Fixed Income
Highlights Look below the surface, and the euro area economy reveals some surprising and encouraging truths: Euro area employment is near an all-time high. Euro area inflation is little different to other major economies. The euro area excluding Germany is among the world's top-performing major economies. Stay underweight German bunds versus U.S. T-bonds. Stay long euro/pound until the trigger of Article 50. Stay long euro/yuan structurally. But underweight the Eurostoxx600 because the European equity index is a play on sectors and currencies, not on the euro area economy. Feature "There's nothing so absurd that if you repeat it often enough, people will believe it." - William James In today's post-truth world, the rigorous scrutiny and analysis of facts and data has never been so important. With that in mind, this week's report puts some of the prejudices about the euro area economy under the microscope. Look below the surface, and euro area employment, inflation and growth reveal some surprising and encouraging truths. Euro Area Employment: Near An All-Time High The percentage of the euro area population in employment is close to an all-time high (Chart of the Week). Chart of the WeekThe Percentage Of The Euro Area Population In Work Is Near An All-Time High How could this be when the unemployment rate stands at a structurally elevated 10%? The answer is that euro area labour participation is in a very strong uptrend (Chart I-2). As millions of formerly inactive citizens have entered the labour market, it has structurally swelled the numbers of both the employed and the unemployed. Remember that to count as unemployed, a person has to be in the labour market looking for work. Chart I-2Euro Area Labour Participation Is In A Strong Uptrend The euro area's strongly rising labour participation means that we must interpret the headline unemployment rate with care. Indeed, we would argue that the healthy percentage of the working age population in employment is the truer measure of labour utilisation. One counterargument is that euro area citizens have simply flooded into the registered labour force to claim generous and long-lasting unemployment benefits. This argument might be valid during downturns, but it cannot explain the 17-year uptrend since the turn of the century. Unpalatable as it might be to the euro doomsayers, we are left with a more positive explanation. Since the monetary union, many euro area countries have succeeded in bringing down structurally high inactivity levels in the working age population that was the accepted norm in previous decades. Admittedly, Italy and Greece are the laggards in this structural movement, and still have much work to do - but even they have made substantial progress in recent years (Chart I-3). Chart I-3Italy And Greece Are The Laggards, But Even They Are Making Progess Bottom Line: the structural state of euro area employment is much better than the headline unemployment rate might suggest. Euro Area Inflation: Little Different To Other Major Economies The euro area and U.S. inflation rates are almost identical when compared on an apples for apples basis. The key words here are "apples for apples". A fair comparison between inflation rates in the euro area and the U.S. must adjust for a crucial difference in the two price baskets. The euro area's Harmonized Index of Consumer Prices - excludes the consumption costs of owner-occupied housing; whereas the U.S. CPI includes it at a substantial 25% weighting. As Eurostat explains,1 "the comparison of inflation across different countries and regions can be undermined by the use of different approaches to owner-occupied housing." To compare apples with apples, a simple approach is to exclude housing costs from the U.S. CPI too. This shows that the ex-shelter inflation rates - both headline and core - are almost identical in the euro area and the U.S. (Chart I-4 and Chart I-5). Chart I-4Apples For Apples: Little Difference In ##br##Euro Area And U.S. Headline Inflation... Chart I-5...Or Core##br## Inflation A more correct approach would be to estimate the inclusion of housing costs in the euro area consumer basket, given that they represent a sizable proportion of euro area household expenditures. The proportion of homes that are owner-occupied in the euro area, 67%, is actually higher than that in the U.S., 65%. Our approach uses two steps. First, to realise that owner-occupied housing cost inflation just follows house price inflation. Second, to observe that house price inflation in the euro area is now identical to that in the U.S. (Chart I-6 and Chart I-7). We infer that if owner-occupied housing were included in the euro area consumer basket, there would be no major difference in the euro area and U.S. inflation numbers. But what about inflation expectations? The market-based expectations for the euro area and U.S. 5 year inflation rate 5 years ahead - the so-called 5 year 5 year inflation swap - show that the euro area is consistently below the U.S., albeit by just 0.5% (Chart I-8). But again, this difference exists largely because the market is ignoring owner-occupied housing costs, which are not in the euro area's official inflation rate. Chart I-6House Price Inflation Is Now Identical ##br##In The Euro Area And U.S. Chart I-7Owner Occupied Housing Inflation##br## Follows House Price Inflation Chart I-8Inflation Expectations Move Together ##br##In The Euro Area And U.S. Bottom Line: The euro area is not suffering a noticeably greater deflation threat than any other major economy. Euro Area Growth: One Of The Best In Class Since the end of 2013, euro area real GDP per capita has outperformed both the U.S. and Japan. Once again, we must compare apples with apples. To adjust for the different demographics in the major economies, a fair comparison of economic performance must be on a per capita basis. But isn't the euro area's outperformance due mostly to Germany? Actually, no. Over the past three years, the star performers are Spain and the Netherlands, whose per capita real GDPs have grown by 9% and 4.5% respectively. By comparison, the U.S. clocks in at 3.5% and Japan at 3%. The ECB might argue that its extraordinary policy is responsible for this outperformance. However, the evidence does not support this thesis. The revival in the euro area economy began in early 2014, long before the ECB had even mooted its asset-purchases, TLTROs or negative interest rates. Instead, the turning-point can be traced back to December 31, 2013, the mark-to-market date for the bank asset quality review (AQR). As soon as euro area banks ended the aggressive de-levering that the stress tests forced upon them, a deeply negative credit impulse also eased. Which allowed the economy to begin a sustained recovery. Bottom Line: The euro area excluding Germany is among the world's top-performing major economies (Chart I-9). Chart I-9The Euro Area Ex Germany Is Among The World's Top-Performing Major Economies The Investment Implications The proportion of the euro area working age population in employment is close to an all-time high, underlying inflation is almost identical to that in the U.S., and the euro area ex Germany is the world's best-performing major economy over the past three years. Yet the expected difference between ECB looseness and Federal Reserve tightness stands at a multi-decade extreme (Chart I-10). Chart I-10The Expected Difference Between ECB Looseness And Fed Tightness Is Too Extreme Lean against this. Either go long the Eurodollar two year out interest rate future contract and short the equivalent Euribor contract. Or go long the U.S. 5-year T-bond and short the German 5-year bund.2 A further ramification comes in the currency market. The dominant recent driver of the euro has been the so-called fixed income portfolio channel. When global bond investors fled the euro area in search of higher safe nominal yields, the euro came under pressure. These outflows are abating, and indeed reversing, as investors come to realise that the ECB's radical and experimental policy-easing has peaked. Stay long euro/pound until the trigger of Article 50. Stay long euro/yuan structurally. Finally, contrary to popular perception, the state of the euro area economy does not translate into Eurostoxx600 relative performance. Major equity market indexes are a collection of multinational dollar-earning companies which happen to be quoted in a particular city - say, Frankfurt, London, or New York - in a particular currency - say, the euro, pound, or dollar. Therefore, as demonstrated in More Investment Reductionism,3 the main driver of equity market relative performance tends to be currency movements, or the relative performance of industry sectors that dominate the particular index. Based on this currency and sector logic, stay underweight Eurostoxx600 versus FTSE100, and underweight Eurostoxx600 versus S&P500.4 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Detailed Technical manual on Owner-Occupied Housing for Harmonised Index of Consumer Prices, Eurostat. 2 BCA strategists differ on this position. 3 Published on November 24, 2016 and available at eis.bcaresearch.com 4 BCA strategists differ on this position. Fractal Trading Model* This week's trade is to go long Norwegian krone / Russian ruble. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations
Highlights Inflation: Inflation will trend higher this year, but at a measured pace. The impact of a tight labor market and accelerating wage growth will be mitigated by deflating import prices. Even if the economic recovery remains on track, year-over-year core PCE inflation is likely to still be below the Fed's 2% target by the end of this year. Yield Curve: With core inflation still low, the Fed will be quick to back away from its rate hike plans if there is any indication that inflation might reverse its uptrend. This supports a bear-steepening of the yield curve and the continued outperformance of TIPS versus nominal Treasuries. Spread Product: Excess returns to spread product are not likely to turn deeply negative until core PCE inflation is above 2% and Fed policy becomes more focused on halting inflation than supporting the recovery. We retain a neutral allocation to spread product in our portfolio. Feature Chart 1A Sustainable Recovery After seven years of false starts and disappointments, a durable recovery in inflation is finally under way (Chart 1). The key difference between the current uptrend and prior episodes of rising inflation - such as those witnessed in 2011 and 2014 - is that this time around most labor market indicators suggest the economy is very close to full employment. For this reason the recovery in core inflation is likely to persist, and will eventually settle at a level close to the Fed's 2% target for core PCE. That being said, it is still far too soon for investors to worry about inflation, particularly as it relates to the performance of risk assets. The remainder of this report discusses why the recovery in inflation is likely to be slow moving, and also how the inflation outlook impacts our major fixed income investment calls. Some Near-Term Headwinds There are two reasons why year-over-year measures of core inflation are likely to moderate during the next three months. First, diffusion indexes for both CPI and PCE inflation have recently dipped below the zero line (Chart 2), meaning that more components of each index have decelerating prices than have accelerating prices. Historically, rising year-over-year core inflation has been associated with diffusion indexes above zero. Second, January and February of last year saw incredibly large price increases in both core CPI and core PCE (Chart 3). This means that gains in January and February of this year will also have to be very strong to overcome the large base effect and cause the year-over-year growth rates to move higher. Chart 2Diffusion Indexes Point To Deceleration Chart 3A Large Base Effect In Jan & Feb Now these are only very short term arguments. The base effects will be out of the way by March and diffusion indexes can reverse course very quickly. However, they do suggest that inflation readings are likely to be relatively weak during the next few months. This will be critical for the near-term path of monetary policy and, in our view, makes it likely that the Fed will keep rates steady until the June FOMC meeting. The Phillips Curve Chart 4A Phillips Curve Model Of Inflation Turning to the longer run outlook for inflation, we employ a Phillips curve model of core PCE inflation based on one that Janet Yellen referred to in a speech from September 2015.1 In this framework, the year-over-year change in core PCE inflation is modeled using: Lagged core inflation Inflation expectations (from the Survey of Professional Forecasters) Non-oil import price inflation relative to core PCE inflation Resource utilization (calculated as the difference between the unemployment rate and the Congressional Budget Office's (CBO) estimate of the natural rate of unemployment) The model does an excellent job capturing changes in core PCE inflation since 1990 (Chart 4), and is also useful because it gives us a glimpse of the mental framework that Fed policymakers apply to the task of inflation forecasting. Most importantly, the model allows us to generate inflation forecasts given estimates for inflation expectations, the unemployment rate and the U.S. dollar (which closely tracks relative import prices). For example, in a base case scenario where we assume that inflation expectations and the dollar remain flat, but that the unemployment rate declines from its current level of 4.7% to 4.5% by the end of this year, the model predicts year-over-year core PCE inflation will rise from its current level of 1.65% to 1.87% by November, still below the Fed's 2% target. If we keep the same forecast for a steadily declining unemployment rate but also incorporate a 5% increase in the value of the trade-weighted U.S. dollar, then core PCE inflation is projected to rise to 1.76% by November. The stronger dollar means that import prices exert a bit more of a drag. Conversely, if we keep the same unemployment assumption but assume that the U.S. dollar depreciates by 5%, then core PCE inflation is projected to reach 1.98% by November. In this scenario import prices actually provide a slight boost to core inflation. Overall, to create a scenario where core inflation reaches the Fed's target before the end of this year we need to make a fairly optimistic assumption about the unemployment rate and also incorporate a substantial dollar depreciation. In our view, it is more likely that the dollar remains under mild upward pressure this year as the U.S. economy continues to de-couple from the rest of the world. Fiscal policy remains the wildcard, as any protectionist measures implemented by the new U.S. government could lead to import price shocks. Although at first blush any watering-down of trade deals, imposition of tariffs, or protectionist tweaks to the tax code would seem likely to send import prices higher, much depends on how much of the adjustment to the new trade policy occurs through the exchange rate or through prices. This is incredibly hard to determine until the details of any protectionist trade measures are known. Our Global Investment Strategy service explored the potential ramifications of one such trade proposal - a border-adjusted corporate tax - in a Special Report published last week.2 A Bottom-Up Perspective An alternative to the Phillips curve approach is to split core inflation into its major sub-components: shelter, core goods and core services excluding shelter. We can then examine each sub-component separately and identify different macro drivers for each (Chart 5). Shelter has been the strongest contributor to core inflation so far in this recovery and can be modeled using home prices, the rental vacancy rate and household formation (Chart 5, panel 1). Based on these relationships, we expect shelter inflation will remain elevated for quite some time, while our model suggests it is even likely to move a bit higher during the next few months. After briefly seeming like it might rebound earlier last year, the rental vacancy rate has since fallen to new lows while home price appreciation continues at a steady rate of just above 4% per year (Chart 6). Further, the vacancy rate should remain under downward pressure and home prices under upward pressure as long as household formation continues to outpace home construction. The top panel of Chart 6 shows that the difference between housing starts and household formation closely tracks the rental vacancy rate. The vacancy rate rose throughout the 1990s and early 2000s as housing starts outpaced the creation of new households, but starts have not been sufficiently robust so far in this recovery. In addition, housing inventory as a percent of households is near the lows of the early 1990s (Chart 6, bottom panel). This inventory calculation includes the "shadow inventory" from foreclosed homes which has almost normalized back to pre-crisis levels, in any case. Chart 5The Components Of Core CPI Chart 6Drivers Of Shelter Inflation We expect that shelter inflation will remain elevated at least until housing construction starts to outpace the creation of new households, but will moderate once that supply response starts to emerge. Chart 7Atlanta Fed Wage Growth Tracker* ##br##Versus Unemployment Rate Core goods inflation (Chart 5, panel 2) has been, and will continue to be, the major source of deflation in this cycle. A large fraction of core goods are imported and, as such, core goods inflation tends to follow the trend in the U.S. dollar. The bull market in the U.S. dollar will continue to keep a lid on core goods prices, and will limit how quickly inflation can rise. Any meaningful increase in inflation this year is likely to come from the core services excluding shelter component, which historically tends to track fluctuations in wage growth (Chart 5, bottom panel). As we have previously highlighted, the labor market is close to full employment and the relationship between the unemployment rate and wage growth remains strong (Chart 7). In this environment, even modest further declines in the unemployment rate should exert meaningful upward pressure on wages. Bottom Line: Inflation will trend higher this year, but at a measured pace. The impact of a tight labor market and accelerating wage growth will be mitigated by deflating import prices. Even if the economic recovery remains on track, year-over-year core PCE inflation is likely to still be below the Fed's 2% target by the end of this year. Investment Implications Duration & TIPS Chart 8Leading Inflation Indicators & Breakevens Long-maturity TIPS breakeven inflation rates still have upside, although the rate of increase is unlikely to maintain its current rapid pace. As core inflation converges with the Fed's target so should long-dated measures of inflation expectations such as TIPS breakevens. Historically, core PCE inflation close to 2% has coincided with long-dated TIPS breakevens in a range between 2.4% and 2.5%. With the 10-year breakeven currently at 2.05%, we expect it has another 35 to 45 basis points of upside. Measures of pipeline inflation pressure, such as producer prices and the prices paid and supplier deliveries components of the ISM manufacturing survey also point to rising breakevens (Chart 8). We continue to recommend an overweight allocation to TIPS versus nominal Treasury securities. With rate hike expectations still relatively depressed,3 real yields do not have much downside. Rising breakevens should therefore also pressure long-dated nominal yields higher in the months ahead. While we currently recommend a benchmark duration stance, we are actively looking for an opportunity to shift to below-benchmark duration, as was discussed in last week's report.4 Yield Curve As breakevens and nominal yields move higher the yield curve should also steepen (Chart 9). The strong positive correlation between the slope of the yield curve and TIPS breakevens is the result of the impact of Fed policy on both variables. Chart 9Wider Breakevens Correlated With A Steeper Yield Curve Fed policy tends to be accommodative in the early stages of a recovery, and this causes the yield curve to steepen and breakevens to widen as investors logically expect that easy money will cause both growth and inflation to move higher. In contrast, the yield curve tends to flatten and breakevens tend to fall later in the recovery once Fed policy turns more restrictive. Chart 105-Year Bullet Still Cheap Given that core inflation and TIPS breakevens both remain below the Fed's targets, it is too soon to expect a shift toward restrictive Fed policy. In other words, the Fed will be quick to back away from its rate hike plans if there is any indication that breakevens or inflation might reverse their uptrends. It is only once core inflation and TIPS breakevens have returned to the Fed's targets that the stated purpose of Fed policy will shift from supporting the recovery to snuffing out inflation. To profit from a steeper yield curve we entered a long 5-year bullet short duration-matched 2/10 barbell trade on December 20. So far this trade has returned 14 bps, and the 5-year bullet continues to look very cheap on the curve (Chart 10). Spread Product In prior research we considered the performance of spread product throughout the four phases of the Fed cycle (Chart 11).5 We define the four phases of the Fed cycle as follows: Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first hike of a new tightening cycle and ends when the fed funds rate crosses above its equilibrium level. Phase II represents the late stage of the tightening cycle, when the Fed hikes its target rate above equilibrium in an effort to slow the economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate descends to its cycle trough and the subsequent adjustment period when the Fed remains on hold in an effort to kick start an economic recovery. Chart 11Stylized Fed Cycle Using a very simple estimate of the equilibrium fed funds rate based on potential GDP and a long-run moving average of the funds rate itself, we have found that excess returns to investment grade corporate bonds are highest in phase IV and phase I, when the fed funds rate is below equilibrium (Table 1). However, the key problem with this analysis is that it is very difficult to estimate the equilibrium fed funds rate in real time. As stated above, the estimate used in Table 1 incorporates the CBO's estimate of potential GDP which is frequently revised after the fact. So while we are confident that we are currently in phase I of the Fed cycle, the challenge becomes looking for other indicators that might warn us about the transition from phase I to phase II, where excess returns are much worse. We have found that core PCE inflation is one such indicator. We calculated average monthly excess returns to investment grade corporate bonds when year-over-year core PCE inflation is below 1.5%, between 1.5% and 2%, and between 2% and 2.5% (Table 2). Table 1Investment Grade Corporate Bond Excess Returns* Under The Four Phases##br## Of The Fed Cycle (August 1988 To Present) Table 2Investment Grade Corporate Bond Excess Returns* Under Different Ranges##br## For Year-Over-Year Core** PCE (August 1988 To Present) The results show that the highest returns occur when inflation is below 1.5%. This should not be surprising since an environment of low inflation is most likely to coincide with phase IV of the Fed cycle. We found mixed results for when inflation is between 1.5% and 2%. In this environment average monthly excess returns are close to zero and a 90% confidence interval places them between -19 bps and +17 bps. This environment likely encompasses phase I of the Fed cycle and the transition into phase II. It is not until core PCE inflation is above 2% that excess returns turn decisively negative. Monthly excess returns average -13 bps in this environment, with a 90% confidence interval of -35 bps to +10 bps. With inflation likely to remain between 1.5% and 2% for the balance of the year, it is too soon to turn all-out bearish on spread product. For the moment we recommend a neutral allocation, but with an underweight allocation to high-yield bonds where valuations are exceedingly tight. Given that inflation is low and Fed policy is accommodative, we would be quick to upgrade both investment grade and high-yield corporates on any near-term sell off. The current uncertainty surrounding fiscal policy also complicates the outlook for spread product. On the one hand, it raises the risk of a near-term sell off if it appears as though some of the more stimulative aspects of Trump's agenda will not be implemented. On the other hand, in addition to headline-grabbing promises of increased infrastructure spending, there are many other policy details that could also have significant market implications. One example would be the elimination of the tax deductibility of corporate interest expenses. Such a provision is currently included in the Republican's plan for corporate tax reform, and would severely diminish supply in the corporate bond market if it is implemented. Bottom Line: Excess returns to spread product are not likely to turn deeply negative until core PCE inflation is above 2% and Fed policy becomes more focused on halting inflation than supporting the recovery. We retain a neutral allocation to spread product in our portfolio. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 http://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 2 Please see Global Investment Strategy, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017", dated January 20, 2017, available at gis.bcaresearch.com 3 The overnight index swap curve is priced for 54 basis points of rate hikes during the next twelve months. 4 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Investment Strategy / U.S. Bond Strategy Special Report, "Bonds And The Fed Funds Rate Cycle", dated May 27, 2014, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Global Growth: If global demand follows the recent improvements seen in economic sentiment, growth will surprise positively relatively to expectations in 2017. With global inflation also likely to continue drifting higher over the course of the year, the medium-term bearish implications for bonds are clear. Duration Technicals: Government bond markets remain technically stretched, as the bearish positioning from late 2016 is still intact. Combined with price momentum measures that have barely corrected from oversold extremes, yields are not quite ready to resume their ascent. It is too soon to reduce portfolio duration exposure to position for the higher yields that we expect this year. Canada: The Canadian economy has shown clear signs of improvement of late. This trend can continue in the first half of 2017, thus we are closing our short Canadian corporates/long Canadian provincial debt trade and entering a new position - shorting Canadian 10-year government bonds versus 10-year U.S. Treasuries. Feature Chart of the Week Post-Truth: relating to or denoting circumstances in which objective facts are less influential in shaping public opinion than appeals to emotion and personal belief. - Oxford Dictionary Oxford voted that term, "post-truth", as the 2016 international word of the year. That is not a surprise, as the two dominant news stories of the past twelve months, Brexit and Trump, represented triumphs of hot emotional arguments over cold hard facts. Pessimists may argue that what we are currently seeing in the U.S. is a "post-truth" economic upturn, where confidence is soaring in expectation of the potential positive impact from Donald Trump's proposed pro-business agenda, but without a corresponding boost in actual growth. Financial markets appear to have already discounted a more rapid pace of growth, as evidenced by the surge in government bond yields in November/December and sharp outperformance of economically-sensitive asset classes like equities and high-yield (Chart of the Week). We do expect growth to deliver some upside surprises in 2017, putting additional upward pressure on government bond yields and downward pressure on credit spreads. In the meantime, however, markets need to consolidate the recent moves while the hard economic data catches up to booming sentiment. This leads us to maintain a cautious tactical investment stance, both towards duration exposure and credit allocations, while looking for more attractive levels to position for the improving global growth dynamic in 2017 by re-establishing below-benchmark duration positions and increasing corporate bond exposure. Real Growth Or Fake News? In our previous Weekly Report, we discussed how improving U.S. business confidence within the corporate sector could lead to a revival of capital spending after three years of decline.1 Not all of this is attributable to the "Trump effect", though. Global leading economic indicators were already starting to tick upward even before the U.S. election, while actual data in the major economies was surprising to the upside. This suggests that some pickup in global growth is likely in the next few quarters which would put additional upward pressure on the real component of government bond yields (Chart 2). Growth forecasts remain subdued, however, even with the recent bump in sentiment. The Bloomberg consensus expectation for real global GDP growth in 2017 is 3.2%. The International Monetary Fund is slightly more optimistic, projecting growth of 3.4% in 2017 but with only 2.3% growth in the U.S. (this is an updated forecast released yesterday, so after the U.S. election). Central bank growth forecasts at the country level are also relatively downbeat; for example, the Fed is expecting U.S. growth of only 2.1% in 2017 while the European Central Bank (ECB) is projecting Euro Area growth of 1.7%. Given the relatively high level of uncertainty over the potential effects of the incoming Trump administration's economic agenda, it is no surprise that professional forecasters are being cautious as they wait for the details to unfold. Yet while improving sentiment among consumers and businesses does not guarantee a faster pace of economic growth in the absence of rising household incomes and healthier corporate profits. However, greater confidence (i.e. "animal spirits") is often a prerequisite before a cyclical upturn can blossom, turning "post-truth" sentiment into a true recovery. Looking at the data among the major economic regions shows that, if the confidence indicators are to be believed, then global growth could deliver some upside surprises this year: United States: Consumer confidence is soaring, with the Conference Board measure reaching an 8-year high at the end of 2016. The December reading for U.S. National Federation of Independent Business (NFIB) survey released last week showed a similar spike in confidence among U.S. small businesses, with capital expenditures, hiring plans and overall optimism returning to levels not seen since before the Great Recession (Chart 3). This is a similar move to the strong confidence data for corporate CEOs that we presented in last week's report. Chart 2A Cyclical Upturn In Growth & Yields Chart 3U.S. Economic Confidence Improving Euro Area: Euro Area sentiment measures, such as the European Commission confidence surveys or the widely-followed German IFO and ZEW indices, hooked upward at the end of 2016 (Chart 4). Both household and business confidence improved, underscoring how the current cyclical upturn in the Euro Area is broad-based. Japan: While Japan should not be expected to be a major contributor to overall global growth given its well-known structural economic impediments (contracting population, weak productivity, high government debt, etc), the most recent data does show a slight uptick in consumer confidence, business confidence and the Japan leading economic indicator (Chart 5). Chart 4A Solid Uptick In Euro Area Confidence Chart 5Japanese Sentiment Inching Higher Chart 6Upside Risks For Chinese Growth? China: Both consumer and business confidence have improved alongside the cyclical Chinese recovery seen in 2016, but this has not been enough to boost consensus forecasts for Chinese growth this year. Importantly, this creates the possibility of an upside growth surprise as both the OECD leading indicator for China and the proprietary GDP growth model from our colleagues at BCA China Investment Strategy are calling for faster growth in 2017 (Chart 6).2 A potential increase in trade or even military tensions between China and the U.S. is a potential risk to this sunny scenario but, given what we know now about the underlying economy, China looks poised to deliver another year of solid growth. The data does show that the improvement in economic sentiment goes beyond what is happening in the U.S. Some of that could be the spillover effect from greater optimism on the Trump-fueled U.S. economy to the rest of the world. The synchronized uptick in global leading economic indicators, however, suggests that there is more going on than a simple post-election hope that Trump can deliver faster U.S. growth. A genuine synchronized global upturn is underway, which is not "fake news" (which we expect will be the Oxford word of the year in 2017!) Bottom Line: If global demand follows the improvements seen in economic sentiment, growth will surprise positively relative to expectations. With global inflation also likely to continue drifting higher over the course of 2017, the bearish implications for bonds are clear. Bond Market Technicals Have Not Moved Much Normally, such a growing body of evidence pointing to improving global economic sentiment would be a bearish development for bond prices. Fixed income markets have already moved very rapidly, however, to discount a more optimistic outlook for growth. The rise in yields over the final two months of 2016 has left the major sovereign bond markets in a highly stretched position. This was one of the reasons we shifted our recommended duration stance from below-benchmark to neutral in early December.3 Looking at technical indicators such as the deviation of 10-year government bond yields from their 200-day moving averages, or momentum measures such as the 26-week total return for the sovereign bond indices, show that bonds remain deeply oversold in the main "G-4" markets: the U.S. (Chart 7), Germany (Chart 8), the U.K. (Chart 9) and Japan (Chart 10). Chart 7UST Technicals: Stretched Chart 8German Bund Technicals: Stretched Chart 9U.K. Gilt Technicals: Stretched Chart 10JGB Technicals: Stretched In the case of U.S. Treasuries, indicators of market positioning suggest that most traders have not unwound their bearish bets. The Commitment of Traders report shows that speculators currently have the largest net short position in Treasury futures in the history of the data. Meanwhile, the Market Vane index of Treasury sentiment has bounced slightly off the recent lows, but remains at generally downbeat levels (Chart 11) - and still above the levels that heralded prior peaks in yields in 2010, 2013 & 2015. Only the JPMorgan duration survey has shown a closing of net short positions for the more "active" trader base, but not for the overall set of bond investors. We will continue to monitor these positioning and momentum indicators in the weeks ahead to assess when the oversold market conditions have unwound enough to justify a shift back to a below-benchmark duration stance. For now, keep portfolio duration exposure at benchmark. Bottom Line: Government bond markets remain technically stretched, as the bearish positioning from late 2016 is still intact. Combined with price momentum measures that have barely corrected from oversold extremes, yields are not quite ready to resume their ascent. It is too soon to reduce portfolio duration exposure to position for the higher yields that we expect this year. Encouraging Signs From Canada Last October, this publication laid out a sobering view on the Canadian economy.4 Softening exports were a concern, especially in the non-commodity related sectors and even with a weaker Canadian dollar. Growth in corporate capital spending growth was still contracting, constrained by tight lending conditions. Moreover, household consumption appeared at risk, given the depressed labor force participation rate and low wage increases. This view led us to adopt: a neutral stance - but with a positive bias - on Canadian bonds versus global hedged benchmarks; a slightly more dovish view then the consensus on the next monetary policy move by the Bank of Canada (BoC), not discarding the possibility of a rate cut in 2017 and; a short position on Canadian corporates versus Canadian provincial government debt. Since then, however, the Canadian economic cycle has taken a positive turn. The euphoria surrounding Trump's economic plan for Canada's largest trading partner has definitely prompted some of the improvements. The enthusiasm towards possible pro-business American economic policies seems to have seeped into Canadian business owners' mindset as well (Chart 12). Chart 11UST Positioning Still Very Short Chart 12Trump Is Also Influencing Canada's Mood But there is more to it than that. First, employment data have firmed up. The net change in Canadian employment has been positive in each of the last five months, increasing on average by a robust 47.5k. The previously declining labor force participation rate has stabilized, posting a 65.8% reading in December versus the July low of 65.3%. Plus, more jobs have been created in the private sector versus the public sector and in more stable "regular" employment rather than self-employment (Chart 13). Second, the business sector's mood has brightened. According to the BoC's Winter Business Outlook Survey, sales expectations, investment plans and employment intentions are all recovering.5 More striking, firms' pricing power has jumped higher; prices of products and services sold are expected to increase substantially in the next twelve months (Chart 14, top panel). Better pricing power should help Canadian corporate profits, going forward. Chart 13Employment Firming up Chart 14A Business Cycle Reversal? Chart 15Exports Perking Up This, combined with better credit conditions, could potentially turn the Canadian economic cycle around. Real capital expenditure has been the big missing ingredient to a healthy economic expansion in the last few years. This is about to change as the BoC's Senior Loan Officer survey shows that Canadian bank lending conditions re-entered "easing" territory in Q4 2016 (Chart 14, bottom panel).6 Looser credit conditions usually lead to faster loan growth and stronger investment spending. Third, better sentiment globally, and especially in the U.S., has lifted demand for Canadian products, with growth for both commodity and non-commodity-related exports showing improvement in the last quarter of 2016. While higher commodity prices have certainly boosted commodity-related exports, improving U.S. consumer confidence suggests that Canadian goods exports numbers will perk up in the coming months (Chart 15). Fourth, Canadian housing prices could still grind higher for a while longer and a broad retrenchment in the construction sector might be avoided again in 2017. Granted, the backdrop remains quite risky given high prices and soaring household debt levels. According to the BoC, about 15% of high loan-to-income mortgages issued in 2016 would have been ineligible under the new regulatory framework for allowable mortgage lending.7 Hence, the construction sector will face some headwinds going forward as some new mortgage loans will be harder to come by, on the margin. However, it is not a given either that housing affordability (or lack thereof) has reached peak levels yet (Chart 16).8 Lately, the housing market has held up relatively well, despite the regulatory tightening measures put in place to reduce the systemic risks from overvalued Canadian real estate. New house prices grew at a 3% year-over-year rate in December - the fastest pace in four years - while housing starts have averaged 198k in the last twelve months, surpassing the levels seen during the previous three years. In sum, the Canadian economy has performed better than we previously expected. As such, we remain open to the idea that it could continue in that vein over at least the first half of 2017. That said, our optimism remains guarded. The health of the Canadian non-financial, non-energy corporate sector has been deteriorating over the last two years, limiting the potential for the kind of revival of animal spirits that we are seeing in the U.S. Plus, the cyclical data for Alberta - Canada's fourth most important province - remains moribund. A more robust expansion in that province would be necessary to solidify our conviction level towards the strength of the overall economy. Chart 16Not That Unaffordable Chart 17No Inflation On The Horizon Canada remains fragile; consumer indebtedness levels are elevated by international standards. Accordingly, this economy remains a hiccup away from disappointing in the event of an external shock. A global equity market correction, softer oil prices, a reversal in the latest Chinese reflationary push, a Trump geopolitical blunder and/or a move toward more trade protectionism in the U.S. (especially concerning NAFTA9) could negatively impact Canada at any moment - and in a much bigger fashion compared to most other developed economies. As such, the BoC will be prudent and probably stay on hold in 2017. Inflationary pressures are simply not strong enough to justify turning hawkish. Unemployment at 6.9% remains close to half a percentage point away from full employment levels.10 Our Canadian weekly earnings diffusion index is pointing to lower wage pressures, as well (Chart 17). The 30% probability of a rate hike by year-end currently discounted in the OIS market could easily be priced out if inflation remains subdued. Nonetheless, we have to acknowledge the improving backdrop in our portfolio recommendations: we are choosing to close our trade, shorting Canadian corporates versus Canadian provincial debt, at a loss of -53bps. The defensive characteristics of that trade, which also incurs negative carry, now appear less appealing, especially considering the global "risk on" environment currently in place. For now, we are maintaining our neutral stance on Canadian bonds in our global model portfolio, with Canada unlikely to see the same degree of upside inflation pressures that we expect in the other developed economies. However, we are opening a tactical trade, shorting Canadian government bonds versus U.S. Treasuries at the 10-year maturity. From a historical stand point, Canadian yields are very low compared to the U.S., offering an interesting entry point. In addition, the Canada-U.S. employment ratio and the price ratio of Brent oil to lumber - which have been broadly correlated to the Canada-U.S. spread over the years - are both hooking up, pointing to a wider Canada-U.S. spread and representing an interesting macro signal (Chart 18). U.S. inflation prospects add to this trade's attractiveness. Our colleagues at BCA U.S. Investment Strategy recently made a compelling case for U.S. inflation not being a major threat in 2017 after assessing the prospects for the main components of U.S. core PCE inflation (shelter, core goods and core services).11 Core PCE should converge on the Fed's target of 2% in the second half of 2017, but an inflation overshoot beyond that is not the base case (Chart 19). That could allow Canadian bonds yields to catch up to higher U.S. yields, especially if the oversold conditions in the U.S. Treasury market described earlier persist. Chart 18Go Short Canadian Bonds Versus U.S. Treasuries Chart 19Only A Mild Uptrend Is Likely In 2017 Bottom Line: The Canadian economy has shown clear signs of improvement of late. This trend can continue in the first half of 2017, thus we are closing our short Canadian corporates/long Canadian provincial debt trade and entering a new position - shorting Canadian 10-year government bonds versus 10-year U.S. Treasuries. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "4 Big Questions For Bond Markets In 2017", dated January 10, 2017, available at gfis.bcaresearch.com 2 Please see BCA China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard", dated January 12, 2017, available at cis.bcaresearch.com 3 Please see BCA Global Fixed Income Strategy Weekly Report, "The Bond Vigilantes Take A Break For The Holidays", dated December 6, 2016, available at gfis.bcaresearch.com 4 Please see BCA Global Fixed Income Strategy Weekly Report, "The Bond Bear Phase Continues", dated October 11, 2016, available at gfis.bcaresearch.com 5 http://www.bankofcanada.ca/2017/01/bos-winter-2016-17/ 6 http://www.bankofcanada.ca/wp-content/uploads/2017/01/slos-winter2016.pdf 7 http://www.bankofcanada.ca/2016/12/fsr-december-2016/ 8 A description of the Bank of Canada Housing Affordability Index can be found at http://credit.bankofcanada.ca/financialindicators/hai 9 NAFTA (the North American Free Trade Agreement) is a treaty between Canada, the United States, and Mexico aimed at removing trade barriers and encouraging economic activity. 10 NAIRU stands at 6.5% 11 Please see BCA U.S. Investment Strategy Weekly Report, "Inflation In 2017: An Idle Threat", dated January 9, 2017, available at usis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Duration: In the absence of a major economic shock we will reinitiate a below-benchmark duration recommendation once the Global Economic Policy Uncertainty Index displays some mean reversion and positioning indicators are at less bearish extremes. Fed Balance Sheet: The Fed could start to reduce the size of its balance sheet as early as the end of this year, but more likely in 2018. In any case, allowing securities to run off its portfolio will not have much of an impact on long-dated Treasury yields. MBS: Remain underweight MBS. Spreads are already low and have near-term upside based on the slope of the yield curve and the uptrend in interest rate volatility. Feature As we pointed out in our December 6 report, the bond selloff had proceeded too far, too fast, and was due for a pause. The 10-year Treasury yield then peaked at 2.6% on December 16 and has now fallen back to 2.4% as we go to press. It is of note that all of the reversal has come from the real component of yields while the compensation for expected inflation has remained firm (Chart 1). Chart 1Bear Market On Pause In our end-of-year "Themes For 2017" Special Report 1 we explained why we believe Treasury yields will level-off in the near term before heading higher throughout most of 2017. Now that we have entered this first "consolidation phase" it is time to consider what factors would cause us to reinstate a below-benchmark duration stance. But first, let us quickly recap our bearish 6-12 month outlook for Treasuries. The Cyclical Outlook For Treasury Yields Many of the headwinds that held back economic growth last year - including fiscal policy, inventory drawdowns and the impact of a distressed energy sector on capital spending - are poised to abate in 2017. With stronger growth and an already tight labor market, core inflation will continue to gradually rise toward the Fed's target. We expect trailing 12-month core PCE inflation will reach the Fed's 2% target near the end of 2017. Consequently, the cost of inflation protection embedded in bond yields will also converge with levels that are consistent with the Fed's target (Chart 2). We judge this level to be in the range of 2.4% to 2.5% for long-dated TIPS breakevens. With the 5-year/5-year forward TIPS breakeven rate at 2.13% and the 10-year TIPS breakeven rate at 2%, long-dated Treasury yields have approximately 30-50 bps of upside from the inflation component alone. Chart 2Breakevens Still Too Low Chart 3Real Yields Also Biased Higher We are less certain about how much higher real yields might move during the next 12 months. However, the downside in real yields is surely limited. Chart 3 shows that changes in the 10-year real yield and changes in our 12-month Fed Funds Discounter2 are almost always positively correlated. At present, the reading from our discounter is 46 bps, meaning the market is priced for about 2 more rate hikes during the next 12 months. Given our positive economic outlook, 2 or 3 rate hikes in 2017 sounds reasonable. Is Now The Time To Trim Duration? Barring any major economic setbacks we will consider three factors when making this decision: (i) valuation, (ii) economic policy uncertainty and (iii) sentiment & positioning. Factor 1: Valuation When we last shifted from a below-benchmark to a benchmark duration stance on December 6 the 10-year Treasury yield traded 14 bps above the fair value reading from our 2-factor Global PMI Model. At present, the 10-year yield is only 9 bps cheap on this model (Chart 4). In other words, valuation is essentially neutral. But since global PMI is likely to trend higher over the course of the year, we would be comfortable cutting duration at current valuation levels should the other two factors on our checklist fall into place. Factor 2: Uncertainty We've been talking a lot about uncertainty recently, mostly in reference to the Global Economic Policy Uncertainty Index created by Baker, Bloom and Davis.3 This index exhibits a strong inverse correlation with Treasury yields over time and has shot higher during the past couple of months without a corresponding decrease in yields. When we consider the uncertainty index alongside Global PMI and bullish sentiment toward the U.S. dollar in our 3-factor model of Treasury yields, we find that the 10-year Treasury yield now appears 38 bps cheap (Chart 5). Chart 4Close To Fair Value... Chart 5...But Uncertainty Remains Elevated What is particularly odd is that the uncertainty index has diverged so sharply from measures of both consumer and small business confidence (Chart 6). This epic split can mean only one of two things: Chart 6Excessive Optimism Or A False Reading From The Uncertainty Index? Businesses and consumers are excessively optimistic in the face of an increasingly uncertain back-drop, or The uncertainty index is unable to distinguish between policy shocks with positive and negative economic implications We turn to history in an attempt to determine whether the warning from the uncertainty index should be heeded. Specifically, we searched for other one-month periods when there was a one standard deviation increase in the uncertainty index alongside increases in both consumer and small business confidence. Since 1991, ten months meet these criteria (Table 1). Table 1Periods Displaying One Standard Deviation Increase In Global Economic Policy##br## Uncertainty Index* And Increase In Both Consumer Sentiment Index** ##br##And Small Business Confidence Index*** (1991 To Present) First we note that Treasury yields declined in 7 out of the 10 flagged periods, but in many of those episodes the scale of the positive confidence shocks was not very large. The two months that appear most similar to the present situation are September 2008 and December 2013. Chart 7Investors Still Bearish The Fed announced the tapering of its asset purchases in December 2013 amidst signs of an improving economy. The hawkish Fed announcement and improving economic outlook sent yields higher on the month, while the uncertainty index spiked as a large number of Fed-related news stories hit the papers.4 One thing that makes December 2013 an imperfect comparable to the present day is that the uncertainty shock was relatively small compared to the confidence shocks. In September 2008 the confidence shocks were not as large as the uncertainty shock, much like today, and the 10-year Treasury yield managed a 2 bps increase. However, it is definitely unfair to draw a conclusion based on the extremely volatile price movements that were witnessed at the height of the financial crisis in September 2008. Based on the example of December 2013, we cannot decisively rule out the possibility that the uncertainty index is simply giving a false signal. However, if that is the case we would expect the uncertainty index to mean revert in relatively short order. Given the strong historical relationship between the uncertainty index and Treasury yields, we will wait for some mean reversion in the uncertainty index before shifting back to a below-benchmark duration stance. Factor 3: Sentiment & Positioning When we shifted from a below-benchmark to a benchmark duration stance measures of investor sentiment and positioning were at bearish extremes, sending a decisive signal that the bond market was oversold. As of today, some of these indicators have started to reverse course while others have not (Chart 7). Our BCA Bond Sentiment Indicator, a composite of a survey of bullish sentiment toward bonds and the 13-week rate of change in bond yields is no longer at an oversold extreme. However, net speculative positions in the 10-year Treasury futures contract have moved even further into "net short" territory. The J.P. Morgan client survey shows that investors remain below benchmark duration in aggregate, although active traders are no longer net short. Although some capitulation of shorts has already taken place, we will await some further normalization of positioning - particularly in net speculative futures - before reinitiating a below-benchmark duration stance. Bottom Line: In the absence of a major economic shock we will reinitiate a below-benchmark duration recommendation once the Global Economic Policy Uncertainty Index displays some mean reversion and positioning indicators are at less bearish extremes. The Fed's Balance Sheet & The Shortage Of Bills The minutes from December's FOMC meeting revealed that: Several participants noted circumstances that might warrant changes to the path for the federal funds rate could also have implications for the reinvestment of proceeds from maturing Treasury securities and principal payments from agency debt and mortgage-backed securities Since then, three different FOMC members have also spoken about the size of the Fed's balance sheet. Philadelphia Fed President Patrick Harker said that the Fed should consider shrinking its balance sheet once the fed funds rate reaches 1%.5 Boston Fed President Eric Rosengren made the case for more immediate action6 and St. Louis Fed President James Bullard said the Fed should consider shrinking its balance sheet in 2017.7 Clearly, talk of unwinding the Fed's balance sheet is heating up. The Fed's only official stated position on this topic is that it will keep its balance sheet level until normalization of the fed funds rate is "well under way", a statement we have long interpreted to mean "until the fed funds rate is 1%, or perhaps even higher". As such, we would not expect any action on winding down the Fed's balance sheet until late this year at the earliest, and more likely in 2018. The Impact On Treasury Yields In any case, as we detailed in a report published in August 2015,8 we do not think that the Fed allowing its balance sheet to shrink will itself have much of an impact on Treasury yields. The reason relates to the way in which maturing Treasury securities are currently rolled over at auction and the persistent shortage of T-bills in the market. Chart 8Fed Runoff Will Increase##br## Issuance To Public ... At the moment, balances of matured Treasury securities are added to upcoming note/bond auctions as non-competitive bids. In other words, as Treasury securities mature the Fed buys an equal amount at upcoming Treasury auctions. If the Fed were to cease this reinvestment, that amount would need to be added to the competitive portion of the auctions and would greatly increase the gross issuance of Treasury debt to the public. For a sense of scale, we calculate that Treasury issuance to the public would need to increase by $426 bn in 2018 and $378 bn in 2019 if the Fed were to cease the reinvestment of its portfolio at the end of this year (Chart 8). We contend, however, that a significant portion of this extra financing requirement will be met through increased T-bill issuance and will therefore not impact long-dated Treasury yields. The Treasury department has had a stated goal of increasing T-bill issuance since May 2015 and bill supply as a percentage of total Treasury debt remains near a multi-decade low (Chart 9). Further, T-bills are still in high demand as evidenced by the fact that they are trading at a substantial premium to other money market instruments (Chart 10). This premium exists despite the fact that the Fed has been soaking up a lot of T-bill demand through its Overnight Reverse Repo facility (Chart 10, bottom panel). If the Fed were to phase this program out alongside a reduction in the size of its balance sheet - which is its current stated exit strategy - the shortage of T-bills would be exacerbated. Chart 9... But Mostly Through T-Bills Chart 10T-Bills In High Demand Of course there is a new regime about to enter the White House and the Treasury department, and also a lot of uncertainty about how large the deficit will be going forward. If the deficit is increased substantially then it would likely be necessary for the Treasury department to increase the size of both bill and coupon issuance in the years ahead. Bottom Line: It is necessary to consider both fiscal policy and the Fed's balance sheet together when forecasting Treasury issuance. Further, whatever the government's financing requirement, a considerable portion of it will be addressed through increased T-bill issuance in the years ahead. This will limit the impact on long-dated Treasury yields. A Quick Note On MBS Chart 11MBS Spreads Are Too Low Any unwind of the Fed's balance sheet will have a much greater impact on MBS spreads than on Treasury yields since it will add directly to the supply of MBS available to the public, which tends to correlate with MBS option-adjusted spreads (Chart 11). Of course, other factors such as the rate of prepayments will determine how quickly the Fed's MBS holdings run off and the state of the housing market will determine how much new mortgage origination takes place. We hope to explore these issues in more depth in the coming weeks. Of more immediate concern for MBS spreads though is the recent divergence between nominal spreads, rate volatility and the slope of the yield curve (Chart 11, bottom two panels). MBS spreads have not widened in recent weeks despite curve steepening and rising rate vol. MBS spreads are already low compared to investment alternatives and have upside in the near term, especially if the yield curve continues to steepen, as we expect it will. Looking further out, the eventual wind down of the Fed's balance sheet is another risk the MBS market will have to face. Bottom Line: Remain underweight MBS. Spreads are already low and have near-term upside based on the slope of the yield curve and the uptrend in interest rate volatility. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 207", dated December 20, 2016, available at usbs.bcaresearch.com 2 Our 12-month discounter measures the expected change in the fed funds rate during the next 12 months as discounted in the overnight index swap curve. 3 www.policyuncertainty.com 4 The uncertainty index is in part based on an algorithm that scans newspapers for coverage of policy-related economic uncertainty. 5 http://www.reuters.com/article/us-usa-fed-harker-idUSKBN14W1W4 6 http://www.cnbc.com/2017/01/09/reuters-america-interview-rosengren-urges-more-rate-hikes-slimmer-balance-sheet.html 7 http://www.businessinsider.com/lets-shrink-the-balance-sheet-bullard-says-2016-12 8 Please see U.S. Bond Strategy Weekly Report, "Currencies: The Tail Wagging The Dog", dated August 18, 2015, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The global 6-month credit impulse is now in its longest upcycle in a decade. Given also that bond yields have had their sharpest spike in a decade, we would not bet on the upcycle lasting much longer. Lean against the rise in bond yields and bank equities. Underweight the Eurostoxx600 versus the S&P500. Underweight the IBEX versus the Eurostoxx600. Feature A few days into the New Year, two over-arching economic questions are exercising our minds. Is the relationship between sharply higher bond yields and weaker bank credit creation still valid? And is the relationship between weaker bank credit creation and decelerating economic growth still valid? Chart of the WeekCredit Impulses Heading In Different Directions We suspect the answers are yes and yes. European Investors Must Think Globally, Not Locally Europe is not an investment island. Major European stock market indexes comprise large multinational companies whose sales and profits come from across the world. The upshot is that European stock markets almost always move up and down in tandem with other major world stock markets, such as the S&P500 and Nikkei225 (Chart I-2). Mainstream bond markets might seem to be more parochial, given that they are supposedly under the influence of the local central bank. But investors buy and sell high quality bonds as a global asset class. The upshot is that European bond markets also almost always move up and down in tandem with other major developed bond markets (Chart I-3). Chart I-2Major Equity Markets Move Together Chart I-3Major Bond Markets Move Together Hence, European investors must look first and foremost at global drivers. For us, the most important such driver is the global 6-month credit impulse - which sums the 6-month (dollar) credit impulses in the euro area, the United States and China. Does the global 6-month credit impulse have any predictive power? Yes. Chart I-4 shows that it has consistently led the 6-month cycle in the global government bond yield, which is a good proxy for the global growth cycle. Admittedly, this powerful predictive relationship weakened somewhat through 2013-14 during the most aggressive and distortive phase of worldwide QE. However, in the past couple of years, as QE has waned, the global 6-month credit impulse's predictive power has strongly re-asserted itself (Chart I-5). Chart I-4The Credit Impulse Leads ##br##The Global Growth 'Mini-Cycle' Chart I-5The Credit Impulse's Predictive ##br##Power Has Re-Asserted Itself In effect, the charts illustrate that whatever the structural economic backdrop, the global economy experiences a perpetual 'mini-cycle' lasting about 15-24 months. Higher bond yields (or credit restrictions) weaken the credit impulse; the weaker impulse then depresses growth; the depressed growth lowers bond yields; lower bond yields (or credit easing) strengthen the credit impulse; the stronger impulse then boosts growth; the boosted growth lifts bond yields; and back to the beginning... Remember, the credit impulse measures the growth in the credit flow. The important point to grasp is that the impulse can weaken even if the credit flow numbers themselves seem strong. For example, if the credit flow increased from $100bn to $150bn to $190bn it might appear to be growing very healthily. But actually, the impulse would have weakened from $50bn to $40bn, creating a headwind. Where are we in the perpetual mini-cycle? Today, the euro area credit impulse is losing momentum, while the U.S. impulse is waning. Which leaves China's rising credit impulse as the only component supporting the global credit impulse (Chart of the Week). But for how much longer? To repeat, it would just take the global credit flow to decelerate for the impulse to roll over. Now consider that high-quality bond yields have had their sharpest 6-month spike in a decade. And that the current 10 month upcycle in the global credit impulse already makes it the longest in a decade. Hence, we would not bet on this mini-upcycle lasting much longer. A Few Words On Our Credit Cycle Framework Our credit cycle framework has several features which uniquely define it. First, the framework focusses on bank credit. This is because the magic of fractional reserve banking allows a bank to create money and new spending power out of thin air. When somebody borrows from a bank, his bank account and spending power goes up, but nobody's spending power has to go down. In contrast, when somebody borrows by issuing a bond, it merely reallocates spending power from one person to another person. The borrower sees his bank account and spending power go up, but the lender sees his bank account and spending power go symmetrically down. Spending will rise to the extent that the borrower has a higher propensity to spend than the lender, but this may or may not be the case. Second, as already discussed, the framework focusses on the bank credit impulse - which measures the growth in the bank credit flow. This is just to compare apples with apples. Remember that GDP is itself a flow statistic. So the growth in GDP receives a contribution from the growth in the credit flow1 (and not from the flow itself). Third, the framework focusses on the 6-month bank credit impulse. We choose this periodicity because 6 months is about the time that it takes to for credit to be fully spent, thereby yielding the greatest predictive power from the credit impulse to economic activity. Fourth, the framework calculates the credit cycle using bank credit to the non-financial sector2 rather than the more commonly-quoted money supply statistics such as euro area M3. The simple reason is that not all loans generate economic activity. Bank to bank lending may stay trapped in the financial system. The money supply - which is on the liabilities side of the banks' balance sheet - would not pick up this distinction. As M3 captures all bank deposits, it would still be expanding rapidly, giving the false signal that demand should be growing. Hence, it is better to focus on bank lending - which is on the assets side of the banks' balance sheet - and only count lending that is likely to generate economic activity (Chart I-6). This reasoning only works if the official data on bank loans is accurate and complete. In China, this is unlikely to be the case, given its large shadow banking system. But unofficial shadow lending must eventually show up in the money supply. Therefore, exceptionally for the China sub-component, our credit cycle framework does prefer to use the money supply (Chart I-7). Chart I-6Our Euro Area Credit Impulse##br## Uses Bank Lending... Chart I-7...But Our China Credit Impulse ##br##Uses Money Supply A Few Words On Our Reductionist Framework We are also strong believers in Investment Reductionism. This philosophy stems from two guiding principles: Occam's Razor - which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle - which says that 80% of effects come from just 20% of causes.3 The important point is that most of the moves in most financial markets result from a very small number of over-arching macro drivers. To reiterate, Europe is not an investment island. Investment Reductionism means that much of asset allocation, sector selection, and regional and country allocation distills down to getting the global growth cycle right. The remaining charts should leave readers in no doubt. Chart I-8 shows that the global 6-month credit impulse leads the cyclical direction of the global bond yield, and thereby determines asset class selection. Chart I-9 then shows that the direction of bond yields determines sector selection: for example Banks versus Technology. Chart I-8Investment Reductionism Step 1: The Global##br## Credit Impulse Leads The Bond Yield Cycle Chart I-9Step 2: The Bond Yield ##br##Drives Sector Selection Chart I-10 and Chart I-11 then show that the sector selection of Banks versus Technology determines both the regional allocation of Eurostoxx600 versus S&P500, and the country allocation of IBEX versus Eurostoxx600. Chart I-10Step 3: Sector Selection Drives##br## Regional Allocation Chart I-11Step 4: Sector Selection Drives ##br##Country Allocation To sum up, the global 6-month credit impulse is now in its longest up-cycle in a decade, and bond yields have had their sharpest spike in a decade. Hence, we would not chase cyclicality at this juncture. Which means that on a 6-month horizon: Lean against the rise in bond yields and bank equities. Underweight the Eurostoxx600 versus the S&P500.4 Underweight the IBEX versus the Eurostoxx600. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Equivalently, the credit impulse is the growth in the growth (second derivative) of the credit stock. 2 The non-financial sector includes households, (non-financial) firms and government. 3 Often known as the 80-20 rule. 4 BCA Strategists differ on this position. Fractal Trading Model* This week's trade is to express a tactical short in equities via Italy's MIB. An alternative market-neutral trade is to go short Italy's MIB and symmetrically long Hong Kong's Hang Seng. * 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 For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 Chart I-13 Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II_2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations