Canada
Highlights It has not been a lot of fun being a corporate bond investor in 2018. Global credit markets have struggled to deliver positive returns, amid a news flow that has been overwhelming at times. Geopolitical uncertainty, shifting monetary policy biases, greater inflation pressures, intensifying trade tensions, a rising U.S. dollar, slowing Chinese growth - all have combined to form a backdrop where investors should require wider risk premiums to own risky assets like corporate debt. Yet are wider spreads justified relative to the underlying financial health of companies? Feature Chart 1Global Corporates: Fading Support From##BR##Growth & Monetary Policy Against this backdrop of more uncertainty in credit markets, we are presenting our latest update of the BCA Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 16. The broad conclusion from the latest readings on our CHMs is that global credit quality has been enjoying a cyclical improvement across countries, regions and credit tiers. The U.S. has delivered the biggest improvement in corporate health, compared to the recent past and to bearish investor perceptions as well. Much of that can be attributed to the impact of the Trump corporate tax cuts, though. At the same time, there have even been significant improvements in profitability metrics in regions that have lagged during the current global economic expansion, like Peripheral Europe. We recently downgraded our overall global spread product allocation to neutral.1 This reflected the increased concerns of the BCA Strategists that valuations on global risk assets looked rich compared to growing geopolitical risks (U.S.-China trade tensions, U.S.-Iran military tensions). Yet it also was related to the ongoing development of our biggest investment theme for 2018 - the eventual likely collision between tightening global monetary policy and rich valuations on global risk assets. Looking ahead, the tailwinds that have been supportive for corporate health and the performance of global corporate debt in the past couple of years - a coordinated cyclical upturn driving solid earnings growth, with low inflation allowing monetary policies to stay accommodative - are becoming headwinds (Chart 1). The overall OECD leading economic indicator, which is well correlated to the annual excess returns of global high-yield debt, has peaked. Central banks are either delivering rate hikes, talking about rate hikes, or cutting back on the pace of balance sheet expansion. All of these factors will weigh on corporate bond returns over the next 6-12 months. U.S. Corporate Health Monitors: Improving Thanks To Resilient Growth & Tax Cuts Chart 2Top-Down U.S. CHM:##BR##Boosted By Cyclically Strong Profits Our top-down CHM for the U.S. has been in the "deteriorating health" region for fifteen consecutive quarters dating back to the middle of 2014 (Chart 2). That streak appears set to end soon, as the indicator has been falling since peaking in 2016 and now sits just above the zero line. The resilience of the U.S. economy, combined with the positive impact on U.S. profitability from the Trump corporate cuts, has put U.S. companies in a cyclically healthier position, even with relatively high leverage. It is important to note that the top-down CHM uses after-tax earnings measures in several of the ratios the go into the indicator: return on capital, profit margin and debt coverage. All three of those ratios saw significant upticks in the first quarter of 2018, which is the latest available data for the top-down CHM. The Trump tax cuts did take effect at the start of the year, but given the robust results seen in reported second quarter profits reported so far, a bigger impact will likely be visible once we are able to update the CHM for the most recently completed quarter. The ability for U.S. companies to continue expanding margins will be tested in the next 6-12 months. The tight U.S. labor market is pushing up wage growth, which will pressure margins and prompt some firms to try and raise prices to compensate. Firming U.S. inflation is already keeping the Fed on a 25bps-per-quarter pace of rate hikes, and perhaps more if U.S. inflation continues to accelerate without any slowing of U.S. economic growth. If the Fed starts actively targeting a slower pace of U.S. growth to cool off inflation, credit markets will take notice and U.S. corporate debt will underperform. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. There are no imminent domestic pressures on U.S. corporate finances that should require wider credit spreads to compensate for rising default risk. The bottom-up versions of the U.S. CHMs for investment grade (IG) corporates (Chart 3) and high-yield (HY) companies (Chart 4) have also both improved, with the HY indicator now crossing over the zero line into "improving health" territory. This confirms that the signal from our top-down CHM is being reflected in both higher-rated and lower quality companies. Yet the longer-term issues of high leverage and low interest/debt coverage are not going away, suggesting that potential problems are being stored up for the next U.S. economic downturn. What also remains worrying is the fact that IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This indicates that the stock of U.S. corporate debt is now so large that the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is still quite strong. This will raise downgrade risk if corporate borrowing rates were to rise significantly or if U.S. earnings growth slows sharply. We moved our recommended stance on U.S. IG and HY to neutral at the end of June as part of our downgrade of overall global spread product exposure. We may consider a move back to overweight (versus U.S. Treasuries) on any meaningful spread widening given our optimistic view on U.S. economic growth and the positive measure on credit risk signaled by our CHMs. Yet it may be difficult to get such an opportunity. The U.S. is reaching a more challenging point in the monetary policy cycle with the Fed likely to shift to a restrictive stance within the next 6-12 months. At the same time, there are risks to the U.S. economy stemming from the widening U.S.-China trade conflict, a stronger U.S. dollar and, potentially, the growing turmoil in emerging markets. Yet the state of U.S. corporate health has improved substantially, leaving companies less immediately vulnerable to any of those shocks. Given this balance of risks, a neutral stance on U.S. corporates remains appropriate (Chart 5). Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##Stable, But Watch Profit Margins Chart 4Bottom-Up U.S. High-Yield CHM:##BR##Cyclical Improvement Chart 5U.S. Corporates:##BR##Stay Neutral IG & HY Euro Corporate Health Monitors: Strong Economy, Big Improvements Our top-down euro area CHM remains in "improving health" territory, as has been the case for the past decade (Chart 6). The indicator had been worsening towards the zero line during 2016-17, but rebounded in the first quarter of 2018 thanks to a pickup in profit margins and debt coverage. Those positive developments are even more impressive since they occurred during a quarter when there was some cooling from the robust pace of economic growth seen in 2017. Chart 6Top-Down Euro Area CHM: Modestly Improving Interest coverage and liquidity remain in structural uptrends, supported by the super-easy monetary policies of the European Central Bank (ECB) that have lowered corporate borrowing costs (negative short-term interest rates, liquidity programs designed to prompt low-cost bank lending, and asset purchase programs that include buying of corporate bonds). Our bottom-up versions of the CHMs for euro area IG (Chart 7) and HY (Chart 8), which are based on individual company earnings data, both confirm the positive message from the top-down CHM. For IG, a noticeable gap has opened up between domestic and foreign issuers in the euro area corporate bond market. Return on capital, operating margins, interest coverage and debt coverage all ticked higher in the first quarter of this year, while leverage slightly declined. Those developments were not repeated among the foreign issuers in our sample. Within the Euro Area, our bottom-up CHMs show that the gap has closed between IG issuers from the core countries versus the periphery, but both remain in the "improving health" zone. (Chart 9). Somewhat surprisingly, the only ratios where there is a material difference are leverage (150% and falling in the periphery, 100% and stable in the core countries) and interest coverage (rising sharply toward 5x in the periphery, stable just above 6x in the core). Despite the improvement in the CHMs, credit spreads for euro area IG and HY have both widened over the course of 2018, while excess returns have been negative year-to-date (Chart 10). Looking ahead, we see the biggest threat for euro area corporate bond performance to come from a shift in ECB policy. We expect the ECB to follow through on its commitment to fully taper net new government bond purchases by the end of 2018, while continuing to reinvest the proceeds of maturing debt in 2019 and beyond. It is less clear what the ECB will do with its corporate bond buying program, and there has been some speculation that the ECB could leave its corporate program untouched while tapering the government purchases. We doubt that the ECB would want to make such a distinction that would artificially suppress corporate borrowing costs relative to government yields. The ECB is more likely to end both programs concurrently at the end of the year, which will remove a major prop under the euro area corporate bond market. This is a main reason why we are currently recommending an underweight stance on euro area corporates versus U.S. corporates. Chart 7Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Chart 8Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Chart 9Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Yet the bigger reason why we prefer corporates from the U.S. over the euro area is that the relative improvement in corporate health has been bigger in the U.S. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs Europe (Chart 11). That CHM gap continues to favor U.S. credit, which has been outperforming over the past several months (on a common currency basis compared to euro area debt hedged in USD). Chart 10Euro Area Corporates:##BR##Stay Underweight IG & HY Chart 11Relative Top-Down CHMs:##BR##Continue To Favor U.S. over Europe U.K. Corporate Health Monitor: Deteriorating Amid Rising Domestic Risks The U.K. CHM saw a significant deterioration in the first quarter of 2018, thanks largely to slowing U.K. growth that has impacted all the profit-focused ratios (Chart 12). The CHM is still in the "improving health" zone, but just barely. Seeing the return on capital, profit margin, interest coverage and debt coverage ratios all roll over at historically low levels is a worrying sign for future U.K. credit quality. This is especially true given the extremely stimulative monetary policy run by the Bank of England (BoE) since the 2008 Global Financial Crisis. The only ratio in the U.K. CHM that has seen steady improvement over the past decade is short-term liquidity (bottom panel), which has been boosted by steady increases in working capital. The performance of U.K. credit has benefited from the BoE's additional monetary policy measures taken after the shock Brexit vote in 2016. This involved both interest rate cuts and asset purchases, which included buying of U.K. corporate bonds. The BoE has shifted its policy bias from easing to tightening over the past year, even with sluggish U.K. economic growth and still-unresolved uncertainty about the future U.K. trading relationship with the European Union. This has raised the risks that the BoE could commit a policy error through additional interest rate hikes over the next 6-12 months, especially if policymakers focus more on targeting higher real policy rates as we discussed in a recent Weekly Report.2 U.K. corporates have been a laggard among global credit markets throughout 2018 and especially so in the month of July during a generally positive month for global corporate debt (Chart 13). We see the underperformance continuing in the coming months, as wider spreads will be required given the uncertainties surrounding Brexit, economic growth and BoE monetary policy. Stay underweight U.K. corporate debt within an overall neutral allocation to global spread product. Chart 12U.K. Top-Down CHM: Cyclical Deterioration Chart 13U.K. Corporates: Stay Underweight Japan Corporate Health Monitor: No Problems Here We added Japan to our suite of global CHMs earlier this year.3 Although the Japanese corporate bond market is small (the Bloomberg Barclays Japan Corporates index only has a market capitalization of $116bn), the asset class does provide opportunities for investors to pick up a bit of yield versus zero-yielding Japanese government bonds (JGBs) Japanese corporate health has been excellent for the past decade, with the CHM steadily holding in "improving health" territory (Chart 14). The trends in the Japan CHM ratios since 2008 are quite different than those seen in the CHMs for other countries. Leverage has been steadily falling, return on capital has been steadily rising (and has now converged to the 6% level seen in other countries' CHMs), and the interest coverage multiple of 9.6x is by far the largest in our CHM universe. Default risk is non-existent in Japan. Only pre-tax operating margins for our bottom-up Japan CHM have lagged those in other countries, languishing at 6% for the past three years. Yet Japanese corporate profits are at all-time highs, a logical outcome when companies can borrow at less than 50bps and earn a return on capital of 6%. That wide gap should allow Japanese companies to continue to earn steady, strong profits even with wage inflation finally showing life in Japan alongside a 2.3% unemployment rate. Japanese corporate bond spreads have widened a bit in 2018, but remain far more stable compared to corporates in other developed markets (Chart 15). The lack of spread volatility has allowed Japanese corporates to steadily outperform JGBs since 2011, even as all Japanese bond yields have collapsed. That trend is likely to continue, as the Bank of Japan (BoJ) is still a long way from being able to credibly pull off any upward adjustment of the current 0% BoJ yield target on 10-year JGBs. Chart 14Japan Bottom-Up CHM: Still Healthy,##BR##But Has Cyclical Improvement Peaked? Chart 15Japan Corporates:##BR##Stay Overweight vs JGBs Importantly, the BoJ recently introduced new forward guidance that states there will be no interest rate hikes until at least 2020. This will positively affect Japanese corporate health by keeping borrowing costs extremely low and preventing any unwanted strength in the yen that could damage Japanese competitiveness. There is a risk that increasing global trade tensions could impact the export-heavy Japanese economy and damage corporate profit growth and corporate bond performance. We do not yet see that as a major risk that could derail the Japanese economy and we continue to recommend an overweight stance on Japanese corporate debt vs JGBs. Canada Corporate Health Monitor: Faster Growth Hiding Structural Warts We introduced both top-down and bottom-up CHMs for Canada in our previous CHM Chartbook in April. As was the case then, both CHMs are in "improving health" territory (Chart 16). These CHMs are typically correlated to the price of oil, as befits Canada's status as a major energy exporter. Yet the strong CHMs also reflect the solid pace of overall Canadian economic growth. Looking at the individual components of the Canada CHMs, the leverage ratios for both measures have been steadily rising and currently sit above 100%. The return on capital has been in a structural downtrend, as is the case for most countries in our CHM universe (excluding Japan), but has ticked up alongside faster economic growth over the past couple of years. There was a noticeable drop in the margin ratio for the bottom-up CHM, coming entirely from the HY firms within our sample group of companies. Interest coverage and debt coverage ratios remain depressed, even with some improvement in corporate profits. This is partially due to rising interest rates as the Bank of Canada (BoC) has been tightening monetary policy - a trend that we expect to continue over the next 6-12 months. Canadian corporate bond spreads have widened slightly since the start of 2018, but remain tight relative to a longer-term history (Chart 17). Excess returns over Canadian government bonds have flattened out after enjoying a very solid period of outperformance in 2016-17. Looking ahead, there are balanced risks to the outlook for Canadian corporate debt. Chart 16Canada CHMs: Cyclically Improving,##BR##But Longer-Term Problems Are Building Chart 17Canadian Corporates:##BR##Stay Neutral Vs Canadian Government Debt We continue to expect the BoC to hike rates because of solid growth and faster inflation in Canada. Yet we do not see the BoC moving rapidly to a restrictive monetary stance that would damage growth expectations and trigger some credit spread widening. At the same time, we also see risks stemming from Canada-U.S. trade disagreements that could hurt Canadian growth and cause investors to demand cheaper valuations for Canadian corporate bonds. Adding it all up, a neutral stance on Canadian corporates versus government debt remains appropriate, largely as a carry trade. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.4 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. Table 1Definitions Of Ratios That Go Into The CHMs With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix Chart 1We Now Have CHM Coverage For 92% Of The Developed Market Corporate Bond Universe 1 Please see BCA Global Fixed Income Weekly Report, "Time To Take Some Chips Off The Table; Downgrade Global Corporate Bond Exposure To Neutral", dated June 26 2018, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "An R-Star Is Born", dated August 7th 2018, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Sticking With The Plan", dated March 13th 2018, available at gfis.bcaresearch.com. 4 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Duration Checklist: An update of our medium-term Duration Checklist highlights that the strategic backdrop for global government bonds remains bearish. A below-benchmark overall portfolio duration stance is still warranted - even after our recent move to downgrade spread product exposure. Canada: The Bank of Canada hiked rates again last week, and additional increases are likely given growing capacity constraints and accelerating Canadian inflation. Stay underweight Canadian government bonds. Feature Chart of the WeekStagflation Keeping Yields Afloat Developed market bond yields are lacking direction at the moment, pulled by competing forces. Overall global economic activity has lost some momentum and is now less synchronized. Yet the majority of major countries in the developed world are still growing at an above-potential pace that is keeping unemployment low and slowly boosting wages. This is helping underpin inflation, both realized and expected, while keeping government bond yields elevated despite increasing concerns about the future path of the global economy (Chart of the Week). The growing worries about a potential "U.S. versus the world" trade war are weighing on growth expectations, although not yet by enough to cause a meaningful pullback in global equity markets which remain supported by current solid earnings growth. Credit spreads have increased for both developed market corporate debt, but are still at historically narrow levels suggesting that investors are not overly concerned about default/downgrade risk. Emerging market (EM) debt has seen more significant spread widening in recent months, with a stronger U.S. dollar playing a large role there, but there has been little spillover from weaker EM markets into developed market credit valuations. We recently downgraded our recommended allocation to global corporate debt to neutral, while also upgrading our weighting on government bonds to neutral. Yet we maintained our below-benchmark overall duration stance, given our view that bond markets were still underpricing the potential for faster global inflation and tighter monetary policies given the persistent underlying strength of economic growth (especially in the U.S.). In light of that change in our view, an update of one of more reliable tools over the past eighteen months - our Duration Checklist - is timely. The Duration Checklist Is Still Bearish We have maintained our strategic below-benchmark stance on duration exposure for some time now, dating back to January 2017. Shortly afterward, we introduced a list of indicators to monitor going forward to determine if that defensive duration posture on U.S. Treasuries and German Bunds was still justified.1 We called that list our "Duration Checklist", and it contains elements focused on economic growth, inflation, central bank policy biases, investor risk appetite and bond market technicals. The Checklist is meant to be a purely objective read on the data and how it relates to the likely future path of bond yields. We last updated the Checklist back on January 30th of this year.2 The conclusion was that the underlying economic and inflation backdrop was still indicating more upside for yields on a 6-12 month horizon in both the U.S. and Europe. There was a risk, however, that the bond selloff could pause given heightened bullishness on risk assets and extremely oversold conditions in government bond markets. Since that last update of the Checklist, the 10-year U.S. Treasury yield is higher (2.86% vs. 2.72%) while the 10-year German Bund yield is lower (0.36% vs. 0.70%). Although yields in both markets did climb to even higher levels - 3.12% and 0.78%, respectively - in February and March before pulling back to current levels. As we update the Checklist once again this week, we see that the backdrop is still conducive to rising bond yields in the U.S. and Europe, but with differing risks compared to six months ago (Table 1). Note that the Checklist was designed to assess if we should maintain our duration tilt, thus we apply a checkmark ("check") to any indicator that points to potentially higher bond yields, and an "x" to any element that could signal a bond market rally. Table 1The Message From Our Duration Checklist Is Still Bearish For Both USTs & Bunds Global growth momentum is decelerating. The OECD's global leading economic indicator (LEI) is in a clear downtrend, having fallen for five consecutive months (Chart 2). That weakening is broad based, as shown by the depressed level of our LEI diffusion index. The global ZEW index, measuring investor sentiment towards growth in the major developed economies, has been falling sharply since March of this year and now sits at the lowest level since January 2012. The Citigroup Global Data Surprise index peaked at the beginning of 2018 and has fallen steadily to below zero, although it may be in the process of bottoming out. Meanwhile, our global credit impulse - a reliable leading indicator of global growth - has noticeably slowed. We are giving an "x" to all these elements of our Duration Checklist, indicating that the current "soft patch" of global growth represents a risk to the performance of our below-benchmark duration stance. U.S. growth remains solid, but Europe is cooling a bit. The U.S. economy is firing on all cylinders at the moment (Chart 3). The ISM manufacturing index is near 60, while both consumer and business confidence are above the mid-2000s peak of the previous business cycle. Corporate profits are growing around 20% and our models suggest that this trend can continue over the rest of 2018. All these indicators earn a "check" on the U.S. side of our Duration Checklist. Chart 2Global Growth Indicators Are##BR##No Longer Bond Bearish Chart 3U.S. Growth##BR##Remains Strong The growth story is mixed in the euro area, however (Chart 4). The manufacturing PMI has been steadily falling since February of this year, but still remains well above the 50 line indicating an expanding economy. Consumer and business confidence are both at cyclical highs, but the upward momentum has stalled. Corporate profits are growing at a robust pace, but our models suggest that earnings should slow over the remainder of this year. In our Duration Checklist, the momentum of the growth indicators is the relevant measure and not the level. So we are now placing an "x" on the manufacturing PMI, which is giving a clear signal on slowing growth, while maintaining a "check" next to confidence and profit growth but with a question mark given that both may be in the process of rolling over. Inflation pressures are strengthening on both sides of the Atlantic. Back in January, the inflation elements of the Checklist were providing the most mixed signals. That is no longer the case (Charts 5 & 6). Oil prices are accelerating in both U.S. dollar and euro terms, which suggests upside risks on headline inflation in the U.S. and euro area. Unemployment rates are now below the OECD estimates of full employment, and wage inflation is accelerating, in both regions. Thus, all the inflation components of our Duration Checklist earn a "check". Chart 4Is Euro Area Growth Peaking? Or Just Cooling? Chart 5U.S. Inflation Backdrop Is Bond Bearish Chart 6Euro Area Inflation Backdrop Is Bond Bearish Both the Fed and European Central Bank (ECB) are biased to tighten monetary policy. The Fed continues to signal that additional rate hikes are coming given the underlying strength of the U.S. economy and rising trend in U.S. inflation. The ECB has announced that it will taper its net new bond purchases to zero by year-end in its asset purchase program, and has provided forward guidance on the timing of a first rate hike in 2019. Both policies are credible given falling unemployment and rising core inflation rates in both the U.S. and euro area. Thus, we are keeping the "check" on both sides of the policy portion of the Checklist. Investor risk appetite has grown more cautious. This element of our Checklist was a potential headwind to our below-benchmark duration stance back in January, but is much less of an impediment to higher yields now (Charts 7 & 8). Chart 7U.S. Investor Risk Appetite##BR##Has Cooled Off A Bit Chart 8European Investor Risk Appetite##BR##Has Also Cooled Off The cyclical advances of both the S&P 500 and EuroStoxx 600 have stalled, and both indices are now back close to their 200-day moving averages, suggesting that equity markets are not overstretched (and, therefore, ripe for a correction that could drive down bond yields in a risk-off move). The VIX and VStoxx volatility indices remain at low levels, even after the spike that occurred in early February and the more modest volatility shock in the aftermath of the Italian election in May. This implies that investors still prefer owning risky assets over risk-free government bonds. These elements warrant a "check" on both sides of our Duration Checklist. Corporate bond spreads, however, have widened over the past few months, suggesting that investors are pricing in some increased uncertainty over future creditworthiness. While the overall level of spreads is still historically low, the rising trend justifies an "x" in our Checklist as a possible headwind to rising Treasury and Bund yields from waning investor risk appetite. Treasuries and Bunds are not as oversold compared to January, but large short positions remain an issue. The 10-year U.S. Treasury yield is now trading just above its 200-day moving average, while the deeply oversold price momentum seen earlier in the year has eased up a bit but remains negative (Chart 9). The combined signal is a neutral one but, in our Checklist framework, neither of these measures is stretched enough to suggest that yields cannot move higher. Thus, we are giving a weak "check" to both momentum elements on the U.S. side. There is still a large short position in 10-year Treasury futures according to the CFTC data, however, and this remains an impediment to higher Treasury yields - we are keeping the "x" for this piece of the Checklist. For Bunds, yields are now trading just below the 200-day moving average while price momentum has turned slightly positive (Chart 10). While neither indicator is stretched from an historical perspective, they are not sending a message that Bunds are oversold. Thus, we are giving a weak "check" to both technical elements on the European side of our Checklist (note that due to a lack of available data, we exclude investor positioning when evaluating the technical backdrop for Bunds). Chart 9USTs Not Oversold,##BR##But Large Short Positions Remain Chart 10Bund Technicals##BR##Are Neutral The majority of indicators in our Duration Checklist continue to point to upward pressure on U.S. Treasury and German Bund yields. Thus, we conclude that a continued below-benchmark duration stance is warranted for both markets. Not all of the news is bond bearish, however. The cooling of global growth indicators, the euro area manufacturing PMI, the widening of corporate credit spreads and the persistent short position in the Treasury market remain potential headwinds to a renewed period of rising bond yields. Yet without evidence that U.S. or European capacity constraints are loosening up, triggering a dovish shift from the Fed and ECB, the upward trend in inflation will prevent any meaningful decline in yields from current levels. Bottom Line: An update of our medium-term Duration Checklist highlights that the strategic backdrop for global government bonds remains bearish. A continued below-benchmark overall portfolio duration stance is warranted - even after our recent move to downgrade spread product exposure. Canada Delivers Another Rate Hike, With More To Follow Chart 11The BoC & The Fed: Follow The Leader The Bank of Canada (BoC) hiked its policy rate last week by 25bps to 1.5%, once again delivering a tightening in lagged response to U.S. rate increases over the past year. The hike was not a surprise, as the Canadian economy is operating at full capacity and core inflation is at the midpoint of the BoC's 1-3% target band. Overnight Index Swap (OIS) markets are now pricing that both the BoC and the Fed will raise rates by another 75bps over the next twelve months, and we see the potential for even more increases than that - even with the Canadian economy cooling from the very rapid growth seen last year (Chart 11). The current spread between 2-year government bond yields in the U.S. and Canada is the widest since 2008, which is weighing on the level of the Canadian dollar versus the greenback (3rd panel). The latter is helping to ease financial conditions in Canada (bottom panel), especially at a time when the country is benefitting from the positive terms of trade impact of strong oil prices. The loonie is also being impacted by worries about future U.S. trade policy. The Trump administration has already imposed tariffs on Canadian steel and aluminum exports and is demanding serious concessions in the renegotiation of the North American Free Trade Agreement (NAFTA). In their latest Monetary Policy Review (MPR) that was released after the BoC policy meeting last week, the central bank provided an estimate of the impact of the steel and aluminum tariffs that went into effect on June 1st. The conclusion was that the 25% tariff on U.S. imports of Canadian steel, and 10% levy on U.S. aluminum imports, would have little net impact on the Canadian economy once the Canadian response was factored in. The BoC concluded that the level of total real Canadian exports would be reduced by -0.6% by year-end, but that Canadian real imports would also decline by a similar amount as the Canadian government slapped its own tariffs on U.S. exports of steel, aluminum and various consumer products. This neutral view on U.S.-Canada trade tensions appeared throughout the BoC's updated economic forecasts, as its projections on the growth of Canadian exports, imports and U.S. real GDP growth (the critical driver of Canadian trade) were all increased from the previous MPR published in April. That may be an overly optimistic assessment of the potential impact of a trade dispute with the U.S. Yet the BoC did admit that it can only estimate the impact of tariffs once the precise details are known, thus it cannot adjust its forecasts based on what might happen in the NAFTA negotiations. The BoC can only base its forecasts on what they can observe now, which is that Canada's overall economy remains in decent shape, even though the composition of growth is shifting. The BoC's latest Business Outlook Survey indicates that Canadian firms continue to see robust demand and are facing increasing capacity constraints. This is boosting hiring plans and keeping capital spending intentions reasonably firm even with the uncertainties over NAFTA that is causing some firms to delay investment (Chart 12). The BoC is projecting that overall Canadian real GDP will only grow by 2% in 2018, even with a smaller contribution to growth from consumer spending and housing. The year-over-year rate of change in retail sales volumes has already dipped into negative territory and is now at the lowest since the end of 2009 (Chart 13). The BoC has attributed this to some slowing in interest-sensitive spending in response to tighter BoC monetary policy. At the same time, household debt growth has been slowing and house price inflation has plunged over the past year (although most of this decline occurred in the overheated Toronto market). The BoC is not concerned about the impact of its rate hikes on the interest burden for households, despite the high level of household debt, given the accelerating pace of wages and income growth. The BoC is likely happy to see a shift away from overheating consumption fueled by speculative increases in house prices, but there is a risk that additional rate hikes could finally trigger the long-awaited bursting of the Canadian housing bubble. Chart 12Canadian Businesses Are Optimistic,##BR##Even With Trade Worries Chart 13Higher BoC Rates##BR##Do Have An Impact (On a related note - the topic of housing bubbles will be discussed at the upcoming BCA Investment Conference in Toronto on September 23-25 by Hilliard Macbeth of Richardson GMP, who has written several books on the topic of global asset bubbles and has some particularly strong views to share on Canadian housing.) Yet the BoC will have to take the risk that additional rate increases could cause a bigger shakeout in the Canadian housing market, given that Canadian inflation is trending higher. Headline CPI inflation is now above the midpoint of the BoC's 1-3% target band, while all the various measures of core inflation that the BoC monitors are hovering around 2% (Chart 14). The BoC estimates that the output gap in Canada is now closed, and that the tight labor market will continue to boost inflation. Chart 14Inflation On The Rise In Canada Chart 15Market Is Underpricing The BoC Already, the average hourly earnings measure of wage inflation is growing close to 4% on a year-over-year basis, although the BoC has noted in recent research that other measures of labor costs are not growing as fast.3 Nonetheless, with 10-year inflation expectations in the Canadian inflation-linked government bond market now trading just below the BoC's 2% target (bottom panel), and with a high number of Canadian businesses reporting increasing difficulties in sourcing quality labor, the inflationary message sent by the surging rate of average hourly earnings growth will likely prove to be correct. Even though the Canadian OIS curve is now discounting another 75bps of rate hikes over the next year, that would only take the BoC policy rate to 2.25% - still below the central bank's estimate of the neutral policy rate, which is between 2.5-3% (Chart 15). Given the likely need for the BoC to eventually move to a restrictive stance to cool off an overheating economy and keep inflation around the 2% target, we see more potential upside for Canadian bond yields, especially with very little increase currently priced in the forwards. Stay underweight Canada in hedged global bond portfolios. Bottom Line: The Bank of Canada hiked rates again last week, and additional increases are likely given growing capacity constraints and accelerating Canadian inflation. Stay underweight Canadian government bonds. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15th, 2017, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Some Thoughts On The Treasury-Bund Spread", dated January 30th, 2018, available at gfis.bcaresearch.com. 3 https://www.bankofcanada.ca/wp-content/uploads/2018/01/san2018-2.pdf Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights The fundamental case to buy the dollar and sell non-U.S. risk assets is currently extremely obvious. This suggests that investors likely have already placed their bets. As such, the case for a counter-trend correction espoused last week has grown. The impact of tariffs on the dollar seems more dependent on the dollar's momentum than economics. As a result, getting a handle on how the greenback's momentum will evolve seems crucial. The behavior of Chinese assets, various currency pairs and other assets suggests the dollar may experience a significant loss of momentum that could prompt a correction of DXY to 92. The Canadian dollar seems the best place to take advantage of this move. Feature The currency market does not feel right. We do not mean that it is sick; however, we cannot help but feel a great level of discomfort right now. The economic environment clearly supports a stronger dollar. Global liquidity is weak, global growth has weakened, the yuan has been very soft and trade wars are on the front page of newspapers as the Trump administration has announced an additional $200 billion of potential new tariffs on Chinese exports. Hence, the bullish-dollar negative-EM story seems like a "no brainer." However, there rarely, if ever, is such thing as a "no-brainer" in the FX market. When fundamentals point as obviously in one direction as they do today, the narrative is likely to be appreciated by the vast majority of market participants. As a result, the bets are likely to have been placed. This risk seems especially acute today. Hence, we recommend investors temporarily move away from the dollar-bullish thesis. Occam's Razor At first glance, the recent wave of strength in the dollar seems to have been prompted by the new wave of trade war intensification. While China has not announced new tariffs on the U.S., the renminbi has continued to depreciate, evocating memories harkening back to August 2015 and the emerging market calamity that culminated in January 2016. While the risk created by a lower CNY is real, the dollar has had a schizophrenic approach to pricing in the impact of tariffs. In the first half of 2018, announcements of tariffs were greeted by a weaker dollar. However, since May, the same type of news has been greeted by a stronger dollar. An economic argument can be made as to why this is the case. In early 2018, global rates were still at rock-bottom levels, with the GDP-weighted average policy rate in the G-10 outside the U.S. being at 0.2%. Moreover, U.S. inflation was still tepid, but the fed funds rate was 1.5%. As result, if tariffs were to slow growth, only the Fed had room to ease. Moreover, since as of early 2018 global growth still looked to be on the upswing, it was argued that global monetary conditions were still accommodative enough than non-U.S. growth would barely be affected. Today, global growth is already showing signs of sagging, with weakness in Korean exports vindicating this analysis (Chart I-1). This means that growth outside the U.S. is perceived as more vulnerable to tariffs than was the case back in the first quarter of this year, especially as the amount of tariffs imposed on the world has grown. While the U.S. will also suffer from these tariffs, it is in better position to weather their impact. As such, since FX determination goes beyond just rate differentials and is also affected by growth differentials, the greater risk to non-U.S. growth is what is lifting the dollar. This narrative makes sense and is probably playing a role in the dollar's strength. However, we suspect something much simpler is exerting an even greater influence on the greenback: momentum. As we have long been arguing, the dollar is the epitome of momentum currencies in the G-10 (Chart I-2).1 Chart I-1Global Growth Slowdown Chart I-2USD Is A Momentum Currency Among all the momentum strategies we have tested, the one that works best at capturing the momentum continuation effect in the USD is tracking crossovers of the 20-day and 130-day moving averages. When the 20-day moving average is above the 130-day one, the dollar has an upward bias that is tradeable, and vice versa when the faster moving average lies below the slower one. Through most of 2017 all the way until May 9, 2018, the 20-day moving average for the dollar was in fact underneath the 130-day moving average. However, since May 10, it has been above (Chart I-3). Here is where things get interesting. When the moving average crossover strategy was sending a bearish signal for the greenback, tariff announcements would weaken the dollar; but since the crossover has been in bullish territory, tariff announcements have been lifting the dollar (Chart I-4). Chart I-3Favorable Momentum ##br##Backdrop On The Dollar Chart I-4Momentum Drives The Dollar's ##br##Reaction To Tariffs What does this mean for investors going forward? So long as the dollar is in a bullish momentum configuration, trade announcements will support the greenback. However, on this front we could expect a period of temporary calm after the storm (a low-conviction call, to be clear). The Trump team just announced an enormous tariffs package, Europe and Canada have put in place their own retaliation tariffs, the NATO meeting is over and the CNY has fallen by 6.4% since April 11. For the dollar to strengthen further, the onus thus falls back on momentum itself and market signals. But, as we highlighted last week, we are concerned that the dollar momentum could actually weaken from current levels. Bottom Line: Trade war risks seem to have been supporting the USD and weakened EM assets. However, the picture is not that clear-cut. Until May, moving average crossovers for the dollar were sending a bearish signal; during that time frame, tariff announcements were welcomed by a weak dollar. Since May, the dollar's moving average crossovers have been sending a bullish signal; since that time, tariff announcements have been welcomed by a strong dollar, which in turn has weighed on non-U.S. risk assets. Thus, with a likely period of calm on the trade front in the coming weeks, the outlook for momentum is likely to determine the trend in the dollar and in the price of risk assets outside the U.S. Reading The Market Tea Leaves At this point, having a sense of how momentum is likely to evolve is crucial. This is where that sinking feeling comes into play. Fundamentals seem to give a clear picture, but when the picture is so clear, a trap often lies ahead. The first clue to this trap comes from the Zew expectations survey. The Zew is a survey of market professionals, asking them their view on growth, and so on. These views are likely to be reflected in current market pricing. What is interesting is that this global growth survey has been tanking violently. The perception is thus that global growth is decelerating fast. Indeed, global growth has slowed, but as the global PMI illustrates - a variable that moves coincidently with the global Zew - it is not falling nearly as fast as expectations are (Chart I-5). This creates a risk for the dollar bulls - bulls who need further growth weakness to justify additional dollar strength. China is at the epicenter of the global growth slowdown. Interestingly, the Shanghai Composite Index is already testing the lows it experienced in early 2016 (Chart I-6). However, the Chinese economic picture is not as dire as was the case back then. PPI inflation is at 4.6% today, while it hit -5.9% at its nadir in November 2015. Thus, real interest rates faced by borrowers are 9.9% lower than they were back then. Moreover, the Li-Keqiang index of industrial activity is rebounding smartly. Finally, while FX reserves are contracting, they are not falling at the pace of US$108 billion a month endured in the worst months of 2015, which means that liquidity conditions in China are not experiencing the same tightening as back then. In fact, the Chinese repo rate is currently falling, supporting this notion (Chart I-7). This combination of economic indicators and financial market prices suggests that ample bad news is already priced into Chinese assets and thus China-linked assets for now. Chart I-5Analysts Know Growth Is Slowing Chart I-6Chinese Shares As Sick As In Early 2016 Chart I-7Some Reflation In China? Chinese shares expressed in USD-terms are also interesting. Not only are they re-testing their 2016 lows, but by the end of June their RSI oscillator had hit more deeply oversold levels than in January 2016 (Chart I-8). Very saliently, despite this week's announcement of a potential $200 billion of new tariffs imposed on China, Chinese shares expressed in U.S. dollars are not making new lows, and the RSI is slowly rebounding. This resilience is surprising, considering the magnitude of the bad news. Copper too is interesting. It seems that Dr. Copper has had a bit of a hangover lately, as its response speed has slowed considerably. Copper used to be a very reliable leading indicator, but since 2015 it seems to have become a coincident indicator of EM equities (Chart I-9). The recent 16% decline in the price of copper seems to be a catch-up to the weakness already evident in EM assets and EM currencies more than an early signal of additional problems to come for these markets. In fact, it may even indicate an intermediate capitulation in the price of these assets. Chart I-8Chinese Shares In USD: A Rebound Soon? Chart I-9Dr. Copper Is Hungover Other than these assets directly linked to China, since the end of June Treasury yields have also not been able to fall lower, and have proven very resilient in the face of the latest wave of CNY weakness and Trump tariffs (Chart I-10, top panel). Additionally, the euro/yen exchange rate, which is normally very levered to global growth conditions, has not only been rallying but breaking out of a downward trend in place since the beginning of 2018 (Chart I-10, second panel). Moreover, the extraordinarily pro-cyclical AUD/JPY cross bottomed in March and looks barely affected by the recent tumult (Chart 10, third panel). Finally, the growth-sensitive EUR/CHF is currently also strengthening, not weakening (Chart I-10, bottom panel). The behavior of all these market prices is inconsistent with an imminent new upswing in the dollar. The behavior of these variables is instead consistent with the movement of our favorite leading indicator of global growth: EM carry trades. We have used the EM carry trade to flag risks to global growth that have gripped the dollar and non-U.S. risk assets in recent months. However, despite the bad news piled onto the global economy, the performance of EM carry trades funded in yen seems to be trying to form a bottom (Chart I-11). This could indicate that we may be in for a period of temporary stabilization in global growth - a phenomenon that would weigh on the dollar's momentum. Without this ally, the dollar should correct meaningfully and non-U.S. risk assets should stage a rally. When thinking of a target for the dollar, a correction toward 92 on the DXY, implying a rebound of just under 1.20 on EUR/USD, seems very likely. At these levels, it will be time to re-evaluate whether the thesis we espoused last week - that this correction is a counter-trend move - is still valid or not. Also, we would expect commodity currencies to benefit even more than the euro in the context of this correction. Commodity currencies are especially levered to China, and Chinese stocks seem well positioned for a significant rebound. Moreover, as Chart I-12 illustrates, commodity currencies have been stronger than the relative performance of Swedish stocks vis-à-vis U.S. ones suggests, implying some underlying support. Finally, the yen and Swiss franc should prove the greatest losers in this environment. Chart I-10Despite Bad News, These Pro-Cylical Prices Are Resilient Chart I-11Stabilization In EM Carry Trades Chart I-12Important Divergence In terms of factors we continue to monitor, the price of gold remains a key variable. While the trend line we flagged last week has been re-tested, the yellow metal has not been able to punch through it. Meanwhile, EM bonds and junk bonds too have not suffered much in the face of the recent tariffs, and the rebound that has materialized since early July still seems in place. If any of these development change, the rebound in EM assets will peter off, and the dollar greenback will continue its march higher without much of a pause. Bottom Line: Fundamentals are making an extremely clear case that the dollar will strengthen further in the coming months, and that non-U.S. risk assets are in for a dive. However, when fundamentals are as clear as they are today, especially after the market moves we have seen in recent months, they rarely translate into the price action one would anticipate. The behavior of Chinese shares, of bond yields and of various currency pairs, including EM carry-trades, suggests instead that the dollar is likely to lose momentum. However, the life blood of any dollar rally is this very momentum. As such, we worry that despite apparently massively favorable fundamentals, the dollar could experience a correction toward 92 before being able to move higher as the fundamentals currently suggest. Commodity currencies could enjoy the greatest dividend from this counter-trend move. A Few Words On The CAD The Bank of Canada was anticipated to deliver a dovish hike this week, increasing rates to 1.5%, but also downgrading the path of additional expected rates. The BoC did deliver a hike, but it stuck to its guns and did not temper future interest rate expectations. Within the BoC's analytical framework, this move makes sense. Despite incorporating both tariff and NAFTA risks into its forecast, the BoC has barely changed its growth expectations for Canada. Essentially, the hit to Canadian exports will be balanced out by the hit to Canadian imports created by Canada's own retaliatory tariffs on the U.S. This means that the lack of excess capacity in the Canadian economy remains as salient a problem for the BoC as it was before NAFTA risks entered the picture. This warrants higher rates. The economic backdrop seems to indeed be in agreement with the BoC. This summer's Business Outlook Survey showed that Canadian businesses continue to find it increasingly difficult to meet demand and that labor shortages are still prevalent and becoming more intense, highlighting the upside risk to wages (Chart I-13). Higher wages are thus likely to buffet Canadian households from the risk created by higher policy rates. Moreover, higher wages also stoke inflationary pressures, while core inflation is already at target. In this environment, a real short rate at -0.4% makes little sense. The CAD looks like the best vehicle to take advantage of a rebound in commodity currencies. The CAD is currently trading at a deep discount to its fair value (Chart I-14) and the Canadian dollar proved surprisingly resilient in the face of a 7% decline in Brent prices on Wednesday. Additionally, speculators have accumulated large short bets on the Canadian currency. With the BoC being the only central bank among G-10 commodity producing nations that is lifting rates, this would create an additional impetus for the loonie to rebound and outperform other commodity currencies. Chart I-13Canadian Capacity Pressures ##br##Point To A Hawkish BoC Chart I-14Loonie Is ##br##Cheap Bottom Line: The BoC has resumed its hiking campaign because the economy is at full capacity and inflationary pressures continue to build up, while monetary policy remains too accommodative. As a result, the cheap CAD currently seems the best G-10 currency to take advantage of the correction in the USD. We are selling USD/CAD this week. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled “Riding The Wave: Momentum Strategies In Foreign Exchange Markets”, dated December 8, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was positive: JOLTS Job Openings climbed to 6.638 mn in May, beating expectations; Headline producer prices increased by 3.4% annually, the most in 11 years; Core producer prices increased by 2.8% in annual terms; Core consumer prices increased by 2.3% annually in June, in line with expectations, however, the month-on-month number was a bit soft; Continuing jobless claims underperformed, while initial jobless claims came in lower than expected. New threats from the White House of tariffs for USD 200 billion worth of Chinese imports circulated the media networks. At this point in time, almost 90% of U.S. imports from China are under threat of tariffs. The risks surrounding these tariffs going forward is likely to add substantially more pressure on emerging markets and commodity currencies down the road. Meanwhile, the U.S. is experiencing a robust economy with higher inflation supported by more expensive raw materials, higher lumber and housing prices, and a tight trucking market. This should keep the Fed in line with its hawkish bias, and the greenback afloat, even if on the short-run, much of this seem well discounted, raising the risk of a tactical correction in the DXY. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed: The German trade balance increased to EUR 20.3 billion on the back of a 1.8% annual export growth and a 0.7% annual import growth; The Sentix Investor Confidence increased to 12.1 in July from 9.3 in June, and beating the expected 8.2; French and Italian industrial output both underperformed expectations, coming in at -0.2% and 0.7% in monthly terms, respectively; The Economic Sentiment from the ZEW Survey came in less than expected for both Germany and the euro area, at -24.7 and -18.7 respectively; A slight misunderstanding between policymakers at the ECB emerged as the interpretation of interest rates being held "through the summer of 2019" proved contentious. Some officials say an increase as early as July 2019 is possible, while others rule out a move until autumn. We believe the latter is more likely, given the euro's negative reaction to the U.S.' announcement of additional tariffs of USD 200 billion imports from China, and also due to the current slowdown within the common area. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been positive: Machinery orders yearly growth outperformed expectations, coming in at 16.5%. Moreover, labor cash earnings yearly growth also surprised to the upside, coming in at 2.1%. Finally, housing starts yearly growth also outperformed expectations, coming in at 1.3%. USD/JPY has rallied by more than 1.4% this week. Even amid the increasing trade tensions and risk-off sentiment, the yen has been unable to rally against the dollar, as the momentum for the greenback is too strong for the yen to overcome. Overall, we favor the yen over the euro, however if the dollar were to correct at current levels, EUR/JPY would likely suffer in the process. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Manufacturing production yearly growth underperformed expectations, coming in at 1.1%. Moreover, Industrial production yearly growth also surprised negatively, coming in at 0.8%. However, mortgage approvals outperformed expectations, coming in at 64.526 thousand. Finally, Markit Services PMI also surprised positively, coming in at 55.1. GBP/USD has remained flat this week. Overall, we expect cable to continue to fall, as the dollar should continue its upward momentum for the time being. That being said, on the remainder of 2018, the pound will probably outperform the euro, as the U.K. is less exposed to the effects of Chinese tightening than Europe. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was mixed: NAB Business Confidence and Conditions both underperformed expectations, coming in at 6 and 15 respectively; Westpac Consumer Confidence increase to 3.9% in July from 0.3%; Home Loans grew by 1.1%, much better than the expected -1.9%. The Aussie sold off substantially as the U.S. threatened China with further tariffs amounting to USD 200 bn worth of goods. Adding to the sell-off were copper prices, which fell by almost 3%, also triggered by the tariff announcement. Furthermore, as the Australian economy remains mired in slack, the RBA is unlikely to hike in an environment with no real wage growth. As such, the AUD is unlikely to see much durable upside this year and is likely to lag other commodity currencies in the event of a dollar correction. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 NZD/USD has been flat this week. Even if it can rebound on the back of USD correction, we expect this currency to ultimately fall, given that the current environment of trade tensions and Chinese tightening will weigh on high yielding currencies like the NZD. Additionally, the policies implemented by the new government like lower immigration and a dual mandate will structurally lower the neutral rate in New Zealand, which will create further downside on the NZD. However, the NZD should outperform the AUD cyclically, as Australia is more exposed to a slowdown in the Chinese industrial cycle, given that copper has a higher beta than dairy products. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was decent: Housing starts grew by 248,100 year-on-year, beating expectations of 210,000; Building permits increased by 4.7% in monthly terms. The Bank of Canada this week hiked interest rates to 1.5%. The Bank displayed quite a hawkish stance in its statement and Monetary Policy report, noting a stronger than expected U.S. economy, high export growth, robust inflation, and a tight labor market. In addition, the Bank incorporated the newly implemented tariffs into its policy function. Nevertheless, recent comments by Governor Poloz imply a "data dependent" approach, which is consistent with policy responses to internal inflationary pressures. We therefore expect the CAD to continue to outperform all G10 currencies except USD. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: The KOF leading indicator outperformed expectations, coming in at 101.7. Moreover, the SVME PMI also outperformed expectations, coming in at 61.6. However, the unemployment rate underperformed expectations, coming in at 2.6%. Finally, headline inflation came in at 1.1%, in line with expectations. EUR/CHF has been flat since last week. Overall, we expect this cross to continue to go up, given that the SNB will keep intervening in the currency markets to keep the franc low enough for the economy to reach the central bank inflation mandate. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Retail sales yearly growth outperformed expectations, coming in at 1.8%. Moreover, headline inflation surprised positively, coming in at 2.6%, while core inflation came in at 1.1%, in line with expectations. Finally, registered unemployment, came in at 2.2%, in line with expectations. USD/NOK has gone up by roughly 0.6% this week. While it has short-term downside, we continue to be cyclically bullish on this cross, as the upside to oil prices is limited at this point, while a tightening fed should continue to put upward pressure on the U.S. dollar. That being said, the NOK will likely outperform the AUD and the NZD, given that the constrained supply of oil will help it to outperform other commodities. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The minutes from the July meeting highlighted some reservation by officials given the current economic background. The forecast is that slow rate rises will be initiated towards the end of the year. However, the majority of the Executive Board emphasized that monetary policy proceeds cautiously with hikes, given the volatile development of the exchange rate and the increased risks associated with Italy and trade protectionism. The majority also advocated for the extension of the mandate that facilitates foreign exchange intervention. However, Governors Ohlsson and Flodén argued against this view, even supporting hikes earlier as inflation is already at target. The SEK is very cheap on several valuation metrics, and thus is ripe for an up move, which is likely when the majority of the Riksbank officials aligns with a hawkish view. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights BCA's Geopolitical Power Index (GPI) confirms that we live in a multipolar world; Most of President Trump's policies are designed to strike out against this structural reality; Trade war with China is real and presents the premier geopolitical risk in 2018; President Trump's aggression towards G7 allies boils down to greater NAFTA risk; We remain bullish USD, bearish EM, maintain our short U.S. China-exposed equities and closing all our "bullish" NAFTA trades; Remain short GBP/USD, Theresa May's days appear numbered. Feature "We're going to win so much, you're going to be so sick and tired of winning." Candidate Donald Trump, May 26, 2016 In 2013, BCA's Geopolitical Strategy introduced the concept of multipolarity into our financial lexicon.1 Multipolarity is a term in political science that denotes when the number of states powerful enough to pursue an independent and globally relevant foreign policy is greater than one (unipolarity) or two (bipolarity). At the time, the evidence that U.S. global hegemony was in retreat was plentiful, but the idea of a U.S. decline was still far from consensus. By late 2016, however, President Donald Trump was overtly campaigning on it. His campaign slogan, "Make America Great Again," promised to reverse the process by striking out at the perceived causes of the decline: globalization, unchecked illegal immigration, and the ineffective foreign policy of the D.C. establishment. How can we quantitatively prove that the world is multipolar? We recently enhanced the classic National Capability Index (NCI) with our own measure, the Geopolitical Power Index (GPI). The original index, created for the Correlates of War project in 1963, had grown outdated. Its reliance on "military personnel" and "iron and steel production" harkened back to the late nineteenth century and overstated the power of China (Chart 1). Chart 1The National Capability Index Overstates China's Power Our own index avoids these pitfalls, while retaining the parsimony of the NCI, by focusing on six key factors: Population: We adapted the original population measure by penalizing countries with large dependency ratios. Yes, having a vast population matters, but having too many dependents (the elderly and youth) can strain resources otherwise available for global power projection. Global Economic Relevance: The original index failed to capture a country's relevance for the global economy. Designed at the height of the Cold War, the NCI did not foresee today's globalized future. As such, we modified the original index by introducing a measure that captures a country's contribution to global final demand. The more an economy imports, the greater its bargaining power in terms of trade and vis-à-vis its geopolitical rivals. Arms Exports: Having a large army is no longer as relevant now that wars have become a high-tech affair. To capture that reality, we replaced the NCI's focus on the number of soldiers with arms exports as a share of the global defense industry. We retained the original three variables that measure primary energy consumption, GDP, and overall military expenditure. Chart 2 shows the updated data. As expected, the U.S. is in decline, having lost nearly a third of its quantitatively measured geopolitical power since 1998. Over the same period, China has gone from having just 30% of U.S. geopolitical power to over 80%. Other countries, like Russia, India, Turkey, Iran, and Pakistan, have also seen an increase in geopolitical power over the same period, confirming their roles as regional powers (Chart 3). Chart 2BCA's Geopolitical Power Index Illustrates A Multipolar World Chart 3China Was Not The Only EM To Rise President Trump was elected with the mandate of changing the trajectory of American power and getting the country back on a "winning" path. Investors can perceive nearly all the moves by the administration - from protectionist actions against China and traditional allies, to applying a "Maximum Pressure" doctrine against North Korea and Iran - as a fight against the structural decline of U.S. power. Isn't President Trump "tilting at windmills"? Fighting a vain battle against imaginary adversaries? Yes. The decline of the U.S. is a product of classic imperial overstretch combined with the natural lifecycle of any global hegemon. U.S. policymakers have made decisions that have hastened the decline, but the overarching American geopolitical trajectory would have been negative regardless: Global peace brought prosperity which strengthened Emerging Markets (EM), particularly China, relative to the U.S. That said, Trump is not as crazy as the media often imply. Chaos is not necessarily bad for a domestically driven economy secured by two oceans. The U.S. tends to outperform the rest of the world - economically, financially, and geopolitically - amid turbulence. Our own updated GPI shows that both World Wars were massively favorable for U.S. hegemony (Chart 4), although this time around the chaos is mostly self-inflicted. Chart 4America Profits From Chaos Similarly, Trump's economic populism at home is buoying sentiment and assuaging the negative consequences - real or imagined - of his protectionism. Meanwhile, the threat of tariffs is souring the mood abroad. This policy mix is causing U.S. assets to outperform (Chart 5). Most importantly, the U.S. dollar is now up 2.7% since the beginning of the year, putting pressure on EM assets. When combined with continued counter-cyclical structural reforms in China, we maintain that the overall macro and geopolitical context remains bearish for global risk assets. This is not the first time that an American president has deployed both an aggressive trade policy and an aggressive foreign policy. The difference, this time around, is that the world is multipolar. A defining feature of multipolarity is that it is less predictable and more likely to produce inter-state conflict (Chart 6). As more countries matter - geopolitically, economically, financially - the number of "veto players" rises, making stable equilibria more difficult to produce. As such, bullying as a negotiating tactic worked when used by Presidents Nixon, Reagan, Bush Jr., and Clinton, but may not work today. Investors should therefore prepare for a long period of uncertainty this summer as the world responds to a U.S. administration focused on "winning." Chart 5U.S. Assets Outperform Chart 6Multipolarity Produces Uncertainty Bottom Line: There is a clear logic behind President Trump's foreign and trade policy. He is trying to reverse a decline in U.S. hegemony. The problem is that his policy decisions are unlikely to address the structural causes of America's decline. What is much more likely is that his policy will cause the rest of the world to react in unpredictable ways. The U.S. may benefit, but that is not a forgone conclusion. Investors should position themselves for a volatile summer. Below we review three key issues, two negative and one positive. The U.S. Vs. China: The Trade War Is Real The Trump administration has announced that it will go ahead with tariffs on $50 billion worth of Chinese imports in retaliation for forced technology transfer and intellectual property theft under Section 301 of the 1974 Trade Act. The tariffs will come in two tranches beginning on July 6. China will respond proportionately, based on both its statements and its response to the steel and aluminum tariffs (Chart 7). If the two sides stop here, then perhaps the trade war can be delayed. But Trump is already saying he will impose tariffs on a further $200 billion worth of goods. At that point, if Beijing re-retaliates, China's proportionate response will cover more goods than the entire range of U.S. imports (Chart 8). Retaliation will have to occur elsewhere. Chart 7Trump's Steel/Aluminum Tariffs Chart 8Trump's Tariffs On China We would expect the CNY/USD to weaken as negotiations fail. We would also expect tensions to continue spilling over into the South China Sea and other areas of strategic disagreement.2 The South China Sea or Taiwan could produce market-moving "black swan" geopolitical events this year or next.3 Chart 9Downside Risks Continue It is critical to distinguish between the U.S. trade conflict with China and the one with the G7. In the latter case, the U.S. political establishment will push against the Trump administration, encouraging him to compromise. With China, however, Congress is becoming the aggressor and we certainly do not expect the Defense Department or the intelligence community to play the peacemaker with Beijing. In particular, members of Congress are trying to cancel Trump's ZTE deal while expanding the powers of the Committee on Foreign Investment in the United States (CFIUS) to restrict Chinese investments.4 These congressional factors underscore our theme that U.S.-China tensions are structural and secular.5 Would China stimulate its economy to negate the effects of tariffs? We see nothing yet on the policy side to warrant a change in our fundamental view, which holds that any stimulus will be limited due to the agenda of containing systemic financial risk. Credit growth remains weak and fiscal spending has not yet perked up (Chart 9), portending weak Chinese imports and negative outcomes for EM. The risk to Chinese growth remains to the downside this year (and likely next year) as the government continues with the reforms. Critically, stimulus is not the only possible Chinese response to trade war. A trade war with the United States will provide Xi with a "foreign devil" on whom he can blame the pain of structural reforms. As such, it is entirely possible that Beijing doubles-down on reforms in light of an aggressive U.S. Bottom Line: The U.S.-China trade war is beginning and will cause additional market volatility and, potentially, a "black swan" event, especially ahead of the U.S. midterm elections. We do not expect 2015-style economic stimulus from Beijing. Stay long U.S. small caps relative to large caps; short U.S. China-exposed equities; and remain short EM equities relative to DM. The U.S. Vs. The G6: This Is About NAFTA There was little rhyme or reason to President Trump's smackdown of traditional U.S. allies at the G7 summit in Quebec. As our colleague Peter Berezin recently pointed out, the U.S. is throwing stones while living in a glass house.6 While the overall level of tariff barriers within developed countries is low, the U.S. actually stands at the top end of the spectrum (Chart 10). The decision to launch an investigation into whether automobile imports "threaten to impair the national security" of the U.S. - under Section 232 of the Trade Expansion Act of 1962 - falls into the same rubric of empty threats. The U.S. has had a 25% tariff on imported light trucks since 1964, a decision that likely caused its car companies to become addicted to domestic pickup truck demand to the detriment of global competitiveness. Meanwhile, only 15% of U.S. autos shipped to the EU were subject to the infamous European 10% surcharge on auto imports. This is because U.S. autos containing European parts are exempt from the tariff. Many foreign auto manufacturers have already adjusted to the U.S. market, setting up manufacturing inside the country (Chart 11). Tariffs would hurt luxury brands like BMW, Daimler, Volvo, and Jaguar.7 As such, we doubt the investment-relevance of Trump's threat against autos. Either way, the investigation is unlikely to be completed until the tail-end of Q1 2019. Chart 10Tariffs: Who Is Robbing The U.S.? Chart 11Car Imports? What Imports? Instead, investors should take Trump's aggressive comments from the G7 in the context of the ongoing NAFTA negotiations and the closing window for a deal. President Trump wants to get a NAFTA deal ahead of the U.S. midterms in November and prior to the new Mexican Congress being inaugurated on September 1.8 This means that a deal has to be concluded by late July, or early August, giving the "old" Mexican Congress enough time to ratify it before the new president - likely Andrés Manuel López Obrador - comes to power on December 1. This would conceivably give the U.S. Congress enough time to ratify a deal by December, assuming Republicans can remove some procedural hurdles before then. The rising probability of no resolution before the U.S. midterm election will increase the risk that Trump will trigger Article 2205 and announce the U.S.'s withdrawal. Trump has always had the option of triggering the six-month withdrawal period as a negotiating tactic to increase the pressure on Canada and Mexico. Withdrawing might fire up the base, while major concessions from Canada or Mexico might be presented as "victories" to voters. Anything short of these binary outcomes is useless to Trump on November 6. Therefore, if Canada and Mexico do not relent in the next month or two, the odds of Trump triggering Article 2205 will shoot up. The key is that Trump faces limited legal or economic constraints in withdrawing: Legal Constraints: Not only can Trump unilaterally withdraw from the agreement, triggering the six-month exit period, but Congress is unlikely to stop him. Announcing withdrawal automatically nullifies much of the 1993 NAFTA Implementation Act.9 Some provisions of NAFTA under this act may continue to be implemented, but the bulk would cease to have effect, and the White House could refuse to enforce the rest. Economic Constraints: The U.S. economy has far less exposure to Canada and Mexico than vice- versa (Chart 12). Certain states and industries would be heavily affected - ironically, the U.S. auto industry would be most severely impacted (Chart 13) - and they would lobby aggressively to save the agreement. But with the American economy hyper-charged with stimulus, the drag from leaving NAFTA is not prohibitive to Trump. Voters will feel any pocketbook consequences about three months late i.e., after the election. Chart 12U.S. Economy:##br## Largely Unaffected By NAFTA Chart 13NAFTA Has Made U.S. Auto ##br##Manufacturing More Competitive The potential saving grace for Canada is the Canada-U.S. Free Trade Agreement (CUSFTA), which took effect in 1989 and was incorporated into NAFTA. The U.S. and Canada agreed through an exchange of letters to suspend CUSFTA's operation when NAFTA took effect, but the suspension only lasts as long as NAFTA is in effect. However, reinstating CUSFTA is not straightforward. The NAFTA Implementation Act suspends some aspects of the CUSFTA and amends others (for instance, on customs fees), so there will not be an easy transition from NAFTA to a fully operational CUSFTA.10 Trump may well walk away from both CUSFTA and NAFTA in the same proclamation, or he could walk away from NAFTA while leaving CUSFTA in limbo. The latter would mitigate the negative impact on Canada, but it would still see rising tariffs, customs fees, and rising policy uncertainty. Bottom Line: We originally assigned a high probability to the abrogation of NAFTA.11 Subsequently, we lowered the probability due to positive comments from the White House and Trump's negotiating team. This was a mistake. As we initially posited, there are few constraints to abrogating NAFTA, particularly if President Trump intends to renegotiate the deal later, or conclude two separate bilateral deals that effectively maintain the same trade relationship. We are closing our trade favoring an equally-weighted basket of CAD/EUR and MXN/EUR. We are also closing our trade favoring Mexican local government bonds relative to EM. North Korea: A Geopolitical Opportunity, Not A Risk Not every move by the Trump administration is increasing geopolitical volatility. Trump's Maximum Pressure doctrine may have elevated risks on the Korean Peninsula in 2017, but it ultimately worked. The media is missing the big picture on the Singapore Summit. Diplomacy is on track and geopolitical risk - namely the risk of war on the peninsula - is fading. It is false to claim that President Trump got nothing in return for the summit. Since November 28, North Korea has moderated its belligerent threats, ceased conducting missile tests, released three U.S. political prisoners, and largely blocked off access to the Punggye-ri nuclear testing site. Now, North Korean leader Kim Jong-un has held the summit with Trump, reaffirmed his longstanding promise of "complete denuclearization," reaffirmed the peace-seeking April 2018 Panmunjom Declaration with South Korea, and pledged to dismantle a ballistic missile testing site and continue negotiations. In response, President Trump has given security guarantees to the North Korean regime and has pledged to discontinue U.S.-South Korea military drills for the duration of the negotiations. Trump has not yet eased economic sanctions and his administration has ruled out troop withdrawals from South Korea for now. There is much diplomatic work to be done. But the summit was undoubtedly a positive sign, dialogue is continuing at lower levels, and Kim is expected to visit the White House in the near future. Table 1 shows that the Singapore Summit is substantial when compared with major U.S.-North Korea agreements and inter-Korean summits - and it is unprecedented in that it was agreed between American and North Korean leaders. Table 1How The Singapore Summit Stacks Up To Previous Pacts With North Korea Because Trump demonstrated a credible military threat, and China enforced sanctions, the foundation is firmer than that of President Barack Obama's April 2012 agreement to provide food aid in payment for a cessation of nuclear and missile activity. It is much more similar to that of President Clinton and the "Agreed Framework" of 1994, which lasted until 2002, despite many serious failures on both the U.S. and North Korean sides. We should also bear in mind that it was originally U.S. Congress, not North Korea, which undermined the 1994 agreement. Aside from removing war risk, Korean diplomacy is of limited global significance. It marginally improves the outlook for South Korean industrials, energy, telecoms, and consumer staples relative to their EM peers (Chart 14). In the long run it should also be positive for the KRW. Chart 14Winners And Losers Of Inter-Korean Engagement We maintain that a U.S.-China trade war will not be prevented because of a Korean deal. But we do not expect China to spoil the negotiations. Geopolitically, China benefits from reducing the basis for U.S. forces to be stationed in South Korea. Bottom Line: Go long a "peace dividend" basket of South Korean equity sectors (industrials, energy, consumer staples, and telecoms) and short South Korean "loser" sectors (financials, IT, consumer discretionary, and health care), both relative to their EM peers. Stick to our Korean 2-year/10-year sovereign bond curve steepener trade. Brexit Update: A New Election Is Now In Play Prime Minister Theresa May is fending off a revolt within her Conservative Party this week that could set the course for a new election this year. May reneged on a "compromise" with soft-Brexit/Bremain Tory backbenchers on an amendment that would have given the House of Commons a meaningful vote on the final U.K.-EU Brexit deal. According to the press, the compromise was killed by her own Brexit Secretary, David Davis. There is a fundamental problem with Brexit. The current path towards a hard Brexit, pushed on May by hard-Brexit members of her cabinet and articulated in her January 2017 speech, is incompatible with her party's preferences. According to their pre-referendum preferences, a majority of Tory MPs identified with the Bremain campaign ahead of the referendum (Chart 15). That would suggest that a vast majority prefer a soft Brexit today, if not staying in the EU. We would go further. The current trajectory is incompatible with the democratic preferences of the U.K. public. First, polls are showing rising opposition to Brexit (Chart 16). Second, most voters who chose to vote for Brexit in 2016 did so under the assumption that the Conservative Party would pursue a soft Brexit, including continued membership in the Common Market. Boris Johnson, the most prominent supporter of Brexit ahead of the vote and now the foreign minister, famously stated right after the referendum that "there will continue to be free trade and access to the single market."12 Chart 15Westminster MPs Support Bremain! Chart 16Bremain On The Rise So what happens now? We expect the government to be defeated on the crucial amendment giving Westminster the right to vote on the final EU-U.K. deal. If that happens, PM May could be replaced by a hard-Brexit prime minister, most likely Davis. Given the lack of support for an actual hard-Brexit outcome - both in Westminster and among the public - we believe that a new election remains likely by March 2019. Bottom Line: Political risk remains elevated in the U.K. A new election could resolve this risk, but the potential for a Jeremy Corbyn-led Labour Party to win the election could add additional political risk to U.K. assets. We remain short GBP/USD. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013; and "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," dated June 8, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan," dated March 30, 2018, available at gps.bcaresearch.com. 4 The Senate has passed a version of the National Defense Authorization Act with a rider that would boost CFIUS and maintain stringent restrictions on ZTE's business with the U.S. These restrictions have crippled the company but would have been removed under the Trump administration's snap deal in June. The White House claims it will remove the rider when the House and Senate hold a conference to resolve differences between their versions of the defense bill, but it is not clear that the White House will succeed. Congress could test Trump's veto. If Trump does not veto he will break a personal promise to Xi Jinping and escalate the trade war further than perhaps even he intended. 5 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 6 Please see BCA Global Investment Strategy Weekly Report, "Piggy Bank No More? Trump And The Dollar's Reserve Currency Status," dated June 15, 2018, available at gis.bcaresearch.com. 7 We do not include Porsche in this list as we would gladly pay the 25% tariff on top of its current price. 8 Mexican elections for both president and Congress will take place on July 1, but the new Congress will sit on September 1 while the new president will take office on December 1. 9 Please see Lori Wallach, "Presidential Authority to Terminate NAFTA Without Congressional Approval," Public Citizen's Global Trade Watch, November 13, 2017, available at www.citizen.org. 10 The National Customs Brokers and Forwarders Association of America, "Issues Surrounding US Withdrawal From NAFTA," available from GHY International at www.ghy.com. See also Dan Ciuriak, "What if the United States Walks Away From NAFTA?" C. D. Howe Institute Intelligence Memos, dated November 27, 2017, available at www.cdhowe.org. 11 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 12 Please see "U.K. will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. Geopolitical Calendar
Highlights Global Inflation has upside on a cyclical basis, but this narrative is well known and investors have already placed their bets accordingly, buying inflation protection in a wide swath of markets. However, global growth has not yet found its footing, suggesting a mini-deflation scare, at least relative to expectations, is likely this summer. The U.S. dollar will benefit in such a scenario, and NOK/SEK will depreciate. While GBP/USD has downside, the pound should rally versus the euro. Weakness in EUR/CAD has not yet fully played out; the recent bout of strength was only a countertrend move. Feature Inflation is coming back, and this will obviously have major consequences for both asset and currency markets. However, macro investing is not just about forecasting fundamentals correctly; often, just as importantly, it is about understanding how other investors have priced in these expected economic developments. Therein lies the problem. While we understand why inflation could pick up, so too have most investors, and they have positioned themselves accordingly. With global growth currently looking shaky, we believe a better entry point for long-inflation plays will emerge in the coming months. In the meanwhile, a defensive, pro-U.S. dollar posture still makes sense. Investors Are Long Inflation Bets We have long argued that inflation was likely to make a cyclical comeback, a return that would begin in the U.S. before spreading to the rest of the globe. This story is currently playing out. However, in response these developments, investors have placed their bets accordingly, and the story currently seems well baked in. Prices of assets traditionally levered to inflation have already moved to discount a significant pick-up in inflation. The most evident dynamics can be observed in the U.S. inflation breakevens. Both the 10-year breakevens as well as the 5-year/5-year forward breakevens just experienced some of their sharpest two-year changes of the past 20 years, notwithstanding the pricing out of a post-Lehman, depression-like outcome (Chart I-1). Breakevens are not alone. Other assets have displayed similar behavior. In the U.S., investors have aggressively sold their holdings of utilities stocks, which have been greatly outperformed by industrial stocks. Traditionally, investors lift the price of XLI relative to that of XLU when they anticipate global inflation to pick up (Chart I-2). Chart I-1Markets Are Positioning Themselves##br## For Higher Inflation Chart I-2U.S. Sectoral Performance Suggests Investors ##br##Have Already Bet On Higher Inflation... It is not just intra-equity market dynamics that support this assertion. The behavior of the U.S. stock market relative to Treasurys further buttresses the idea that investors have already aggressively discounted an upturn in global consumer prices (Chart I-3). Potentially, the best illustration of investors' preference for inflation protection is currently visible in EM assets. A seemingly paradoxical phenomenon has been puzzling us: How have EM equities managed to avoid the gravitational pull that has caused EM bonds to nearly flirt with the nadir of early 2016? After all, EM equities, EM currencies and EM bonds are normally closely correlated, driven by investors' wagers on the direction of global growth. A simple variable can explain this strange dichotomy: anticipated inflation. As Chart I-4 illustrates, the performance of a volatility adjusted long EM stocks / short EM bonds portfolio tends to anticipate fluctuations in global inflation. The current price action in this basket indicates that investors have made their bets, and they think inflation is going up. Chart I-3...So Does The Stock-To-Bond Ratio Chart I-4Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Anecdotal evidence suggests that in recent quarters, pension plans have been aggressive buyers of commodities - a move that normally coincides with these long-term investors putting in place some inflation hedges. Moreover, positioning in the futures markets corroborates these stories: speculators are still very long commodities like copper and oil - commodities traditionally perceived as efficient protectors against inflation spikes (Chart I-5). Finally, despite the potentially deflationary risks created by Italy three weeks ago, speculators remain short U.S. Treasury futures, bond investors are underweight duration, and sentiment toward the bond market remains near its lowest levels of the past eight years (Chart I-6). Again, this behavior is consistent with investors being positioned for an inflationary environment. Chart I-5Money Has Flown Into Resources Chart I-6Bond Market Positioning Is Still Very Short Bottom Line: There is a well-defined case to be made that a global economy that was not so long ago defined by the presence of deflationary risks is now morphing into a world where inflation is on the upswing. However, based on inflation breakevens, sectoral relative performance, equities relative to bonds in both DM and EM as well as on the positioning of investors in commodity and bond markets, this changing state has been quickly discounted by investors. The Decks Are Stacked, But Where Does The Economic Risk Lie? The problem facing investors already long inflation protection every which way they can be is that the global economy is slowing, which normally elicits deflationary fears, not inflationary ones. This seems a recipe for disappointment, albeit one that is likely to help the dollar. Our global economic and financial A/D line, which tallies the proportion of key variables around the world moving in a growth-friendly fashion, has fallen precipitously. This normally heralds a slowdown in global economic activity (Chart I-7). Chart I-7Global Growth Is Losing Traction In similar vein, global leading economic indicators have also begun to roll over - a trend that could gain further vigor if the diffusion index of OECD economies experiencing rising versus contracting LEIs is to be believed (Chart I-8). The global liquidity picture has also deteriorated enough to warrant caution. Currency carry strategies - as approximated by the performance of EM carry trades funded in yen - have sagged violently. This tells us that funds are flowing out of EM economies and moving back to countries already replete with excess savings like Japan or Switzerland (Chart I-9). Historically, these kinds of negative developments for global liquidity have preceded industrial slowdowns, as EM now accounts for the lion's share of global IP growth. Finally, China doesn't yet look set to bail out the world's industrial sector. This month's money and credit numbers were weaker than anticipated, and our leading indicator for the Li-Keqiang index - our preferred gauge of industrial activity in the Middle Kingdom - points to further weakness (Chart I-10). This makes it unlikely that China's imports will rise, lifting global growth. Additionally, China has re-stocked in various commodities, suggesting it is front-running its own domestic demand, highlighting the risk that its commodities intake could become even weaker than what domestic growth implies. Chart I-8More Weakness In LEIs Chart I-9Global Liquidity Tightening Chart I-10China Not Yet Set To Bail Out The World With this kind of backdrop, we expect the current slowdown in global growth to run further before ebbing, probably in response to what will be a policy move out some kind from China to put a floor under growth. As a result, the current infatuation with inflation hedges among investors may wane for a bit as slower growth could shock inflation expectations downward, especially in a global context that has been defined by excess capacity since the late 1990s. An environment where global inflation expectations could be downgraded in response to slower growth is likely to be an environment where the dollar performs well, particularly as U.S. growth continues to outperform global growth (Chart I-11). This also confirms our analysis from two weeks ago that showed that when bonds rally the dollar tends to outperform most currencies, with the exception of the yen.1 Moreover, with the Federal Open Market Committee upgrading its path for interest rates by one additional hike in 2018, this reinforces the message from our previous work noting that once the fed funds rate moves in the vicinity of r-star, the dollar performs well, nearly eradicating the losses it incurred when the fed funds rate rises but is well below the neutral rate (Table I-1). This is especially true if vulnerability to higher rates rests outside - not inside - the U.S., as is currently the case.2 Chart I-11The Dollar Likes Lower Global Inflation Table I-1Fed And The Dollar: Where We Stand Matters As Much As The Direction Beyond the dollar, one particular currency cross has historically been a good correlate to investors betting on higher inflation: NOK/SEK. As Chart I-12 illustrates, when investors buy inflation hedges such as going long EM equities relative to EM bonds, this generates a rally in NOK/SEK. These dynamics played in our favor when we were long this cross earlier this year. However, not only are EM equities extended relative to EM bonds, the current economic environment portends a growing risk of investors curtailing these kinds of bets. The implication is bearish for NOK/SEK, and we recommend investors sell this cross at current levels. Chart I-12NOK/SEK Suffers If Inflation Bets Are Unwound Bottom Line: Investors have quickly and aggressively positioned themselves to protect their portfolios against upside inflation risks. However, the global economy is still slowing - a development that has further to run. As a result, this current anticipation of inflation could easily morph into a temporary fear of deflation, at least relative to lofty expectations. This would undo the dynamics previously seen in the market. This is historically an environment in which the dollar performs well, suggesting the greenback rally is not over. Moreover, NOK/SEK could suffer in this environment. The Bad News Is Baked Into The Pound There is no denying that the data flow out of the U.K. has been poor of late. In fact, despite what was already a low bar for expectations, the U.K. economy has managed to generate large negative surprises (Chart I-13). One of the direct drivers of this poor performance has been the complete meltdown in the British credit impulse (Chart I-14). Additionally, the slowdown in British manufacturing can be easily understood in the context of slowing global growth (Chart I-15). Chart I-13Anarchy In The U.K. Chart I-14The Credit Impulse Has Bitten Chart I-15U.K. Exports Are Slowing Because Of Global Growth But, the bad new seems well priced into the pound, especially when compared to the euro. Not only is the GBP trading at a discount to the EUR on our fundamental and Intermediate-term timing models, speculators have accumulated near-record short bets on the pound versus the euro (Chart I-16). This begs the question: Could any positive factor come in and surprise investors, resulting in a fall in EUR/GBP? We think the answer to this question is yes. First, despite the negatives already priced in, incremental bad news have had little traction in dragging the pound lower versus the euro in recent weeks, suggesting that EUR/GBP buying has become exhausted. Second, a falling EUR/USD tends to weigh on EUR/GBP, as the pound tends to act as a low-beta version of the euro (Chart I-17). Chart I-16Investors Are Well Aware Of Britain's Problems Chart I-17EUR/GBP Sags When EUR/USD Weakens Third, the economic outlook for the U.K. is improving. It is true that in the context of slowing global growth, the manufacturing and export sectors are unlikely to be a source of positive surprises for Great Britain. However, the domestic economy could well be. As Chart I-14 highlights, the credit impulse has collapsed, but the good news is that outside of the Great Financial Crisis it has never fallen much below current levels, suggesting that a reversion to the mean may be in offing. Additionally, U.K. inflation is peaking, which is lifting British real wages (Chart I-18). In response, depressed consumer confidence is picking up. This is crucial as consumer spending, which represents roughly 70% of the U.K.'s GDP, has been the key drag on growth since 2016. Any improvement on this front will lift the whole British economy, even if the manufacturing sector remains soft. Fourth, Brexit is progressing. This week's vote in the House of Commons was confusing, but it is important to note than an amendment that gives Westminster the right to force a renegotiation between the U.K. and the EU if no deal is reached in 2019 has been passed. This also decreases the risk of a completely economically catastrophic Brexit down the road, but increases the risk that PM Theresa May could be ousted over the next 12 months. Our positive view on the pound versus the euro (or negative EUR/GBP bias) is not mimicked in cable itself. Ultimately, despite the GBP/USD's beta to EUR/GBP being below one, it is nonetheless greater than zero. As such, it is unlikely that GBP/USD will be able to rally if the DXY rallies and the EUR/USD weakens (Chart I-19). Therefore, while we recommend selling EUR/GBP, we are not willing buyers of GBP/USD. Chart I-18A Crucial Support To Growth Chart I-19Cable Will Not Avoid The Downward Pull Of A Strong Dollar Bottom Line: The British economy has undergone a period of weakness, which is already reflected in the very negative positioning of investors in the GBP versus the EUR. However, the bad data points are losing their capacity to push EUR/GBP higher, and the British economy may begin to heal as consumer confidence is rebounding thanks to improving real wages. The low beta of GBP/USD to the euro also implies that a falling EUR/USD will weigh on EUR/GBP. However, while the pound has upside against the euro, it will continue to suffer against the dollar if EUR/USD experiences further downside. What To Do With EUR/CAD? One weeks ago, we were stopped out of our short EUR/CAD trade. Has EUR/CAD finished its fall, or was the recent rally a pause within a downward channel? We are inclined to think the latter. Heated rhetoric on trade has hit the CAD harder than the EUR, as exports to the U.S. represent a much larger share of Canada's GDP than of the euro area, forcing the pricing of a risk premium in the loonie. However, even after a rather explosive G7 meeting, we do believe that a compromise is still feasible and that NAFTA is not dead on arrival. A deal is still likely because, as Chart I-20 demonstrates, Canadian tariffs on U.S. imports are not only marginally in excess of U.S. tariffs on Canadian imports, they are also in line with international comparisons. This suggests only a small push is needed to arrive to a deal that salvages NAFTA, which ultimately is much more important to Canada than the dairy industry. Chart I-20Canada And The U.S. Can Find A Compromise Despite this reality, we cannot be too complacent, U.S. President Donald Trump is likely to be playing internal politics ahead of the upcoming mid-term elections. U.S. citizens are distrustful of free trade (Chart I-21), a trend especially pronounced among his base. However, a good result for the GOP in November is contingent on the Republican base showing up at the polls. Firing this base up with inflammatory trade rhetoric is a sure way to do so. This means that risks around NAFTA are still not nil. Chart I-21America Belongs To The Anti-Globalization Bloc However, EUR/CAD continues to trade at a substantial premium to fair-value on an intermediate-term horizon (Chart I-22). Moreover, as the last panel of the chart illustrates, speculators remain massively short the CAD against the EUR. This creates a cushion for the CAD versus the EUR if global growth slows. Moreover, technicals are still favorable of shorting EUR/CAD. Not only is EUR/CAD still overbought on a 52-week rate-of-change basis, it seems to be in the process of forming a five-wave downward pattern, with the fourth one - a countertrend wave - potentially ending (Chart I-23). Chart I-22EUR/CAD Is Still Vulnerable Chart I-23Wave Pattern Not Completed Finally, EUR/CAD tends to perform poorly when the USD strengthens, which fits with our current thematic for the remainder of 2018. Bottom Line: The headline risk surrounding NAFTA has weighed on the loonie against the euro, stopping us out of our short EUR/CAD trade with a small profit. However, the valuation, positioning and technical dynamics suggest the timing is ripe to short this cross once again. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Rome Is Burning: Is It The End?", dated June 1, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different", dated May 25, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was stellar: NFIB Business Optimism Index climbed to 107.8, outperforming expectations; the price changes and good times to expand components are also very strong; Headline and core PPI both outperformed expectations, auguring well for future consumer inflation; Headline and core retail sales grew by 0.8% and 0.9% in monthly terms, beating expectations; Both initial and continuing jobless claims also came out below expectations, highlighting that the labor market is still tightening, and wage growth could pick up further. The Fed raised interest rates this week to 2%, and added one additional rate hike to its guidance for 2018. FOMC members once again highlighted the "symmetric" target, suggesting that the Fed expects the economy to overheat slightly. An outperforming U.S. economy relative to the rest of the world is likely to propel the greenback this year. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Economic data was largely disappointing: Italian industrial output contracted by 1.2% on a monthly basis, and grew only by 1.9% on a yearly basis; The German ZEW Survey declined substantially across all metrics; European industrial production increased by 1.7% annually, less than the expected 2.8% increase; However, Spanish headline inflation spiked up from 1.1% to 2.1%. Yesterday, ECB President Mario Draghi announced the ECB's plan to taper asset purchases to EUR 15 bn a month in September, and phase them out completely by year-end. Moreover, Draghi highlighted that the ECB was not anticipating to implement its first hike until after the summer of 2019. Furthermore, the ECB President highlighted the current slowdown in global growth, as well as the rising protectionist risk from the U.S. potentially negatively impacting the European economy and the ECB's decisions going forward, suggesting that the plans are not set in stone. 2018 is likely to remain a volatile year for the euro. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Japanese data has been strong this week: Machine orders increased on a 9.6% annual basis, and a 10.1% monthly basis, in April, outperforming expectations by a large margin; The Domestic Corporate Goods Price Index also increased by 2.7% annually, higher than the expected 2.2% increase. As political and economic risks in Europe and South America having subsided for now, the yen has lost some of its glitter. However, with ongoing uncertainty on trade and populism across the globe, we maintain our tactically bullish stance on the yen, especially against commodity currencies and the euro. However, beyond the short-term horizon, the BoJ will remain determined to cap any excess appreciation in the yen, as a strong JPY tightens Japanese financial conditions, weighing on the BoJ's ability to hit its inflation target. This will ultimately limit the yen's upside on a cyclical basis. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Data from the U.K. was somewhat disappointing: Manufacturing and industrial production both increased less than expected, at 1.4% and 1.8%, respectively; The goods trade deficit widened to GBP 14.03bn from GBP 12bn, and the overall trade deficit widened to GBP 5.28bn from GBP 3.22bn; Average earnings grew by 2.8%, less than the expected 2.9%; However, headline inflation came in at 2.4%, less than the expected 2.5%, while retail price inflation also underperformed expectations. This means that the uptrend in real wages continues. Given the limited movement in the pound, it seems that a lot of the bad news was already priced in by last month's depreciation. However, Theresa May's ongoing blunders in parliament represent a continued source of risk for the pound. While the GBP has downside against the EUR, it is unlikely to see much upside against the greenback. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Do Not Get Flat-Footed By Politics - March 30, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was weak: NAB Business Confidence and Conditions surveys both declined, also underperforming expectations; Australian employment grew by 12,000, less than expected. Moreover, full-time employment contracted. While the unemployment rate dropped as a result, this was largely due to a fall in the participation rate. RBA's Governor Lowe, in a speech on Wednesday, announced that any increase in interest rates "still looks some time away" as the slack in the labor market does not seem to be diminishing. Annual wage growth has been constant at 2.1% for the past three quarters, and did not pick up despite an improvement in full-time employment earlier this year. We remain bearish on the AUD. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The NZD is likely to face significant downside against the greenback along with the other commodity currencies as global growth slows down. However, due to its weaker linkages to Chinese industrial demand, the kiwi is likely to see less downside than the AUD. Nevertheless, it is likely to weaken against the CAD and the NOK as the NZD is expensive against these oil currencies, and oil's is likely to continue to outperform other commodities will support this view. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has been on an uptrend given the greenback generally strong performance since February year, a force magnified by the volatile rhetoric surrounding NAFTA negotiations. However, the Canadian economy has been accelerating this year, thanks to robust growth in the U.S., to a strong Quebecer economy, and to a pickup in Alberta. In addition, the Canadian labor market is tightening further and wage growth is above 3%. Furthermore, risks surrounding NAFTA seem already reflected in the CAD's behavior and valuation. There is more clarity on the CAD versus its crosses than on the CAD versus the USD. Outperforming U.S. and Canadian growth relative to the rest of the world mean that the CAD should outperform most other G10 currencies. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data out of Switzerland was decent: Industrial production increased by 9% in annual terms, albeit less than the previous 19.6% growth; Producer and import prices increased by 3.2% year on year, in line with expectations, however the monthly increase underperformed markets anticipations. With global trade tensions rising, and Germany having entered President Trump's line of sight, the CHF could experience additional upside against the euro in the coming months. However, the SNB is unlikely to deviate from its ultra-accommodative stance, which means that any downside in EUR/CHF will proved to be short lived. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Both headline and core inflation underperformed, coming in at 2.3% and 1.2%, respectively. However, the Regional Network Survey hinted at a pickup in capacity utilization as expectations for industrial output remained robust, as well as at an additional strength in employment. This led to a forecast of a resurgence in inflationary pressures. We expect the NOK to outperform the EUR. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish inflation rose from 1.7% to 1.9%, coming in line with expectations. Additionally, Prospera 1-year inflation expectations survey rose to 1.9% from 1.8% in the March survey. This is likely to provide the Riksbank with reasons to turn gradually more hawkish, which should support the very cheap krona. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights In this Weekly Report, we review all of the individual trades in our Tactical Overlay portfolio. These are positions that are intended to complement our strategic Model Bond Portfolio, typically with shorter holding periods, and sometimes in smaller or less liquid markets that are outside our usual core bond coverage (like Swedish government bonds or euro area CPI swaps). This report includes a summary of the rationale for each position, as well as a decision on whether to retain the position, close it or switch it into a new trade that has more profit potential for the same theme underlying the original trade (Table 1). Table 1Global Fixed Income Strategy Tactical Overlay Trades Feature U.S. Long 5-year U.S. Treasury bullet vs. 2-year/10-year duration-matched barbell (CLOSE AND SWITCH TO NEW TRADE) Long U.S. TIPS vs. nominal U.S. Treasuries (HOLD) Short 10-year U.S. Treasuries vs. 10-year German Bunds (HOLD) Chart 1UST Curve Trading More Off The Funds##BR##Rate Than Inflation Expectations We have three U.S.-focused tactical trades that are all expressions of our core views on U.S. inflation expectations and future Fed monetary policy moves. We first recommended a U.S. butterfly trade, going long the 5-year U.S. Treasury bullet and short a duration-matched 2-year/10-year Treasury barbell (Chart 1), back on December 20th, 2016. We have kept the recommendation during periodic reviews of our tactical trades since then. This is a position that was expected to benefit from a bearish steepening of the U.S. Treasury curve as the market priced in higher longer-term inflation expectations. The trade has not performed according to our expectations, however, generating a loss of -0.40% since inception.1 There was a positive correlation between the slope of the Treasury curve, the butterfly spread and TIPS breakevens shortly after trade inception. However, the Treasury curve flattened through 2017 as the Fed continued to hike rates, even as realized inflation fell (2nd panel), pushing the real fed funds towards neutral levels as measured by estimates like r* (3rd panel). This has left the 2/5/10 Treasury butterfly cheap on our valuation model (bottom panel), Looking ahead, the case for a renewed bear-steepening of the U.S. Treasury curve, and widening of the 2/5/10 butterfly spread, rests on the Fed accommodating the current rise in U.S. inflation by being cautious with future rate hikes. Recent comments from Fed officials suggest that policymakers are in no hurry to rapidly raise rates in order to cool off an "overheating" U.S. economy. Yet at the same time, U.S. inflation continues to rise and the economy is in good shape, so the Fed can't take a pause on rate hikes. This will likely leave the Treasury curve range bound, with the potential for some periods of bear-steepening as inflation expectations rise. Our conviction on this Treasury butterfly spread trade has fallen of late. Yet with our model suggesting that the belly of the curve is somewhat cheap to the wings, and given our view that U.S. inflation expectations have not reached a cyclical peak, we are reluctant to completely exit this position. Instead, we are opting to switch out of the 2/5/10 U.S. Treasury butterfly into another butterfly that our colleagues at BCA U.S. Bond Strategy have identified as cheap within their newly-expanded curve modeling framework - the 1/7/20 butterfly (long the 7-year bullet vs. short a duration-matched 1/20 barbell).2 That butterfly offers better carry than the 2/5/10 butterfly (Chart 2), and is nearly one standard deviation cheap to estimated fair value. Another of our U.S.-focused tactical trades has been to directly play for rising U.S. inflation expectations by going long TIPS versus nominal U.S. Treasuries. This is a long-held trade (initiated on August 23rd, 2016) which has performed very well, delivering a return of 4.13%.3 We continue to see the potential for TIPS breakevens to widen back to levels consistent with the market believing that inflation can sustainably return to the Fed's 2% target on the PCE deflator, which is equivalent to 2.4-2.5% on CPI-based 10-year TIPS inflation expectations. Given the persistent strong correlation between oil prices and breakevens, and with the BCA Commodity & Energy Strategy team continuing to forecast Brent oil prices jumping above $80/bbl over the next year (Chart 3), there is still solid underlying support for wider breakevens. This is especially true given the uptrend in overall global inflation (middle panel), and the likelihood that core U.S. inflation can also continue to rise alongside an expanding U.S. economy (bottom panel). We are sticking with our long TIPS position vs. nominal Treasuries. Chart 2Switch The UST Butterfly##BR##Trade From 2/5/10 to 1/7/20 Chart 3Stay Long U.S. TIPS##BR##Vs. Nominal Treasuries Our final U.S.-focused tactical trade is actually a cross-market trade where we are short 10-year U.S. Treasuries versus 10-year German Bunds. We initiated that trade on August 8th, 2017 when the Treasury-Bund spread was at 179bps. With the spread now at 252bps, the trade has delivered a solid total return of 4.23%. This was driven primarily by the rapid move higher in Treasury yields in response to faster U.S. growth (Chart 4), more rapid U.S. inflation and Fed rate hikes versus a stand-pat European Central Bank (ECB).4 From a medium-term perspective, those three fundamental drivers of the Treasury-Bund spread continue to point to U.S. bond underperformance (Chart 5). From this perspective, the peak in the spread will not be reached until U.S. economic growth and inflation peak and the Fed signals an end to its current tightening cycle. None of those outcomes is on the horizon, and we continue to target an eventual cyclical top in the 10-year Treasury yield in the 3.25-3.5% range as inflation expectations move higher. Yet the Treasury-Bund spread has reached an overvalued extreme according to our "fair value" model (Chart 6). In other words, the markets have moved to more than fully discount the cyclical differences between the U.S. and euro area - a trend that surely reflects the huge short positioning in the U.S. Treasury market. Yet it is also important to note that the fair value spread continues to steadily climb higher. In our model, the spread is primarily a function of differences in central bank policy rates between the Fed and ECB, relative unemployment rates and relative headline inflation rates. All three of those factors continue to move in a direction favorable to a wider Treasury-Bund spread, and the gap is only growing wider with both growth and inflation in the euro zone losing momentum. Chart 4Stay Long 10yr UST##BR##Vs. 10yr German Bund Chart 5UST-Bund Spread Widening##BR##Due To Relative Fundamentals... Chart 6...But The Spread##BR##Has Overshot A Bit The spread is currently being pushed to even wider extremes by the current turmoil in Italy, which is pushing money out of Italian BTPs into safer assets like Bunds. The situation remains fluid and new elections are likely in Italy later this year, thus it is unlikely that any more to restore investor confidence in Italy is on the immediate horizon. This will keep Bund yields depressed versus Treasuries, even as the ECB continues to signal that it will fully taper its asset purchases by year-end (rate hikes remain a long way off in Europe, however). We continue to recommend staying short Treasuries versus Bunds, and would view any tightening of the spread back towards our model estimate of fair value as an opportunity to enter the position or add to an existing position. Euro Area Long 10-year euro area CPI swaps (HOLD, BUT ADD A STOP AT 1.5%) Short 5-year Italy government bonds vs. 5-year Spain government bonds (HOLD) Chart 7Stay Long 10-Year Euro Area CPI Swaps We have two tactical trades that are purely within the euro area: positioning for higher inflation expectations through a long position in 10-year euro CPI swaps, and playing relative credit quality within the Peripheral countries by shorting 5-year Italian bonds versus a long position in 5-year Spanish debt. The long 10-year CPI swaps trade, which was initiated on December 20th, 2016, has generated a total return of +0.45% over the life of the trade so far (Chart 7).5 The rationale for the recommendation, and our conviction behind it, has evolved over that time. We first recommended the trade when the ECB was aggressively easing monetary policy and there was clear positive momentum in euro area economic growth that was driving down unemployment. At a time when oil prices were steadily climbing and the euro was very weak, the case for seeing some improvement in inflation expectations in the euro area was a strong one. Inflation expectations stayed resilient in 2017, however, despite the unexpected strength of the euro. Continued gains in oil prices and above-trend economic growth that rapidly absorbed spare capacity in the euro area more than offset any downward pressure on inflation from a stronger currency. Looking ahead, the combination of renewed weakness in the euro and firm oil prices should allow headline inflation in the euro area to drift higher from current levels in the next 3-6 months (2nd panel). However, the euro area economy has lost the positive momentum seen last year with steady declines in cyclical data like manufacturing PMIs, industrial production and exports (3rd panel). Admittedly, that deceleration has come from a high level and leading indicators are not yet pointing to a prolonged period of below-potential growth that could raise unemployment and reduce domestic inflation pressures. Yet with core inflation still struggling to climb beyond the 1% level (bottom panel), any worsening of euro area economic momentum could lead to inflation expectations stalling out well before getting close to the ECB's 2% target level. Thus, we continue to recommend this long 10-year CPI swaps position, but we are adding a new stop-out level at 1.5% to protect against downside risks if the euro area growth outlook darkens. On our other euro area tactical trade, we have been recommending shorting Italian government bonds versus Spanish equivalents. We initiated that trade on December 16th, 2016 and it has produced a total return of +0.57% over the life of the trade. The original logic for the trade was based on an assessment that Italy's medium-term growth potential, sovereign debt fundamentals and political stability were all much worse than that of Spain (Chart 8), yet Italian bond yields were still trading at too low a spread to Spanish debt. The cyclical improvement in the Italian economy in 2017 helped pushed Italian yields even closer to Spanish yields, yet we stuck with the trade given the looming political risk from the Italian parliamentary elections. The recent political turmoil in Italy has justified our persistence with this trade, with the 5-year Italy-Spain spread widening out by 46 bps over just the past two weeks. With the situation remaining highly fluid as the Italian coalition partners (the 5-Star Movement and the League) struggle to form a new government, Italian assets will continue to trade with a substantial risk premium to Spain and other European bond markets. Yet with the Italian economy now also showing signs of losing cyclical momentum, the case for continued Italian bond underperformance is a strong one, and we moved to a strategic underweight stance on Italian debt last week.6 Looking ahead, we see the potential for additional spread widening between Italy and Spain in the coming months. Spain is enjoying better economic growth, the deficit outlook is worsening for Italy with the new coalition government proposing a stimulus that could widen the budget deficit by as much as 6% of GDP, and Spanish support for the euro currency is far higher than it is in Italy. All those factors justify a wider risk premium for Italian debt over Spanish bonds (Chart 9). Chart 8Spain Trumps Italy On All Fronts Chart 9Stay Short 5-Year Italy Versus 5-Year Spain Our view on Italian debt, both from a tactical and strategic viewpoint, is bearish. We are maintaining our tactical trade, and we also advise selling into any rallies in Italy rather than buying the dips. U.K. Long 5-year Gilt bullet vs. duration-matched 2-year/10-year Gilt barbell (HOLD) We entered into a U.K. Gilt butterfly trade, long the 5-year bullet versus the duration-matched 2-year/10-year barbell, back on March 27th, 2018.7 The logic of the trade was a simple one. We simply did not believe that the Bank of England (BoE) would follow through on its hawkish commentary by hiking rates as much as was discounted in the Gilt curve. Our view came to fruition as the BoE held rates steady at the May monetary policy meeting, which resulted in a bullish steepening at the front end of the Gilt curve. Our butterfly trade has returned +0.25% since inception, and we see more to come in the coming months.8 The U.K. economy has lost considerable momentum, with no growth shown in Q1 (real GDP only expanded +0.1%). The OECD leading economic indicator for the U.K. is at the weakest level in five years, and now consumer confidence is rolling over as rising oil costs are offsetting the pickup in wages (Chart 10). Overall headline inflation has peaked, however, after the big currency-fueled surge in 2016 and 2017 (bottom panel). With both growth and inflation slowing, and with the lingering uncertainty of the Brexit negotiations weighing on business confidence and investment, the BoE will have a tough time hiking rates even one more time this year. There are still 34bps of rate hikes priced into the U.K. Overnight Index Swap (OIS) curve, which leaves room for 2-year Gilts to decline as the BoE stays on hold for longer (Chart 11). This will cause the front-end of the Gilt curve to steepen. Meanwhile, longer-term Gilt yields will have a difficult time falling given the deceleration of global central bank asset purchase programs that is slowly raising depressed term premia on government bonds (3rd panel). Another factor that will help keep the Gilt curve steeper, all else equal, is the path of the inflation expectations curve. Shorter-dated expectations are likely to fall faster as growth slows and headline inflation continues to drift lower (bottom panel). Chart 10Fading Momentum For##BR##U.K. Growth & Inflation Chart 11Stay Long The 5yr U.K. Gilt Bullet##BR##Vs. The 2/10 Gilt Barbell Although some narrowing of the butterfly spread is already priced in the forwards (top panel), we see that outperformance of the 5-year happening faster, and by a greater amount, than the forwards. Stay long the belly of the Gilt curve versus the wings. Canada Long 10-year Canada inflation-linked government bonds vs. nominal Canada government bonds (HOLD) We recommended entering a long Canada 10-year breakeven inflation trade on January 9th, 2018.9 Since then, the 10-year breakeven inflation rate rose by 6bps along with the rise in oil prices denominated in Canadian dollars (Chart 12). This has helped our tactical trade deliver a return of +0.64% since inception.10 More fundamentally, the breakeven has risen as strong Canadian growth has helped close the output gap and push realized Canadian inflation back to the middle of the Bank of Canada (BoC)'s 1-3% target band. The rapid rate of real GDP growth has decelerated a bit after approaching 4% last year, and the OECD leading economic indicator for Canada may be peaking at a high level (Chart 13). Growth in consumer spending is also look a bit toppy, with bigger downside risks evident in the sharp declines in the growth of retail sales and house prices (3rd panel). Both were affected by a harsher-than-usual Canadian winter, but the cooling of the overheated Canadian housing market (especially in Toronto) is a welcome development for financial stability. Chart 12Stay Long Canadian##BR##Inflation Breakevens Chart 13Canadian Inflation At BoC Target,##BR##But Has Growth Peaked? On balance, however, the current state of Canadian economic data shows an economy that is slowing a bit from a very overheated pace, but is still likely to grow above potential with no spare capacity available. Both headline and core inflation will remain under upward pressure against this backdrop, at a time when the BoC's policy rate is still well below neutral. We continue to recommend staying long Canadian inflation-linked government bonds over nominal equivalents with a near-term target of 2% on the 10-year breakeven inflation rate. We will re-evaluate the position with regards to Canadian growth and inflation trends once that target is reached. Australia Long December 2018 Australian Bank Bill futures (SELL AND SWITCH TO NEW TRADE). We entered into a long December 2018 Australian Bank Bill futures trade on October 17, 2017 as a focused way to express the view that the Reserve Bank of Australia (RBA) would stay on hold for longer than markets expect. The trade has worked out nicely, generating a profit of +0.25%. The potential for further upside is fairly low at these levels so we are now closing the trade. However, our view remains that the RBA will not be able to hike as early as markets are pricing. As such, we are opening a new position - long October 2019 Australia Bank Bill futures. Markets expect the first rate hike will occur in nine months' time. The October 2019 Australia Bank Bill futures are currently pricing in a massive 180bps of rate hikes over the next sixteen months. That will not happen. The RBA will not be able to hike this much given the lack of inflation pressures and a wide output gap. Our Australia Central Bank Monitor, which measures cyclical growth and inflation pressures, has pulled back to the zero line, confirming that there is no current need to tighten policy (Chart 14). Real GDP growth slowed to 2.4% in Q4 2017, from 2.9% the previous quarter. Weakness in the OECD leading economic indicator and Citigroup economic surprise index for Australia suggest that the Q1 reading will also disappoint. Consumer spending will be dampened by weak wage growth, softening consumer sentiment and the recent decline in house prices in multiple major cities. As a result of easing house prices, the growth rate of household net wealth was considerably lower in 2017 relative to the previous four years. Additionally, credit growth has been slowing, even before the recent news of the bank scandals that will force banks to be more stringent with lending practices. Most importantly, however, inflation remains below the RBA's target and there is a lack of inflationary pressures. The inflation component of our Central Bank Monitor has collapsed and is now well below the zero line. Both headline and core inflation readings are stable but remain persistently below 2%. Tradeable goods prices have declined for nine consecutive months despite the currency weakness seen in the Australian dollar over the past twelve months. The IMF is not projecting Australia to have a closed output gap until 2020, and that is with the optimistic expectation that Australia achieves 3% growth. Labor markets have plenty of slack as evidenced by rising unemployment rate, nonexistent wage growth and elevated level of underemployment. The RBA estimates that the current unemployment rate is still approximately 0.5% above full employment. Against this backdrop, it is unlikely that inflation will sustainably rise enough to force the RBA's hand, leaving scope for interest rate expectations to decline (Chart 15). Chart 14The RBA Will##BR##Stay Dovish Chart 15Switch Long Australia Bank Bill Futures##BR##Trade From Dec/18 Contract To Oct/19 Contract New Zealand Long 5-year New Zealand government bonds vs. 5-year U.S. Treasuries, currency-hedged into U.S. dollars (HOLD) Long 5-year New Zealand government bonds vs. 5-year German government bonds, with no currency hedge (HOLD) One of our more successful tactical trades has been in New Zealand (NZ) government bonds. We entered long positions in 5-year NZ debt versus 5-year U.S. Treasuries and 5-year German Bunds on May 30th, 2017, but we reviewed, and decided to maintain, those positions in a recent Weekly Report.11 The NZ-US spread trade has returned 4.67% since inception, hedged into U.S. dollars (Chart 16).12 The NZ-Germany trade, however, was a very rare instance where we recommended a cross-country spread trade on a currency UN-hedged basis, based on the negative view on the euro that we had last year. With the euro rising sharply against the New Zealand dollar, the unhedged return on that trade has been -2.87% (a return that, if hedged back into the euro denomination of the German bonds, would have generated a return of +3.56%). Looking ahead, we see continued scope for NZ bond outperformance, although the return potential is far less than it was when we first put on the trade. NZ economic growth is in the process of peaking, with export growth already rolling over (Chart 17, top panel). Net immigration inflows, which have been a major support for the NZ housing market and overall consumer spending over the past five years, have already begun to slow with the Reserve Bank of New Zealand (RBNZ) projecting bigger declines in the next couple of years (2nd panel). Both headline and core CPI inflation took a surprising downward turn in Q1 of this year, and both are well below the midpoint of the RBNZ target band (3rd panel). Chart 16Stay Long NZ 5yr Bonds##BR##Vs. The U.S. & Germany... Chart 17...With NZ Growth &##BR##Inflation Losing Momentum With both growth and inflation slowing, the RBNZ can remain dovish on monetary policy. An additional factor is the NZ government has recently changed the mandate of the RBNZ to include both inflation targeting and "maximizing employment" in a similar fashion to the Federal Reserve. With inflation posing no threat, the RBNZ can focus on its employment mandate by maintaining highly accommodative policy settings. With the NZ OIS curve still discounting one full 25bp RBNZ hike over the next year (bottom panel), there is scope for NZ bonds to outperform as that hike will not happen. This will allow NZ bond spreads to tighten, or at least outperform versus the forwards where some modest widening is currently priced. We are sticking with both spread trades, but we are choosing to leave the NZ-Germany trade currency unhedged given the renewed weakness in the euro (the unhedged return has already improved by over two full percentage points since the euro peaked earlier this year). We will monitor levels of the NZD/EUR currency cross rate to determine when to potentially hedge the currency exposure of our trade back into euros. Sweden Long Sweden 10-year government bond vs. 2-year government bond Short 2-year Sweden government bond vs. 2-year German government bond We recently entered two Sweden tactical bond trades on May 8, 2018, going long the Swedish 10-year vs. the 2-year and shorting the Swedish 2-year vs. the German 2-year (Chart 18).13 We expect that strong growth momentum, rising inflation and a tight labor market will force the Riksbank to raise rates earlier, and by more, than markets expect. Since inception for these "young" trades, each has returned -1bp.14 Sweden's economy made a solid recovery in 2017, with year-over-year real GDP growth reaching 3.3% in Q4. Going forward, export growth will remain supported by strong global activity, low unit labor costs, and a weak krona. Our own Swedish export growth model is already signaling a pickup over the rest of 2018. Consumption has been resilient and should continue to be supported by steadily recovering wages. Capital spending has been robust and industrial confidence remains in an uptrend. Additionally, leading indicators are still signaling positive growth momentum. The Riksbank's preferred measure of inflation, CPIF, slowed to 1.9% in April after briefly touching the central bank's target last month (Chart 19). In our view, this is a minor pullback rather than the start of a sustained reversal. Our core inflation model projects a gradual increase in the coming months, driven by above-trend growth that has soaked up all spare capacity. Labor markets have tightened considerably, and the unemployment rate is now more than one percentage point below the OECD's estimate of the full-employment NAIRU. During the last period when unemployment was this far below NAIRU, wage growth surged to over 4%. Chart 18Stay In A Sweden 2/10 Curve Flattener##BR##& Short 2yr Swedish Bonds Vs Germany Chart 19The Riksbank Will Not Ignore##BR##The Coming Inflation Overshoot For the curve flattener trade, our expectation is that the Riksbank will shift to a more hawkish tone in the coming months, leading markets to reprice the shape of the Swedish yield curve, as too few rate hikes are discounted in the short-end. With their mandates met, the Riksbank will be forced to act more aggressively. Importantly, there is no flattening currently priced into the Swedish bond forward curve, thus there is no negative carry associated with putting on a flattener now. In the relative value trade, we shorted the Swedish 2-year relative to the German 2-year. Growth in Sweden is likely to outpace that of the euro area once again in 2018. Swedish inflation is almost at the Riksbank target while euro area inflation continues to undershoot the ECB benchmark. The ECB is signaling that it is in no hurry to begin raising interest rates, therefore policy rate differentials will drive the 2-year Sweden-Germany spread wider over the next 12-18 months, with no spread move currently priced into the forwards. South Korea Short Korea 10-Year Government Bonds Vs. Long 2-Year Korea Government Bonds (CLOSE) We first introduced this trade on May 30th, 2017, after the election of Moon Jae-In as the South Korean president.15 The new government made major campaign promises to greatly expand fiscal spending on social welfare, public sector job creation, and increased aid to North Korea. With the central government's budget balance set to worsen significantly, we expected longer-term Korean bond yields to begin to price in faster growth and rising future debt levels, resulting in a bearish steepening of the yield curve (Chart 20). Since the new president was elected, however, the Korean economy worsened - even as much of the global economy was enjoying a cyclical upturn - with the trend likely to continue (Chart 21). The OECD leading economic indicator for Korea is weakening, while the annual growth in industrial production now sits at -4.2% - the worst level since the 2009 recession. Capital spending and exports are also slowing rapidly. Chart 20Close The 2yr/10y Korean##BR##Government Bond Curve Steepener Chart 21Korean Curve Stable,##BR##Despite Slower Growth & Fiscal Stimulus Due to the slowdown in the economy, Korean firms' capacity utilization is now at the worst level since the middle of 2009. Although businesses were already suffering from downward pressure on revenues, the Moon administration dramatically increased the minimum wage last year, directly leading to a rise in bankruptcies for small and medium size firms (the bankruptcy rate rose from 1.9% in the first half of 2017 to 2.5% in the latter half). Looking ahead, the Moon government will continue to increase spending on welfare and financial aid for North Korea, especially if the domestic economy continues to struggle. We still believe that the rise in deficits and debt will eventually lead the market to price in some increase in the fiscal risk premium and a steeper Korean yield curve. Yet with the Bank of Korea (BoK) having already surprised the markets last November with a rate hike, and with Korean inflation now ticking higher alongside a stable won, we fear that any renewed steepening of the Korean curve awaits a shift to a more dovish BoK that is not yet on the horizon. For now, given the competing forces on the Korean yield curve, we are choosing to close our 2/10 Korea curve steepener at a loss of -0.63%.16 We will continue to monitor the Korean situation to look for opportunities to re-enter the trade at a later date. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Returns are calculated using Bloomberg pricing of the total return of a 2/5/10 butterfly. 2 Please see BCA U.S. Bond Strategy Special Report, "More Bullets, Barbells And Butterflies", dated May 15th 2018, available at usbs.bcaresearch.com. 3 Return is taken directly from Bloomberg Barclays index data on the duration-adjusted excess return of the entire TIPS index versus the entire Treasury index. 4 This return is calculated using Bloomberg data on actual U.S. and German bonds, and is shown on a currency-hedged basis into U.S. dollars - the currency denomination of the bond we are short in this spread trade. 5 Returns are calculated using Bloomberg Barclays inflation swap index data for a euro area CPI swap with a rolling 10-year maturity. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "Is It Partly Sunny Or Mostly Cloudy?", dated May 22nd 2018, available at gfis.bcaresearch.com. 7 Please see BCA Global Fixed Income Strategy Weekly Report, "Nervous Complacency", dated March 27th, 2018, available at gfis.bcaresearch.com. 8 Returns are calculated using Bloomberg data on actual Gilts, rather than bond index data. 9 Please see BCA Global Fixed Income Strategy Weekly Report, "Let The Good Times Roll", dated January 9th 2018, available at gfis.bcaresearch.com. 10 This return is measured as the total return of the Canadian inflation-linked bond index less that of the nominal Canadian government bond index from the Bloomberg Barclays family of bond indices. 11 Please see BCA Global Fixed Income Strategy Weekly Report, "Serenity Now", dated May 15th 2018, available at gfis.bcaresearch.com. 12 Returns are calculated using Bloomberg data on actual New Zealand government bonds, with our own adjustments for the impact on returns from currency hedging. 13 Please see BCA Global Fixed Income Strategy Special Report, "Sweden: The Riksbank Cannot Kick The Can Down The Road Anymore", dated May 8th 2018, available at gfis.bcaresearch.com. 14 Returns are calculated using Bloomberg data for actual individual Swedish government bonds, rather than bond index data. Both legs of the trade are duration-matched. 15 Please see BCA Global Fixed Income Strategy Weekly Report, "Distant Early Warning", dated May 30th 2017, available at gfis.bcaresearch.com. 16 Returns are calculated using Bloomberg data for actual individual Korean government bonds, rather than bond index data. Both legs of the trade are duration-matched and funding costs are included. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns