Economy

Special Report

Highlights So What? Ongoing reforms will drag on China's policy easing measures. Why? Xi Jinping is not abandoning his "Three Tough Battles" against leverage, pollution, and poverty. China is striving to contain leverage, despite the shift of rhetoric away from deleveraging. China's anti-pollution targets have eased, but in a pragmatic way. Barring a sharp economic deceleration, China's stimulus measures will be about stability rather than reacceleration. Feature China's leader Xi Jinping has clearly focused on two systemic risks: leverage and pollution (Table 1). Xi redoubled his efforts to address these risks in 2017 when he launched the "Three Tough Battles" against financial systemic risk, pollution, and poverty that will last through 2020. In this Special Report we provide a "status update" on the three battles, particularly the anti-pollution campaign. Investors should not mistake China's policy easing for a wholesale reversal of reform in order to stimulate growth. Today's policy environment and response is different from what investors are familiar with, which is large-scale fiscal and credit injections that pump up infrastructure and property construction and materially reaccelerate global and Chinese demand. Table 1Central Government Spending Preferences (Under Leader's Immediate Control) The First Battle: Financial Systemic Risk First, a word about financial systemic risk, which is of the utmost importance to China's economic trajectory, the global investment outlook, and Xi Jinping's other two policy battles. We have now had two months of full data - August and September - since China's top leaders announced in late July that they would ease economic policy. The data show that there has not been a major acceleration in total private credit growth. This is based on the adjusted total social financing measure used by BCA's China Investment Strategy, which now includes the special purpose bonds that local governments have been issuing rapidly in response to central government demands to ease policy (Chart 1). Chart 1No Credit Spike ... Yet We also closely watch China's money supply. Monetary impulses are bottoming and the M2 impulse is now positive (Chart 2). This is a marginal positive for both the Chinese and global economic outlook in 2019, though it is at odds with China's credit impulse. Chart 2Money And Credit Impulses At Odds While bank loan growth remains steady, informal lending growth is starting to pick up (Chart 3). This could herald a relaxation of controls on shadow banking, although that is by no means clear yet. Chart 3Shadow Banking Crackdown Is Easing Fiscal spending is also becoming more proactive, as is apparent from the spike in local government bond issuance (Chart 4). However, these new bonds hardly make a dent in the total credit picture, as shown in Chart 1 above. Chart 4Fiscal Policy Becomes More Proactive We expect China to stimulate more if internal or external conditions worsen. That looks likely, as we also have a structurally bearish view of the U.S.-China relationship. The trade war could prompt the U.S. to extend tariffs to all Chinese imports at the 25% rate that will apply to $200 billion worth of imports as of January 1, 2019. To be prudent, investors need to be prepared for even a 45% tariff rate on all Chinese imports, as President Trump first threatened on the campaign trail. People's Bank of China Governor Yi Gang has recently implied that benchmark interest rates could be cut if necessary, in addition to further cuts to the required reserve ratio. These measures would have the additional effect of weakening CNY/USD, which could also be stimulative for China, but may first disrupt emerging markets and worsen the trade war. The foregoing data reveal that, while the government has clearly toned down its rhetoric about deleveraging, it continues to try to contain the rise in leverage. China's administration - in contrast to many bullish investors - views leverage as a form of systemic risk. The top leaders perceive that excess leverage is bad for productivity. It delays China's adjustment to a more sustainable, consumer-driven economic model. And it exacerbates quality-of-life problems that could lead to socio-political instability, such as land appropriation and environmental degradation. China's economy can only reaccelerate sharply if Xi Jinping and his deputies - namely his top economic adviser Liu He and also Guo Shuqing, the party secretary of the PBOC - throw in the towel and allow total credit to skyrocket. President Xi is pragmatic and ultimately may have to do this - if conditions get bad enough. But for now, the pace of deceleration is not so quick that throwing in the towel is warranted. Furthermore, the trade war provides Xi with ample domestic political "coverage" to blame the U.S. for any economic pain incurred while pursuing badly needed domestic restructuring. Bottom Line: The Chinese administration wants to contain leverage, and this policy imperative will not easily waver. Data shows that the policy shifts announced in July were indeed evidence of "fine-tuning" rather than wholesale stimulus. The U.S. trade war provides the Xi administration with a scapegoat to absorb public anger when the pain of long-needed economic adjustments sets in. We remain data-dependent and will alter our global asset allocation recommendation - long DM / short EM - if evidence of a wholesale policy shift occurs. The Second Battle: Pollution What about Xi's second battle, the anti-pollution campaign? Is China already throwing out its new environmental regulations in order to stimulate growth? No, but it is compromising them for the sake of stability. Chart 5China Is Resource Intensive China's rapid rise from an agrarian society to an industrial power came at a devastating environmental cost. The heavy resource intensity of its economy (Chart 5) translates to extremely high pollution levels (Chart 6). Chart 6A Highly Polluting Economy To some extent, this is a natural phase of development. The "environmental Kuznets curve" hypothesizes that as economies industrialize they become increasingly polluting - and yet at a certain level of income the relationship reverses and economic growth becomes associated with environmental improvement (Diagram 1).1 Diagram 1The 'Environmental Kuznets Curve' Applies To Air Pollution Chart 7China Following In The Footsteps Of Less Resource-Intensive Neighbors As China transitions to a services-led economy, its appetite for commodities will slow. This is what happened in the advanced economies - and China is already on this path (Chart 7). The transition points away from export-manufacturing, which means that the share of electricity consumed by the industrial sector - currently disproportionately large - will ease (Chart 8). Chart 8Manufacturing Intensity Will Moderate Chart 9Reliance On Coal Power Will Fall China's consumption of coal, on which it depends very heavily (Chart 9), will continue to fall as a share of total energy consumption. And coal is significantly more polluting than other forms of energy (Table 2). Table 2Natural Gas Emits Less Carbon Already, growth in the service sector - the so-called tertiary industries - now outpaces manufacturing growth and accounts for more than half of Chinese GDP (Chart 10). Chart 10Rising Service Sector Means Less Pollution However, the pace of change is too slow for the Chinese public, which has been suffering from the health-related costs of rapid industrialization. The World Health Organization reports that in 2016, over a million deaths in China were attributed to ambient air pollution.2 Chart 11There Is A Reason Xi Jinping Cracked Down On Corruption And Pollution The Pew Research Center finds that 76% of survey respondents would classify air pollution as a "big problem," and nearly half of which a "very big problem" (Chart 11). On top of that, a 2016 survey shows that the Chinese public favors clean air over industry if forced to make a tradeoff (Chart 12). Chart 12The Public Understands The Tradeoff To prevent public discontent from boiling over, China launched a sweeping effort to restrain pollution when Xi Jinping took power in 2012-13 - particularly after the appallingly smoggy winter of 2013, known as "airpocalypse." Chart 13Air Pollution Is Trending Downwards These measures have broadly been effective. Readings of China's preferred measure of air pollution - PM2.5 concentration3 - have fallen steadily (Chart 13). The goals were achieved by means of overcapacity cuts in the coal and steel sectors - including shutting down low-quality steel plants - and replacing coal with cleaner forms of energy, particularly natural gas (Chart 14). Chart 14Coal Reliance Is Declining However, pollution is a structural challenge, not one that can be solved in a single five-year plan. Though PM2.5 emissions have fallen by 35% in 2017 compared to 2012, the current concentration of 47.3 µm/m3 remains well above China's national standard for maximum annual average exposure of 35 µm/m3. China's standards are also lax relative to international peers. The World Health Organization recommends a much lower annual mean for the concentration level at 10 µm/m3. Furthermore, air pollution is not equally concentrated throughout the country. The industrialized north is significantly more polluted than the rest of the country (Map 1). The provinces of Shanxi and Shaanxi saw PM2.5 levels rise from 2015-17, reaching the highest alert levels. Map 1China's Air Pollution By Province As a result, the Xi administration has doubled down on its anti-pollution goals. The 13th Five Year Plan, covering 2016-20, was the first national economic blueprint to include air pollution targets. It got off to a rocky start because China had to stimulate the economy aggressively in 2015-16 to fend off a destabilizing slowdown. Pumping credit and fiscal spending into the industrial economy led to a rebound in high-polluting activity (Chart 15). Yet, as mentioned, when Xi consolidated power in 2017, he elevated the war on pollution to the "second battle" of the three battles. Chart 15Excess Credit Means Excess Pollution Pursuant to this 2018-20 framework, the latest action plan for air pollution reinforces the targets of the Five Year Plan and its 2020 deadline: The plan applies to all cities of prefectural or higher level, and thus expands the government's actions beyond the major cities in the Beijing-Tianjin-Hebei, Yangtze River Delta, and Pearl River Delta areas. Furthermore, the Pearl River Delta is no longer one of the key regions, having made substantive progress. It has been replaced by the Fen-Wei Plains, which include Xi'an and parts of Shaanxi, Henan, and Shanxi provinces. These provinces rely on coal for energy and contain polluting industries. PM2.5 levels must fall by at least 18% from 2015 baseline levels in cities of prefectural or higher level and anywhere else where standards have not been met. Targets for reducing volatile organic compounds (VOC) and nitrogen oxide emissions are set to 10% and 15%, respectively, by the end of the period. The number of good-air days should reach 80 percent annually and the percentage of heavily polluted days should decrease by more than 25 percent from 2015 levels. The new air pollution goals are not as aggressive as those of the 2012-17 plan. For instance, the 18% cut in PM2.5 levels is less than the maximum 25% cut in the previous plan. However, the new goals are more precise and targeted. Rather than impose further declines in regions where air pollution has been successfully reduced, the plan aims to prevent heavy industries from migrating to other parts of China to evade environmental restrictions. After all, many of China's coal producers are located in the Fen-Wei Plains, which will no longer escape the regulator's eye (Chart 16). Chart 16The Fen-Wei Plain Now Under Scrutiny What is the market implication of the above? In our view, some market participants have misread the new anti-pollution targets as a form of economic stimulus because they are less aggressive than those of the previous five years. While it is true that China faces a tradeoff between clean air and economic growth (Chart 17), the regulatory easing looks like an attempt to make the anti-pollution goals more realistic and achievable rather than abandoning the overarching anti-pollution push (see Box 1). In net terms, China is still tightening regulation. Chart 17Heavy Industrial Model Drives Pollution Box 1 Easing Up On winter Curbs? China has recently relied on heavy industry production curbs to limit pollution during the especially smog-prone winter months. The 2017-18 season saw the first of these wintertime cuts. Production in highly polluting industries such as coal, aluminum, and steel was slashed by up to 50% in 28 northern cities between mid-November 2017 and mid-March 2018. As a result, fine particle emissions fell. The year-on-year change in emissions peaked with the start of the cuts and troughed with their end, falling by an average 18% y/y over the period (Chart 18). Chart 18Last Winter's Anti-Pollution Crackdown Cuts will continue this winter, in theory limiting steel and aluminum production as well as coal consumption. However, the impact looks to be less dramatic this time around: While the August draft plan reportedly set PM2.5 reduction targets at 5% y/y for the 2018-19 winter, the final plan, released by the newly formed Ministry of Ecology and Environment, set a less ambitious objective of a 3% reduction in emissions. Blanket production cuts are being replaced by more flexible measures that will be overseen by local governments. Central government inspection teams will be dispatched less frequently. The new changes reflect the fact that Chinese policymakers are fine-tuning their policies to minimize the negative impact on industry as well as households that use coal-fired heating: The revision of emissions cuts from 5% in the August draft to 3% in the final plan reflects a more realistic cut than the 15% cut last year. But it is still a cut. The scrapping of blanket measures, in favor of more flexible cuts determined by regional emissions levels, will avoid penalizing producers who have already abided by the targets. It will also reward producers who have upgraded their facilities to be more eco-friendly. While year-on-year changes in emissions fell in northern China last winter, they spiked in the rest of the country, as economic agents shifted to areas not covered by the new rules. The same pattern emerged in the steel industry: steel production cuts in northern China were offset by a ramp-up in steel production from other regions (Chart 19). The newest plan expands the coverage of the regulations even as its demands are less draconian. Chart 19Polluters Know How To Evade Controls Last winter, local governments frantically shut down coal usage in order to meet strict 2017 deadlines for the plan to convert 20 million rural households from coal-heating to gas-heating by 2020. However, natural gas supplies could not pick up the slack - storage capacity, LNG import capacity, internal distribution, Central Asian imports, and bureaucratic coordination all fell short.4 Millions of households lost heating during the winter months, the authorities were forced to backtrack and allow coal imports, and a massive public backlash ensued. It is not surprising, then, that the government is compromising its coal-to-gas requirements for the coming winter.5 While the gas crunch is not expected to be as bad this winter, the underlying problems with natural gas storage, import, or distribution problems remain unresolved. So it makes sense for Beijing to give local governments more flexibility. A total conversion to natural gas heating is still supposed to be accomplished by 2020 in the Beijing-Tianjin-Hebei region as well as in Shanxi and Shaanxi.6 The goal post may be moved but policies will still push in this direction. Ultimately, pollution is a cross-regional phenomenon - and it has proven to generate significant political opposition movements over time. Many developed nations have gone through a period of political upheaval sparked by popular backlash against the excesses of industrialization - including pollution.7 China does not have voters who can vote on environmental demands, but it greatly fears the political ramifications of widespread protests due to unbearable living and health conditions. As with the anti-corruption and anti-leverage campaigns, the Xi administration is trying to catch up to the magnitude of the problem and mitigate it before something snaps and triggers a general uproar. Bottom Line: China has pared back its emissions cuts for 2018-20 and softened its pollution curbs for the winter. These actions are less negative for economic growth than earlier curbs and proposals would have been. However, they still amount to a net increase in China's environmental regulation, which is in keeping with Xi Jinping's overarching policy priorities. The Third Battle: Poverty Poverty rates have collapsed in China since its opening up and reform in 1979. Xi's third battle is to eliminate rural poverty by 2020. This is the only battle of the three that is growth-enhancing rather than growth-constraining. It lifts China's growth by transferring government funds to the poorest citizens, who have the highest propensity to consume. At the average rate of rural poverty reduction over the past several years, there will still be around 11-12 million rural poor by the end of 2020 (Chart 20). Thus China will have to spend more to meet the target, creating a net increase in fiscal spending. Chart 20Anti-Poverty Campaign Requires Spending The war on poverty underscores a constraint on the previous two battles: growth and stability. Financial and environmental regulation cannot be imposed so aggressively as to lead to a sharp drop in growth or employment. This is China's "Socialist Put" - and it remains in place despite the fact that the government has a higher threshold for economic pain since 2017. While Xi has signaled that China will do away with annual GDP growth targets, he has not discarded them immediately. The leadership is still bound by the economic targets due in 2020 - the doubling of GDP from 2010 levels and the doubling of rural and urban incomes (Chart 21). Chart 21Stimulus Necessary If 2020-21 Goals In Jeopardy These targets are especially important because they more or less coincide with the "centenary goal" of making China a "moderately prosperous society" by 2021. The latter year will mark the 100th anniversary of the Communist Party; the administration will want to make sure that the economy is in good shape. The Chinese leadership takes its two centenary goals (2021 and 2049) seriously.8 As long as headline GDP growth does not fall too far below the average of 6.5% per year in 2018-20, the first centenary goals will be met. New tax cuts worth an estimated 1% of GDP, and other targeted measures, will help reach the goal for urban income, which is the one most at risk. If these goals look to be met, China can save its biggest stimulus measures for later. In recent years, China's economic "mini-cycles" have lasted about 1.4-to-2 years, from the trough of the total credit impulse to the peak of nominal GDP (Chart 22). If China launches a large-scale stimulus now, peak output will occur in 2020 and the economy will be decelerating into 2021. This would be bad timing for the centenary. It would make more sense for China to save some dry powder for 2019 or 2020 to ensure a positive economic backdrop in 2021. Chart 22Economy Peaks Two Years Post-Stimulus Bottom Line: We would need to see a much bigger shock to the economy than is currently in the offing for Xi to abandon his reform agenda for a traditional fiscal-and-credit splurge that exacerbates the credit bubble, fires up overbuilt industries, and annihilates all the hard work of his recent financial and environmental regulations. Investment Conclusions The above findings suggest that coal prices can rise in the near term.Demand will be supported by more flexibility on pollution curbs, while supply will be constrained by the ongoing supply-side cuts in coal production. Steel prices may fall, as production will rise amid less stringent environmental rules. More broadly, however, investors should understand what the recent tactical "easing" measures suggest about China's policy settings overall. China's political system is a system of single-party rule, in which the Communist Party explicitly rejects the legitimacy of "checks and balances" or political liberalism. However, the government cannot do whatever it wants. Its authoritarian model still requires it to address public pressure and maintain general popular approval - otherwise it would lose legitimacy and ultimately power. For the past four decades, the Communist Party has maintained legitimacy by providing economic growth and rising incomes - and these are still essential. But as the economy matures and growth rates naturally fall, it becomes more important to re-establish the party's legitimacy on improving quality of life. Xi Jinping made this point official in his address to the nineteenth National Party Congress last October, but it has driven his administration since 2012.9 The Communist Party is flush with tax revenues and maintains absolute control over government branches, banks, key corporations, security forces, and most forms of civil association. With these tools it can, for the most part, maintain its rule against regional or topical challenges. What it fears are systemic risks - challenges to its authority that span ideological, ethnic, class, or regional divides. Here the government is behind the curve, as quality of life has been entirely neglected during the country's high-growth phase of economic development. Thus Xi has tried to make up for lost time and tackle the most flagrant quality-of-life concerns. His anti-corruption campaign, for instance, sought to address the chief source of public discontent from the moment he came into office - as well as to recentralize power into his own hands so that he could tackle the other major grievances with zero resistance from the party or state bureaucracy. Now his top priorities are leverage and pollution, both of which pose systemic risks and hence the forthcoming improvement in fiscal and credit indicators will not proceed unchecked. Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com 1 There is a large body of literature on the Environmental Kuznets Curve; the important point for this study is that it holds up well to empirical scrutiny when it comes to modeling air pollution concentrations. Please see David I. Stern, "The Environmental Kuznets Curve After 25 Years," Australian National University, CCEP Working Paper 1514 (December 2015), available at ageconsearch.umn.edu. 2 The death rate attributable to ambient air pollution is 81 per 100,000 people, which places China among the most dangerously polluted countries, alongside North Korea, Russia, and several developing eastern European countries. Please see the WHO's Global Health Observatory data repository, available at www.who.int/gho/en. 3 PM2.5 is a general term for particles and liquid droplets in the atmosphere with aerodynamic diameters less than or equal to 2.5 microns (µm). Short- or long-term exposure to these particles has been found to lead to adverse cardiovascular effects such as heart attacks and strokes. 4 Please see David Sandalow, Akos Losz, and Sheng Yan, "A Natural Gas Giant Awakens: China's Quest for Blue Skies Shapes Global Markets," Columbia Center on Global Energy Policy, July 27, 2018. 5 Please see Yujing Liu, "China scrambles to avoid a repeat of last winter's botched coal-to-gas conversion programme in highly polluting northern rural areas," SCMP, September 24, 2018, available at www.scmp.com. 6 Please see "China coal city vows 'no-coal zones' in bid to curb pollution," Reuters, October 11, 2018, available at reuters.com. 7 The Great London Smog of 1952 is a classic example, but for a detailed study please see Russell J. Dalton and Manfred Kuechler, Challenging the Political Order: New Social and Political Movements in Western Democracies (Cambridge: Polity, 1990). 8 The first goal is to create a "moderately prosperous society in all respects," namely by doubling real GDP and rural and urban per capita income from 2010 levels by 2020. The second goal is to make China into a "modern socialist country that is prosperous, strong, democratic, culturally advanced, and harmonious," with the GDP per capita of a moderately developed country at around $55,000 in 2014 dollars. Please see "CPC Q&A: What are China's two centennial goals and why do they matter?" Xinhua, October 17, 2017, available at www.xinhuanet.com. 9 Xi, in his work report at the party congress in 2017, said, "what we now face is the contradiction between unbalanced and inadequate development and the people's ever-growing needs for a better life." This is a new formulation of the "principal contradiction" facing Chinese society, by contrast with the earlier formulation, which emphasized "the ever-growing material and cultural needs of the people and the low level of social production," according to former President Hu Jintao in 2007.

Highlights Duration: Foreign economic growth continues to diverge negatively from growth in the United States. The resulting upward pressure on the U.S. dollar will eventually drag U.S. growth down, and could temporarily threaten the cyclical uptrend in Treasury yields. But so far there is no evidence that dollar strength is too much for the U.S. economy to handle. Investors should maintain below-benchmark duration until signs of contagion are more apparent. Yield Curve: A reading of the macro drivers of the yield curve suggests that the slope of the curve will not steepen or flatten dramatically during the next 6-12 months. In this environment, trades that are long the belly of the curve and short a duration-matched barbell consisting of the short and long ends will profit, due to extremely attractive valuation. We currently recommend going long the 7-year bullet and short the 1/20 barbell. Feature If investors were already worried about the impact of restrictive Fed policy on credit spreads and equities, the minutes from September's FOMC meeting - released last Wednesday - did nothing to calm their nerves. The minutes revealed that "a few participants expected that policy would need to become modestly restrictive for a time" while an additional "number" of participants "judged that it would be necessary to temporarily raise the federal funds rate above their assessments of its longer-run level." There is a small distinction between the "few" participants who expect that a fed funds rate above the estimated longer-run neutral level of 3% will be necessary because restrictive monetary policy will be warranted and the "number" of participants who think that the fed funds rate will move above 3% without policy turning restrictive. However, the main takeaway for investors should be that a large portion of the committee expects that rate hikes will continue until the fed funds rate is at least above 3%. In last week's report we explored the risk that higher yields lead to an excessive tightening of financial conditions and actually sow the seeds of their own decline.1 But we do not view that as the greatest threat to our recommended below-benchmark portfolio duration stance. The biggest risk to that view comes from the ongoing divergence between strong U.S. and weak foreign economic growth. No Contagion... Yet Chart 1 shows that, since 1993, every time our Global (ex. U.S.) Leading Economic Indicator (LEI) has fallen below zero, the U.S. LEI has eventually followed. But while the Global (ex. U.S.) LEI has now been below zero for nine consecutive months, there is so far no evidence of contagion into the United States. The resilience of the U.S. economy probably explains why the September FOMC minutes only briefly mentioned the risk from weak foreign growth. Chart 1U.S. And Foreign Growth Continue To Diverge From the minutes:2 The divergence between domestic and foreign economic growth prospects and monetary policies was cited as presenting a downside risk because of the potential for further strengthening of the U.S. dollar... But: Participants generally agreed that risks to the outlook appeared roughly balanced. The concern is that, much like in the 2014-16 period, the divergence in growth between the U.S. and the rest of the world puts so much upward pressure on the dollar that it eventually drags U.S. growth and bond yields lower. But despite this year's 4.6% appreciation in the trade-weighted dollar, we have yet to see any impact on our Fed Monitor and Treasury yields remain in an uptrend (Chart 2). This suggests that we have not yet reached peak divergence between U.S. and foreign growth. Further divergence and dollar strength is necessary before the U.S. economy is negatively impacted. Chart 2More $ Strength Required The reason why the dollar's recent appreciation has not yet exerted a discernible impact on the U.S. economy might be because overall global GDP growth is on a more solid footing than it was in 2014-16 (Chart 3). The IMF forecasts that global GDP growth will be 3.7% in 2018 and 2019, compared to 3.5% in 2015. Meanwhile, the moderation in Eurozone growth represents a decline from lofty 2017 GDP growth of 2.4%. Even in emerging markets, where the global growth slowdown is most apparent, the IMF is still forecasting GDP growth of 4.7% for both 2018 and 2019, a far cry from the 4.3% seen in 2015 (Chart 3, bottom panel). Chart 3Global Growth Stronger Than 2014-16 Of course, IMF forecasts can always change, and they likely will be revised lower if current trends continue. However, the key point for bond investors is that the global economy is in much better shape than it was between 2014 and 2016. This means that non-U.S. growth needs to see further significant weakness before the uptrend in U.S. Treasury yields is threatened. Bottom Line: Foreign economic growth continues to diverge negatively from growth in the United States. The resulting upward pressure on the U.S. dollar will eventually drag U.S. growth down, and could temporarily threaten the cyclical uptrend in Treasury yields. But so far there is no evidence that dollar strength is too much for the U.S. economy to handle. Investors should maintain below-benchmark duration until signs of contagion are more apparent. Can Uncertainty Steepen The Yield Curve? The yield curve has steepened somewhat during the past few weeks, the result of much higher yields at the long-end of the curve and short-end yields that have been roughly unchanged. We think Fed communication has been an important catalyst for this curve action. Specifically, the Fed's deliberate attempt to introduce uncertainty around its estimates of the neutral fed funds rate.3 Bond investors are finally getting the message that the Fed's median forecast of a 3% longer-run fed funds rate is not written in stone. Depending on the economic outlook, the funds rate could peak for the cycle at a level that is well above or below 3%. Given the recent spate of strong U.S. economic data, the market is starting to discount a peak that is above 3%, no matter what median forecast appears in the Fed's dots. This raises the question of whether a further un-anchoring of long-dated yields could occur. Is it possible that the yield curve will continue to steepen, even with the Fed lifting short rates at a gradual pace of 25 basis points per quarter? Below, we review a few different macro drivers of the yield curve and conclude that neither a large steepening nor large flattening is likely during the next 6-12 months. Nominal GDP Growth One useful rule-of-thumb for when monetary policy turns restrictive is when the 10-year Treasury yield exceeds the rate of growth in nominal GDP. In the past, a 10-year yield above the rate of growth in nominal GDP has coincided with downward pressure on core inflation (Chart 4). With that in mind, we note that nominal GDP has grown by 5.44% during the past year, by 3.98% (annualized) during the past two years and by 3.85% (annualized) during the past three years. Chart 410-Year Yield & Nominal GDP We discount the recent 5.44% growth rate because it was largely fueled by fiscal thrust that will fade in the coming quarters. This leaves us with a recent trend of 3.85% - 4% in nominal GDP growth. Even with no further deterioration in growth as the cycle matures, this puts an approximate cap on how high long-dated yields can rise before policy becomes restrictive and the cycle starts to turn. With the 10-year Treasury yield already at 3.19%, it can rise by between 66 bps and 81 bps before it reaches that range. If that adjustment were to occur very quickly, then the yield curve would steepen sharply and then re-flatten as the Fed lifted rates to catch up with the long end. Alternatively, if that adjustment were to occur over a period of 6-9 months, with the Fed hiking at a pace of 25 bps per quarter, the slope of the yield curve would be roughly unchanged. Wage Growth While nominal GDP growth is useful for thinking about long-maturity yields, wage growth correlates quite strongly with the slope of the yield curve itself. Specifically, rapid wage gains tend to coincide with curve flattening, and vice-versa. In fact, a typical cyclical pattern is that first the yield curve flattens and then wage growth accelerates to catch up with the curve (Chart 5). It would be highly unusual for the yield curve to steepen significantly while wage growth is rising, which it finally appears to be doing. Chart 5Higher Wage Growth = Flatter Curve We cannot completely rule out the possibility that stronger productivity growth actually causes unit labor costs to decelerate even as "top line" wage pressures mount. Unit labor costs are essentially the ratio of wages (compensation per hour) to productivity (output-per-hour), and the bottom panel of Chart 5 shows that a deceleration in unit labor costs could cause the yield curve to steepen. However, we note that there is not much precedent for strong productivity growth overwhelming an acceleration in wages, causing unit labor costs to diverge from other wage measures. For example, even as productivity growth strengthened in the 1990s, unit labor costs continued to rise alongside other measures of wage growth. Inflation Expectations We have frequently noted that inflation expectations embedded in long-dated Treasury yields remain too low compared to levels that are consistent with inflation being well-anchored around the Fed's 2% target. It stands to reason that long-maturity TIPS breakeven inflation rates could steepen the yield curve as they adjust higher. However, the 10-year TIPS breakeven inflation rate is currently 2.11%, only slightly below the range of 2.3% to 2.5% that has historically been consistent with well-anchored inflation expectations (Chart 6). In other words, the upside in long-dated breakevens is now fairly limited. In contrast, the 2-year TIPS breakeven inflation rate stands at only 1.70%, still considerably below "well-anchored" levels (Chart 6, bottom panel). Chart 6More Upside In Short-Dated Breakevens Further, since the financial crisis, breakevens at both the short- and long-ends of the curve have been driven by trends in the actual inflation data (Chart 7). If it is rising realized inflation that has driven both the 2-year and 10-year TIPS breakeven inflation rates higher this cycle, and the 2-year rate is further away from target than the 10-year rate, then it stands to reason that inflation expectations are more likely to exert flattening pressure on the nominal yield curve than steepening pressure. Chart 7Realized Inflation Is Driving Expectations Rate Volatility & The Term Premium One final macro driver that could steepen the yield curve would be a spike in interest rate volatility and an increase in the term premium at the long-end of the curve. Our prior research has shown that implied interest rate volatility is linked to uncertainty about the macro environment, and Chart 8 shows that the MOVE index of implied interest rate volatility has tended to track the dispersion of individual forecasts of 3-month T-bill rates and GDP growth. In this context, it should not be surprising that implied volatility fell to very low levels when interest rates were pinned at zero and not expected to move for an extended period. Chart 8Macro Uncertainty & Rate Volatility But, as was mentioned above, the Fed has been trying scale back its forward guidance and inject some uncertainty into the market. Indeed, we think this is one reason why the yield curve steepened and rate volatility increased during the past few weeks. Taking a broader view, we also observe that, historically, macro uncertainty and implied interest rate volatility have tended to fall when the Fed is hiking rates, only spiking once monetary policy becomes restrictive and the economic recovery is threatened. The yield curve is typically inverted by that point. This leaves us to conclude that some further increase in interest rate volatility from exceptionally low levels is possible, but a large spike is unlikely until monetary policy becomes restrictive. Investment Implications A survey of the macro drivers of the yield curve leaves us to conclude that the most likely outcome for the next 6-12 months is that the slope of the curve remains close to its current level, meaning that the curve undergoes a roughly parallel upward shift as the Fed continues to lift rates. However, if nominal GDP growth fails to decelerate from its current 5.44% clip, it is possible that the yield curve steepens first and then flattens as the Fed lifts rates more quickly to catch up. This is not the most likely outcome, but rather a risk to our base case scenario. The final piece of the puzzle is the observation that curve steepener trades continue to look attractively priced. Our current recommendation is to favor the 7-year bullet over a duration-matched barbell consisting of the 1-year and 20-year notes. This trade offers a spread of +8 bps above the reading from our fair value model (Chart 9). Or alternatively, our model shows that the 1/7/20 butterfly spread is currently priced for 29 bps of 1/20 curve flattening during the next six months (Chart 9, bottom panel). Chart 9Curve Steepeners Are Still Attractive That much curve flattening is highly unlikely in the current macro environment, and we continue to recommend curve steepener trades to profit from an unchanged yield curve during the next six months. Bottom Line: A reading of the macro drivers of the yield curve suggests that the slope of the curve will not steepen or flatten dramatically during the next 6-12 months. In this environment, trades that are long the belly of the curve and short a duration-matched barbell consisting of the short and long ends will profit, due to extremely attractive valuation. We currently recommend going long the 7-year bullet and short the 1/20 barbell. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1Please see U.S. Bond Strategy Weekly Report, "Rate Shock", dated October 16, 2018, available at usbs.bcaresearch.com 2https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20180926.pdf 3Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification