Japan

Highlights The world remains mired in a manufacturing recession. As such, it is still too early to put on fresh pro-cyclical trades. Focus on the crosses rather than outright U.S. dollar bets. Two new trade ideas: sell EUR/NOK and buy GBP/JPY. Also consider selling the gold/silver ratio. Feature Currency markets tend to trade into and out of various regimes. This means that to be an effective FX manager, you have to be extremely fluid. For example, interest rate differentials might dominate FX moves during a particular period, pivoting your job to a central bank monitor. Other times, flows dominate, perhaps even equity flows, like when a disruptive technology is developed in a specific market. The outperformance of U.S. equities, specifically technology stocks, is a case in point. Balance-of-payments dynamics usually matter mostly at critical turning points, making them not very useful as timing indicators. The exorbitant privilege of the U.S. dollar we discussed a fortnight ago is also a case in point. But more often than not, being able to identify whether the investment climate is about to become more hostile or not could be the key difference between being a successful FX manager or a relic. There has been no shortage of news for investors to digest over the last few days, from the Brexit imbroglio, to the Fed, to the drone attacks in Saudi Arabia and finally to U.S. President Donald Trump’s possible impeachment. But the most perplexing (and perhaps the most important) has been the German manufacturing flash PMI print for the month of September of 41.4, the lowest in over a decade (Chart I-1). If the country with the “cheapest currency” cannot manage to pull itself out of a manufacturing recession, then the message to the periphery is clearly that they have an impending problem. In short, our contention that the euro was close to a bottom might be offside by a few months, based on the latest manufacturing data release (Chart I-2). Chart I-1A Eurozone Manufacturing Recession Chart I-2The Euro Needs Stronger Growth Which FX Regime? Chart I-3A Recession Will Be Dollar Bullish The performance of the dollar since the 10/2 yield curve inverted is instructive. So far, we are tracking both the 2005 and 1998 roadmaps, meaning the window for cautious optimism on risk assets could still pan out (Chart I-3). Specifically, the dollar tends to rally during recessions but the window before the dollar bull market takes hold can be quite long. In both 2006 and 1998, the dollar eventually catapulted higher, but it took longer than 12 months. Having an accurate recession probability-timing model is therefore crucial for strategy. Historically, domestic flows have been a very timely indicator, since repatriation by residents occurs during episodes of severe capital flight. In 2005, domestic individuals were deploying funds outside the U.S., which suggested patience before positioning for dollar strength. This made sense, since the return on capital was higher outside the U.S. with the EM and commodity bull market in full swing. More often than not, FX markets tend to favor regions with the highest return on capital. These tend to be the most difficult to bet against, but potentially the most potent blindside at turning points. If economic data continues to deteriorate due to much larger endogenous factors, a defensive strategy is clearly warranted. One way to tell will be an emerging divergence between our leading indicators and actual underlying data as is occurring so far in September. On the flip side, any specter of positive news could light a fire under sectors, currencies and countries that have borne the brunt of the slowdown. Both are highly risky bets. For now, we prefer to focus on the crosses rather than outright U.S. dollar bets. Sell EUR/NOK Sometimes, the best ideas are the simplest ones. The Norges bank is the most hawkish G-10 central bank, while the European Central Bank restarted QE at its latest meeting. This is a powerful catalyst for a short EUR/NOK trade: The dollar tends to rally during recessions but the window before the dollar bull market takes hold can be quite long.  The slowdown in the euro zone has been concentrated in the manufacturing sector, but the deflationary impulse is starting to shift to other parts of the economy. Euro area overall core CPI continues to blast downwards, which has historically been a bad omen for the euro (Chart I-4). We expect euro zone inflation expectations to eventually rise, in part helped by the recovery in oil prices (Chart I-5), but this will also benefit the Norwegian krone. EUR/NOK has historically tracked the performance of relative stock prices between Europe and Norway, but a gaping wedge opened up in 2018 (Chart I-6). This divergence is unsustainable. In short, it is a bet on oil fields in Norway versus European banks. The ECB’s tiering of reserves might prevent euro zone banks from teetering over the edge, but unless the manufacturing recession ends soon and firms start to borrow to invest, banks will continue to have a demand problem. Meanwhile, the flareup in the Middle East means that oil prices will remain bid in the near term. This should favor Norwegian equities over those in the euro zone, and be negative for EUR/NOK (Chart I-7). 10-year German bunds are yielding -0.57% while the yield pickup on Norwegian bonds is a positive carry of 1.8%, despite liquidity concerns. In their latest policy meeting, Central Bank Governor Øystein Olsen stressed that Norway had much more fiscal room to maneuver in the event of a downturn, meaning the supply of Norwegian paper could increase, easing the liquidity premium. Chart I-4Deflation Remains Predominant In The Eurozone Chart I-5A Rise In Oil Prices Will Help Inflation Expectations Chart I-6Stocks And Currencies: An Unsustainable Divergence Chart I-7Higher Oil is Negative ##br##For EUR/NOK Bottom Line: Sell EUR/NOK at 9.937. Buy GBP/JPY Last week’s Special Report made the case for a cyclical recovery in the U.K., even though structural factors remain a headwind. This week, we are re-attempting to buy cable versus the yen: Most importantly, the Bank of England stood pat at its latest policy meeting while the Bank of Japan is likely to introduce more stimulus or stronger guidance. Real interest rate differentials favor a stronger pound. Most importantly, the Bank of England stood pat at its latest policy meeting while the Bank of Japan is likely to introduce more stimulus or stronger guidance (Chart I-8). Chart i-8A Tactical Bounce In GBP/JPY Is Likely Chart I-9The Benefit Of A Weaker Pound Speculators are very short the pound while they have been covering their short bets on the yen, as the investment environment has become more uncertain. The fall in the pound should begin to improve the U.K.’s balance-of-payment dynamics relative to Japan (Chart I-9). Bottom Line: Buy GBP/JPY at 132.6. Concluding Thoughts We continue to track various indicators for the dollar, from interest rate differentials, balance-of-payment dynamics, valuations, portfolio flows and positioning – and none of them are sending a bullish signal at the moment. Global growth remains in a funk, which has been supercharging dollar bulls. However, long-dollar bets remain susceptible should global growth stabilize. Our strategy is to continue focusing on the crosses until categorical evidence emerges that global growth has bottomed.  In our trading portfolio, we continue to favor the NOK, SEK, petrocurrencies and the AUD. So far, these trades have been implemented at the crosses to limit downside risk, should our view on the dollar be offside. We intend to eventually start placing outright dollar bets once evidence emerges that global growth has bottomed and the world has skidded a recession.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been relatively strong: The Markit flash manufacturing PMI rebounded to 51 in September from 50.3. Flash services PMI increased to 50.9. The Chicago Fed national activity index increased to 0.1 from -0.4 in August. The Richmond Fed manufacturing index fell to -9 in September from 1. The Conference Board consumer confidence fell to 125.1 in September from 135.1. On the housing front, home prices grew by 0.4% month-on-month in July. Mortgage applications decreased by 10% for the week ended September 20th, but new home sales increased by 7% month-on-month in August. Initial jobless claims increased to 213,000 for the week ended September 20th. Annualized GDP growth was unchanged at 2% quarter-on-quarter in Q2. Trade deficit of goods was little changed at $72.8 billion. Headline and core PCE increased to 2.4% and 1.9% quarter-on-quarter, respectively in Q2. The DXY index appreciated by 0.6% this week. The recent data from the U.S. have been holding up quite well compared with the rest of the world. Net speculative positions on the greenback remain elevated due to U.S. relative strength. While we see dollar resilience in the near term, declining net foreign purchases of U.S. securities, diminishing interest rate differentials and the plunging bond-to-gold ratio all suggest the path of least resistance for the dollar is down. Report Links: Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 USD/CNY And Market Turbulence - August 9, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area continue to deteriorate: The Markit flash manufacturing and services PMIs for the euro area both fell to 45.6 and 52, respectively in September. In France, the Markit flash manufacturing PMI fell to 50.3; services PMI decreased to 51.6. In Germany, the manufacturing PMI collapsed to 41.4; services PMI fell to 52.5. German IFO current assessment increased to 98.5 in September. However, the IFO expectations fell to 90.8. Monetary supply (M3) grew by 5.7% year-on-year in August. German Gfk consumer confidence nudged up to 9.9 in October. The EUR/USD fell by 0.8% this week. The recent data from the euro area has unfortunately showed no signs of global growth bottoming. The manufacturing PMI in Germany is now at its lowest level since the Great Financial Crisis. A major concern faced by investors is that weak activity in manufacturing may have already begun to infiltrate the service sectors. That said, the services PMIs in major economies, though falling, still remain in expansionary territory above 50. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japense Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: National headline inflation fell from 0.5% year-on-year to 0.3% year-on-year in August. Core inflation was unchanged at 0.6% year-on-year. The Markit flash manufacturing PMI fell to 48.9 in September from 49.3. Services PMI also fell to 52.8 from 53.3. The leading index and coincident index were both little changed at 93.7 and 99.7, respectively, in July.  The USD/JPY has been flat this week. Japanese exports have been weak, weighed by the global trade war and manufacturing slowdown. However, accordingly to the BoJ, domestic demand has remained firm, and capex also continues to increase. Moreover, the consumption tax hike next month will probably have a marginal impact compared with previous tax hikes. In a speech this week, BoJ Governor Haruhiko Kuroda emphasized that the central bank will ease without hesitation if the economy loses momentum. Report Links: Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Battle Of The Central Banks - June 21, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 There is little data from the U.K. this week: Mortgage approvals decreased slightly to 42,576 in August from 43,303 in July. The GBP/USD fell by 1.4% this week. British Prime Minister Boris Johnson has now lost his majority in Westminster after large profile defections from the so-called rebels, thus another election is highly likely by year-end. Besides, a further delay of Brexit is almost certain. We have downgraded the probability for a no-deal Brexit. We remain positive on the pound and are buying GBP/JPY this week. Report Links: United Kingdon: Cyclical Slowdown Or Structural Malaise? - September 20, 2019 Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: The preliminary commonwealth manufacturing PMI fell to 49.4 in September from 50.9 in August. On the other hand, the services PMI rebounded to 52.5 from 49.1, back to above-50 expansionary territory. Consumer confidence increased to 110.1 from 109.3 this week. The AUD/USD fell by 1% this week. Reserve Bank of Australia Governor Philip Lowe commented on Tuesday that the Australian economy is picking up, and is now at a “gentle turning point.” The previous rate cuts have allowed the property markets in big cities like Sydney and Melbourne to regain some strength, but will likely take longer to flow through the whole economy. In terms of monetary policy, Governor Lowe reiterated his commitment to ease monetary conditions when needed, though he did not signal an imminent move for next week. Australia has a large beta to global shifts as a small, open economy. Should the global manufacturing recession come to an end, the positive fundamentals will continue to lift the Australian economy through the rest of the year and into 2020. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Imports increased by NZ$30 million to NZ$5.69 billion in August, while exports fell by NZ$830 million to NZ$4.13 billion. The total trade deficit widened from NZ$700 million to NZ$1.57 billion. The NZD/USD appreciated by 1% initially, then plunged after the Reserve Bank of New Zealand’s policy meeting, returning flat this week. As widely expected, the RBNZ kept its official cash rate unchanged at 1% this Wednesday while signaling that there is more scope to ease if necessary amid a global slowdown. The market is currently pricing an 80% probability of a rate cut for the next policy meeting in November, reflecting weak business confidence. We are playing the kiwi weakness through the Australian dollar and Swedish krona, which are 1.9% and 1.95% in the money, respectively. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been resilient: Bloomberg Nanos confidence increased to 57.4 this week from 56.7. Retail sales increased by 0.4% month-on-month in July, lower than the expectations of a 0.6% monthly growth. The USD/CAD has been flat this week. Oil prices have been on a wild ride this year. Since the drone attack a fortnight ago, Saudi Arabia has claimed that it is recovering faster than expected, beating its own targets. Brent crude oil spot prices have fallen by 6% from their September 16th peak, while Western Canada Select (WCS) oil prices have dropped by 12.3%, dampening the loonie’s upside potential. Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mostly negative: The trade balance narrowed to CHF 1.2 billion in August from CHF 2.6 billion in July.  Credit Suisse survey expectations came in at -15.4 in September, up from the last reading of -37.5 in August. The USD/CHF has been flat this week. As a small, open economy, Switzerland belongs to those countries with highest foreign trade-to-GDP share. The trade balance in August has been the lowest since January 2018, with lower exports of main goods including chemical and pharmaceutical products. Among trading  partners, exports to Germany, Italy, and France all declined, reflecting the recent manufacturing slowdown in Europe. That said, we remain positive on the safe-haven Swiss franc during the risk-off period amid trade war uncertainties, Brexit chaos, Middle-East tensions, and more recently, the Trump Impeachment imbroglio. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There is scant data from Norway this week: The unemployment rate increased to 3.8% in July, 0.6 percentage points higher than in April, accordingly to the recent Labour Force Survey. The USD/NOK appreciated by 0.5% this week. The Norges Bank, the one and only hawkish central bank among the G-10, raised its interest rate by 25 basis points to 1.5% last week. Since last September, the Norges Bank has hiked rates four times in total, resulting in a one-percentage-point increase in rates. The central bank stated that “the Norwegian economy has been solid; Employment has risen; Capacity utilization appears to be somewhat above a normal level; Inflation is close to target.” A higher interest rate would also help take the wind out of skyrocketing house prices and household debt levels. In addition, the central bank lowered its projection path for the krone, stating that the factors it outlined, including weaker activity in the petroleum sector, would probably keep weighing on the krone in the years ahead. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: Consumer confidence fell to 90.6 in September. PPI yearly growth fell from 2% in July to 1.4% in August. Trade balance shifted to a deficit of SEK 5.4 billion in August. USD/SEK has been flat this week. We are closely monitoring the Swedish foreign trade as a leading indicator for global growth. The Swedish trade balance has shifted to a deficit for the first time this year. However, compared to last August, the deficit was narrowed by SEK 2.6 billion. Year to date, the Swedish trade surplus amounted to SEK 27 billion. Notably, the trade in goods with non-EU countries resulted in a surplus of SEK 6.6 billion, while the trade with EU resulted in a deficit of SEK 12 billion. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The structural message for equities: prefer equities over bonds. As long as the global 10-year bond yield remains below 2 percent, the equity market’s rich valuation is underpinned, albeit the long-term return from equities is likely to be a feeble low single-digit. The structural message for bonds: overweight the higher yielding versus the lower yielding quality sovereigns, most notably overweight U.S. T-bonds versus German bunds. 10-year yields cannot rise much – maybe only 50-100 basis points – before the rise destabilises equity and other risk-asset valuations. But 10-year yields that are deeply in negative territory can fall even less. The structural message for currencies: tilt towards lower yielding currencies, with a preference for the yen. Once monetary policy is already ultra-accommodative, a central bank’s ability to devalue its currency becomes more and more constrained. Feature Japanification: Bring It On! I have always been bemused and perplexed by people using ‘Japanification’ as a pejorative for the European economy (Chart of the Week). In the west, the received wisdom is that Japan is a ‘basket case’, a fate to be avoided at all costs. Yet nothing could be further from the truth: Japan is, in many ways, an economic role model to which Europe and the rest of the western world should aspire. Chart of the WeekEmbrace 'Japanification' Over the past twenty years, Japan’s productivity growth has outperformed all the other major economies (Chart I-2). To be clear, this is based on real GDP per head of working age (15-64) population, the cohort of people who generate economic output. Still, some people counter that this definition flatters Japan’s productivity growth by omitting the significant number of over 65s who work, and that a fairer definition should divide by the total population. Yet even on this alternative definition, Japan has been doing just fine, performing better than France and broadly in line with Canada (Chart I-3). Chart I-2Japan Is Not A 'Basket Case' Chart I-3Japan Is Doing Just Fine Japan’s real output per head has improved while consumers have enjoyed genuine price stability (Chart I-4). Meaning zero inflation, and not the ‘fake price stability’ of 2 percent inflation that central banks are trying – and failing – to reach. ‘Japanification’ is a state that Europe should not eschew; it is a state that Europe should espouse. Moreover, contrary to what the Philips Curve would have you believe, the absence of inflation does not mean there is a reserve army of the unemployed. Japan’s unemployment rate, at 2.2 percent, is one of the lowest in the world. As is income inequality (Chart I-5). While life expectancy is one of the highest in the world. Chart I-4Japan Has Enjoyed Genuine ##br##Price Stability... Chart I-5...And The Absence Of Extreme Income Inequality This combination of rising productivity, genuine price stability, absence of extreme income inequality, and rising life expectancy means that, in Japan, living standards have been rising for the many, and not just for the few. In turn this has meant that while populist backlashes have erupted elsewhere in the world, Japan has remained a paragon of political stability. In all of these important regards, ‘Japanification’ is a state that Europe should not eschew; it is a state that Europe should espouse. Countering The Counterarguments Nevertheless, in the interests of a balanced debate, we must address the main counterarguments: First, isn’t Japan’s declining population evidence of a national malaise? No. Japan lacks living space. Its mountainous islands are habitable on only tiny slivers along the coasts, and these are among the most densely populated regions in the world. Therefore, as the journalist and Japan specialist Eamonn Fingleton explains, Japan’s low birth rate is a fundamental national policy that can be traced back to the late 1940s. Japan lacks living space. Shorn of empire, Japan faced a major food security problem. At a stroke, Japanese officials stopped dead in its track a huge baby boom which took hold between 1946 and 1948. Ever afterwards Japan has enjoyed – yes, that is the appropriate word – a low birth rate. Although the program’s rationale is not recognized in the West, it is fully understood in the East and both Singapore and China went on to formulate similar policies. Chart I-6Japan's Rising Public Indebtedness Counterbalanced A Plunge In Private Indebtedness Clearly, a nation whose working population is shrinking will produce less than it otherwise might have, but this doesn’t mean the economy is a basket case. Far from it. On a per head basis, as we have shown, Japan is doing just fine, and the imbalance between workers and retirees will gradually work out as people adjust their retirement ages (just as they will have to in the west). A second counterargument is that Japan’s government indebtedness has skyrocketed to over 200 percent of GDP, the highest among any major economy. But this increase in public debt was needed as a crucial counterbalance to a sharp decline in private indebtedness, and thereby prevent a deep slump (Chart I-6). Japan’s total indebtedness has remained broadly flat for decades. Third, the Nikkei 225, at 21,500 today, is barely at half of its 39,000 peak value in 1989. The simple explanation is that the main determinant of any long-term return is the starting valuation. The 1989 peak bubble valuation was so extreme – a price to sales of 2.2 compared to 0.75 today – that the subsequent dire returns were baked in the cake (Chart I-7). Chart I-7Japan's Bubble Was So Extreme That Subsequent Dire Returns Were Inevitable Fourth, Japanese bond yields have been near-zero or negative for almost two decades, which some commentators claim is a classic sign of an economy in ‘secular stagnation’. But as we have shown, these ultra-low yields have coexisted with a Japanese economy that is doing just fine. More recently, the residents of Switzerland and Sweden will vouch for the same thing – that negative bond yields categorically do not mean that their economies are ‘basket cases’. But have these economies progressed only because they have these ultra-low bond yields? No, the charts in this report show no (inverse) relationship between bond yields and long-term productivity growth. Which begs the question: if ultra-low bond yields are not a sign of an economy stuck in a funk, what are they a sign of? The Real Reason For Ultra-Low Bond Yields Chart I-8Inflation Is Stuck Well Short Of The 2 Percent Target Today, like a stuck record, the ECB will repeat again that inflation remains well short of its 2 percent target (Chart I-8), but that its resolve to reach the target is unwavering. Just as it was at the last meeting… last year… the year before that… and five years before that! Instead of loosening even further, the ECB should be explaining why, in spite of years of negative interest rates and trillions of euros of QE, inflation expectations have barely budged. As the ECB will not provide the explanation, we will. The public’s expected inflation – a fundamental input into economists’ models during the past half-century – is not well defined when an economy has reached price stability, as it has now. Chart I-9Unemployment Rates Are At Multi-Decade Lows Confirming what this publication has previously argued, Professor Jeffrey Frankel of Harvard University explains “most people pay little attention to the inflation rate when price growth is as low as it has been in recent years.” As a result, argues a paper from the NBER, large policy change announcements in the U.S., the U.K., and the euro area seem to have only limited effects on the inflation expectations of households and firms.1 However, as most economists and central banks fear that their credibility is at stake, they remain fixated on the need to reach the 2 percent inflation target. This requires them to double down, triple down, and then quadruple down on extreme accommodation, even though prices are stable, the economy is progressing, and unemployment rates have declined to multi-decade lows (Chart I-9). So in answer to our previous question, ultra-low bond yields are not a sign of an economy stuck in a funk; they are a sign of central banks that are chasing the wrong inflation target, and that are too scared to change the target for the damage it would do to their credibility. What Does This Mean For Stocks, Bonds, And Currencies?   Ultra-low bond yields are coexisting with economies that are doing fine, as we have seen in Japan, Switzerland, and Sweden. But at such low yields, the unattractive asymmetry of limited bond price upside with unlimited downside justifies exponentially higher valuations for equities and other risk-assets. Chart I-1010-Year Bond Yields Can Rise By Only 50-100 Basis Points So the structural message for equities is: as long as the global 10-year bond yield remains below 2 percent, the equity market’s rich valuation is underpinned. And on anything other than a trading horizon, equities are to be preferred over bonds – albeit the long-term return from equities is likely to be a feeble low single-digit. The structural message for bonds is: 10-year yields cannot rise much – maybe only 50-100 basis points – before the rise destabilises equity and other risk-asset valuations, thereby acting as a limiter (Chart I-10). But given that there is a lower bound to policy interest rates, 10-year yields that are deeply in negative territory can fall even less. Hence, the risk-reward dynamic suggests going overweight the higher yielding versus the lower yielding quality sovereigns: most notably, overweight U.S. T-bonds versus German bunds. On a structural horizon, prefer equities over bonds. The structural message for currencies is essentially the opposite to that for bonds: tilt towards lower yielding currencies because in a ‘race to the bottom’, a central bank’s ability to devalue its currency becomes more and more constrained. But which low yielding currency? As Japan has already undergone its ‘Japanification’, we like the yen. Fractal Trading System* With geopolitical risks having ebbed somewhat, a good tactical trade would be to lean against the technically overbought conditions in high-quality government bonds. Hence, this week’s recommended trade is to short the U.S. 10-year T-bond setting a profit target of 1.5 percent with a symmetrical stop-loss. In yield terms, this broadly equates to a target yield of 1.9% and stop-loss at 1.5%. Chart I-11U.S. 10-year T-Bond Price For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Footnotes 1 Please see http://conference.nber.org/conf_papers/f117592.pdf and the European Investment Strategy Special Report ‘The Case Against Secular Stagnation’ August 29, 2019 available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Content Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

Special Report

Feature Feature ChartNo 'Secular Stagnation' In Japan! Bond yields have plummeted to all-time lows and inflation has continued to undershoot the 2 percent target which central bankers tell us is ‘price stability’. This configuration has led to renewed fears that the European and global economies are entering a so-called ‘secular stagnation’. We strongly disagree with this line of thinking. Near-zero bond yields and inflation are categorically not portents of a long-term drought in economic progress. Quite the opposite. Chart I-2Japan Has Experienced Near-Zero Inflation For Decades Japan has experienced near-zero bond yields and inflation for decades (Chart I-2). Yet since the late 1990s, the growth in Japan’s real GDP per head has outperformed every other major economy1 (Feature Chart). Granted, the Japanese government has been running persistent deficits, but this is to counterbalance private sector de-levering. Total indebtedness as a share of GDP has not been rising. In the post credit boom era, Japan’s economic progress has come entirely from productivity improvements. The ability to learn, experiment, and innovate boosts the quality and/or quantity of output from a fixed set of inputs. Unlike the unsustainable growth that is fuelled by credit booms and asset bubbles, real growth that comes from productivity improvements marks genuine and sustainable economic progress. In Europe, Switzerland tells a similar tale. Swiss bond yields and inflation have been near zero for decades, but they have not defined a secular stagnation. Real GDP per head and living standards have steadily advanced, even from an already high base. In the post credit boom era, Japan’s economic progress has come entirely from productivity improvements.  But the best counterexample comes from economic history. At the height of the British Empire in 1914, British consumer prices were little different to where they stood at the end of the English Civil War in 1651 – meaning that Britain experienced near-zero inflation and low bond yields for almost three centuries (Chart I-3). Did these define a secular stagnation? No, quite the opposite. For Britain, this was a golden epoch in which it emerged as the world’s preeminent economy. Chart I-3Britain Experienced Near-Zero Inflation For Centuries The Real Reason For Near-Zero Inflation And Bond Yields The fear-mongering about a secular stagnation misses the real reason for today’s sub-2 percent inflation and record low bond yields. Central banks have wrongly defined price stability. Central banks have wrongly defined price stability because they think of it in terms of the economics and mathematics in which they have expertise. Their models tell them that they can nail inflation to one decimal place – two point zero. But price stability has as much to do with biology and psychology. Biologists will tell you that the human brain cannot distinguish inflation rates between -1 and 2 percent, a range we indistinguishably perceive as ‘price stability’. If biology teaches us that we cannot distinguish between -1 and 2 percent inflation, then central banks have a huge problem. It is impossible for a central bank to change our inflation expectations within that range, because the entire range just feels the same to us. Therefore, our behaviour in terms of wage demands and willingness to borrow will also stay unchanged. And if our economic behaviour is unchanged, what is the transmission mechanism to fine tune inflation within the -1 to 2 percent range? Central banks have wrongly defined price stability.  Therefore, price stability is actually like a ‘quantum state’. You’re in the state or you’re out of the state, but once you’re in the state you cannot then fine tune inflation to an arbitrary number like two point zero. In fact, average inflation over, say, five years will gravitate to the mid-point of the price stability state, 0.5 percent, which is a long way below the central bank’s arbitrary target of 2 percent (Chart I-4). This forces the central bank into drastic and prolonged monetary policy easing – which depresses bond yields (Chart I-5). Chart I-4Central Banks Have Wrongly Defined Price Stability... Chart I-5...Forcing Them To Depress Bond Yields Monetary Policies Will Ultimately Converge As structural credit booms have sequentially ended, economies have one by one entered the state of price stability. First it was Japan; then it was Switzerland; more recently it has been the euro area and the United States. It follows that the 5-year annualised inflation rates have also sequentially tumbled to the mid-point of the price stability state, around 0.5 percent. By which point, inflation is so far below the misplaced 2 percent target, that the central bank’s drastic and prolonged monetary policy easing has depressed the 5-year bond yield to near zero. Japan reached this point in the late 1990s, Switzerland in the early 2010s, and the euro area in the late 2010s. Begging the question: why has the 5-year inflation rate in the U.S. not tumbled towards 0.5 percent too?  The answer is that actually, it has. On a like-for-like basis, 5-year inflation rates are way below the 2 percent target in all the major jurisdictions. You see, the Americans measure inflation differently to the Europeans. In the U.S., the consumer price basket includes owner-occupied housing costs at a substantial weighting, while in Europe it is completely excluded. Using the same definition of inflation as in Europe, the U.S. 5-year inflation rate is not at 1.5 percent, it is at a feeble 0.6 percent (Chart I-6). Chart I-6On a Like-For-Like Basis, U.S. 5-Year Inflation Is A Feeble 0.6 Percent Crucially, on a like-for-like basis, 5-year inflation rates are way below the 2 percent target in all the major jurisdictions: the U.S., euro area, and Japan. This leads us to believe that the current chasm in monetary policies is unsustainable. Even including owner-occupied housing in the consumer price basket, as the U.S. does, the long run boost to annual inflation is only about 0.2 percent (Chart I-7). Meaning that it is only a matter of time before U.S. structural inflation and bond yields converge with those in the euro area. Chart I-7Owner-Occupied Housing Boosts Inflation, But In The Long Run By Only 0.2 Percent In the meantime, the chasm between monetary policies has become a major geopolitical risk. This is because it has depressed the euro versus the dollar by at least 10 percent – based on the ECB’s own competitiveness indicators. The exchange rate distortion stemming from polarised monetary policies is the culprit for the euro area’s huge trade surplus with the United States (Chart I-8). On this point, President Trump is spot on to complain that the Fed’s policy stance relative to other central banks is severely handicapping U.S. manufacturers. As the president tries to counter this handicap with tariffs, real or threatened, the Fed is being forced to lean against the risks to growth and inflation. Chart I-8Blame Polarised Monetary Policies For The Euro Area’s Huge Trade Surplus With The U.S. What Does All Of This Mean? One way or another, the dollar will come under structural pressure in the coming years as the current chasm in monetary policies proves to be unjustified. However, in the near term, we prefer to express this not via the euro, but via the yen. The corollary is that U.S bond yields will eventually converge with their European counterparts. But to reiterate, a world with near-zero inflation is categorically not a portent of secular stagnation. It is just the true state of price stability as the human brain perceives it, rather than the over-precise two point zero that central banks have arbitrarily picked. In turn, ultra-low bond yields stem from the monetary policy response to this massive undershoot of true price stability from central bank defined price stability.   All of this raises a fascinating question: if bond yields are lower than is truly required, why hasn’t it created a new inflation? The answer is that it has, but the new inflation is not in the real economy. The reason is that the world has just been through a structural credit boom, remains heavily indebted, and is still unwinding some of the credit excesses. In this world, as Japan has illustrated in recent decades, productivity growth must drive economic progress. Instead, the new inflation is in equity and other risk-asset prices. At ultra-low bond yields the prospect of bond capital gains diminishes versus potential losses, making bonds as risky as equities. This removes the need for an excess return on equities and other risk-assets versus bonds, meaning that the valuation of risk-assets inflates exponentially (Chart I-9). So long as bond yields remain depressed, this new inflation in risk-asset valuations is well justified and supported.2  But be very careful if the global 10-year bond yield rises above 2 percent.3   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Based on real GDP per working age (15-64) population, but also broadly true for real GDP per total population. 2 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance”, October 25 2018, available at eis.bcaresearch.com. 3 The global 10-year bond yield is the simple average of 10-year government bond yields in the U.S., euro area (or France as a proxy), and China.

Special Report

Dear Client, Please note that there will be no regular Weekly Report next week, as we take a summer break. Our regular publication will resume September 6th. Best regards, Chester Ntonifor, Vice President Foreign Exchange Strategy Highlights Our PPP models show the DXY index to be overvalued by 10-15%. Within the G10 universe, the cheapest currencies are the Swedish krona, the British pound, the Japanese yen and the Norwegian krone. Look to go short CHF/GBP on valuation grounds. Feature Regular readers of our publication will notice that we tend to adhere to very simple and time-tested ideas. One such is the concept of purchasing power parity (PPP). The beauty comes from its simplicity. If the price of a good in Sweden is rising faster than in South Africa, then the krona should depreciate versus the rand to equalize prices across both borders. Otherwise, the krona becomes incrementally expensive, relative to the rand. In practice, various models have shown PPP to be a very poor tool for managing currencies. One roadblock comes from measurement issues, since consumer price baskets tend to differ in composition from one country to the next. Second, there is less price discovery for services, than there is for tradable goods. For example, it is rather difficult to import a haircut from Mumbai into the U.S., and so arbitraging those prices away tends to be impractical. Tariffs, trade restrictions and transport costs also tend to dampen the explanatory power of PPP models, though those have had diminishing importance over time. In order to get closer to an apples-to-apples comparison across countries, we make two adjustments. First, we divide the consumer price index (CPI) baskets into five major groups. In most cases, this breakdown captures 90% of the national CPI basket: Food, restaurants and hotels Shelter Health, culture and recreation Energy and transportation Household goods The second adjustment is to run two regressions with the exchange rate as the dependent variable. The first regression (call it REG1) uses the relative price ratios of the five groups as independent variables. This allows us to observe the most influential price ratios that help explain variations in the exchange rate. The second regression (call it REG2) uses a weighted average combination of the five groups to form a synthetic relative price ratio. If for example, shelter is 33% in the U.S. CPI basket, but 19% in the Swedish CPI basket, relative shelter prices will represent 26% of the combined price ratio. This allows for a uniform cross-sectional comparison, compared to using the national CPI weights. The results were largely consistent: Both regressions were statistically significant, but more so for REG1. This makes intuitive sense, as the number of variables were higher in the first regression. The sign for household goods was negative for some countries. This could be due to some specter of multicollinearity, if the tradable goods price effect is captured in other categories. There is also the low value-to-weight ratio for many household goods such as refrigerators or air conditioners, which could make currency deviations from PPP persistent. The shelter sign was also negative for some countries, meaning rising shelter prices tended to be associated with an incrementally cheaper currency. This could be due to the Balassa-Samuelson effect. Rising incomes (one key determinant of rising house prices) usually reflect rising productivity levels, which tend to lift the fair value of the exchange rate. The results showed the U.S. dollar as overvalued, especially versus the Swedish krona, British pound and Norwegian krone. Commodity currencies were closer to fair value, and within the safe haven complex, the Japanese yen was more attractive than the Swiss franc. The euro was less undervalued than implied by the overvaluation in the DXY index. As a final note, PPP models are just an additional kit to our currency toolbox, and so should never be used in isolation, but in conjunction with other currency signals. This is just a first iteration in our PPP modelling work, which we intend to improve in the months to come. U.S. Dollar We reverse-engineered the fair value for the DXY index by aggregating the model results from its six constituents. This includes the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona, and the Swiss franc, using the corresponding DXY weights. The message from the synthetic model is clear: the U.S dollar is above its fair value, in line with our fundamental view (Chart 1). Chart 1The Dollar is Slightly Expensive Americans spent 35% of their income in 2018 on goods and 65% on services. Shelter remains the single largest consumption item for American households, which makes up 33% of the consumption basket. However, the relative importance of shelter is dwarfed by much more rampant rent and house price increases in other developed countries. Medical care accounts for 8.7% of the CPI basket, and is the highest in the developed world on a per capita basis. Total spending on health care accounts for almost 20% of nominal GDP. Since the 1980s, the CPI for medical care has risen fivefold, far outpacing many developed countries. This makes the dollar incrementally expensive.  Core CPI edged higher to 2.2% in July, driven by medical care and shelter. While above the Federal Reserve’s 2% target, the risks to inflation remain asymmetric to the downside. That will keep the Fed on a dovish path near-term, which should help close overvaluation in the dollar. Euro We had limited data for the euro area, and so our regression results were less robust. REG1 shows the euro as cheap, while REG2 is more ambiguous (Chart 2). In short, a PPP model for the euro had one of lowest explanatory powers within the G10 universe. Food, restaurants and hotels are the largest consumption item in the euro CPI basket. Looking at the details, food and non-alcoholic beverages account for 14%, alcohol and tobacco make up 4%, and restaurant and hotels account for about 10% (Table). Relative price trends have moved to undermine the fair value of the euro. Chart 2The Euro Is Slightly Cheap Euro Area CPI Weights Shelter’s weight in the euro area CPI basket currently stands at 16.7%, the smallest among G10 countries. Since 2012, relative house and rent prices in the euro area have been decreasing compared with that in the U.S. Rampant rent controls, especially in places like Germany have subdued housing CPI, and tempered the fair value of the euro. This makes sense to the extent that it represents a concomitant rise in the welfare state. It is well-known that the euro area is relatively open and so tradable goods prices are important for the fair value of the euro. Given that the epicenter of trade tensions is between the U.S. and China, this will act to boost the relative attractiveness of European goods, which will be a bullish underpinning for the euro. Inflation expectations have collapsed in the euro area. However, compared to the Federal Reserve, there is little the European Central Bank can do to boost inflation. This is relatively euro bullish. Once global growth eventually picks up, improved competitiveness in the periphery will allow for non-inflationary growth. Japanese Yen The yen benefits from being cheap, as well as being a safe-haven currency (Chart 3). The overarching theme for Japan is a falling (and rapidly aging) population, which means that deficient demand and falling prices are the norm. This makes the yen relatively attractive on a recurring basis. Most of the Heisei era in Japan has been characterized by deflation. Importantly, all categories in Japan have been in a relative price downtrend during this period (Table). Domestically, an aging population (that tends to be a large voting base), prefer falling prices. Meanwhile, the bursting of the asset bubble in the late 80s/early 90s led to a powerful deleveraging wave that undermined prices. Chart 3The Yen Is Quite Cheap Japan CPI Weights The relative prices for most items have been decreasing, but culture and recreation inflation have experienced a meaningful rebound since 2013, largely due to a booming tourism industry in Japan.1 According to tourism statistics, the number of international visitors to Japan reached 31 million in 2018, almost five times the number ten years ago. But as long as the younger generation in Japan continues to save more and consume less, prices will remain under pressure. BoJ Governor Haruhiko Kuroda remains committed to achieving a 2% inflation target, but inflation expectations are falling to historical lows at a time when the BoJ is running out of policy bullets.2  That means inflation will likely lag that of other developed countries, lifting the fair value of the yen. British Pound Both regressions show the pound as undervalued. This supports our view that over the long term, the pound is a categorical buy (Chart 4). The consumption baskets in both the U.K. and the U.S. are roughly similar, which means traditional PPP models do a good job at capturing the true underlying picture of price differentials (Table). For example, OECD PPP models, based on national expenditure, show the pound as 15% undervalued. Chart 4The Pound Is Cheap U.K. CPI Weights Housing is the largest item in the consumption basket, with a total weight close to 30% (including housing electricity and water supply). The shelter consumer price index in the U.K. started to fall relative to the U.S. in 2016, which has lowered the fair-value of the pound (in the Balassa-Samuelson framework). That said, the fall in the pound has been much more deep and violent than suggested by domestic price fundamentals. For example, food restaurants and hotels are 10% cheaper in the U.K. compared to the U.S. over the last half decade. However, rather than appreciating 10%, the pound has plummeted by about 30%. Brexit will continue to dictate the ebb and flow of sterling gyrations, but the reality is that the pound should be higher on a fundamental basis. Meanwhile, a pick up in the global economy will benefit the pound. Going short CHF/GBP on valuation grounds is an attractive bet today. Australian Dollar As a commodity currency, PPP models are less useful for the Australian dollar than terms of trade, or even interest rate differentials. That said, the Aussie dollar is still relatively cheap versus the USD on a PPP basis (Chart 5). The key driver for value in the AUD has been a drop in the currency, relative to what price differentials will dictate. Food, restaurants and hotels comprise 23% of the Australian CPI basket, with the alcohol and tobacco category alone making up 7.4% (Table). Given food price differentials have been stable versus the U.S. in over a decade, Aussie citizens have not been particularly worse off. Chart 5The Aussie Is Slightly Cheap Australia CPI Weights Shelter accounts for almost a quarter percent of the basket. Relative shelter prices in Australia have been rising since the late 1990s, but started to soften in the past few years, on the back of macro prudential measures. Meanwhile, holiday travel and accommodation have a total weight of 6%, of which domestic travel makes up 2.9%, and international travel 3.1%. The overall cost of tourism in Australia has been falling relative to the U.S., boosting the fair value of the Aussie. In the 1980s, inflation in Australia averaged around 8.3% year-on-year. This made the Aussie incrementally expensive, creating grounds for a subsequent 50% devaluation from 1980 to 1986. Inflation targeting was finally introduced and has realigned Aussie prices with the rest of the world. Our bias is that the Aussie will be less driven by price differentials going forward, but more by RBA policy and terms of trade. New Zealand Dollar The New Zealand dollar is at fair value according to both models (Chart 6).  Like the aussie, the kiwi is less driven by price differentials and more by terms of trade. Food and shelter account for the largest share of the consumption basket, and relative prices have not been moving in favor of the kiwi (Table). So, while the kiwi was overvalued earlier this decade, the overvaluation gap has been mostly closed via a higher dollar. Chart 6The Kiwi Is At Fair Value New Zealand CPI Weights Relative shelter prices in New Zealand have been soaring in recent decades compared to the U.S. Higher immigration, foreign purchases and a commodity boom helped. However, in August 2018, the ban on foreign property purchases came into effect, which helped cool down the housing market. Like in Australia, the inflation rate in New Zealand reached 18% year-on-year in the early 1980s, and was subsequently addressed via inflation targeting. This has realigned New Zealand prices somewhat with the rest of the world. Our bias is that going forward, the kiwi will underperform the aussie, mainly because of a negative terms of trade shock. Canadian Dollar The loonie is currently trading below its fair value, according to both of our models (Chart 7).  Shelter remains the largest budget item for Canadian households (Table). The average Canadian household spent C$18,637 on shelter per year, around 29.2% of the total consumption in 2017.3 Interestingly, the shelter consumer price index does not fully capture skyrocketing house prices in Canada over the last decade. Since 2005, Canadian house prices relative to U.S. have doubled, according to OECD. On the contrary, the relative shelter CPI has trended downwards. These crosscurrents have dampened the explanatory power of the exchange rate. Chart 7The Loonie Is Slightly Cheap Canada CPI Weights Canadians are avid users of private transportation. The average spending on transportation accounted for 20% of total consumption, the second-largest expenditure item. Relative prices in this category have been rising, which has lowered the fair value of the exchange rate. Canada stands as the sixth largest energy producer in the world, but due to heavy taxation, Canadian consumers are paying more for gas prices than their U.S. neighbors. That said, terms of trade have been more important than PPP concerns for the loonie. In the near term, we believe energy prices (and the Western Canadian Select price spread) will continue to be important for the loonie. Swiss Franc USD/CHF is trading slightly below fair value, despite structural appreciation in the franc in recent years (Chart 8). The largest consumption item in Switzerland is the food, restaurants and hotels category (Table). The second item is shelter. Social services have a higher weight in the CPI basket, compared to other developed nations. This has been a huge driver of relative prices between Switzerland and the rest of the world, with falling relative prices boosting the fair value of the franc. Chart 8The Swiss Franc Is At Fair Value Switzerland CPI Weights Healthcare notably accounts for 15.5% in the total CPI basket, of which patient services makes up 11.5%. The Swiss healthcare system is a combination of public, subsidized private, and entirely private systems. It is mandatory for a Swiss resident to purchase basic health insurance, which covers a range of treatments. The insured person then pays the insurance premium plus part of the treatment costs. Finally, as a small open economy, tradable goods prices are important for Switzerland. Given high levels of specialization, terms-of-trade in Switzerland are soaring to record highs. This makes the franc a core holding in a currency portfolio. Norwegian Krone The Norwegian krone is undervalued according to both models (Chart 9). Food and shelter account for the largest share of the Norwegian CPI basket (Table). While the share of shelter is lower than in the U.S., other categories share similar weights, allowing traditional PPP models to be adequate for USD/NOK. One difference is that in terms of social services, only 0.2% of the expenditures are allocated to education, since all schools are free in Norway, including universities. Chart 9The Norwegian Krone Is Cheap Norway CPI Weights As a large energy producer, Norwegians pay less for electricity, gas, and other fuels. Norway is also a heavy producer of renewable energy, notably hydropower. This makes the domestic energy basket less susceptible to the ebbs and flows of energy prices. Going forward, the path of energy prices will continue to dictate ebbs and flows in the krone. Meanwhile, long NOK positions also benefit from an attractive valuation starting point.  Swedish Krona The krona is the cheapest currency in our universe by a wide margin (Chart 10). This stems less from fluctuations in relative prices and more from negative rates that have hammered the exchange rate. Like many countries, food and shelter is the largest component of the consumption basket (Table). Transportation is also important. However, an important driver for undervaluation in the currency has been a drop in the relative price of social services. Chart 10The Swedish Krona Is Very Cheap Sweden CPI Weights Sweden experienced very high inflation rates in the 1980s, and since then, has been in a disinflationary regime. More recently, the inflation rate has edged down below the Riksbank’s target, mostly dragged down by recreation, culture, and healthcare. This makes Swedish real rates relatively attractive. We remain positive on the Swedish krona and believe that it will be one of the first to benefit, should global growth pick up.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com   Kelly Zhong, Research Analyst kellyz@bcaresearch.com Footnotes 1 We removed the shelter component in regression 1, since it was distorting results. 2 Please see Foreign Exchange Strategy Weekly Report, titled “Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much”, dated May 31, 2019, available at fes.bcaresearch.com 3 Please see “Survey of Household Spending, 2017,” Statistic Canada, December 12, 2018. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades