Inflation/Deflation
Highlights Despite our tactical bullish stance, the cyclical outlook remains firmly negative for the yen, with a 12-month target for USD/JPY above 120. The BoJ is currently committed to an inflation overshoot, with this solid commitment, a strong economy will be able to lift inflation expectations, depress real interest rates, and hurt the yen. The key improvements pointing to higher inflation expectations are: Already positive inflation expectation dynamics, the closing of the output gap, the removal of the fiscal drag, the tightness in the labor market, and the end of the private-sector deleveraging. The tactical environment suggests that nimble traders with short investment horizons should stay short USD/JPY for now. Longer-term investors may want to add to short bets on the yen on further weaknesses. Feature We have espoused a cyclically bearish stance on the yen since September when the BoJ began targeting the price of money instead of the quantity of money, aiming for stable JGB yields around 0%.1 More recently, we have been buyers of the yen on a tactical basis. Here, we are reviewing whether this tactical call should morph into a cyclical bullish stance on the yen or whether the primary trend for the yen still points lower. Ultimately, we expect USD/JPY to punch through 120 on a 12 month basis. The Liquidity Trap Our framework to analyze the yen rests on one key assumption: Japan remains mired in liquidity trap dynamics. As we have pointed out before, the key symptom of this disease is evident in the Land of the Rising Sun: Loan demand has become irresponsive to changes in private sector borrowing costs (Chart I-1). In this environment, we can experience strange dynamics. As we argued in details a few months ago, when both in a liquidity trap and at the lower bound of interest rates, the demand for money is infinite, and interest rates are independent of the level of output in the economy.2 In other words, a decrease in exports, government spending, or investment, hurts demand without affecting nominal interest rates (Chart I-2, middle panel). However, in the long run, decreases in aggregate demand exert downward pressure on prices, and thus, lower inflation expectations today (Chart I-2, bottom panel). The opposite is true for a positive demand shock. Chart I-1The Symptom Of Disease Chart I-2The Thing That Should Not Be In this topsy-turvy world, a negative shock to growth, by decreasing inflation expectations, pushes up real interest rates, and thus the exchange rate. Meanwhile, a positive shock increases inflation expectations, pulling down real rates and the exchange rate as well. This is fundamental as USD/JPY continues to trade closely in line with real rate differentials between the U.S. and Japan (Chart I-3). Chart I-3USD/JPY: No Money Illusion Here This is even truer now that the Bank of Japan is both trying to keep 10-year JGB yields near 0%, and has promised to keep a very accommodative monetary policy in place until inflation has overshoot the price stability target of an average inflation rate of 2% over the whole business cycle. In other words, the BoJ's inflation target is near symmetrical and monetary policy will only harden once previous inflation undershoots below 2% have been compensated by an extended period of inflation overshoot. Also, we expect the BoJ to stay committed to this policy. Not only does Abenomics remain popular in Japan, but we expect Kuroda to be re-appointed to lead the BoJ. Moreover, the last two members of the policy committee not appointed by Abe will see their terms end in 2017. After this year, the BoJ committee will fully represents Abe's wishes. Under this framework, the key to expect the yen to fall is therefore not valuation, nor the current account outlook - two factors pointing to a higher yen - but whether or not the economy and inflation expectations can improve durably on a cyclical basis. In the next section, we explore the key positive economic developments underpinning our negative JPY stance. Bottom Line: As the BoJ is strongly committed to maintaining an extremely dovish stance until inflation overshoots by a wide-enough margin to compensate for previous undershoots, key economic improvements in Japan should lead to higher inflation expectations, falling Japanese real interest rates, and a much weaker yen. The Five Samurais We see five reasons to remain bearish the JPY: Inflation expectation dynamics, the closing output gap, the disappearance of the fiscal drag, the labor market tightness, and the end of the Japanese private sector's deleveraging. Factor 1: Inflation Expectations Are Already Unhinged Even before the BoJ aggressively targeted 0% JGB yields, Japanese inflation expectations were on an improving path. During the 2012 summer, markets began correctly anticipating the December electoral victory of Shinzo Abe, apprehending that his BoJ was about to massively ramp up quantitative easing. Japanese 5-year/5-year forward CPI swaps soon decoupled from the rest of the world and the U.S. (Chart I-4). Chart I-4The BoJ Policy Has Already Borne Fruit Chart I-5The Mechanics Of Price-Level Targeting So strong has the perceived commitment of the BoJ to higher inflation been that Japanese inflation expectations never tanked the way U.S. ones did after 2014. These dynamics contributed to keep Japanese real rates depressed relative to U.S. ones. Moreover a virtuous circle was created where lower real rates supercharged the USD/JPY's rally, lifting it by more than 60% from 77 in September 2012 to 125 in June 2015, and this further supported Japanese inflation expectations. In the summer of 2015, as EM and commodity prices began imploding on the growing expectation of a Chinese economic hard landing, Japanese inflation expectations did relapse, strengthening the yen rally. But again, unlike in the U.S., Japanese CPI swaps never fell to new lows, pointing to some improving dynamics for the domestic component of Japanese inflation expectation formations. Going forward, we expect Japanese inflation expectations to move further up. The price level targeting mechanism put in place by the BoJ last fall reinforces inflationary dynamics (Chart I-5). Any anticipated tightening in monetary policy in response to economic improvements has been pushed further away in the future, in a world where inflation may be higher locally and globally. Additionally, if global and local inflation rises, because nominal interest rates are pegged at low levels, the increase in inflation expectations puts additional downward pressure on real rates, further stimulating the domestic economy, further weakening the yen, and further boosting inflation expectations. The circuits for positive feedback loops are being laid in place. Factor 2: The Output Gap Based on the OECD's estimates, the Japanese output gap has now moved into positive territory for the first time since 2007-2008, the last episode where Japan experienced anything close to inflation (Chart I-6). Prior to then, the last time the Japanese output gap was as positive as it will be in 2017 was in 1993, among the last years when Japanese core inflation was still above 1%. While this reflects the global phenomenon of low productivity growth, the low level of supply expansion in Japan has been augmented by the 2% decline in the labor force since 1998. This means that the capacity constraints in the Japanese economy are easy to reach even if average real GDP growth has only been 0.8% since 2010. The cyclical improvements in the business cycle only point toward an increasingly positive output gap and rising inflationary pressures. To begin with, business confidence and PMIs are all very robust (Chart I-7). Chart I-6No More Slack In Japan Chart I-7Japanese Businessmen Feel Good The strength of the U.S. ISM index suggests that Japanese exports have more upside (Chart I-8) as well. Not only does a stronger Japanese trade balance contributes to a larger positive output gap, but also, strong export growth has often been the key precursor to higher capex in Japan (Chart I-8, bottom panel). Finally, the credit dynamics remain supportive. Bank loan growth has not slowed much, despite the large tightening in Japanese monetary conditions in 2016. With conditions now easing in the country, we expect the credit impulse, which has bottomed around the zero line, to re-accelerate going forward, supporting excess demand above potential GDP growth (Chart I-9). Together, all these factors suggest that the improvement in the Japanese shipments-to-inventory ratio witnessed since March 2016 will continue to lift Japanese inflation expectations higher (Chart I-10). Chart I-8Strong Japanese Exports ##br##Will Filter To Capex Chart I-9The Japanese Credit ##br##Impulse Will Rebound Chart I-10Upward Momentum In ##br##Japanese Inflation Expectations Factor 3: Fiscal Policy Another key factor that has hampered the Japanese economy since 2013 has been the large fiscal belt-tightening experience by the country. In the wake of the 2011 Tohoku earthquake, the government primary deficit blew up to 7.7% of potential GDP in 2011. It will hit 3.5% for 2017, but the IMF does not forecast much more narrowing of the government budget gap (Chart I-11). This signifies that the great brake that slowed the Japanese economy and prevented a rise in inflation is being lifted. In fact, we expect the Japanese government deficit to increase again. First, Abe's upper house electoral victory last summer was built on a campaign of larger government spending. Second, with an approval rating of 56% four years into his premiership, Abe remains a highly popular prime minister for a country plagued by 15 changes of government since 1990. This is a vote of confidence by the Japanese public toward his "Abenomics" program. Finally, military spending is likely to increase. As recently as 2005, Japan's and China's defense budgets were the same; today, China outspends Japan by four times (Chart I-12). In an increasingly unstable Asia-Pacific region, where China, Russia, and North Korea are all conducting more independent foreign policy agendas, Japan will be forced to fend for itself with more military spending, underscoring the relatively hawkish agenda of the Abe administration on this front. This will require more spending by Tokyo in this arena. Chart I-11Vanishing Japanese##br## Fiscal Drag Chart I-12The Geopolitical Imperative To Increase ##br##Japanese Government Spending Factor 4: The tightening Labor Market The Japanese labor market has now become very tight and key supply-side adjustments are behind us. The job-openings-to-applicants ratio stands at July 1991 levels, the last time when Japan was able to generate any durable wage growth. Additionally, the level of participation of women in the labor force is very elevated. The employment-to-population ratio for prime-age females stands at 74%, well above the 71.4% level of the U.S. today, and just as high as the U.S. in 2000, when that ratio was at its highest (Chart I-13). Additionally, despite a shrinking labor force and population, the total number of employed individuals stands at 65 million, the highest level since 1999 (Chart I-14). Hiring growth is also experiencing its most vigorous upswing in 20 years. Unsurprisingly, nominal wages have been growing since 2013, the longest upswing since 2004 to 2006, and wages are now at their highest level since 2009 (Chart I-14, middle panel). Chart I-13The Japanese Labor Market Is Very Tight (I) Chart I-14The Japanese Labor Market Is Very Tight (II) With the economy remaining robust, the output gap being closed, and the fiscal drag disappearing, this tightening in the labor-market should lead to additional wage gains in Japan. As the labor market slack dissipates further, we expect Japanese employment growth to slow and wages to accelerate their upward path. It is true that the Japanese labor market duality still constitutes a structural damper on Japanese wages, but for now, the very important positive cyclical factors noted above should overpower this long-term negative. Only with additional reform of the labor market will this duality dissipate structurally. Factor 5: End Of The Private Sector Deleveraging The last factor that has turned the corner in Japan is the evolution of the private sector's deleveraging. Non-financial private debt fell from 220% of GDP in 1994 to 160% of GDP today, after having stabilized since 2009 (Chart I-15). At these levels, the Japanese non-financial private debt to GDP is in line with the worldwide average of 157%, much below China's 210%, as well as below the levels recorded in Canada, Australia, New Zealand or Sweden. This development is key for many reasons. First, since 2011, Japanese households have in fact re-levered, with their debt load rising by 6.5% since their trough. This means that Japanese households are generating demand in excess of their earnings, and are therefore a source of inflation in the country. Second, the end of deleveraging has coincided with an end to the decline in Japanese land prices that has put downward pressure on all prices since 1991 (Chart I-16). Finally, the rising debt load of the Japanese government is no longer just a compensating mechanism for the deficiency in demand created by the private sector's sector deleveraging. In fact, like for households, government dissaving is now purely adding to the aggregate demand of Japan, and at the margin, is inflationary. Unsurprisingly, since 2012, periods of accelerating growth in the Japanese broad money supply have now been associated with periods of weakness in the yen (Chart I-17). This highlights the fact that money creation is now generating some increase in inflation expectations as the private sector is not furiously building its savings anymore and as the Kuroda BoJ is not leaning against inflationary developments. Chart I-15Private Sector Deleveraging Is Over Chart I-16Land Prices Are Not A Source Of Deflation Anymore Chart I-17Money Matters Putting It All Together In our view, in an environment where Japan is beginning to generate domestic inflationary pressures of its own, where the output gap is now positive, where the government is not putting a brake on growth anymore, where the labor market is at its tightest in decades, and where private sector deleveraging is not an handicap anymore, any improvement in global growth is likely to result in further increases in Japanese inflation expectations. Our sister service, Global Investment Strategy is long Japanese CPI swaps, a trade we agree with. In the context of FX, with the BoJ firmly on an easing path, rising Japanese inflation expectations will only depress Japanese real rates, exactly as the Fed becomes more aggressive. As a result, on a 12-18 months basis, the downside for the yen is very large. What About Trump? Chart I-8Japan FDI Profile President Trump wants to see a lower dollar to achieve his goal of creating manufacturing jobs in the U.S. Much ink has been spilled on the potential emergence of a Plaza 2.0 accord. We disagree. The U.S. has very little leverage to boost the value of the yen. The Bank of Japan's policy is designed to generate domestic inflationary pressures, the yen is only a casualty of this policy. In fact, with inflation expectations having been so low for so long, no country in the world can better justify having a very loose monetary policy setting than Japan. Also, the 97% surge in the yen that followed the Plaza accord of 1985 caused Japanese interest rates to stay too low relative to the state of the economy. As a result, a massive debt bubble ensued that lifted the economy further, but then prompted the bust which Japan still pays for. Today, the Japanese are unlikely to want to repeat the same mistake. While we do think that deleveraging has ended in Japan, a country with a falling population is unlikely to begin a new private-sector debt supercycle either. Finally, China continues to be an economy that saves too much. This means that China can either allocate these savings domestically through the debt market or export them internationally through its current account surplus. We expect Chinese authorities, who are already very worried by the high debt load in China to choose the second option for the next two years. As a result, BCA foresees further declines in the RMB over the next 12 to 18 months. In this environment, the Japanese would find it very difficult to remain competitive in the Chinese market if their currency rises as the RMB weakens.3 That being said, Trump will want some concessions out of the Japanese. Already, the February 10 meeting between the U.S. president and PM Abe is giving us a glimpse of things to come. Japanese non-tariff barriers on U.S. products are likely to decrease, potentially in the agricultural and automotive field especially. Additionally, Japan still runs a large current account surplus and therefore, a large capital account deficit. We expect Japanese FDIs in the U.S. to only grow going forward. The main beneficiary is likely to be the automotive sector as it would be the key mechanism for Japanese firms to avoid paying large tariffs / punitive taxes and still access the vital U.S. market (Chart I-18). Moreover, this fits well within Trump's agenda as it creates manufacturing jobs in the U.S. Call it a win-win situation if you will. Not Time To Close Short USD/JPY Yet Despite this very negative cyclical view on the yen, we remain committed to our tactical short USD/JPY position: For one, positioning on the yen remains too extreme (Chart I-19). Second, as argued by our European Investment Strategy service, we may be on the cusp of a mini down cycle in the credit impulse, suggesting a temporary deceleration in the G10.4 The recent collapse in quarterly credit growth in the U.S. points exactly in this direction (Chart I-20). Because U.S. 10-year bond yields are so tightly linked to global economic surprises, negative surprises could put temporary downward pressure on Treasury yields (Chart I-21). A move lower in yields would be very supportive of the yen, even if only for a few months. Chart I-19Speculators Are Still Too ##br##Short JPY Tactically Chart I-20Falling Short-Term Credit##br## Impulse In The U.S. Chart I-21Falling Surprises Can##br## Temporarily Help Bond Prices Third, the dollar correction is not over. Sentiment and positioning on the dollar represent tactical hurdles that need to be overcome before the greenback can resume its ascent. Also French OAT / German bunds spreads are at distressed levels, having only been higher at the height of the euro crisis in 2012, and not far off the levels experienced during the ERM crisis of the early 1990s (Chart I-22). This suggests that the risk of a Le Pen presidency is now well known. We agree that the impact of such an event would be enormous, but the 34.5% odds currently assigned to it on Oddschecker are too great, especially now that Bayrou - a centrist politician - is not entering the race and putting his support behind Macron. Finally, the dollar has followed a textbook wave pattern since October. A continuation of this pattern suggests that the DXY has downside toward 97-98 (Chart I-23). Chart I-22OAT / Bund Spreads Price In A Lot Of Negatives Chart I-23A Textbook Wave Pattern In The Dollar The ultimate factor in favor of the continuation of the yen correction is the higher degree of complacency that has settled globally. Our Global Complacency indicator, based on the G10 stock-to-bond ratio, commodity prices, and the VIX is at an extremely elevated level warning of a potential risk-off event globally. Any rollover in this very mean-reverting indicator would prompt a further weakness in USD/JPY as well as AUD/JPY, especially if the BoJ doesn't increase stimulus in the meantime (Chart I-24). Chart I-24AUnless The BoJ Eases Further, Too Much ##br##Complacency Equals Tactically Long JPY Chart I-24BUnless The BoJ Eases Further, Too Much ##br##Complacency Equals Tactically Long JPY Bottom Line: Tactical investors should continue shorting USD/JPY for the moment. More cyclical players can begin deploying capital to short the yen as the cyclical outlook for this currency remains dire, but better opportunity to sell this currency are likely to emerge over the coming months. A dollar-cost averaging strategy seems wise at this point. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see the Foreign Exchange Strategy Weekly Report, "How do You Say "Whatever It Takes" In Japanese?", dated September 23, 2016, available at fes.bcaresearch.com 2 Please see the Foreign Exchange Strategy Weekly Report, "Down The Rabbit Hole", dated April 15, 2016, available at fes.bcaresearch.com 3 For a more detailed discussion on the RMB, please see the Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?", dated February 24, 2017, available at gis.bcaresearch.com 4 For a more detailed discussion of the mini-cycle, please see the European Investment Strategy Weekly Report, "Slowdown: How And When?", dated February 2, 2017, available at eis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The U.S. economy is giving a green light to the Fed to hike. Headline CPI is at 2.5% annually, and core CPI is at 2.3%; Retail sales beat expectations at 0.4% MoM; The core CPI measure is evidence that the U.S. economy is fundamentally strong and dynamic. Real GDP now stands 11% above its pre-recession peak, and it is approaching the Congressional Budget Office's estimate of potential output. The unemployment and output gap are also close to their long-term levels. With the economy closing in on its potential, it is only natural that FOMC participants "expressed the view that it might be appropriate to raise the federal funds rate again fairly soon" in the Minutes. Although a risk of disappointment from Trump's fiscal proposal is possible, the economy's momentum will continue. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro area remains robust, with this week's data showing a strong outperformance: German, French and overall euro area PMI increased and beat expectations across all measures, with the exception of France which only outperformed on the Composite measure; Euro area producer prices strengthened to a 2.4% annual pace; After seeing some downside from worries about a Le Pen victory, markets have calmed François Bayrou, a centrist, announced an alliance with presidential candidate Emmanual Macron, adding a resistance to the euro's downside. Substantial volatility can still be expected, however, as a Le Pen victory is not completely out of the realm of possibility, which means that the euro can see some weakness in the near term. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Positive signs continue to emerge in Japanese data: Industrial production yearly growth came in at 3.2% Nikkei Manufacturing PMI came in at 53.5, outperforming expectations Japan's Leading Economic Index came at 104.8, the highest level since 2015 These economic developments are good news for the BoJ, as it shows them that their price level targeting and yield curve control measures seem to be working. However the objective of these measures is not to achieve these marginal improvements in the economy. The objective is to catapult Japan out of the liquidity trap it is in, which means that these measures will likely stay in place for a while. Therefore, on a cyclical basis we remain short the yen, as we expect USD/JPY to reach 120 on a 12 to 18 month horizon. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data has painted a mixed picture for the U.K. Industrial and manufacturing production yearly growth came in at 4.3% and 4% respectively. Both measures blew past expectations. Also, in spite of the dramatic fall in the pound, Inflation seems to be relatively contained, as both core and headline numbers came in below expectation at 1.8% and 1.6% respectively. However not everything is good news. Yearly growth for retail sales and retail sales ex fuel underperformed expectations coming at 1.5% and 2.6%, respectively. Additionally, wage growth has been limited, as average weekly earnings yearly growth came below expectations at 2.6%. We continue to be bullish on the pound, particularly against the euro as any additional political risks caused by Brexit are now well known by participants, making the pound very cheap, especially if one takes into account real rate differentials. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD has been the top performing currency against the USD out of the G10, having appreciated 7.11% since the beginning of the year. This rally is increasingly tenuous. Full-time employment has struggled to pick up, while part-time employment increased by 4%. This will hamper wage growth and consumption going forward. This is important as consumption is already 58% of the economy. Meanwhile, net exports have made a negative contribution to GDP growth for almost two years. In fact, Australian exports to China subtracted 1% of GDP growth last year, due to a decline in commodity prices. Going forward, a limited upside in commodity prices and an end to the Chinese easing cycle can exacerbate this decline. On a technical basis, AUD/USD has sustained momentum since the beginning of the year, with the RSI displaying overbought levels since mid-January. The cross is also approaching a key resistance level, pointing to growing risks ahead. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data for New Zealand has not been particularly positive and have weighed on the kiwi: Retail sales underperformed, growing by 0.8% QoQ against expectations of 1.1%. Business NZ PMI fell to 51.6 from last month's 54.5. Nevertheless, a closer look at the data paints a much brighter picture: the decline in NZ PMI seems to have been primarily due to bad weather conditions, which means that the strong fundamentals of the kiwi economy should show up in the data once seasonal factors start to dissipate. Therefore, we are bullish on the NZD versus the AUD, as the structural backdrop for these countries could not be further apart, yet the market is now pricing less than a 10 basis points difference from here until the end of the year. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian employment numbers came out seemingly strong, with a net change in employment of 48,300 and a decrease in the unemployment rate to 6.8%. However, these numbers mask numerous underlying inconsistencies. The decrease in unemployment was the result of a robust part-time employment growth of 5.6%, not the 0.3% growth in full-time employment. Wage growth remains subdued, with average hourly earnings of permanent workers currently increasing at a 1% annual pace, compared to 3.3% a year ago. Furthermore, hours worked have declined by 0.8%, exacerbating the weakness of full-time employment's contribution to activity. Retail sales underperformed expectations, contracting at a 0.5% monthly pace; the measure excluding Autos also contracted at a 0.3% pace. Increasing household debt and festering labor market complications are likely to weigh on consumer confidence. An uncertain outlook on trade developments is an additional handicap to future CAD strength. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 During the last couple of weeks, fear of a Eurosceptick government in Europe's second biggest economy, has lowered EUR/CHF below the implied floor that the SNB has had for the last couple of years. Indeed, last week, as La Pen surged on French presidential polls, this crossed reached 1.063, its lowest level since August 2015. This is bad news for Switzerland, as economic data continues to indicate that the country has not been able to shake off the shackles of deflation: Headline inflation outperformed expectations as it finally exited deflationary territory, coming in at 0%. Industrial production contracted by 3.3% on a year on year basis Given this deflationary backdrop, the SNB will continue to try to limit the downside for this cross. However, on the months leading to the French elections, the floor will continue to get tested. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Inflation seems to be abating in Norway as core and headline inflation numbers fell sharply from last month reading, coming in at 2.1% and 2.8% respectively. This is the result of various factors: First, the inflation caused by the collapse of the krone is starting to fade away. From 2014 to 2016, the krone collapsed along with oil prices. This selloff in the krone passed through inflation to the Norwegian economy via rising imported goods, with a lag. Today, roughly one year after the NOK bottomed, the effects of the currency on inflation is starting to dissipate. Furthermore, labor market dynamics in Norway are anything but inflationary as wage growth is contracting by 4% and although unemployment is low, the Norges Bank has pointed out that is in largely caused by a fall in the participation rate. Thus, given that high inflation is receding, the Norges Bank will keep its easing bias for the time being. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The February 2017 Monetary Policy Statement illustrated a clear dovish stance. Governors and economists at the Riksbank are paranoid about risks emanating from a strong currency and political developments. Tensions from a recently strong SEK have created worries about a potential slowdown in inflation. The Bank has therefore reiterated the possibility of an intervention if the Krona's appreciation is too rapid, making it a very real possibility. A questionable political outlook from the U.S. and the euro area has further hampered the Riksbank's optimism. The euro area is a particular risk since it represents a large source of Sweden's growth, and any damage to the monetary union will have a catastrophic effect on Sweden. Because of these reasons, the Riksbank explicitly stated that it is "still prepared to make monetary policy more expansionary if the upward trend in inflation were to be threatened and confidence in the inflation target weakened." Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Price inflation is paradoxically deflationary for European consumers, because there is no feedthrough from price inflation to wage inflation. Whenever price inflation has risen towards the ECB's highly-misguided 2% target, euro area real wages have gone into recession. The same is true in the U.K. Do not expect a structural sell-off in high-quality bonds. Go overweight the broad-based Eurostoxx600 versus the bank-heavy Eurostoxx50. Stay overweight the international dollar-earning FTSE100 versus the more domestic pound-earning FTSE250. Feature We have a love-hate relationship with inflation. Love, if the inflation refers to our wages. Hate, if the inflation refers to our weekly grocery bill. Put another way, inflation is good for our purchasing power when wages are going up faster than prices; it is bad when prices are going up faster than wages. Unfortunately, recent inflation has been unequivocally bad for European purchasing power. Through the past 7 years, euro area nominal wages have been growing at a remarkably steady 1-2% clip. Whereas price inflation has swung between -0.5% and 3% (Chart I-2). Therefore, whenever price inflation has stayed close to 0% (the true definition of price stability), real wages have grown very healthily. But whenever inflation has risen towards the ECB's highly-misguided 2% target, euro area real wages have gone into recession (Chart of the Week). Chart I-1The Inflation Paradox: When Price Inflation Rises to 2%, Real Wages Go Into Recession Chart I-2Nominal Wages Have Been Growing At A Remarkably Steady 1-2% The same is true in the U.K. There has been no feedthrough from price inflation to wage inflation (Chart I-3 and Chart I-4). If anything, an inverse relationship has existed. Hence, whenever inflation has declined, it has boosted real wages. And whenever inflation has risen, it has choked real wages (Chart I-5 and Chart I-6). Chart I-3Very Little Connection... Chart I-4...Between Price Inflation And Wage Inflation Chart I-5When Price Inflation Has Declined,##br## It Has Boosted Real Wages Chart I-6When Price Inflation Has Increased,##br## It Has Choked Real Wages Households Dislike 2% Price Inflation An argument we frequently hear is that highly indebted economies need higher inflation to 'inflate away their high debts'. But this logic only works if inflation is boosting the incomes of those burdened with the high debt, such as households. The problem, as we have just seen, is that there has been very little connection between the price inflation that central banks are targeting and the wage inflation that eases households' debt burdens. To its credit, the Bank of England recognises this paradox. "Continued moderation in pay growth and higher import prices following sterling's depreciation are likely to mean materially weaker household real income growth over the coming few years" 1 Inflation is ultimately a transfer of resources from those paying the higher prices to those receiving them. In a closed economy, the winners and losers might balance out. However, Europe is a large net importer of food and energy, whose demand is inelastic and whose prices are denominated in dollars. Therefore, currency weakness transfers resources from domestic consumers to foreign producers. As the BoE goes on to say: "Over the next few years, a consequence of weaker sterling is that the higher imported costs resulting from it will boost consumer prices... and the hitherto resilient rates of household spending growth will slow as real income gains weaken." Exactly the same dynamic applies to the euro area as a consequence of the weaker euro. The difference is that sterling's Brexit-induced slump was out of the BoE's control, whereas the euro's weakness is a direct consequence of the ECB's extreme and experimental monetary easing. The ECB is keen to tell us about the benefits of its extreme monetary easing; it is less keen to tell us about the costs. However, we believe that the benefits have diminished while the costs are rapidly rising. And absent a major shock, the ECB should end its risky experiment. What's Up With Wage Growth? The intriguing question is: why has there been little connection between price inflation and wage inflation? The BoE observes that pay growth has remained persistently subdued by historical standards - strikingly so in light of the decline in the rate of unemployment to below 5%. This outcome is likely to reflect a substantial decline in the 'equilibrium unemployment rate', the point at which wage pressures start to bubble up. The explanation comes from the type of jobs created in recent years. ECB research points out that the dynamics of wages not only reflect changes in wages at the individual level, but are also influenced by changes in the composition of employment. "The structure of recent employment creation may have contributed to low wage growth in the euro area. Since the second quarter of 2013, employment creation in the euro area has been stronger in sectors associated with relatively lower wage levels and wage growth rates. This employment composition effect puts a drag on average wage growth." 2 Automation and Artificial Intelligence (AI) are major drivers of this composition effect. Moreover, as we argued in The Superstar Economy: Part 2,3 the effect has much further to run. "Many of the jobs that AI will destroy - like credit scoring, language translation, or managing a stock portfolio - are regarded as skilled, have limited human competition and are well-paid. Conversely, many of the jobs that AI cannot (yet) destroy - like cleaning, gardening, or cooking - are relatively unskilled and are low-paid." With well-paid jobs being displaced by low-paid jobs, job creation itself might still seem very healthy and the unemployment rate might be falling to levels associated with 'full employment' - prompting some people to warn that wage inflation is about to take off. Except it won't, for two reasons: first, the AI-displaced formerly well-paid workers are downshifting to lower-paid work; second, the added supply of labour competing for the lower-paid work keeps a lid on the wages for that lower-paid work. In the U.S., the Federal Reserve Board of San Francisco points out that: "As long as employers can keep their wage bills low by replacing or expanding staff with lower-paid workers, labour cost pressures for higher price inflation could remain muted for some time." 4 A further point is that if employment creation is in jobs with lower wages, wage growth, and job security, then it will also constrain credit growth. Lacking income growth or security, households will be unwilling to borrow and banks will be unwilling to lend. Absent strong credit growth, we subscribe to a monetarist conclusion: a generalised and sustained inflation - a wage-price spiral - cannot take hold. Some Investment Considerations For the foreseeable future, there will be little feedthrough from price inflation to wage inflation. So whenever price inflation picks up - as is now happening in the U.K. and the euro area - it will choke real wages. Therefore paradoxically, price inflation will be deflationary for European consumers. This will prevent a structural sell-off in high-quality bonds. For a U.K. equity portfolio at this juncture, it means tilting towards international exposure. Stay overweight the international dollar-earning FTSE100 versus the more domestic pound-earning FTSE250 - especially given that sterling could come under renewed pressure after the U.K. formally files for its divorce from the EU (Chart I-7). For a broader European equity portfolio, prefer non-financials over financials. A very easy way to implement this is to go overweight the broad-based Eurostoxx600 versus the bank-heavy Eurostoxx50 (Chart I-8). Chart I-7Overweight The International Dollar-Earning ##br##FTSE100 Versus The FTSE250 Chart I-8Overweight The Broad Eurostoxx600##br## Versus The Bank-Heavy Eurostoxx50 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 From the Bank of England Monetary Policy Summary and minutes of the Monetary Policy Committee meeting on February 1, 2017. 2 From the ECB Economic Bulletin, Issue 3 / 2016: Recent wage trends in the euro area. 3 Published on January 19, 2017 and available at eis.bcaresearch.com 4 From the FRBSF Economic Letter March 7, 2016: What's Up with Wage Growth? Fractal Trading Model* This week's recommendation is a commodity pair-trade: long tin / short copper. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 * 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 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Monetary Policy: Investors should fade the recent increase in expectations of a March rate hike. Still-low inflation and elevated policy uncertainty will keep the Fed on hold until June. Continue to position for a bear-steepening of the Treasury curve, driven by the combination of above-trend growth and accommodative Fed policy. Economy: U.S. growth will be higher this year than in 2016, driven mainly by rebounds in residential and non-residential investment. Consumer spending should also remain firm, driven by solid income growth and a savings rate that has scope to decline in the coming months. High-Yield: High-Yield valuations are tight, but still consistent with small positive excess returns to corporate credit during the next twelve months. Feature Chat 1A Hawkish Market Reaction After having been relatively subdued in the two months since the Fed's last rate increase, rate hike expectations priced into money market curves awakened last week following Janet Yellen's semi-annual Congressional testimony. Expectations priced into the overnight index swap curve have returned close to levels last seen on the day of the December 2016 FOMC meeting (Chart 1). As of last Friday's close, the market was priced for 53 basis points of rate increases between now and the end of the year, with a 26% chance that the next rate hike occurs in March. The implied probability of a March hike peaked at 34% last Wednesday.1 In this week's report we discuss why a March rate hike is unlikely. We also consider the outlook for U.S. economic growth in 2017, which we expect will remain decidedly above trend. Above-trend growth will allow the gradual increase in core inflation to persist, reaching the Fed's target by the end of the year. As a result, the Treasury curve will bear-steepen during this timeframe. To position for this outcome, investors should maintain below-benchmark duration and favor the belly (5-year bullet) of the curve relative to the wings (2/10 barbell) in duration-matched terms.2 Yellen's Hawkish Turn? Most news reports of Janet Yellen's testimony last week perceived a hawkish tone in her remarks and focused specifically on the following sentence: As I noted on previous occasions, waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession.3 However, more important than the above boilerplate is the simple fact that inflation remains below target and the Fed has an incentive to tread cautiously to support its eventual recovery. There is no pressing need to move quickly on rate hikes and we expect that the next rate increase will not occur until June. One reason is that, in the current cycle, the Fed has not lifted rates without having first guided market expectations in the months leading up to the hike. As can be seen in Chart 2, rate hike probabilities implied by fed funds futures were already well above 50% one month prior to each of the last two rate hikes. If there was a strong desire to lift rates in March, Yellen would have likely sent a more powerfully hawkish signal in her testimony last week. Instead, Yellen chose not to mention the March meeting specifically and said only that the Fed would continue to evaluate the case for further rate hikes at its upcoming "meetings". Chart 2Market-Implied Rate Hike Probabilities: March Looks Too High Second, as was alluded to above, core PCE inflation is running at 1.7% year-over-year, still below the Fed's 2% target. What's more, long-dated TIPS breakeven inflation rates are also below levels that are consistent with inflation being anchored near the Fed's target (Chart 3). At present, the 5-year/5-year forward TIPS breakeven rate is 2.17%. Historically, a range of 2.4% to 2.5% is consistent with inflation at the Fed's target. Further, even though a strong January core CPI print, released last week, seemed to strengthen the case for a March hike, the details of the report show that only a few components (new cars +0.9% m/m, apparel +1.4% m/m, and airline fares +2.0% m/m) accounted for most of the gains. In fact, our CPI diffusion index fell even further below the zero line. With both our CPI and PCE diffusion indexes in contractionary territory (Chart 4), it is very likely that inflation will soften in the coming months. Chart 3Inflation Still Too Low Chart 4Inflation Recovery Not Broad Based Both our own and the Fed's forecasts for continued inflation increases are contingent on the view that tight labor markets are causing wage pressures to mount, and certainly wages have accelerated during the past few years. However, wage growth in both real and nominal terms is still below where the Fed would like it to be, and there has been scant evidence of wage acceleration during the past few months. While the Atlanta Fed's Wage Growth Tracker remains strong in nominal terms, it has leveled off in real terms, and both the Employment Cost Index and Average Hourly Earnings have recently been flat (Chart 5). A final factor that will prevent the Fed from lifting rates in March is the extremely high degree of policy uncertainty. As shown in Chart 6, economic policy uncertainty traditionally correlates with financial conditions. With financial markets having already discounted a very positive fiscal policy outcome, there is a heightened risk that some disappointing news on the fiscal front will lead to a sharp tightening of financial conditions in the near term. Such an event would definitely put the Fed on hold until financial markets recovered. Chart 5Fed Needs Wage Growth To Pick Up Chart 6Policy Uncertainty Remains Elevated Bottom Line: Investors should fade the recent increase in expectations of a March rate hike. Still-low inflation and elevated policy uncertainty will keep the Fed on hold until June. Continue to position for a bear-steepening of the Treasury curve, driven by the combination of above-trend growth and accommodative Fed policy. Policy Aside, U.S. Growth Is Heating Up Chart 7ISM Surveys Point To Strong Growth Most recent economic discussion has focused on when President Trump will get around to enacting some of the more stimulative parts of his policy agenda, and whether or not the impact of these policies (tax cuts, infrastructure spending) will ultimately be offset by other spending cuts. But in the meantime, leading indicators of GDP growth have been picking up steam. Both the manufacturing and non-manufacturing ISM surveys point to an increase in GDP growth in the first quarter (Chart 7), and consistently, the New York Fed's tracking model suggests Q1 GDP will grow by 3.1%. The Atlanta Fed's GDP tracking model pegs Q1 growth slightly lower at 2.4%. Our own sense is that GDP growth will remain solidly above trend this year, in the range of 2.5% to 3%, even in the absence of major fiscal stimulus. This forecast hinges on the view that both residential and non-residential investment will rebound from the depressed levels seen last year and that consumer spending will remain strong. Residential Investment Chart 8Residential & Non-Residential Investment Residential investment was actually a drag on GDP growth for two quarters in 2016, even though leading indicators such as the months supply of new homes and homebuilder confidence remained supportive (Chart 8, panels 1 & 2). The progress made on foreclosures since the financial crisis has driven housing inventory to its lowest level since the mid-1990s,4 meaning that housing supply no longer poses a headwind to construction. Further, demographics should also help boost the housing market during the next few years. According to the Joint Center for Housing Studies of Harvard University, over the next ten years, the aging of the Millennial generation will boost the population in their 30s. The growth in this age cohort implies an increase of 2 million new households each year on average.5 While rising mortgage rates will be a drag on housing at the margin, they will not pose a significant headwind to residential investment in 2017. At least so far, mortgage purchase applications have been resilient in the face of rising rates (Chart 8, panel 3). Non-Residential Investment Non-residential investment was a small drag on growth in 2016, but this was largely related to depressed investment in the energy sector (Chart 8, panel 4). Now that the oil price has recovered, non-residential investment should return to being a small positive contributor to growth. Our composite indicator of New Orders surveys also suggests that non-residential investment will trend higher this year (Chart 8, bottom panel). While there is some concern that the optimism displayed in these survey measures may not filter through to the "hard" economic data, a Special Report from our Bank Credit Analyst publication that will be published on Thursday concludes that a tangible growth acceleration is indeed underway throughout the G7. Consumer Spending As always, the consumer is the main driver of U.S. growth and we expect consumer spending will remain firm in 2017. Our U.S. Investment Strategy service recently undertook a detailed analysis of consumer spending,6 focusing on its two main drivers - income growth and the savings rate (Chart 9). A look at past cycles suggests that income growth can remain strong even after the economy reaches full employment as rising wages compensate for decelerating payroll growth (Chart 10). The recent spike in consumer income expectations suggests that the impact from rising wages might be particularly important in the current cycle (Chart 10, panel 1). Chart 9Consumer Spending Is Driven By Income Growth And The Savings Rate Chart 10Wages Can Drive Income Growth Another benefit of the economy reaching full employment is that increased job security can translate into greater consumer confidence and a lower savings rate (Chart 9, bottom panel). Confidence trends suggest that the savings rate has scope to decline during the next few months. One possible headwind to consumer spending is the recent tightening of consumer lending standards. The Fed's Senior Loan Officer Survey for the fourth quarter of 2016 shows that lending standards on auto loans have tightened for three consecutive quarters and that credit card lending standards also recently spiked into "net tightening" territory. In other words, more banks are now tightening lending standards on consumer loans than easing them. Prior to the financial crisis, consumer lending standards were strongly correlated with the savings rate (Chart 11). More stringent lending standards slowed the pace of consumer credit growth and led to reduced consumer spending. But this relationship broke down following the financial crisis. After the housing bust, households were no longer eager to supplement their consumption with as much credit as possible. Their chief concern became repairing their own balance sheets. As such, the supply of credit is no longer the most important driver of the savings rate. In the data, we observe that the savings rate did not fall by as much as would have been predicted by easing lending standards in the early years of the recovery. As a result, we do not think that modestly tighter lending standards will have much of an impact either. The Fed's latest Senior Loan Officer Survey also showed that demand for consumer credit declined sharply in 2016 Q4. This is potentially more worrisome for the savings rate since lower credit demand may still suggest a reduced appetite for spending, even in the wake of the Great Recession. However, a look back at prior cycles shows that loan demand from the Senior Loan Officer Survey tends to decline several years prior to the next recession, but the savings rate has tended to stay low until the next recession actually hits (Chart 11, bottom panel). We would not be surprised to see the same dynamic play out again. Bottom Line: U.S. growth will be higher this year than in 2016, driven mainly by rebounds in residential and non-residential investment. Consumer spending should also remain firm, driven by solid income growth and a savings rate that has scope to decline in the coming months. Chart 11Lending Standards Less Of A Risk Chart 12Default-Adjusted Spread A High-Yield Valuation Update With the release of the Moody's default report for January we are able to update our forecast for High-Yield default losses during the next 12 months, and also our High-Yield default-adjusted spread. The default-adjusted spread is our preferred valuation indicator for both High-Yield and Investment Grade corporate bonds. It is calculated by taking the option-adjusted spread from the Bloomberg Barclays High-Yield index and subtracting an estimate of expected default losses during the next twelve months (Chart 12). Default loss expectations are calculated using the Moody's baseline forecast for the 12-month High-Yield default rate and our own forecast of the recovery rate based on its historical relationship with the default rate (Chart 12, bottom two panels). The current reading from our default-adjusted spread is 152 basis points. Most of the time, a reading of 152 bps on the default-adjusted spread is consistent with small positive excess returns for both High-Yield and Investment Grade corporate bonds (Chart 13 & Chart 14). This is also consistent with the excess returns we expect from corporate credit this year. Chart 1312-Month Excess High-Yield Returns Vs. Ex-Ante ##br##Default-Adjusted Spread (2002 - Present) Chart 1412-Month Excess Investment Grade Returns Vs. Ex-Ante High-Yield##br## Default-Adjusted Spread (2002 - Present) In fact, when the default-adjusted spread is between 150 bps and 200 bps, 12-month excess returns to High-Yield have been positive in 65% of cases, with a 90% confidence interval placing 12-month excess returns in a range between -5.0% and +1.7%. Given the favorable economic back-drop of strong economic growth and accommodative Fed policy, we would expect High-Yield excess returns to be positive during the next 12 months. But given the tight starting valuation, probably not above +1.7%. Bottom Line: High-Yield valuations are tight, but still consistent with small positive excess returns to corporate credit during the next twelve months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our internal calculations of rate hike probabilities implied by fed funds futures are lower than those shown on Bloomberg terminals. Our measure differs because we use the actual data for the effective fed funds rate and also adjust for the well-known fact that the effective fed funds rate tends to fall by approximately 10 basis points on the last day of the month. 2 For further details on our recommended yield curve trade please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/newsevents/testimony/yellen20170214a.htm 4 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 5 Please see "The State Of The Nation's Housing 2016", Joint Center for Housing Studies of Harvard University. 6 Please see U.S. Investment Strategy Weekly Report, "U.S. Consumer: The Comeback Kid", dated January 16, 2017, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Recent economic and inflation data can be characterized as Goldilocks: strong enough to keep recession fears at bay, yet not hot enough to warrant Fed tightening. Historical precedent suggests that the current period of positive economic surprises could persist for at least another month or two, fueling ever-more lopsided positioning into equities. Despite a lot of good news already discounted, we retain a cyclical bias toward small caps. Currently, the main driver of style performance is sector weightings. Value stocks are likely to perform slightly better than Growth by virtue of a smaller weighting in technology and larger weighting to financials. Higher conviction in Value stocks outperformance awaits better credit growth trends. Feature The term Goldilocks is used to describe an economy that is growing, but is not quite hot enough to create serious inflation risks, and not so cold that it fosters recession fears. Last week's major data reports fit this view of the world and helped U.S. equity prices soar to a new all-time high (Chart 1): NFIB Small Business Survey: Since small businesses have long been considered the job engine of the U.S. economy, monitoring the sentiment of small businesses owners, their likelihood to undertake expansion plans, and raise/cut prices, can often give a good glimpse into the likelihood of financial market trends to be sustained on a cyclical basis. In January, the NFIB small business sentiment indexes surged and to our surprise, the positive sentiment did not correct in February (Chart 2). The expectations component actually rose even further! Chart 1Rotation Into Stocks Chart 2Will Hopes Be Dashed? We continue to believe the survey reflects a lot of hope and is likely to reverse substantially. According to the survey, business conditions are the best in thirty years, save for a brief period in the early 2000s. Even the most ardent of Trump supporters will find it difficult to explain how a handful of executive orders and memoranda have so significantly altered the business landscape in such a short space of time! This radical shift in sentiment makes risk asset prices vulnerable: the pace of economic expansion has only gradually improved, but investors and other economic agents have drastically revised upward their expectations. Retail Sales: A number of cyclical tailwinds are beginning to finally align for consumers, as discussed in January 16 Weekly Report, and consumers appear to be in slightly better shopping moods in 2017. January retail sales beat expectations and prior months were revised higher. Spending improved across categories and these broad-based gains reinforce our view that the consumer can lead a gradual, self-reinforcing economic recovery (Chart 3). Inflation: We do not worry that cyclical inflation trends will be strong enough to force the Fed to raise rates faster than the FOMC's current expectations (three rate hikes by end-2017). True, both headline and core CPI were stronger than consensus expectations in January, and producer prices are in a noticeable uptrend. But this should not be viewed as the beginning of a new, more dangerous inflation problem. As Chart 4 shows, producer prices - at all stages of production - have been rising for the past few months. But only a fraction of any price rise at the producer level is likely to be passed on to consumers. Chart 5 shows that core goods prices have decoupled with finished goods producer prices (i.e. the last stage of production) since 2000. This speaks to the massive deflationary impulse at the end of the supply chain: a combination of deflation via imported goods, major technological advances in supply chain management and logistics, and changing consumer behavior in an e-commerce age means that consumers are not price takers. These factors imply that any budding inflation pressures will stay "trapped" at the earlier stages of the supply chain and it should not be a foregone conclusion that PPI can drive CPI prices higher. Chart 3Consumer Supports Are In Place Chart 4Producer Prices Turning Higher... Chart 5...But PPI Barely Leaks Into CPI Similarly, the rise in the headline inflation rate - for the first time since 2013 above core CPI - should not be viewed as an omen for what lies ahead for broader inflation trends. As Chart 6 shows, the relationship between energy prices and core CPI broke down during the early 1980s: a rise in energy prices does not correlate with non-energy consumer prices. Chart 6Energy Prices Uncorrelated With Core CPI Since The 1980s Finally, we note that despite general optimism about business conditions in the NFIB survey, the pricing backdrop remains a glaring exception. In the most recent survey, the number of businesses expecting to raise prices actually fell. With respect to last week's core CPI print, the monthly increase of 0.3% is unlikely to be sustained. A few components were behind the upside surprise. For example, new car prices increased 0.9% m/m, apparel prices rose 1.4% m/m and airline fares spiked 2.0% m/m. The usual suspects behind outsized price gains were actually quite tame in January. Homeowners' equivalent rents increased by 0.2% m/m versus several months of 0.3% gains. Similarly, medical care was up 0.2% m/m. Our CPI diffusion index fell further below the zero line, confirming that inflation pressures are not broad based. Perhaps the only negative development last week was that positive data surprises, combined with a slightly hawkish interpretation of Janet Yellen's testimony, have pushed forward the bond market's expectations of the next Fed interest rate hike. We expect the most likely outcome will be that the next rate hike will be in June. If that forecast proves correct, then any upward pressure on bond yields should be modest in the next few months. We do not expect a resumption of the cyclical bond bear market to be a headwind for stocks until later this year at the earliest. How long can the Goldilocks backdrop persist? As Chart 7 shows, positive economic surprises have been propping up financial markets alongside optimism about a Trump-led Republican government. Importantly, for the first time since 2011, positive economic surprises are occurring in the first quarter of the calendar year. During past episodes, this level (i.e. above 40) in the Economic Surprise Index has persisted for upwards of three months. The implication is that economic surprises may continue to help fuel the momentum in equity prices for another month or even longer. Chart 7Economic Surprises Could Persist A While Longer This corroborates our review two weeks ago of technical indicators, which showed that apart from extreme sentiment and despite the persistent run-up in equity prices, most short-term indicators are not yet flashing warning signs. In sum, recent data prints show that the U.S. economy is on sturdier footings. The absence of a meaningful inflation threat implies that a prolonged economic cycle can feed positive gains in the stock/bond ratio over a cyclical horizon. But these positive underpinnings cannot explain the speed and magnitude of the recent financial market adjustments. Although the bulk of our indicators suggest that positioning may become more lopsided in the short term, the current phase of the rally is high-risk. Size And Style Guide Several clients have asked about size and style investing in recent weeks. We remain overweight small caps relative to large, and are only slightly more optimistic about Value versus Growth. In the case of Value versus Growth, we echo the advice of our Global ETF strategy:1 the Value/Growth decision has become, more than ever, a matter of sector preference. As Table 1 shows, there are three sectors with vastly differing weights between S&P Growth and Value Indexes. The Value index is dominated by Financials (27% of the index, versus a 4% weight in the Growth index and 15% in the S&P 500) and Energy (12% in the Value Index versus 3% and 7% in the Growth and S&P 500 Indexes, respectively). Meanwhile, technology stocks make up a whopping 34% of the Growth Index. It is no wonder then that Value stocks shot higher on the back of a post-election financial sector outperformance streak (Chart 8). Financials (as well as the energy sector) received a big boost due to the promise of drastic de-regulation of the industry under a majority-Republican government. TABLE 1Sector Composition Our U.S. Equity Strategy service is underweight the technology sector, but only neutral on financials and energy stocks. On this basis, only a slight Value bias would make sense. At present, relative sector weightings appear to be the highest conviction argument in favor of a particular style, since many indicators that have reliably gauged style performance are not convincingly tilting in one direction or another. For example, growth stocks tend to need rising long-term earnings expectations to help them outperform. But this cycle, Growth stocks outperformed long before long-term earnings expectations started to move higher. Now that EPS have adjusted upward, it is hard to see - absent a repeat of the tech bubble in the late 1990s - long-term earnings growth rising enough to drag relative share performance higher. Conversely, the conditions for a plunge in long-term earnings expectations do not exist (Chart 8). Similarly, Value stocks tend to require improving global growth conditions in order to sustain relative outperformance over Growth stocks (Chart 8, bottom panel). That condition is in place, though the strength of the trend is unclear. In an upcoming publication by our Bank Credit Analyst, BCA editors uncover that although it is clear that an upswing in global growth is occurring in both the "soft" and "hard" data, there is little concrete evidence that this cyclical upturn will be any more enduring than previous mini-cycles so far in this lackluster expansion. The bottom line is that the outperformance in Value stocks relative to Growth may endure, by virtue of Value stocks having a comparably small allocation to technology stocks and a relatively larger allocation to financials (and energy). A more compelling case for Value stocks requires a higher conviction view in a prolonged financial sector outperformance phase. The latter awaits a move from promises to watch action on financial deregulation and more importantly, a more positive outlook on credit creation. As for small caps relative to large, we expect that the cyclical outperformance trend in small caps is sustainable (Chart 9). True, in the near term, there is room for overbought conditions to be further unwound. The consensus opinion that corporate tax reform and Trump trade policy will disproportionately benefit small companies is likely already fully discounted, making small cap share prices vulnerable to political disappointment. Chart 8Growth Will Struggle ##br##To Keep Up With Value Chart 9Small Cap Outperformance##br## Is Not Constrained By Valuation Meanwhile, if the dip in the U.S. dollar becomes a more sustainable trend, then small caps will be at further risk. However, that is not our base case: we expect broad dollar strength to be supportive of small cap stocks over the next six to twelve months. The U.S. economy is on sounder footing than its global counterparts and the Fed is far out in front; both of these conditions are supportive of a stronger dollar. Fortunately, small caps earnings are far more insulated from dollar strength, by virtue of the fact that small caps revenues are much more domestically oriented than large caps. The one area that small caps earnings may come under more pressure than large caps is margins. As noted above, small businesses are not yet particularly optimistic about their ability to raise prices in order to match wage hikes. Nonetheless, we expect better domestic (and thus small-cap positive) top-line growth to outweigh a margin squeeze felt more heavily for small caps versus large. Finally, small caps are often viewed as a higher beta play on growth (although this has not always been the case). Since relative valuations are not yet problematic, then if our base case of a prolonged, albeit not necessarily overly robust, non-inflationary economic expansion pans out, then the small cap outperformance phase could also endure for a prolonged period. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see Global ETF Strategy/ETS Equity Trading Strategy Special Report “Smart-Beta ETF Selection, Part I - Value Funds,” dated February 15, 2017, available at bcaresearch.com.
Feature The FX Market has a strange way of proving everyone wrong. Currently, we are finding ourselves uncomfortable with our cyclically bullish stance on the dollar as it has become a consensus view. A review of the rationale and risks to our view is in order. To begin with, let's review valuations. The dollar is overvalued by 8% at the current juncture. However, this overvaluation is still much more limited than the overvaluation of 22% registered in 1985 and of 17.7% recorded in 2002 (Chart I-1). Chart I-1Dollar Is Not Cheap, Yet It Can Get More Expensive This has two implications. First, we have always considered valuations as the ultimate measure of sentiment. After all, it is a reflection of how much people are willing to pay for an asset or currency, and therefore, how optimistically they view the prospects for that asset/currency. The USD's overvaluation being limited compared to previous instances suggests that investors' love affair with the greenback has yet to reach the exuberant heights reached in 1985 and 2002. In fact, at this point in time, the U.S. basic balance has improved considerably, especially vis-à-vis the euro area (Chart I-2). This suggests that investors are finding more attractive investments in the U.S. than in the euro area, and that so far, the strong dollar has not had a deleterious enough effect to hurt the perceived long-term earning power of the U.S. This can continue to weigh on EUR/USD, lifting DXY in the process. Second, the dollar has yet to represent the same drag on the U.S. economy that it did at its previous peaks. It is true that U.S. potential GDP growth is now lower than previously, dragged down by both lower labor force growth and lower trend productivity growth. However, manufacturing represents a much smaller share of employment than in these two instances, suggesting that the labor market should prove more robust in the face of the strong USD (Chart I-3). Chart I-2Basic Balance Dynamics Have ##br##Favored The USD Until Now Chart I-3The U.S. Dwindling ##br##Manufacturing Employment Thus, we continue to expect that the ongoing labor market tightening can run further. With the amount of slack in that market having now vanished, we are disposed to expect a quickening in wage growth in the coming quarters (Chart I-4). Additionally, we expect the U.S. labor market to promote a virtuous circle for the economy. As the job market tightens, wages and salary as a share of the economy rise. This skews the income distribution away from the top 1% of households - families who derive more than 50% of their incomes from profits, rents, and proprietors' incomes - toward the middle class. This redistribution effect should support consumption: middle class and poor households have marginal propensities to spend ranging between 90% and 100% while rich families have a marginal propensity to spend of around 60% Not only does household consumption represent nearly 70% of the U.S. economy, but also 70% of this consumption goes toward services. Services are principally domestically sourced and are a sector of the economy where productivity is hard to come by. As a result, we expect the boost in household consumption to be a key mechanism that will support employment and wage growth. Additionally, the strength of wages and salaries as a share of gross national income, coupled with the high degree of consumer confidence, could be a harbinger of a revival in capex. Historically, when these two measures of household health are behaving as they currently do, investment in the economy increases (Chart I-5). A few factors can explain this relationship: First, this strength in households boosts residential investment; Second, it also gives confidence to the business sector that final domestic demand is durable, a key factor boosting domestic producers willingness to invest; Third, the boost to residential investment lifts investment in the sectors of the economy linked to consumer durable goods. Moreover, the stabilization of U.S. profits, along with the narrowing of U.S. corporate spreads have boosted the capex intentions of businesses, a move that began even before Trump won the election. This has historically been a reliable leading indicator of both capex and the overall business cycle (Chart I-5). Chart I-4A Tight Labor Market ##br##Will Support Households... Chart I-5...And Households Support ##br##Domestic Businesses With U.S. trend GDP growth having fallen, lower growth is needed than in prior cycles to absorb the slack in the economy. In fact, our composite capacity utilization gauge currently shows an absence of slack (Chart I-6). Any further acceleration of growth would move the economy into "no slack" territory, an environment that has historically coincided with protracted Fed tightening campaigns. Chart I-6If The Fed Doesn't Heed The Message From Capacity Utilization, The Dollar Will Weaken However, if the Fed does let capacity move much above its constraint and does not react as much as it ought to, the inflationary outcome created by such a move would be devastating for the dollar: Rapidly rising U.S. price levels would hamper the USD's long-term PPP fair value; The process would also result in falling U.S. real yields, especially vis-à-vis nations with more signs of excess capacity, like the euro area, pushing down the greenback from a real interest-rate parity perspective; The easy Fed policy would ease global liquidity conditions, creating a shot in the arm for the global economy and EM in particular. Historically, an accelerating global economy hurts the dollar. We remain with the view that the Fed is unlikely to let such an outcome materialize. Yellen has gone out of her way to highlight that generating a "high-pressure" economy in the U.S. was a dangerous outcome that the FOMC wanted to avoid. In fact, the potential for Trump's fiscal stimulus, whenever it may be enacted, only raises the likelihood that the Fed leans against the inflationary under-current created by dissipating economic slack. The second risk to the dollar is the growing talk of a new Plaza Accord in the U.S. At this point, with Trump attacking China, the EU, and in fact, most trading partners, we think that the likelihood of moral suasion achieving its goal is low. However, we want to study this topic in more detail before coming to definitive conclusion. So where does this leave us with regard to our original discomfort with standing in the middle of the crowd? We continue to expect the dollar cycle to expand. However, we expect that the correction that begun after the December Fed meeting could run further before exhausting itself. This would be the key mechanism through which the stale longs that are accumulating will get shaken off. In fact, the current push-back against Trump by the political establishment, from both the republicans and the bureaucratic apparatus could raise doubts on Trump's ultimate capacity to achieve his fiscal policy goals. While we expect that these doubts will stay just that, doubts, and that Trump will ultimately make stimulus into law, this period of questioning could be enough to hurt a dollar still too loved by investors. Bottom Line: We are finding ourselves in the middle of the consensus with our cyclical dollar-bullish stance. However, U.S. economic fundamentals are still firmly bullish for the dollar and valuations are not yet potent enough to prompt the end of the dollar bull market. Short AUD/NZD After a long hiatus, inflation is making a comeback in New Zealand. Last week, inflation numbers for Q4 came in at 1.3%, marking the first time since 2014 that it exceeded 1%. This has significant implications for the RBNZ, given that persistently low inflation was the shackle that kept its dovish bias in place. As inflation starts to creep up, this should put upward pressure in rates and lift the NZD. Chart I-7Domestic Factor Points Will Help ##br##The Kiwi Outperform The Aussie Nevertheless, we are reticent to buy NZD/USD outright, as the dollar bull market should continue to weigh on the kiwi as well as on other commodity currencies. Instead we are expressing our view by shorting AUD/NZD. The outlook for these Oceanian countries could not be more different. New Zealand has been the best performing economy in the G10 with real GDP rising by 3.5% and employment growing at a staggering 6% pace, the highest level of the last 23 years. Meanwhile, Australia's real GDP growth has slowed down to 1.7% while employment growth is currently in negative territory. This contrast in economic performance is likely to dramatically increase inflationary pressures in New Zealand relatively to Australia, particularly if one considers that New Zealand's economy is growing at 2% above potential GDP while Australia's output gap is far from closed. Furthermore, growing divergences in housing and stock prices are also pointing to a widening in rate differentials (Chart I-7). These factors along with inflation should push kiwi rates up vis-à-vis Australian rates, and consequently weigh on AUD/NZD. The outlook for New Zealand's and Australia's main commodities (dairy products and iron ore respectively) also points to further downside in this cross. As previously highlighted, a weakening Chinese industrial sector and a tightening of global dollar liquidity should translate to an underperformance of base metals in the commodity space, given that China consumes roughly half of the world's industrial metals and that these commodities are highly sensitive to EM liquidity conditions. Meanwhile, although China is also the main consumer of dairy products, prices should hold up thanks to the recent loosening in the "One child" policy, which should increase demand for baby formula.1 This view is not without risks. The all-time low for AUD/NZD of 1.02 is not that far away, and could likely provide significant support to this cross. Indeed, one could argue that much of the widening in rate differentials is probably already priced in the cross. However, the difference in overnight rates between the central banks of these countries is a measly 25 basis points (with roughly another 25 basis points priced by the market until the end of 2017). Given the stark difference between the outlooks for these two economies we believe further widening could be warranted. Moreover, while it is true that the recent disappointment in kiwi unemployment numbers might provide fuel for the doves in the RBNZ for a bit longer, the markets have already reacted accordingly, with AUD/NZD rallying sharply since. Thus, we think that this recent rally provides a good entry point to short this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Assistant juanc@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "The OPEC Debate", dated November 24, 2016, available at ces.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The FOMC held the federal funds rate at 0.75%, as expected. The Committee highlighted that the economy is growing "at a moderate pace", also as expected. The labor market, consumer and business sentiment, and household spending all are improving. It is also expected that this trend continues and eventually leads to their 2% inflation target. Unlike the other G10 central banks, the FOMC sees near-term risks to the economic outlook as "roughly balanced", which may warrant a greenlight for their planned hikes. ISM Prices Paid, Manufacturing PMI, and the change in employment all beat expectations, confirming the economy's healthy path. The dollar will likely display limited movements, according to both seasonality and the economy developing as expected, and will likely remain relatively weak, in wait of fiscal policy information. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 Update On A Tumultuous Year - January 6, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Economic activity within the common market this week was mixed, however the overall euro area is accelerating: Confidence indicators (consumer, services, overall economic, and industrial) beat expectations across the board; Annual GDP growth outperformed at 1.8%; Unemployment came at better than expected at 9.6%; Most importantly, inflation was recorded at 1.8% - more or less in line with the ECB target. Nevertheless, core inflation remains at 0.9%, which is corroborated by the mixed performance of the major euro states - Germany, in particular, performed relatively poorly. The European Commission upgraded their forecasts for GDP, unemployment and inflation, however, highlighted that risks can emanate from emerging markets and the U.S, affecting financial markets and global trade. Report Links: GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data continues to show indications of a recovery in the Japanese economy: The jobs/applicants ratio beat expectations, and now stands at 1.43 The contraction in spending seems to be receding, with overall household spending falling by 0.3% vs a 1.5% contraction in November. December industrial production also outperformed expectations, growing by 0.5%. In their latest monetary policy report the BoJ took into account the good economic data that we have been highlighting as they have raised their forecast in GDP growth going forward. This should not be taken as a sign that the BoJ is starting to back off from its radical policies, as they project that inflation will reach 2% in 2018 (the target, as we have mentioned before lies above this level). Thus, the cyclical outlook for the yen remains bearish. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 In their monetary policy meeting yesterday, the BoE decided to keep their policy rate unchanged. While it is true that they raised their inflation forecast for the short term, they also decreased their forecast for inflation for the long term compared to their last meeting. More importantly they adjusted their equilibrium unemployment rate to 4.5% from 5%, a development which makes the BoE more dovish than otherwise. Markets have taken notice of this, as the pound has depreciated against all major currencies. Despite this development we continue to have a bullish bias towards the pound, as we still believe that both the BoE and the market are overestimating the negative effects that Brexit can have on the British economy. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Just as the dollar began to correct, AUD displayed an upbeat performance, appreciating 6.75% since then. The weak dollar has helped commodity prices rally, iron and copper prices have appreciated in anticipation of U.S. infrastructure spending, Chinese Manufacturing PMI beat expectations, and the trade balance also outperformed expectations. While it is possible that a weak dollar can help alleviate much of the pressure off AUD, we remain obstinate on the fundamental weakness of the AUD. The Australian economy is still haunted by the mining industry slump, with the labor market feeling much of the pain. As mentioned before, a longer-term bull market in the dollar, and Trump's expected policies, can have very adverse effects on EM, global growth, global trade, and thus commodity currencies. AUD is also approaching overbought RSI-levels, as well as an important resistance level, and is likely to see some downside soon. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 On Tuesday unemployment came in at 5.2%, significantly above the market expectation of 4.8%. This caused the NZD to fall off, particularly against its crosses. However we believe that the bullish story for the NZD is still intact. Immigration continues to increase, with visitor arrivals increasing by 11% YoY. This should continue to add fuel to the stellar kiwi economy. On the commodity side, in spite of a slowdown, dairy prices continue to grow at an astonishing 47% YoY pace. Moreover the relative robustness of dairy prices to EM liquidity conditions should help the NZD outperform the AUD, as base metals are more likely to bear the brunt of a shortage in EM liquidity triggered by a rising dollar. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 On Tuesday, USD/CAD fell below 1.30 for the first time since September, breaking through an important trend line, displaying newfound strength on the back of a weak greenback. As the USD continues its corrective phase, the strong CAD could hurt Canadian exports in the near future. Canada's exports represent 25% of its GDP, and 77% of its exports are to the U.S. An implementation of the Border-Adjustment Tax could have adverse consequences for this export-oriented economy. Although this tax will likely be bullish for the greenback, Trump has emphasized his view on the excessively strong dollar. The recent GDP monthly figure of 0.4% beat consensus due to the improving domestic economy. However, the aforementioned points can be a very real threat to this improvement, and should be monitored closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 After falling to an 18-month low, below 1.065, EUR/CHF has once again rallied and is now close to reaching 1.07. This is the third time that our recommendation of buying this cross whenever it falls below the crucial 1.07 level proves successful. We continue to reiterate that whenever EUR/CHF approaches this level, the SBN will not be shy to intervene, as a strong franc would accentuate the deflationary pressures that plague the Swiss economy. Recent data has been disappointing, and one should expect that the SNB will be more overzealous in its management of the franc: The KOF leading indicator stood at 101.7, falling from the previous month and underperforming expectations. SVME Manufacturing PMI also fell short of expectations and fell relative to November. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 This week, the Norwegian Krone built on its stellar 2017 rally. Indeed, USD/NOK has fallen by almost 5% since the start of the year. This rally in the krone has been particularly surprising, as it has happened in an environment where oil prices have stayed relatively flat. Thus, If OPEC cuts start to cause significant inventory drawdowns, the NOK could rally much further. Additionally it is worth reminding that Norwegian inflation is a unique case in the G10, as it is the only country which has an inflation level above their central bank target. A breaking point will eventually come, where the Norges Bank will have to choose between backing off their dovish bias and letting inflation run amok. Thus, we will continue to monitor inflation in Norway closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Sweden's economy continues to show strength. Producer prices increased at a 6.5% yearly pace, and a 2.1% monthly pace; Consumer confidence increased to 104.6 from last month's 103.2; Manufacturing PMI increased to 62; The monthly trade balance is positive for the first time since August. The data paints a positive picture of the economy: improving inflation, high consumer confidence, and a healthy industrial and export sector. Sweden's future for its exports seems hopeful on the back of an increasing manufacturing PMI and the lagged effects of a weak SEK. Additionally, Sweden is unlikely to be majorly affected by U.S. protectionism. Exports to the U.S. only account for 2% of GDP, and 7.7% of overall exports, whereas exports to the euro area account for 11% of GDP and 40.6% of exports. The risk of a strong SEK will be limited as the Riksbank monitors its pace of strength, and the USD will eventually resume its appreciation. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights In line with our House view, we expect the USD will weaken near term, and are recommending a tactical long gold position if the metal trades to $1,180/oz. Longer term, the Trump administration's presumed fiscal-policy goals - e.g., lighter regulation, lower taxes - will be hitting an economy at or near full employment, and will run smack up against deflationary pressures if a border-adjusted tax (BAT) scheme is implemented. Expect higher volatility. Energy: Overweight. Fundamentals continue to point toward global oil storage drawing by ~ 300mm bbl by 3Q17. Brent was backwardated going to press in the Dec/17 vs. Dec/18 spread, while WTI is in contango.1 Our WTI backwardation trade (long Dec/17 vs. short Dec/18) stopped out at -$0.05/bbl. Markets appear reluctant to take 2018 prices below 2017 levels, but we still like the position and will look to put it on again. Base Metals: Neutral. A weaker USD and marginally softer real rates will support base metals short term. We remain neutral. Precious Metals: Neutral. We are going tactically long gold, and are bracing for more ambiguity in U.S. fiscal-policy. This will keep the Fed on hold till 2H17. Ags/Softs: Underweight. Grains and beans will remain under pressure with Argentine growing conditions improving. High stocks-to-use levels will remain a headwind. Feature Gold prices will get a short-term bounce from financial markets' recalibration of when fiscal stimulus in the U.S. actually will start contributing to growth. With nothing for the Fed to react to in terms of fiscal policy other than sundry indications the Trump administration favors lighter regulation, lower taxes and higher infrastructure spending, we believe the U.S. central bank will remain on the sidelines until mid-year before it starts guiding toward a rate hike. In the meantime, synchronized global growth (Chart of the Week) will continue to fan medium-term inflation expectations (Chart 2). Chart of the WeekSynchronized Global Growth... Chart 2...Is Lifting Inflation Expectations At this point in the cycle, it is unlikely the Fed or other systematically important central banks will tighten policy to arrest the emerging growth. Besides, the U.S. central bank is, for all intents and purposes, on hold until it sees the outlines of the fiscal policy to be proposed by the Trump administration, which has indicated strong preferences for lighter regulation, lower taxes and infrastructure spending. The market is putting the odds of a Fed rate hike by March at just over 20% (Chart 3). The odds of seeing a hike by June, on the other hand, increase to 64%. Chart 3Fed Most Likely On Hold Until June Given the constraints on the Fed for now, and indications of synchronized global growth, we expect some inflation pickup near term. This will lower real rates and weaken the USD over the short term, which will, in turn, support gold prices. Given this expectation, we are recommending a tactical long gold position if the spot contract trades to $1,180/oz. Because this is a tactical position, we will use a 5% stop-loss. Ambiguous Inflation Signals For 1H17, we expect inflation and inflation expectations to remain buoyant, given the synchronized global upturn we are seeing and the prospect - and so far it is only a prospect - for stimulative fiscal policy in the U.S. All else equal, with the U.S. labor market at or close to full employment, and the Trump administration signaling its desire for stimulative fiscal policy, we would be inclined to look for inflation hedges within commodities that are highly sensitive to rising inflation. The top candidates here would be gold and oil (WTI, in particular). But all else is not equal. President Trump and officials within the administration have floated the idea of a border-adjusted tax (BAT) scheme, which would tax imports into the U.S. and subsidize U.S. exports, and replace the existing corporate income tax. Our House view on the BAT is it has a 50% chance of becoming law. Even so, we believe there is a greater-than-50% chance apparel and energy products would be exempt from a BAT, if it became the law of the land, but we obviously cannot be sure this will occur. The first-round effects of a BAT would be felt domestically. U.S. inflation and inflation expectations would increase after it is rolled out, as prices on taxed imports rose by the inverse of (1 - Tax Rate). As an indication, a 10% BAT would lift domestic prices of taxed items by ~ 11%. If the BAT were extended to oil, the domestic price lift there would incentivize higher domestic oil production, which also would find its way to export markets. Taken together, these domestic effects arising from the imposition of a BAT would cause the U.S. trade deficit to contract, which would rally the USD, in addition to lifting domestic inflation. As we noted last week, even under the assumption a somewhat watered down version of a BAT is passed, our colleagues at BCA's Global Investment Strategy service anticipate the USD would rally another 10%.2 The second-round effects on the back of such an increase in the USD would be felt globally, particularly in oil markets and EM economies. In addition to the broad trade-weighted dollar rallying by 10%, we expected a 5% rise in the greenback prior to the discussion of the BAT. So, overall, we'd expect a 15% appreciation in toto following the implementation of a BAT in the U.S. This would stifle EM commodity demand, particularly for oil and base metals, given the stronger USD would make these commodities more expensive in local-currency terms ex U.S. In addition, it would encourage higher commodity production in the U.S. (if a BAT were to be imposed on oil imports) and ex U.S., where local-currency drilling costs once again would fall, leading to increased supplies at the margin. The possibility of deflationary blowback to the U.S. is high in this scenario. Positioning In Ambiguous Markets Investors seeking to profit from rising inflation, which we would expect in the U.S. in the first round of adjustment to a BAT, or to hedge against it often turn to commodities expecting they will rally as inflation increases. They typically do this via index exposure or individual commodity exposure, e.g., going long gold or oil. In the current environment, we believe gold offers the best commodity alternative for participating in a rising inflation environment, or hedging against it, which is why we recommend a tactical long position if the market corrects to $1,180/oz. We compared the one-year return performance of gold and oil as inflation hedges by regressing annual returns of both commodities against annual core PCE and the broad trade-weighted USD returns (Chart 4).3 The R2 goodness-of-fit statistics for both were extremely close - 0.88 (oil) vs. 0.85 (gold), indicating core PCE and USD returns do a good job of explaining oil and gold returns. However, the volatility of the gold regression (its standard error) was half that of the oil regression (0.06 vs. 0.12), indicating gold's relationship is more stable vis-à-vis core PCE inflation and the USD (i.e., subject to less dispersion). This would indicate returns for an inflation hedge using gold would be less volatile than a hedge employing oil futures.4 These tests indicate both gold and oil are well suited to hedging inflation, and that gold hedges will perform as well as an oil hedge with far less volatility in the returns. Longer term, we're concerned with the second-round effects attending a stronger USD on the back of the BAT discussed above - i.e., lower commodity demand and higher commodity supply. Over the medium to longer term, the above dynamic suggests oil and gold volatility will increase (Chart 5). Chart 4Gold Hedges Inflation And USD Risk ##br##As Well As Oil, With Lower Volatility Chart 5Oil And Gold Vol Likely Rise Besides being an inflation hedge, gold, unlike oil, also functions as a store of value. In the event of deflationary blowback arising from the imposition of a BAT, we believe gold also would hedge investor portfolios against the possibility of currency debasement. That is to say, it would hold its value while central banks and governments rolled out fiscal and monetary policy responses to deflation. It is worthwhile recalling nominal gold prices held fairly steady during the Great Depression, while real gold prices appreciated. We believe the optimal vehicle for such a hedge would be call options, but we await clarity the likelihood of a BAT and its provisions before recommending such a position. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant hugob@bcaresearch.com 1 Backwardation and contango are terms describing the shape of commodity forward curves. When a curve is backwardated, prompt-delivery prices (e.g., oil delivered next week) exceed deferred-delivery prices (e.g., oil delivered next year), indicating supplies are tight. A contango curve describes a market in which deferred-delivery prices exceed prompt-delivery prices, which indicates supplies are relatively more abundant. 2 We discussed the implications of a possible border-adjusted tax scheme in last week's Commodity & Energy Strategy Weekly Report, in an article entitled "Taking A Bat To Commodities", dated January 26, 2017, available at ces.bcaresearch.com. See also BCA Research's Global Investment Strategy Special Report entitled "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017" dated January 20, 2017, which examined the BAT in depth, available at gis.bcaresearch.com. 3 We ran a simple regression of the percent returns of gold and oil against core PCE and USD annual returns over the 2001 - 2016 interval to assess the performance of each as inflation hedges. By using one-year returns, we were able to regress stationary variables and use an AR(1) model. 4 Along similar lines, the sum of squared residuals for the oil returns was almost 4x that of the gold returns, indicating far less dispersion in the errors and a tighter fit with gold vs. core PCE once again. The Durbin-Watson statistic measuring the degree of autocorrelation in the errors is was slightly > 2.0 for the gold regression, for the oil regression the DW statistic was < 2.0. This suggests the gold regression is better behaved in that the error terms more closely conform to the assumptions for them in the type of regression we're running. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017
Table 1Recommended Allocation The Reflation Trade Continues It is wrong to think that the recent rally in risk assets is mainly due to the election of President Donald Trump. Yes, since November 8, U.S. equities have risen by 7% and global equities by 3%. But the rally began as long ago as February last year, and since then U.S. and global equities have risen by 25% and 20% respectively. A more useful narrative is that the U.S. went through a "mini-recession" in late 2015/early 2016 (as indicated by the manufacturing ISM and credit spreads, Chart 1). Since then, assets have moved as they typically do in the first year of a cyclical recovery: small caps, cyclicals and value stocks have outperformed, bond yields risen, and equity multiples expanded in anticipation of a recovery in earnings. Expectations of Trump's fiscal stimulus and deregulation merely gave that momentum an extra boost. Our view is that global economic growth is likely to continue to accelerate. With the U.S. now at full employment, wage growth should rise further (Chart 2). Trump's policies are igniting animal spirits among companies, whose capex intentions have jumped sharply (Chart 3). U.S. real GDP growth this year could be 2.5-3%, somewhat above the consensus forecast of 2.3%. Meanwhile, Europe is growing above trend, and China will continue for a while longer to see the effects from last year's massive monetary stimulus (Chart 4). Chart 1One Year On From A Mini Recession Chart 2Wage Growth Is Set To Accelerate Chart 3Comapanies' Animal Spirits On The Rise Chart 4China's Reflation Still Coming Through In the short term, a correction is possible: the rally looks technically over-extended, and investors have begun to notice that in addition to "good Trump" (tax cuts, deregulation and infrastructure spending), there is also a "bad Trump" (market unfriendly measures such as immigration control, confrontation with China, and arbitrary interference in companies' investment decisions). But, on a 12-month view, our expectations of accelerating growth and only a moderate rise in inflation imply that the "sweet spot" for risk assets will continue, and so we maintain the overweight on equities and underweight on bonds we instituted in late November. What could end the reflation trade? The main risks we see (and the reasons we don't think they are serious enough to derail the rally for now) are: Extreme moves by the new U.S. administration. The biggest risk is a confrontation with China over trade. Our view is that Trump will use the threat of recognizing Taiwan to force concessions out of China. A precedent is the way the U.S. handled its trade deficit with Japan in the 1980s (note that new U.S. Trade Representative Robert Lighthizer was deputy USTR at the time). China is unlikely to accept significant currency appreciation, understanding how this caused a bubble in Japan. But it might agree to voluntary export restrictions, to increasing investment in the U.S., opening the Chinese market more to foreign companies, and to stimulating domestic consumption, as Japan did in the 1980s (Chart 5). This may even chime with how Xi Jinping wants to reform the economy, though missteps by the U.S. could force him into a nationalistic position. Fiscal policy fails. The details of tax cuts are complex: alongside lowering the headline rate of corporate tax to 15% or 20%, for example, Republicans are discussing a border-adjustment tax, one-year depreciation, and an end of the tax offset for interest payments. Infrastructure spending won't happen quickly either, not least since it is disliked by Republican fiscal hawks (who are much less averse to tax cuts). BCA's geopolitical strategists, however, believe that Trump will able to get a program of personal and corporate tax cuts through Congress by August. Economic (and earnings) growth stumble. While corporate and consumer sentiment have picked up recently, hard data has not yet. U.S. 4Q GDP growth of only 1.9%, for example, was disappointing. Earnings growth will need to recover this year to justify elevated multiples. EPS growth for the S&P500 stocks in Q4 2016 looks to have been around 4% YoY according to FactSet. Stocks might fall if earnings do not come in somewhere close to the 12% that the bottom-up consensus forecasts for 2017. Inflation risks rise, triggering the Fed and the European Central Bank to rush to tighten monetary policy. Core U.S. PCE inflation, at 1.7% YoY, is not far below the Fed's 2% target and inflation could accelerate as fiscal policy stimulates an economy where slack has already disappeared. However, it is likely to take some time for inflation expectations to rise, and over the past few months core PCE inflation has, if anything, slowed (Chart 6). We expect the Fed to raise rates three times this year (compared to market expectations of twice) but not to move faster than that. German inflation, at 1.9% YoY, is starting to get uncomfortably high too, but the ECB will probably continue to set policy with more focus on the periphery, especially Italy. Chart 5When U.S. Pushed Japan In The 1980's Chart 6Inflation Has Been Slow To Pick Up Equities: We prefer U.S. equities over European ones in common currency terms. This is partly because we expect further U.S. dollar appreciation. But we also remained concerned about the structural weakness in the European banking system, and by the higher volatility of eurozone equities. Moreover, European earnings will not be boosted by currency depreciation as much as will Japanese earnings, since the euro has hardly weakened on a trade-weighted basis (Chart 7). We continue to like Japanese equities (with a currency hedge). The Bank of Japan remains committed to an overshoot of its 2% inflation target, which should weaken the yen and boost earnings. We are underweight Emerging Market equities: structural vulnerabilities remain, and the inverse correlation with the U.S. dollar is intact. Chart 7Euro Hasn't Weakened Much Fixed Income: For now, U.S. 10-year Treasury bonds are at around fair value. But we expect the yield to rise moderately further, as growth and inflation pick up, to about 3% by year-end. Yields on eurozone government bonds will also rise, but not by as much. This means that global sovereigns could produce a YoY negative return for the first time since 1994. In the U.S. we continue to prefer TIPS over nominal bonds: inflation expectations are still 30-40 bps below a normalized level (Chart 8). With risk assets likely to outperform, we recommend exposure to spread product, but find investment grade bonds more attractively valued than high-yield. Currencies: Short term, the dollar has probably overshot and could correct. But growth and interest rate differentials (Chart 9) suggest that the dollar will appreciate further until such time as Europe and Japan can contemplate raising rates. Additionally, if the proposal of a border-adjustment tax looks like becoming reality, the dollar could appreciate sharply: a BAT of 20% would theoretically be offset by a 25% rise in the dollar. The yen is likely to depreciate further (perhaps back to JPY125 against the dollar) as the Bank of Japan successfully maintains its target of a 0% 10-year government bond yield. The euro will fall by less, especially if the market begins to worry about ECB tapering in the face of rising inflation. Chart 8TIPS Have Further to Go Room To Rise Chart 9Interest Rate Differentials Suggest Stronger Dollar Commodities: The supply/demand picture for industrial metals looks roughly balanced for the year, with Chinese demand likely to remain robust, suppliers more disciplined, but the stronger dollar acting as a headwind. In the oil market, Saudi Arabia and Russia seem to be sticking to their commitment to cut supply, but U.S. shale oil producers are filling the gap, with the rig count up 23% in Q4 over the previous quarter. We continue to expect crude oil to average US$55 a barrel for the next two years. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Recommended Asset Allocation Model Portfolio (USD Terms)
Highlights Look below the surface, and the euro area economy reveals some surprising and encouraging truths: Euro area employment is near an all-time high. Euro area inflation is little different to other major economies. The euro area excluding Germany is among the world's top-performing major economies. Stay underweight German bunds versus U.S. T-bonds. Stay long euro/pound until the trigger of Article 50. Stay long euro/yuan structurally. But underweight the Eurostoxx600 because the European equity index is a play on sectors and currencies, not on the euro area economy. Feature "There's nothing so absurd that if you repeat it often enough, people will believe it." - William James In today's post-truth world, the rigorous scrutiny and analysis of facts and data has never been so important. With that in mind, this week's report puts some of the prejudices about the euro area economy under the microscope. Look below the surface, and euro area employment, inflation and growth reveal some surprising and encouraging truths. Euro Area Employment: Near An All-Time High The percentage of the euro area population in employment is close to an all-time high (Chart of the Week). Chart of the WeekThe Percentage Of The Euro Area Population In Work Is Near An All-Time High How could this be when the unemployment rate stands at a structurally elevated 10%? The answer is that euro area labour participation is in a very strong uptrend (Chart I-2). As millions of formerly inactive citizens have entered the labour market, it has structurally swelled the numbers of both the employed and the unemployed. Remember that to count as unemployed, a person has to be in the labour market looking for work. Chart I-2Euro Area Labour Participation Is In A Strong Uptrend The euro area's strongly rising labour participation means that we must interpret the headline unemployment rate with care. Indeed, we would argue that the healthy percentage of the working age population in employment is the truer measure of labour utilisation. One counterargument is that euro area citizens have simply flooded into the registered labour force to claim generous and long-lasting unemployment benefits. This argument might be valid during downturns, but it cannot explain the 17-year uptrend since the turn of the century. Unpalatable as it might be to the euro doomsayers, we are left with a more positive explanation. Since the monetary union, many euro area countries have succeeded in bringing down structurally high inactivity levels in the working age population that was the accepted norm in previous decades. Admittedly, Italy and Greece are the laggards in this structural movement, and still have much work to do - but even they have made substantial progress in recent years (Chart I-3). Chart I-3Italy And Greece Are The Laggards, But Even They Are Making Progess Bottom Line: the structural state of euro area employment is much better than the headline unemployment rate might suggest. Euro Area Inflation: Little Different To Other Major Economies The euro area and U.S. inflation rates are almost identical when compared on an apples for apples basis. The key words here are "apples for apples". A fair comparison between inflation rates in the euro area and the U.S. must adjust for a crucial difference in the two price baskets. The euro area's Harmonized Index of Consumer Prices - excludes the consumption costs of owner-occupied housing; whereas the U.S. CPI includes it at a substantial 25% weighting. As Eurostat explains,1 "the comparison of inflation across different countries and regions can be undermined by the use of different approaches to owner-occupied housing." To compare apples with apples, a simple approach is to exclude housing costs from the U.S. CPI too. This shows that the ex-shelter inflation rates - both headline and core - are almost identical in the euro area and the U.S. (Chart I-4 and Chart I-5). Chart I-4Apples For Apples: Little Difference In ##br##Euro Area And U.S. Headline Inflation... Chart I-5...Or Core##br## Inflation A more correct approach would be to estimate the inclusion of housing costs in the euro area consumer basket, given that they represent a sizable proportion of euro area household expenditures. The proportion of homes that are owner-occupied in the euro area, 67%, is actually higher than that in the U.S., 65%. Our approach uses two steps. First, to realise that owner-occupied housing cost inflation just follows house price inflation. Second, to observe that house price inflation in the euro area is now identical to that in the U.S. (Chart I-6 and Chart I-7). We infer that if owner-occupied housing were included in the euro area consumer basket, there would be no major difference in the euro area and U.S. inflation numbers. But what about inflation expectations? The market-based expectations for the euro area and U.S. 5 year inflation rate 5 years ahead - the so-called 5 year 5 year inflation swap - show that the euro area is consistently below the U.S., albeit by just 0.5% (Chart I-8). But again, this difference exists largely because the market is ignoring owner-occupied housing costs, which are not in the euro area's official inflation rate. Chart I-6House Price Inflation Is Now Identical ##br##In The Euro Area And U.S. Chart I-7Owner Occupied Housing Inflation##br## Follows House Price Inflation Chart I-8Inflation Expectations Move Together ##br##In The Euro Area And U.S. Bottom Line: The euro area is not suffering a noticeably greater deflation threat than any other major economy. Euro Area Growth: One Of The Best In Class Since the end of 2013, euro area real GDP per capita has outperformed both the U.S. and Japan. Once again, we must compare apples with apples. To adjust for the different demographics in the major economies, a fair comparison of economic performance must be on a per capita basis. But isn't the euro area's outperformance due mostly to Germany? Actually, no. Over the past three years, the star performers are Spain and the Netherlands, whose per capita real GDPs have grown by 9% and 4.5% respectively. By comparison, the U.S. clocks in at 3.5% and Japan at 3%. The ECB might argue that its extraordinary policy is responsible for this outperformance. However, the evidence does not support this thesis. The revival in the euro area economy began in early 2014, long before the ECB had even mooted its asset-purchases, TLTROs or negative interest rates. Instead, the turning-point can be traced back to December 31, 2013, the mark-to-market date for the bank asset quality review (AQR). As soon as euro area banks ended the aggressive de-levering that the stress tests forced upon them, a deeply negative credit impulse also eased. Which allowed the economy to begin a sustained recovery. Bottom Line: The euro area excluding Germany is among the world's top-performing major economies (Chart I-9). Chart I-9The Euro Area Ex Germany Is Among The World's Top-Performing Major Economies The Investment Implications The proportion of the euro area working age population in employment is close to an all-time high, underlying inflation is almost identical to that in the U.S., and the euro area ex Germany is the world's best-performing major economy over the past three years. Yet the expected difference between ECB looseness and Federal Reserve tightness stands at a multi-decade extreme (Chart I-10). Chart I-10The Expected Difference Between ECB Looseness And Fed Tightness Is Too Extreme Lean against this. Either go long the Eurodollar two year out interest rate future contract and short the equivalent Euribor contract. Or go long the U.S. 5-year T-bond and short the German 5-year bund.2 A further ramification comes in the currency market. The dominant recent driver of the euro has been the so-called fixed income portfolio channel. When global bond investors fled the euro area in search of higher safe nominal yields, the euro came under pressure. These outflows are abating, and indeed reversing, as investors come to realise that the ECB's radical and experimental policy-easing has peaked. Stay long euro/pound until the trigger of Article 50. Stay long euro/yuan structurally. Finally, contrary to popular perception, the state of the euro area economy does not translate into Eurostoxx600 relative performance. Major equity market indexes are a collection of multinational dollar-earning companies which happen to be quoted in a particular city - say, Frankfurt, London, or New York - in a particular currency - say, the euro, pound, or dollar. Therefore, as demonstrated in More Investment Reductionism,3 the main driver of equity market relative performance tends to be currency movements, or the relative performance of industry sectors that dominate the particular index. Based on this currency and sector logic, stay underweight Eurostoxx600 versus FTSE100, and underweight Eurostoxx600 versus S&P500.4 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Detailed Technical manual on Owner-Occupied Housing for Harmonised Index of Consumer Prices, Eurostat. 2 BCA strategists differ on this position. 3 Published on November 24, 2016 and available at eis.bcaresearch.com 4 BCA strategists differ on this position. Fractal Trading Model* This week's trade is to go long Norwegian krone / Russian ruble. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 * 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 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations