Gov Sovereigns/Treasurys
Highlights Duration: Last week’s bond market sell-off was a headfake and does not portend a sustained move higher in Treasury yields. We will need to see a stabilization in confirmed COVID-19 cases and signs of improving global growth before calling the bottom in yields. Keep portfolio duration close to benchmark. Yield Curve: A fed funds rate pinned at zero means that the yield curve will trade directionally with yields for the foreseeable future. The yield curve’s recent re-shaping also means that a barbelled Treasury portfolio now only offers a small yield advantage. We recommend shifting out of a barbell and into a position long the 5-year bullet and short a duration-matched 2/10 barbell. Corporate Spreads: High-yield spreads are now fairly priced for a default cycle of similar magnitude to the 2001/02 recession, and the Fed’s entrance into the corporate bond market is a potential game changer for investment grade spreads. Investors should increase exposure to investment grade corporates from neutral to overweight. High-yield investors with horizons of 12 months or more should also start adding exposure. Fed Policy: The Fed is frantically trying to mitigate the impact of three different (though related) shocks: An economic shock, a liquidity shock and a credit shock. We assess its progress to date and discuss what could be done next. Feature Headfake Chart 1Not A Reflationary Environment Bond yields jumped early last week, shortly after the Fed cut rates back to the zero bound. At one point the 10-year Treasury yield reached as high as 1.18%. But make no mistake, this was not the start of a protracted bond sell off. By Monday morning, the 10-year was back down to 0.75%. Evidently, the conditions for a sustained move higher in Treasury yields are not yet in place. To see why this is so, we need to look a little bit beyond the headline grabbing change in nominal yields and notice that, even when the nominal 10-year yield moved up early last week, the 10-year real yield increased much more quickly, causing the implied cost of inflation protection to fall (Chart 1). This is unusual behavior. Typically, real yields, nominal yields and breakeven inflation rates are all positively correlated. This is because an improving economic outlook usually leads investors to expect both higher inflation and a higher fed funds rate in the future, and vice-versa. When the correlation breaks down it is usually related to some policy action or constraint. For example, investors could come to believe that the Fed will keep interest rates too low for far too long, causing real yields to fall even as inflation expectations jump. Or, as is the case right now, the market could recognize the zero-lower-bound constraint on Fed policy and start to price-in a scenario where the Fed can’t cut rates far enough to jumpstart economic growth. Real yields move higher in this scenario, but inflation expectations crash. We are seeing the same dynamic of rising real yields and falling inflation expectations that was witnessed in 2008. This same dynamic of rising real yields and falling inflation expectations was witnessed in 2008, when the Fed was rapidly cutting rates but investors did not view that action as sufficient (Chart 2). Falling equity prices and a rising dollar further underscored that the environment was becoming more deflationary, not reflationary. A sustained rise in bond yields can only be caused by a reflationary environment. Chart 2Shades Of 2008 How Close To The Bottom? The relevant question then becomes: How close are we to returning to a reflationary environment? To answer this question we will rely on the checklist to call the bottom in bond yields that we unveiled two weeks ago.1 That checklist contains four factors: A stabilization in confirmed COVID-19 cases Improving global economic growth (particularly in China) Weaker US economic data A trigger from one or more technical trading rules Last week we started to see the first signs of weaker US economic data. Initial jobless claims spiked to 281k and both the New York and Philadelphia Fed regional manufacturing surveys plunged (Chart 3). We expect the bottom in bond yields will occur when the US economic data are very weak and when economies that experienced the outbreak earlier – such as China – are showing signs of rebounding. Investors will superimpose the Chinese experience onto the US. But it is still too early for that. Global growth bellwethers such as the CRB Raw Industrials commodity price index remain in freefall (Chart 3, bottom panel). We also noted that we want to see stabilization in the global number of confirmed COVID-19 cases. Essentially, this would mean the number of daily new cases falling close to zero. We are far from that point, as the daily number of new cases continues to rise exponentially (Chart 4). Chart 3Weaker US Data, But No Global Recovery Chart 4New Cases Still Rising We should also mention that we expect risk assets – equities and corporate credit – to bottom before Treasury yields, as the Fed will take care not to signal a premature removal of crisis stimulus measures. Finally, two weeks ago we described several technical trading rules that have demonstrated some success at calling troughs in Treasury yields in the past. Since last week, one of our three proposed trading rules was briefly triggered, but that signal was quickly reversed. Bottom Line: Last week’s bond market sell-off was a headfake and does not portend a sustained move higher in Treasury yields. We will need to see a stabilization in confirmed COVID-19 cases and signs of improving global growth before calling the bottom in yields. Keep portfolio duration close to benchmark. A Quick Note On TIPS In last week’s report we made the case for long-term investors to buy TIPS relative to equivalent-maturity nominal Treasuries.2 The reasoning is that TIPS breakeven inflation rates offer exceptional value relative to likely future inflation outcomes. For example, the 5-year TIPS breakeven inflation rate is currently 0.31% and the 10-year rate is 0.75%. This means that a buy-and-hold investor will make money owning TIPS versus nominals if inflation averages more than 0.31% per year for the next five years, or 0.75% per year for the next decade. Chart 51-Year TIPS Return Scenarios We also observed last week that TIPS breakeven inflation rates have turned negative at the front-end of the curve. We described this pricing as irrational because of the embedded deflation floors in TIPS. This was incorrect. While TIPS will always pay at least par at maturity, seasoned TIPS with only a year or two left to maturity already have inflation-adjusted principal values that are well above par. In other words, there is room for deflation to influence the returns from these securities before any floor is triggered. Specifically, we can take a look at the TIPS maturing in just over one year, on April 15 2021 (Chart 5). This note has an accumulated principal of just under $109 and is currently trading at an ask price of $97.63.3 According to our calculations, this security will earn 2.55% if headline CPI inflation is 0% over the next 12 months. It will only lose money if headline CPI inflation comes in at -2.49% or below. What’s more, it will return more than a 12-month nominal T-bill as long as inflation is above -2.4%. Note that the lowest year-over-year headline CPI inflation print during the Great Financial Crisis was -2.1%. TIPS offer exceptional value relative to nominal Treasuries for investors who are able to hold the trade for at least one year. Bottom Line: TIPS offer exceptional value relative to nominal Treasuries for investors who are able to hold the trade for at least one year. Treasury Curve: Re-Visiting The Zero-Lower-Bound Playbook Chart 6Curve Will Trade Directionally With Yields The Fed’s aggressive policy easing has caused the yield curve to re-shape dramatically during the past few weeks. The 2/10 Treasury slope is up to 55 bps from a 2019 low of -4 bps. The 2/30 Treasury slope is up to 118 bps from a 2019 low of 42 bps, and the 2/5 Treasury slope is up to 15 bps from a 2019 low of -13 bps. Looking through the recent volatility, the fact that the fed funds rate is back to a range between 0% and 0.25% means that we can dust off our yield curve playbook from the last zero-lower-bound period. Fortunately, that playbook is quite straightforward. With the front-end of the curve pinned near zero, the slope of the yield curve will essentially trade directionally with the level of Treasury yields for the foreseeable future. Chart 6 shows that during the last zero-lower-bound period, the 2/30, 2/10 and 2/5 slopes were all positively correlated with the 5-year Treasury yield. This correlation suggests one obvious strategy. If you think yields will rise, put on steepeners. If you think they will fall, put on flatteners. Or if, like us, you suspect that bond yields will be higher in 12 months but are not quite ready to call the bottom, you could hedge benchmark or above-benchmark portfolio duration by entering a duration-neutral steepener. What About Value Across The Curve? Chart 7Bullets Looking Less Expensive Until recently, investors could earn large positive carry by owning a barbell consisting of the long and short ends of the Treasury curve (e.g. 2/30) and shorting the belly (e.g. 5yr), in duration-matched terms. But this has changed. The 2/10 barbell now only offers 6 bps of positive carry versus the 5-year bullet, while the 2/30 barbell and 5-year bullet offer approximately the same yield. Both the 2/5/10 and 2/5/30 butterfly spreads are also much closer to the fair values suggested by our models (Chart 7).4 Though we are not ready to call the bottom in Treasury yields, we think the 5-year yield is sufficiently attractive to initiate a duration-neutral curve steepener trade: go long the 5-year bullet and short a duration-matched 2/10 barbell. This trade should perform well if the 2/10 slope steepens going forward. Since a steeper curve is now positively correlated with the level of yields, this trade will profit if yields move higher. Viewed this way, the trade acts as a hedge when implemented alongside our conservative ‘At Benchmark’ portfolio duration recommendation. Bottom Line: A fed funds rate pinned at zero means that the yield curve will trade directionally with yields for the foreseeable future. The yield curve’s recent re-shaping also means that a barbelled Treasury portfolio now only offers a small yield advantage. We recommend shifting out of a barbell and into a position long the 5-year bullet and short a duration-matched 2/10 barbell. Corporate Spread Update Corporate spreads continue to widen very quickly. As such, our conclusions from last week about the amount of value in corporate bonds are already out of date. Our value assessment is based on our High-Yield Default-Adjusted Spread, which is the excess spread left over in the high-yield index after removing actual 12-month default losses. Table 1 shows how often the Default-Adjusted Spread has been in different 50 basis point intervals, and what sort of 12-month junk excess returns occurred during those periods. One conclusion from the table: To be confident that high-yield will outperform duration-matched Treasuries on a 12-month horizon, we would need to expect a Default-Adjusted Spread of at least 150 bps. Preferably, the spread would be greater than or equal to 250 bps, the historical average. The red numbers down the right-hand side of Table 1 indicate what the Default-Adjusted Spread will be for the next 12 months if the speculative grade default rate hits a specific value. For example, a default rate of 6%, which would correspond to a default cycle of a similar magnitude as 2015/16, implies a very attractive Default-Adjusted Spread of +633 bps. In contrast, a default rate of 14% or greater would lead to a negative Default-Adjusted Spread. For context, the default rate peaked at 15% and 11% in the 2008 and 2001/2 recessions, respectively. Table 1What's Priced In Credit Spreads? As of now, our base case scenario is that the current default cycle will be more severe than the 2015/16 episode but probably not as bad as the 2008 financial crisis. Something on the order of 9% - 11% seems plausible. If that’s the case, then the Default-Adjusted Spread will be somewhere between 216 bps and 394 bps. This looks quite attractive. Additionally, yesterday’s announcement that the Fed will effectively be entering the investment grade corporate bond market could be a game changer. As a result, we recommend increasing exposure to investment grade corporate bonds from neutral to overweight. For high-yield, it is possible that spreads will widen more in the near-term, but value is now sufficiently attractive for investors with investment horizons of 12 months or more to start adding exposure. We retain our neutral 6-12 month recommended allocation for now, but will re-visit the question in more detail in next week’s report. To be confident that high-yield will outperform duration-matched Treasuries on a 12-month horizon, we would need to expect a Default-Adjusted Spread of at least 150 bps. Bottom Line: High-yield spreads are now fairly priced for a default cycle of similar magnitude to the 2001/02 recession, and the Fed’s entrance into the corporate bond market is a potential game changer for investment grade spreads. Investors should increase exposure to investment grade corporates from neutral to overweight. High-yield investors with horizons of 12 months or more should also start adding exposure. The Fed’s War On Three Fronts Events continue to unfold rapidly in financial markets and in terms of the Fed’s response to the market turmoil. We conclude this week’s report with a brief discussion of the three main shocks that the Fed is frantically trying to contain. We also assess how successful the Fed’s responses might be. #1: The Economic Shock The first shock that the Fed is trying to contain is the pure shock to aggregate demand that is occurring as a result of widespread quarantine measures. In cutting rates to zero and signaling that rates will not rise any time soon, the Fed has effectively done all it can to help fight the economic shock. It should help a little. Lower interest rates will ease the debt burden of homeowners who can refinance their mortgages. They may also lower costs for firms that are able to issue debt to weather the current storm. But these effects are minor compared to the fiscal measures currently making their way through Congress.5 Next steps for the Fed: None. The Fed is effectively out of bullets to contain the economic shock. It’s all about fiscal policy now. #2: Market Liquidity Shock Chart 8Bond Market Liquidity Shock In addition to the economic shock, the Fed is also responding to a severe market liquidity shock. What we mean by a “market liquidity shock” is that investors are finding it more expensive (or difficult) to transact in certain markets because of the scarce amount of capital being deployed to those areas. This is different than credit risk (see Shock #3). We are not talking about investors having trouble transacting because there are few willing buyers of credit risk. We are talking about high transaction costs in otherwise risk-free parts of the bond market. The issue is critical because these risk-free parts of the bond market (overnight repo, for example) are often used to fund riskier investments. Disruption in funding markets can have ripple-on effects into other, less opaque, areas. We currently see several examples of disruptions to bond market liquidity (Chart 8): Repo rates have spiked relative to the overnight index swap curve (Chart 8, top panel). The iShares 20+ year Treasury Bond ETF (TLT) is suddenly trading at a huge discount to its net asset value (Chart 8, panel 2). Cross-currency basis swap spreads have turned deeply negative, meaning that it is more expensive for non-US actors to obtain US dollar funding (Chart 8, bottom panel). Wider-than-normal bid/ask spreads are being reported in the Treasury market (not shown). These disruptions are occurring because the financial system is not deploying enough capital to market-making activities in these areas. Essentially, nonfinancial firms have drawn on their revolving credit lines during the past few weeks and this has left the financial system short of cash to deploy toward market-making activities. To fix the problem, the Fed has started to transact directly (in large amounts) in both the repo and Treasury markets. This essentially replaces the function that banks were performing until a few weeks ago. But perhaps more importantly, the Fed is also encouraging banks to deploy the capital that already sits on their balance sheets. Unlike during the 2008 financial crisis, banks now carry a lot of capital – the result of Dodd-Frank and Basel III regulations. What the banks need now is tacit permission from regulators to deploy that capital into financial markets, without concern that they will face consequences during a future stress test. Table 2Banks Have Excess Capital Even without any specific changes to regulation, Table 2 shows that the big 5 US financial institutions all carry significant buffers above the regulatory minimum 100% Liquidity Coverage Ratio and 6% Supplementary Leverage Ratio. At a minimum, these excess buffers must be deployed to aid market liquidity. Next steps: The Fed is already transacting directly in both the repo and Treasury markets, and behind closed doors it is most certainly encouraging banks to deploy more capital toward market-making activities. If these actions prove insufficient, the next step would be for the Fed – along with other regulators and possibly Congress – to offer temporary regulatory relief for banks, lowering the required Liquidity Coverage and Supplementary Leverage ratios. We view this market liquidity problem as one that regulators will be able to solve. And given the Fed’s aggressive policy response to date, we expect that regulators will get a handle on the issue and restore bond market liquidity fairly soon. #3 Credit Shock Chart 9Can The Credit Shock Be Contained? We draw a distinction between spreads widening because of a lack of market liquidity and spreads widening because investors are unwilling to take credit risk. Though admittedly, it is not always easy to distinguish between these two factors in real time. But there is no doubt that the economy is also grappling with a credit shock, in addition to the economic and liquidity shocks we already mentioned. Some evidence that market players are less willing to take credit risk (Chart 9): The average option-adjusted spread on the Bloomberg Barclays Investment Grade Corporate Bond index has spiked (Chart 9, top panel). The spread between the 3-month commercial paper rate and the overnight index swap rate has surged (Chart 9, panel 2). The Municipal / Treasury yield ratio is higher than it was during the financial crisis (Chart 9, panel 3). The 30-year mortgage rate has so far not followed Treasury yields lower (Chart 9, bottom panel). The Fed can take some measures to mitigate the negative impacts of a credit shock, and it has already taken quite a few. The Fed has set up facilities to back-stop commercial paper and short-maturity municipal debt. It also announced yesterday morning that it will, in conjunction with the Treasury department, enter the investment grade corporate bond market out to the 5-year maturity point, effectively back-stopping a large portion of corporate issuance. The Fed has not yet set up a facility to purchase longer-maturity municipal bonds, but this could be forthcoming. The Fed is also directly purchasing large amounts of Agency MBS in an effort to tighten the spread between the mortgage rate and Treasury yields. The Fed’s measures to guarantee some risky debt can help solve some problems related to a credit shock. For example, if Fed purchases increase asset values for corporate and municipal bonds, then it lessens the risk of bankruptcy both for the issuing firms and for any systemically-important investment fund that may be levered to those markets. However, Fed purchases do not guarantee that stressed firms will be able to take out new debt, nor do they prevent firms from cutting payrolls in the face of lower demand. Only direct cash bailouts from the government can fix those problems. Next steps: The Fed could add another facility to purchase long-maturity municipal bonds. It could also implement a “funding for lending” scheme similar to what the Bank of England has done. These measures, along with what has already been announced, will help ease the credit shock at the margin. But ultimately, cash bailouts from Congress to firms and state & local governments will be required. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “When And Where Will Bond Yields Trough?”, dated March 10, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Buying Opportunities & Worst-Case Scenarios”, dated March 17, 2020, available at usbs.bcaresearch.com 3 Numbers quoted assuming a par value of $100. 4 For details on our yield curve models please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 5 The global fiscal response to the COVID crisis is discussed in more detail in Geopolitical Strategy Weekly Report, “De-Globalization Confirmed”, dated March 20, 2020, available at gps.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Market Turmoil: The combination of accelerating global cases of COVID-19, a surging US dollar and elevated market volatility has wreaked havoc on financial markets. A sustainable bottom in global risk assets (and, potentially, bond yields) requires a reversal of all three of those trends. Fed & ECB: Central bankers on both sides of the Atlantic are now committing to provide liquidity backstops for both government bonds and corporate debt by promising “unlimited” purchases. This effectively removes the left tail of the return distribution on debt of more questionable quality that has seen significant spread widening, like US BBB-rated corporates and Peripheral European sovereign debt. Fixed Income Strategy: Upgrade US investment grade corporates to overweight from neutral, and upgrade Italian government bonds to overweight from underweight, on both a tactical (0-6 months) and strategic (6-12 months) basis. Buy What The Central Banks Are Buying Chart of the WeekAre These Market Stress Points Turning? The COVID-19 outbreak has become a full-blown global health crisis, with country after country imposing lockdowns on their populations to control the spread of the disease. The economic ramifications are now obvious: a certain deep global recession, but one of indeterminate length. The investment implications are also now clear: bear markets in global equities, credit and growth-sensitive currencies and commodities. There is a new bull market, however, in pessimism. Economic forecasters are tripping over themselves to offer up the most shocking estimate of the severity of the downturn. The IMF is now expecting a recession in 2020 “at least as bad” as during the global financial crisis. Wall Street investment banks are forecasting double-digit declines in US GDP growth during the second quarter. St. Louis Fed President Fed James Bullard wins the prize for the most gloomy prediction, suggesting that we could see a 30% US unemployment rate and a -50% (!) decline in US GDP growth in Q2. Investors have seen few positive headlines on the spread of the virus, resulting in a de-risking “dash for cash” that has impeded liquidity across equity, fixed income and currency markets. Global policymakers have responded with trillions of dollars of monetary and fiscal policy announcements designed to calm nervous markets while ensuring liquidity provision for temporarily shuttered businesses, of all sizes, facing painful layoff announcements. Chart 2Get Ready For Shockingly Weak Global Economic Data Have we seen enough stimulus to stop the market turmoil? In our view, three things must all occur for a sustainable bottom in global risk assets, and potentially bond yields, to unfold (Chart of the Week): Slowing growth in new COVID-19 infections outside China. As long as the global spread of the virus shows no signs of slowing down, it will be impossible for markets to ascertain the full hit to global growth from the outbreak. A cooling off of the surging US dollar. The greenback has soared 8% since March 9, and is wreaking havoc on global borrowers who have significant USD-denominated liabilities. Global financial market volatility must peak. Volatility spikes across all major asset classes have forced investors to de-risk portfolios; lower volatility will have the opposite effect. Of late, the news on all three fronts is tentatively more positive. The US DXY dollar index is off from the peak, the VIX index of US equity volatility is off the extreme highs and the number of new cases of COVID-19 in virus-ravaged Italy has declined for the past two days. While it is still early to call a lasting peak in these measures, it is potentially a sign of optimism coming at a time when economic confidence measures like the ZEW surveys are back to 2008 levels and a China-like collapse in activity is now expected in the US (Chart 2). We now think it is time to pick through the ashes of the global market rout and begin to add back some risk in global bond portfolios. We now think it is time to pick through the ashes of the global market rout and begin to add back some risk in global bond portfolios. After seeing the policy announcements of the past week, however, we are choosing to dip our toes back into the water in assets that now have direct central bank liquidity backstops – namely US investment grade corporates and Italian sovereign debt. The Fed Is Now Truly The Lender Of Last Resort … To Corporates The Fed unloaded their biggest of bazookas yesterday, expanding existing stimulus programs while introducing new initiatives that reach into parts of the US economy and financial markets previously untouched by the central bank. Specifically, the Fed did the following: Announcing unlimited quantitative easing (QE) for US Treasuries and agency mortgage-backed securities (MBS) Increasing the size of money market and commercial paper liquidity programs announced last week, and expanding the range of eligible assets Adding commercial MBS (CMBS) to asset purchases, which was never done even in 2008 Reviving the 2008 crisis-era Term Asset-Backed Loan Facility (TALF) to make loans directly to companies, while introducing a new “Main Street Business Lending Program” that will fund small businesses directly (details are yet to be determined) Most significantly for bond investors, the Fed will begin buying corporate bonds, in both primary and secondary markets, while also providing direct lending to eligible companies through loans. This will be done through off-balance sheet Special Purpose Vehicles (SPV), initially funded with $10 billion from the US Treasury and levered up by the Fed to whatever amount is necessary The Fed primary market SPV will buy newly-issued bonds with credit ratings as low as BBB- and maturities of four years or less. Eligible issuers are US businesses with material operations in the United States, although the Fed noted that the list of companies in the program may be expanded in the future. Eligible issuers do not include companies that are expected to receive direct financial assistance from the US government (i.e. no buying of bonds from companies getting bailout funds). The most significant details of the Fed’s new primary market corporate bond buying program are the numerical limits of what can be purchased. Any eligible company can “borrow” from the Fed, though bond purchases or direct loans, an amount greater than the maximum outstanding debt (bonds plus loans) on any day over the past twelve months. Those percentages are determined by credit quality: 140% of all debt for AAA-rated issuers, 130% for AA-rated issuers, 120% for A-rated issuers and 110% for BBB-rated issuers. Since those percentages are all greater than 100, this effectively means that the Fed will allow eligible companies to roll over their entire stock of debt through this program, plus some net new borrowing. The Fed is even calling this “bridge financing for up to four years” in their official term sheets for the new program.1 Issuers can even defer interest payments on the funds borrowed from the Fed for up to six months, with the interest payments added to the final repayment amount (again, any company choosing this option can do no share buybacks or dividend payments). In addition to this direct lending to investment grade rated issuers, the Fed is introducing another SPV that will buy corporate bonds of eligible investment grade issuers in the secondary market. This will be for bonds with maturity of up to five years and credit ratings as low as BBB-, with a buying limit of 10% of the entire stock of eligible debt of any single company. This secondary market SPV will also buy investment grade bond ETFs, up to 20% the outstanding shares of any single ETF. All of these programs are set to run to September 30 of this year, with an option to extend as needed. The Fed’s new initiatives represent a new step for the central bank, providing direct lending to any company that needs it. The Fed had to do this through off-balance-sheet SPVs, since direct buying of corporates is not permitted under the Federal Reserve Act. Thus, it is not like the Fed’s QE programs that used to buy Treasuries and MBS – in fact, it is the US Treasury that is taking on the initial credit risk through its $10 billion funding of each SPV. In this sense, the Fed's new program is also different than the corporate bond QE programs of the ECB, Bank of England and Bank of Japan, where the credit risk is directly taken onto the central bank balance sheet. The purpose of these new corporate bond programs is two-fold: 1. To ensure that companies do not suffer a credit crunch, either by being unable to roll over maturing corporate debt in primary markets or by only doing so at prohibitively high yields and spreads 2. To ensure the proper functioning of US corporate bond markets, by providing liquidity to both cash bonds and related ETFs. By doing this, the Fed can help mitigate the severe tightening of financial conditions that has already occurred because of the credit selloff in recent weeks. Also, by helping to reduce the extreme price/spread volatility in higher-quality credit, the Fed may be hoping this can spill over into lower volatility of other asset classes which are at the historical extremes of the past quarter century (Chart 3). Both can help mitigate the second round effects of the virtual shutdown of the US economy that has taken place to contain the spread of COVID-19. Chart 3Few Places To Hide From Historically High Volatility The Fed’s unprecedented intervention in the US corporate bond market is a positive step that has improved the risk/reward profile for US investment grade credit, coming after a period of significant spread widening that has restored some value to the asset class. We will further discuss the implications of the Fed’s actions in a corporate bond Special Report that we will publish jointly next week with our colleagues at BCA US Bond Strategy. For now, however, the Fed’s unprecedented intervention in the US corporate bond market is a positive step that has improved the risk/reward profile for US investment grade credit, coming after a period of significant spread widening that has restored some value to the asset class (Chart 4). Chart 4A New Huge IG Liquidity Backstop From The Fed Could the Fed’s actions spill over into non-US credit, as well? Chart 5This Is A Global Widening Of Credit Spreads Chart 6Signs Of USD Funding Stress, But Nothing Like 2008 The COVID-19 crisis has resulted in credit spread widening across the world, especially so for the big borrowers of USD-denominated debt in the emerging markets and US shale oil industry (Chart 5). For those issuers, a weaker USD would be more positive development, as would higher oil prices. The Fed’s other monetary policy actions – cutting the funds rate to 0%, moving to unlimited QE for Treasuries and MBS, should be helping to weaken the US dollar. The problem, however, is that all other major central banks are now doing similar policy easings as well, with even the likes of the Reserve Bank of Australia and Reserve Bank of New Zealand now starting bond-buying QE programs. This exacerbates the strong USD problem, seen in the stresses in USD funding markets (Chart 6). Simply put, the Fed cannot generate easier financial conditions, both in the US and elsewhere, through a weaker USD. Thus, the Fed has to seek other ways to ease US financial conditions – like helping cap borrowing costs for investment grade US borrowers by direct intervention in those markets. Bottom Line: The Fed’s move into buying investment grade corporate debt, and providing term lending to corporates more broadly, has effectively eliminated the left tail of the return distribution for investment grade US credit. The ECB Is Moving Towards Being The Lender Of Last Resort – For Euro Area Sovereigns The Fed is not the only central bank that ramped up its asset purchases. The ECB also increased its existing Asset Purchase Program by a massive €750bn last week, across both sovereign and corporate debt. This new program was dubbed the “Pandemic Emergency Purchase Program” (PEPP) and is to take place over the rest of 2020 in order to help fight the negative impacts on the European economy and financial markets from the COVID-19 outbreak. The most important part of the announcement of the PEPP, however, was in the loosening of previous restrictions of the ECB’s €2.6 trillion Asset Purchase Program (APP). Greek bonds were included in the PEPP by allowing a waiver to the rules of the APP that forbid the inclusion of Greece in the funding program. Also, the ECB hinted in its statement announcing the new program that the self-imposed limits on the APP could be revised, if necessary, for the more “temporary” PEPP to help fight the COVID-19 crisis. That was a clear signal to the markets that the ECB could deviate from the “capital key” country weightings, and the 33% single sovereign issuer limit, that have governed the APP. This is very positive news for Italy, where COVID-19 has been particularly devastating and deadly, causing the entire country to be locked down to control its spread. The ECB could deviate from the “capital key” country weightings, and the 33% single sovereign issuer limit, that have governed the APP. This is very positive news for Italy, where COVID-19 has been particularly devastating and deadly, causing the entire country to be locked down to control its spread. Already, Italy and the rest of the EU have been given a temporary waiver of the EU’s fiscal policy targets (government deficit no larger than 3% of GDP, government debt no larger than 60% of GDP). Now that the ECB is also willing to consider suspending its own limits on asset purchases, Italy has been given the “space” to run larger deficits without the market punishment of higher bond yields – especially with the ECB only owning around 20% of the stock of Italian government debt, well below the 33% single country APP limit (Chart 7). Chart 7The ECB Can Buy More Italian Debt, If Necessary Already, the ECB announcement triggered a sharp decline in Italian bond yields (and Greek yields, for that matter) and tightening of the spread between Italian and German bond yields. So far, the threat of the ECB buying more Italy has been enough to get private investors to buy more Italian bonds, similar to Mario Draghi’s “whatever it takes” promise back in 2012. Draghi never had to buy a single bond to get the market to move in his favor then. In 2020, given the collapse in European growth seen so far in response to COVID-19 lockdowns, and the acute hit to the Italian economy from the virus, we suspect that Christine Lagarde will be far likely to actually buy more Italian debt – especially with even the hard-money Germans now engaged in deficit spending to stimulate the virus-stricken German economy. We interpret all this similarly to our read of the Fed’s buying of corporate debt – the ECB has changed the risk/reward profile of Italian government bonds by not only introducing the PEPP, but having it operated under different rules than the APP. Bottom Line: The ECB’s new bond buying program has significantly reduced the downside risk of Italian government debt over the next 6-12 months. Fixed Income Strategy Implications The Fed’s dramatic move into direct funding of US companies is a game changer for the US corporate bond market. By providing a full liquidity backstop to all companies, the Fed is ensuring that no US investment grade issuer will have to worry about rolling over their maturing debt in an illiquid and nervous corporate bond market. Simply put, the Fed has cut out the left side of the distribution of corporate bond returns for the foreseeable future. The same argument goes for the ECB’s increased purchases of government bonds, with promises to buy more Italian debt, if necessary. For these reasons, we are upgrading our recommended stance on US investment grade corporate debt, and Italian sovereign debt to overweight - both on a tactical (0-6 months) basis in our model bond portfolio and on a strategic (6-12 months) basis. Chart 8Upgrade US IG Corporates And Italian Sovereign Debt On CB Buying For these reasons, we are upgrading our recommended stance on US investment grade corporate debt, and Italian sovereign debt to overweight - both on a tactical (0-6 months) basis in our model bond portfolio and on a strategic (6-12 months) basis (Chart 8). We are focusing only on these two markets for now, as an initial step to increase our recommended exposure to fixed income risk assets. There may be a spillover into other credit markets and sovereign debt, like European investment grade and Spanish government bonds. For now, however, we are focusing on US investment grade and Italy, while keeping underweights in other credit markets as a hedge against a renewed flare-up of COVID-19 related market risk. Bottom Line: Upgrade US investment grade corporates to overweight from neutral, and upgrade Italian government bonds to overweight from underweight, on both a tactical (0-6 months) and strategic (6-12 months) basis. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The details of the Fed’s new corporate bond buying programs can be found here: https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200323b1.pdf https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200323b2.pdf Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Our short EM equity index recommendation has reached our target and we are booking profits on this trade. The halt to economic activity will produce a global recession that will be worse than the one that took place in late 2008. We continue to recommend short positions in a basket of EM currencies versus the US dollar. In EM fixed-income markets, the duration of the ongoing selloff has been short, and large losses will trigger more outflows ensuring further carnage. Stay defensive for now. Russia is unlikely to make a deal with Saudi Arabia to restrain oil output for now. Feature The global economy is experiencing a sudden, jarring halt. The only comparison for such a sudden stop is the one that occurred in the fall of 2008, following Lehman’s bankruptcy. In our opinion, the global economic impact of the current sudden stop is shaping up to be worse than the one that occurred in 2008. That said, we are taking profits on our short position in EM equities. This position – recommended on January 30, 2020 – has produced a 30% gain. EM share prices have reached the long-term support that acted as the ultimate floor during the bear markets in 1997-‘98, 2001-‘02, 2007-‘08 and 2015. Our decision to take profits reflects investment discipline. The MSCI EM stock index in US dollar terms has reached our target. In addition, this decision is consistent with two important indicators that we follow and respect: 1. EM stocks have become meaningfully cheap. Chart I-1 illustrates that our cyclically-adjusted P/E (CAPE) ratio for EM equities is about one standard deviation below its fair value – the same level when the EM equity market bottomed in 1998, 2008 and 2015. Chart I-1EM Equities Are Cheap According To The Cyclically-Adjusted P/E Ratio For this EM CAPE ratio to reach 1.5 standard deviations below its fair value – the level that is consistent with EM’s 2001-02 lows – EM share prices need to drop another 15%. 2. In term of the next technical support, EM share prices have reached the long-term support that acted as the ultimate floor during the bear markets in 1997-‘98, 2001-‘02, 2007-‘08 and 2015 (Chart I-2). Chart I-2EM Share Prices Are At Their Long-Term Support While share prices are likely to undershoot, it is risky to bet on a further decline amid current extremely elevated uncertainty and market volatility. The Global Downturn Will Be Worse Than In Late 2008 Odds are that the current global downturn is shaping up to be worse than the one that occurred in late 2008. From a global business cycle perspective, the current sudden halt is beginning from a weaker starting point. Global trade growth was positive back in August-September 2008 – just prior to the Lehman bankruptcy – despite the ongoing US recession (Chart I-3A). In comparison, global trade was shrinking in December 2019, before the COVID-19 outbreak (Chart I-3B). Chart I-3AGlobal Trade Growth Was Positive In September 2008… Chart I-3B…But Was Negative In December 2019 This is because growth in EM and Chinese economies was still very robust in the middle of 2008. Moreover, the economies of EM and China were structurally very healthy and were anchored by solid fundamentals. Still, the blow to confidence emanating from the crash in global financial markets and plunge in US domestic demand in the fall of 2008 produced major shockwaves in EM/Chinese financial markets. Provided the ongoing negative confidence shock and lingering uncertainty persist, odds are that the risk premium will initially overshoot before settling down. Consistently, risk markets will undershoot in the interim. This is in contrast with current cyclical growth conditions and structural economic health, both of which are very poor in EM/China going into this sudden stop. In China, economic growth in January-February 2020 was much worse than at the trough of the Lehman crisis in the fourth quarter of 2008. Chart I-4 reveals that industrial production, auto sales and retail sales volumes all contracted in January-February 2020 from a year ago. The same variables held up much better in the fourth quarter of 2008 (Chart I-4). Business activity in China is recovering in March, but from very low levels. Reports and evidence from the ground suggest that many companies are operating well below their ordinary capacity – the level of economic activity remains well below March 2019 levels. US real GDP, consumer spending and capital expenditure shrunk by 4%, 2.5% and 17% at the trough of 2008 recession (Chart I-5). Odds are that these variables will plunge by an even greater magnitude in the coming months as the US reinforces lockdowns and public health safety measures. Chart I-4China Business Cycle Was Much Stronger In Q4 2008 Than Now Chart I-5US Growth At Trough Of 2008 Recession Chart I-6US Small Caps: Overlay Of 2008 And 2020 About 50% of consumer spending in the US is attributed to people over 55 years of age. Provided COVID-19’s fatality rate is high among the elderly, odds are this cohort will not risk going out and spending. How bad will domestic demand in the US be? It is impossible to forecast with any certainty, but our sense is that it will plunge by more than it did in the late 2008-early-2009 period, i.e., by more than 4% (Chart I-5, bottom panel). Interestingly, the crash in US small-cap stocks resembles the one that occurred in the wake of the Lehman bankruptcy (Chart I-6). If US small-cap stocks follow their Q4 2008 - Q1 2009 trajectory, potential declines from current levels will be in the 10%-18% range. Bottom Line: The current halt in economic activity and impending global recession will be worse than the one that took place in late 2008. Reasons Not To Jump Into The Water…Yet Even though EM equities have become cheap and oversold and we are booking profits on our short position in EM stocks, conditions for a sustainable rally do not exist yet: So long as EM corporate US dollar bond yields are rising, EM share prices will remain under selling pressure (Chart I-7). Corporate bond yields are shown inverted in this chart. Chart I-7EM Stocks Fall When EM Corporate Bond Yields Rise Chart I-8Chinese And Emerging Asian Corporate Bond Yields Are Spiking The selloff in both global and EM credit markets began only a few weeks ago from very overbought levels. Many investors have probably not yet trimmed their positions. Hence, EM sovereign and corporate credit spreads and yields will likely rise further as liquidation in the global and EM credit markets persists. Consistently, bond yields for Chinese offshore corporates as well as emerging Asian high-yield and investment-grade corporates are rising (Chart I-8). EM local currency bond yields have also spiked recently as rapidly depreciating EM currencies have triggered an exodus of foreign investors. Rising local currency bond yields are not conducive for EM share prices (Chart I-9). Chart I-9EM Equities Drop When EM Local Bond Yields Rise EM ex-China currencies correlate with commodities prices (Chart I-10). Both industrial commodities and oil prices have broken down and have further downside. The path of least resistance for oil prices is down, given anemic global demand and our expectation that Russia and Saudi Arabia will not reach any oil production cutting agreement for several months (please refer to our discussion on this topic below). Finally, our Risk-On/Safe-Haven currency ratio1 is in free fall and will likely reach its 2015 lows before troughing (Chart I-11). This ratio tightly correlates with EM share prices, and the latter remains vulnerable to further downside as long as this ratio is falling. Chart I-10EM Currencies Move In Tandem With Commodities Prices Chart I-11More Downside In Risk-On/ Safe-Haven Currency Ratio Bottom Line: Although we are taking profits on the short EM equity position, we continue to recommend short positions in a basket of EM currencies – BRL, CLP, ZAR, IDR, PHP and KRW – versus the US dollar. Liquidation in EM fixed-income markets has been sharp, but the duration has been short –only a few weeks. Large losses will trigger more outflows from EM fixed-income markets. Stay defensive for now. What We Do Know And What We Cannot Know Amid such extreme uncertainty, it is critical for investors to distinguish between what we know and what we cannot know. What we cannot know: With regards to COVID-19: The speed of its spread, the ultimate number of victims it claims and – finally – its impact on consumer and business confidence and psyche. Related to lockdowns: Their duration in key economies. These questions will largely determine this year’s economic growth trajectory: Will it be V-, U-, W-, or L-shaped? Unfortunately, no one knows the answers to the above questions to have any certainty in projecting this year’s global growth. The key factor that gives Russia an advantage over Saudi Arabia in terms of its ability to deal with a negative terms-of-trade shock is not only its better fiscal position but also its ability to depreciate its currency. What we do know: Authorities in all countries will stimulate aggressively so long as financial markets are rioting. Nonetheless, these stimulus measures will not boost growth immediately. With entire countries locked down and plunging consumer and business confidence, stimulus will not have much impact on growth in the near term. In brief, all policy stimulus will boost growth only when worries about the pandemic subside and the economy begins to function again. Both are not imminent. Hence, we are looking at an air pocket with respect to near-term global economic growth. As we argued in our March 11 report titled, Unraveling Of The Policy Put, the pre-coronavirus financial market paradigm – where stocks and credit markets were priced to perfection because of the notion that policymakers would not allow asset prices to drop – has unravelled. In recent weeks, policymakers around the world have announced plans to deploy massive amounts of stimulus, yet the reaction of financial markets has been underwhelming. The reason is two-fold: Both demand shrinkage and production shutdowns have just started, and they will run their due course regardless of announced policy stimulus measures. Equity and credit markets were priced for perfection before this selloff, and investors are in the process of recalibrating risk premiums. Provided the ongoing negative confidence shock and lingering uncertainty persist, odds are that the risk premium will initially overshoot before settling down. Consistently, risk markets will undershoot in the interim. Bottom Line: DM’s domestic demand downturn is still in its initial phase, and there is little foresight in terms of the pandemic’s evolution. These are natural forces, and any stimulus policymakers enact are unlikely to preclude them from occurring. Reflecting the economic contraction and heightened uncertainty, the selloff in risk assets will likely continue for now. Do Not Bet On An Early Resuscitation Of OPEC 2.0 As we argued in our March 11 report, Russia is unlikely to make a deal with Saudi Arabia to restrain oil output in the immediate term. Russia may agree to restart negotiations, but it will not agree to reverse its position for some time. Both nations will be increasing crude output (Chart I-12). As a result, a full-fledged oil market share war is underway. Consistently, crude prices have experienced a structural breakdown (Chart I-13). Chart I-12The Largest Oil Producers Are Ramping Up Output Chart I-13Structural Breakdown In Oil Prices The key factor that gives Russia an advantage over Saudi Arabia in terms of its ability to deal with a negative terms-of-trade shock is not only its better fiscal position but also its ability to depreciate its currency. Russia has a flexible exchange rate, which will allow the currency to depreciate in order to soften the blow from lower oil prices on the real economy and fiscal accounts. The Russian economy and financial system have learned to operate with recurring major currency depreciations. Saudi Arabia has been running a fixed exchange rate regime since 1986 and cannot use currency depreciation to mitigate the negative terms-of-trade shock on its end. Even though Russia’s fiscal budget break-even oil price is much lower than that of Saudi Arabia’s, it is not the most important variable to consider in this confrontation. The fiscal situation in both Russia and Saudi Arabia will not be a major problem for now. Both governments can issue local currency and US dollar bonds, and there will be sufficient demand for these bonds from foreign and local investors. This is especially true with DM interest rates sitting at the zero-negative territory. Falling oil prices and downward pressure on exchange rates will trigger capital outflows in both countries. Russia has learned to live with persistent capital flight. In the meantime, capital outflows will stress Saudi Arabia’s financial system and, eventually, its real economy. This is in fact the country’s key vulnerability. We will be publishing a Special Report on Saudi Arabia in the coming weeks. Bottom Line: Do not expect a quick recovery in oil prices. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 Average of CAD, AUD, NZD, BRL, RUB, CLP, MXN & ZAR total return indices relative to average of CHF & JPY total returns. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Policy Responses: The COVID-19 pandemic has become a full-blown global crisis and recession. Governments and central bankers worldwide are now responding with aggressive monetary easing and fiscal stimulus. Markets will not respond positively to such stimulus, however, until there is some visibility on the true depth, and duration, of the economic downturn. Fixed Income Strategy: With a global recession now a certainty, bond yields will remain under downward pressure and credit spreads should widen further. Given how far yields have already fallen, we recommend emphasizing country and credit allocation in global bond portfolios, while keeping overall duration exposure around benchmark levels. Model Portfolio Changes: Following up on our tactical changes last week, we continue to recommend overweighting government debt versus spread product. Specifically, overweighting US & Canadian government bonds versus Japan and core Europe, and underweighting US high-yield and all euro area and EM credit. Feature In stunning fashion, the sudden stop in the global economy due to the COVID-19 pandemic has triggered a rapid return to crisis-era monetary and fiscal policies. The battle has now shifted to trying to fill the massive hole in global private sector demand left by efforts to contain the spread of the virus. It is unlikely that lower interest rates and more quantitative easing can mitigate the negative growth effects from travel bans, closing of bars and restaurants, and full scale lockdowns of cities. Fiscal policy, combined with efforts to boost market liquidity and ease the coming collapse of cash flows for the majority of global businesses, are the only plausible options remaining. It is unlikely that lower interest rates and more quantitative easing can mitigate the negative growth effects from travel bans, closing of bars and restaurants, and full scale lockdowns of cities. While the speed of these dramatic policy moves is unprecedented, the reason for them is obvious. Plunging equities and surging corporate bond credit spreads are signaling a global recession, but one of uncertain depth and duration given the uncertainties surrounding the spread of COVID-19 (Chart of the Week). Chart of the WeekCan Crisis-Era Monetary Policies Be Effective During A Pandemic? Chart 2Risk Assets Will Not Bottom Until New COVID-19 Cases Ex-China Peak The ability for policymakers to calibrate stimulus measures is pure guesswork at this point. The same thing goes for investors who see zero visibility on global growth, with the full extent of the virus yet to be felt in large economies like the United States and Germany – even as new cases in China, where the epidemic began, approach zero. The response from central bankers has been swift and bold – rapid rate cuts, increased liquidity programs for bank funding and increased asset purchases. The fact that global financial markets have remained volatile, even after what is a clear coordinated effort from policymakers, highlights how the unique threats to growth from the COVID-19 pandemic may be beyond fighting with traditional demand-side stimulus measures. We continue to recommend a cautious near-term investment stance, particular with regards to corporate bond exposure, until there is clear evidence that the growth rate of new COVID-19 cases outside China has peaked (Chart 2). Policymakers Throw The Kitchen Sink At The Problem The market moves and policy announcements have come fast and furious this past week, from virtually all major economies. We summarize some of the moves below: United States The Fed cut rates by -100bps in a Sunday night emergency move, taking the funds rate back to the effective lower bound of 0% - 0.25%. Importantly, Fed Chair Powell made it clear at his press conference that negative rates are not on the table, suggesting that we may have seen the last of the rate cuts for this cycle. A new round of quantitative easing (QE) was also announced, with purchases of $500 billion of Treasury securities and $200 billion of agency MBS that will occur in the “coming months”; Powell hinted that those amounts could be increased, if necessary (Chart 3). The MBS purchases are a clear effort to help bring down mortgage rates, which have not declined anywhere near as rapidly as US Treasury yields during the market rout (bottom panel). The Fed also cut the discount window rate – the rate at which banks can borrow from the Fed for periods of up to 90 days – by -150bps, bringing it down to 0.25%. The Fed said it is “encouraging banks to use their capital and liquidity buffers” – essentially telling banks to hold less cash for regulatory purposes. The Fed also reduced the rate on its US dollar swap lines with other central banks. The new rate is OIS +25bps. Coming on top of the massive increase in existing repo lines last week, the Fed is attempting to ensure that banks, both in the US and globally, that need USD funding have more liquidity available to support lending. Already, there are signs of worsening liquidity in the bank funding markets, like widening FRA-OIS spreads, but also evidence of illiquidity in financial markets like wide bid-ask spreads on longer-maturity US Treasuries and the growing basis between high-yield bonds and equivalent credit default swaps (Chart 4). Chart 3A Return To Fed QE Chart 4Market Liquidity Issues Forced The Fed's Hand Turning to fiscal policy, the full response of the Trump administration is still being formed, but a major $850bn spending package has been proposed that would provide tax relief for American households and businesses while also including a $50bn bailout of the US airline industry. This comes on top of previously announced plans to offer free testing for the virus, paid sick leave, business tax credits and a temporary suspension of student loan interest payments. Chart 5The ECB Has Limited Policy Options Euro Area The European Central Bank (ECB) unexpectedly made no changes to policy interest rates last week. It opted instead to increase asset purchases by €120bn until the end of 2020 (both for government bonds and investment grade corporates), while introducing more long-term refinancing operations (LTROs) to “provide a bridge” to the targeted LTRO (TLTRO-3) that is set to begin in June. The terms of TLTRO-3 were improved, as well; banks that accessed the liquidity to maintain existing lending could do so at a rate up to -25bps below the current ECB deposit rate of -0.5%, for up to 50% of the existing stock of bank loans. The ECB obviously had to do something, given the coordinated nature of the global monetary policy response to COVID-19. Yet the decisions taken show that the ECB is much more limited in its ability to ease policy further, with interest rates already negative, asset purchases approaching self-imposed country limits and, most worryingly, inflation expectations falling to fresh lows (Chart 5). The bigger responses to date have come on the fiscal front, with stimulus packages proposed by France (€45bn), Italy (€25bn), Spain (€3bn) and the European Commission (€37bn). The biggest news, however, came from Germany which has offered affected businesses tax breaks and cheap loans through the state development bank, KfW – the latter with an planned upper limit of €550bn (and with the German government assuming a greater share of risk on those new KfW loans). The German government has also vaguely promised to temporarily suspend its so-called “debt brake” to allow deficit financing of virus-related stimulus programs, if necessary. Other Countries The Bank of England cut interest rates by -50bps last week, while also lowering capital requirements for UK banks by allowing use of counter-cyclical buffers for lending. On the fiscal side, a £30bn package was introduced last week that included a tax cut for retailers, cash grants to small business, sick pay for those with COVID-19 and extended unemployment benefits. The Bank of Japan held an emergency meeting this past Sunday night, announcing no changes in policy rates but doubling the size of its ETF purchase program to $56 billion a year to $112 billion, while also increasing purchases of corporate bonds and commercial paper. The central bank also announced a new program of 0% interest loans to increase lending to businesses hurt by the virus. The Bank of Canada delivered an emergency -50bps cut in its policy rate last Friday, coming soon after the -50bp reduction from the previous week. The central bank also introduced operations to boost the liquidity of Canadian financial markets. The Canadian government also announced a fiscal package of up to C$20bn, including increased money for the state business funding agencies. The Reserve Bank of Australia did not cut its Cash Rate last week, which was already at a record-low 0.5%. It did, however, signal that it would begin a quantitative easing program for the first time, and introduce Fed-like repo operations, to provide more liquidity to the economy and local financial markets. The Australian government has also announced A$17bn of fiscal stimulus. Fiscal packages have also been introduced in New Zealand (where the Reserve Bank of New Zealand just cut its policy rate by -75bps), Sweden, Switzerland, Norway, and South Korea. To date, China has leaned more on monetary and liquidity measures – lowering interest rates and cutting reserve requirements – rather than a big fiscal stimulus package. Will all these policy measures be enough to offset the hit to global growth from COVID-19 and help stabilize financial markets? It is certainly a good start, particularly in countries with low government and deficit levels that have the fiscal space for even more stimulus, like Germany, Australia and Canada (Chart 6). Given these competing forces of global recession and monetary policy exhaustion on one side, but with increasingly more expansive fiscal policy on the other, we recommend a neutral (at benchmark) stance on overall global duration exposure on both a tactical and strategic basis. The ability to calibrate the necessary policy response is impossible to assess without knowing the full impact of COVID-19 pandemic on the global economy – including the size of related job losses and corporate defaults/bankruptcies. Policymakers are likely to listen to the combined message of financial markets – equity prices, credit spreads and government bond yields. The low level of yields and flat yield curves, despite near-0% policy rates across the developed world (Chart 7), suggests that investors see monetary policy as “tapped out”, leaving fiscal stimulus as the only way to fight the economic war against COVID-19. Chart 6At Global ZIRP, The Policy Focus Shifts To Fiscal Chart 7Are Bond Yields Discounting A Global Liquidity Trap? Given these competing forces of global recession and monetary policy exhaustion on one side, but with increasingly more expansive fiscal policy on the other, we recommend a neutral (at benchmark) stance on overall global duration exposure on both a tactical and strategic basis. Bottom Line: The COVID-19 pandemic has become a full-blown global crisis and recession. Governments and central bankers worldwide are now responding with aggressive monetary easing and fiscal stimulus. Markets will not respond positively to such stimulus, however, until there is some visibility on the true depth, and duration, of the economic downturn. Corporate Bonds In The US & Europe – Stay Tactically Defensive Chart 8This Crisis Is Different Than 2008 The COVID-19 global market rout has generated levels of market volatility not seen since the 2008 Global Financial Crisis. The US VIX index of option-implied equity volatility spiked to a high of 84, while the equivalent German VDAX measure reached a shocking high of 93. Equity valuations in both the US and Europe remain much higher on a forward price/earnings ratio basis compared to the troughs seen in 2008, even after the COVID-19 bear market. Yet even though volatility has returned to crisis-era extremes, and corporate credit has sold off hard in both the US and Europe, credit spreads remain well below the 2008 highs (Chart 8). Nonetheless, the credit selloff seen over the past few weeks has still been intense. Both investment grade and high-yield spreads have blown out, and across all credit tiers in both the US (Chart 9) and euro area (Chart 10). Even the highest-rated segments of the corporate bond universe have seen spreads explode, with AAA-rated investment grade spreads having doubled in both the US and Europe. Chart 9Broad-Based Spread Widening For Both Investment Grade... Chart 10...And High-Yield With the COVID-19 pandemic tipping the global economy into recession, it is not clear that the spread widening seen to date has been enough to compensate for the typical surge in downgrades and defaults seen during recessions – even though spreads do look wide on a duration-adjusted basis. With the COVID-19 pandemic tipping the global economy into recession, it is not clear that the spread widening seen to date has been enough to compensate for the typical surge in downgrades and defaults seen during recessions – even though spreads do look wide on a duration-adjusted basis. One of our favorite metrics to value corporate bonds is to look at option-adjusted spreads, adjusted for interest rate duration risk. We call this the 12-month breakeven spread, as it measures the amount of spread widening over one year that would leave corporate bond returns equal to those of duration-matched US Treasuries. We then look at the percentile rankings of those breakeven spreads versus their history as one indicator of corporate bond value. Chart 11US Corporates Look Cheaper On A Duration-Adjusted Basis For the US, the 12-month breakeven spreads for the overall Bloomberg Barclays investment grade and high-yield indices are in the 82nd and 97th percentiles, respectively (Chart 11). This suggests that the latest credit selloff has made corporate debt quite cheap, although only looking through the prism of spread risk rather than potential default losses. Another of our preferred valuation metrics for high-yield debt is the duration-adjusted spread, or the high-yield index option-adjusted spread minus default losses. We then look at that default-adjusted spread versus its long-run average (+250bps) as a measure of high-yield value. To assess the current level of spreads, we use a one-year ahead forecast of the expected default rate using our own macro model. Over the past 12 months, the high-yield default rate was 4.5% and our macro model is currently calling for a rise to 6.2%. That estimate, however, does not yet include the certain hit to corporate profits from the COVID-19 recession. By way of comparison, the default rate peaked at 11.2% during the 2001/02 default cycle and at 14.6% during the 2008 financial crisis. In Chart 12, we show the historical default rate, our macro model for the default rate, and the history of the default-adjusted spread. We also show what the default-adjusted spread would look like in four different scenarios for the default rate over the next 12 months: 6%, 9%, 11% and 15%. The placement of these numbers in the bottom panel of Chart 12 indicates where the Default-Adjusted Spread will be if each scenario is realized. Chart 12US High-Yield Is Not Cheap On A Default-Adjusted Basis Right now, our expectation is that there will be a virus driven US recession, but it will be shorter in magnitude than past recessions; this suggests a peak default rate closer to 9%. Such a scenario would still be consistent with a positive default-adjusted spread and likely positive excess returns for US high-yield relative to US Treasuries on a 12-month horizon. However, if a default rate similar to that seen during past recessions (11% or 15%) is realized, that would lead to a negative default-adjusted spread. Adding up both pieces of our valuation framework suggests that, while US high-yield spreads offer value on a duration-adjusted basis, spreads do not compensate enough for potential default losses if the US recession lasts longer than we expect. Thus, we recommend a tactical underweight position in US high-yield until we see better visibility on the severity, and duration, of the US recession. Adding up both pieces of our valuation framework suggests that, while US high-yield spreads offer value on a duration-adjusted basis, spreads do not compensate enough for potential default losses if the US recession lasts longer than we expect. As for euro area corporates, spreads for both investment grade and high-yield do look relatively wide on a breakeven spread basis, although less so than US credit (Chart 13). However, with the World Health Organization declaring Europe as the new epicenter of the COVID-19 pandemic, the harsh containment measures seen in Italy, Germany, France and elsewhere – coming from a starting point of weak overall economic growth – suggest that euro area spreads need to be wider to fully reflect downgrade and default risks. Chart 13Euro Area Corporates Look A Bit Cheaper On A Duration-Adjusted Basis We recommend a tactical underweight allocation to both euro area corporate debt and Italian sovereign debt, as spreads have room to reprice wider to reflect a deeper recession (Chart 14). Chart 14Stay Underweight Euro Area Spread Product Bottom Line: Corporate bond spreads on both sides of the Atlantic discount a sharp economic slowdown, but the odds of a deeper recession – and more spread widening - are greater in Europe relative to the US. A Quick Note On Recent Changes To Our Model Bond Portfolio In last week’s report, we made several adjustments to our model bond portfolio recommended allocations on a tactical (0-6 months) basis.1 Specifically, we downgraded our overall recommended exposure to global spread product to underweight, while increasing the overall allocation to government debt to overweight. The specific changes made to the model bond portfolio are presented in tables on pages 14 & 15. Within the country allocation of the government bond side of the portfolio, we upgraded US and Canada (markets more sensitive to changes in global bond yields, and with central banks that still had room to ease policy) to overweight, while downgrading core Europe to underweight and Japan to maximum underweight (both markets less sensitive to global yields and with no room to cut rates). On the credit side of the portfolio, we downgraded US high-yield to underweight (with a 0% allocation to Caa-rated debt), while also downgrading euro area investment grade and high-yield debt to underweight. We also lowered allocations to emerging market USD denominated debt, both sovereign and corporate, to underweight. We left the allocation to US investment grade debt at neutral, as the other reductions left our overall spread product allocation at the desired level (35% versus the 43% spread product weighting in our custom benchmark portfolio index). In terms of the specific weightings, the portfolio is now +11% overweight US fixed income versus the benchmark, coming most through US Treasury exposure. The portfolio is now -7% underweight euro area versus the benchmark, equally thorough government bond and corporate debt exposure. The portfolio is now also has a -7% weight in Japan versus the benchmark, entirely from government bonds. Note that these weightings represent a tactical allocation only, as we are recommending a defensive stance on spread product exposure given the near-term uncertainties over COVID-19 and global growth. On a strategic (6-12 months) horizon, however, we are neutral overall spread product exposure versus government bonds. Corporate bond spreads already discount a sharp economic slowdown and some increase in defaults. However, the rapid shift to aggressive monetary and fiscal easing by global policymakers to combat the virus will likely limit the duration and, potentially, the severity of the global slowdown currently discounted in wide credit spreads. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Train Is Empty", dated March 10, 2020, available at gfis.bcarsearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Yesterday, BCA Research’s US Bond Strategy service recommended investors with horizons of 1-year or longer buy TIPS versus equivalent-maturity nominal Treasuries. The COVID-induced global demand shock and the OPEC-induced oil supply shock have taken…
Highlights Duration: We are not prepared to say that bond yields have troughed, even with the fed funds rate now back to the zero bound. Investors should keep portfolio duration close to benchmark. We do not rule out longer-maturity Treasury yields falling to 0% during the next couple of months, but negative bond yields in the US are not possible. TIPS: Current low TIPS breakeven inflation rates signal a rare buying opportunity. Though price swings will be volatile for the next few months, investors with horizons of 1-year or longer would be well advised to go long TIPS versus equivalent-maturity nominal Treasuries. Corporate Bonds: Corporate spreads are widening rapidly but still don’t offer above-average compensation if we adjust for likely future default scenarios. We will wait for a better entry point before recommending a shift back to overweight. Feature Does The Fed’s Bazooka Signal The Bottom In Yields? Chart 1Back To The Zero-Lower-Bound In response to liquidity stresses witnessed in Treasury and MBS markets last week, the Fed decided to move this month’s FOMC meeting up to Sunday afternoon. It then took the opportunity to roll out a massive amount of easing. First the facts: The Fed cut the policy rate by 100 bps, back to the effective lower bound of 0% - 0.25%. Chair Powell also made it clear at his press conference that negative rates are not on the table. The Fed announced purchases of at least $500 billion of Treasury securities and $200 billion of agency MBS that will occur in the “coming months.” The Fed cut the discount window rate – the rate at which banks can borrow from the Fed for periods of up to 90 days – by 150 bps, bringing it down to 0.25%. The Fed said it is “encouraging banks to use their capital and liquidity buffers” (more on this below). The Fed also reduced the rate on its US dollar swap lines with other central banks. The new rate is OIS + 25 bps. The first major question for bond investors is whether this move will mark the bottom in yields (Chart 1). We aren’t so sure. As we write this on Monday morning the 2-year yield is 0.35%, down 14 bps from Friday’s close and the 10-year yield is 0.79%, down 15 bps from Friday. Obviously, further rate cuts won’t be the catalyst for lower bond yields, but investors can still push long-dated yields down if they start to price-in a longer period of time at the zero bound. In contrast, long-dated bond yields will only move up if we start to price-in an eventual economic recovery and exit from zero-bound rate policy. The fact that S&P futures went limit down immediately after the Fed’s big announcement suggests we aren’t at that point yet. Further rate cuts won’t be the catalyst for lower bond yields, but investors can still push long-dated yields down if they start to price-in a longer period of time at the zero bound. In last week’s report we introduced four criteria to monitor to decide when to call the trough in bond yields.1 Even with the Fed’s move back to zero, these four factors remain the most important things to watch. First, we want to see signs that the COVID-19 pandemic is becoming contained. That is, we want to see the daily number of new cases fall close to zero. We are still far away from that point (Chart 2), but evidence from China shows that containment is possible if the rest of the world follows a similar roadmap. Second, we want to see evidence of improving global growth, particularly in China. We showed last week how the Global and Chinese Manufacturing PMIs plunged in February. Since then, higher frequency global growth indicators – such as the performance of cyclical equities over defensives and the CRB Raw Industrials index – have not recovered at all (Chart 3). With very few new COVID cases in China and a large amount of stimulus on the way, we expect Chinese growth indicators to rebound in the coming months. Chart 2Tracking ##br##COVID-19 Chart 3Waiting For A Stronger Global Growth & Weaker US Growth Third, we want to see some bad economic data coming out of the US. As of today, the US Economic Surprise Index is a robust +74 and last week’s initial jobless claims and Consumer Sentiment releases were healthy (Chart 3, bottom 2 panels). We know the weak economic data are coming, but they haven’t arrived yet. Until they do, there is an elevated risk of another downleg in bond yields. We expect the time to call the bottom in bond yields will be when the US data are very weak and the Global and Chinese data are improving. Investors will use the global rebound as a roadmap for the US and start to push yields higher. Finally, we would like to see signals from some technical trading rules that have good track records of calling bottoms in bond yields. The technical rules we examined last week are all based on identifying periods when bond market sentiment is extremely bullish and when bond yield momentum hooks up. Chart 4Technical Trading Rules So far, none of the technical rules we identified have been triggered. Our Composite Technical Indicator remains in deeply “overbought” territory (Chart 4), but to generate a sell signal we also need one of our momentum measures to turn positive (Chart 4, bottom 3 panels). This hasn’t happened yet. All in all, none of our four criteria have been met. We are therefore inclined to think that it is too soon to call the bottom in bond yields. Investors should keep portfolio duration close to benchmark. Negative Yields In The US? We think it’s entirely possible that the 10-year Treasury yield could fall as low as 0% during the next couple of months. With the front-end of the curve already pinned at zero, any further market panic will be disproportionately felt at the long-end, and another spate of bad news could easily push the 10-year yield down to 0%. However, if the 10-year yield were to fall to 0%, we would declare that the trough in yields. In other words, negative bond yields will not occur in the US. Why is this the case? We can think of the 10-year Treasury yield as the market’s expected average fed funds rate for the next decade.2 That being the case, the 10-year yield would only turn negative if the market believed that the Federal Reserve was willing to take the policy rate below zero. On Sunday, Chair Powell was adamant that negative interest rates won’t be considered. He said that any further easing would take the form of forward guidance and asset purchases. The strongest form of that would involve caps on intermediate- and/or long-maturity bond yields. Please note that Powell didn’t mention yield caps specifically on Sunday, this is our inference based on past Fed communications. But the main point is that negative bond yields are a policy choice, one that the Federal Reserve is not inclined to make any time soon. It’s highly notable that no country without a negative policy rate has seen negative bond yields further out the curve. One result of the Fed’s “lower for longer” bias is that, coming out of the current crisis, we would expect the equity market to bottom and corporate bond spreads to peak before Treasury yields move higher. Another factor that will weigh on how low long-end Treasury yields fall is whether the market thinks that the Fed views its recent rate cut as an “emergency measure” that will be quickly reversed when the COVID crisis passes, or as a more long-lasting policy change. The Fed was deliberately vague on this question in its statement, saying that it will maintain the current fed funds rate “until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.” The Fed was deliberately vague precisely because it doesn’t know how quickly it will tighten policy. But given that the result of this year’s Strategic Review will likely be an explicit targeting of above-2% inflation, we can be fairly certain that the Fed will be slow to remove accommodation. We continue to view inflation expectations and financial conditions as the two most important indicators to track to determine the pace of eventual tightening.3 One result of the Fed’s “lower for longer” bias is that, coming out of the current crisis, we would expect the equity market to bottom and corporate bond spreads to peak before Treasury yields move higher. Bottom Line: We are not prepared to say that bond yields have troughed, even with the fed funds rate now back to the zero bound. So far, none of the four triggers we will use to call the bottom in yields have sent a signal. In fact, we do not rule out longer-maturity Treasury yields falling to 0% during the next couple of months, but negative bond yields in the US are not possible. The Fed’s Emergency Liquidity Measures Chart 5A Lack Of Liquidity On Sunday, Fed Chair Powell said that the reason for moving the FOMC meeting forward was because of worrying signs of deteriorating liquidity in Treasury and Agency MBS markets. Specifically, many observed that the spreads between short-term financing rates (both secured and unsecured) and the risk-free OIS curve jumped last week (Chart 5). Also, mortgage rates didn’t follow Treasury yields lower (Chart 5, bottom panel) and bid/ask spreads widened in the Treasury market. Diagnosing The Problem Our assessment of last week’s liquidity problems is that they arose because, in this post Dodd-Frank/Basel III world, dealer banks are still not sure how to respond during periods of stress. Last week, a lot of nonfinancial firms tapped their revolving credit lines in an attempt to weather the upcoming downturn. This caused an outflow of cash from the banking system. With banks now holding less cash than they were comfortable with, the price of cash in money markets (repo, LIBOR, etc…) started to spike. Because repo is a commonly used tool for financing Treasury trades, the knock-on effect of a spike in the repo rate is a loss of liquidity in the Treasury market. But are banks really short of cash? We got a small taste of the confusion around this issue when repo rates spiked last September. The Fed assumed that it had plenty of room to shrink its balance sheet and drain cash from the banking system because the banks were operating with large liquidity buffers, in excess of what was mandated by regulations like the Liquidity Coverage Ratio (LCR). However, it turned out that banks wanted to hold much more cash than was required by the LCR, in large part because they worried about the Fed’s periodic stress tests, the criteria of which can change over time. The Fed’s Solutions Fortunately, the Fed has taken a lot of aggressive action to help mitigate these problems. First, it announced a large quantity of repo operations last week, then followed that up by announcing direct Treasury and MBS purchases on Sunday. The Fed also lowered the discount window rate to a mere 0.25%, and is encouraging banks to tap that facility if necessary. But, in our view, perhaps the most important measure the Fed announced is simply that policymakers will encourage banks to “use their capital and liquidity buffers”. The fact of the matter is that banks are carrying large amounts of cash but have been hesitant to deploy it because they are worried about regulatory backlash from the Fed. If the Fed can effectively assure banks that it won’t be aggressively enforcing any regulatory action against them for the foreseeable future, then there is already a lot of liquidity in the system waiting to be deployed. Though we expect the Fed’s measures will have a significant positive impact on market liquidity, it will be important to monitor money market spreads going forward. The Fed has still not taken the extreme step of re-launching its crisis-era commercial paper facility and lending directly to nonfinancial corporates. This would be a likely next step if liquidity conditions continue to deteriorate. A Rare Opportunity In TIPS Together, the COVID-induced global demand shock and the OPEC-induced oil supply shock have taken TIPS breakeven inflation rates down to extraordinarily low levels. As of Friday’s close, the 10-year TIPS breakeven inflation rate was a mere 0.92%, the 5-year rate was 0.56% and the 1-year rate was an absurd -0.49%. In fact, both the 1-year and 2-year breakeven rates were negative! For buy and hold investors, this presents an outstanding opportunity to buy TIPS and short the equivalent-maturity nominal bond. For example, a buy and hold investor will make money by going long TIPS and short nominals as long as headline CPI inflation averages above 0.56% per year for the next five years or above 0.92% per year for the next decade (Chart 6). The fact that the 1-year and 2-year breakeven rates are negative is an even greater mispricing because TIPS come with embedded deflation floors. That is, TIPS principal is adjusted higher by the rate of headline CPI inflation but it is never adjusted lower if headline CPI inflation turns negative. The deflation floor means that a negative 1-year or 2-year TIPS breakeven inflation rate represents risk-free profit for anyone who can commit capital for the entire 1-year or 2-year investment horizon. A buy and hold investor will make money by going long TIPS and short nominals as long as headline CPI inflation averages above 0.56% per year for the next five years or above 0.92% per year for the next decade. But abstracting from deflation floors, is it even realistic to expect negative headline CPI during the next 12 months? Even in a worst-case scenario, it is difficult to imagine. First, let’s assume that the Brent crude oil price falls to $20 during the next month and then stays there. The second panel of Chart 7 shows that this would cause year-over-year Energy CPI to hit -20% before recovering. Second, let’s assume that core CPI follows the path implied by our Pipeline Inflation Pressure Gauge, falling from its current 2.4% to 1.8% for the next 12 months (Chart 7, panel 4). Third, let’s assume that year-over-year food inflation collapses all the way to 0% (Chart 7, panel 3). Chart 6TIPS Breakeven Inflation Rates Are Too Low Chart 7Worst-Case Scenario For CPI This worst-case scenario would result in 12-month headline CPI of +0.09% for the next 12 months (Chart 7, bottom panel). Now, core CPI inflation did fall below 1% during the last recession, an occurrence that would certainly lead to headline CPI deflation if it happened again. However, shelter makes up 42% of core CPI. Without a significant slowdown in the housing market, such a large decline in core inflation is unlikely. Bottom Line: Current low TIPS breakeven inflation rates signal a rare buying opportunity. Though price swings will be volatile for the next few months, investors with horizons of 1-year or longer would be well advised to go long TIPS versus equivalent-maturity nominal Treasuries. Corporate Bond Spreads:Too Soon To Buy Corporate bond spreads have widened dramatically during the past few weeks. Within the investment grade space, the overall index spread and the average spread excluding the energy sector have both broken above their 2016 peaks. The investment grade energy spread is still 56 bps below its 2016 peak (Chart 8A). In high-yield, the overall index spread is still 112 bps below its 2016 peak. The energy spread is 23 bps below its 2016 peak and the ex-energy spread is 112 bps below its 2016 peak (Chart 8B). Chart 8AInvestment Grade Corporate Bond Spreads Chart 8BHigh-Yield Corporate Bond Spreads Obviously, spreads are widening quickly and value is returning to the sector. This raises the important question of: When will it be a good idea to step in and buy? To answer this question we need to view current spread levels relative to the magnitude of the upcoming economic shock. During the past 12 months, the speculative-grade corporate default rate was 4.5% and our macro model already anticipates a rise to 6.2%. This would bring the default rate above the 5.8% peak seen in 2017, but is probably still too low of an estimate given that the upcoming corporate profit hit is not yet reflected in our model (Chart 9). Gross leverage – the ratio of total debt to pre-tax profits – enters our default rate model with a roughly six month lag, meaning that we wouldn’t expect any current hit to profits to impact the default rate for another six months. For further context, we note that the default rate peaked at 11.2% during the 2001/02 default cycle and at 14.6% during the 2008 financial crisis. Chart 9An Above-Average Default-Adjusted Spread Signals A Buying Opportunity The bottom panel of Chart 9 shows our High-Yield Default-Adjusted Spread. This is a measure of the excess spread in the high-yield index after subtracting ex-post default losses. Its historical average is around 250 bps. We shocked our Default-Adjusted Spread to see what it would be in four different scenarios for the default rate: 6%, 9%, 11% and 15%. The placement of these numbers in the bottom panel of Chart 9 indicates where the Default-Adjusted Spread will be if each scenario is realized. For example, if the default rate comes in at 6% for the next 12 months then the Default-Adjusted Spread will be +347 bps, above its historical average. If the default rate is 9% during the next 12 months the Default-Adjusted Spread will still be positive, at +108 bps, but will be below historical average. A default rate similar to what was seen during past recessions (11% or 15%) would lead to a negative Default-Adjusted Spread. Right now, our best estimate of a short-lived recession would suggest a peak default rate of somewhere between 6% and 9%, probably closer to 9%. Such a scenario would be consistent with a positive Default-Adjusted Spread and likely positive excess returns for corporate bonds (both investment grade and high-yield) relative to Treasuries on a 12-month horizon. However, we also note that periods of spread widening usually culminate with our Default-Adjusted Spread measure well above its historical average. This was the case in 2016, 2009 and 2002. As of now, this sort of attractive valuation will only be achieved if the default rate is 6% or lower during the next 12 months, a forecast that seems overly optimistic. The bottom line is that we are inclined to wait for a more attractive entry point before recommending a shift back to an overweight allocation to corporate bonds versus Treasuries. Though it is probably too late for investors with long time horizons (12 months or more) to sell. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “When And Where Will Bond Yields Trough?”, dated March 10, 2020, available at usbs.bcaresearch.com 2 Technically, the 10-year yield is equal to 10-year rate expectations plus a term premium to compensate investors for locking up funds for 10 years instead of rolling over a series of overnight investments. The term premium is difficult to estimate in practice, but it is likely to be quite close to zero at present. 3 For further details on why investors should focus on these two measures to assess the pace of eventual policy tightening please see US Bond Strategy / Global Fixed Income Strategy Special Report, “The Fed In 2020”, dated December 17, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The S&P 500 is in a bear market, and a recession appears to be inevitable, … : The longest bull market in S&P 500 history succumbed last week to the Saudi-Russia oil war, the relentless drumbeat of spreading COVID-19 disruptions and the realization that it will take even worse market conditions to prompt a meaningful fiscal response. … but it is BCA’s view that the recession will be short, if sharp: Although our conviction level is low, and our view is subject to change as more information becomes available, we expect that the recession is much more likely to produce a V-bottom than a U-bottom. Pent-up demand will be unleashed once the coronavirus runs its course, stoked by monetary and fiscal stimulus initiatives around the world. Are central banks out of bullets?: We are not yet ready to embrace the most provocative idea that came up at our monthly View Meeting last week, but the question highlights the uncertainty that currently pervades markets. First, do no harm: What should an investor do now? Watch and wait. It is too early to re-risk a portfolio, but safe-haven assets are awfully overbought. Cash is worth its weight in gold right now, and those who have it should remember that they call the shots. Feature The S&P 500 entered a bear market last Thursday, bringing down the curtain on the longest US equity bull market in recorded history at just under 11 years.1 We are duly chastened by the misplaced bravado we expressed in last week’s report, which crumbled under the force of the ensuing weekend’s oil market hostilities between Saudi Arabia and Russia. We see the plunge in oil prices, and the looming spike in oil-patch defaults, bankruptcies and layoffs, as the straw that broke the camel’s back, ensuring a 2020 recession. Now that it has slid so far, we expect that the S&P 500 will generate double-digit returns over the next twelve months, but we do not believe that investors should be in any rush to buy. Wild oscillations are a sign of an unhealthy market, and stocks don’t establish a durable bottom while they are still experiencing daily spasms. The Fundamental Take (For What It’s Worth) We nonetheless believe that the recession will be fairly brief, even if it is sharp. The global economy was clearly turning around before the virus emerged, and the US economy was as fit as a fiddle. Data releases across February were decidedly positive, on balance, and the year-to-date data, as incorporated in the Atlanta Fed’s GDPNow model, pointed to robust first quarter growth in an economy that was firing on all cylinders (Chart 1). We continue to believe that most of the demand that goes missing across the first and the second quarters will not be lost for good, but will simply be deferred to the second half of this year and the beginning of next year. The coronavirus has brought an end to the expansion, but the US economy was in rude health before it was infected, and we expect it will make a full and swift recovery. Chart 1The First Quarter Had Been Shaping Up Really Well Chart 2Old Faithful That pent-up demand will be goosed by abundant monetary and fiscal stimulus. We expect that China and the US will take the lead, and will have the most impact on global aggregate demand, but that policymakers in other major economies will also lend a hand. Central banks in Australia, Canada and England have all cut rates in the last two weeks, and British policymakers took the boldest step, pairing last week’s rate cut with an immediate 30-billion-pound infusion of emergency spending, and a pledge to spend 600 billion pounds on infrastructure upgrades between now and 2025.2 Australia announced a plan to inject fiscal stimulus equivalent to about 1% of GDP Thursday morning, and Germany’s ruling party indicated a willingness to run a budget deficit to combat the virus.3 Our China Investment Strategy team notes that the Chinese authorities are already supporting domestic demand via aid to threatened businesses and out-of-work individuals, and are poised to open the infrastructure taps (Chart 2). Global aggregate demand is also set to receive a boost from the oil plunge, although it will arrive with a lag. Energy sector layoffs and the tightening in monetary conditions from wider bond spreads and marginally tighter bank lending standards will exert an immediate drag on activity. Once that drag fades, however, the positive supply-shock effects will take hold, helping households stretch their paychecks and non-energy businesses expand their profit margins. Although the effect of falling oil prices is mixed for the US now that fracking has made it a heavyweight oil producer, more economies are oil importers than exporters, and global growth is inversely related to oil price moves. We are keenly aware that markets are paying no attention whatsoever to economic data releases right now. They are backward-looking, after all, and fundamentals are not the driving force behind current market moves anyway. The data are useful, however, for evaluating the fundamental backdrop once the non-stop selling abates, as it eventually will. When it becomes important to take the measure of the economy and where it’s headed, investors will be able to make a more informed judgment if they have a good read on how the economy was doing before it was exposed to the virus (Chart 3). Chart 3Layoffs Are Coming, But They Hadn't Started By Early March Investment Strategy The near-term equity view was cautious when we held our View Meeting Wednesday morning before the open. No one thought investors should be in any hurry to buy, and while not everyone shared the bleakest S&P 500 downside estimate of 2,400 (well within sight now), no one suggested that the index had already bottomed. One participant made the case for a negative 10-year Treasury yield, but we still have little appetite for Treasuries as a house. We expect the 10-year yield will be higher in twelve months than it is now, if perhaps only modestly. We like equities' 12-month prospects, but they may have to decline some more before Congress joins hands and puts a floor under them. For anyone expecting US fiscal stimulus to bail out the markets, our geopolitical team sounded a note of caution. A recession is kryptonite for incumbent presidential candidates, and the more the virus squeezes the economy, the greater the Democrats’ chances of capturing the White House and the Senate. Our Geopolitical Strategy service fully expects that Democrats will eventually agree to a sizable spending package, but only after allowing the situation to deteriorate some more. As long as they don’t look like they’re putting party concerns ahead of the nation’s welfare, they can dent the president’s re-election prospects by waiting to throw a lifeline to the economy and financial markets. The administration’s initial proposal, as alluded to in the president’s prime-time Oval Office address on Wednesday night, fell way short of what the market sought. Its small-bore items seemed woefully inadequate to stem the tide, and raised the unsettling prospect that the fiscal cavalry might fail to ride to the rescue because the administration didn’t think it needed to be summoned. The good news for markets is that governments get an almost unlimited number of do-overs.4 The first iteration’s failure ensures that the second will be more ambitious, and if that fails, the third iteration will be even bigger. Thank You, Sir, May I Have Another? News of disruptions to economic activity, and daily life, in the United States piled up last week. Colleges closed their gates en masse for what remains of the academic year; concerts and music festivals were cancelled; the NCAA basketball tournament was initially closed to fans, then cancelled altogether; and all of the major North American professional sports leagues have suspended their seasons. In many instances, city and state ordinances banning mass gatherings forced sports franchises’ and concert promoters’ hands. The relentless drumbeat of bad news did markets no favors, and it surely did not help business or consumer confidence as broadcasters, hotels, restaurants, bartenders, taxi drivers and arena staff totted up their lost income. Today’s pain may be tomorrow’s gain, however. While draconian measures weigh on peoples’ spirits and crimp economic activity in the immediate term, they increase the chances of limiting the virus’ spread and mitigating its ultimate effect. As our Global Investment Strategy colleagues have pointed out, there is a trade-off between health and growth. Bulking up health safeguards unfortunately involves some growth sacrifices. Are Central Banks Out Of Bullets? Chart 4If At First You Don't Succeed, ... The most provocative line of argument in last week’s firm-wide discussion was the idea that the coronavirus is a bit of a red herring, and that the true driver of the global market selloff is the failure of the policy put. That’s to say that the efficacy of, and the belief in, central banks’ ability to shore up markets and the economy has crumbled. So far, this round of emergency rate cuts has failed to stem the flow of red on Bloomberg terminals and television screens (Chart 4). Spending plans have underwhelmed as well, with British, Australian and Japanese equities all fizzling following the announcement of fiscal stimulus measures. The end of markets’ monetary policy era would mark a major inflection point, if not a full-on regime change. We are hesitant to make such a sweeping declaration now, however. As one of our colleagues put it in making the case for further declines in rates, the golden rule of investing is never to lean against a primary trend. Positioning for an end to central banks’ influence on markets would mean going against 33 years of history that began with the Fed’s post-Black Monday statement affirming its “readiness to serve as a source of liquidity to support the economic and financial system.” Central bankers are neither omniscient nor omnipotent, but there’s a reason why You can’t fight the Fed became a cherished truism. It affects the real economy when it turns its policy dials. If monetary stimulus is aligned with fiscal stimulus, as it just might be next week, it can make for a potent cocktail. A devotee of the Austrian School of Economics may grind his or her teeth to dust over the endless intervention in markets, but the results are popular with the public and elected officials, and we can expect that they’ll continue over most professional investors’ relevant timeframes. Public officials will let go of the Debt Supercycle controls only when they’re pried out of their cold, dead hands. What Now? It feels like it was a month ago, but just last week we were of the view that a correction was more likely than a bear market. As we wrote then: We remain constructive on risk assets because we think the selling has gotten overdone. There may well be more of it, and the S&P 500 could reach its 2,708.92 bear-market level before we can publish again next Monday, but we will be buying it in our own account all the way there. Compounding our embarrassment and regret, we actually did buy shares in a SIFI bank on Tuesday as they approached their tangible book value. Markets were unimpressed with the initial monetary salvo, but there's more where that came from (and some fiscal artillery, too). We have learned our lesson and will wait before committing any more capital. We have also learned our lesson about “overdone selling.” Despite the dramatic gap between the S&P 500 and its 200-day moving average (Chart 5), every single sale over the last three weeks has proven to be a good one. Cutting one’s losses is a deservedly celebrated portfolio management rule, and we cannot object to any client who wants to take some exposure off the table. Chart 5The Equity Selloff Has Become Extreme We have little love for the havens that have already spiked, like gold, Treasuries, utilities and makers and sellers of hand sanitizer, disinfectant wipes and surgical masks. Insurance in the form of index puts is bracingly expensive. Our preferred way of taking advantage of the massive market disruption (Chart 6 and Table 1) is to write out-of-the money puts on individual stocks at strike prices where we’d be happy to own them. With the VIX in the 50s, much less the 60s or 70s, an investor writing puts 10% out of the money on a range of S&P 500 constituents5 can get paid double-digit annualized returns in exchange for agreeing to get hit down 10% between now and March 20th or April 17th. Chart 6Selling Insurance Looks More Appealing Than Buying It Right Now Table 1One Week, Two Historic Declines We recognize that not every investor has discretion to write puts, and it is not something to be done lightly in any event. The compensation is so high because it is a contractual agreement to buy stock in a relentlessly falling market. (Options only confer a right to transact for their buyers; they’re an iron-clad obligation to transact for their sellers.) Our species’ cognitive biases being what they are, however, we like the strapped-to-the-mast feature of writing puts because it commits an investor to following through on a course of action s/he decided upon before price declines had a chance to shake his/her resolve. It is one thing to have said that one would buy a 35-dollar stock if it ever got to 18, and quite another to follow through now that it’s gone from 35 to 21 in short order. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The bull market began on March 10, 2009, at 676.53, and ended February 19, 2020, at 3,386.15. Its 400% advance was achieved at an annualized rate of 15.8%. 2 Nominal 4Q19 UK GDP was about 560 billion pounds. 3 Believe it or not, this is kind of a big deal for Berlin. 4 As we were going to press, it looked as if House Democrats and the administration were nearing agreement on a package to protect vulnerable workers and small businesses, while the combined private- and public-sector efforts outlined in the Rose Garden suggested that the US might be capable of stemming the spread of the virus soon. 5 Type [ticker]-F8-PUT into Bloomberg for the full menu of maturities and strike prices for any given stock. The annualized return for writing the put is equal to the option premium divided by the strike price, multiplied by (360/the number of days until expiration). For near-month contracts, if the premium is around 1% of the strike, the annualized return on the notional capital committed is 10%.
Feature “People have been asking me whether this is the time to buy. My answer is more nuanced: it’s probably a time to buy.” Howard Marks, Oaktree Capital, Monthly Memo March 2020 Markets have moved dramatically since we published our Monthly Portfolio Update on March 2. Global stocks have fallen by 27% since then. The 10-year US Treasury yield fell from 1.2% to 0.4% before rebounding to 0.8%. And there have been some strange market moves: the US dollar fell then rebounded, and the classic safe haven, gold, has fallen by 7%. Investors are struggling with how to think about this environment, and how to position. Chart 1Risk Assets Should Bottom When New Ex-China Cases Peak Table 1US Healthcare Is Top Quality Our view has not greatly changed. We still believe that risk assets will bottom around the time when global COVID-19 cases peak. They showed signs of a rebound when cases in China peaked on February 13. And they started their recent crash when ex-China cases began to accelerate dramatically (Chart 1). It is likely – and well anticipated – that there will be a sharp rises in cases in the US (and probably the UK and Canada too) over the coming two or three weeks. It is wrong to think, though, that the US is particularly badly prepared for this. The US has a high standard of healthcare, with many more intensive-care beds per person than other developed countries (Table 1) – though it is worrying that some 20% of the US population is uninsured. We see two possibilities for how the pandemic will pan out in coming weeks: The US is the last big cluster and new cases peak there in early April. This causes a two-quarter recession. But if COVID-19 turns out to be seasonal (it has not spread much in hot countries such as Singapore, or in the southern hemisphere where it is now summer – Chart 2) and by April and May it peters out. US consumers stop going out for a while (the professional hockey, basketball, and soccer seasons have been put on hold) and so demand falls. Typically, stocks fall by 25-30% in a recession of this type (Table 2) – and so this is already close to being discounted. There are no longer-term impacts, and soon the world economy is getting back close to normal. Chart 2Will Hot Weather End The Pandemic? Table 2Peak-To-Trough Falls In Equities In Bear Markets The pandemic continues for months. Governments are able to slow contagion via social distancing in order to spread out the pressure on their health services over a longer period. But ultimately one-half to two-thirds of the world’s population gets the disease and the death rate among those people is 0.7% (the rate in Korea, which extensively tested for the virus and has a good medical system). This means worldwide deaths of about 20 million, disproportionately concentrated among the over-70-year-olds and those with chronic illnesses (Chart 3). The disease could spread to poor countries, such as India and Africa, where healthcare services would not be able to cope. The global economy would slow significantly, causing a severe recession. There would be second-round effects: for example, a blow-up in the US corporate credit markets, where debt is already high as a percentage of GDP (Chart 4), which could cause banks to drastically tighten lending conditions. This could cause problems with foreign-currency EM borrowers. It could trigger another euro zone crisis, as banks in southern Europe prove unable to cope with rising defaults. In this scenario, the peak-to-trough decline in global equities could be 40-50%. Chart 3COVID-19 Mostly Kills Old And Sick People Chart 4US Corporate Debt Is A Vulnerability In our last Monthly, we talked about the usefulness of a Bayesian approach in this sort of uncertain environment. We ascribed a “prior” probability of 10-20% for the latter scenario. The probability has now risen, to perhaps 25%. Chart 5Close To Capitulation But the potential upside from Scenario 1) is considerable. Central banks around the world are throwing everything at the problem. Countries from the UK and Italy, to Japan and Australia have rolled out big fiscal packages this week. The key now is what will the US do. How positively would markets react if the US in coming days scripted a coordinated announcement, with the Fed cutting rates to zero, and the White House and Congress agreeing an $800 billion fiscal package. The Fed is likely to do this – indeed the market is pricing in the Fed Funds Rate at zero by the next FOMC meeting on March 18. The dynamics of fiscal stimulus are more complicated – the Democrats don’t want to give President Trump a boost that will help his election prospects, but they don’t want to be seen to be obstructive in a time of emergency either.1 So what should investors do? We have been tempted in recent days to lower our Overweight recommendation on equities, which has evidently proved wrong, to Neutral. But we fear it is too late to do this, particularly with equities having fallen by 15% over the past two days. There is probably still some downside. We would now look for signs of a bottoming-out, most notably the peak in new COVID-19 cases outside China, but also evidence of capitulation by investors (Chart 5). Moreover, we would pay attention to potential upside surprises (in addition to a Fed/White House/Congress joint package, maybe a making-up between Russia and Saudi Arabia on oil production cuts). In the meantime, when markets move as violently as they have, often the baby gets thrown out with the bathwater. There are many individual securities, in both debt and equity markets, that look very attractively valued now. For example, we see a lot of attraction in high-dividend-yield stocks, which might appeal to investors who no longer see the point of investing in government bonds, where the upside – even in a severe recession – is likely to be very limited. Table 3 shows a screening of large-cap stocks in developed markets with a dividend yield of more than 10%, taken from BCA Research’s ETS quants screening service. While many of these are in the Energy sector (where the price/book ratio is now below the lows of 2008 and 2015 – Chart 6), quality names among European Financials and Asia Industrials are also prominent. Table 3Stocks With Dividend Yield Above 10% Chart 6Energy Sector Valuation At Record Low For investors who want to remain risk-off, we would not recommend government bonds as a hedge. It is notable that the Swiss 10-year government bond yield has not fallen in the recent melt-down. They are simply at their theoretical lower bound. German Bunds must be close. The Fed has been clear that it will not cut policy rates below zero, which means that the lower limit for US Treasurys is probably around 0% too. Even in the severest recession, therefore, the upside for Treasurys is limited to 9% (Table 4). This means returns are likely to be very asymmetrical since, in a rebound in risk appetite, yields could rise sharply. Table 4Little Upside From Government Bonds We prefer cash as a hedge. This gives investors dry powder for use when they do want to reenter risk assets. We have been recommending gold, and it will probably continue to serve as a safe haven in the event of our most pessimistic scenario happening. But it looks very overbought in the short term (Chart 7) – as demonstrated by the way that it has recently been correcting even on days when equities fall. TIPS offer a better hedge than nominal bonds, given how low inflation expectations have fallen – the 5-year/5-year forwards now point to CPI inflation in 2025-2030 averaging 1.5% (Chart 8). This implies – highly unrealistically – that the Fed will miss its 2% PCE inflation target by 1 percentage point a year over that period. Chart 7Gold Is Overbought Chart 8Inflation Expectations Unrealistically Low Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy, Weekly Report, "GeoRisk Update: Leap Year, Or Steep Year?" available at gps.bcaresearch.com.
On a happy personal note, I will be away on paternity leave for a short time, reacquainting myself with nappies. As such, there will be no Weekly Reports for the next two weeks, but you will receive two excellent Special Reports penned by my colleagues. Given the ongoing turbulence in the financial markets I will also send out short Alerts as and when necessary. Highlights After the worst three-day rout for stocks versus bonds in living memory, six-month investors have fully capitulated, and the markets are now priced for a technical recession. If the recession can be limited to two quarters, stocks are more likely to outperform long-dated bonds by 12 percent than to underperform by a further 12 percent. Tactical trade: overweight S&P500 versus German 30-year bund, currency hedged, setting a 12 percent profit target with symmetrical stop-loss. The closer that a bond yield gets to the -1 percent lower bound, the more limited becomes the possibility for a further yield decline. Overweight positive yielding bonds versus negative yielding bonds, currency hedged. The most attractive structural pair is overweight the US 30-year T-bond versus the German 30-year bund. Feature Chart of the WeekWidow Makers: Shorting Bonds In Japan, Switzerland... And Now The US A Recession Is Now Fully Priced Financial markets have fully priced a downturn when the time horizon of investors that have fully capitulated = the length of the downturn. A week can be a long time in the financial markets. Seven days ago, the markets were not priced for a global recession. Then came the worst three-day rout for stocks versus bonds in living memory, in which stocks underperformed long-dated bonds by 25 percent (Chart I-2).1 Chart I-2The Worst 3-Day Rout: Stocks Underperformed Bonds By 25 Percent The upshot is that investors with six-month horizons have now fully capitulated, meaning the markets are now fully priced for a technical recession (Chart I-3) – defined as a downturn lasting two straight quarters. But the markets are not priced for a more prolonged downturn lasting longer than two quarters. Raising the question: can the downturn be limited to the first half of the year? Chart I-3Six-Month Investors Have Capitulated, Meaning A Recession Is Fully Priced The pessimistic case is that the coronavirus can neither be contained nor normalised by the summer. Or that even if its direct impact ebbs, there might be second-round effects. A major credit default from, say, a distressed airline or other travel-dependent company could trigger aftershocks in the financial system. Moreover, the recent collapse in the oil price injects new uncertainty into the energy patch as well as into geopolitics. The optimistic case is that large segments of the economy are set to receive a 2009 type triple-boost: from a sharp deceleration in bond yields; from a sharp deceleration in the oil price; and from government spending and/or tax cuts – creating a potent cocktail of stimulants for the second half of this year. Investors with six-month horizons have now fully capitulated. Balancing the pessimistic and optimistic cases, we assess that the downturn can be limited to two quarters – albeit this cannot be our highest conviction view, as we are not experts in epidemiology or immunology. Nevertheless, if this assumption holds, there is now a higher probability that stocks outperform long-dated bonds by 12 percent than that they underperform by a further 12 percent. This three-month tactical trade has a slight twist. It is best expressed as: overweight US stocks versus European bonds (currency hedged). This is because core European bond yields are close to their lower limit, meaning that core European bond prices are close to their mathematical upper limit. All of which brings us to a much higher conviction recommendation. The ‘Widow Maker’ Is Back First the widow maker came to Japan, next to Switzerland, then to the rest of Northern Europe. Now the widow maker has come to America. In the financial lexicon, ‘widow maker’ refers to the fatal strategy of shorting high-quality government bonds in an era when yields have been grinding inexorably lower. Any investment manager who has dared to bet that government bond yields would rise, whether starting from 3 percent, 2 percent, or even 1 percent, and whether in Japan, Switzerland, or even the US – has ended up being carried out of their job in a box, feet first (Chart of the Week). Except that in Switzerland over the past year, the widow maker trade has not been as fatal as it used to be. While the 5-year yield in the US has collapsed by 200 bps, in Switzerland it has edged down by just 20 bps (Chart I-4). Put another way, shorting the US 5-year T-bond has cost 11 percent, but shorting the Swiss 5-year bond has been relatively painless (Chart I-5). Chart I-4Swiss Bond Yields Cannot Fall Much... Chart I-5...Meaning Swiss Bond Prices Cannot Rise The simple reason is that Swiss government bond yields are now very close to their lower bound. The Lower Bound To Bond Yields Is Around -1 Percent The practical lower bound to the policy interest rate is -1 percent, because -1 percent counterbalances the storage cost of holding physical cash and/or other stores of value.2 Imagine the policy rate fell to well below -1 percent. If banks passed this deeply negative rate to their depositors, it would be logical for the bank depositors to flee wholesale into cheaper-to-hold physical cash. This deposit flight would kill the banking system. But if the banks didn’t pass the deeply negative policy rate to their depositors, it would wipe out the banks’ net interest margin – the gap between rates on loans and deposits. This inability to make profits would also kill the banking system. At deeply negative interest rates, bank deposits would flee. Could policymakers just abolish physical cash, forcing us all into ‘digital cash’ with unlimited negative interest rates? No, because that would just push us into other stores of value: for example, gold, or ‘decentralised’ cryptocurrencies. The common objections to cryptocurrencies are that their susceptibility to volatility and fraud makes them a poor store of value. But both objections are also true for gold. Yet who has ever argued that gold cannot be a store of value just because it is volatile and can be stolen (Chart I-6)! Chart I-6Gold Is A Store Of Value Despite Its Volatility The lower bound to the policy rate at around -1 percent also sets the lower bound of the bond yield, because a bond yield is just the expected average policy rate over the bond’s lifetime. For completeness, we should mention one technical exception. If bond investors price in the possibility of being repaid in a different and more valuable currency, the bond yield will carry a further redenomination discount as an offset for the potential currency gain. This is relevant to euro area bonds because there remains the remote possibility of euro disintegration. Therefore, bonds which carry the small possibility of a currency redenomination gain – notably, German bunds – possess a small additional discount on their yields. But in jurisdictions where no currency redenomination is possible, such as Switzerland or Sweden, the practical lower bound to bond yields is around -1 percent. Overweight Positive Yielding Bonds Versus Negative Yielding Bonds Switzerland teaches us that the closer that a bond yield gets to the -1 percent lower bound, the more limited becomes the possibility for a further yield decline (price gain), whereas the possibility for a yield increase (price loss) stays unlimited. Making such bonds a ‘lose-lose’ proposition. The convergence in bond yields has much further to go. Therefore, our high conviction recommendation is to short negative yielding bonds in relative terms. In other words, overweight positive yielding bonds versus negative yielding bonds. And currency hedge the position – as, right now, the cost of currency hedging is low. The recommendation is applicable for both tactical (3-month) and structural (2-year plus) investment horizons, and it is applicable for all bond maturities: 5-year, 10-year, and 30-year. Given where yields now stand, the most attractive structural pair is overweight the US 30-year T-bond versus the German 30-year bund (Chart I-7 and Chart I-8). Chart I-7Expect Yields To Converge At 10-Year Maturities... Chart I-8...And At Ultra-Long ##br##Maturities Our structural overweight to a 50:50 combination of U.S. T-bonds and Italian BTPs versus a 50:50 combination of German Bunds and Spanish Bonos at 30-year bond maturities is up by 7 percent in just nine months. But the convergence in yields has much further to go (Chart I-9). Chart I-9Overweight Positive Yielding Bonds Versus Negative Yielding Bonds Fractal Trading System* As discussed, this week’s recommended trade is to overweight stocks versus long-dated bonds expressed as overweight S&P500 versus German 30-year bund. The profit target is 12 percent with a symmetrical stop-loss. In a turbulent week for financial markets, overweight Poland versus Portugal achieved its profit target, short US utilities versus oil and gas and short EUR/CHF hit their stop-losses, and short palladium versus nickel moved comfortably into profit. The rolling 1-year win ratio now stands at 62 percent. Chart I-10Poland Vs. Portugal When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 MSCI All-Country World Index (in dollars) versus US 30-year T-bond. 2 The cost of holding physical cash or gold is the cost of its safe storage. Fractal Trading Model Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations