Developed Countries
Highlights Subdued long-term inflation expectations and central bank bond purchases have suppressed the term premium. This is set to change, as quantitative easing turns into quantitative tightening and shrinking output gaps around the world start to push up inflation. The neutral rate in the U.S. is likely higher than the Federal Reserve realizes, which could leave the Fed behind the curve in normalizing monetary policy. A spike in the term premium is unlikely this year, given the prospect of a stronger dollar and ongoing stresses in emerging markets. Next year may be a different story, however. Fixed-income investors with a 12-to-18 month horizon should maintain duration risk at below-benchmark levels. Asset allocators should keep equity and credit exposure at neutral. Within the equity space, investors should favor developed market equities over their EM peers and defensive sectors over cyclicals. Feature The Mystery Of The Falling Term Premium The yield on a bond can be decomposed into the expected path of short-term rates and a term premium. Historically, the term premium has been positive, meaning that investors could expect to earn a higher return by purchasing a bond rather than by rolling over a short-term bill.1 More recently, the term premium has turned negative in many economies (Chart 1). Not only are investors willing to forego the extra return for taking on duration risk, but they are actually willing to sacrifice return when buying long-term bonds. Chart 1Term Premia Across Developed Markets Are Low There are two main reasons why the term premium has fallen: Long-term inflation expectations have been very subdued, which has made bonds a hedge against bad economic outcomes. Central bank purchases have depressed yields, while forward guidance has dampened interest-rate volatility. Bonds And Risk Some commentators like to describe the riskiness of a security by how volatile its price is, or if they want to get a bit more sophisticated, the skew of its returns. But this is not really the right way to think about risk. As Harry Markowitz first discussed in 1952 in his seminal paper "Portfolio Selection," investors ultimately care about their overall level of wealth. If the price of a certain security goes up when the prices of all others go down, investors should prefer to hold this particular security even if it offers a subpar expected return. Bonds today play the role of this safe security. Chart 2 shows the rolling correlation between monthly changes in the 10-year Treasury bond yield and the S&P 500. The correlation was generally negative between the late-1960s and late-1990s: Bond yields back then tended to rise whenever the S&P 500 was falling. This made bonds a bad hedge against lower equity prices. Chart 2Bond Yields Now Tend To Rise When Equity Prices Go Up Over the past two decades, however, bond yields have generally declined whenever the stock market has swooned. Since a lower bond yield implies a higher bond price, bonds have been a good hedge against equity risk in particular, and a weaker economy in general. As a consequence, investors are now willing to pay a premium to hold long-term bonds. This has bid up the price of bonds, so much so that the term premium has dipped into negative territory. Receding Inflation Fears Have Made Bonds Safer Why did the correlation between bond yields and stock market returns change? The answer has a lot to do with what happened to inflation. Bond yields can go up because of expectations of stronger growth or because of the anticipation of higher inflation. The former is good for equities, while the latter is typically bad for equities because it heralds additional monetary tightening. As inflation expectations became increasingly unhinged in the second half of the 1960s, inflationary shocks became the dominant driver of bond yields. When bond yields went up during that period, stock prices usually fell. That changed in the 1990s, as inflation stabilized at low levels and growth became the primary driver of yields once again (Chart 3). Chart 3Long-Term Inflation Expectations Have ##br##Remained Subdued For Over Two Decades Following the financial crisis, inflationary concerns were supplanted by worries about deflation. Falling inflation is generally good for bond investors. If inflation declines, the real purchasing power of a bond's interest and principal payments will go up. For investors who have to mark-to-market their portfolios, the benefits of lower inflation are especially clear. A decline in inflation will take the pressure off central banks to hike rates. This will cause the price of existing bonds to rise, delivering an immediate capital gain to their holders. Moreover, to the extent that falling inflation expectations typically accompany rising worries about the growth outlook, investors will benefit from a decline in the expected path of real interest rates. QE And The Term Premium While falling inflation expectations have been the most important driver of the decline in the term premium, central bank asset purchases have also lent a helping hand. In standard macroeconomic models, bond yields are determined at the margin by the willingness of private investors to hold the existing stock of debt. If a central bank buys bonds, this reduces the volume of bonds that the private sector can hold. To induce private investors to hold fewer bonds, bond yields must decline. There is no consensus about how much quantitative easing has depressed bond yields. A Fed study published in April of last year estimated that QE had depressed the 10-year yield by 100 basis points at the time of writing, a number that the authors expected to decline to 85 basis points by the end of 2017.2 Other studies found that the peak impact on yields has ranged from 90-to-200 basis points. One thing that is empirically undeniable is that there is a large international component to bond yields. The steep decline in the U.S. term premium in 2014 was mainly driven by the expectation - ultimately proven correct - that the ECB would launch its own QE program. Asset purchases by the Bank of Japan, along with its yield curve control policy, also contributed to lower bond yields in the rest of the world. Things are beginning to change, however (Chart 4). The Fed is now letting its balance sheet shrink by about $40 billion per month, a number that will rise to $50 billion in October. The Bank of England has kept its holdings of gilts and corporate bonds constant for over a year, while the ECB intends to start tapering asset purchases later this year. The Bank of Japan continues to buy assets, but even there, the pace of annual purchases has fallen from about 80 trillion yen in 2015-16 to 35 trillion at present. Meanwhile, the use of forward guidance - which was arguably even more instrumental in suppressing interest rate volatility and pushing down the term premium than QE - is likely to be scaled back, at least in the United States. Fed Chair Powell said on May 25: "I think [forward guidance] will have a significantly smaller role going forward." Incoming New York Fed President John Williams echoed this sentiment, noting in a Bloomberg interview that "I think this forward guidance, at some point, will be past its shelf life."3 Opening The Fiscal Spigots Just as central banks are purchasing fewer bonds in the open market, bond issuance is set to rise. Usually the U.S. budget deficit narrows whenever the unemployment rate declines, as strong economic growth draws in more tax revenue and spending on social programs drops (Chart 5). Things are different this time around. The Congressional Budget Office (CBO) expects the U.S. budget deficit to increase from 2.4% of GDP in 2015 to 4.6% of GDP in 2019. Chart 4From Quantitative Easing To ##br##Quantitative Tightening Chart 5Unlike In The Past, The U.S. Budget Deficit Is Set To Widen Even ##br##If The Unemployment Rate Continues To Decline The Trump tax cuts have imperiled the long-term fiscal outlook. Up until last year, the U.S. fiscal picture appeared much better than it once did. In 2009, the amount of federal debt held by the public was projected to exceed 250% of GDP in 2046. By 2016, that forecast had been reduced to 113% of GDP, thanks mainly to the economic recovery and slower projected spending growth on health care following the introduction of the Affordable Care Act (Chart 6). The Trump tax cuts have blown those forecasts out of the water. We estimate that government debt held by the public will increase to almost 190% of GDP in 2046 if current policies are maintained. Chart 6Trump Tax Cuts Have Put Debt Trajectory ##br##Back On An Unsustainable Path While the stock of debt, rather than the flow, determines bond yields in the standard bond pricing model, flows can still matter if they provide a reliable signal as to how large the stock of debt will be in the future. Given that changes in fiscal policy are often hard to reverse, the deterioration in the fiscal outlook suggests that the stock of government debt will be much larger than investors had expected a few years ago. This justifies a higher term premium today. Broken Accelerator? Subdued inflation expectations have kept the term premium in check, but the prospect of ill-timed fiscal stimulus raises doubts about whether this state of affairs will persist. What would happen to inflation if the economy found itself in an overheated state for a prolonged period of time? The truth is that no one really knows the answer to that question. Some prominent economists have contended that nothing terrible would transpire. They argue that the entire concept of the Non-Accelerating Inflation Rate of Unemployment (NAIRU) is passé. In their view, the magnitude of economic slack determines the level of inflation, not the rate of change in inflation. Recent data provides some support to their views. Shrinking output gaps in much of the world during the past eight years have failed to raise inflation by very much, let alone cause inflation to accelerate to the upside (Chart 7). If an overheated economy simply results in modestly higher inflation, rather than increasing inflation, central banks have little to fear. A bit more inflation would allow central bankers to target a higher nominal interest rate, thus giving them greater scope to cut rates in the event of an economic downturn. Higher inflation could also improve labor market flexibility by permitting real wages to fall in the presence of nominal wage rigidities.4 In addition, as we have argued in the past, modestly higher inflation could make the financial system less susceptible to asset bubbles.5 Unfortunately, the case for letting the economy overheat is not so straightforward. For one thing, the relationship between inflation and unemployment tends to be non-linear. As Chart 8 illustrates, an economy's aggregate supply curve is likely to be quite shallow when there is a lot of excess capacity but rather steep when most of the slack has been absorbed. We may simply have not yet reached the steep side of the aggregate supply curve. Chart 7Developed Markets: Inflation Has Remained ##br##Low Despite Shrinking Output Gaps Chart 8Inflationary Pressures Tend To Increase ##br##When Spare Capacity Is Absorbed The experience of the late 1960s illustrates this point. Core inflation was remarkably stable during the first half of the decade, even as the unemployment rate continued to drift lower. In economic parlance, the Phillips curve was very flat. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 9). Inflation ultimately made its way to 6% in 1970, three years before the first oil shock struck. Anchors Away The upward trend in inflation observed during the 1970s underscores another point, which is that there is no unique mapping between the unemployment rate and inflation. To use a bit of economic jargon, not only does the slope of the Phillips curve vary depending on what the unemployment rate is, but the intercept of the curve could potentially move up or down in response to changes in long-term inflation expectations (Chart 10). Chart 9Inflation In The 1960s Took Off Once ##br##The Economy Began To Overheat Chart 10An Increase In Inflation Expectations Can ##br##Cause The Phillips Curve To Shift Upwards Chart 11Market Expectations Versus The Fed Dots This is a point that Milton Friedman and Edmund Phelps made more than fifty years ago. Friedman and Phelps argued that central banks could only stimulate the economy if they delivered more inflation than people were anticipating. Higher-than-expected inflation would push down real interest rates, leading to more spending. As the two economists correctly noted, however, such an outcome would only occur if people systematically underestimated what inflation would end up being. If people made inflation forecasts in a fairly rational manner, the apparent trade-off between higher inflation and lower unemployment would evaporate: Inflation would rise, but output would not be any greater than before. One of the errors that central banks made in the 1970s is that they kept interest rates too low for too long in the mistaken belief that slower growth was the result of inadequate demand rather than a decline in the growth rate in the economy's productive capacity and a higher equilibrium rate of unemployment. Today, the error may be in thinking that the neutral rate of interest is lower than it really is. As we argued several weeks ago, cyclical factors have probably pushed up the neutral rate quite a bit over the past few years.6 Neither the Fed dots nor market pricing are adequately discounting this possibility (Chart 11). Inflation is a notoriously lagging indicator. It typically does not peak until after a recession has begun and does not bottom until the recovery is well underway (Chart 12). By the time the Fed realizes it is behind the curve, inflation could already be substantially higher. The fact that the New York Fed's Underlying Inflation Gauge - which leads core CPI inflation by about 18 months - has risen to over 3% provides some evidence in support of this view (Chart 13). Chart 12Inflation Is A Lagging Indicator Chart 13Upside Risks To U.S. Inflation Investment Conclusions A sudden increase in the term premium could set in motion a vicious circle where bond yields rise and the stock market falls at the same. In such a setting, bonds would lose much of their appeal as a hedge against equity drawdowns. This could put even more upward pressure on the term premium, leading to even lower stock prices. Chart 14 shows that the MOVE index, a measure of implied volatility for the Treasury market, remains near historically low levels. Just as investors were too complacent about the possibility of an equity volatility spike earlier this year, they are too complacent about the possibility of an increase in bond volatility. Chart 14Investors Are Too Complacent Getting the timing of any change in the term premium is critical, of course. It often takes a while for an overheated economy to generate inflation. The unemployment rate fell nearly two percentage points below its full employment level in the 1960s before inflation took off. The U.S. economy is only now starting to boil over. Moreover, if the dollar continues to strengthen over the coming months, as we expect, this could put downward pressure on commodity prices. Thus, we do not foresee a major inflation-induced spike in the term premium this year. Next year may be a very different story. If inflation ratchets higher in 2019, the term premium could jump. The resulting tightening in financial conditions could pave the way for a recession in 2020. Fixed-income investors with a 12-to-18 month horizon should maintain duration risk at below-benchmark levels. We downgraded global equities and credit exposure to neutral last month. Within the equity space, investors should favor developed market equities over their EM peers and defensive sectors over deep cyclicals such as industrials and materials. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Note that the term premium and the slope of the yield curve are different concepts. The slope of the yield curve measures the difference in yields between two maturities at any given point in time. In contrast, the term premium measures the difference between the return on a long-term bond and the return an investor would receive by rolling over a short-term bill over the life of that bond. Unlike the slope of the yield curve, which can be observed directly, the term premium has to be estimated using market expectations of the future path of short-term rates. 2 Please see Brian Bonis, Ihrig, Jane, and Wei, Min, "The Effect of the Federal Reserve's Securities Holdings on Longer-term Interest Rates," FEDS Notes, Federal Reserve (April 20, 2017); Edison Yu, "Did Quantitative Easing Work?" Economic Insight, Federal Reserve Bank of Philadelphia Research Department (First quarter 2016); and "Unconventional Monetary Policies -- Recent Experience And Prospects," IMF (April 18, 2013). 3 Jeanna Smialek, "Powell Sees Significantly Smaller Role for Fed Forward Guidance," Bloomberg (May 25, 2018); and Jeanna Smialek, "The Incoming New York Fed Chief Talks About Inflation and the Yield Curve," Bloomberg (May 16 2018). 4 A low-inflation environment can have adverse economic consequences during economic downturns due to the presence of downward rigidity of nominal wages. Firms typically try to reduce costs when demand for their products and services declines, but employers tend to be unwilling or unable to cut nominal wages. In this context, higher inflation provides a potential way to overcome nominal wage rigidity as it helps real wages to adjust to negative shocks. When inflation is low, real wages become less flexible, making it more likely that firms will opt for job cuts as a means to decrease overall costs. 5 Please see Global Investment Strategy Weekly Report, "Tinbergen's Ghost," dated May 11, 2018. 6 Please see Global Investment Strategy Weekly Report, "U.S. Housing Will Drive The Global Business Cycle... Again," dated July 6, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
The long S&P homebuilding/short S&P REITs pair trade is off to a flying start. Already, this market- and industry-neutral trade has generated alpha for our portfolio to the tune of 7% since the early-July inception.1 There is a long runway ahead for additional gains in this pair trade. Importantly, the recent slew of bank earnings releases had a common thread: across the board, banks are pulling in their horns with regard to extending commercial real estate (CRE) loans. This represents a bearish backdrop for the overextended CRE sector (second panel). As the Fed continues to tighten the monetary screws, delinquency rates have nowhere to go but up, especially in CRE that currently enjoys an ultra-low starting point (fourth panel). Bottom Line: We reiterate our long S&P homebuilding/short S&P REITs pair trade. The ticker symbols for the stocks in the S&P homebuilding and S&P REITs indexes are: BLBG: S5HOME - LEN, PHM, DHI and BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE, respectively. 1 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com.
Overweight (High Conviction) The S&P software index has continued to soar this year, helping the NASDAQ set an all-time high this week. Capex surveys are bouncing around the highest levels this millennium; such optimism has typically led software investment and, hence, earnings growth (second and third panels). The market has fully adopted an ebullient stance on U.S. software with the result that our high-conviction overweight trade has gained 15% versus the SPX since the late-November inception.1 At least part of the ascent of the S&P software index has been due to M&A premia being built into stock prices, with CA already being the subject of a takeover bid from AVGO. With the amount of industry consolidation, a speculative lift is hardly a surprise (bottom panel). Still, we view this as the flightiest sort of valuation upside and, from a portfolio management perspective, this morning we suggest that clients institute a stop in this high-conviction call at the 10% relative return mark, in line with our late-January introduced risk management policy. Bottom Line: We reiterate our high-conviction overweight status in the S&P software index, but recommend a 10% stop. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, RHT, ADSK, CTXS, ANSS, SNPS, SYMC, TTWO, CDNS, CA. 1 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com.
Highlights The real culprit for the mushrooming U.S./euro area trade imbalance is the ECB, and specifically its post-2014 experiment with ultra-loose monetary policy. There could be a major sea-change in ECB policy after November 2019 when Draghi's Presidency ends - just as there was after the last two changes in the ECB Presidency in November 2003 and November 2011. The yield spread between 30-year U.S. T-bonds and German bunds has much more scope to tighten than to widen. The euro's undervaluation - as calculated by the ECB itself - will ultimately correct. European exporters and equity markets heavily exposed to exporters - such as Sweden's OMX - will find the going tough, one way or another. If a stronger currency doesn't hit them, then President Trump surely will. Feature Chart of the WeekThe U.S./Euro Area Trade Imbalance Is A Near-Perfect Function Of Relative Monetary Policy Here in London last week President Trump trumpeted one of his biggest gripes: "The European Union treats the United States horribly. And that's going to change. And if it doesn't change, they're going to have to pay a very big price... Last year, we lost $151 billion with the European Union. We can't have that. We're not going to have that any longer, okay?" 1 President Trump is absolutely right about the size of the U.S. trade imbalance with Europe. But he is wrong to place the blame entirely on "trade barriers that are beyond belief". At least half of the imbalance - including with Germany - has appeared since 2014 (Chart I-2). Therefore, by definition, this part of the bilateral deficit is neither a structural issue, nor about trade barriers. Chart I-2Half of Germany's Export Surplus Appeared After 2014 The Real Culprit For The Mushrooming U.S/Euro Area Trade Imbalance As we have identified on these pages many times, the real culprit for the mushrooming U.S./euro area trade imbalance is the ECB, and specifically its post-2014 experiment with ultra-loose monetary policy. This experiment has resulted in a significantly undervalued euro, which has made the euro area grossly over-competitive vis-à-vis the United States, as calculated by the ECB itself. The Chart of the Week provides the damning and incontrovertible evidence: the U.S./euro area bilateral deficit is a near-perfect function of relative monetary policy. Of course, the ECB is targeting neither the euro nor the trade imbalance; the ECB is targeting its definition of price stability. The trouble is that the ECB definition of price stability omits owner-occupied housing costs, and thereby understates true euro area inflation by 0.5 per cent. To the extent that the ECB thinks in terms of real interest rates based on its own (faulty) definition of inflation, this means that the ECB is setting real interest rates that are far too low for the euro area's true economic fundamentals, resulting in the significantly undervalued euro and the associated trade imbalance (Chart I-3 and Chart I-4). Chart I-3Relative Monetary Policy Has Driven The Euro's Undervaluation... Chart I-4...And The Euro's Undervaluation Has Driven The U.S./Euro Area Trade Imbalance The bilateral deficit, by definition, is based on a true cross-border comparison, so it is tracking the 'apples for apples' real interest rate differential almost tick for tick, as our charts compellingly show. This true real interest rate differential is stretched relative to the fundamentals. In effect, while incorrectly measured inflation is deceiving the ECB, the mushrooming trade imbalance tells us that something is seriously awry. That something is not trade barriers that are too high; that something is ECB monetary policy that is too loose. The Target2 Imbalance Reaches €1.5 Trillion The ECB's ultra-loose policy has spawned another huge distortion: the euro area Target2 banking imbalance, which now amounts to an unprecedented €1.5 trillion (Chart I-5). What is the Target2 imbalance (Box 1), and why should we care about it anyway? Chart I-5ECB Policy Has Lifted The Target2 Banking Imbalance To Euro 1.5 Trillion BOX 1 What Is Target2? Target2 stands for Trans-European Automated Real-time Gross settlement Express Transfer system. It is the settlement system for euro payment flows between banks in the euro area. These payment flows result from trade or financial transactions such as deposit transfers, sales of financial assets or debt repayments. If the banking system in one member country has more payment inflows than outflows, its national central bank (NCB) accrues a Target2 asset vis-à-vis the ECB. Conversely, if the banking system has more outflows than inflows, the respective NCB accrues a Target2 liability vis-à-vis the ECB. Target2 balances therefore show the cumulative net payment flows within the euro area. The ECB has delegated its QE sovereign bond purchases to the respective national central banks within the Eurosystem. In the case of Italian bonds, Italian investors have offloaded their BTPs to the Bank of Italy and deposited the received cash cross-border in countries with healthier banking systems - like Germany. Strictly speaking, this flow of Italian investor cash to German banks is not the same as the deposit flight during the depths of the euro debt crisis in 2012. Rather, we might call it precautionary cash management. Nevertheless, in Eurosystem accounting terms it still means that the Bundesbank has a new liability to German banks denominated in 'German' euros, while the Bank of Italy has a new asset - the BTP - denominated in 'Italian' euros (Chart I-6 and Chart I-7). The Target2 imbalance is the aggregate of such mismatches between Eurosystem liabilities denominated in 'German and other core' euros and assets denominated in 'Italian and other periphery' euros. Chart I-6The Target2 Imbalance Reflects The##br## Cross-Border Flow Of Italian Investor Cash... Chart I-7...To German Banks Does any of this Target2 accounting gymnastics really matter? No, so long as a 'German' euro equals an 'Italian' euro, the imbalance is just an accounting identity within the Eurosystem. But if Germany and Italy started using different currencies, then suddenly all hell would break loose. The Bundesbank liability to German banks would be redenominated into deutschemarks, while the Bank of Italy asset would be redenominated into lira. Thereby the ECB would end up with much greater liabilities than assets, and a solvency shortfall potentially equivalent to hundreds of billions of euros would end up on the shoulders of the ECB's shareholders - largely, German taxpayers. Some people might argue that by increasing the cost of a divorce, an actual split becomes less likely. But this reasoning is weak. As we have seen in recent election and referendum outcomes, the biggest risk comes from a populist backlash against the status quo. And populist backlashes do not stop to do a detailed cost benefit analysis. A Sea-Change For The ECB In 2019? Although the ECB is unlikely to broadcast the undesired side-effects of its ultra-loose policy, it must by now be acutely aware that it is spawning huge imbalances. The costs are rising while the benefits are becoming questionable. The irony is that the one euro area economy that arguably does need stimulus - Italy - has a dysfunctional banking system which makes ultra-loose monetary policy largely ineffective anyway. Despite record low interest rates through the past four years, Italian bank credit growth has been virtually non-existent (Chart I-8). As we pointed out last week in Monetarists Vs Keynesians: The 21st Century Battle, the M5S/Lega coalition government is right to say: Italy would be better off with fiscal stimulus, not monetary stimulus.2 Chart I-8Italian Banks Have Not Been Lending The ECB will end its QE purchases at the end of this year, though the central bank has promised to maintain its current constellation of negative and zero interest rates "at least through the summer of 2019". However, it might be problematic to extend this forward guidance much beyond that. This is because Mario Draghi's eight year term as ECB President ends on October 31 2019, and it would be difficult both politically and operationally to tie the steering hands of his successor, especially if he/she comes from outside the current Governing Council. Interestingly, the last two changes in the ECB Presidency marked major sea-changes in policy direction: in 2003, Jean-Claude Trichet immediately stopped the rate cutting of his predecessor, Wim Duisenberg; and in 2011, Mario Draghi immediately reversed the rate hikes of his predecessor, Trichet. We would not bet against another major sea-change at the end of 2019 (Chart I-9). Chart I-9A Sea-Change For The ECB In 2019? If the end of 2019 does mark a turning point in relative monetary policy, investors should plan for three medium-term repercussions: The yield spread between 30-year U.S. T-bonds and German bunds has much more scope to tighten than to widen. The euro's undervaluation - as calculated by the ECB itself - will ultimately correct. European exporters and European equity markets heavily exposed to exporters - such as Sweden's OMX - will find the going tough, one way or another. If a stronger currency doesn't hit them, then President Trump's vow that "they're going to have to pay a very big price" surely will (Chart I-10). Chart I-10If A Stronger Currency Doesn't Hit European Exporters, Then President Trump Surely Will! 1 At the joint press conference with Theresa May. 2 Please see the European Investment Strategy Special Report 'Monetarists Vs Keynesians: The 21st Century Battle' July 12 2018 available at eis.bcaresearch.com. Fractal Trading Model* This week's recommended trade is to go long gold, whose 65-day fractal dimension is close to the lower bound that has reliably signaled previous tradeable trend reversals. Set a profit target of 3% with a symmetric stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Refiners have taken it to the chin over the past six weeks, underperforming both the SPX and the broad energy complex, and deteriorating industry fundamentals signal that more pain lies ahead. Crack spreads have given way recently, and as the Brent/WTI crude oil spread closes in on the zero line, refining margins will remain under intense downward pressure (second panel). Not only is demand faltering (not shown), but the news is equally grim on refining inventories. In fact, there is no apparent supply side offset: gasoline stocks are rising (gasoline inventories shown inverted, third panel). This supply/demand backdrop will weigh on industry profitability. Adding insult to injury, relative valuations do not offer any cushion in case of any profit mishaps as they are hovering near previous cyclical peaks and significantly higher than the historical mean (bottom panel). Netting it out, decreasing refining margins, a deteriorating supply/demand backdrop and extended relative valuations suggest that refiners are a sell. Bottom Line: We trimmed the S&P oil & gas refining & marketing index to underweight; please see Monday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, ANDV and HFC.
Highlights President Trump is a prisoner of his own mercantilist rhetoric - there is more trade tension and volatility to come; China's depreciation of the RMB can go further - and will elicit more punitive measures from Trump; Gasoline prices are a constraint on Trump's Maximum Pressure campaign against Iran, but only until midterm elections are done; Brexit woes are keeping us short GBP/USD, but Theresa May has discovered the credible threat of new elections - we are putting a trailing stop on this trade at 2%; The EU migration "crisis" is neither a real crisis nor investment relevant. Feature General Hummel: I'm not about to kill 80,000 innocent people! We bluffed, they called it. The mission is over. Captain Frye: Whoever said anything about bluffing, General? The Rock, 1996 As BCA's Geopolitical Strategy has expected since November 2016, the risk of trade war poses a clear and present danger for investors.1 The U.S. imposed tariffs of 25% on $34 billion of Chinese goods on July 6, with tariffs on another $16 billion going into effect on July 20. President Trump announced on July 10 that he would levy a 10% tariff on an additional $200 billion of Chinese imports by August 31 and then on another $300 billion if China still refused to back down. That would add up to $550 billion in Chinese goods and services that could be subject to tariffs, more than China exported to the U.S. last year (Chart 1)! Chart 1President Trump Magically Threatens ##br##Even Non-Existent China Imports Table 1Market's Couldn't Care##br## Less About Tariffs The S&P 500 couldn't care less. Trade-related events - and other geopolitical crises - have thus far had a negligible impact on U.S. equities (Table 1). If anything, stocks appear to be slowly climbing the geopolitical wall of worry since plunging to a low of 2,581 on February 8, which was before any trade tensions emerged in full focus (Chart 2A and Chart 2B).2 Chart 2AStocks Climbing The 'Wall Of Worry' On Trade Tensions... Chart 2B...And On Military Tensions Speaking with clients, the consensus appears to be that President Trump is "bluffing." After all, did he not successfully create a "credible threat" amidst the tensions with North Korea, thus forcing Pyongyang to stand down, change its bellicose rhetoric, free U.S. prisoners, and freeze its nuclear device and ballistic tests? This was a genuinely successful application of his "Maximum Pressure" tactic and he did not have to fire a shot!3 Yes, but the Washington-Pyongyang 2017 brinkmanship caused 10-year Treasuries to plunge 35bps from their July 7 peak to their September 7 low.4 Our colleague Rob Robis - BCA's Chief Fixed Income Strategist - assures us that this move in Treasuries last summer was purely North Korea-related, which suggests that not all investors were relaxed and expecting tensions to resolve themselves.5 President Trump may be bluffing on protectionism, on Iran, and on the U.S.'s trade and geopolitical relationship with its G7 allies. However, we should consider two risks. The first is that his opponents might not back down. Yes, we agree with the consensus that China will ultimately lose a trade war with the U.S. It is a trade surplus country fighting a trade war with its chief source of final export demand (Chart 3). Chart 3China Has More To Lose Than The U.S. Forecasting when China backs down, however, is difficult. If Beijing backs down in 2018, investors betting on stocks ignoring trade risks will be proven correct. We do not see this happening. Instead, we expect Beijing to continue using CNY depreciation to offset the impact of tariffs, likely exacerbating the ongoing USD rally in the process, and eventually putting pressure on U.S. corporate earnings in Q3 and Q4. China does not appear to be panicking about the threat of a 10% tariff. In fact, Beijing may decide to double-down on its structural reform efforts, which have negatively impacted growth in the country thus far, blaming President Trump's protectionist policies for the pain. The other question is whether the U.S. political context will allow President Trump to end the trade war. Our clients, colleagues, and friends in the financial industry seem to have collective amnesia about the "trade truce" orchestrated by Treasury Secretary Steven Mnuchin on May 20. The truce lasted merely a couple of days, with the U.S. ultimately announcing on May 29 that the tariffs on $50 billion of Chinese imports would go forward. President Trump may have wanted to present the Mnuchin truce as a big victory ahead of the midterm elections. His tweets the next day were triumphant.6 However, once the collective American establishment (Congress, pundits, and even Trump's ardent supporters in the conservative media) got hold of the details of the deal, they were shocked and disappointed.7 Why? The American "median voter" is far more protectionist than the political establishment has wanted to admit. Now that this public preference has been elucidated, President Trump himself cannot move against it. He is a prisoner of his own mercantilist rhetoric. President Trump may be dealing with a situation similar to the one General Hummel faced in the iconic mid-1990s action thriller The Rock. Hummel, played by the steely Ed Harris, holed up in Alcatraz with VX gas-armed M55 rockets, threatening to take out tens of thousands in San Francisco unless a ransom was paid by the Washington establishment. Unfortunately for Hummel, the psychotic marines he brought to "The Rock" turned against him when he suggested that the entire operation was in fact a bluff. As such, we reiterate: Whoever said anything about bluffing? China: Beware Beijing's Retaliation Since 2017, we have cautioned investors that Beijing was likely to retaliate to the imposition of tariffs by weakening the CNY/USD.8 June was the largest one-month decline in CNY/USD since the massive devaluation in 1994 (Chart 4). BCA's China Investment Strategy has shown that the PBOC is indeed allowing China's currency to depreciate against the U.S. dollar.9 Chart 5 shows the actual CNY/USD exchange rate alongside the value that would be predicted based on its relationship with the dollar over the year prior to its early-April peak. The chart suggests that the decline in CNY/USD appears to have reflected the strength in the U.S. dollar until very recently. However, CNY/USD has fallen over the past few days by a magnitude in excess of what would be expected given movements in the greenback, implying that the very recent weakness is likely policy-driven. Chart 4The Biggest One-Month Yuan Drop Since 1994 Chart 5The CNY Is Much Weaker Than The DXY Implies BCA's Foreign Exchange Strategy has pointed out that currency depreciation is also a way to stimulate the economy in the face of the central government's ongoing deleveraging policy.10 Not only does a weaker CNY dull the impact of Trump's tariffs, it also insulates China against a slowdown in global trade volumes (Chart 6). Moreover, China's current account fell into deficit last quarter (Chart 7). A weaker RMB helps deal with this issue, but the PBoC may be forced to cut Reserve Requirement Ratios (RRRs) further if the deficit remains in place, forcing the currency even lower. Chart 6China Needs A Buffer Against Slowing Trade Chart 7Supportive Conditions For A Lower CNY There is no silver lining in this move by Beijing. Evidence that China is manipulating its currency would be a clear sign of an outright, full-scale trade war between the U.S. and China. On one hand, a falling RMB will improve the financial position of China's exporters. On the other hand, it may invite further protectionist action from the U.S., including a threat by the White House to increase the tariff levels on the additional $500 billion of imports from the current 10% rate, or to enhance export restrictions on critical technologies, or to add new investment restrictions. Several of our clients have pointed out that China does not want a trade war, that it cannot win a trade war, and that it is therefore likely to offer concessions ahead of the U.S. midterm election. We agree that China is at a disadvantage.11 But we also reiterate that the concessions have already been offered, in mid-May following the Mnuchin negotiations with Chinese Vice Premier Liu He. China and the U.S. may of course resume negotiations at any time, but it will likely take months, at best, to arrange a deal that reverses this month's actual implementation of tariffs. We think that the obsession with "who will win the trade war" is misplaced. Of course, the U.S. will "win." The problem is that what the Trump administration and what investors consider a "victory" may be starkly different: victory may not include a rip-roaring stock market. In fact, President Trump may require a stock market correction precisely to convince his audience, including those in Beijing, that his threats are indeed credible. Bottom Line: President Trump's promise of a 10% tariff on $500 billion of Chinese imports can easily be assuaged by a CNY/USD depreciation. If we know that Beijing is depreciating its currency, so does the White House. The charge against Beijing for currency manipulation could occur as late as the Treasury Department's semiannual Report to Congress in October, or informally via a presidential tweet at any time before then. While the formal remedies against a country deemed to be officially engaged in currency manipulation are relatively benign in the context of the ongoing trade war, we would expect President Trump to up the pressure on China regardless. Iran: Can Midterm Election Stay President Trump's Hand? We identified U.S.-Iran tensions in our annual Strategic Outlook as the premier geopolitical risk in 2018 aside from trade concerns.12 We subsequently argued that President Trump's application of "Maximum Pressure" against Iran would likely exacerbate tensions in the Middle East, add a geopolitical risk premium to oil prices, and potentially lead to a military conflict in 2019 (Diagram 1).13 Diagram 1Iran-U.S. Tension Decision Tree The Brent crude oil price has come off its highs just below $80/bbl in late May and appears to be holding at $75/bbl. Is the market once again ignoring bubbling U.S.-Iran tensions or is there another factor at play? We suspect that investors are placing their hopes on White House pressure on producers to bring massive amounts of crude online to offset the impact of "Maximum Pressure" on Iran. First, Trump tweeted in April that "OPEC is at it again," keeping oil prices artificially high. He followed this with another tweet at the end of June, directly requesting that Saudi Arabia increase oil production by up to 2 million b/d so that he may continue to play brinkmanship with Tehran. Second, the Libyan media leaked that President Trump sent letters to the representatives of Libya's warring factions, imploring them to restart oil exports or face international prosecution and potential U.S. military intervention.14 The pressure on the Libyan authorities appears to have worked, with the Tripoli-based National Oil Corporation (NOC) ending its force majeure, a legal waiver on contractual obligations, on the ports of Ras Lanuf, Es Sider, Zueitina, and Hariga. Third, Secretary of State Mike Pompeo signaled on July 10 that the U.S. would consider granting waivers to countries seeking to avoid being sanctioned for buying oil from Iran. On July 15, however, the administration clarified the comment by stating that it would only grant limited exceptions based on national security or humanitarian efforts. The White House is realizing that, unlike its brinkmanship with North Korea, "Maximum Pressure" on Iran comes with immediate domestic costs: higher gasoline prices (Chart 8). The last thing President Trump wants to see is his household tax cut trumped by the higher cost of gasoline. Chart 8How Badly Do Americans Want A New Iran Deal? Chart 9Iran Is Not Yet At Peak North Korean Levels Of Threat Applying Maximum Pressure on Iran is tricky. Politically, the upside is limited for President Trump. First, a majority of Americans (62%) do not want to see the U.S. withdraw from the deal, and do not consider Iran to be as critical of a threat as North Korea (Chart 9). That said, 40% believe that Iran is a "very serious" threat - up from just 30% in October, 2017 - and 62% of Americans believe that "Iran has violated the terms" of the nuclear agreement. These are numbers that President Trump can "work with," but not if gasoline prices rise to consumer-pinching levels. As such, the question is whether we should stand down from our bullish oil outlook given President Trump's active role in eking out new supply. We should, if there were supply to be eked out. BCA's Commodity & Energy Strategy believes that global supply capacity will not be sufficient to keep prices below $80/bbl in the event that Venezuela collapses in 2019 or that Iranian export losses are greater than the 500,000 b/d we are currently projecting.15 The U.S. EIA estimates there is only 1.8mm b/d of spare capacity available worldwide this year, to fall to just over 1 mm b/d next year (Chart 10). Our commodity strategists believe that the idle and spare capacity of KSA, Russia, and other core OPEC 2.0 states that can actually increase production would be taxed to the extreme to cover losses of Iranian exports, especially if the losses reached 1 mm b/d. In fact, many secondary OPEC 2.0 producers are struggling to produce at their 2017-2018 production quota, suggesting that lack of investment and natural depletion have already taken their toll (Chart 11). Chart 10Global Spare Capacity##br## Stretched Thin Chart 11OPEC 2.0's Core Producers Would##br## Struggle To Replace Lost Exports Could President Trump back off from the threat of brinkmanship with Iran due to the risk of rising oil prices? Yes, absolutely. We have argued in the past that President Trump appears to be an intensely domestically-focused president. We also see little logic, from the perspective of U.S. interests broadly defined or President Trump's "America First" strategy specifically, in undermining the Obama-era nuclear agreement. As such, domestic constraints could stay President Trump's hand. On the other hand, these constraints would have the greatest force ahead of the November 2018 midterm and the 2020 general elections. This gives President Trump a window between November 2018 and at least the early summer of 2020 to put Maximum Pressure on Iran. As such, we think that investors should fade White House attempts to shore up global supply. Once the midterm election is over, the pressure will fall back on Iran. What about Iran's calculus? Tehran has an interest in dampening tensions ahead of the midterms as well. However, if the U.S. actually enforces sanctions, as we expect it will, we are certain that Iran will begin to ponder the retaliatory action we describe in Diagram 1. In fact, Iran's population appears to be itching for a confrontation, with an ever-increasing majority supporting the restart of Iranian nuclear facilities in response to U.S. withdrawal from the JCPOA nuclear agreement (Chart 12). Iranian officials have also already threatened to close the Straits of Hormuz as we expected they would. Chart 12Iranians Supported Ending Nuclear Deal If The U.S. Did (And It Did!) Bottom Line: Between now and November, U.S. policy towards Iran may be much ado about nothing. However, we expect the pressure to rise by the end of the year and especially in 2019. Our subjective probability of armed conflict remains at an elevated 20%, by the end of 2019. This is four times greater than our probability of kinetic action amidst the tensions between the U.S. and North Korea. Brexit: Has Theresa May Figured Out How Credible Threats Work? We have long argued that a soft Brexit is incompatible with Euroskeptic demands for increased sovereignty (Diagram 2). And, indeed, sovereignty was one of the main demands - if not the main demand - of Brexit voters ahead of the referendum. A large percent, 32% of "leave" voters, said they would be willing to vote "stay" if a deal with the EU gave "more power to the U.K. parliament," an even greater share than those focused on migration (Chart 13). As such, since March 2016, we have expected the U.K. Conservative Party to split into factions regardless of the outcome of the vote on EU membership.16 Diagram 2The Illogic Of ##br##Soft Brexit Chart 13Sovereignty Topped The##br## List Of Brexit Voter Concerns U.K. Prime Minister Theresa May has fought against the inevitable by inviting notable Euroskeptics into her cabinet and by trying to pursue a hard Brexit in practice. The problem with this strategy is that it won't work in Westminster, where a whopping 74% of all members of parliament, and 55% of all Tory MPs, declared themselves as "remain" supporters ahead of the 2016 referendum (Chart 14). Given that the House of Commons has to approve the ultimate U.K.-EU deal, a hard-Brexit deal is likely to fail in Parliament. While such a defeat would not automatically bring up an election, May would be essentially left without any political capital with which to continue EU negotiations and would either have to resign or call a new election. Chart 14Westminster MPs Support Bremain! Theresa May therefore has two options. The first is to trust the political instincts of David Davis and Boris Johnson and try to push a hard Brexit through the House of Commons. But with a slim majority of just one MP, how would she accomplish such a feat? Nobody knows, ourselves included, which is why we shorted the GBP as long as May stubbornly listened to the Euroskeptics in her cabinet. However, it appears that May has finally decided to ditch her Euroskeptic cabinet members and establish the "credible threat" of a new election. While May has not uttered the phrase directly, she hinted at a new election when she suggested that "there may be no Brexit at all." The message to hard-Brexit Tory rebels is clear: back my version of Brexit or risk new elections. From an economic perspective, retaining some semblance of Common Market membership is obviously superior to the hard-Brexit alternative. It is so superior, in fact, that Boris Johnson himself called for it immediately following the referendum!17 From a political perspective, it is also much easier to persuade less than two-dozen committed Tory Euroskeptics that a new election would be folly than it is to convince half of the party that the economic risks of a hard-Brexit are inconsequential. The switch in May's tactic therefore warrants a cautionary approach to our current GBP/USD short. The recommendation is up 5.55% since February 14. However, the GBP could be given a tailwind if investors sniff out fear amongst hard Brexit Tories. We still believe that downside risks exist in the short term. First, there is no telling if the EU will accept the particularities of May's Brexit strategy. In fact, the EU may want to make May's life even more difficult by asking for more concessions. Second, Euroskeptic Tories in the House of Commons may be willing martyrs, rebelling against May regardless of the economic and political consequences. Bottom Line: We are keeping our short GBP/USD on for now, which has returned 5.55% since February 14, but we will tighten the stop to just 2%. We think that Theresa May has finally figured out how to use "credible threats" to cajole her party into a soft Brexit. The problem, however, is that she still needs Brussels to play ball and her Euroskeptic MPs to act against their ideology. Europe: Will The Immigration Crisis End The EU? Chart 15European Migration Crisis Is Over No. There is no migration crisis in the EU (Chart 15). Despite the posturing in Europe over the past several months, the migration crisis ended in October 2015. As we forecast at the time, Europe has since taken several steps ovet the succeeding years to increase the enforcement of its external borders, including illiberal methods that many investors thought beyond European sensibilities.18 Today, EU member states are openly interdicting ships carrying asylum seekers and turning them away in international waters. Chancellor Angela Merkel has become just the latest in a long line of policymakers to succumb to her political constraints - and abandon her preferences - by agreeing to end the standoff with her conservative Bavarian allies. Merkel has agreed to set up transit centers on the border of Austria from where migrants will be returned to the EU country where they were originally registered, or simply sent across the border to Austria. The idea behind the move is to end the "pull" that Merkel inadvertently created by openly declaring that Germany was open to migrants regardless of where they came from. Why wouldn't migrants keep coming to Europe regardless? Because if the promise of a job and a legal status in Germany or other EU member states is no longer available, the cost - in treasure, limb, and life - of the journey through the Sahara and unstable states like Libya, and the Mediterranean Sea will no longer make sense. As Chart 15 shows, potential migrants are capable of making the cost-benefit calculation and are electing to stay put. Bottom Line: The EU migration crisis is not investment-relevant. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see the Appendices for the detailed description of events. 3 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," June 8, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 5 BCA Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," dated September 12, 2017, available at gfis.bcaresearch.com. 6 His tweets in the immediacy of the deal suggest that this was the case. He tweeted, immediately following Mnuchin's Fox News appearance, "China has agreed to buy massive amounts of ADDITIONAL Farm/Agricultural Products - would be one of the best things to happen to our farmers in many years!" He then tweeted again, suggesting that his deal was superior to anything President Obama got, "I ask Senator Chuck Schumer, why didn't President Obama & the Democrats do something about Trade with China, including Theft of Intellectual Property etc.? They did NOTHING! With that being said, Chuck & I have long agreed on this issue! Trade, plus, with China will happen!" His third tweet suggested that the deal being negotiated was indeed a big compromise, "On China, Barriers and Tariffs to come down for first time." All random capitalizations are President Trump's originals. 7 We reacted to the truce by arguing that it would not "last long." It lasted merely three days! Please see BCA Geopolitical Strategy Weekly Report, "Some Good News (Trade), Some Bad News (Italy)," dated May 23, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, and "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com. 9 Please see BCA China Investment Strategy Weekly Report, "Now What?" dated June 27, 2018, available at cis.bcaresearch.com. 10 Please see BCA Foreign Exchange Strategy Weekly Report, "What Is Good For China Doesn't Always Help The World," dated June 29, 2018, available at fes.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 14 Please see "Trump's letter to rivals allegedly results in resumption of oil exports in Libya," Libyan Express, dated July 11, 2018, available at libyanexpress.com. 15 Please see BCA Commodity & Energy Strategy Weekly Report, "Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf," dated July 5, 2018, available at ces.bcaresearch.com. 16 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 17 Johnson stated right after the referendum that "there will continue to be free trade and access to the single market." 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. 18 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. Appendix Appendix 2A Appendix 2B Appendix 2B (Cont.) Geopolitical Calendar
Overweight Disbelief in the longevity of the increase in oil prices is the likely culprit weighing on exploration & production (E&P) stocks along with a bottleneck-induced steep shale oil price discount to WTI. Nevertheless, the sizable recovery in underlying commodity prices has restored some semblance of normality in the E&P space. The second panel of the chart at the side shows that shale oil production is rising at a healthy clip following a long bottoming phase on the heels of reaccelerating WTI crude oil prices. Similar to the broad energy complex that integrateds dominate, oil & gas E&P producers are a capital expenditure upcycle play, which remains a key BCA theme for the year (third panel). Rising oil prices are conducive to additional energy-related investments (bottom panel). Adding it up, there are high odds that E&P stocks will continue to outpace the broad energy complex and the SPX on the back of firming capex budgets and sustained oil inflation. Bottom Line: We lifted the S&P oil & gas E&P index to an overweight stance; please see Monday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5OILP - COP, EOG, APC, PXD, DVN, CXO, MRO, APA, HES, NBL, EQT, COG, XEC and NFX.
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 Duration: Weakening global growth is unlikely to derail the Fed, which must also contend with mounting domestic inflationary pressures. Maintain below-benchmark portfolio duration and only a neutral allocation to spread product versus Treasuries. MBS & CMBS: Non-Agency CMBS offer attractive return potential, but remain too risky for the current environment. Agency MBS are unattractively valued but should remain insulated from negative shocks. Agency CMBS offer an alluring combination of risk and potential reward. Monetary Policy: The effective fed funds rate has been creeping toward the upper-end of the Fed's target band, signaling that bank reserves are becoming scarce. If the situation persists the Fed will be forced to cease the shrinking of its balance sheet. Feature Crosscurrents Two opposing forces are acting on financial markets at the moment and U.S. Treasury yields are caught in the middle. One the one hand, rising U.S. inflation and the gradual tightening of monetary policy are pressuring yields higher. But on the other hand, cyclical indicators point to a slowdown in global economic growth at a time when protectionist trade policies already have investors on edge. The end result is that U.S. Treasury yields are aimless, awaiting a catalyst that will push the prevailing winds in one direction or the other. On the domestic front, inflationary pressures are clearly mounting. The year-over-year core consumer price index rose to 2.23% in June while the New York Fed's Underlying Inflation Gauge moved up to 3.33%, its highest level since 2005 (Chart 1). The Fed's preferred core PCE deflator grew 1.96% during the 12 months ending in May, only a hair below the 2% target. Meanwhile, our Boom/Bust Indicator - a composite of global metals equities, commodity prices and U.S. unemployment insurance claims - has rolled over and investor expectations as measured by the Global ZEW survey have collapsed. Both indicators correlate strongly with long-maturity bond yields (Chart 2). Chart 1Inflation Picking Up Steam Chart 2Global Growth Slowdown The plunge in Global ZEW investor expectations is particularly interesting because the same survey shows that investors continue to describe current economic conditions as incredibly strong (Chart 3). Clearly, investors view the current state of global demand as constructive but are worried about threats to the global economy from trade barriers and the persistent removal of monetary accommodation. Oftentimes, negative readings from the Global ZEW expectations survey precede similar drops in the current conditions survey, such as prior to the 2008 and 2001 recessions. But other times, such as in 1998, the drop in expectations sends a false signal that is quickly unwound. Chart 3ZEW Expectations Vs. Current Conditions Only time will tell which outcome will occur, but we think global growth will slow further before finding a floor.1 The implication for U.S. bond portfolios is that investors should maintain only a neutral allocation to spread product versus Treasuries. Weakening foreign growth and the resultant upward pressure on the U.S. dollar will negatively impact corporate bond spreads, as will persistent Fed tightening. Investors should also maintain below-benchmark overall portfolio duration, as rising inflation will make it difficult for the Fed to pause its rate hike cycle for any significant length of time. Picking Up Yield In MBS And CMBS? The combination of weakening global growth and rising domestic inflation makes finding attractive U.S. fixed income plays difficult. This week we consider the risk/reward proposition in residential mortgage-backed securities (Agency only) and commercial mortgage-backed securities (both Agency and non-Agency). We conclude that non-Agency CMBS offer attractive return potential, but remain too risky for the current environment. Agency MBS are unattractively valued but should remain insulated from negative shocks. Agency CMBS offer an alluring combination of risk and potential reward. Chart 4 shows our excess return Bond Map, a good place to start when considering the risk/reward trade-off between the different spread sectors of the U.S. fixed income universe. The horizontal axis shows the number of months of average spread widening required for each sector to lose 100 bps versus an equivalent-duration position in Treasury securities. The vertical axis shows the number of months of average spread tightening required to earn 100 bps. Sectors plotting closer to the bottom-left are less likely to lose 100 bps, but are also less likely to gain 100 bps. Sectors plotting closer to the top-right are more likely to gain 100 bps, but are also more likely to lose 100 bps. In Chart 4 we use an interval from 2000-present to estimate monthly spread volatility. Since the Agency CMBS index only begins in 2014, it is excluded from this chart. Chart 4Excess Return Bond Map (Spread Volatility Estimated From 2000 - Present) The Bond Map shows that neither Agency MBS nor non-Agency CMBS offer an attractive risk/reward proposition. Non-Agency CMBS carry a similar risk of losses as the riskiest corporate bonds while offering less return potential. Agency MBS offer only slightly greater return potential than Consumer ABS, but with considerably more risk. Chart 5 shows the same Bond Map but using a post-2014 time interval to estimate monthly spread volatility. This allows us to include Agency CMBS. Chart 5 shows that Agency CMBS clearly dominate Agency MBS, offering similar reward with less risk. It also makes non-Agency CMBS look much more attractive, since spread volatility in the CMBS sector has been much lower in the post-2014 period. Chart 5Excess Return Bond Map (Spread Volatility Estimated From May 2014 - Present) Macro Environment Favors Residential MBS Despite the poor valuation picture painted by the Bond Map, the macro environment casts Agency MBS in a more favorable light. The two main factors that influence MBS spreads are residential mortgage lending standards and mortgage refinancing activity. Neither factor is likely to send MBS spreads wider during the next 6-12 months. Extension risk can also influence MBS spreads from time to time, but we have shown in prior research that the required yield increase is massive and unlikely to occur.2 The shaded regions in Chart 6 correspond to periods when banks are tightening lending standards on residential mortgage loans. We can see that lending standards tightened sharply during the financial crisis and have generally been easing since then. More important, however, is that the post-crisis easing in lending standards has been extremely modest. The median FICO score for new mortgage borrowers has barely come down, and remains well above pre-crisis levels (Chart 6, panel 3). The Urban Institute's Housing Credit Availability Index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is also extremely low (Chart 6, panel 4). In addition, the household debt-service ratio remains incredibly healthy (Chart 6, bottom panel). With such high borrower quality, banks are much more likely to ease lending standards going forward. Mortgage refinancing activity has also been very low, and this should continue to be the case for some time. A good predictor of refinancing activity is the percentage of the MBS index (by par value) that carries a coupon above the current mortgage rate (Chart 7). At present, only 5% of the index carries a coupon above the current 30-year mortgage rate of 4.53%. We calculate that even if the mortgage rate fell to below 4% the percentage of the MBS index with the incentive to refinance would only rise to 38%, still consistent with muted refi activity. Only a drop in the mortgage rate to below 3.5% would cause the refinanceable percentage to spike significantly, reaching 73%. Chart 6MBS: The Macro Environment Chart 7Refi Risk Is Non-Existant Or course, mortgage rates are much more likely to rise during the next 6-12 months as the Fed continues to tighten monetary policy. In other words, the risk that an increase in refi activity will drive MBS spreads wider is very low. All in all, valuation is not attractive in the Agency MBS sector, but the macro environment is favorable and should ensure that spreads remain tight on a 6-12 month horizon. We recommend a neutral allocation to Agency MBS, and could upgrade the sector further at the expense of corporate bonds as we approach the turn in the credit/default cycle. Fading Headwinds In CMBS? Chart 8CMBS: The Macro Environment Non-Agency Aaa-rated CMBS appear relatively unattractive in Chart 4 and somewhat attractive in Chart 5. The latter chart uses a post-2014 time interval to estimate monthly spread volatility and this period flatters the CMBS sector. The macro picture for the sector is also decidedly mixed. A typical negative environment for CMBS spreads is characterized by tightening bank lending standards on commercial real estate (CRE) loans, falling demand for CRE loans and decelerating CRE prices (Chart 8). CRE lending standards were tightening throughout 2016 and 2017, while demand remained reasonably strong and CRE prices decelerated. But CMBS spreads performed quite well during this period, taking cues from the rally in corporate bonds rather than the slightly negative message from CRE fundamentals. More recently, we are receiving very mixed signals from our CRE indicators. Lending standards are no longer tightening, but CRE prices continue to decelerate and demand is close to unchanged. It is possible that a renewed easing in lending standards will cause CRE prices to accelerate, but that is far from certain. Our U.S. Equity Strategy service recently flagged numerous risks in the CRE space, including the fact that occupancy rates have already begun to contract.3 A possible signal that demand is waning. While the return of CRE lending standards to "net easing" territory is a positive development, it remains to be seen whether the easing will help spur a rebound in CRE prices in the face of weakening demand. The uncertain macro picture and the unattractive valuation shown in Chart 4 cause us to maintain an underweight allocation to non-Agency CMBS. In contrast, we remain overweight Agency-backed CMBS based on the attractive risk/reward profile presented in Chart 5. A Note On Monetary Policy Operations While we maintain that the expected pace of Fed rate hikes is by far the most important monetary policy question for investors, some technical issues related to the implementation of monetary policy have come to light during the past few months that merit a mention. These issues will likely gain even more attention later this summer when they are discussed at the Jackson Hole Monetary Policy Symposium where the chosen theme is "Changing Market Structure and Implications for Monetary Policy". The main problem that has emerged during the past few months is that the effective fed funds rate has begun to creep toward the upper-end of the Fed's target channel (Chart 9). While the Fed currently targets a range of 1.75% to 2% for the effective fed funds rate, the rate itself currently sits at 1.91%, dangerously close to the top. Chart 9Is The Fed Losing Control? IOER Is A Treatment, Not A Cure The Fed tried to push the effective fed funds rate back toward the middle of its target range following the June FOMC meeting when it lifted the interest rate on excess reserves (IOER) by only 20 bps instead of 25 bps. Previously, the IOER had been set at the upper-bound of the Fed's target range, now it is 5 bps below. At best, this manipulation of IOER is a stop-gap measure that will not permanently solve the Fed's problem. This is because the Fed's problem is that the effective fed funds rate is rising because bank reserves are once again becoming scarce. The Fed currently controls interest rates using a "floor system". In order for such a system to work the Fed must ensure that the banking system is supplied with more bank reserves than it wants. The excess supply of bank reserves then pressures the effective funds rate lower, toward a "floor" interest rate set by the Fed. The Fed currently uses two different interest rates to act as the "floor", the IOER and the overnight reverse repo rate (ON RRP).4 The problem is that if banks are not over-supplied with reserves then the floor is not binding and the fed funds rate could break above the Fed's target range. Several factors have conspired to drain reserves from the banking sector during the past few months. First and foremost is that the Fed is allowing the securities to run off its balance sheet. Table 1 shows a simplified version of the Fed's balance sheet as of July 5 and as of September 28 of last year, just before the Fed started to shrink its bond portfolio. The change in each balance sheet item between the two dates is also shown. Table 1A Simplified Federal Reserve Balance Sheet Changes in the Fed's securities holdings are the main driver of bank reserves, and Table 1 shows that the Fed has reduced its portfolio holdings by $156 billion since last September. This has drained $156 billion of reserves from the banking system. Reserves appear as a liability on the Fed's balance sheet, but as an asset on the banking sector's consolidated balance sheet. But Table 1 also shows that the U.S. Treasury's General Account at the Fed has increased by $170 billion since last September, draining bank reserves by the same amount. This occurred because the Treasury department has been rebuilding its cash holdings which had become very low due to repeated encounters with the debt ceiling. But this process is largely complete. The Treasury department was targeting a cash balance of $360 billion by the end of June and that target has essentially been met. Table 1 also shows that reverse repos declined significantly since September, offsetting some of the reserve drain from the run-off of the Fed's securities holdings and the increase in the Treasury's cash balance. As reserves become scarcer it becomes less necessary for banks to engage in reverse repos with the Fed, so reverse repo balances should continue to decline as long as the Fed is shrinking its securities holdings. There Is Only One Cure The key point is that if the Fed continues to shrink its balance sheet and drain reserves from the banking system, then at some point bank reserves will no longer be over-supplied and the Fed will lose control of interest rates if the situation is not rectified. What makes things particularly confusing is that nobody (including the Fed) is quite sure what level of bank reserves constitutes "scarcity" in the new post-crisis environment. Chart 10 shows that if the Fed's planned shrinking of its balance sheet continues un-interrupted then bank reserves will reach zero by March 2022. But under the stricter post-crisis regulatory regime, banks will desire reserve balances that far exceed what they demanded before the financial crisis. Unfortunately, the only way to find out at what point bank reserves become scarce is for the Fed to drain reserves from the system and wait for signs that interest rates are starting to rise above its target range. At that point, the Fed will be forced to stop shrinking its balance sheet in order to maintain control over interest rates. Based on the current behavior of the fed funds rate, we cannot rule out this situation arising within the next year. Some Notes On Treasury Operations Many have blamed sizeable T-bill issuance for the creep higher in the fed funds rate, and this is somewhat true. The Treasury department has been issuing T-bills in large amounts and parking the proceeds in its cash account at the Fed. As explained above, this has drained reserves from the banking system and put upward pressure on the effective fed funds rate. But the focus should be on the Treasury's cash balance and not T-bill issuance itself. This is important because going forward T-bill issuance will remain elevated. The Treasury must finance the increasing deficits mandated by Congress and has pledged to concentrate a large portion of this financing in bills. Specifically, the Treasury is targeting a range of 25% to 30% for the proportion of bills in the outstanding funding mix. At present, bills make up only 15% of the mix (Chart 11). But while bill issuance will stay strong, as long as the Treasury maintains its cash balance near current levels, then there will be no impact on bank reserves or the effective fed funds rate. Chart 10The Pace Of Balance Sheet Reduction Chart 11Gross T-Bill Issuance The Treasury department will also increase coupon issuance to finance the rising fiscal deficit (Chart 12), and has decided to do so by increasing issuance for every coupon but with a focus on the 2-year, 3-year and 5-year notes. Gross issuance in the 2-year and 3-year notes has already started to increase, and it will soon exceed 5-year and 7-year note issuance (Chart 13). Because so much of the Treasury's new issuance will be concentrated at the front-end of the curve (and in bills), it has dropped its prior stated goal of increasing the weighted-average maturity (WAM) of the funding mix. Its current policy states that "the WAM is just an outcome of an issuance strategy and not a goal in and of itself." Chart 12Gross Coupon Issuance Chart 13Gross Coupon Issuance By Maturity Bottom Line: The effective fed funds rate has been creeping toward the upper-end of the Fed's target band, signaling that bank reserves are becoming scarce. If the situation persists the Fed will be forced to cease the shrinking of its balance sheet. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "On The Move", dated February 13, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Equity Strategy Special Report, "UnReal Estate Opportunity", dated July 9, 2018, available at uses.bcaresearch.com 4 A detailed explanation of the floor system and its alternative "corridor system" can be found in U.S. Bond Strategy Special Report, "Cleaning Up After The 100-Year Flood", dated June 10, 2014, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification