short USD/JPY position at 128. In retrospect, USD/JPY rallied above 131 and is finally falling back down to earth. We are already in the money on our short CHF/JPY position, from our last in-depth report on the yen. This week, we recommend shorting EUR/JPY. British Pound: A Volte-Face By The BoE Chart 10The Pound Is Being Traded As High Beta The pound is down 9.8% year-to-date. While the Bank of England raised rates to 1% this month, they also expect the economy to temporarily dip into recession this year. This week’s disappointing GDP release confirmed the BoE’s fears. In short, pricing in the SONIA curve for BoE rate hikes remains aggressive. The Bank of England has been one of the more proactive central banks, yet the currency has been performing akin to an inflation crisis in emerging markets (panel 1). Inflation continues to soar in the UK with headline CPI now at 6.2% (panel 2). According to the BoE’s projections, inflation will rise to around 10% this year before peaking, well above previous forecasts of 8%. Together with tighter fiscal policy, the combination will be a hit to consumer sentiment. While the BOE must contain inflationary pressures (in accordance with their mandate), the risks of a policy mistake have risen, akin to the eurozone. Labor market conditions appear tight on the surface (panel 3), but our prognosis is that the UK needs less labor regulation, especially towards areas in the economy where labor shortages are acute and are pressuring wages higher. That is unlikely to change in the near term. As such, the current stance of tight monetary and fiscal policy will stomp out any budding economic green shoots. We are currently short sterling, via a long EUR position. In our view, the EUR/GBP cross still heavily underprices the risks to the UK economy in the near term. Given that the pound is very sensitive to global financial conditions (panel 1), it could rebound if recession fears ease, but our suspicion is that it will still underperform the euro. Canadian Dollar: The BoC Will Stay Hawkish Chart 11The CAD Will Stay Resilient The CAD is down 3% year-to-date. The key driver of the CAD remains the outlook for monetary policy and the path of energy prices (panel 1). In the near term, oil prices will stay volatile, but the CAD has not priced in the fact that the BoC is matching the Fed during this interest rate cycle, and/or the rise in energy prices. Together with the NOK, we are going long the CAD versus the RUB today. As we expected, the Bank of Canada raised interest rates by 50bps to 1% at the April 13 meeting. Since then, all the measures the BoC looks at to calibrate monetary policy are continuing to suggest more tightening in monetary policy. Both headline and core inflation came in strong, with headline inflation at 6.7% in March. The common, trim, and median inflation prints were at 2.8%, 4.7%, and 3.8%, respectively, well above the BoC’s target. This continues to suggest inflationary pressures in Canada are broad- based (panel 2). The employment report in April disappointed market consensus, but employment in Canada is back above pre-pandemic levels, and the unemployment rate fell to 5.2%, close to estimates of NAIRU. This suggests the BoC’s path for monetary policy will not be altered (panel 3). House price inflation seems to be moderating across many cities, which argues that monetary policy is having the intended effect, but price increases remain well above nominal income growth (panel 4). Speculators are slightly long the CAD, a risky stance over the next three months. That said, we are buyers of CAD over a 12-to-18-month horizon. New Zealand Dollar: Positive Catalysts, But Fairly Valued Chart 12Real NZ Rates Need To Stabilize The NZD is down 8.7% year-to-date. The RBNZ remains the most hawkish central bank in the G10. They further raised interest rates to 1.5% on April 13. Given a strict mandate on inflation, together with house price considerations, long bond yields have accepted that the RBNZ will be steadfast in tightening policy and hit 3.8% this month. This will help stabilize real yields are rising (panel 1). Underlying data suggests that the “least regrets” approach by the RBNZ makes sense – in a nutshell, tighten policy as fast as economically possible, to get ahead of the inflation curve. CPI continues to accelerate, hitting 6.9% year-on-year in Q1, from 5.9% the previous quarter (panel 2). House price inflation is rolling over from very elevated levels (panel 3). This suggests that monetary policy is having the intended effect of dampening demand. A weak NZD could sustain imported inflation, but a hawkish central bank cushions this risk. The RBNZ is forecasting a 2.8% overnight rate for June 2023. The OIS curve suggests that market expectations are much higher. This fits with our view that the market had been overpricing higher interest rates in New Zealand, especially relative to other countries. We already took profits on our long AUD/NZD trade and continue to expect the NZD to underperform at the crosses, even if it rises versus the dollar. Australian Dollar: Our Top Pick Against The Dollar Chart 13The AUD Has A Terms Of Trade Tailwind The Australian dollar is down 5.5% year-to-date. The Reserve Bank of Australia raised interest rates by 15bps on its May 3rd meeting, in line with the hawkish tone telegraphed at the prior meeting. The two critical measures that the RBA is focusing on, inflation and wages, have been improving. That said, we had expected the RBA to wait for fresh wage data, out next week, before calibrating monetary policy. The key point is that emergency monetary settings are no longer required in Australia. Home prices remain robust, the unemployment rate has fallen to a cycle low of 4% in and inflationary pressures remain persistent. Headline CPI was at 5.1% year-on-year in Q1. The trimmed-mean and weighted- median CPI print came in at 3.7% and 3.2%, respectively, above the upper bound of the RBA’s 2%-3% target range. The external environment is one area of concern for the AUD. The trade balance continues to soar, but China’s zero COVID-19 policy is a risk to Australian exports. On the flip side, many speculators are now short the Aussie, which is bullish from a contrarian perspective. We are long the AUD as of 72 cents, expecting this trade to be volatile in the near term, but to pay off over a longer horizon. Swiss Franc: The Yen Is A Better Hedge Chart 14Swiss Inflation Will Fall Year-to-date, CHF is down 9% against USD and flat against the EUR. The Swiss economy continues to perform well and remains relatively insulated from the inflation dynamics taking place in the rest of the G10. In April, headline CPI inched higher to 2.5% and core CPI to 1.5% year-over-year (panel 2), while the unemployment rate was down to 2.3%. The KOF indicator was also above expectations at 101.7. At 62.5, the manufacturing PMI is still well in the expansionary zone. In other data, retail sales were up 0.8% month-on-month in March and the trade surplus was down to CHF 1.8bn, likely due to the elevated exchange rate versus the euro. Since then, the franc has given up all its gains against the euro. Several SNB board members have recently spoken about the beneficial role of a strong franc in helping to control inflation (panel 4). That said, it is unclear whether the SNB, known for rampant currency interventions, will be as welcoming to a highly valued franc should inflation roll over. Switzerland’s trade surplus as a share of GDP has been persistently increasing since the early 2000s. An expensive currency would not be positive for economic growth. In fact, SNB sight deposits, have been on the rise recently. Last week, these deposits posted the largest one-week increase in two years. In a world where inflation starts to roll over, the SNB will be more dovish. In this environment, EUR/CHF can see more upside. Norwegian Krone: Bullish On A 12-to-18 Month Horizon Chart 15NOK Has Upside The NOK is down 10.7% against the USD this year. This is a remarkable development amidst higher real rates in Norway (panel 1). The Norges Bank is one of the most predictable central banks. It is set to deliver quarterly 25bps hikes through the end of 2023 to a total of 2.5%. In April, headline CPI rose 5.4% and the measure excluding energy was up 2.6% (panel 2). Although slightly above the latest projections, these figures are unlikely to make the bank deviate from its projected rate path. Economic activity is recovering steadily since the removal of pandemic-related restrictions in February. Household consumption and retail sales grew 4.3% and 3.3% month-over-month, respectively, in March. The manufacturing PMI broke above the 60 level in April, while industrial production was up 2.2% on the month in March. Registered unemployment fell under 2% in April, below pre-pandemic levels. This is helping boost wages (panel 3). Norway’s trade balance continued to break all-time highs with a NOK 138bn surplus in March. Elevated energy prices and the transition away from Russian energy should be a significant tailwind for the Norwegian economy. Oil companies planned to increase investment even before the invasion, and recent developments will likely induce more capex. NOK has significantly underperformed in the last month largely due to broad risk-off sentiment. Once markets stabilize, the krone should strengthen over the next 12–18 months. Given the relatively “safer” nature of Norwegian oil, we are initiating a long NOK/RUB trade today, along with a long CAD leg. Swedish Krona: Into A Capitulation Phase Chart 16SEK Has Upside The SEK is down 10.8% versus the dollar this year. In a major policy U-turn, the Riksbank raised rates by 25bps during its last meeting, after inflation came in above expectations at 6.1% on the year in March. The Bank also announced a faster pace of balance-sheet reduction, as well as expecting two-to-three more hikes before the end of the year. Just like the euro area, Sweden is within firing range of tensions between Russia and Ukraine (panel 1). Swedish GDP contracted 0.4% from the previous quarter. Global uncertainty and rising prices are weighing on consumer confidence, reflected in subdued retail sales and household consumption in March. The manufacturing PMI remains robust at 55 but is falling quite rapidly, as are real rates (panel 2). As a small open economy, Sweden needs external demand to recover. On a positive note, orders remain very strong and an easing of lockdowns in China should contribute to growth in manufacturing and goods exports later this year. It is also encouraging that Sweden’s trade surplus rose to 4.7bn SEK in March. The krona remains vulnerable to both a growth contraction in Europe as well as geopolitical risk, especially as Finland might join NATO, sparring retaliation from Russia. That said, the negative news is likely already priced in. SEK should benefit from growth normalization and a pick-up in the Chinese credit impulse in the second half of the year. As a way to benefit from this dynamic, we are short CHF/SEK, but short USD/SEK positions will be warranted later this year. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Artem Sakhbiev Research Associate artem.sakhbiev@bcaresearch.com Footnotes Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary
Executive Summary The surge in food prices following Russia's invasion of Ukraine will drive EM headline inflation higher, given more of individuals' incomes in these economies are spent on food. Economies in the MENA will remain at risk for higher food prices, given their reliance on wheat imports from Ukraine and Russia, which together comprise ~ 30% of global wheat exports. Wheat is the most widely traded grain in the world; its production is second only to that of corn. Higher shipping and input costs – especially for fertilizers – will exacerbate the upside price pressure on grains, particularly wheat. Tenuous social contracts raise the risk of social unrest in MENA reminiscent of the Arab Spring unrest of 2011, which was fueled by food scarcity, economic stagnation and popular anger at autocratic governments. A strong USD will continue to raise the local-currency cost of grains and food, which also will fuel EM inflation. The War Increased Food Prices… Bottom Line: Wheat prices will remain volatile with a bias to the upside for as long as the Russia-Ukraine war persists. The uncertain evolution of this war means EM states will be more exposed to grain-price volatility and higher inflation. This could prove to be destabilizing to MENA states in particular. Separately, we update our recommendations below. Feature High food prices will drive EM headline inflation, owing to the fact a higher proportion of individuals’ incomes in these economies are spent on food. These pressures are particularly acute for wheat following Russia's invasion of Ukraine. Related Report Commodity & Energy StrategyCopper Demand Will Ignore Recession Wheat is the most widely traded grain in the world, according to the World Population Review (WPR).1 In terms of global production, it is second only to corn, totaling 760mm tons in 2020. In order, the top three wheat producers in the world are China, India, and Russia, which account for 41% of global output. The US is the fourth-largest producer. The WPR notes that if the EU were to be counted as a single country, its wheat production would be second only to China (Chart 1). Within emerging markets, the Middle East and North African (MENA) nations will be worst hit by rising wheat prices.2 This is because the bulk of their wheat imports are sourced from Russia and Ukraine, and shipped from Black Sea ports, which are literally caught in the crosshairs of the Russia-Ukraine war. Many of these states do not have sufficient grain reserves to tide themselves over this crisis, and will be forced to import food at elevated prices. A strong USD, which this past week hit a 19-year high, will add to the price of USD-denominated commodity imports, particularly wheat. Russia’s invasion of Ukraine will continue to exacerbate EM food scarcity and drive input costs – e.g., fertilizers – and shipping rates higher. This will keep food and wheat prices volatile with a strong bias to the upside (Chart 2). Chart 1Wheat Production Faces Concentration Risk Chart 2The War Increased Food Prices… In addition to the inflation risk from high food and energy prices, the tenuous social contracts in many states again raises the risk of social unrest in MENA, as occurred in the 2011 Arab Spring protests against food scarcity, economic stagnation and autocratic government.3 War Disruptions Will Continue Russia’s invasion of Ukraine jeopardized wheat supply from two countries which together constitute nearly 30% of total global wheat exports. The invasion will continue to keep wheat prices volatile and biased to the upside (Chart 3). The UN Food and Agriculture Organization (FAO) forecasts Ukraine’s 2021/22 wheat output will drop below its 5-year average, since at least 20% of total arable land cannot be used due to the war. While nearly 60% lower than this time last year, Ukrainian wheat exports in March were not completely shut down. However, they were re-routed around the direct routes from the Black Sea.4 In March, Ukraine managed to export 309k tons of wheat. Chart 3...Particularly Wheat Ukraine will need to rely on these convoluted routes until port services are either restored or unblocked. Exports through more circuitous routes will delay distribution and increase transport costs. This, of course, also adds to the delivered cost of wheat that is being rerouted and slows the overall distribution of grains globally. Additionally, Ukrainian exports via other countries will be disrupted by those countries’ own trade slowdowns, since global bottlenecks affects all trade. Thus far, Russia has been able to maintain wheat exports. Russia continued to supply wheat to global markets in March and April. The USDA estimates that during the 2021/22 crop year, which ends in June, Russian wheat exports will total 33mm tons, which is just 2mm tons lower than the USDA's pre-crisis estimate.5 Because of high carryover stocks and record production, Russia's exports in the 2022/23 crop year are expected to be more than 40mm tons. Sourcing Alternative Wheat Supplies With a sizable portion of global wheat supply at risk – primarily from Ukraine – other exporting countries will need to increase output to fill this gap (Chart 4). This production, however, is not guaranteed, as it depends primarily on weather and fertilizer prices. New trade routes will also need to be created. This will tax existing export infrastructures as shipping dynamics are reconfigured. Particularly important will be how far the new-found sources of supply have to travel to deliver grain, shipping availability, and, of course, the incremental costs incurred to move supplies. As of 2021, the EU – the Black Sea states’ principle competitor in the wheat-export market – and 48% of total wheat exports to Middle East and African countries (Chart 5). The EU's ability to increase exports for the remainder of the 2021/22 crop year will depend on its production, since demand for exports will be guaranteed given the crisis in the Black Sea. Chart 4Other Exporters Will Need To Ramp Up Chart 5MENA Is EU’s Primary Wheat Export Market The European Commission expects the EU to export a record 40mm tons of wheat for the 2022/23 market year, 6mm tons higher than its expected 2021/22 exports. Based on past trade patterns, these excesses will go to the Middle East, Northern and Sub-Saharan Africa. Strong USD Favors LatAm Exports US wheat exports will not be competitive this year or next, given the strong USD and relatively high prices (Chart 6). Additionally, this year’s winter-wheat crop will be affected by current drought conditions in the key Hard Red Winter wheat growing regions of Western Kansas, Colorado, Oklahoma and Texas. Canada faces a similar issue to its North American neighbor. Compared to other major wheat exporting states, it exports wheat at the second highest price, after the US. Furthermore, in 2021/22 Canadian wheat output is expected to be the lowest in 14 years following a warm and dry summer. The USDA expects strong Argentinian and Brazilian wheat exports in 2021/22. Compared to exports from the EU, US, Australia and Canada, wheat from these two sources is cheaper and hence will attract price sensitive bids from the Middle East and Africa. Chart 6US Wheat Remains Non-Competitive A strong USD will incentivize the LatAm giants’ wheat exports since their input costs are in local-currency terms and their revenues are in USD. While some countries have taken advantage of high wheat and food prices to increase exports, others have imposed restrictions or outright bans on exports, which will continue to drive prices higher. Kazakhstan, which constitutes nearly 5% of global wheat exports, now has a quota on such exports, which will affect Central Asian import markets. India was expected to constitute an uncharacteristically large share of wheat exports this year and next. However, the country is experiencing its hottest March in 122 years, which most likely will reduce its harvest this year and incentivize it to keep wheat stocks at home. The world’s second largest wheat producing and consuming nation expects a 6% drop in production this year.6 Fertilizer Costs Will Remain High … Countries’ abilities to increase production will depend on fertilizer availability and costs. The USDA cited high fertilizer prices as one of the causes for lower expected Australian wheat output in 2022/23. Prices of natural gas – the primary feedstock for fertilizers – took off like a rocket following Russia's invasion of Ukraine. High natgas prices feed directly into fertilizer costs (Chart 7). The EU's proposal to ban Russian oil imports could see Russia embargo natgas supply in retaliation, which would further spike natgas and fertilizer costs. This will have knock-on effects on all ags markets. Fertilizer export bans announced by Russia and China are another factor driving fertilizer prices higher (Chart 8). High fertilizer costs most likely will dissuade farmers from using fertilizers in volumes associated with more normal market conditions, and likely will cause them to wait on planting and treating acreage, which will lower crop quality or delay planting. Both scenarios will lead to higher crop prices (Chart 9). Chart 7High Natgas Prices Feeds Right Into Fertilizers Chart 8Russia, China Are Big Fertilizer Exporters Chart 9Nitrogen Fertilizer Prices Continue To Rise …As Do Shipping Costs Redrawing trade routes – i.e., finding new supplies and new shippers to compensate for the loss of Ukrainian wheat exports – will be expensive. For example, US grain shipping costs soared to an 8-year high after countries, led by China, dramatically increased soybean imports from the US due to a drought in Brazil.7 In 2021, high shipping costs led directly to higher food prices (Chart 10).8 Shipping, like any other commodity, is a function of supply and demand for different types of vessels capable of carrying grain from one part of the world to another. On the supply-side, port closures in China and the Black Sea are increasing port congestion, and making ships available for moving grains scarce. The Ukraine war has stranded ships in the Black Sea and forced merchants to re-route their shipments. This increases sailing times, which has the effect of contributing to supply scarcity in shipping markets. Fewer available ships, coupled with high fuel prices are keeping freight rates elevated. A low orderbook of expected new-vessel additions to the global shipping fleet in 2022 and 2023, along with guidance for ships to reduce speeds to increase fuel efficiency, will exacerbate current ship supply scarcity.9 On the demand side, the major international economic organizations have reduced 2022 GDP estimates due to lower economic activity. Lower economic activity will translate into lower ship demand and hence reduce prices (Chart 11). Chart 10Shipping Prices Remain Elevated Chart 11Shipping Demand Driven By Economic Activity Shipping prices will drop meaningfully once port congestion clears. This will depend on the duration of COVID-19 in China and the evolution of the Russia-Ukraine war. A recession – the probability of which will increase if the EU bans Russian oil imports and Russia retaliates with its own natgas ban – acts as a downside risk to shipping costs. Investment Implications The gap in Black Sea wheat exports produced by the Russia-Ukraine war will require a ramp-up in other countries’ supply. Higher production is contingent on weather conditions and input costs. Changing weather patterns, due to climate change, will increase food insecurity, and make it more difficult to predict how ag markets – particularly grain trading – will handle this shock and other shocks down the road. We remain neutral agricultural commodities but will follow wheat and food market developments closely. Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Commodity Round-Up Energy: Bullish Going into the Northern Hemisphere's summer driving season, US retail gasoline prices are trading at record levels -- $4.328/gal ($181.78/bbl) as of 9 May 2022, according to the US Energy Information Administration (Chart 12). Regular gasoline (RBOB specification traded on the NYMEX) for delivery in the NY Harbor settled at $144.27/bbl ($3.4349/gal) on Tuesday, giving refiners a rough wholesale margin (versus Brent crude oil) of $41.81/bbl. Retail diesel fuel prices also have been extremely well bid, posting record highs as well of $5.623/gal ($236.17/bbl) on 9 May 2022 (Chart 13). On the NYMEX, the ultra-low sulfur diesel fuel contract for July delivery settled at $3.6793/gal ($154.53/bbl). Jet fuel prices also are extremely well bid, as demand increases against a backdrop of lower refinery output pushed NY Harbor prices to $7.61/gal ($319.62/bbl) on 4 April 2022. NY Harbor jet-fuel prices have been much stronger than US Gulf prices and European prices seen in the Amsterdam-Rotterdam-Antwerp (ARA) markets, which were averaging ~ $3.60/gal, according to the EIA. This is accounted for by robust demand – evident since mid-2021, when it recovered pandemic-induced losses – and lower-than-normal output of jet by refiners. Assuming the US does not go into a profound recession, refined-product markets likely will remain tight during the summer-driving season and into the rest of this year, in our estimation. As is the case with the Exploration & Production companies, refiners also have been parsimonious with their capex, which translates into lower capacity to meet demand. Base Metals: Bullish Per the latest US CFTC data, we believe hedge funds and speculators investing in copper are dismissing bullish micro fundamentals and are focusing on bearish macroeconomic factors, such as the probability of an economic slow down increases. This would explain why funds’ short positions have exceeded long positions for the first time since end-May 2020. We have written about medium-to-long-term bullish micro fundamentals at length in previous reports.10 On micro fundamentals, the Chilean constitutional assembly passed articles expanding environmental protection from mining over the weekend. These will be added to the draft constitution to be voted on in September. The article expanding state control in Chilean mining activity did not pass and will be renegotiated before being sent back to the constitutional assembly for a second vote. Uncertain governance will affect mining investment in the state, as BHP recently highlighted. Chart 12 Chart 13 Footnotes 1 Please see Wheat Production by Country 2022, published by worldpopulationreview.com. 2 Awika (2011) notes, "… cereal grains are the single most important source of calories to a majority of the world population. Developing countries depend more on cereal grains for their nutritional needs than the developed world. Close to 60% of calories in developing countries are derived directly from cereals, with values exceeding 80% in the poorest countries." Please see Joseph M. Awika (2011), "Major Cereal Grains Production and Use around the World," published by the American Chemical Society. The three most important grains in this regard are rice, corn and wheat. 3 Please see Egypt's Arab Spring: The bleak reality 10 years after the uprising, published by dw.com on January 25, 2021. 4 Please see First Ukrainian corn cargo leaves Romanian Black Sea port, published by Reuters on April 29, 2022. 5 All USDA estimates mentioned in this report are taken from the USDA’s Grain and Feed Annual for each country. 6 Please refer to After five record crops, heat wave threatens India’s wheat output, export plans, published by Reuters on May 2, 2022. 7 Please refer to U.S. Grain Shipping Costs Soar With War and Drought Swinging Demand, published by Bloomberg on March 18, 2022. 8 For a more detailed discussion, please refer to Risk of Persistent Food-Price Inflation, which we published on November 11, 2021. 9 For estimates of orderbook vessels in 2022/23 please see Shipping market outlook 2022 Container vs Dry bulk, published by IHS Markit on November 30, 2021; slower speeds could reduce effective shipping capacity by 3-5%, according to S&P Global (see Shipping efficiency targets could prompt slower speeds and reduced capacity: market sources). 10 For the latest on this, please see Copper Demand Will Ignore Recession, which we published on April 14, 2022. Investment Views and Themes Recommendations Recommendations: We are re-establishing our positions in XME, PICK and XOP, which were stopped out APRIL 22, 2022 with gains of 42.42%, 9.77% and 20.91%, respectively, at tonight's close. We also will be adding the VanEck Oil Refiners ETF (CRAK) to our recommendations, given our bullish view of the global refining sector. Strategic Recommendations Trades Closed in 2022
Executive Summary India’s annual consumer price inflation will rise a notch from current levels but is unlikely to surpass 8% in a sustained manner. Demand-driven price pressures are absent in the Indian economy. So are wage pressures. That leaves commodity prices as the sole source of inflation. Global industrial commodity prices dictate India’s producer price inflation, but not consumer price inflation. The latter is determined by domestic factors. Higher import costs on fertilizer and edible oils will push up India’s food inflation a bit, but food inflation is mainly affected by the ‘Minimum Support Price’ that the government pays to farmers for food procurement. The central bank is making a policy mistake by raising interest rates to suppress commodity price-driven inflation when domestic demand is quite weak. The Indian profit outlook has deteriorated meaningfully due to falling margins. Higher interest rates will add to the headwinds. This bourse is also very expensive relative to its EM peers. India: Consumer Price Inflation Is A Function Of Broad Money Supply Bottom Line: Absolute return investors should avoid this bourse. Asset allocators should stay underweight India in EM and Emerging Asian equity portfolios. Bond investors should stay neutral India in EM and Emerging Asian domestic bond portfolios. Feature In much of the developed world, inflation has risen to 40-year highs. Inflation has surged in many developing countries as well. India has been one major exception in the latter group − where both headline and core consumer inflation have remained rangebound so far (Chart 1). The question is, if and for how long will India be able to buck the tide of higher global inflation? On a related note, what would be the likely effects of higher inflation on Indian markets? We believe headline and core CPI in India will rise from the current levels of around 6.5%; but will not go past 8% on a sustainable basis. This is much below the double digit levels the country often witnessed in the 1990s and 2000s. The main reason behind our optimism is that demand-driven price pressures are absent in the current cycle. The sole source of inflation is higher global commodity prices, which could be peaking on a rate of change basis. The commodity-led nature of inflation in India also makes monetary policy a less effective tool to control it in this cycle. In fact, considerable monetary tightening will be a policy error as it could nip the already weak domestic demand in the bud. We turned bearish on Indian stocks in March this year, and believe they have more downside in absolute terms. Their recent relative outperformance will also fizzle out sooner rather than later, as this was partially due to investors forsaking the Chinese market. This caused a sharp fall in the latter boosting other bourses’ relative performances (Chart 2). Chart 1India Has So far Been An Exception To The Global Trend Of Surging Inflation Chart 2Indian Stocks Will Weaken More And Underperform EM Investors would therefore do well to stay underweight Indian stocks in EM and Emerging Asian equity portfolios for now. Local currency bond investors should stay neutral India in the respective EM and Emerging Asian bond portfolios. Why Has Inflation Stayed Downbeat? Just like in other economies, labor productivity trends set the tone of India’s structural inflation backdrop. Up until the early 2000s, India’s average productivity gains used to be rather low: of the order of 3% annually. Thereafter, a surge in capital spending on infrastructure and other productive capacity propelled India’s average annual productivity growth rate to twice as high. This has helped improve India’s structural inflation backdrop considerably. That said, over a cyclical horizon, it is the ebbs and flows of broad money supply (M3) that determines India’s consumer inflation trajectory (Chart 3). Chart 3India: Consumer Price Inflation Is A Function Of Broad Money Supply Chart 4Money Supply Will Stay Tame As Its Sources Are Rather Muted Broad money supply in India has decelerated over the past year and a half. This is in sharp contrast to most developed economies and many emerging economies in Latin America and EMEA; and it is the main reason why inflation prints have diverged between those countries and India. In the foreseeable future, there is little indication that India’s broad money supply will accelerate by any meaningful measure. This is because the major sources of money creation – bank credit origination and the central bank and commercial banks’ purchases of non-bank securities − have all remained rather muted in the recent past. Bank credit has grown only at a 7% nominal annualized rate over the past three years. In real terms (deflated by headline CPI), they have barely risen. Commercial banks’ purchases of government bonds are growing at only 5%. The central bank’s monetization of government debt, the other source of money creation, has also decelerated since early 2020 (Chart 4). The decelerating broad money supply means the odds of a demand-driven surge in consumer price inflation is also quite low. What About Commodity-Led Inflation? Elevated commodity prices have pushed up India’s consumer price inflation by a notch. Yet, given that much of the rally in global industrial commodities is probably already behind us, it’s effect on future inflation in India will likely be limited: Global industrial commodity prices drive India’s producer price inflation1 (PPI). But the correlation with India’s consumer price inflation is only tenuous (Chart 5). Moreover, given that India’s PPI tracks global commodity prices with a few months lag, this is also set to decelerate in the coming months. Consistently, the pass-through effect from high global crude prices to local gasoline and diesel prices in India has also rolled over on a rate of change basis (Chart 6, top panel). Chart 5Global Commodity Prices Dictate India's Producer Prices, But Not Consumer Prices Chart 6Domestic Fuel Price Inflation Is Much Lower Than Crude Price Would Suggest Notably, Indian authorities did not reduce local gasoline and diesel prices back in 2020-21 when global crude prices had slumped. Hence, the incremental rise in local fuel prices in the past several months has not been as steep as they might have been (Chart 6, bottom panel). As a result, energy-related inflation prints in India are not as high as crude oil prices would suggest. In fact, CPI for Fuel & Light and Transport & Communication2 have both decelerated from 12%+ YoY rate to 8% and are slowing further. That means the pass-through from higher fuel prices to the rest of the economy going forward will also be receding. Fertilizer (mostly potash) and edible oil3 are the two other major commodities that India imports. The import bill of these two items has almost doubled in dollar as well as in rupee terms in the past year due to surging prices globally. Together, they now account for 5% of India’s total imports. Higher import costs of these items will lead to slightly higher food prices in future. That said, India’s food inflation moves more with the “Minimum Support Price” (MSP). This is the price that the government pays to farmers for procuring various food grains every year (Chart 7, top panel). Since the government is by far the single largest purchaser, the price it pays sets the floor in the market. In recent years, authorities did not hike procurement prices by much. Unless authorities announce a much higher MSP for the current year, both food and headline CPI will likely stay under control. Finally, India is largely self-reliant when it comes to food. The buffer stock of the country’s food grains, currently at 74 million tons, far exceeds the estimated requirements (Chart 8). Short of any logistics debacle therefore, it’s hard to imagine that food prices could soar sustainably. Chart 7The Government's Support Prices Have A strong Bearing On Food Inflation And Rural Wages Chart 8India's Buffer Stock Of Food Grains Is Quite Robust All that said, food inflation is the main risk on India’s inflation horizon. The reason for that is rising food prices often unmoor household inflation expectations, and eventually lead to higher realized inflation. Chart 9 shows that higher food prices in India do leak into non-food prices, albeit to a limited extent. As such, marginally higher food prices owing to higher import costs of fertilizer and edible oils will see India’s core inflation also rise a bit. Chart 9Higher Food Inflation Leaks Into Core Inflation, But Only So Much How High Can Core CPI Rise? As discussed, India’s core inflation will likely remain mostly under control. A crucial reason for that is wage pressures are absent in India. This is in stark contrast to the US, where high wage pressures are threatening to morph into a wage-inflation spiral. In rural India, both farm and non-farm nominal wages have been growing at an average sub-5% rate since 2016, which is below CPI inflation. One reason rural wages have stayed low is that authorities have not raised the MSP much in recent years. A lower MSP not only reins in food prices, but it also keeps a tab on wages (Chart 7, bottom panel). As such, unless the government decides to raise the MSP meaningfully this year, it will be difficult for rural wages to rise materially. On the urban side, the RBI survey on expectations for industrial salary and remunerations also depicts a similarly subdued outlook (Chart 10). Going forward, as tens of millions of young people continue to join the workforce every year, the broader wage picture in India is unlikely to change much. Subdued wage pressures will help keep a tab on the general inflationary pressures in the economy. On its own, India’s core CPI (i.e., CPI ex-food and ex-fuel) is largely a function of domestic money and credit trends. Global crude oil prices also matter to some extent. However, as discussed above, few of these variables are accelerating sharply. That means odds are low that core CPI will rise much more from the current levels. Indeed, our in-house model for core CPI, based on the variables just mentioned, points to a rather benign outlook (Chart 11). Chart 10Wage Pressures Are Absent, Entailing Core Inflation Will Stay Under Control Chart 11India's Inflation Outlook Is Sanguine Does Inflation Hurt Indian Stocks? The primary drivers of Indian stocks are economic growth and corporate profits. Stock prices do not usually get hurt as long as CPI stays in low and mid-single digits. However, once CPI breaches the 8% mark sustainably, stocks typically sell off (Chart 12). Chart 12Indian Stocks Face Major Headwinds When CPI Breaches The 8% Mark Chart 13Indian Stocks Have A Positive Correlation With PPI, As Both Benefit From Global Growth The reason is that when inflation is sustainably high, meaningful monetary tightening ensues. Higher interest rates make it costlier to borrow for either consumption or investment purposes, and therefore depresses demand in the economy. That leads to a squeeze in profit margins, which in turn weighs on equity multiples and thus equity prices. Interestingly, unlike CPI, which has no stable correlation with Indian stock prices, PPI has a robust positive correlation with stocks. The link is via corporate earnings. Indian PPI tracks the ebbs and flows in global commodity prices, and therefore global growth. Strong global growth boosts all corporate earnings, including that of India. Accelerating PPI is therefore a harbinger of higher Indian earnings and stock prices. Going forward, however, a decelerating PPI is pointing to lower stock prices in India (Chart 13). Is RBI Making A Policy Mistake? India’s central bank seems to be committing a policy mistake by raising interest rates to suppress commodity price-driven inflation when domestic demand is already very weak. This is negative for the economy and share prices. Chart 14Household Consumption Is Quite Weak; Domestic Production Is Far Below Trend The Reserve Bank of India surprised the market last week by raising policy rates by 40 basis points to 4.4%. They also raised commercial banks’ cash reserve ratio by 50 basis points to 4.5% in order to tighten banking sector liquidity. Monetary tightening, as a policy tool, works by stifling domestic demand. It makes borrowing for the purpose of investments and consumption more costly. It is, however, rather ineffective in resolving inflation caused by higher food and fuel prices – as is the case in India presently. Notably, high commodity inflation itself forces consumers to spend a lower amount on other core items – leading to weaker demand for the latter. Further monetary tightening would exacerbate that weakness. As explained before, Indian consumer prices are driven mostly by domestic factors, such as money supply and productivity (Chart 3, above), rather than global commodity prices. This distinction is important given that the central bank’s mandate is to manage CPI, not PPI. As such, monetary policy should ideally be based on mostly domestic dynamics. India’s domestic demand is extremely soft compared to the US where inflation has skyrocketed. Given the massive negative output gap that opened up in the Indian economy during the pandemic-related lockdowns, it will take a while before this economy sees genuine, sustained overheating. In view of this softness, any meaningful hike in interest rates (say another 100 basis points) could have a material negative impact on the recovery, and by extension, on stock prices: Household consumption is quite weak − as is evident in local car and 2-wheeler sales (Chart 14, top panel). One reason for that is the subdued wage growth mentioned above. Pandemic-era fiscal stimulus, at less than 2% of GDP, has not been nearly enough to compensate for lost household income during the lockdowns. Consistent with lackluster household demand, manufacturing and other industrial productions are also languishing at far below the pre-pandemic trend (Chart 14, bottom panel). Robust capex is what spearheaded India’s post-pandemic recovery. But, now with decelerating corporate profits, capital investments have begun to slow. Higher costs of borrowing will further discourage capex plans. If so, lower investments will do more than shave off GDP growth in the coming quarters. If continued, this could be a major risk for India’s sustainable growth story, and its ill-effects may linger. Chart 15Higher Interest Rates Are A Headwind For Stock Prices All in all, given the nature of inflation in India in the current cycle, it will be a mistake to raise policy rates by any meaningful measure. Both consumption and investments will be hurt. Stock prices, which clearly benefit from lower interest rates, will be facing higher rates, and will therefore sell off (Chart 15). As such, it will be difficult for the RBI to continue to tighten monetary policy without causing a significant bear market in Indian stocks. Investment Conclusions Equities: The Indian profit outlook has deteriorated meaningfully as a result of falling margins and an impending growth slowdown. This bourse is also very expensive relative to its EM peers. Higher interest rates will add to the headwinds. Absolute return investors should avoid this market. Asset allocators should stay underweight in EM and Emerging Asian equity portfolios. Currency And Bonds: The Indian rupee could depreciate marginally along with a likely sell-off in Indian stocks. Given that higher interest rates will likely be detrimental to a growth recovery, it will discourage capital inflows, and will therefore be negative for the rupee. As the rupee could be weaker, and bond yields could rise marginally with tighter banking sector liquidity, investors should stay neutral on India in EM and Emerging Asian bond portfolios. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1 Also called ‘wholesale prices.’ 2 CPI for Fuel & Light has a 6.8% weight in the CPI basket. Transportation & Communication has 8.6% weight. 3 Edible oil has a weight of 3.6% in India’s CPI basket.
Executive Summary The Fed, Bank of England (BoE) and Reserve Bank of Australia all hiked rates last week. The BoE, however, signaled a note of caution on future UK growth, given soaring energy prices and plunging consumer and business confidence. Interest rate markets are pricing in a peak in UK policy rates over the next year near 2.5%, above realistic estimates of neutral that are more in the 1.5-2% range. UK productivity and potential growth remain too weak to support a higher neutral rate than that. With the BoE forecasting near recessionary conditions over the next couple of years if those market-implied rate hikes come to fruition, the time is right to increase exposure to UK government bonds in global fixed income portfolios. UK Rate Expectations Are Too High Bottom Line: Markets are overestimating how much additional tightening the Bank of England can deliver. We are upgrading our recommended strategic stance on UK Gilts from underweight (2 out of 5) to overweight (4 out of 5). Not All Central Bankers Can Credibly Restore Credibility Chart 1Developed Market Bond Yields Back To 2018 Highs Three more central bank meetings, three more rate hikes. Last week brought a 50bp hike from the Fed, a 25bp hike – the first of this tightening cycle – by the Reserve Bank of Australia (RBA) and a 25bp rate increase from the Bank of England (BoE). The Fed and RBA moves did little to stabilize the government bond bear markets in the US and Australia, but the BoE was able to provide a temporary reprieve for the Gilt selloff by playing up potential UK recession (stagflation?) risks. Bond yields worldwide remains laser focused on high global inflation and the associated monetary policy response that will be needed to stabilize inflation expectations (Chart 1). That includes both interest rate hikes and reducing the size of bloated central bank balance sheets. The threat of such “double tightening” is weighing on global growth expectations and risk asset valuations. The MSCI World equity index is down -6.4% (in USD terms) so far in the Q2/2022 and down -14.5% since the mid-November/2021 peak. Although in a more mitigated way, credit markets are also being impacted, with the Bloomberg Global High-Yield index down -2.6% so far in Q2 on an excess return basis versus government bonds. Rate hike expectations have started to catch up to elevated inflation expectations, at least according to inflation linked bonds. The yield on 10-year US TIPS now sits at +0.29%, a huge swing from the -1% level seen just one month ago (Chart 2). The 10-year real yield is even higher in Canada (+0.81%) where the Bank of Canada just delivered its own 50bp rate hike in April. On the other hand, 10-year real yields remain deeply below 0% in Europe and the UK, where central bankers have been providing less explicit guidance on future rate hikes and asset purchase reductions compared to the Fed or Bank of Canada. Interest rate markets remain reluctant to price in significantly positive real policy interest rates at the peak of the current tightening cycle. Our proxy for the real terminal rate expectation, the 5-year/5-year overnight index swap rate (OIS) minus the 5-year/5-year CPI swap rate, is only +0.18% in the US. It is still deeply negative in Europe (-1.53%) and the UK (-0.97%). Our estimates of the term premium component of 10-year government bond yields in those three markets is rising alongside interest rate expectations yet remains deeply negative in Europe and the UK (Chart 3). Chart 2Real Rate Divergences In The Face Of A Global Inflation Shock Chart 3Markets Still Pricing In Structurally Low Rates Of those three major bond markets, we see the UK term premium as being the least likely to see additional upward repricing, with the BoE less likely than the Fed or ECB to push for an aggressively smaller balance sheet given domestic economic risks. UK Rate Expectations Are Too Hawkish Chart 4Our BoE Monitor Justifies Recent Tightening Moves The Bank of England raised rates by 25bps last week, pushing Bank Rate to a 13-year high of 1.0%. The decision was a 6-3 majority, with three Monetary Policy Committee (MPC) members calling for a 50bp hike – matching recent moves by other G-10 central banks like the Fed and Bank of Canada – given tight UK capacity constraints (i.e. low unemployment) and high realized inflation. The MPC noted that additional rate increases would likely be necessary to tame very high UK inflation, a message confirmed by the elevated level of our UK Central Bank Monitor (Chart 4). However, the new economic forecasts presented by the BoE painted a gloomy picture on UK growth, raising the risks of a recession even as UK inflation is expected to continue climbing to a 10% peak in late 2022 on the back of high energy prices.1 Strictly looking at current inflation, the case for the BoE to continue hiking rates is obvious. Yet the BoE may now be placing more weight on the downside risks to growth from the energy shock, at a time when fiscal tightening is no longer providing stimulus. In the press conference following last week’s MPC meeting, BoE Governor Andrew Bailey noted the difficult situation policymakers are facing given the huge surge in energy prices that is fueling inflation while also weighing on household and business real incomes. So what is “neutral” anyway? Related Report Global Fixed Income StrategyThe UK Leads The Way The BoE is one of the least transparent major central banks when it comes to providing guidance on what it thinks the neutral policy rate is. Market participants are left to arrive at their own conclusions and those can vary substantially, as is currently the case. The UK OIS curve is discounting a peak in rates of 2.72% in 2023 and discounting rate cuts after that starting in 2024. Yet the respondents to the BoE’s new Market Participants Survey are calling for a much lower trajectory with rates peaking at 1.75% before falling to 1.5% in 2024 (Chart 5). Those rate levels are in the lower half of the range of longer-run neutral rate estimates from the same Market Participants Survey, between 1.5% and 2.0% (the shaded box in the chart). Chart 5UK Rate Expectations Are Too High Chart 6Recessionary BoE Forecasts, Except For GDP Combining the messages from the OIS curve and the Survey, markets are pricing in a path for the BoE Bank Rate that will become restrictive by mid-2023, with another 172bps of rate hikes. The BoE uses market pricing for future interest rates in its economic forecasts. The Bank’s models suggest that a move to raise rates to 2.5% in response to high UK inflation, as markets are discounting, would result in a severe UK downturn that would both push up unemployment from the current 3.7% to 5.4% by Q2/2025 (Chart 6). Headline inflation would plunge to 1.3% over the same period as the UK output gap widens to -2.25% of GDP from the current “excess demand” level of +0.5%. Oddly enough, the BoE is only forecasting a flat profile for real GDP growth over that entire three-year forecasting period, although there will clearly be some negative GDP prints during that period to generate such a massively disinflationary outcome. A mixed picture on UK growth Currently, the UK economy is flashing some warning signs on growth momentum. The UK manufacturing PMI was 55.8 in April, still well above the 50 level indicating growth but 9.8 pts below the cyclical peak in 2021 (Chart 7). The services PMI is in better shape at 58.9, but it did dip lower in the latest reading. The GfK consumer confidence index has fallen sharply in response to contacting real household income growth, reaching the second-lowest reading in the history of the series dating back to 1974 in April. This is a warning sign for consumer spending – retail sales fell in April for the first time in fifteen months (middle panel). Business confidence is also impacted by the high costs of both energy and labor that is squeezing profit margins. UK real investment spending is nearly contracting on a year-over-year basis, despite the robust readings on investment intentions from the BoEs’ Agents Survey of UK businesses (bottom panel).UK firms are facing higher wage costs at a time of very tight labor market and robust labor demand. The BoE estimates that UK private sector wage growth, after adjusting for compositional effects related to the pandemic, will accelerate to 5.1% by the end of Q2/2022 (Chart 8). Chart 7UK Growth Facing Inflationary Headwinds Chart 8UK Labor Market Remains Healthy Chart 9Will House Prices Signal The Peak In UK Inflation? A robust labor market and quickening wage growth is forcing the BoE to maintain a relatively hawkish bias at a time of high energy inflation, even with the growth outlook darkening in the central bank’s own forecasts. Booming house prices are also making the central bank’s job more challenging. The annual growth rate of the Nationwide UK house price index reached 12.4%, a 17-year high, in March. However, rising mortgage rates and declining household real incomes will likely begin to eat into housing demand and, eventually, help slow the rapid pace of house price growth (Chart 9, bottom panel). Summing it all up, the overall UK inflation picture, including wages and housing costs in addition to energy prices and durable goods prices, will force the BoE to deliver a few more rate hikes before year-end before reaching a peak level that is lower than current market pricing. The neutral UK interest rate is likely very low Chart 10Structurally Weak UK Growth = A Low Neutral Rate The UK economy has suffered from structurally low potential economic growth dating back to the Brexit referendum in 2016. UK businesses stopped investing in the face of the uncertainty over the UK’s relationship with Europe. There has basically been no growth in UK fixed investment over the past five years. In response, UK productivity has only grown an annualized 0.9% over that same period (Chart 10) and the OECD’s estimate of UK potential GDP growth has been cut from 2% to 1.1%. With such low potential growth, the neutral BoE policy interest rate is likely even lower than the 1.5-2% range of estimates from the BoE’s Market Participant Survey. Tighter fiscal policy also lowers the neutral UK interest rate, with the UK Office of Budget Responsibility forecasting a narrowing of the UK budget deficit of -13.6 percentage points between the 2021 peak and 2027 (bottom panel). A flat UK Gilt curve is also a sign that the neutral interest rate is quite low. The 2-year/10-year Gilt curve now sits at a mere -49bps with Bank Rate only at 1% (Chart 11). While this is modestly steeper from the near-inversion of the curve seen at the start of 2022, a very flat curve at a nominal policy rate of only 1% suggests that the neutral rate is not far from the current level. Sluggish UK equity market performance and widening UK corporate credit spreads also argue that Bank Rate may already be turning restrictive, although a lower trade-weighted pound is helping to mitigate the overall tightening of UK financial conditions. Chart 11UK Financial Conditions Are Not Restrictive (Yet) Chart 12Pressure On The BoE Will Not Peak Until Inflation Does In the end, the pressure on the BoE to tighten will not ease until UK inflation peaks. The BoE is suffering a severe credibility crisis, with its own public opinion survey showing the deepest level of public dissatisfaction with the bank since the Global Financial Crisis (Chart 12). Inflation expectations are at similar levels that prevailed during that period, although the unique nature of the current inflation upturn, fueled by global supply-chain squeezes and war-related boosts to commodity prices, will likely prevent a repeat of the relatively fast reversal of inflation expectations seen after the Global Financial Crisis. Investment Implications – Get Ready For Gilt Outperformance Chart 13Upgrade UK Gilts To Overweight With the BoE already pushing Bank Rate towards a plausible neutral range, we do not expect many more rate hikes in the UK. Our base case is that the BoE hikes 2-3 more times by year-end, pushing Bank Rate to 1.5-1.75%, before pausing. This would represent a lower peak in policy rates than currently priced in the UK OIS curve. That is a relatively dovish outcome that typically leads to positive performance for a government bond market according to our “Global Golden Rule” framework, which we will revisit in next week’s Strategy Report. For now, however, we see a strong case to turn more positive on UK Gilts, with the BoE likely to deliver fewer rate hikes than discounted (Chart 13). The BoE is also far less likely to begin reducing its balance sheet by selling its Gilt holdings back to the market. BoE Governor Bailey strongly hinted last week that such aggressive quantitative tightening (QT) was not a given, even after the Bank research staff presents its proposals to the MPC in August. A delay in QT would also be a factor boosting UK Gilt performance versus other developed economy bond markets where more aggressive reductions in central bank balance sheets are more likely, like the US and potentially even the euro area. This week, we are upgrading our recommended strategic UK weighting from underweight to overweight. In next week’s report, we will consider the proper allocation for the UK within our model bond portfolio, after reviewing potential bond return forecasts stemming from our Global Golden Rule. Bottom Line: Markets are overestimating how much additional tightening the Bank of England can deliver. We are upgrading our recommended strategic stance on UK Gilts from underweight (2 out of 5) to overweight (4 out of 5). Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The mechanical way that the UK government’s energy price regulator, Ofgem, sets price caps on retail gas and electricity costs - based on changes in wholesale energy costs implied by futures curves – means that UK household energy prices will rise by 40% in October, according to BoE estimates. GFIS Model Bond Portfolio Recommended Positioning Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Tactical Overlay Trades