Economy

Highlights Cross-Atlantic Policy Divergence: A steadily tightening US labor market means that the Fed remains on track to formally announce tapering next month. Meanwhile, the ECB is signaling that they are in no hurry to do the same given scant evidence that surging energy prices are seeping into broader European inflation. This leads us to make the following changes to our tactical trade portfolio – taking profits on the 10-year French inflation breakeven spread widener; while switching out of the long December 2023 Euribor futures trade into a 10-year US Treasury-German Bund spread widening trade. Surging Antipodean Inflation: Australia and New Zealand are both seeing higher realized inflation, but market-based inflation expectations are falling in the former and rising in the latter. This leads us to make the following changes to our tactical trades: taking profits on the Australia-US 10-year spread widener; entering a new 10-year Australia inflation breakeven spread widener; and closing the underwater 2-year/5-year New Zealand curve flattening trade. Feature This week, we present a review of the shorter-term recommendations currently in our list of Tactical Overlay trades. These are positions that are intended to complement our strategic Model Bond Portfolio, with shorter holding periods – our goal is no longer than six months - and sometimes in smaller markets that are outside our usual core bond market coverage. As can be seen in the table on page 17, we typically organize these ideas by the type of trade (i.e. yield curve flatteners or cross-country spread wideners). Yet for the purposes of this review, we see two interesting themes that better organize the current trades and help guide our decision to keep them or enter new ones. Playing A Hawkish Fed Versus A Dovish ECB Federal Reserve officials have spent the past few months signaling that a tapering of bond purchases was increasingly likely to begin before year-end given the steadily improving US labor market. The September payrolls report released last Friday, even with the headline employment growth number below expectations for the second consecutive month, does not change that trajectory. Chart of the WeekCyclical UST Curve Flattening Pressures The US unemployment rate fell to 4.8% in September, continuing the uninterrupted decline from the April 2020 peak of 14.8% (Chart of the Week). The pace of that decline has accelerated in recent months, although the Delta variant surge in the US has created distortions in both the numerator and denominator of the unemployment rate. Now that the US Delta wave has crested and case numbers are falling, growth in both employment and the labor force should start to accelerate in the next few payrolls reports. This will result in a faster pace of US job growth, albeit with a slower decline in the unemployment rate, likely starting as soon as the October jobs report. The US Treasury curve has already been reshaping in preparation for a less accommodative Fed, with flattening seen beyond the 5-year point (middle panel). We have positioned for a more hawkish Fed, and a flatter Treasury curve, in our Tactical Overlay via a butterfly trade. Specifically, we are short a 5-year Treasury bullet versus a long position in a 2-year/10-year barbell, all using on-the-run cash Treasuries. That trade was initiated on June 22, 2021 and has so far generated a small profit of +0.27%. Our butterfly spread valuation model for that 2/5/10 Treasury butterfly shows that the 5-year bullet has not yet reached an undervalued extreme versus the 2/10 barbell (Chart 2). We are keeping this trade in our Tactical Overlay, as the current 2/5/10 butterfly spread of 23bps is still 6bps below the +1 standard deviation level implied by our model. Chart 2Stay In Our 2/5/10 UST Butterfly Trade Moving across the Atlantic, our trades have been the mirror image of our Fed recommendations, positioning for a continued dovish, reflationary ECB policy bias. We have expressed that via two trades: long 10-year French inflation breakevens and long December 2021 Euribor futures. We continue to see no reason for the ECB to follow the Fed’s path towards imminent tapering and signaling future rate hikes. Growth momentum has cooled in the euro area, with both the Markit composite PMI and the ZEW growth expectations index having peaked in June (Chart 3). At the same time, inflation expectations have picked up. The 5-year/5-year forward CPI swap rate has risen to 1.8%, still below the ECB’s 2% inflation target but well above the 2020 low of 0.7% (middle panel). Markets are focusing on the higher inflation and not the slowing growth, with the EUR overnight index swap (OIS) curve now pricing in 12bps of rate hikes in 2022 (bottom panel). We see that as a highly improbable outcome. There is little evidence that the latest pickup in euro area realized inflation is broadening out beyond surging energy price inflation and supply-constrained goods inflation (Chart 4). Euro area headline CPI inflation hit a 13-year high of 3.0% in August, with the “flash” estimate for September showing a further acceleration to 3.4%. Yet core inflation only reached 1.6% in August - a month when the trimmed mean euro area CPI inflation rate calculated by our colleagues at BCA Research European Investment Strategy was a scant 0.2%. Chart 3ECB Will Not React To This Cyclical Bout Of Inflation Chart 4Euro Area Inflation Upturn Is Not Broad-Based While the September flash estimate of core inflation did perk up to 1.9%, the trimmed mean measure shows that the rise in euro area inflation to date has not been broad based. Like the Fed, ECB officials have indicated that they view this pick-up in inflation as “transitory”, fueled by soaring energy costs and base effect comparisons to low inflation in 2020. Signs that higher inflation was feeding into “second round” effects like rising wage growth might change the ECB’s thinking. From that perspective, the recent increase in labor strike activity in Germany is a potentially worrisome sign, but the starting point is one of low wage growth – the latest available data on euro area wage costs showed a -0.1% decline during Q2/2021. Chart 5Close Our Long Dec/23 Euribor Futures Trade We have been trying to fade ECB rate hike expectations via our long December 2023 Euribor futures trade. That position, initiated on May 18, 2021 has generated a small loss of -0.11% (Chart 5). We still expect the ECB to keep rates on hold in 2022, and most likely 2023, so there is the potential for that trade to recover that underperformance. However, that position has now reached the six-month holding period “re-evaluation” limit that we have imposed on our Tactical Overlay trades. Thus, we are closing that trade this week. In its place, we are initiating a new tactical trade to position for not only persistent ECB dovishness but a more hawkish Fed – a US Treasury-German Bund spread widening trade using 10-year bond futures. The specific details of the trade (futures contracts, duration-neutral weightings on each leg of the trade) can be found in the table on page 17. This new UST-Bund trade is attractive for three reasons: Our valuation model for the Treasury-Bund spread - which uses relative policy interest rates, relative unemployment, relative inflation and the relative size of the Fed and ECB balance sheets as inputs – shows that the spread is currently undervalued by more than one full standard deviation, and fair value is rising (Chart 6). The technical backdrop for the Treasury-Bund spread has turned more favorable for wideners, with the spread having fallen back to its 200-day moving average and the 26-week change in the spread now down to levels that preceded past turning points in the spread (Chart 7). Chart 6Enter A New 10yr UST-Bund Spread Widening Trade Relative data surprises are pointing to relatively higher US yields and a wider Treasury-Bund spread, with the Citigroup Data Surprise Index for the US now rising and the euro area equivalent measure falling (Chart 8). Chart 7UST-Bund Technical Backdrop Positioned For Widening Chart 8Relative Data Surprises Favor Wider UST-Bund Spread While we are entering a new trade to play for a relatively dovish ECB, we are also choosing to take the substantial profit in our tactical trade in French inflation breakevens. Specifically, we are closing our 10-year French inflation breakeven spread widening position – long a 10-year cash OATi bond, short 10-year French bond futures – with a solid gain of +6.3%. Chart 9Take Profits On Our Long 10yr French Breakevens Trade We have held this trade for nine months, a bit longer than our typical tactical trade holding period. We did so because French 10-year breakevens continued to look cheap on our valuation model. Now, the breakeven spread has risen to fair value (Chart 9), prompting us to take our gains and move on. Diverging Inflation Expectations In Australia & New Zealand Playing Fed/ECB policy divergence was the first main theme of this Tactical Overlay trade review. The second broad theme is also a divergence, between inflation expectations in New Zealand (which are rising) and Australia (which are falling). This trend leads us to close two existing trades and enter a new position. Chart 10An Inflation-Induced Bear Steepening Of Yield Curves In New Zealand, we are closing out our 2-year/5-year government bond yield curve flattener trade, initiated on July 21, for a loss of -0.32%. While we were correct in our expectation of ramped-up hawkishness from the Reserve Bank of New Zealand (RBNZ), we were caught offside by persistently sticky inflation which has become a headache for global central bankers. With supply squeezes and high commodity prices not going away anytime soon, sovereign curves have bear-steepened across developed markets, driven by rising long-dated inflation expectations (Chart 10). This global steepening pressure also hit the New Zealand curve, to the detriment of our domestic RBNZ-focused flattener trade. There was also a technical component to the steepening in the New Zealand 2-year/5-year curve (Chart 11). With the 2-year/5-year curve having dipped far below its 200-day moving average and the 26-week rate of change at stretched levels, the flattener was already “overbought” when we entered the trade. Despite a steady stream of hawkish messaging from the RBNZ, leading to an actual rate hike last week, technicals did win out in the short term as the 2-year/5-year spread steepened back up towards the 200-day moving average. Chart 11The NZ 2s/5s Curve Has Also Steepened Due To Technical Factors On the positive side, our decision to implement this trade as a duration-neutral “butterfly”, selling a 2-year bond, and using the proceeds to buy a weighted combination of a 5-year bond and a 3-month treasury bill with an equivalent duration to the 2-year bond, worked as intended with the butterfly underperforming as the underlying 2-year/5-year curve steepened. Looking forward, technicals are still some distance from turning favorable and will remain a headwind for the flattener trade. Implied forward rates are also not in our favor, with markets already pricing in some flattening, making this a negative carry trade. Over a cyclical horizon – i.e. beyond our normal six-month holding period for tactical trades - we still expect the shorter-end of the New Zealand to flatten. The experience of past hiking cycles shows that the 2-year/5-year curve tends to continue flattening during policy tightening, usually leveling out at 0bps before re-steepening (Chart 12). Considering that we have already been in this trade for three months, however, we do not believe our initial curve flattening bias will play out successfully over the remainder of our six-month tactical horizon. While we are closing out our flattener trade, we will investigate ways to better express our bearish cyclical view on New Zealand sovereign debt in a future report. Turning to Australia, we are closing out our long Australia/short US spread trade, implemented using 10-year bond futures, taking a healthy profit of +2.1%. We have held this trade for longer than our typical six-month holding period (the trade was initiated on January 26, 2021) because our Australia-US 10-year spread valuation model has continued to flash that the spread was too wide to its fair value (Chart 13). The model has been signaling that the spread should be negative, yet Australian yields have been unable to trade below US yields for any sustained length of time in 2021. Furthermore, the model-implied fair value is now starting to bottom out, suggesting a diminishing tailwind from the relative fundamental drivers of the spread embedded in our model. Chart 12The NZ 2s/5s Curve Will Flatten Over A Cyclical Horizon Chart 13Take Profits On Our 10-Yr Australia-US Spread Narrowing Trade Chart 14Inputs Into Our Australia-US Spread Model The inputs into our 10-year spread model are relative policy interest rates, core inflation, unemployment and the size of central bank balance sheets (to incorporate QE effects) for Australia and the US. Of these variables, the biggest drivers of the decline in the fair value since the start of the COVID pandemic in 2020 have been relative inflation and the relative size of the Fed and Reserve Bank of Australia (RBA) balance sheets as a percentage of GDP (Chart 14). Both of those trends are related. Persistently underwhelming Australian inflation – despite accelerating inflation in the US and other developed economies over the past year – has forced the RBA into a pace of asset purchases relative to GDP that exceeded even what the Fed has done since the pandemic started (bottom panel). However, Australian inflation finally began catching up to the rising trends seen elsewhere in the spring of this year, with headline CPI inflation jumping from 1.1% to 3.8% on a year-over-year basis during Q2. Australian bond yields have traded more in line with US yields since that mid-year pop in inflation, preventing the Australia-US spread from narrowing below zero and converging to our model-implied fair value. This is despite a severe COVID wave that forced much of Australia into the kind of severe lockdowns that the nation avoided during the worst of the global pandemic in 2020. With Australian inflation now moving higher and converging towards US levels, economic restrictions starting to be lifted thanks to a rapid vaccination campaign, and the RBA having already done some tapering of its asset purchases before the Fed, the fundamental rationale for holding our Australia-US trade is no longer valid, leading us to take profits. The convergence to fair value in our spread model is now more likely to come from fair value rising rather than the actual spread falling. The pickup in Australian inflation also leads us to enter a new trade Down Under. This week, we are initiating a new trade, going long 10-year Australia inflation breakevens, implemented by going long a 10-year cash inflation-linked bond and selling 10-year bond futures. The details of the new trade are shown in the table on page 17. Despite the uptick in realized Australian inflation, breakevens have actually been declining over the past several months, falling from a peak of 247bps on May 13 to the current 208bps. That move has accelerated more recently due to a rise in Australian real yields that has coincided with markets pricing in more future RBA rate hikes. Our 24-month Australia discounter, which measures the total amount of tightening over the next two years discounted in the AUD OIS curve, now shows that 104bps of rate hikes are expected by the fourth quarter of 2023 (Chart 15, bottom panel). This has occurred despite Australian wage growth remaining well below the 3-4% range that the RBA believes is consistent with underlying Australian inflation returning sustainably to the RBA’s 2-3% target band (top two panels). Chart 15Market Expectations For The RBA Are Too Hawkish Chart 16Go Long 10-Yr Australian Inflation Breakevens Australian real bond yields have begun to move higher in response to this more hawkish market policy expectation that seems overdone, helping push breakeven inflation even lower more recently. This has helped unwind some of the overvaluation of 10-year inflation breakevens from earlier in 2021. Our fundamental model for the 10-year Australian breakeven showed that the spread was over two standard deviations above fair value to start 2020 (Chart 16). The decline in the spread since that has largely eliminated that overvaluation, providing a better entry point for a new breakeven spread widening trade. With survey-based measures of inflation expectations rising even as breakevens fall back to fair value (bottom panel), we see a strong case for adding a new Australian inflation trade to our Tactical Overlay.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Next week is the BCA Annual Conference, at which I will debate Professor Nouriel Roubini on ‘The Outlook For Cryptocurrencies’. I will make the passioned case for cryptos, and Nouriel will make the passioned case against. I do hope that many of you can join the debate, as well as the other insightful sessions at the conference. As such, there will be no report next week and we will be back on October 28. Highlights The anomaly of the current ‘inflation crisis’ is not that goods and commodity prices have surged. The anomaly is that state intervention protected services prices from a massive (and continuing) negative demand shock. Absent the state intervention, there would not be the current ‘inflation crisis’. On a 6-12-month horizon: Underweight the durables-heavy consumer discretionary sector versus the market. Underweight commodities that have not yet sharply corrected versus those that have sharply corrected. For example, underweight tin versus iron ore. From the current ‘inflation crisis’, the real surprise could be how low inflation ends up 12 months from now. Hence, stay overweight US T-bonds versus US TIPS. Fractal analysis: Natural gas, plus industrial metals versus industrial metal equities. Feature Chart of the WeekServices Prices Suffered In The Post-GFC Services Slump... Chart of the Week...But Not In The Post-Pandemic Services Slump. Why Not? The great writers, artists, and musicians tell us that the most profound messages often come from what is not said, not painted, and not played. What does not happen is sometimes more significant than what does happen. In this vein, we believe that the real story of the current ‘inflation crisis’ is not what has happened to goods and commodity prices, but what has not happened to services prices. The real story is that while goods and commodity prices have reacted exactly as would be expected to a positive demand shock, services prices have not reacted as would be expected to the mirror-image negative demand shock. The Anomaly Is Not Goods Prices, It Is Services Prices The following analysis quantifies the impact of the pandemic on different parts of the economy by examining the deviations of current spending and prices from their pre-pandemic trends. The analysis uses US data simply because of its timeliness and granularity, but the broad patterns and conclusions apply equally to most other developed economies. Looking at the overall economy, we know that, thus far, we have experienced neither a lasting negative demand shock from the pandemic, nor a lasting positive demand shock from the ensuing stimulus. We know this, because current spending is not far short of its pre-pandemic trend. The real story of the current ‘inflation crisis’ is not what has happened to goods and commodity prices, but what has not happened to services prices. Yet when we drill down to the components of spending, we see a different story. The pandemic and its policy response unleashed a massive and unprecedented displacement of spending from services to goods (Chart I-2). Chart I-2The Pandemic Unleashed A Massive Displacement Of Spending From Services To Goods By March 2021, while US spending on services was still below its pre-pandemic trend by $700 billion, or 8 percent, the displacement of those dollars of spending had boosted spending on the smaller durable goods component by 26 percent. Suffice to say, a 26 percent excess demand for durable goods cannot be satisfied by a modern manufacturing sector that utilises just-in-time supply chains and negligible spare capacity! As surging demand met relatively fixed supply, the price of durable goods skyrocketed to the current 11 percent above its pre-pandemic trend (Chart I-3). Chart I-3The Inflation In Durables Prices Is Rational, The Absence Of Deflation In Services Prices Is Irrational It follows that the inflation in durables prices is the perfectly rational outcome of a classic positive demand shock – meaning, surging demand in the face of limited supply. What is much less rational is that a massive negative demand shock for services has had almost no negative impact on services prices. This is the untold story of the current ‘inflation crisis’ which requires further explanation. Government Intervention Prevented A Collapse In Services Prices If the pandemic had unleashed a classic negative demand shock for services, then services prices would have collapsed. We know this because in the aftermath of the global financial crisis (GFC), services prices fell below their pre-GFC trend exactly in line with the decline in services demand. But in the aftermath of the pandemic’s massive negative shock for services spending, services prices have remained on their pre-pandemic trend (Chart of the Week). The question is, how? The answer is that this was not a classic negative demand shock. The reason that service spending collapsed was that a large swathe of services – such as leisure and hospitality – became unavailable because of mandated shutdowns or lockdowns. In this case, there was no point in reducing prices to reattract demand from durable goods because nobody could buy these services anyway! In effect, while the goods sector remained subject to market forces, a large swathe of the service sector came under state intervention, and was no longer subject to market forces. Meanwhile, statisticians continued to record the seemingly unaffected price of eating out or going to the theatre, even though most restaurants and entertainment venues were shuttered, making their prices meaningless. Absent state intervention in the services sector, we would not be talking about the current ‘inflation crisis’. Absent state intervention, these service providers would have had to reduce their prices to attract wary consumers amid a pandemic. This we know from Sweden, the one major economy that did not have any mandated shutdowns or lockdowns. While leisure and hospitality have remained largely open, Sweden’s services prices have declined markedly from their pre-pandemic trend – in sharp contrast to the unchanged trend in the US (Chart I-4). Chart I-4Services Prices Have Declined In Non-Interventionist Sweden, But Not In The Interventionist US Hence, while inflation now stands at a sedate 2 percent in Sweden, it stands at a hot 5 percent in the US. If the US (and other country) governments had not intervened in the services sector, then the evidence from the GFC in 2008 and Sweden today strongly suggests that services prices would be below their pre-pandemic trend, offsetting goods prices that are above their pre-pandemic trend. The result would be that the overall price level would be on, or close to, its pre-pandemic trend. Just as overall spending is on its pre-pandemic trend. To repeat the key message of this analysis, the anomaly in most economies is not that goods and commodity prices have surged. The price surge is the perfectly rational response to a positive demand shock. The anomaly is that services prices did not react negatively to a negative demand shock (Chart I-5 and Chart I-6), as they did post-GFC and post-pandemic in non-interventionist Sweden. Chart I-5The Anomaly Is Not That Goods Prices ##br##Rose... Chart I-6...The Anomaly Is That Services Prices Did Not Fall The untold story is that, absent state intervention in the services sector, we would not be talking about the current ‘inflation crisis’. What Happens Next? The surging demand for durables is correcting. Since March, it is already down by 15 percent but requires a further 7 percent decline to reach its pre-pandemic trend, which we fully expect to happen. After all, there are only so many smartphones and used cars that you can own! Meanwhile, as manufacturers respond with a lag to recent high prices, expect a tsunami of durables supply to hit in 6-12 months just as demand has fallen off a cliff. The result will be a major threat to any durable good or commodity price that has not already corrected. As a salutary warning of what lies ahead, witness the recent 75 percent crash in lumber prices. The same principle applies to non-durables such as food and energy. Non-durables spending is likely to fall back to its pre-pandemic trend, and non-durables prices are likely to follow. Again, outside a short-lived surge in demand from, say, a very cold winter, there is only so much energy and food that you can consume. For services, there are two opposing forces. The inflationary force is that the recent inflation in goods will transmit into wages and therefore into services prices. Against this, the deflationary force is that structural changes, such as hybrid home/office working, mean that services spending will struggle to make the near 6 percent increase to reach its pre-pandemic trend. Underweight the durables-heavy consumer discretionary sector versus the market. Pulling these effects together, we reiterate three investment recommendations on a 6-12 month horizon: Underweight the durables-heavy consumer discretionary sector versus the market (Chart I-7). Underweight commodities that have not yet sharply corrected versus those that have sharply corrected. For example, underweight tin versus iron ore. From the current ‘inflation crisis’, the real surprise could be how low inflation ends up 12 months from now. Hence, stay overweight US T-bonds versus US TIPS. Chart I-7As Durables Spending Normalises, The Durables-Heavy Consumer Discretionary Sector Underperforms Natural Gas Prices Are Technically Extreme The surge in natural gas prices in both Europe and the US has reached a point of extreme fragility on its 130-day fractal structure. Hence, if the tight fundamentals show the slightest signs of abating, natural gas prices would be vulnerable to a sharp reversal (Chart I-8). Chart I-8Natural Gas Prices Are Technically Extreme Elsewhere, we see an arbitrage opportunity between industrial metal prices, which are still close to highs, and industrial metal equities, which have plunged by 20 percent since May. The relationship between the underlying metal prices and the metals equities sector is now stretched versus its history, and on its composite 65/130-day fractal structure (Chart I-9). Chart I-9The Relationship Between Metal Prices And Metal Equities Is Stretched Hence, the recommended trade is to go short the LMEX Index/ long nonferrous metals equities. One way to implement the long side of the pair is through the ETF PICK. Set the profit target and symmetrical stop-loss at 8 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural And Thematic Recommendations Closed Fractal Trades   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- 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  

Special Report

Dear Client, Owing to BCA’s Annual Investment Conference next week, there will be no report on Wednesday, October 20. We will return to our regular publication schedule on Wednesday, October 27. Please note that there will be a China Outlook panel discussion at 9 AM on Thursday, October 21. We hope you will join us for the event. Best regards, Jing Sima China Strategist   Highlights In the next six to nine months, the long-end of the yield curve will likely drop as investors start to price in weaker-than-expected economic growth amid measured stimulus. China’s 10-year government bond yields are set to structurally shift to a lower bound as domestic demand decelerates along with the nation’s total population. Policymakers will favor lower borrowing costs to reduce stress due to high debt levels among companies, central and local governments, and households. National savings are not a constraint for a country to lower domestic bond yields. China will continue to open domestic financial markets to global investors. The country’s large foreign exchange reserves limit the risk to its internal markets from extreme volatility in foreign fund flows. Feature In the past two decades policy rates in advanced economies have been brought close to zero and bond yields have dropped to extremely low levels. The yields on China’s government bonds, however, have remained well above their peers in advanced economies and in neighboring countries (Chart 1). Chart 1China's Government Bond Yields Far Above Other Major Economies Moreover, despite China’s growth slowing from double to mid-single digits, yields on China’s 10-year government bonds have remained at around 2006 levels. China’s working-age population continues to decline and its total population is estimated to start falling in the next five years. China’s demographic headwinds, combined with high leverage in the private sector at around 220% of GDP, will cap the upside in yields. In this report we share our views on China’s short rates and long-term bond yields on a cyclical basis (next six to nine months) and in the next five years. The Cyclical Outlook The yield curve will likely flatten with China’s long-term government bond yields dropping more than short-term rates in next six to nine months. This will occur in the expectation of a further growth slowdown in at least the next two quarters. Meanwhile, the downside is limited on the short-end of the curve, given it is more sensitive to the PBoC’s guidance and monetary authorities will ease policy only gradually. Stimulus in the next two quarters may also disappoint. Credit growth will bottom in Q4 this year, but the rebound will be modest. Stronger issuance in local government bonds in the next two quarters will be offset by sluggish bank loan impulse. Chinese policymakers will refrain from using stimulus for the property market as a counter-cyclical policy tool to revive the economy. Restrictions will be maintained on bank lending to the real estate sector including mortgages and these controls will limit the rebound in credit expansion. Furthermore, infrastructure investment will improve modestly in the next two quarters, but local governments remain under pressure to deleverage, which will limit their incentive and capacity to spend. Chart 2Stimulus In 2018/19 Was Very Measured We maintain our view that the current policy backdrop is shaping up to resemble that of H2 2018 and 2019. At that time, even though the central bank maintained an accommodative monetary policy stance and kept liquidity conditions ample, the size of the stimulus was measured and the economy was lackluster (Chart 2). Recent liquidity injections by the PBoC through open market operations should not be viewed as monetary easing because they represent the bank’s efforts to keep policy rates steady, at best (Chart 3). The central bank provided the interbank system with substantial financing to avoid liquidity crunches following the May 2019 Baoshang Bank takeover and the November 2020 Yongcheng Coal company debt default (Chart 4). In both cases, 10-year bond yields did not fall by as much as short rates, reflecting investors’ expectations that the liquidity injections and resulting drop in short rates were not long-lasting. Chart 3Recent PBoC Liquidity Injections Intended To Keep Policy Rates Steady Chart 4APBoC Also Injected Liquidity After Previous High-Profile Defaults Chart 4BPBoC Also Injected Liquidity After Previous High-Profile Defaults Our view on China’s bond yields will not change with the liftoff of US Fed policy rates,  even if the Fed hikes rates earlier and by more than anticipated. The Fed’s policy has little bearing on China’s long-dated yields, which are driven by domestic business cycles and monetary policy (Chart 5). Concerning the exchange rate, we believe that the RMB will modestly depreciate in the next six to nine months, given that the China-US nominal and real interest rate differentials will narrow (Chart 6). While some depreciation in the currency is modestly reflationary for China’s exporters, it will not be enough to offset weaknesses in domestic demand. Chart 5Domestic Economic Fundamentals Drive Yields On China's Government Bonds Chart 6China-US Rate Differentials Are Set To Narrow Chart 7Pipeline Inflationary Pressures in China Remain Elevated Inflation remains a risk to our cyclical view on the 10-year bond yield. While the economy is weakening, pipeline inflationary pressures remain elevated (Chart 7).  We do not foresee that the PBoC will change its modestly dovish policy stance because of inflationary pressures stemming from supply-side bottlenecks. However, supply constraints will not abate soon and consequently, pipeline inflationary pressures and producer price inflation may not subside in the next six months. Thus, fixed-income investors may start to price in higher inflation, which could prevent long-duration bond yields from declining by much. Bottom Line: In the coming months, the long-end of the yield curve will likely drop as investors start to price in weaker-than-expected economic growth and very measured stimulus. The short-end of the curve will have limited downside potential because there is only a slim chance of aggressive monetary easing. Bond Yields Are On A Structural Downtrend Bond yields in China will likely downshift in the next three to five years. Our secular outlook for government bond yields is based on the country’s demographic trends, inflation, productivity growth and debt levels. While China’s long-term bond yields have persistently averaged below nominal GDP growth, in the past decade the gap has significantly narrowed as economic growth slowed while yields remained within a tight range (Chart 8).  This contrasts with other manufacturing and export-oriented Asian economies where interest rates have moved to a lower range in proportion with economic growth rates (Chart 9). Chart 8China's Economic Growth Has Downshifted But Yields Have Not... Chart 9...In Contrast With Other Asian Manufacturing-Based Economies China’s long-dated bond yields will also downshift in the next three to five years given the nation’s declining long-term potential output growth, based on the following: Chart 10Wages Have Risen In China A shrinking workforce can be inflationary due to higher labor costs and we expect Chinese workers’ compensation will continue to increase in the next five years (Chart 10). However, wage inflation will likely be offset by labor productivity, which has remained robust. The nation’s unit-labor cost (ULC), measured by the wages paid for each employee to produce one unit of output, has been flat to slightly down in the past decade despite strong wage growth (Chart 11). Similarly, ULC has sagged in Japan and is muted in South Korea (countries with shrinking labor forces) due to fast-growing labor productivity. This contrasts with the US, where ULC has risen even though the labor force has expanded in the past 10 years (Chart 12) China’s labor productivity will not likely undergo a significant decline in the next five years, particularly if China successfully maintains the manufacturing sector’s share in its aggregate economy, because productivity growth in this sector is usually higher than in others. Chart 11ULC Has Been Relatively Flat Chart 12ULC Muted In Asian Economies Compared With US   Meanwhile, China’s total population will shrink within the next five years, which will likely bring powerful disinflationary forces that will more than offset price increases created by labor shortages. Disinflation will cap the upside in interest rates/bond yields. Chart 13Japan's Household Consumption Share Fell Sharply When Total Population Started Shrinking A shrinking total population can significantly reduce demand, as evidenced in Japan in the past two decades. Japan’s working-age population started falling in the early 1990s, but the country’s household consumption share in GDP fell sharply after its total population peaked in 2010 and the urban population growth started contracting (Chart 13). In other words, Japan’s rapidly falling demand more than offset a muted increase in wage growth. China’s housing demand may have already peaked and the decline will gather speed in the next five years (Chart 14). Long-term growth in household consumption moves in tandem with housing and, therefore, will also downshift in the coming years (Chart 15). In the next five years or longer, China’s de-carbonization efforts will require shutting down production of many old economy enterprises.  Policymakers may keep low interest rates to accommodate such a transformation. Furthermore, amid the geopolitical confrontation with the US, Beijing will need lower interest rates to support the manufacturing sector and to undertake an industrial upgrade. Chart 14China's Demand For Housing Is On A Structural Downshift... Chart 15...Along With Consumption The main risk to our view is that China’s total factor productivity1 growth could accelerate to more than offset a declining total population. This would boost real per capita income and result in higher potential growth in the economy. In this scenario, long-duration bond yields could climb.  However, total factor productivity growth will need to outpace the rate of a shrinking labor pool and capital formation to prop up growth in the aggregate economy (Chart 16A and 16B). This is a daunting mission that Japan and South Korea, where productivity growth has been on par with China, have failed to accomplish. Chart 16AChina's Neighbors Have Not Accelerated Their Productivity Gains To Structurally Boost Economic Growth Chart 16BChina's Neighbors Have Not Accelerated Their Productivity Gains To Structurally Boost Economic Growth Chart 17China Cannot Drastically Improve Its Productivity Growth In The Next Five Years It is unrealistic to expect that China will drastically improve its productivity growth.  Productivity level is much higher now than it was 10-20 years ago when China’s manufacturing sector accounted for more than 40% of GDP (Chart 17). Even though China’s manufacturing share in the economy will stabilize and even increase from the current 27% of the economy, it cannot boost the sector drastically, particularly because its export market share cannot expand much further due to rising geopolitical tensions. In short, sectors of the economy where productivity gains have been most rapid – manufacturing sector including exports that drove China’s productivity in the past 20 years - cannot fully offset the deceleration in other growth drivers going forward. The service sector will grow, but it is much more difficult to achieve fast productivity gains in the service sector. All in all, productivity and economic growth will moderate as China’s growth model shifts from capital-intensive infrastructure and real estate to services. Bottom Line: In the next five years, China’s 10-year government bond yields are more likely to structurally move to a lower bound as final demand falls along with the nation’s total population. Savings, Debt And Interest Rates China’s national savings rate is one of the highest in the world, but it will drop as the population ages. Thus, some economists may argue that a structural decline in the national savings rate will lead to higher interest rates in the long run. Chart 18Lower Savings Rates Do Not Necessarily Herald Higher Interest Rates However, there is no empirical evidence that national savings drive interest rates. There has not been an inverse relationship between national savings rates and government bond yields in either Japan or the US, as illustrated in the middle and bottom panels of Chart 18.  There are more periods of positive rather than negative correlation between savings rates and bond yields. Note that China’s national savings rate and its interest rates also are not inversely related; a rising saving rate does not lead to lower interest rates and vice versa (Chart 18, top panel). This empirical evidence is in line with special reports published by BCA’s Emerging Markets Strategy that concluded the following: Banks cannot and do not lend out or intermediate national or households “savings.” In an economy with banks, one does not need to save in the form of a deposit in a bank in order for a bank to lend money to another entity. In any economy, new money originates by commercial banks “out of thin air” when they lend to or buy assets from non-banks. Hence, there is little relationship between national savings (flow concept in economics) and money supply growth (a flow variable too) (Chart 19). The term “savings” in macroeconomics denotes an increase in the economy’s capital stock, not deposits at banks. China’s banking system has an enormous amount of deposits, created by the banks “out of thin air” and not from households’ savings. The above factors explain why Japan’s government bond yields and national savings rate have been falling since 1990 (Chart 18 on Page 12, bottom panel). A lack of demand for borrowing was not why bond yields fell. A reason why China’s bond yields will likely be in a secular decline is that commercial banks will purchase government and corporate bonds en masse as they have done in the past 10 years (Chart 20). To do so, commercial banks will not use existing deposits, but rather they will create new deposits/money “out of thin air.” Chart 19There Is Little Relationship Between National Savings And Money Growth Chart 20China's Commercial Banks Will Continue To Purchase Government And Corporate Bonds The same is true for the banks’ purchases of corporate bonds. In China, commercial banks own about 75% of government (including local government) bonds and 20% of onshore corporate bonds. To avoid a spike in bond yields, Chinese regulators could relax the limitations on commercial banks to purchase government and corporate bonds. The upshot will be a lack of crowding out and no upward pressure on bond yields despite a large bond issuance. Chart 21China's Debt-To-GDP Ratio And Service Costs Have More Than Doubled In The Past 10 Years What are the implications of high indebtedness on interest rates? China’s domestic debt-to-GDP ratio has jumped from 120% of GDP in 2008 to 260% (Chart 21, top panel). This includes local currency borrowing by/debt of government, enterprises and households. Critically, the debt-service ratio2 for enterprises and households has more than doubled from 10% of disposable income in 2008 to over 20% (Chart 21, bottom panel). China cannot afford much higher interest rates because enterprises and households will struggle and will not be able to service their debts. Mortgage rates in China are at around 5.5%, the one-year prime lending rate for companies is 3.85% and onshore corporate bond yields are 3.7%. These are not particularly low borrowing costs given both high indebtedness and the outlook for structurally slower economic growth. Onshore borrowing costs may be brought down further in the years ahead to rule out debt distress among households, enterprises and local governments. Since 2015 and prior to the pandemic, China’s debt-service ratio has been mostly flat despite a rising debt-to-GDP ratio.3 This has been achieved through declining interest rates. In the next five years policymakers will likely maintain a stable debt-to-GDP ratio. Hence, lower bond yields are all but inevitable to decrease the debt-servicing burden. In addition, China’s “common prosperity” policy means larger government spending/deficits. However, to cap the government debt-to-GDP ratio, bond yields should be kept down. This is another reason why China’s will opt for lower interest rates/bond yields. Bottom Line: The high level of debt among local governments, companies and households means that borrowing costs in China will be reduced in the years ahead. National savings are not a constraint in any country for commercial banks to expand credit and/or to buy bonds. China will encourage its banks to buy government and corporate bonds to trim yields amid continuous heavy bond issuance. Will China’s Financial Opening Continue? In the current environment which geopolitical tensions are rising between China and the West, many global investors are concerned whether China will impose tighter capital controls and even seize foreign assets. Despite these challenges, China has continued to make progress opening its domestic markets. The nation seems to be sticking to its key policy goals of attracting foreign capital and internationalizing the RMB; both aspects require open access and repatriation of foreign capital. In addition, the share of foreign holdings in onshore securities is very low and thus, poses limited risk to China’s onshore financial markets during global economic or geopolitical crises. China’s current exposure to foreign capital flows is much smaller than its Asian neighbors during the 1997 Asian Financial Crisis, as well as Russia during the geopolitical standoff in 2014-2016 following the capture of Crimea.4 Despite years of easing access to financial markets, foreign ownership (mostly concentrated in government bonds) remains at only around 3-4% of China’s entire onshore bond market. Furthermore, unlike other Asian economies in 1997-98, China has large foreign exchange reserves to buffer shocks from foreign fund flows. In recent years its capital control mechanism has also been successful in preventing implicit capital outflows and stabilizing the RMB exchange rate. We expect Chinese policymakers to feel confident in continuing their financial opening because they have the capability and sufficient funds to safeguard the economy against retrenchments by global investors. Bottom Line: China will continue to open its domestic financial markets, albeit gradually, to global investors. The country’s domestic financial markets have limited exposure to the extreme volatility of foreign capital flows. Investment Conclusions Chart 22The RMB Still Has Upside Structurally, But Will Modestly Depreciate On A Cyclical Basis We are constructive on China’s government bonds, both cyclically and structurally. In the next six to nine months, the yield curve will likely flatten, with long-duration bond yields dropping faster than the short-end. China’s 10-year government bond yield will structurally shift to a lower range in the next five years, driven by the impact of falling population on domestic demand, and the country’s rising debt levels and debt-servicing costs. Although the RMB still has upside structural potential, in the next 6 to 12 months the currency will likely modestly depreciate against the US dollar (Chart 22).   Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Footnotes 1Total Factor Productivity (TFP) is a measure of productive efficiency,  determining how much output can be produced from a certain amount of inputs. 2Defined by BIS as the ratio of interest payments plus amortizations to income. 3Despite a rising debt load, debt-servicing costs were contained due to (1) LGFV debt swap as new provincial government bonds had lower yields than LGFV bonds and (2) a large decline in the prime lending rate and mortgage rates. 4Foreign investors held more than 40% of local currency bonds in Indonesia, and over 20% in Malaysia. Foreign ownership accounted for 26% of Russia’s local currency bonds in 2014. Market/Sector Recommendations Cyclical Investment Stance