Currencies
Highlights The drubbing that cryptocurrencies have received over the past two weeks is just a taste of things to come. Crypto markets will continue to face tighter regulation, as this week’s announcements from China and the US Treasury underscore. The hope that cryptocurrencies can ever truly “go green” is wishful thinking. Given their decentralized nature, cryptocurrencies require real resources to be expended to permit secure transactions to take place. In addition to their technical limitations, cryptocurrencies face a fundamental constraint, which we dub the “Crypto Impossibility Theorem.” The Crypto Impossibility Theorem states that cryptocurrencies will be viable only if they offer a higher return than equities. The assumption that cryptos can generate a return in excess of equities is almost certain to be false since it would require that cryptocurrency holdings rise more quickly than income in perpetuity. In the near term, the pain in crypto markets could drag down other speculative assets such as tech stocks. In the long term, diminished investor interest in cryptos will benefit the stock market, as investor attention focuses back on equities. Cryptos: Can’t Have It All Investors who track the cryptocurrency market might be aware of the “blockchain trilemma.” It posits that cryptocurrencies can possess only two of the following three attributes: decentralization, security, and scalability. Bitcoin is both highly decentralized and reasonably secure. However, because control of the Bitcoin blockchain is distributed across thousands of individual computer nodes, it is also very slow. The Bitcoin network can barely process five transactions per second, compared to over 20,000 for the Visa network (Chart 1). The average fee for a Bitcoin transaction is around $30, a number that has risen over the past few years (Chart 2). Chart 1Speed Of Transactions, Or Lack Thereof Chart 2Rising Cost Per Transaction The elaborate puzzles that the Bitcoin algorithm must solve to verify transactions are extremely energy intensive. Bitcoin mining consumes more energy than entire countries such as Sweden, Argentina, and Pakistan (Chart 3). About two-thirds of Bitcoin mining currently takes place in China, often using electricity generated by burning coal. Chart 3Bitcoin And Ethereum: How Dare You! Some claim that Bitcoin and other cryptocurrencies are shifting to renewable energy sources, a trend that will continue in the years ahead. However, this argument misses the point, which is that the “proof of work” mechanism that underpins Bitcoin requires that real resources be expended. Suppose that all Bitcoin mining could be performed entirely for free using solar energy. This would reduce the cost of running a “mining rig,” incentivizing more mining. The Bitcoin algorithm operates in such a way that the difficulty of mining coins increases as the total computational power of all miners grows. In this computational rat race, miners would need to purchase more servers with ever more powerful specifications to keep up with their competitors. And semiconductors do not grow on trees. It takes real resources to produce them. As this recent Bloomberg article pointed out, Taiwan Semiconductor generates almost 50% more greenhouse emissions than General Motors. Like Bitcoin, Ethereum uses the “proof of work” mechanism to verify transactions. There have been active discussions to shift Ethereum to a “proof of stake” mechanism, which would greatly expedite transactions.1 However, some have argued that a proof of stake system would degrade security, allowing for “double-spend attacks” where someone transfers coins to someone else but then spends the coins before the transaction is completed. The Crypto Impossibility Theorem We will not delve any further into the technical nature of the blockchain trilemma other than to note that it poses a serious challenge to the entire cryptocurrency project. Instead, let us highlight another obstacle that has received less attention – one that could be even more damaging for the prospects of cryptocurrencies in the long run. Let us hyperbolically call it the “Crypto Impossibility Theorem.” The Crypto Impossibility Theorem states that a cryptocurrency will be viable only if it offers a higher return than equities. As we discuss below, the assumption that cryptos can generate a return in excess of equities is almost certain to be false since it would require that cryptocurrency holdings rise more quickly than income in perpetuity. This implies that the value that investors currently attach to cryptos will turn out to be illusory. To see the theorem in action, recall that money serves three functions: As a unit of account, as a medium of exchange, and as a store of value. It is doubtful that anyone seriously thinks that the price tag on a box of cereal will ever be displayed in units of Bitcoin, ether, or any of the various dog coins currently in vogue. Thus, we can scratch “unit of account” off the list of possible crypto uses. What about medium of exchange? One can imagine a scenario where the prices of goods and services are still listed in dollars, but one may transfer the equivalent in cryptocurrencies to purchase them. However, this raises an obvious question: Why would anyone choose to hold a cryptocurrency if wages and prices are denominated in fiat currencies such as US dollars or euros? The only possible answer is that people must see cryptocurrencies as fulfilling the third function of money, namely being a store of value. Would people be willing to hold cryptocurrencies if their prices generally moved sideways? It is doubtful. Cryptocurrencies are risky. Cryptocurrency accounts are not subject to deposit insurance. Crypto prices are also extremely volatile. During the pandemic, the S&P 500 fell by 34%, but the price of Bitcoin sank by an even greater 53%. Other cryptocurrencies fared even worse. In contrast, the trade-weighted US dollar strengthened by about 4% while gold prices only fell marginally (Chart 4). Thus, to incentivize people to hold cryptos, the prospective capital gain has to be large enough to offset the inherent volatility in owning these currencies. Chart 4Cryptocurrencies Fared Badly During Last Year’s Equity Sell-Off This is where the Crypto Impossibility Theorem comes in. Unlike dividend-paying stocks, cryptocurrencies do not provide any income to their holders. Thus, even if cryptos were just as risky as stocks, the price of cryptos would still need to rise more than the price of stocks in order to ensure that investors remain indifferent between the two asset classes. In practice, as the experience of the pandemic demonstrates, cryptos are even riskier than stocks. Thus, the expected return on cryptos has to exceed the expected increase in stock prices by more than the dividend yield. The problem for crypto holders is that this is not mathematically possible. Even if one controls for the rise in price-earnings multiples over time, equity returns have generally exceeded nominal GDP growth (Table 1). Hence, if cryptos need to offer superior returns to equities, and if the return on equities is at least equal to nominal GDP growth, then the market capitalization of cryptocurrencies will not only end up rising faster than for stocks, it will rise faster than aggregate national income. In a digital world where people need ever-less money to facilitate transactions, there is no good reason to expect this to happen. Table 1Equity Returns And GDP Growth A Fashion Choice Crypto-optimists might argue that the required rate of return to holding cryptos will decline as the market matures. This is wishful thinking. Equities derive their value from the fundamentals of a company’s business. In contrast, cryptocurrencies have no intrinsic value. Their value is whatever others are willing to pay for them. Not only does this make cryptocurrencies inherently more risky than equities, it also makes them highly susceptible to fashion trends. It is not surprising that many upstart cryptocurrencies have crafted ties with celebrities and other “influencers.” The whole point is to get enough people interested in a cryptocurrency to generate a feedback loop of wider adoption, thus allowing the currency’s early backers to cash out. The drubbing that cryptocurrencies have received over the past two weeks is just a taste of things to come. In this sense, cryptocurrencies are even more vulnerable to affinity scams than other assets such as precious metals. While apocalyptic warnings of “currency debasement” have long been used to sell bullion, at least with gold and silver, you truly do get something that is in short supply. In the case of cryptocurrencies, while the supply of any individual cryptocurrency may be limited, the overall supply is unbounded. This means that the average price of each currency is likely to rise much less than the aggregate value of all cryptocurrencies, making the entire asset class even less viable over time. Cryptogeddon The drubbing that cryptocurrencies have received over the past two weeks is just a taste of things to come. As Matt Gertken and Guy Russell discuss in this week’s Geopolitical Strategy report, crypto markets will continue to face tighter regulation (Table 2). Just this week, China reiterated its ban on financial companies offering cryptocurrency services. As part of its broader effort to crack down on tax evasion, the US Treasury Department also announced that it will require any cryptocurrency transfer worth $10,000 or more to be reported to the IRS. Table 2Regulation Of Cryptos: What Can And Cannot Be Done The blockchain trilemma will make it impossible for cryptos to overcome ESG concerns, while the Crypto Impossibility Theorem will prevent cryptocurrencies from ever being stable stores of value. In the meantime, an ebbing of input price inflation will take some of the wind out of the sails from the argument that cryptos are an indispensable hedge against the “inevitable” debasement of fiat monies. Chart 5 shows that DRAM prices have rolled over. Lumber prices have dropped 11% so far this week. Corn, soybean, and steel prices have also backed off their highs. Cryptos are like sharks; they need to move forward or they will sink. Back when they were unknown to most investors, a speculative case could have been made for buying cryptos. However, that case vanished earlier this year when the aggregate value of cryptocurrencies briefly surpassed the entire stock of US dollars in circulation (Chart 6). Even with the recent correction, there are 17 cryptocurrencies with market capitalizations above $10 billion (Table 3). Chart 5To The Moon And Back? Chart 6Aggregate Value Of Cryptos Briefly Surpassed The Entire Stock Of US Dollars In Circulation Table 3Close To 20 Cryptos Have A Market Cap In Excess Of US$10bn What will the ongoing crypto collapse mean for the broader investment landscape? In the near term, the pain in crypto markets could drag down other speculative assets such as tech stocks. In the long term, diminished investor interest in cryptos will benefit the stock market, as investor attention focuses back on equities. For the broader economy, the impact of a crypto bear market will be limited. The banking system has very little exposure to cryptos. There will be a modest adverse wealth effect from falling crypto prices. However, the inability of a few laser-eyed crypto traders to buy their Lambos is hardly going to matter much against the backdrop of strong stimulus-fueled consumption growth in the US and a number of other economies. Investors should continue to overweight stocks in a global asset portfolio, favoring value over growth, cyclicals over defensives, and non-US stocks over their US peers. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1 Proof of Work (PoW) and Proof of Stake (PoS) are two methods used to ensure the integrity of a coin’s ledger or record of transactions. PoW achieves this by requiring miners (those who add transactions to the ledger) to solve a time-consuming mathematical puzzle. PoS achieves this through a different mechanism, where anyone who stakes their own coin can be randomly selected to add new transactions to the ledger. Those holding or “staking” more coin have a higher probability of being selected. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Highlights ECB Tapering?: Investor fears that the ECB could follow the Bank of Canada and Bank of England and begin to taper its bond buying sooner than expected – perhaps as soon as next month’s policy meeting – are misplaced. The last thing the ECB wants to see is the surge in the euro and Italian bond yields that would surely follow any move to pre-emptively begin reducing monetary accommodation in response to faster European growth and inflation. Euro Area Bond Strategy: We are sticking with our current European bond recommendations: overweighting Europe within global bond portfolios - favoring Peripheral sovereigns and corporates versus government debt of the core countries - while also overweighting inflation-linked bonds in France, Italy and Germany where breakevens are undervalued. We also suggest a new tactical trade to fade the current market pricing of ECB rate hikes by going long the December 2023 euribor interest rate futures contract. Feature Dear Client, Next week, we will be jointly publishing a Special Report, discussing the investment implications of the current global housing boom, with our colleagues at the monthly Bank Credit Analyst. You will be receiving that report on Friday, May 28. We will return to regular weekly publishing schedule on Tuesday, June 1. - Rob Robis Chart of the WeekAn Underwhelming Rise In European Bond Yields For next month’s monetary policy meeting, European Central Bank (ECB) President Christine Lagarde reportedly plans to invite the Governing Council members to meet in person for the first time since the start of the pandemic. That provides an interesting subtext to a meeting that will surely involve a debate over how much monetary support is still necessary for an increasingly vaccinated Europe that is emerging from the depths of COVID-19. Some ECB officials have already noted that the risks to economic growth and inflation expectations were now “tilted to the upside”, according to the minutes of the last ECB meeting in April. With European economic confidence improving, European bond yields have moved higher in response (Chart of the Week). The benchmark 10-year German bund yield now sits at -0.11%, up 46bps year-to-date but with half of that move occurring over the past month. The pickup up in yields has not been contained to the core countries of Germany and France – the 10-year Italian government bond yield is now up to 1.11%, over twice the level that began 2021 (0.52%). Inflation expectations have picked up sharply, with the 5-year/5-year forward euro CPI swap now up to 1.63%, a level last seen in December 2018. These yield increases have lagged the big moves seen in other countries; 10-year government bond yields in the US and Canada have seen year-to-date increases of 72bps and 90bps, respectively. In those countries, yields have surged because of rising inflation expectations and worries about a tapering of central bank bond buying – concerns that turned out to be accurate in the case of Canada, where the Bank of Canada did indeed announce a slower pace of bond buying last month. In our view, it is still too soon for the ECB to contemplate such a shift to a less dovish policy stance. This message is corroborated by our ECB Monitor that has risen but is still not signaling a need for tighter monetary policy. The bond selloff in Europe looks like a case of "too much, too fast". The ECB Now Has A Lot To Think About Recent euro area economic data has not only caught up to the earlier strength visible in the US, but in some cases is back to levels not seen for many years. The expectations component of the German ZEW survey surged nearly 14 points in May and is now up to levels last seen in 2000. The Markit PMI for manufacturing reached an all-time high of 62.9 in April. The European Commission’s consumer confidence index for the euro area is nearly back to pre-pandemic levels (Chart 2), which bodes well for a continued recovery of the Markit PMI for services. More positive news on the pandemic is driving the surge in growth expectations. The pace of new COVID-19 cases has fallen steadily, with Italy – one of the hardest-stricken regions during the initial months of the pandemic – now seeing the lowest rate of new cases since October (on a rolling 7-day basis). Meanwhile, the pace of vaccinations has accelerated after a slow initial rollout; the number of daily jabs administered (per 100 people) is now greater in Germany, France and Italy than in the US (Chart 3). Chart 2European Growth Is Recovering Chart 3Inoculation Acceleration In Europe Chart 4How Much Spare Capacity Is There In Europe? The rapid increase in inoculations is setting Europe up for a solid recovery from the lockdown-driven double-dip recession of Q4/2020 and Q1/2021. The European Commission upgraded its growth forecasts for the euro area last week, with real GDP now expected to expand by 4.3% in 2021 and 4.4% in 2022, compared with previous forecasts of 3.8% in both years. All euro area countries are now expected to see a return to the pre-pandemic level of economic output by the end of 2022 – a number boosted by a pickup in public investment through the Next Generation EU (NGEU) package, which is expected to begin paying out funds later this summer. The ECB will surely raise its own forecasts at the June meeting, both for economic growth and inflation. The outlook for the latter will likely turn into the biggest source of debate within the ECB Governing Council. Despite the fairly coordinated recovery of survey-based data like the manufacturing PMIs, there remains a wide divergence of unemployment rates - and measures of spare capacity, more generally - within the euro area (Chart 4). This will make it difficult for the ECB to determine if the current surge in realized inflation, which has pushed the annual growth of headline HICP inflation towards the 2% level in many euro zone nations, can persist with countries like Italy and Spain still suffering from very high unemployment. The wide dispersion of unemployment rates within the euro zone also suggests that the current level of policy rates (at or below 0%) is appropriate. One simple metric to measure the “breadth” of European labor market strength is to look at the percentage of euro area countries that have an unemployment rate below the OECD’s estimate of the full employment NAIRU.1 That metric correlates well with an estimate of the appropriate level of euro area short-term interest rates generated by a basic Taylor Rule. Currently, only 43% of euro zone countries are beyond full employment, which is consistent with an ECB policy rate round 0% (Chart 5). Chart 5Policy Rates Near 0% Are Still Appropriate A slightly larger share of countries (47%) is witnessing an acceleration in wage growth (bottom panel). This could mean that some of the NAIRU estimates for the individual countries are too low, which would fit with the acceleration in overall euro area wage growth seen since 2015. With so many euro area countries still working off the rise in unemployment generated by the pandemic, however, it will take some time for the ECB to get a clear enough read on labor market dynamics to determine if any necessary monetary policy adjustments should be made. The “breadth” of data trends do not only correlate to theoretical interest rate measures like the Taylor Rule. Actual ECB policy decisions are motivated by the degree to which higher growth and inflation is evident across the euro area. In Chart 6, we show a similar metric to the labor market breadth measures from Chart 5, but using other economic and inflation data. Specifically, we show the percentage of euro area countries that are seeing: Chart 6ECB Typically Tightens When Growth AND Inflation Are Broad Based a) Accelerating growth momentum, indicated by an OECD leading economic indicator that is higher than the level of one year earlier; b) Accelerating inflation momentum, comparing the latest reading on headline HICP inflation to that of one year earlier; c) Relatively high inflation, measured by headline HICP inflation being above the ECB’s “just below 2%” target. Looking at all previous periods of ECB monetary tightening since the inception of the euro in 1998 – taking the form of actual policy rate hikes or a flat-to-declining trend in the ECB’s balance sheet – it is clear that the ECB does not tighten without at least 75% of euro area countries seeing both economic growth and inflation accelerate. Actual rate hikes occur when at least 75% of countries had inflation above 2%, as occurred during the hiking cycles of 2000, 2005-2007 and 2011. More recently, the ECB paused the expansion of its balance sheet in 2017 when growth and inflation accelerated, but did not make any policy rate adjustments as only 50% of countries had inflation above 2%. Today, essentially all euro area countries are seeing accelerating growth momentum compared to the pandemic-depressed levels of a year ago. 59% of the euro area is seeing faster inflation, a number that is likely to move higher as more of Europe reopens from lockdown amid a surge in global commodity prices. Yet only 12% of euro area countries have headline inflation above 2%, suggesting that realized inflation is not yet strong enough to trigger even an ECB balance sheet adjustment, based on the 2017 experience. Don’t Bet On A June ECB Taper So judging by past ECB behavior, an announcement to taper bond buying at the June policy meeting would be highly premature. A more likely scenario is that an upgrade of the ECB’s growth and inflation forecast prompts a discussion of what to do with all the varying parts of the ECB’s monetary stimulus – quantitative easing, bank funding programs like TLTROs, as well as policy interest rates. Yet it will be impossible for the ECB Governing Council to reach any conclusions on their next step(s) at the June meeting because the very nature of the ECB's inflation target might soon change. The ECB is currently conducting a review of its monetary policy strategy – the first since 2003 – that is scheduled for completion later this year. Some adjustment to the ECB inflation target is expected to allow more flexibility, but it is not yet clear what that change will look like. Could the ECB follow the lead of the Federal Reserve and move to an “average inflation target” regime, tolerating overshoots of the inflation target after periods of below-target inflation? ECB Chief Economist Philip Lane noted back in March that “there was a very strong logic” to the Fed’s new approach. He also said that the “very different histories of inflation” in some European countries may make it difficult to reach an agreement on any system that allows even temporary periods of higher inflation.2 More recently, Bank of Finland Governor Olli Rehn – a moderate member of the Governing Council who was considered a candidate for the current ECB presidency – came out in favor of the ECB shifting to a Fed-like average inflation target for Europe in a recent Financial Times interview.3 Rehn noted that a Fed-like focus on aiming for maximum unemployment “makes sense in the current context of a lower natural rate of interest.” Rehn went on to describe the ECB’s current wording of its inflation target as having “generated a perception of asymmetry” such that “2 per cent is perceived as a ceiling and that is dampening inflation expectations.” We imagine that Jens Weidmann from the Bundesbank would vehemently oppose any move to change the ECB inflation target to tolerate even a temporary period of inflation above 2%. German headline HICP inflation already reached 2.1% in April, with more increases likely as the German economy reopens from extended pandemic lockdowns. Yet even if Weidmann were to not dig in his heels against any “loosening” of the ECB inflation target, the looming conclusion of the ECB strategy review makes it highly unlikely that any change in policy – like tapering – could credibly be announced before then. If higher inflation will be tolerated, then why bother to taper at all? Looking beyond the inflation strategy review, there are other factors that could weigh on the ECB in its deliberations on the next monetary policy move: China policy tightening: China – Europe’s largest trading partner – has seen its policymakers begin to rein in credit growth, and fiscal spending, after allowing a surge in borrowing in 2020 to help boost growth during the pandemic. Our measure of the China credit impulse leads the annual growth rate of European exports to China by around nine months (Chart 7), and is flagging a dramatic slowing of exports in the latter half of this year. This represents a downside risk to euro area growth, particularly in countries that export more heavily to China like Germany. Slowing loan growth: The annual growth rate of overall euro area bank lending peaked at 12.2% back in February and is now down to 10.9% (Chart 8). Much of the softening has occurred in Germany and France – countries that had seen a big take-up of subsidized bank funding through the ECB’s TLTROs. The pricing incentives set up by the ECB for the latest TLTRO program were highly attractive, and it appears that German and French banks took advantage of the cheap funding to ramp up lending activity. This makes the economic interpretation of the bank lending data more challenging for the ECB, especially with Italian loan growth – and TLTRO usage – now accelerating. Chart 7Warning Signs For European Export Demand Chart 8ECB LTROs Are Becoming Italy-Focused NGEU spending: As mentioned earlier, disbursements from the €750bn NGEU (a.k.a. “recovery fund”) are expected to begin later this year, pending EU approval of government investment proposals. NGEU funds are intended to finance initiatives that can boost future economic growth, like investments in digital and green programs. Most euro area countries have already submitted their proposals, led by Italy’s request for €192bn. Chart 9NGEU Will Give A Big Boost To European Growth Over The Next Five Years Chart 10NGEU Impact Will Be Front Loaded A recent study by S&P Global concluded that NGEU investments could boost overall euro area growth by between 1.3 and 3.9 percentage points, cumulatively, between 2021 and 2026 (Chart 9).4 That same study also noted that the impacts of the spending will be front-loaded over the next two years (Chart 10). The Italian government believes that NGEU investment could double Italy’s anemic trend growth rate to 1.5%. Many ECB officials have noted that NGEU is the kind of structural fiscal stimulus that makes it less necessary to maintain highly accommodative monetary policy. Until the NGEU proposals are finalized and the final approved amounts are dispersed, however, the ECB will be unable to adjust its economic forecasts to account for more government investment. Given all of these immediate uncertainties, including how successfully Europe can reopen from pandemic lockdowns, we do not see a plausible scenario where the ECB Governing Council could conclude at the June policy meeting that an immediate change in the current monetary policy tools and guidance was needed. Bottom Line: Investor fears that the ECB could follow the Bank of Canada and Bank of England and begin to taper its bond buying sooner than expected – perhaps as soon as next month’s policy meeting – are misplaced. Likely ECB Next Moves & Investment Implications While a June taper announcement from the ECB is unlikely, a hint towards a future move is quite possible. The ECB is notorious for preparing markets well in advance of any policy shifts, thus the official statement following the June meeting – as well as ECB President Lagarde’s press conference – could contain clues as to what the ECB will do next. Chart 11ECB Easing Takes Many Forms A discussion of what will happen with the Pandemic Emergency Purchase Program (PEPP) – which is scheduled to end next March – could come up in June. We deem it more likely that the topic will be raised at the September policy meeting when there will be more clarity on the success of the reopening of Europe’s economy, and to the final approved size of the NGEU funds, which will determine the need to maintain an asset purchase program introduced because of the COVID-19 shock. There are certainly many policy options available for the ECB to choose from when they do decide to dial back accommodation. There are several policy interest rates that could be adjusted. Although it is likely that when the ECB next tries to hike interest rates, the first rate to move will be the overnight deposit rate which is currently at -0.5% and represents the “floor” for short-term interest rates in Europe (Chart 11). Rate hikes will not occur before the balance sheet tools are reduced or unwound, however, which means asset purchases will be dialed back first. Market participants are well aware of that order of policy choices, as a very flat path for short-term interest rates is currently discounted in the European overnight index swap (OIS) curve. The spread between forward rates in the OIS and CPI swap curves can be used as a proxy for the market forward pricing of real interest rates. Currently, the market-implied real ECB policy rate is expected to stay between -2% and -1% over the next decade (Chart 12). Put another way, the markets are pricing in a very flat path for ECB policy rates that will stay below expected inflation over the next ten years. While the natural real rate of interest in Europe is likely very low given low trend growth, a real rate as low as -2% discounts a lot of bad structural news for the European economy. By comparison, the NY Fed’s last estimate of the natural real rate (r-star) for Europe – calculated in Q2/2020 before the economic volatility surrounding the pandemic made r-star estimation more unreliable – was positive at +0.6%. The prolonged path of negative expected real interest rates in Europe goes a long way in explaining the persistence of negative real bond yields in the benchmark German government yield curve. Simply put, there is little belief that the ECB will ever be able to engineer a full-blown rate hike cycle – an outcome that Japanese fixed income investors are quite familiar with. Given the ECB’s constant worry about the level of the euro, and its role in impacting European growth and inflation expectations, markets are correct in thinking that it will be difficult for the ECB to lift rates much without triggering unwanted currency appreciation. It is no coincidence that the euro has been consistently undervalued on a purchasing power parity (PPP) basis ever since the ECB moved to a negative interest rate policy back in 2014 (Chart 13). Chart 12Markets Expect Negative European Real Rates For The Next Decade Looking ahead, the ECB will need to be careful about signaling any changes in monetary policy, including tapering, that would force markets to revise up the future path of European interest rates and give the euro a large boost. Chart 13Low ECB Rates Keeping The Euro Undervalued That means that European real bond yields are likely to stay deeply negative over at least the latter half of 2021, with any additional nominal yield increases coming from higher inflation expectations (Chart 14). This will limit how much more European bond yields can rise from current levels. Chart 14European Bond Strategy Summary We continue to believe that core European bond yields will trade with a “low yield beta” to US Treasury yields over at least the second half of 2021 and likely into 2022 when we expect the Fed to begin tapering its bond buying. Thus, we are sticking with our strategic recommendation to overweight core European government bonds versus US Treasuries in global bond portfolios. We simply see greater odds of a taper occurring in the US than in Europe, with the Fed more likely to deliver subsequent post-taper rate hikes than the ECB. We still recommend a moderately below-benchmark duration stance within dedicated European bond portfolios, although if the 10-year German bund yield rises significantly into positive territory, we would likely look to raise our suggested European duration exposure. We are also maintaining our recommended overweight on European inflation-linked bonds, as breakeven spreads in Germany, France and Italy are the only ones that remain below fair value in our suite of global valuation models. On European credit, we continue to recommend overweighting spread product versus sovereign bonds. That includes Italian and Spanish government bonds, as well as both investment grade and high-yield corporate debt. The time to turn more bearish on those markets will be when the ECB does begin to taper its asset purchases, as credit spreads have tended to widen during periods when the growth of the ECB’s balance sheet has been decelerating (Chart 15). We expect that when the ECB does finally decide to taper, the net amount of TLTROs will likely be maintained near current levels (by introducing new TLTROs to replace expiring ones). This will ensure that borrowing costs in the more fragile countries like Italy do not spike higher from the double-whammy of reduced ECB buying of Italian bonds and diminished access to cheap ECB bank funding. One final note – we are introducing a new trade in our Tactical Overlay portfolio on page 19 this week, as a way to fade the markets pricing in a more hawkish ECB outlook. A 10bp rate hike – the most likely size of any first attempt for the ECB to lift rates – is now priced in the OIS curve around mid-2023. By the end of 2023, nearly 25bps of hikes are discounted in forward rate curves. We do not expect the ECB to lift rates at all in 2023, but even if rates were increased, a cumulative 25bps of hikes within six months is unlikely to be delivered. Thus, we recommend going long the December 2023 3-month Euribor interest rate futures contract at an entry price of 100.27 (Chart 16). Chart 15ECB Tapering Would Be Bad News For European Credit Chart 16Go Long Dec/2023 Euribor Futures Bottom Line: The last thing the ECB wants to see is the surge in the euro and Italian bond yields that would surely follow any move to pre-emptively begin reducing monetary accommodation in response to faster European growth and inflation. We are sticking with our current European bond recommendations: overweighting Europe within global bond portfolios - favoring Peripheral sovereigns and corporates versus government debt of the core countries - while also overweighting inflation-linked bonds in France, Italy and Germany where breakevens are undervalued. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 NAIRU is an acronym for the Non-Accelerating Inflation Rate of Unemployment. 2 Lane’s comments came from a wide-ranging interview with the Financial Times published on March 16, 2021, which can be found here: https://www.ft.com/content/2aa6750d-48b7-441e-9e84-7cb6467c5366 3 Rehn’s comments were published earlier this month on May 9 and can be found here: https://www.ft.com/content/05a12645-ceb2-4cd5-938e-974b778e16e0 4 The S&P Global report, titled “Next Generation EU Will Shift European Growth Into A Higher Gear”, can be found here: https://www.spglobal.com/ratings/en/research/articles/210427-next-generation-eu-will-shift-european-growth-into-a-higher-gear-1192994 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
The US dollar was down across the board on Tuesday, and the DXY slipped to 89.79 – the lowest level since January 6th. This performance comes despite the latest data from the US Treasury International Capital (TIC) system which shows that inflows into US…
Highlights Global currencies are at a critical level versus the dollar. From a positioning standpoint today, a break below 89-90 on the DXY index will be extremely bearish, while a bounce from current levels should be capped in the 3-4% range. Two key factors have pushed the dollar down: lower real rates in the US and recovering economic momentum outside the US. There could be some seasonal strength in the dollar as equity markets churn in May. However, this will provide an opportunity for fresh short positions. The Federal Reserve will maintain its resolve to view the current inflation overshoot as transitory, while it will still focus on the labor market. This will keep real rates in the US depressed relative to other countries. New trade idea: Go long CHF/NZD as a play on rising currency volatility. Also sell USD/JPY if it touches 110. Feature Chart I-1The Dollar Is At A Critical Juncture After a brief rally from January to March, the dollar is once again on the verge of a technical breakdown. Both the DXY index, the Federal Reserve trade-weighted dollar and EM currency benchmarks are sitting at critical levels (Chart I-1). A breakdown will confirm that the dollar bear market that began in March 2020 remains intact. It will also trigger a flurry of speculative outflows from the dollar. In our December FX outlook,1 our view was that the DXY was headed towards 80 on a cyclical (12-18- month horizon). However, we also predicted the DXY index would hit 94-95 in the first quarter, a view we have reinforced multiple times since then. With the DXY index having peaked at 93.5, it is now instructive to explore the most likely next move. To do this, we will revisit what has changed and what has remained the same since our December piece. Gauging Investor Positioning Chart I-2Dollar Bulls Are Capitulating Going into 2021, selling the dollar was a consensus trade and the currency was very much oversold. For contrarians, it paid to be bullish (Chart I-2). Since then, investors have closed their short positions on the dollar, shifting their focus to JPY- and CHF-funded carry trades. Speculators are still long the euro, but the magnitude of this bet has declined from a net 30% of open interest to around 10% today. Positioning in GBP and CAD are still elevated, which suggests that these currencies remain vulnerable to a technical pullback. Interestingly, the Citigroup sentiment indicator for the USD is close to its January nadir. From the vantage point of this gauge, there has been an accumulation of dollar short positions in recent weeks. This helps explain recent dollar weakness. Going forward, positioning will not be particularly useful in dictating the next move in the dollar since it only works well at extremes. Even then, it is only useful for gauging countertrend moves. For much of the early 2000s, sentiment on the dollar was bearish yet rallies were capped at 4-6%. During last decade’s dollar bull market, sentiment remained mostly in bullish territory, but the dollar achieved escape velocity (Chart I-3). Chart I-3The Dollar And Regime Shifts From today’s positioning standpoint, a break below 89-90 on the DXY index will be an extremely bearish sign, while a bounce from current levels should be capped in the 3-4% range. This puts the greenback at a critical crossroad in technical terms. The Federal Reserve, Inflation And Interest Rates At the start of 2021, interest rates were moving in favor of the dollar, which continued a trend that has been in place since the middle of last year. The gap between the US and German 10-year yields rose from a low of around 100 basis points last year to a high of over 200 basis points in March. More recently, interest rate differentials have started to move against the dollar, explaining the broad reversal in dollar indices since March. The US-German 10-year spread now sits at 180 basis points. Exchange rates tend to reflect real interest rate differentials, since inflation erodes the purchasing power of a currency. As such, it is important to gauge not only what is happening to nominal rates, but also to underlying inflation trends. This complicates matters because inflation is often a lagging variable, so getting a sense of where inflation is headed can be greatly useful for currency strategy. As a starting point, the US does not rank well when it comes to real interest rates. Chart I-4 shows the broad correlation between real interest rates and the dollar. For low interest rate countries such as Switzerland, Sweden and the euro area, the peak in US real rates also coincided with a cyclical rebound in these currencies. Even for a currency such as the Japanese yen, real rates are favorable compared to the US. Nominal 10-year rates are 10bps and inflation swaps at the 10-year tenor are 23bps. This pins Japanese real rates almost 100bps above rates in the US. Chart I-4AInterest Rates Have Moved Against The Dollar Chart I-4BInterest Rates Have Moved Against The Dollar Chart I-4CInterest Rates Have Moved Against The Dollar Of course, with inflation surprising to the upside in the US, the Fed could taper sooner than they have communicated and/or raise interest rates faster than the market expects. This will not be surprising given other central banks such as the Bank of Canada and the Bank of England have already telegraphed reduced asset purchases. However, even if the Fed does decide to taper its asset purchases, the impact on the dollar will not be as straightforward as some market participants expect. To understand why, consider Chart I-5, which shows that relative to other central banks, the Fed’s balance sheet impulse is already shrinking by approximately 13% of GDP. In essence, the Fed has already been "stealthily" tapering asset purchases compared to other G10 central banks. This action supported the dollar this year. It has also pushed market pricing of the Fed funds rate well above the median dots of the FOMC in 2 years (Chart I-6). Thus the prospect of the Fed tapering asset purchases might already be embedded in the price of assets. Chart I-5Stealth Tapering By The Fed? Chart I-6Markets Have Already Priced A Hawkish Fed Going forward, our Global Fixed Income colleagues have noted that the Fed is already moving down the ladder in terms of who is expected to taper next.2 The Bank of Japan and the European Central Bank have barely tapered their asset purchases. They might not announce anything significant in their June 10 and June 18 meetings respectively, but markets will still be squarely focused on any change in language. Chart I-7A Profligate US Government Has Historically Been Dollar Bearish If investors decide to take the Fed’s messaging at face value, which suggests that the FOMC will look through any upside surprises in inflation, then real rates will remain depressed in the US—which will pressure the dollar lower. We have little conviction about whether US inflation is transient or more permanent. However, we do know that the US economy is more inflationary than most other developed markets because the US is stimulating domestic demand by much more than is required to close the output gap. Historically, this is a bearish development for the US dollar (Chart I-7). Economic Momentum As A Catalyst To the extent that monetary policy is tailored to suit domestic economic conditions, growth momentum is clearly rotating from the US to other countries. This suggests that the case for other central banks, such as the ECB or the RBA, to follow the steps of the BoE or BoC is rising at the margin. Manufacturing PMIs around the world have overtaken US levels, and it is only a matter of time before the services PMIs catchup. Chart I-8 shows that euro area data continues to surprise to the upside, with the economic surprise index between the euro area and the US at a decade high. This has historically been synonymous with modestly higher Eurozone bond yields relative to the US, which has also provided some support for the currency. The expectations component of both the ZEW and the Sentix surveys came out stronger this month, which confirms that both European and German growth should remain healthy over the summer (Chart I-9). Chart I-8Small Window For European Yields To RiseChart I-9Euro Area Data To Stay Strong As for the slowdown in Chinese stimulus, we agree it is a risk to global growth as our China Strategists highlight, but two opposing factors are also at play: Chinese stimulus leads the economy by a long lag. Last cycle, the apex of Chinese credit was in 2016, but it took until 2018 for global trade to slow down (Chart I-10). This partly explains why commodity prices have not relapsed, despite slowing credit creation from their largest buyer. An economy cannot rely on credit formation alone. At some point, the baton has to be passed to the forces of animal spirits. The velocity of money, or how many units of GDP are created for every unit of money creation, is one of these forces. Chart I-11 shows that the velocity of money has been rising faster outside the US, led by China. Chart I-10Chinese Credit Impulse Works With A Lag Chart I-11Money Velocity Versus The US The above trends give us conviction that any strength in the dollar is a countertrend move that should be faded until the Federal Reserve does a volte face and tightens monetary policy faster than they have telegraphed. A period of weak global growth would constitute another risk to our view. Interestingly, the Chinese RMB has hit new cyclical lows, despite a narrowing of interest rate differentials between the US and China. We suggested in our February Special Report that USD/CNY was headed for 6.2, even if interest rate differentials between the US and China narrowed. If Chinese economic activity is able to stay relatively robust despite slowing credit formation, then USD/CNY will decline further. Chart I-12EM Growth Remains Weak A break lower in USD/CNY is a necessary but not a sufficient condition for EM currencies to outperform. Relative to the US, EM growth remains worse than at the depths of the COVID-19 recession last year (Chart I-12). Our Emerging Market Strategists reckon a change in economic conditions will be necessary for EM currencies to outperform on a sustained basis. A broadening of the vaccination campaign toward EM countries is likely to hold the key to this change. The Real Risk To Dollar Short Positions The risk from shorting the dollar at current levels comes from the equity market. Developed market currencies have run ahead of the relative performance of their domestic bourses. This is a departure from historical correlations (Chart I-13). A reset in equity markets that favors defensive equities will lead to inflows into the US equity and bond markets, which will hurt DM currencies and buffet the dollar. It is worrisome that this earnings season, the US enjoyed stronger positive earnings revisions. Correspondingly, the US put/call ratio remains very depressed, with complacency reigning across most equity bourses (Chart I-14). Chart I-13ACurrencies Have Ran Ahead Of Equity Outperformance Chart I-13BCurrencies Have Ran Ahead Of Equity Outperformance Chart I-14Lots Of Exuberance In US Stocks Chart I-15Equities And The Dollar Have Diverged The nature of a potential market reset is important to consider. For example: Global equities correct, but technology and healthcare lead the drop. In this scenario, the dollar underperforms, as is happening now (Chart I-15) because the US has a heavy weighting in these defensive sectors. The reverse will happen if value stocks or cyclicals lead the drop in global equities. Global equities correct, but bond yields drop as well. The initial reaction will be a stronger dollar as US inflows accelerate, but this will also curb the appeal of the US dollar since Treasury yields will converge towards those of Bunds or JGBs. Moreover, US real rates will collapse even further. We will be sellers of the dollar on strength in this scenario. Global equities correct as yields increase. If US yields lead this rise, the dollar will rally at first, but outflows from the US equity market will also accelerate. If this rotation is durable, the dollar will eventually depreciate, because foreign bourses are highly levered to rising yields. In a nutshell, the US bond market offers attractive yields and the US stock market could behave defensively (as has historically been the case) in a market correction. This creates a risk to shorting the dollar today. Currency Strategy Currency markets are at a critical juncture (Chart I-1) where either a breakdown in the dollar or a countertrend reversal is imminent. Our strategy remains the same it has been so far in 2021. Continue to short the USD against a basket of the most attractive currencies. On this basis, we are already long the Scandinavian currencies. Go short USD/JPY given lopsided positioning. We are placing a limit sell on USD/JPY today at 110. We are also raising our limit buy on the euro to 1.18. It is interesting that the EUR/JPY cross broke out from a multi-year downtrend. This cross has an inverse correlation with the dollar. Buy CHF/NZD today as a play on rising currency volatility. This is a good bet as markets grapple with the next central bank taper policy (Fed versus other DM economies) (Chart I-16). Wait for the equity market correction to play out, after which a green light to short the dollar outright will once again emerge. Historically, May is a good month for the dollar and a volatile one for equities (Chart I-17). That said, dollar bear markets often run in long cycles. Chart I-16Buy CHF/NZD As Insurance Chart I-17The Dollar And Seasonality Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, "2021 Key Views: Tradeable Themes," dated December 4, 2020. 2Please see Global Fixed Income Strategy Special Report, "Who Tapers Next?," dated December 04, 2020. Currencies US Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The recent data out of the US have been mixed: Average hourly earnings improved by 0.7% in April versus March, beating the expected 0.1% increase. Non-farm payrolls increased by 266K in April, far below the expected 978K and 770K in March. The unemployment rate worsened slightly from 6% in March to 6.1% in April, versus an expected improvement to 5.8%. The NFIB Small Business Optimism survey edged higher to 99.8 in April from 98.2 the prior month. CPI came in at 4.2% year on year in April, outpacing expectations of a 3.6% rise. Month on month, CPI grew by 0.8% in April, crushing the 0.2% consensus. Core CPI came in at 3% year on year in April, beating the expected 2.3%. PPI also surprised to the upside, clocking in at 6.2% year on year in April, versus an expected rise of 5.8%. The US dollar DXY index dropped by 1.3% this week. While CPI surged ahead, employment severely lagged expectations. The Fed’s “maximum employment” target, a gateway to any asset purchase tapering, is unlikely to be reached when the market expects it. This combination of persistent Fed dovishness and potential sizable inflation is bearish for the dollar. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area have been strong: March German imports strengthened by 6.5% month on month, crushing the expected 0.7%. German ZEW current condition registered at -40.1 in May, far ahead of the -48.8 in April. German ZEW economic sentiment also surprised to the upside in May at 84.4 versus the anticipated 72. For the entire euro area, the ZEW economic sentiment increased to 84 in May from 66 in April. Sentix investor confidence improved to 21 in May from 13.1 in April, beating the expected 14. Sentix investor expectations climbed to an all-time high of 36.8. The current situation crossed into positive territory for the first time since February 2020. March industrial production was up by 0.1% month on month, lower than the expected 0.7%. The euro strengthened by 1.3% this week against the USD. The uplifting ZEW survey results reinforce our expectation of a global growth rotation in favor of the euro area. While the ECB may not taper asset purchases, a forceful vaccination campaign should lead to further upside data surprises, especially in services. The Euro Area Economic Surprise Index (ESI) remains elevated in contrast with the US ESI, which has declined sharply from its July 2020 peak. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 There was scant data out of Japan this week: Household spending strengthened by 7.2% in March versus February, comfortably beating the expected 2.1% increase. The Japanese current account weakened to JPY 2.65tn in March from JPY 2.9tn in February. The Eco Watchers Survey disappointed in April, with current conditions declining from 49 to 39.1 and the expectations component falling from 49.8 to 41.7. The yen was up by 0.5% against the USD this week. The recent extension of the already months-long state of emergency will put downward pressure on the yen in the near term. However, with Japanese equities and the currency in oversold conditions, we are cautiously optimistic on the yen further along in the year. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 The recent data out of the UK have been weak: Construction PMI remained mostly unchanged at 61.6 in April. GDP weakened, quarter on quarter, by 1.5% in Q1. More disappointing was business investment that dropped in Q1 by 11.9% quarter on quarter and 18.1% year on year. March GDP strengthened by 2.1% month on month, suggesting the pullback in the first quarter was mostly due to lockdowns. Manufacturing production was up by 2.1% in March versus February, beating the 1% consensus. The trade deficit narrowed to GBP11.71B in March. The pound was up by 1.7% this week against the USD. The soft Q1 output data, primarily a result of the winter lockdown, mask improvements in March. With restrictions being lifted, services output and household consumption (induced by excess savings) should quickly catch up with the recent bounce in manufacturing. However, markets may have priced in too much of the UK’s vaccination outperformance as is reflected in the overpriced small-cap equities. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The recent data out of Australia have been positive: The NAB Business confidence increased to 26 in April from 17 the prior month. The NAB business survey index also edged higher to 32 in April from 25 in March. Retail sales increased by 1.3% in March month on month, slightly below the expected 1.4%. Quarter on quarter, Q1 retail sales weakened by 0.5% versus the estimated drop of 0.4%. Q1 CPI came in below expectations at 0.6% quarter on quarter and 1.1% year on year. The AUD was up by 1.2% this week against the USD. While the NAB business confidence and conditions indices came in at record highs, the price pressures remain weak in Australia and vaccination progress continues to lag. That said, leading indicators such as capex intentions and forward orders are improving. We are short AUD/MXN mainly to capitalize on Mexico’s proximity to the rebounding US. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The recent data out of New Zealand have been scant: Electronic card retail sales increased by 4% month on month in April after a 0.8% drop in March. The food price index came in at 1.1% month on month in April, compared to 0% in March. The NZD was up by 0.8% this week against the dollar. With positive data coming out of New Zealand recently, our Global Fixed Income Strategy colleagues judge the RBNZ to be the next central bank most likely to taper sometime in the second half of 2021. However, with Q2 inflation expectations that remain soft and the tourism sector still held back by broad border shutdowns, we remain cautious on the kiwi. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The recent data out of Canada have been mildly disappointing: The employment report was disheartening. Canada lost 207.1K jobs in April, and the participation rate dropped from 65.2% to 64.9%. The unemployment rate also weakened from 7.5% to 8.1% in April, higher than expected. The Ivey PMI dropped to 60.6 in April from 72.9 in March, in line with expectations. The CAD was up by 1.35% against the USD this week. Despite the already months-long rallying of the loonie and the housing prices, the CAD is still cheap by its real effective exchange rate. Strengthening oil prices should continue to support the currency. A potential extension to the current COVID-19 lockdown and lagging vaccination progress remain downside risks. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The recent Swiss data have been neutral: Unemployment rate remained relatively unchanged at 3.3% in April, in line with expectations. The Swiss franc was up by 1% this week against the USD. The franc is cheap with a real effective exchange rate that is at one standard deviation below fair value. Should the pickup in global trade continue, this will buffet the franc. However, our bias is that the SNB will continue to fight excessive franc strength, especially against the euro. So we think the franc will lag the euro over the longer term. We are also going long CHF/NZD today should currency volatility pick up. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The recent data out of Norway have been mixed: CPI came in at 3% in April, in line with expectations. PPI growth registered at 22.5% in April, year on year. GDP dropped by 0.6% in Q1 quarter on quarter, a disappointment given an estimated 0.4% decrease. Mainland GDP also undershot expectations, decreasing by 1% in Q1 quarter on quarter. The NOK was up by 1% this week against the dollar. The soft Q1 data may hold back the NOK in the very near term, especially considering its remarkable performance since its March 2020 lows. That said, the rally in oil prices will continue to provide support to the NOK. Vaccination progress, on par with that of the euro area, should also benefit the currency. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent Swedish data have been mildly positive: The unemployment rate came down from 8.4% in March to 8.2% in April. CPI came in at 2.2% year on year and 0.2% month on month in April, in line with expectations. CPIF registered at 2.5% year on year and 0.3% month on month in April, both beating the consensus. The SEK was up by 2% this week against the USD. Vaccination progress in Sweden is only notches below that of the euro area. A potential shift of sentiment out of the crowded commodity-driven trades could also lend support to the export-driven SEK, on the back of a recovery in Europe in the near term. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Footnotes 1 Please see Foreign Exchange Strategy Special Report, "2021 Key Views: Tradeable Themes," dated December 4, 2020. 2 Please see Global Fixed Income Strategy Special Report, "Who Tapers Next?," dated December 04, 2020. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights The US is only one deflationary shock away from a European level of bond yields. On a multi-year horizon, a deflationary shock is a near-certainty. The shock will be deflationary, because even if it starts inflationary, it will quickly morph into deflationary. The reason is that the sharp backup in bond yields resulting from an inflationary shock would undermine the value of $300 trillion worth of global real estate, and thereby unleash a massive deflationary impulse. Hence, the US 30-year bond will ultimately deliver an absolute return approaching 100 percent, in absolute terms… …and relative to core European and Japanese bonds. Fractal trade shortlist: Stocks to consolidate versus bonds; Commodities look dangerously frothy; Buy USD/CAD. Feature Chart of The WeekThe Structural Level Of Bond Yields Depends On The Number Of Lasting Deflationary Shocks Ten years ago, 30-year bond yields in the US, UK and Germany stood at near-identical levels, around 3 percent. Today though, those yields are widely dispersed: the US at 2.3 percent, the UK at 1.3 percent, and Germany at 0.3 percent. What happened? In 2012, the German bond yield decoupled from the UK and the US, because the deflationary shock from the euro debt crisis was focussed in the euro area. Then, in 2016, the UK bond yield decoupled from the US, because the deflationary shock from Brexit was focussed in the UK and EU27 (Chart Of The Week). The ‘Shock Theory’ Of Bond Yields Welcome to a new concept – the ‘shock theory’ of bond yields. According to this theory, the structural level of high-quality government bond yields is simply a function of the number of lasting deflationary shocks that the economy has suffered. Each successive deflationary shock takes the bond yield to a lower structural level until it can go no lower (Chart I-2). Chart I-2Each Successive Deflationary Shock Takes The Bond Yield To A Lower Structural Level, Until It Can Go No Lower Since 2011, US, UK and German bond yields have decoupled because the US has suffered the legacies of one fewer deflationary shock than the UK, and two fewer deflationary shocks than Germany. But the important corollary is that the US is only one deflationary shock away from a European level of bond yields. When that deflationary shock arrives and the US 30-year bond yield reaches the recent low achieved in the UK, it will equate to a price gain of over 50 percent. And if the yield reaches the recent low achieved in Germany, it will equate to a price gain of well over 100 percent. Many people say that such gains are impossible. Yet ten years ago these same people were saying that UK and German long-duration bonds could never reach near-zero yields, and look what happened! Our high-conviction view is that the long-duration US bond will ultimately deliver a stellar absolute return, and a stellar relative return versus core European and Japanese bonds. The simple reason is that another deflationary shock is just a matter of time away. Long-Term Investors Must Always Plan For A Shock Most strategists and investors claim that shocks, such as the pandemic, are inherently unpredictable, and therefore that you cannot plan for them. We disagree. Yes, the timing and nature of individual shocks are inherently unpredictable. But as we explained in How To Predict Shocks, the statistical distribution of shocks is highly predictable. What constitutes a shock? There is no established definition, so our definition is any event that causes the long-duration bond price in a major economy to rally or slump by at least 25 percent.1 (Chart I-3) Using this definition through the last 50 years, we can say that the statistical distribution of the number of shocks in any ten-year period is Poisson (3.33) and the statistical distribution of the time between shocks is Exponential (3.33). Chart I-3A Shock Is A 25 Percent Move In The Long Duration Bond Price, And A Shock Tends To Come Every 3 Years It follows that in any ten-year period, the likelihood of suffering a shock is a near-certain 96 percent (Chart I-4). And even in any five-year period, the likelihood of a shock is an extremely high 81 percent. Chart I-4On A Multi-Year Horizon, A Shock Is A Near-Certainty For many people, this creates a cognitive dissonance. Even though a shock is a near-certainty, they cannot visualise its exact nature or timing, so they resist planning for it. Yet long-term investors must always plan for shocks. Not to do so is unforgiveable. An Inflationary Shock Will Quickly Morph Into A Deflationary Shock The crucial question is, will the next shock be deflationary, or inflationary? Our high-conviction view is that it will be net deflationary. Meaning that even if the shock starts as inflationary, it will quickly morph into deflationary. The simple reason is that the sharp backup in bond yields that would come from an inflationary shock would undermine the value of $300 trillion worth of global real estate, and thereby unleash a massive deflationary impulse. The 2010s housing boom was unprecedented in its penetration and regional breadth, simultaneously encompassing cities, suburbs, and rural areas across North America, Europe, Asia and Australasia. As prices doubled almost everywhere, the value of global real estate surged by $150 trillion (Chart I-5), of which $75 trillion was due to the valuation uplift from lower bond yields (Chart I-6). To put this into context, lower bond yields have boosted the value of global real estate by the equivalent of world GDP! Chart I-5In The 2010s Housing Boom, The Value Of Global Real Estate Surged By $150 Trillion… Chart I-6…Of Which $75 Trillion Was Due To Lower Bond Yields Many people believe that real assets, such as real estate and equities, perform well in an inflationary shock, but this is a misunderstanding. Granted, the income generated by real assets should keep pace with nominal GDP. But the valuation paid for that income will collapse if it starts off at an elevated level, such as now. The starting valuation needed to generate a given real return during an inflationary shock is much lower than during price stability. For example, for equities in the low-inflation 1990s and 2000s, a starting price to earnings multiple of 15 consistently generated a prospective 10-year real return of 10 percent. But in the inflation shock of the 1970s, the same starting multiple of 15 generated a real return of zero. To generate a real return of 10 percent, the starting multiple had to halve to 7 (Chart I-7). Chart I-7In The 1970s Inflationary Shock, Valuations Collapsed How much can bond yields rise before undermining the value of global real estate? Over the past decade the global rental yield has not been able to deviate from the global long-duration bond yield by more than 100 bps.2 Given that the bond yield is already around 25 bps above the rental yield, we deduce that the long-duration bond yield can rise by no more than 75 bps before global real estate prices start getting hurt (Chart I-8). Chart I-8The Bond Yield Can Rise By No More Than 75 Bps Before Global Real Estate Prices Get Hurt To repeat our key structural recommendation, the long-duration US bond will ultimately deliver a stellar absolute return, and a stellar relative return versus core European and Japanese bonds. Candidates For Countertrend Reversal This week we note that the rally in stocks versus bonds (MSCI All Country World versus 30-year T-bond) is likely to consolidate in the coming months – given the fragility in the 260-day fractal structure similar to previous turning points in 2008, 2010, 2013, and 2020 (Chart I-9). Chart I-9The Rally In Stocks Versus Bonds Is Likely To Consolidate In The Coming Months We also repeat our warning to steer clear of commodities. The rally in all commodities is becoming dangerously frothy, displaying the extremes of fractal fragility seen in 2008. (Chart I-10and Chart I-11). Chart I-10The Rally In Commodities Is Becoming Dangerously Frothy... Chart I-11...Displaying The Extremes Of Fractal Fragility Seen In 2008 A good trade right now is to short the Canadian dollar. Based on the loonie’s composite fractal structure, a lot of good news is already priced in, including the dangerously frothy commodity markets and the Bank of Canada’s (hawkish) taper of asset purchases. As such we expect the Canadian dollar to reverse in the coming months (Chart I-12). Chart I-12Short The Canadian Dollar Go long USD/CAD, setting a profit-target and symmetrical stop-loss at 3.7 percent. Dhaval Joshi Chief Strategist Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 25 percent. 2 Here, the global long-duration bond yield is defined as the average of the 30-year yields in the US and China. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
EM stocks, including Chinese equities, tend to perform well during periods of stronger global growth, rising commodity prices and a weaker US dollar. However, a falling dollar index since April has failed to boost Chinese investable stock prices. China’s…
Highlights Important leading indicators of Eurozone activity point to record growth in the coming quarters. Progress on the vaccination front, global pent-up demand, and easing fiscal policy will fuel the Euro Area recovery. Consensus growth expectations for the Eurozone do not reflect this upbeat outlook; hence, European economic surprises will remain firm. Robust economic surprises will help European stocks, especially small-cap ones. They will also allow for a stronger EUR/USD and rising German 10-year yields. The UK economy is strong, and the BoE will be among the first central banks to tighten policy meaningfully. However, investors understand the UK’s strength well. While the cyclical outlook for the pound is bright against both the USD and the EUR, the GBP is vulnerable to some near-term profit taking. Downgrade UK small-cap stocks to neutral on a tactical basis. Feature The case for the Eurozone’s recovery is only growing stronger. However, consensus growth forecasts for the Euro Area remain modest. Faced with this dichotomy, the European economy has ample room to generate positive surprises in the coming months. This process will support European financial assets, small-cap stocks in particular. This contrasts with UK assets, where investors have already embedded generous growth assumptions in response to the country’s rapid pace of vaccination. A tactical downgrade of UK small-cap equities is appropriate. Surprise! Two indicators from outside the Eurozone point to an elevated likelihood that the European economy will generate some exceptionally strong growth numbers over the coming 12 months. First, the Swiss KOF Economic Barometer hit an all-time high in April. The KOF series is an excellent leading indicator of Switzerland’s economic activity, and it currently forecasts record GDP growth and PMIs for that country (Chart 1). This message of strength for Switzerland bodes well for the Eurozone. While the Swiss market is defensive, owing to its heavy exposure to healthcare and consumer staple stocks, the Swiss economy is pro-cyclical. Exports represent 60% of GDP, and exports to the Eurozone account for 40% of this total. Moreover, the growth-sensitive machinery, consumer goods, and chemicals categories account for almost 50% of shipments. Based on these observations, the KOF Economic Barometer forecasting ability unsurprisingly extends beyond Swiss economic variables; it also anticipates positive growth for the Global Manufacturing PMI, the Euro Area Manufacturing PMI, and the Eurozone’s forward earnings (Chart 2). Chart 1Climbing Swiss Peaks Chart 2A Good Sign For The Eurozone Second, an aggregation of Swedish economic data confirms the KOF indicator’s message and also calls for record economic activity in Europe. Our Swedish Economic Diffusion Index, which incorporates 14 data series from the Nordic country, points toward a further acceleration in the Euro Area PMIs relative to the US (Chart 3). It is also consistent with a pick-up in the performance of European equities relative to the US. These important indicators of the European economy reflect a variety of forces at play that increasingly point toward stronger growth. Among them, the improvement in the pace of vaccination is crucial to lifting the mood across the continent. As the top panel of Chart 4 illustrates, the number of daily vaccine doses administered across major Euro Area economies is accelerating sharply. While it took three months to inoculate 20% of the population, it only took one month to raise the vaccinated population to nearly 40% (Chart 4, bottom panel). Chart 3Sweden Leads The Eurozone Chart 4Accelerating Vaccinations Euro Area fiscal policy is also moving in a more growth-friendly direction. The Italian Budget announced on April 26 will add EUR248 billion in spending over the next six years. For the moment, Germany has abandoned its debt brake, and, as we wrote three weeks ago, the September election is likely to reify this outcome and further ease fiscal policy in Europe’s biggest economy. Spain is the second largest recipient of the NGEU funds, and it is expected to increase fiscal spending by EUR167 billion over the coming six years. In addition, France has yet to give clear hints about its plan, but next year’s elections are likely to result in further stimulus measures as well. Thus, fiscal easing in Europe will only increase from this point on (Chart 5). Chart 5The Expanding European Stimulus Accumulated pent-up demand remains another potent fuel for growth in the Euro Area. Unlike in the US, spending on durable goods in the Eurozone has not overtaken its pre-pandemic levels (Chart 6). Furthermore, global inventory-to-sales ratio are low, which hints at a coming inventory restocking cycle. These two trends will benefit Euro Area economic activity. The service sector recovery has more to go. Despite some recent improvements, the Eurozone’s Service PMI remains depressed compared to that of the US (Chart 7, top panel). However, the acceleration in the European vaccination campaign and the continued injection of fiscal support at the same time as the lockdowns ebb should result in a significant catch up in service activity in the Euro Area. Thus, the double-dip recession is on the verge of ending and giving way to a robust GDP expansion (Chart 7, bottom panel). Chart 6Ample European Pent-up Demand Chart 7The Service Sector Recovery Is Paramount Even though the recovery in GDP growth will lead to strong positive economic surprises for the Euro Area, consensus growth expectations for the region remain conservative. According to Bloomberg, Eurozone annual GDP growth is expected to reach 12.6% in Q2 because of an extremely strong base effect. However, growth will decelerate suddenly and hit 2.3% in Q3 and 4.3% in Q4. Growth is anticipated to be 4.1% in 2022. These are low thresholds to beat, and thus, economic surprises will remain positive. Chart 8Decomposing The Surprises The source of positive economic surprises is likely to be broad-based. If the service sector recaptures some of its previous shine, the Surveys and Business Cycle component and the Labor Market component of the Bloomberg surprises index will improve and remain positive for many months (Chart 8). Moreover, the absorption of pent-up demand will allow the Retail and Wholesale as well the Personal/Household components to remain robust or firm up further. Finally, the strength of the global manufacturing sector and the elevated potential for a global inventory restocking will allow the Industrial component to firm up anew. Bottom Line: The European economy is in a good place to validate the upbeat message from the KOF Economic Barometer or the Swedish Economic Diffusion Index. Since expectations for European economic activity are still limited for the second half of 2021, this strong growth performance will result in positive economic surprises. Investment Implications The heightened odds that Europe will generate significant positive economic surprises for the coming quarters means that investors’ perspective of the Euro Area will gradually improve. While this process will ultimately curtail the ability of Europe to beat expectations, it will also lift Eurozone assets. If our forecast is correct that European economic surprises will largely be positive over the coming 6 to 12 months, then European equities are more likely to generate generous returns than otherwise. Table 1 highlights that positive changes in the Economic Surprise Index (ESI) on a 3-month, 6-month, and 12-month horizon coincide with returns of the Euro Area MSCI equity benchmarks that have positive batting averages of 72%, 70%, and 73%, respectively. Moreover, the average and median returns are significantly higher than when the ESI deteriorates. Table 1Forecasting Strong Surprises Means Forecasting Strong Equity Returns The signal from the ESI is weaker if we do not make forecasts about its direction. The batting averages of subsequent 3-month and 6-month equity returns following an improving ESI are 63% and 69%, respectively, and the median subsequent returns are higher than if today’s ESI is deteriorating, but not to the same extent as when we make a forecast of the ESI. 12-month returns for the Eurozone MSCI index have a 58% chance of being positive, if the ESI increases over a 12-month window, which is lower than the 63% batting average if the ESI worsens. Moreover, average and median 12-month expected returns are somewhat higher if the ESI has been deteriorating rather than improving over the past 12-month period. European small cap equities will be prime beneficiaries of the coming growth outperformance. From an economic perspective, this makes sense because small-cap stocks are geared more toward domestic growth than large-cap equities, which are dominated by multinationals. Table 2 shows that 3-month, 6-month, and 12-month periods of improvement in the surprise index precede an outperformance of small-cap relative to large-cap stocks over similar windows of time. Thus, the current positive level of the European ESI and its ability to rise further should favor small-cap European equities. Table 2Favor Small-Cap Stocks Table 3A Bullish Backdrop For EUR/USD The same exercise shows that the outlook also favors the euro. European economic surprises should continue to outpace the US, because Eurozone growth will catch up to the US, but investors already have much loftier expectations for US activity than for the Euro Area. Table 3 illustrates that periods when the Eurozone’s ESI is greater than that of the US, EUR/USD generates a positive 3-month return 65% of the time, with a median gain of 1.3%. When the US ESI is higher, the EUR/USD depreciates 55% of the time, with a median loss of -0.5%. Chart 9Rising German Yields? Finally, the potential for stronger European ESI is negative for Bunds. Speeches by various members of the European Central Bank Governing Council indicate that the ECB will tolerate higher yields, if they reflect stronger economic activity. As the European vaccination campaign advances and the fiscal stimulus increases, the need to maintain depressed Bunds yields recedes. Hence, a continuation of positive ESI readings is now more likely to boost these yields. Additionally, the gap between the European ESI and the US one will remain positive, thus, a period of rising German yields relative to the US is more likely (Chart 9). Bottom Line: The ability of the European economy to continue to surprise positively should generate attractive equity returns on the continent. Moreover, this economic backdrop is consistent with an outperformance of small-cap equities, as well as an appreciating EUR/USD. Under these circumstances, Bunds yields should experience more upside. Country Focus: The UK’s Outlook Is Brightening, Unsurprisingly Last week, the Bank of England left the total size of its asset purchase program in place at GBP875 billion, even if the weekly pace of purchases was slowed to GBP3.4 billion from GBP4.4 billion. The BoE also raised its 2021 growth forecast to 7.5%, from 5% in February. The BoE is joining the Bank of Canada as one of the first central banks to taper its asset purchase program. It will also be one of the first central banks to increase interest rates, after the Norges Bank, but ahead of the Fed. In a way, the UK shares many similarities with our recent positive depiction of the Swedish economy. Chart 10Support For Household Net Worth The rapid pace of vaccination in the UK allows for a vigorous economic recovery. In all likelihood, the UK economy will have contracted in Q1 2021 because of the severe lockdowns that prevailed then; however, these lockdowns are being eased and economic fundamentals point up. Our Global Fixed Income and Foreign Exchange strategists recently demonstrated that house prices are increasing on the back of rising mortgage approvals and falling household debt-servicing obligations (Chart 10). The robust readings of the RICS House Prices survey only confirm the positive outlook for housing prices. Expanding house prices will elevate consumption. An appreciating housing stock boosts the wealth of households and leads to higher UK consumer confidence. Moreover, business confidence is improving; the rise in capex intentions not only indicates that investments will increase, but is also a precursor to climbing job vacancies (Chart 11). Brighter labor market prospects often result in rising consumption, especially if wages firm up, as we argued seven weeks ago. The current bout of economic strength points to some upside in UK inflation as well. The elevated PMI readings and the rapid increase in construction activity are reliable forecasters of higher CPI prints (Chart 12). However, this not a uniquely British phenomenon, and it remains to be seen how durable this rising inflation will be. Chart 11UK Consumption Will Rise More Chart 12Accelerating UK Inflation Despite this positive economic outlook, investors should adopt a more cautious tactical stance toward UK markets. The problem for British assets is that investors have understood UK’s vaccination strength so well that they embed much optimism in the price of financial instruments levered to domestic economic activity. In contrast to the Eurozone, Bloomberg consensus forecast anticipate Q2 year-on-year GDP growth of 20.7%, 6.1% for Q3 and 6.5% for Q4. Cable is particularly ripe for some near-term profit taking. Our Intermediate-Term Technical Indicator and the 52-week rate of change of GBP/USD, as well as net speculative positions and sentiment, all point to a correction in that pair (Chart 13). Moreover, the 13-week momentum measure for EUR/GBP shows that the rapid decline in this cross is also overdone. As a result, BCA’s Foreign Exchange strategists closed their short EUR/GBP position to book some gains. It is also time to downgrade British mid- and small-cap stocks from our current overweight stance, at least on a tactical basis. Compared to large-cap UK stocks, small-cap names have moved in a parabolic fashion, and the ratio’s elevated 52-week rate-of-change measure warns of a pullback, especially in light of the deterioration in near-term momentum (Chart 14). The message from technical indicators is particularly concerning, because the forward earnings of small-cap stocks are plunging relative to large cap ones (Chart 15). Additionally, valuation multiples on UK small-cap stocks have vastly outpaced those of their larger counterparts, despite a rapid decline in relative RoE (Chart 16). Chart 13Cable Is Ripe For Some Near-Term Profit Taking Chart 14UK Small-Cap Stocks Are Technically Vulnerable Chart 15Deteriorating Profit Performance Chart 16Quite The Valuation Premium Ultimately, these cautious views are of a short-term nature. BCA’s Foreign Exchange strategists remain upbeat on the pound on a 12- to 24-month basis. Cable continues to trade at a deep discount to our purchasing-power parity estimate, which adjusts for the composition of price indexes in the UK and the US (Chart 17). Moreover, real short rate differentials still favor GBP/USD. The pound also trades at a discount to the euro based on long-term valuation metrics. Most importantly, real interest rates differentials at both the short- and long-end of the curve, as well as the outlook for the evolution of monetary policy in the UK relative to the Euro Area, indicate a significantly lower EUR/GBP (Chart 18). Chart 17Despite Nera-term risks, Cable's Cyclical Underpinning Is Strong Chart 18Lower EUR/GBP Ahead For small-cap equities, the cyclical picture is more complex. On the one hand, their domestic exposure and a higher pound over the coming 12 to 24 months should help them, unlike the large-cap UK stocks, which derive most of their income from abroad and are negatively affected by a higher GBP. On the other hand, UK small-cap stocks have become so expensive that we need to see how an appreciating pound will boost their earnings relative to large-cap stocks before adjusting our neutral stance. Bottom Line: The strong UK economy will allow the BoE to be one of the first major DM central banks to tighten policy. This will support a further appreciation of the pound against both the dollar and the euro over the coming 12 to 24 months. Nonetheless, the GBP has been overbought on a tactical basis and is vulnerable to a near-term pullback. Similarly, compared to large-cap equities, we are downgrading small-cap UK stocks from overweight to neutral on a tactical basis. Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com Cyclical Recommendations Structural Recommendations Trades Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance Closed Trades
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