Developed Countries

Highlights Current activity indicators are now losing momentum, or outright rolling over. This confirms that European (and global) growth is now entering a down-oscillation. Why? It is the rate of decline in the bond yield that has driven the current up-oscillation in growth and it is mathematically impossible for the rate of decline in the bond yield to keep increasing, or even stay where it is. Equity investors should rotate from pro-cyclical to pro-defensive sectors. But the support to risk-asset valuations from low bond yields will keep the aggregate European equity market in a sideways channel. Feature Chart of the WeekThe Interest Rate Impulse And Credit Impulse Are Both Entering ##br##Down-Oscillations If the level of interest rates drove economic growth then, let’s face it, the economies of Japan and Switzerland would have reached the moon by now! In both Japan and Switzerland, the policy rate and long bond yield have been at ultra-low levels for decades (Chart I-2). This is true for both the nominal level and the real level of the interest rate and bond yield. But we all know that the level of interest rates does not drive economic growth. Chart I-2Japan And Switzerland Have Had Ultra-Low Bond Yields For Decades If Interest Rates Decline At A Reduced Pace, Growth Slows Most people understand that it is the change in interest rates that can drive economic growth. The main transmission mechanism is by adding to or subtracting from credit creation. For example if, in a given period, a -0.5 percent decline in the interest rate added €50 billion to credit creation, then the extra €50 billion would constitute additional economic demand. Many people struggle to understand the subtle and counterintuitive follow-on point. If interest rates decline, but at a reduced pace, it can slow economic growth. To understand why, let’s continue the example. If, in the following period, a further -0.5 percent decline in the interest rate added another €50 billion of credit-sourced demand, it would constitute the same rate of growth as in the first period. But a further -0.25 percent decline in the interest rate which added €25 billion to demand would result in the growth rate halving. The counterintuitive thing is that the interest rate has continued to decline, yet it has caused growth to slow! If interest rates decline, but at a reduced pace, it can slow economic growth. This counterintuitive dynamic is about to unfold in the European and global economy during the second half of this year. The pace of change in the interest rate (inverted) drives the credit impulse, and thereby drives short-term growth oscillations (Chart I-3). Of course, other influences on credit creation can sometimes swamp the interest rate impact. But not in the latest cycle. From the fourth quarter of 2018, both the pace of decline in the interest rate – or more precisely, the bond yield – and the credit impulse were in a synchronised and closely connected up-oscillation. Chart I-3The Pace Of Change In the Bond Yield (Inverted) Drives The Credit Impulse Unfortunately, it is mathematically impossible for the pace of decline in the bond yield to keep increasing, or indeed stay where it is. Hence, both the interest rate and credit impulses are now on the cusp of down-oscillations, which will bear on economies and financial markets in the second half of the year (Chart of the Week). Growth Rebounded, But Will Now Fade From the fourth quarter of 2018, European and global growth very clearly entered an up-oscillation. Let’s list all the evidence: First and foremost, quarter-on-quarter GDP growth rates picked up: by 2.5 percent in Germany; by 1 percent in the euro area; and by 1 percent in the developed economies (Chart I-4).1 The stark evidence that growth rebounded, but is now rolling over. The best current activity indicators rebounded: specifically the ZEW economic sentiment indicators for both Germany and the euro area (Chart I-5 and Chart I-6); the euro area composite PMI picked up too, albeit very modestly. Chart I-4Global Growth Rebounded... But Is Now Likely To Roll Over Chart I-5Current Activity Indicators ##br##Rebounded... Chart I-6...But Are Now Rolling Over The aforementioned interest rate impulses (inverted) and 6-month credit impulses picked up, and sharply in China (Chart I-7). Chart I-7Short-Term Impulses Rebounded... But Are Now Rolling Over The equity sector that is most exposed to growth – the industrials – strongly outperformed the broader market, especially in the euro area (Chart I-8). Chart I-8Industrials Outperformed Strongly... But Are Now Rolling Over In fact, just the first item on our list, the pick-up in GDP growth, should suffice to demonstrate the up-oscillation in growth, and that should be that. After all, GDP – after revisions – is the broadest measure of economic activity. Nevertheless, for the sceptics, the corroboration of four independent pieces of evidence should, once and for all, confirm that growth rebounded late last year and early this year. Now though, all of these indicators are losing momentum, or outright rolling over. This confirms that growth is now entering a down-oscillation. Why? To repeat, it is the rate of decline in the bond yield that has driven the current up-oscillation in growth and it is mathematically impossible for the rate of decline in the bond yield to keep increasing, or even stay where it is. The ultimate test of a good theory is its predictive power. In the case of investment strategy this means calling the markets right. Our bond yield and credit impulse oscillation framework passes this test with flying colours, especially at the last two turning-points. On February 1, 2018 at the onset of the last down-oscillation we correctly recommended: “Downgrade banks to underweight versus healthcare” Then on August 30 2018 at the onset of the last up-oscillation we correctly recommended:  “Take profits in the 35 percent outperformance of European healthcare versus banks” Now, at the onset of a new down-oscillation, we recommended last week that equity investors should as a first step go underweight European industrials and switch once again to the less economically-sensitive and less price-sensitive healthcare sector. Sector rotation has huge implications for equity market regional and country allocation. Nowadays, regional and country relative performance just comes from the dominant stock and sector fingerprints of each stock market. Next week, we will advise on what the onset of a new down-oscillation means for Europe as a region relative to the world as well as for equity market allocation within Europe. Enhancing The ‘Rule Of 4’ And The ‘Rule Of 3’ The level of interest rates does not drive economic growth, but the level of interest rates – or more precisely, bond yields – does drive the valuations of equities and other risk-assets. Moreover, it does so in a viciously non-linear way. Essentially, at a tipping point, higher bond yields can suddenly undermine the valuation support of equities, triggering a plunge in the stock market and other risk-assets which threatens a disinflationary impulse on the economy. How can we sense this tipping point? Previously we defined it as when the sum of the 10-year yields on the T-bond, German bund, and JGB is at 4 percent, the ‘rule of 4’. Conversely, when the sum is below 3 percent, the ‘rule of 3’, the seemingly rich valuation of equities and other risk-assets is well underpinned.2 Higher bond yields can suddenly undermine the valuation support of equities. Did this framework work? Yes, perfectly. On September 13 2018 when the global bond yield was approaching danger level, our framework was spot-on in forecasting that: “Using the 10-year T-bond yield as a roadmap, a short trip to the uplands of 3.5 percent would precede a longer journey down to 2 percent” Nevertheless, today we are enhancing the rule. The global bond yield must include China and it must include the aggregate euro area rather than just Germany. Hence, our enhanced metric is the simple average of the 10-year yields of the U.S., the euro area, and China. But to simplify matters, we can proxy the 10-year yield of the aggregate euro area with the 10-year yield of France. So calculate the simple average of the 10-year yields of the U.S., France, and China (Chart I-9). Chart I-9The Rules Of 4 And 3 Become The Rules Of 2.5 And 2 A value approaching 2.5 equates to danger for equities and risk-assets. A value below 2.0 equates to an underpinning for equities and risk-assets. Today, the value stands at 1.8. So to sum up, European (and global) growth will experience a down-oscillation in the second half of 2019, but the support to risk-asset valuations will keep the aggregate European equity market in a sideways channel. For equity investors, the big game in town will be sector rotation, as well as regional and country rotation. Of which, more next week. Stay tuned. Fractal Trading System*  This week we note that the spectacular rally in the Greek stock market this year is now ripe for a countertrend move. We prefer to play this on a hedged basis, so this week’s recommended trade is short Athex versus the Eurostoxx 600. Set the profit target at 7 percent with a symmetrical stop-loss. Chart I-10 The Fractal Trading System now has five open positions. 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. 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. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Based on a GDP weighted average of the U.S., euro area, and Japan. 2 Please see the European Investment Strategy Weekly Report ‘The Rule Of 4 Becomes The Rule Of 3’ dated March 21, 2019 available at eis.bcaresearch.com. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation 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 - 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  

Overweight, High-Conviction We reiterate our high-conviction overweight call on the BCA Defense Index as three key demand drivers remain upbeat and will continue to underpin relative industry profitability. First, the global arms race is alive and well and any governments seeking to augment their defense capabilities have to solicit the U.S. defense manufacturers. U.S. defense spending is rising at a healthy clip representing the major source of revenue growth for the industry (top panel). Second, there is a space race going on with China and India working on manned missions to the moon, but recently President Trump signaled that he would like to beat both of these countries to the moon and in outer space. The defense industry also benefits when global space related demand is on the rise. Finally, cyber security remains a global threat and governments are serious about fighting it off decisively given the sensitivity of the data that cyber criminals are after. While defense stocks are not pure-play software outfits combating cyber criminals, recent industry tuck-in acquisitions include such software companies in order for defense contractors to offer one-stop shop solutions to governments. Bottom Line: The BCA Defense Index remains a secular overweight and a high-conviction overweight. Please see our most recent Weekly Report for more details. The ticker symbols for the stocks in the BCA Defense Index are: LLL, LMT, NOC, GD and RTN.      

Highlights Corporate Spreads: The Fed’s dovish pivot prolongs the period of time before the yield curve inverts, thus extending the window for corporate bond outperformance. Investors should remain overweight corporate bonds, with a preference for securities rated Baa and below, where spreads remain wide relative to our fair value estimates. Yield Curve: Investors should barbell their U.S. bond portfolios, favoring long-maturity (> 10 years) and short-maturity (< 2 years) securities while avoiding the 5-year and 7-year notes. This positioning will boost average portfolio yield and will benefit from any future hawkish re-assessment of Fed policy. MBS: Lower mortgage rates have led to a jump in mortgage refinancings and wider MBS spreads. However, MBS spreads remain quite low compared to history. Maintain a neutral allocation to MBS in U.S. bond portfolios. Feature Last December, we laid out our key fixed income themes for 2019 in a Special Report.1 In that report we also introduced a framework for splitting the economic cycle into three phases based on the slope of the yield curve. Specifically, we use the 3-year/10-year Treasury slope to divide each cycle into the following three phases:2 Phase 1 runs from the end of the last recession until the 3/10 slope flattens to below 50 bps. Phase 2 encompasses the period when the 3/10 slope is between 0 bps and 50 bps. Phase 3 begins after the 3/10 slope inverts and ends at the start of the next recession. Clearly, as is illustrated in Chart 1, we are smack dab in the middle of a Phase 2 environment. This has implications for how we should think about positioning a U.S. bond portfolio. Chart 1Firmly In Phase 2 What Makes The Middle Phase Awkward? Table 1 shows annualized excess returns for Treasuries and corporate bonds (both investment grade and high-yield) in each phase of every cycle stretching back to the mid-1970s. Treasury excess returns are calculated relative to cash, as a proxy for the returns from taking duration risk. Corporate excess returns are relative to a duration-matched position in Treasury securities. Table 1Bond Performance In Different Yield Curve Regimes A look at Table 1 reveals why we call Phase 2 the “awkward” middle phase of the cycle. The excess returns earned from taking both duration and corporate spread risk tend to be underwhelming. On duration, we observe that in three of the four complete cycles in our sample, Treasury excess returns are lowest in Phase 2. This lines up well with intuition. The flatter yield curve means that Treasuries offer a lower term premium in Phase 2 than in Phase 1. Meanwhile, Phase 3 periods tend to coincide with rapid Fed rate cuts, and thus large capital gains. Phase 2 periods, in contrast, often contain Fed tightening cycles. On corporate credit, we observe that excess returns tend to be lower in Phase 2 than in Phase 1, but are usually still positive. Returns tend not to turn consistently negative until after the 3/10 slope inverts and we enter Phase 3. Overall, if we know nothing other than that we are in Phase 2 of the cycle, our results suggest that we should take less duration risk in our portfolio than in Phases 1 or 3. Overall, if we know nothing other than that we are in Phase 2 of the cycle, our results suggest that we should take less duration risk in our portfolio than in Phases 1 or 3. The results also suggest that we should prefer corporate credit over Treasuries, though to a lesser extent than in Phase 1. What Makes The Middle Phase Long? In last December’s Special Report, we argued that the U.S. economy would remain in a Phase 2 environment for a long time, at least until late 2019. Our reasoning was that, in the absence of inflationary pressures, the Fed would be reluctant to tighten policy enough to invert the 3/10 curve. The Fed’s recent dovish pivot, and the resultant steepening of the curve (see Chart 1), only prolongs the current Phase 2 environment. We now think it will be well into 2020, and possibly later, before the 3/10 slope inverts and the economy enters Phase 3. One obvious investment implication of an extended Phase 2 environment is that we should remain overweight corporate bonds relative to duration-matched Treasuries. However, we also need to consider valuation before drawing too firm of a conclusion. Charts 2A and 2B show spreads for each corporate credit tier, encompassing both investment grade and high-yield, along with our spread targets. The spread targets are the median levels observed in prior Phase 2 environments, adjusted for changes in the average duration of the bond indexes over time.3 The charts reveal that Aaa-rated bonds already look expensive, while Aa and A-rated bonds are close to fairly valued. Baa-rated bonds are 13 bps cheap relative to our target, while the high-yield credit tiers offer significantly more value. Chart 2AInvestment Grade Spread Targets Chart 2BHigh-Yield Spread Targets As discussed in last week’s report, the Fed’s dovish pivot will cause corporate spreads to tighten in the near-term, but it will take longer before Treasury yields respond by moving higher.4 For Treasury yields to move higher, investors must first become convinced that the Fed’s reflationary efforts are translating into stronger global economic growth. Ultimately, we expect this will occur in the second half of this year and Treasury yields will be higher 12 months from now, as the Fed will fail to deliver the 92 bps of rate cuts that are currently priced. The flat yield curve means that the yield give-up is small, and we expect global growth to improve in the second half of the year. Bottom Line: The Fed’s dovish pivot prolongs the period of time before the yield curve inverts, thus extending the window for corporate bond outperformance. Investors should remain overweight corporate bonds, with a preference for securities rated Baa and below, where spreads remain wide relative to our fair value estimates. Investors should also keep portfolio duration low. The flat yield curve means that the yield give-up is small, and we expect global growth to improve in the second half of the year. Barbell Your Portfolio Chart 3Barbell Your Portfolio For those unwilling or unable to deviate portfolio duration significantly from benchmark, there is another way to bet on the Fed delivering fewer cuts than are currently priced into the market. Investors can run a barbelled portfolio, favoring short-maturity (< 2 years) and long-maturity (> 10 years) securities, while avoiding the belly (5-year/7-year) of the curve. This sort of positioning has a few advantages. First, since the financial crisis, the yield curve has tended to steepen out to the 5-year/7-year point and flatten beyond that point whenever our 12-month Fed Funds Discounter rises (Chart 3). Conversely, whenever the market prices in more cuts/fewer hikes and our discounter falls, the yield curve has flattened out to the 5-year/7-year maturity point and steepened beyond that point. This correlation has been very consistent during the past few years, and continued to hold during the most recent decline in rate expectations. Notice that the 5-year yield has fallen by more than either the 2-year or 10-year yields since our Discounter's early-November peak (Table 2). Table 2The Belly Of The Curve Is Most Sensitive To Rate Expectations The upshot is that, if rate expectations rise during the next 12 months, as we expect, the 5-year and 7-year notes will endure the most damage. The second reason why a barbelled portfolio makes sense is that valuation is very attractive. Chart 4 shows that the 5-year yield is below the yield on a duration-matched 2/10 barbell. It also shows that this 2/5/10 butterfly spread is very low relative to our model’s fair value.5  Chart 42/10 Barbell Is Attractive Versus 5-Year Bullet We run similar fair value models for every possible bullet/barbell combination along the yield curve, and barbells appear universally cheap (see Appendix). Bottom Line: Investors should barbell their U.S. bond portfolios, favoring long-maturity (> 10 years) and short-maturity (< 2 years) securities while avoiding the 5-year and 7-year notes. This positioning will boost average portfolio yield and will benefit from any future hawkish re-assessment of Fed policy.   MBS & Housing: The Implications Of Lower Mortgage Rates Alongside bond yields, mortgage rates have fallen sharply during the past few months, a trend that has important implications for both MBS spreads and future housing data. We consider the outlook for both. MBS Spreads Lower mortgage rates encourage homeowners to refinance their loans, and any increase in refinancing activity puts upward pressure on MBS spreads. Not surprisingly, as mortgage rates have declined we have seen a jump in the MBA Refinance Index and a widening of nominal MBS spreads (Chart 5). Chart 5MBS Spreads Still Historically Tight While spreads have widened somewhat, they remain low compared to history (Chart 5, top panel). As such, we do not see a compelling buying opportunity in MBS. This is especially true relative to corporate credit where spreads are more attractive. Chart 6Limited Upside For Refis With the mortgage rate now below 4%, our rough calculation suggests that approximately 44% of the Bloomberg Barclays Conventional 30-year MBS index is refinanceable. A regression of the MBA Refi Index versus the refinanceable share suggests a fair value of 2014 for the Refi Index, slightly above its actual level of 1950 (Chart 6). We also calculate that a further drop in the mortgage rate to below 3.5%, where it troughed in mid-2016, would increase the refinanceable share to 77%. Our regression translates this 77% share to a level of 3309 on the Refi Index. It should be noted that when the refinanceable share rose to 77% in 2016, the MBA Refi Index peaked at 2870. This means that our simple regression analysis probably overstates the surge in refis that would occur if mortgage rates fell another 50 bps. In addition, we think it’s unlikely that mortgage rates will actually fall back to 3.5%, as they did in 2016, and as such, we are hesitant to position for further MBS spread widening. The improvement in housing actitivty is not uniform across all indicators. We recommend maintaining a neutral allocation to MBS for now. If mortgage rates drop and spreads widen further in the near-term, then a buying opportunity may present itself. Housing Activity Chart 7Housing Activity: A Mixed Picture The drop in mortgage rates will also have a significant impact on housing activity data. This is important because, as we have demonstrated in prior reports, housing activity data – particularly single-family housing starts and new homes sales – are reliable indicators of U.S. recessions and interest rates.6 By all measures, housing activity weakened significantly as mortgage rates surged in 2018. But it has improved somewhat now that mortgage rates have declined. However, the improvement is not uniform across all indicators (Chart 7): New home sales jumped sharply early this year, then fell back more recently. The current trend is neutral, with the latest monthly print very close to the 12-month moving average (Chart 7, top panel). Housing starts and permits are both trending below their respective 12-month moving averages, though by less than in 2018 (Chart 7, panel 2 & 3). Existing home sales have popped, and are now exerting upward pressure on the 12-month average (Chart 7, panel 4). Likewise for mortgage purchase applications (Chart 7, panel 5). Homebuilders also report that lower mortgage rates have led to a jump in sales activity (Chart 7, bottom panel).  With mortgage rates still low, the tentative rebound in housing activity data should continue in the coming months. Looking further out, we see significantly more upside in single-family housing starts and new home sales as builders shift construction toward lower-priced properties. The Bifurcated Housing Market Beyond the large swings in mortgage rates, another trend has significantly influenced housing activity in recent years. For the past few years, homebuilders have focused their attention on higher priced homes, and that segment of the market now looks oversupplied. Data from the American Enterprise Institute Housing Center show that the recent deceleration in home prices has been driven by falling prices for the most expensive homes. Homes in the lowest price tier have seen prices accelerate (Chart 8).7 The divergence is also evident in the supply data. New home inventories are roughly consistent with average historical levels, while existing home inventories are incredibly low (Chart 9). In fact, new home inventories now represent 6.4 months of demand while existing home inventories represent 4.3 months of demand (Chart 9, panel 3). Such a wide divergence is historically rare. Chart 8An Oversupply Of High ##br##Priced Homes... Chart 9...And An Undersupply Of Low Priced Homes   The divergence between an oversupply of new homes and an undersupply of existing homes is a result of new construction having focused on higher priced homes in recent years. The median price for a new home used to be only slightly above the median price for an existing home, but the difference shot up to above 75k during the past few years (Chart 9, bottom panel). More recently, the price differential between new and existing homes has started to fall, as builders are starting to recognize that the greater growth opportunity lies at the low-end of the market where demand is strong relative to supply. As this supply-side adjustment plays out, it will provide an additional boost to new homes sales and housing starts going forward. Appendix The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 3 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 3Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of June 27, 2019) Table 4 scales the raw residuals in Table 3 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 4Butterfly Strategy Valuation: Standardized Residuals (As of June 27 2019) Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 2 We use the 3/10 Treasury slope in place of the more commonly referenced 2/10 slope because it is a close proxy that provides an additional 14 years of historical data. 3 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “The Fed’s Got Your Back”, dated June 25, 2019, available at usbs.bcaresearch.com 5 For more details on our yield curve models please see U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “More Than One Reason To Own Steepeners”, dated September 25, 2018, available at usbs.bcaresearch.com 7 Low-tier homes are those in the bottom 40% of the price distribution in each metro area. High-tier homes are those that are both in the top 20% of the price distribution and exceed the GSE loan limit by more than 25%. For further details: http://www.aei.org/wp-content/uploads/2019/06/HPA_market_conditions_report_June_2019.pdf Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Relative Growth & Inflation: Underlying U.S. and European economic growth momentum remains surprisingly similar, with weakness concentrated in manufacturing industries most exposed to trade uncertainty. Realized inflation readings are also fairly close, although there is less spare capacity in the U.S. where wages are growing at a much faster rate. UST-Bund Spread: The yield gap between 10-year U.S. Treasuries and German Bunds is now fairly valued after the larger decline in U.S. yields seen in 2019. The Fed is more likely to deliver less easing relative to market expectations than the ECB, leaving the UST-Bund spread susceptible to a rebound over the 6-12 months. Hedged Vs Unhedged: We continue to recommend overweighting German Bunds vs U.S. Treasuries in global currency-hedged bond portfolios, given the substantial yield pickup gained by hedging into U.S. dollars out of euros. Feature “We should have Draghi instead of our Fed person.” – U.S. President Donald Trump Chart of the WeekIt’s Tough To Get A Weaker USD, Mr. President In his own inimitable way, President Trump in the above quote has called out the glaring difference between the ECB, which seems very willing to deliver more policy stimulus to a struggling euro area economy, and the Fed, which is reluctantly being pulled towards a rate cut. Yet while the current ECB President will be looking for a new job in a few months after his term expires, the reality is that President Trump will have to live with the current Fed leadership for the foreseeable future. Our Central Bank Monitors do indicate a need for easier monetary policy on both sides of the Atlantic (Chart of the Week). The signal from our ECB Monitor is stronger than that of our Fed Monitor, but U.S. Treasury and German bund yields have both fallen sharply with markets pricing in lower inflation expectations and new policy stimulus. The result is a relatively modest narrowing of U.S.-European expected interest rate differentials that has had little impact in weakening the U.S. dollar (USD) versus the euro. With both the Fed and ECB now in play for rate cuts, this is a good time to review the drivers of the spread between U.S. Treasury (UST) yields and German government bond yields – specifically, the widely-followed 10-year Treasury-Bund spread. A Quick Trans-Atlantic Comparison Of Growth, Inflation & Interest Rates The global bond rally seen this year has driven the 10-year UST yield fall back to the 2% level last seen in 2016. The 10-year Bund yield, on the other hand, has plummeted to a new all-time low of -0.3%. The yield move in the U.S. was larger, thus the UST-Bund spread has narrowed from a 2019 peak of 253bps to the current level of 233bps. Breaking down the nominal 10-year yields into the real yield and inflation expectations components illustrates how the current wide UST-Bund spread is almost purely a “real” phenomenon (Chart 2). 10-year CPI rates are 1.9% and 1.4% in the U.S. and euro area, respectively, accounting for 50bps of the overall 233bps UST-Bund spread. Adjusting the nominal yields by those CPI swap rates leaves a real 10-year Treasury yield of +0.1%, compared to -1.7% in Europe (using the 10-year German yield versus 10-year euro CPI swap). Thus, the market-implied real yield differential is 180bps, accounting for the bulk of the nominal UST-Bund spread. Our proxy for the market’s expectation of the real neutral interest rate – the 5-year Overnight Index Swap (OIS) rate, 5-years forward minus the 5-year CPI swap rate, 5-years forward – is indicating that investors now think the neutral real fed funds rate is 0% and the neutral real ECB rate is around -1% (Chart 3). Chart 2Real Yields Dictating UST-Bund Spread Chart 3Global Yields Discounting Fresh ECB QE? Those market-implied measures typically follow the path of our estimate of the term premium for the 10-year Treasury and Bund. For both markets, however, the term premium is now at a much more negative level than suggested by the past relationship with our real neutral rate proxy. The gap between the 10-year UST term premium (-60bps) and the 10-year German Bund term premium (-124bps) now contributes about 64bps to the nominal UST-Bund spread. When looking at the relative cyclical state of the U.S. and European economies at present, there are surprisingly few differences that show up in the data. Term premia are heavily influenced by investor risk aversion and the demand for safe assets during periods of uncertainty. Given the numerous headline risks that investors are faced with at the moment (U.S.-China trade, slowing global growth, U.S.-Iran military tensions, the start of the 2020 U.S. Presidential election cycle), it is understandable that money has flooded into the safety of developed market government debt. Yet when looking at the relative cyclical state of the U.S. and European economies at present, there are surprisingly few differences that show up in the data (Chart 4). The euro area manufacturing PMI is now at 47.8, below the 50 line that indicates an expanding industrial sector, but may be starting to stabilize. The U.S. ISM manufacturing index, at the same time, now sits at 52.1 and is closing in on the levels seen in Europe. Meanwhile, consumer confidence measures remain elevated both in the U.S. and Europe, even after the recent small dips. Business confidence measures like the NFIB U.S. small business survey and the European Commission’s business climate indicator remain firm relative to the post-crisis history, although both are off their cyclical peaks. That relative dearth of spare capacity in the U.S. compared to Europe is the most fundamental reason for the higher level of U.S. interest rates relative to the euro area. Turning to the state of labor markets on both sides of the Atlantic, the stories are also similar (Chart 5). Unemployment rates are well below the OECD’s estimates of the full employment NAIRU level. Wages are starting to gain some upward momentum in Europe, but U.S. Average Hourly Earnings are growing about one percentage point faster than equivalent measures in the euro area. Chart 4Not A Huge U.S.-Europe Cyclical Growth Gap Chart 5Not A Huge U.S.-Europe Structural Growth Gap The implication here is that there is less slack in the U.S. labor market than in Europe, as exemplified by the fast rate of wage growth in the U.S. Chart 6A Bit More Wage Inflation In The U.S. That relative dearth of spare capacity in the U.S. compared to Europe is the most fundamental reason for the higher level of U.S. interest rates relative to the euro area (Chart 6). U.S. potential GDP growth is only marginally faster than it is in Europe, with virtually the same rate of long-term labor productivity growth (about 0.5% per year, according to the OECD). Yet according to the New York Fed’s most recent estimates of the natural real interest rate (“r-star”), the level of the inflation-adjusted policy rate that would be considered neither stimulative nor restrictive given current estimates of spare capacity, is 0.7% in the U.S. and -0.4% in Europe.1 Looking ahead, both the Fed and ECB are likely to deliver some monetary easing in the coming months, perhaps as soon as the next set of policy meetings in late July. The market expects much more from the Fed, though, with 92bps of cuts discounted over the next twelve months. 16bps of cuts are also expected from the ECB, but that is more likely to be delivered than the market expectation for the Fed. There is even a chance that the ECB could restart their Asset Purchase Program, although likely not after delivering a small rate cut first. In any case, there is likely to be more disappointment from the Fed compared to the ECB over the next 6-12 months, with the result being some upward pressure placed on the UST-Bund spread. Bottom Line: Underlying U.S. and European economic growth momentum remains surprisingly similar, with weakness concentrated in manufacturing industries most exposed to trade uncertainty. Realized inflation readings are also fairly close, although there is less spare capacity in the U.S. where wages are growing at a much faster rate. There is likely to be more disappointment from the Fed compared to the ECB over the next 6-12 months, with the result being some upward pressure placed on the UST-Bund spread. Valuation & Currency Risk In The UST-Bund Spread Our valuation model for the 10-year Treasury-Bund spread indicates that the current spread level of 233bps is very close to fair value of 223bps (Chart 7). Chart 7UST-Bund Spread Fairly Valued The main variables in the model are the spread between the fed funds rate and the ECB 1-week refinancing rate, the ratio of the unemployment rates of the U.S. and euro area, and the differential between the headline inflation rates of the U.S. and euro area. The model also includes the balance sheets of the Fed and ECB as variables, to capture any effects on the Treasury-Bund spread from quantitative easing programs. Historically, the UST-Bund spread has been driven mostly by the gap between Fed and ECB policy rates and, to a lesser extent, the relative state of unemployment. Inflation differentials have become less of a driver of the spread during the years since the 2008 financial crisis (Chart 8), although this is part of the broader issue of wage growth diverging from price inflation in the developed economies. The reaction function of the central banks, and of bond yields, is still rooted in the amount of perceived spare economic capacity – and future inflation potential – implied by unemployment rates. Looking ahead, if the Fed and ECB were both to deliver the full amount of easing over the next year discounted in the USD and EUR OIS curves, then the fair value of the spread would narrow to 208bps. The one-year-ahead forward rates for both the 10-year UST and German Bund imply a spread tightening to 229bps, which means that it would likely require the Fed delivering the full 92bps of easing discounted over the next twelve months – not our base case view – to make betting on additional UST-Bund spread tightening a profitable trade that would beat the forwards. So while the case for betting on additional UST-Bund spread narrowing is a poor one at current levels, the case for favoring Bunds over Treasuries on a currency-hedged basis in U.S. dollar terms is strong. Going long German government bonds vs U.S. Treasuries, while hedging the euro currency exposure into U.S. dollars, actually generates a pickup in yield, despite the fact that the entire German yield curve has negative yields out to 15-year maturities. Chart 9 shows the U.S.-German bond yield spreads for the 2-year, 5-year, 10-year and 30-year maturities. The solid line in all panels represents the yield spread in currency-unhedged terms, while the dotted line in all panels shows the spread after hedging the Bund yields into U.S. dollar equivalents (using 3-month currency forwards). Across all four maturities shown, the wide unhedged U.S.-German spreads turn into negative spreads after currency hedging. This is due to the considerably higher short-term interest rates in the U.S. that are gained when selling euros forward for dollars. Chart 8UST-Bund Spread Driven By Fed/ECB Gap Chart 9UST-Bund Spreads Look VERY Different After Hedging FX Risk Thus, going long German government bonds vs U.S. Treasuries, while hedging the euro currency exposure into U.S. dollars, actually generates a pickup in yield, despite the fact that the entire German yield curve has negative yields out to 15-year maturities. When looking at the relative performance of German bonds relative to not only U.S. Treasuries, but the overall Bloomberg Barclays Global Treasury index, Germany has basically matched the index over the past year in currency-hedged terms (Chart 10, middle panel). On an unhedged basis, the relative performance of German debt is obviously far more volatile given the swings in the euro. Yet even in unhedged terms, the relative performance of Germany versus the U.S. appears to be turning around, despite the recent additional narrowing of the UST-Bund spread (bottom panel). Chart 10Favor Bunds Over USTs In USD-Hedged Bond Portfolios Chart 11UST-Bund Spread Tightening Looks Stretched This highlights the risk of solely looking at the spread between yields denominated in different currencies. FX movements can dominate relative yield changes, as has been the case of late with the EUR/USD exchange rate rising off the 2019 lows on the back of falling UST yields. We continue to prefer viewing cross-country spread trades in currency-hedged terms when we make our recommendations. On that basis, we like hedged Bunds over U.S. Treasuries – especially with the current UST-Bund spread now discounting a lot of relatively bad news in the U.S. versus Europe (Chart 11). Bottom Line: The Fed is more likely to deliver less easing relative to market expectations than the ECB, leaving the UST-Bund spread susceptible to a rebound over the next 6-12 months. We continue to recommend overweighting German Bunds vs U.S. Treasuries in global currency-hedged bond portfolios, given the substantial yield pickup gained by hedging into U.S. dollars out of euros. Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com 1 The New York Fed’s r-star estimates can be found here: https://www.newyorkfed.org/research/policy/rstar Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns