Developed Countries

As we highlighted in our most recent Weekly Report, the risk/reward tradeoff remains squarely to the downside and we are turning cyclically (3-12 month horizon) cautious on the prospects of the broad equity market. The Presidential cycle, UBER’s IPO, the S&P 500 hitting all-time highs following the initial December 2018 yield curve inversion, and two additional yield curve inversions signal that this time is no different and a recession is likely upon us in the coming 18 months. Using the NY Fed’s yield curve-derived recession probability forecast is revealing. This recession gauge has been an excellent leading indicator of S&P 500 momentum since the S&L crisis induced recession and its current message corroborates U.S. Equity Strategy’s cautious cyclical equity market view (recession gauge shown inverted, see chart). For additional details, please refer to the most recent Weekly Report.

Highlights Fed: A Fed rate cut in June or July is not a done deal, but is looking increasingly likely purely from a risk management perspective, as it would both calm financial markets and potentially boost the inflation expectations component of Treasury yields. ECB: Easier monetary policy is required in Europe, and Mario Draghi hinted that rate cuts or even more QE are viable policy options. Depressed European bond yields (excluding Italy) suggest that this outcome is already fully priced. Maintain only a neutral allocation to core European government bonds. Feature Chart of the WeekA Lot Of "Negativity" In Bond Yields The Great Global Bond Rally of 2019 has caught many by surprise – including, we admit with some humility, us. Not only has the pace of the decline in yields been impressive, but the outright yield levels seen in many markets are startlingly low. The 10-year German bund reach an all-time low of -0.25% last week, while sub-1% 10-year bond yields can be seen in “risky Peripherals” like Spain and Portugal. The ferocity of the global bond move has left 54% of all developed market government bonds trading with negative yields; the highest such percentage since July 2016 after the U.K. Brexit vote unnerved investors (Chart of the Week). There are parallels to today purely from a political risk perspective, given the trade tensions between the U.S. and China (and potentially any other country that the Trump Administration has issues with). Another comparison can be made versus three years ago when looking at more fundamental drivers of low global yields that require a response from policymakers – namely, slowing growth and sluggish inflation. Our Central Bank Monitors are now sending a clear message that easier monetary policy is needed in all the major developed economies (Chart 2). Given soft market-based inflation expectations, this suggests that policymakers must not only talk dovish, but act dovish, to defend the lower bound of price stability. Chart 2Pressure To Ease GLOBAL Monetary Policy We’re seeing that in places like Australia and New Zealand, where policymakers have already cut rates. We can also see that in the euro area, where the ECB has introduced a new funding program to support bank lending (TLTRO3) and is now even contemplating restarting quantitative easing (QE). The Fed is next in line, with numerous Fed officials hinting that some easing of monetary policy could be on the horizon. Much easier monetary policy is already largely discounted in the current depressed level of global bond yields, though. While there are still risks to the growth outlook from trade uncertainty, we do not foresee a U.S./global recession on the immediate horizon. That means the risk/reward balance now favors some pickup in global bond yields, warranting a below-benchmark medium-term stance on duration exposure. Why “Insurance” Fed Cuts Are Likely Chart 3A Strong Dollar Is Disinflationary Last week, the Federal Reserve held a research conference to discuss its monetary policy framework. Among the topics discussed were potential changes to the way the Fed manages its inflation target, including tolerating faster inflation after a period of below-target inflation. The goal of such “make-up” strategies would be to ensure that periods of low inflation do not get embedded into inflation expectations and bond yields. The problem with such strategies, however, is they are less likely to work if low interest rates and low inflation are a global phenomenon. The coordinated nature of the global bond rally has left the Fed facing a combination of rapidly falling Treasury yields alongside a strong U.S. dollar. With interest rate differentials continuing to favor the greenback, the currency is exerting downward pressure on commodity prices and, more generally, global inflation (Chart 3). Of course, the dollar does not only trade off interest rate differentials, but also global growth expectations, so some of the dollar rally seen this year reflects slowing non-U.S. economies and capital outflows from non-U.S. financial markets. What is clear, however, is that a strong dollar, and all it represents in terms of global growth, is disinflationary. Numerous Fed officials, including Fed Chairman Jay Powell, gave hints last week that they were open to considering interest rate cuts in response to signs of weakening U.S. growth and heightened trade uncertainty. With 5-year/5-year forward inflation expectations in the TIPS market now at 1.9% – still well below the 2.3-2.4% levels consistent with the Fed’s 2% target on the PCE deflator – the Fed has the cover to deliver one or two “insurance” rate cuts in the next few FOMC meetings. This would be consistent with their risk management framework. Our Central Bank Monitors are now sending a clear message that easier monetary policy is needed in all the major developed economies. Given soft market-based inflation expectations, this suggests that policymakers must not only talk dovish, but act dovish, to defend the lower bound of price stability.  If the Fed fails to ratify markets’ dovish expectations at next week’s policy meeting, risk assets will likely sell off – perhaps violently, as occurred last December. That would deliver the kind of tightening in financial conditions that would force the Fed turn more dovish and eventually cut rates anyway. Alternatively, if the Fed actually cuts rates next week or in July and both the economy and inflation eventually recover, and risk assets surge higher, then the Fed can always take back those cuts with tighter policy later (especially if trade uncertainty diminishes with some sort of U.S.-China trade deal at the G20 meeting later this month). Such a strategy could even help Fed credibility by boosting inflation expectations back to levels more consistent with the Fed’s inflation target, which would also help put upward pressure on Treasury yields. Our Fed Monitor is now signaling the need for easier U.S. monetary policy, but that is already discounted in the 75bps of rate cuts (over the next twelve months) priced at the front-end of the yield curve, and in the current low level of Treasury yields (Chart 4). The Treasury rally also looks overdone when looking at other measures, such as the low level of mean-reverting U.S. data surprises, overbought price momentum and extended long duration positioning (Chart 5). Chart 4Treasuries Fully Priced For Fed Easing   Net-net, the medium-term risk/reward balance favors moderate below-benchmark duration positioning for Treasury investors, and underweight tilts for the U.S. in global government bond portfolios. More tactically, the amount of Fed rate cuts now discounted seems excessive with only the U.S. manufacturing sector cooling while the rest of the economy remains on firm footing. For that reason, we are already taking profits on one leg of our fed funds futures calendar spread trade initiated last week. The Treasury rally also looks overdone when looking at other measures, such as the low level of mean-reverting U.S. data surprises, overbought price momentum and extended long duration positioning  Chart 5The Treasury Rally Looks Stretched Chart 6Fed Funds Futures Trade: Exit Long Aug 2019, Stay Short Feb 2020 We recommended buying the August 2019 fed funds futures contract to hedge the risk that the Fed tries to get ahead of market sentiment by cutting rates in June or July. That contract would have returned a positive return in a scenario where the Fed delivered one 25 basis point rate cut in either June or July, and a negative return in a scenario where rates are unchanged. In only one week, that contract’s risk/reward profile has shifted dramatically. The contract is now priced for a loss in both the “one rate cut” and “no rate cut” scenarios. We therefore exit our long position in the August 2019 fed funds futures contract for a gain of +5bps. The second leg of our proposed trade was to short the February 2020 fed funds futures contract. This remains an excellent bet. As of last Friday, a short position in the February 2020 contract will earn a positive return as long as three or fewer rate cuts occur between now and next February (Chart 6). We are keeping this position on as a pure rates trade to play for the Fed delivering less than the market expects. Bottom Line: A Fed rate cut in June or July is not a done deal, but is looking increasingly likely purely from a risk management perspective, as it would both calm financial markets and potentially boost the inflation expectations component of Treasury yields. Are European Bond Yields Discounting More ECB QE? While we see little absolute value in U.S. Treasuries, there may not be much near-term upside in yields without an improvement in European economic growth. Simply put, Europe remains an anchor weighing on global bond yields. While we see little absolute value in U.S. Treasuries, there may not be much near-term upside in yields without an improvement in European economic growth. Simply put, Europe remains an anchor weighing on global bond yields. Our country diffusion indicators for the euro area – measuring the share of countries within the region that are seeing faster GDP growth, rising leading economic indicators and quickening headline inflation rates – all show that the current downturn is broad-based (Chart 7). Dating back to the introduction of the single currency zone in the late 1990s, there have been three periods where the country diffusion indicators were as weak as they are now. All three times lead to multiple interest rate cuts by the ECB. Chart 7A Broad-Based Slowing Of European Growth & Inflation Our ECB Monitor is also calling for easier monetary policy in the euro area (Chart 8), driven by weakness in both the growth and inflation components. Chart 8Our ECB Monitor Says 'Ease', Bund Yields Agree With the ECB policy rate already negative, however, the central bank is reluctant to push rates even lower and starve euro area banks of badly needed net interest margin. Chart 9TLTRO3 Will Help Italian & Spanish Banks The Most   At last week’s policy meeting, the ECB Governing Council committed to leaving rates unchanged through the first half of 2020. ECB President Mario Draghi noted in his press conference that forward guidance has “become the major monetary policy tool we have now”, suggesting that actual changes in interest rates will be more difficult to implement. Draghi also noted that the new TLTRO3 program was intended only as a “backstop” to sustain current levels of bank lending as the old TLTRO programs begin to roll off, not as a fresh source of stimulus. This was almost certainly aimed at the banks of Italy and Spain – countries that took up nearly 60% of the last TLTRO program that is now starting to roll off and where credit growth is contracting (Chart 9). The ECB worries that the weaker parts of the European banking system are becoming too reliant on cheap central bank funding, making it more difficult to end the liquidity program in the future without causing a credit crunch.   German bunds have already priced in some sort of ECB easing (rate cuts or fresh bond buying). Our estimate of the term premium on the 10-year German bund yield is already deeply negative, which reflects both a risk aversion bid for safety and, potentially, some market expectation of incremental ECB QE. Chart 10Market Discounting Fresh ECB Bond Buying? So if the ECB is reluctant to cut rates or subsidize more lending, what monetary ammunition is left? Draghi did hint last week that the topic of restarting the Asset Purchase Program (APP) came up in the ECB meeting as an option if the economic and inflation backdrop deteriorated further, or global trade uncertainty intensified. The ECB is facing a situation similar to when the APP was first announced in 2014. Inflation expectations, as measured by the 5-year/5-year forward euro CPI swap rate, are now down to 1.2% (Chart 10). It was a similar plunge in inflation expectations that wore down ECB hawks’ reticence to deploy quantitative easing back in 2014. German bunds have already priced in some sort of ECB easing (rate cuts or fresh bond buying). Our estimate of the term premium on the 10-year German bund yield is already deeply negative, which reflects both a risk aversion bid for safety and, potentially, some market expectation of incremental ECB QE. The latter interpretation would also explain the low level of bond yields seen in Peripheral Europe (excluding Italy, dealing with a deficit battle with the European Commission), as investors stretch for yield in anticipation of supportive future ECB policy. We see little investment value in euro area bonds at such low levels, given how much bad news on growth and inflation, and the potential monetary easing in response, is already discounted. Similar to U.S. Treasuries, the risk/reward balance favors a modest below-benchmark structural duration stance. The upside in European yields is still far more limited than for U.S. Treasury yields, given the much more fragile state of European growth and inflation expectations. Treasuries are thus more overpriced than bunds. Bottom Line: Easier monetary policy is required in Europe, and Mario Draghi hinted that rate cuts or even more QE are viable policy options. Depressed European bond yields (excluding Italy) suggest that this outcome is already fully priced. Maintain only a neutral allocation to core European government bonds.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Yesterday we were stopped out on our long S&P managed health care/short S&P semis market neutral pair trade initiated on May 13, 2019 for a gain of 10%. Our thesis remains intact that a lot of negative news has been priced into HMOs on the back of the threat of the “Medicare For All” bill passage, while a lot of euphoria has been baked in the cake for semis despite their current down cycle. However, portfolio risk management is forcing our hand and given our ongoing de-risking, we are obeying our trailing stop loss for a gain of 10% in a very short time span. Bottom Line: Book gains of 10% in the long S&P managed health care/short S&P semis pair trade since inception and move to the sidelines for now.