Gov Sovereigns/Treasurys
Highlights Duration: The bond market is not providing adequate compensation for the inflationary economic back-drop. Remain below-benchmark duration on a 6-12 month investment horizon. The Fed & Inflation: Even in the most deflationary of the four scenarios we consider, inflation is still projected to be very close to the Fed's median forecast by year end. The Fed is still on track for two more rate hikes this year. The Fed's Balance Sheet: The run-down of the Fed's balance sheet will lead to a substantial increase in gross Treasury issuance next year. Most, if not all, of this extra issuance will be met by greater demand from the banking sector. Feature Chart 1Inflationary Pressures Are Building No, the title of this report does not refer to the challenge of getting a tax reform bill through Congress when betting markets say there is a 44% chance that the President won't keep his job through 2018.1 Although bond markets are clearly sending the message that progress on tax reform is less likely with the White House embroiled in controversy. The 10-year Treasury yield fell to 2.22% last week after having briefly broken above 2.4% earlier in the month (Chart 1). For the record, our Geopolitical Strategy service thinks that even a growing scandal within the Trump administration won't be enough to prevent tax cuts,2 and from our point of view, we worry that bond markets might be distracted by the political soap opera and are missing the underlying economic picture. As the nominal 10-year yield fell last week, the 10-year TIPS breakeven inflation rate also declined to 1.78%, its lowest level since prior to the election. Meanwhile, the base case scenario from our Phillips Curve model of core PCE inflation, which closely tracks the 10-year TIPS breakeven rate (Chart 1, bottom panel), is sending the message that inflationary pressures are building in the economy, tax reform or no tax reform. Chart 2The Fed's 2017 Forecasts The next section of this report provides more detail on the assumptions underlying our Phillips Curve model, but suffice it to say that the bond market is not providing adequate compensation for the inflationary economic back-drop. Remain below-benchmark duration on a 6-12 month investment horizon. The remainder of this report focuses on two key challenges that U.S. policymakers will face this year. The first is the Fed's challenge of whether to focus on Phillips Curve derived forecasts of inflation or the actual core inflation data. The second challenge relates to how the Treasury department will deal with the run-off of the Fed's balance sheet. The Fed's Phillips Curve Challenge As of the March FOMC meeting, the Fed's median projection called for two more 25 basis point rate hikes before the end of the year, and also for core PCE inflation to reach 1.9% (Chart 2). It would be logical to assume that if inflation were no longer expected to reach 1.9%, that the anticipated pace of rate hikes would also decline. On that note, a cursory glance at recent inflation data makes 1.9% look a tad aspirational. Core PCE inflation is running at only 1.56% year-over-year through March, and will probably stay low in April given that year-over-year core CPI fell from 2% in March to 1.89% in April (see Box). BOX A Note On The Divergence Between CPI And PCE While weak core CPI probably does indicate that core PCE will stay low, we would not expect the entirety of April's CPI drop to translate into the PCE data. A key driver of last month's disappointing core CPI was a 0.2% month-over-month decline in medical care prices, and the treatment of medical care costs is an important difference between CPI and PCE. The weight of medical care in core PCE is more than double the 10% weighting of medical care in core CPI, because the PCE deflator also factors in the medical care spending of government agencies on behalf of consumers while CPI only tracks the amount spent by consumers directly. For this reason, we see that the medical care components of CPI and PCE are not closely correlated (Chart 3). In fact, CPI medical care inflation has been decelerating for some time while PCE medical care inflation has been grinding higher alongside the health care component of the Producer Price Index (PPI). The health care component of PPI was flat in April, but the underlying uptrend remains unbroken. We would expect the spread between core CPI and core PCE to tighten in the months ahead as relative medical care costs continue to converge (Chart 3, bottom panel). Chart 3Expect CPI and PCE To Converge Meanwhile, a forecast based on trends in the labor market would suggest that inflation is set to accelerate. This, in a nutshell, is the Fed's conundrum. It can rely on Phillips Curve-type inflation forecasts and risk tightening too quickly if inflation does not respond as expected. Or, it can rely on the actual inflation data and risk staying easy for too long. For now, we believe the Fed will cling firmly to the Phillips Curve option. In a speech from September 2015,3 Chair Yellen outlined her model for inflation forecasting. In Yellen's model, core inflation tends to fluctuate around a long-run trend that is determined by inflation expectations. Changes in resource utilization (aka the employment gap) and relative import prices can cause inflation to deviate from this trend but, as long as these shocks prove transitory, inflation should gradually move back toward the level determined by expectations. Inspired by this approach, we created a Phillips Curve model of core PCE - the output of which was shown in Chart 1 on page 1. Specifically, we model core PCE as a function of: 12-month lag of core PCE Long-run inflation expectations from the Survey of Professional Forecasters Resource utilization (proxied by the difference between the unemployment rate and the Congressional Budget Office's (CBO) estimate of the long-run natural unemployment rate) Non-oil import prices relative to overall core PCE The value of this approach is that we can assess how core inflation is likely to react to varying assumptions about inflation expectations, the unemployment rate, the natural unemployment rate (NAIRU), and the trade-weighted U.S. dollar. We use the trend in the dollar to forecast relative import prices. A stronger dollar leads to lower import prices, and vice-versa. Charts 4-7 show the results of running this model under four different scenarios. We conclude that it is very difficult to create a set of reasonable assumptions where core PCE inflation does not approach the Fed's 1.9% forecast by year end. Given that Fed policymakers are very likely using a similar framework, we would expect them to arrive at the same conclusion. Scenario 1: The Base Case. In the first scenario we assume that the unemployment rate stays at its current level (4.4%) and also that the trade-weighted dollar remains flat. We also use the CBO's NAIRU estimate and assume no change in inflation expectations. In this environment, our model projects that year-over-year core PCE inflation will reach 2.11% by the end of December (Chart 4). Scenario 2: Strong Dollar. In this scenario we make the same assumptions as in Scenario 1, except that we allow the dollar to appreciate at a pace of 10% per year. The result is that import price deflation is more pronounced, but year-over-year core PCE inflation is still projected to reach 1.95% by year end (Chart 5). Chart 4Phillips Curve Model: Base Case Scenario Chart 5Phillips Curve Model: Strong Dollar Scenario Scenario 3: Bad NAIRU. In this scenario we consider that the CBO's NAIRU assumption might be too high. Specifically, we allow NAIRU to decline linearly from 5.07% at the end of 2012 to 4% by the end of 2013, we then hold it constant at 4%. Currently, the CBO's NAIRU estimate is 4.74%. In this scenario we also hold the unemployment rate, inflation expectations and the dollar flat. The result is that year-over-year core PCE inflation is projected to reach 2.03% by the end of the year (Chart 6). Scenario 4: The Deflation Case. In this scenario we make the same NAIRU assumption as in Scenario 3, but also incorporate 10% per year dollar appreciation. In this most deflationary scenario, the model still projects 1.88% core PCE inflation at year end (Chart 7). Chart 6Phillips Curve Model: Bad NAIRU Scenario Chart 7Phillips Curve Model: The Deflation Case Bottom Line: Even in the most deflationary of our four scenarios we still project inflation that is very close to the Fed's median forecast. We expect the Fed will arrive at a similar conclusion and will stay on track for two more rate hikes this year. However, if the actual core inflation data do not respond by moving higher during the next 3-4 months, then the Fed's hawkish stance will increasingly come into question. The Fed's Balance Sheet Is The Treasury's Problem Janet Yellen is sure to face some questions about how the Fed plans to unwind its balance sheet at next month's FOMC press conference, but the truth is that we already have a lot of information about how the Fed intends to proceed. The more challenging questions should be asked to the Treasury department, since it is the Treasury that will decide in what form the Fed's balance sheet run-off ultimately finds its way back into private hands. We have written about this topic twice in recent months. First, we published a detailed Special Report on how we expect monetary policy to evolve from an operational perspective in February.4 Then, we updated our expectations based on information contained in the March FOMC minutes.5 This week, we provide some additional observations based on what we learned from the recent meeting of the Treasury Borrowing Advisory Committee (TBAC). Chart 8Fed's Balance Sheet Will Still Be Large First, a brief recap. The Fed has told us that it plans to: Start shrinking its balance sheet later this year (assuming its growth forecasts remain intact) Shrink its balance sheet by ceasing the reinvestment of both MBS and Treasury securities at the same time The Fed has still not decided whether it will simply cease reinvestment all at once, or whether reinvestment will be phased out gradually (i.e. "tapered"). It has also not provided any guidance on what level of reserve balances it intends to maintain going forward. In Chart 8 we show that even if the Fed decides to drain reserves all the way down to zero, this process is likely to be complete by mid-2021. In fact, it might not even take that long since we have assumed a relatively slow pace of $15 billion MBS run-off per month. What is notable is that the Fed's balance sheet will still be sizeable even after reserves have fallen to zero. The reason is that the Fed's balance sheet needs to increase over time to keep pace with the growth of currency in circulation. Our calculations show that by the time reserve balances reach zero in mid-2021, the Fed will still be holding $1.3 trillion of Treasury securities and $1.1 trillion of MBS. After 2021, the Fed would likely continue to allow MBS to run off, but would once again start reinvesting the proceeds into Treasuries. Where Does The Treasury Department Come In? At present, the Fed reinvests the proceeds from its maturing securities by purchasing Treasury notes and bonds at regularly scheduled auctions. This means that when the Fed ceases the reinvestment of the securities running off its balance sheet, the Treasury department will have to increase the amount of issuance that is made available to the public. The Treasury is therefore tasked with determining whether the extra issuance will take the form of T-bills, short-dated notes or long-dated bonds. At the most recent TBAC meeting, committee members seemed to favor a strategy where the extra issuance is spread evenly across all maturities in proportion to current auction sizes, and where the proportion of T-bills in the overall funding mix is held constant. In Chart 9 and Chart 10 we show what this will mean for gross Treasury issuance of 2-year, 5-year, 10-year and 30-year securities, both in dollar terms and as a percentage of GDP. Chart 9Gross Coupon Issuance: In Dollar Terms Chart 10Gross Coupon Issuance: % Of GDP Interestingly, the Treasury department decided against placing a larger portion of the extra issuance in T-bills, as we had thought they might, and we remain concerned about the lack of short-term low-risk debt instruments in the market. The demand for short-term, low-risk instruments - largely from non-financial corporations, asset managers and foreign exchange reserve funds - is in a secular uptrend. Prior to the financial crisis this demand was met by broker/dealers in the repo market. Then, when regulations killed the repo market, the Fed increased the supply of bank reserves to make up for the shortfall (Chart 11). If the Fed drains reserves from the system and T-bill issuance does not increase substantially to compensate, a supply shortage of short-maturity instruments could develop. We would not be surprised to see the Treasury increase the proportion of T-bills in its funding mix, from historically low levels (Chart 12), if stresses in short-term rates markets start to appear at some point down the road. Chart 11A Shortage Of Cash-Like Instruments Chart 12Bill Issuance Has Room To Rise Can The Treasury Market Absorb All The Extra Issuance? Obviously, the most important question is whether the Treasury market will be able to absorb the substantial extra issuance shown in Charts 9 & 10. There are two reasons why we don't think the extra issuance will have a material impact on yields. First, the path of inflation and the expected pace of rate hikes will continue to drive the movement in long-dated yields. While the inflation component of nominal yields is tied to realized inflation, the real component of yields is closely linked to the expected number of rate hikes during the next 12 months (Chart 13). From this perspective, it is difficult to see how shrinkage of the Fed's balance sheet can have a material impact on yields unless it influences inflation or the expected pace of hikes. Second, the draining of reserves from the banking system will increase banks' demand for Treasury securities, providing a powerful offset to the increased supply of Treasuries. The newly implemented Liquidity Coverage Ratio (LCR) mandates that banks must hold High-Quality Liquid Assets (HQLA) that are at least sufficient to cover net cash outflows over a stressed 30-day period. HQLAs are divided into tiers, with Treasury securities and reserves at the Fed qualifying as Tier 1 assets. Agency MBS are considered Tier 2A assets, this means that a 15% haircut must be applied to MBS balances for the purposes of the HQLA calculation. An even larger haircut is applied to riskier assets such as corporate bonds. Chart 14 shows the aggregate balances of reserves, Treasury securities and Agency MBS for all private depository institutions, as well as a proxy for banking sector HQLAs that we calculated to include only: reserves, Treasury securities, and agency MBS with a 15% haircut. Chart 13Focus On Rate Expectations Chart 14Banks Need Safe Assets As the Fed's balance sheet shrinks and reserves are drained from the banking system, banks will be forced to buy Treasuries in numbers that are at least sufficient to maintain mandated HQLA balances. At the moment, it is difficult to calculate how much Treasury buying will be necessary. The regulation only forces banks to start reporting their LCRs on a quarterly basis starting on April 1 of this year. Citigroup did report an LCR of 121% in its 2016 annual report, and we suspect that the ratios for other banks are in the same neighborhood. The mandated LCR is 100%. If Citigroup's reported LCR is a reasonable guide, this means that banks are just barely above mandated LCR levels. In other words, banks will need to replace almost all of the decline in bank reserves with purchases of Treasury securities. This surge in demand will offset a good chunk, if not all, of the extra Treasury issuance that is on its way. Bottom Line: The run-down of the Fed's balance sheet will lead to a substantial increase in gross Treasury issuance next year. Most, if not all, of this extra issuance will be met by increased demand from the banking sector. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.predictit.org/Contract/5367/Will-Donald-Trump-be-president-at-year-end-2018#data 2 Please see Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment", dated May 17, 2017, available at gps.bcaresearch.com 3 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 4 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet", dated February 28, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights U.S. Politics: We recommend that investors look through the political noise in D.C., which is unlikely to arrest the current cyclical economic upturn. Maintain a pro-growth asset allocation within fixed income portfolios: below-benchmark duration, favoring corporate credit over government bonds, especially in the U.S. Duration Checklists: An update of our Duration Checklists shows that the backdrop remains conducive to rising Euro Area bond yields, while the upward pressures on U.S. yields have diminished somewhat. The majority of the indicators, however, continue to point to higher U.S. Treasury and German Bund yields. Europe: Reduce European duration exposure, but wait for wider spread levels before moving out of European government bonds into U.S. Treasuries. Feature The Economy Trumps Politics Chart of the WeekHas Anything Really Changed? A whiff of panic swept across global financial markets last week, as the political risk bugaboo came back with a vengeance. In the U.S., the deepening morass surrounding President Trump's decision to fire former FBI Director Comey, and the potential links to the ongoing investigation of the White House's ties to Russia, raised concerns that Trump's ambitious pro-growth policy agenda would never make it out of Congress. Even this year's darling in the Emerging Markets, Brazil, suffered a huge financial rout after news broke of corruption allegations against the current president. Amid growing talk of a potential impeachment of Trump, the market action was a classic risk-off move, with equity markets falling, the VIX finally waking from its slumber and safe-haven assets like gold, U.S. Treasuries and the Japanese yen rallying. The euro climbed to new 2017 highs versus the U.S. dollar, without any changes in expectations about potential policy moves from the European Central Bank (ECB), as the market knocked down the probability of a June Fed rate hike (Chart of the Week). Some creative commentators called these market moves "the Trump fade" - the beginnings of a reversal of the so-called "Trump trade" that has sent U.S. equity prices and bond yields higher since the U.S. election on expectations of a large U.S. fiscal stimulus. We remain skeptical, however, that expectations of tax cuts and increased government spending have been the main drivers of the post-election boost in U.S. stock prices and Treasury yields, as the current cyclical upturn in global growth was already underway before Trump's election victory. Our colleagues at the BCA Geopolitical Strategy service note that, despite Trump's terrible overall approval ratings (Chart 2), his support among his Republican voters remains strong (Chart 3). Thus, an impeachment is only likely if the Republicans were to lose control of the House of Representatives in next year's U.S. midterm elections. Fear of that outcome should motivate the GOP to try and push through tax and healthcare reform well ahead of the 2018 midterms, in order to present a positive economic message to voters.1 Unless the evidence against Trump becomes so damning that even the Republicans in Congress have to focus on impeachment instead of policy, investors should ride out any market volatility associated with worries that the Trump economic agenda is at risk. Chart 2Trump's Support Abysmal Chart 3GOP Not Yet Willing To Impeach Trump Even without a boost to growth from D.C., however, we continue to expect the U.S. economy to grow above 2.5% in 2017. This above-trend pace will keep the Fed in play for at least two additional rate hikes before year-end, as it would give policymakers confidence that U.S. inflation expectations would return back the Fed's 2% target. In addition, as we discuss in the next section, the cyclical upturn in the Euro Area economy is showing no signs of cooling off, which will put more pressure on the ECB to begin preparing the markets for an eventual tapering of its asset purchases. The recent decline in bond yields is unlikely to persist much longer. Bottom Line: We recommend that investors look through the political noise in D.C., which is unlikely to arrest the current cyclical economic upturn. Maintain a pro-growth asset allocation within fixed income portfolios: below-benchmark duration, favoring corporate credit over government bonds, especially in the U.S. Checking In On Our Duration Checklists In a Special Report published back in February, we introduced a list of indicators to follow to assess the likely direction of U.S. Treasury and German Bund yields.2 We called these our "Duration Checklists", incorporating data on economic growth, inflation, investor risk aversion and market technicals to judge whether our bias to maintain a below-benchmark duration stance should be maintained. This week, we provide an update on those Checklists. The current message from the Checklists is that there is reduced upward pressure on bond yields from the overall strength of the global economy than existed four months ago. Domestic forces, however, are still pointing to higher yields in the U.S. and, especially, the Euro Area (Table 1). Specifically: Table 1A More Bond-Bearish Backdrop For Bunds Than USTs Global economic activity indicators have lost some momentum. While the global leading economic indicator (LEI) is still rising, our global LEI diffusion index has fallen sharply and is now below the 50 line, indicating that a more countries now have a falling LEI. In addition, the global ZEW index has drifted a touch lower, global data surprises are no longer positive, and the global credit impulse has ticked downward (Chart 4). Only the rising LEI warrants a "check" in our Checklists (i.e. justifies our current below-benchmark duration stance). U.S. & European domestic economic activity remains in good shape. Consumer and business confidence remains at strong levels on either side of the Atlantic, with corporate profit growth still accelerating (Charts 5 & 6). Only the modest decline in the U.S. manufacturing purchasing managers' index (PMI) is worthy of an "x" in our U.S. Checklist, although the index remains well above 50 and is not pointing to a more serious deterioration in the U.S. economy. Chart 4Global Growth Backdrop Has##BR##Turned Less Bond-Bearish Chart 5U.S. Economic Strength##BR##Still Supports Higher UST Yields Chart 6Euro Area Growth Is##BR##Gaining Upward Momentum Inflation pressures have eased a bit, especially in the U.S. The slowing momentum in global energy prices has taken some of the steam out of headline inflation in both the U.S. and Europe. Wage inflation has eased up a bit in the U.S., even with the labor market running at full employment (Chart 7). Wage growth and core inflation have recently ticked higher in the Euro Area, however, while the unemployment rate there has fallen to within less than a percentage point away from the OECD estimate of the NAIRU (Chart 8).3 The only indicators worthy of a "check" are the unemployment gap in both the U.S. and Euro Area, although we will give a potential "check" (with a question mark) to European wage inflation. If the recent uptick gains additional momentum, the case for the ECB to begin moving to a less accommodative policy stance will be much stronger. Chart 7Inflation Pressures On UST Yields Have Eased Chart 8Core Inflation & Wages Bottoming Out In Europe? There is still a pro-risk bias among global investors. U.S. and Euro Area equity markets are still in bullish trends, trading well above their 200-day moving averages. At the same time, corporate credit spreads remain tight and option-implied equity volatility is very low (even after last week's pop in the U.S. on the Trump drama). All indicators are worthy of a "check", suggesting that easier financial conditions can lead to higher bond yields (Charts 9 & 10). We are, however, giving an "x" to the European Checklist for the deviation of the Stoxx 600 from its moving average, as it is now at the +10% extreme that we defined as being potentially bond-bullish as it could foreshadow a near-term correction of an overheated stock market. Chart 9Still Generally A Risk-Seeking Backdrop In The U.S. Chart 10Strong Risk-Seeking Behavior In Europe Bond markets no longer look technically stretched. The sharp move higher in yields at the end of 2016 left all our indicators of yield momentum at bearish extremes (for bond prices). With bond yields pulling back from 2017 highs, however, the momentum measures all look neutral at the moment and are not an impediment to higher yields (Charts 11 & 12). The same goes for duration positioning in the U.S., with the net longs on 10-year Treasury futures now at the highest level since 2007. All of the technical indicators in our Checklists warrant an "check". Chart 11UST Technicals No##BR##Longer Stretched Chart 12Technicals Are No Impediment##BR##To Higher Yields In Europe Summing it all up, our Duration Checklists show that the majority of indicators are still pointing to higher bond yields in the U.S. and Europe, although not as decisively as when we first published the Checklists in February. There are more "check" on the European side of the ledger, however, suggesting that there is more room for European government bond yields to rise relative to U.S. Treasuries. This would indicate a potential trade opportunity to cut allocations to Europe and raise allocations to the U.S. Chart 13UST-Bund Spread Is Now Too Low The recent decline in U.S. yields, however, has narrowed the U.S. Treasury/German Bund spread to levels that make putting on a tightening trade unattractive on a tactical basis. (Chart 13). The gap between the data surprise indices in the U.S. and Euro Area already reflects the recent soft patch for the U.S. economy (middle panel). That spread in the surprise indices now at historically wide levels, suggesting more potential for Treasury yields to rise if the U.S. data begins to rebound soon, as we expect. Also, the gap between U.S. and Euro Area inflation expectations has narrowed alongside the recent downtick in U.S. core inflation (bottom panel), although we expect the decline in U.S. core inflation to be short-lived given the persistent tightness of the U.S. labor market. Net-net, we would prefer to see a wider Treasury-Bund spread before making switching our country exposure out of Europe and into the U.S. We can, however, listen to the message from our Checklists and reduce our duration exposure in Europe. Specifically, we are cutting our allocations to the longer maturity buckets (5 years out to 30 years) by 50% in our model portfolio for Germany, France and Italy, putting the proceeds into the 1-3 year buckets (see the table on Page 12). This will reduce our overall recommended portfolio duration by just over 1/10th of a year, as well as put an additional bear-steepening curve tilt within our European government allocations. We are comfortable with that bias, given the growing risk that the ECB will soon begin signaling a tapering of asset purchases once the current program expires at the end of the year. Bottom Line: An update of our Duration Checklists shows that the backdrop remains conducive to rising Euro Area bond yields, while the upward pressures on U.S. yields have diminished somewhat. The majority of the indicators, however, continue to point to higher U.S. Treasury and German Bund yields. Reduce European duration exposure, but wait for wider spread levels before moving out of European government bonds into U.S. Treasuries. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment", dated May 17 2017, available at gfis.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15 2017, available at gfis.bcaresearch.com 3 Non-Accelerating Inflation Rate Of Unemployment. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Four separate indicators provide compelling evidence for a 'mini-cycle' in activity. 1. The bond yield. 2. The credit impulse. 3. The steel equity sector price. 4. The consumer price index (CPI). Right now, the mini-cycle is about 4 months into downswing whose average duration tends to be about 8 months. Hence, the surprise in the coming months could be that inflation comes in below expectations. Feature Central to our European investment philosophy is the existence of what we call a 'mini-cycle' in global activity. Right now, this cycle is about 4 months into a mini-downswing whose average duration tends to be about 8 months. Within this global mini-cycle the irony is that Europe itself has been a paragon of stability. Quarter on quarter growth has remained within a remarkably narrow 1.2-2.2%1 band for eight consecutive quarters. And the dispersion of growth across euro area countries now stands at a historical minimum. We expect the euro area's relative stability to persist given the recent bottoming of the euro area 6-month bank credit impulse. Nevertheless, for the European investment and inflation outlook, the global growth cycle is as important, or more important, than the domestic cycle. In highly integrated and correlated international markets, the absolute direction of European asset prices takes its cue from a global rather than a local conductor. The pace of consumer price inflation also tends to be a global rather than a local phenomenon. For example, through the past 10 years, the inflation cycles in the euro area, U.K. and U.S. have been near identical (Chart I-2). Chart Of the WeekThe Steel Sector Has A Clear Mini-Cycle Chart I-2The Inflation Cycle Is Global, Not Local In this light, the ECB now correctly assesses that "the risks surrounding the euro area outlook relate predominantly to global factors." As we go on to show below, the surprise in the coming months could be that inflation comes in below expectations. This would slow the ECB's exit from its current ultra-accommodative monetary policy. But because these downside inflation surprises were coming from outside the euro area, it would force other central banks to become even more dovish relative to current expectations. On this basis, we are very comfortable to maintain our relative return positions in European investments: expect euro currency outperformance; T-bond/German bund yield spread convergence; and euro area Financials outperformance versus global Financials. For absolute return positions, expect the relatively benign backdrop for bonds to continue into the summer months. Mini-Cycles: The Evidence Mounts In previous reports, we presented two pieces of evidence for economic mini-cycles. First, the global bond yield shows a remarkably regular wave like pattern with each half-cycle averaging about 8 months (Chart I-3). Second, the acceleration and deceleration of bank credit flows - as measured in the credit impulse - also exhibits a remarkably regular wave like pattern, with each half-cycle also lasting about 8 months (Chart I-4). Chart I-3The Bond Yield Has A Clear Mini-Cycle Chart I-4The Credit Impulse Has A Clear Mini-Cycle We proposed that the bond yield and credit impulse cycles are inextricably embraced in a perpetual feedback loop: a higher bond yield weighs on credit flows; this slows economic growth which then shows up in activity data; in response, the bond market lowers the bond yield; the lower bond yield boosts credit flows, which lift economic growth; and so on... But as each stage in the sequence comes with a delay, the bond yield and credit impulse mini-cycles should be 'out of phase'. And this is precisely what the empirical evidence shows (Chart I-5). Chart I-5The Bond Yield And Credit Impulse Mini-Cycles Are Out Of Phase Now, to build an even stronger case for mini-cycles we will add a third and fourth piece of compelling evidence. The third piece of evidence is the steel equity sector price, which is an excellent real-time indicator of the growth cycle, and shows exactly the same mini-cycle profile as the bond yield (Chart of the Week). The fourth piece of evidence is the consumer price index (CPI) which also presents an identical mini-cycle profile (Chart I-6). Chart I-6The Consumer Price Index Has A Clear Mini-Cycle As with the bond yield and the steel equity sector price, we have de-trended the CPI to better show the underlying cyclicality. But in the case of the CPI, our chosen de-trending rate of 2% has special significance: 2% is the inflation target for most central banks. Hence, if the de-trended CPI is rising, inflation is running above the 2% target; if the de-trended CPI is falling, inflation is running below the 2% target. In this regard, the mini-cycle in the CPI carries a disturbing asymmetry. Observe that in recent mini-upswings, inflation has just about reached the 2% target. But in each and every mini-downswing, inflation has substantially undershot the 2% target. Based on the regularity of the mini-cycle through the past 10 years, we can estimate that we are about half way into a mini-downswing. If so, the surprise in the coming months could be that inflation comes in below expectations, frustrating the ECB. Still, as the disinflationary surprises will emanate from outside the euro area, other major central banks might be even more frustrated. And this supports our aforementioned relative positions in European investments. What Is Your Most Provocative Non-Consensus View? The observation that inflation has struggled to reach 2% in mini-upswings, but substantially undershot 2% in each and every mini-downswing is very telling. The strong suggestion is that the recent modest uplift in inflation towards 2% could just be a mini-cyclical rather than structural phenomenon. The death of debt super-cycles combined with an incipient wave of Artificial Intelligence (AI) led automation still constitutes a very powerful structural deflationary force, which should not be underestimated. The technical pattern of bond yields also supports this thesis. Chartists will point out that the global bond yield is still in a well-defined pattern of lower highs and lower lows - which is to say a well-established downward channel (Chart I-7). And that it would take the yield to rise by a quarter (about 40 bps) to breach this channel. The German 30-year bund yield gives a very similar message (Chart I-8). Chart I-7Still In A Structural Downtrend: The Global Bond Yield... Chart I-8...And The German 30-Year Bund Yield At meetings, clients often ask for the most non-consensus investment view - something to which the street attributes a 10% chance, but to which I attribute a 50% or higher chance. Given the asymmetrical mini-cycle behaviour of both inflation and bond yields and the powerful structural forces of deflation shown in the preceding charts, here is my provocative answer: Perhaps the structural low in bond yields is not behind us; perhaps it is to come in the next major global downturn. But this is a personal view. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 At an annualized rate. Fractal Trading Model* There are no new trades this week, leaving us with four open trades. 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. Fractal Trading Model * 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 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. 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
Highlights Duration: The opposing forces currently pulling on global bonds - softer growth and core inflation readings vs. tightening labor markets - are keeping yields locked into narrow trading ranges. We expect the strength of the global upturn to reassert itself, leading to higher government bond yields and corporate credit outperformance over the balance of 2017. U.K./Canada/Australia: Economic data, as well as our bond market indicators, are giving conflicting signals for the outlook for yields in the U.K., Canada & Australia. Our analysis of the relative growth and inflation dynamics in the three countries leads us to recommend a 2-year/30-year yield curve box trade, positioning for a relatively flatter curve in Canada and a relatively steeper curve in the U.K. Portugal Trade Update: Improving growth indicators, and declining measures of banking sector risk, in Portugal have resulted in a sharp narrowing of government spreads versus Germany. We are exiting our short 10-year Portugal/long 10-year Germany Tactical Overlay trade this week, at a loss of -1.6%. Feature Chart of the WeekMarket Volatility Is Low For A Good Reason What was once a fairly straightforward narrative for global bond markets earlier this year is now being challenged. Growth data has cooled a bit in the U.S. and China, while commodity prices have fallen, suggesting that the global economy may be losing steam even with leading indicators still rising and the European economy looking robust. At the same time, core inflation measures have ticked lower despite the signs of tighter labor markets throughout the developed world. These moves on the margin have stalled the upturn in global bond yields, resulting in lower fixed income market volatility that is likely playing a role in keeping realized equity market volatility at depressed levels (Chart of the Week). We continue to see the recent pullback in U.S. data as being temporary in nature. The economy should improve in the coming months given the still-solid trends in U.S. corporate profits and household income and the still-low level of interest rates. The signs of a building China slowdown are potentially more worrisome, especially on the inflation front given how much Chinese demand has boosted commodities and overall traded goods prices over the past year. Although we are not expecting a major Chinese downturn that could spill over more broadly to the world economy, it is likely that the next leg up in inflation in the developed economies will come from diminished spare capacity and rising core inflation, rather than a commodity-driven reacceleration of headline inflation. We continue to recommend a strategic underweight overall portfolio duration stance, as we expect the Fed to deliver on its planned rate hikes before year-end and the European Central Bank (ECB) to soon begin signaling a tapering of its asset purchases next year. We continue to favor corporate credit over sovereign debt, particularly in the U.S., given the strength of the current global upturn, but staying up in credit quality (i.e. focusing on Investment Grade and higher-rated credit tiers in High-Yield). Stuck On Neutral: Considering Trades Between Canada, Australia & The U.K. Over the past few months, we have upgraded our stance on government bond exposure in the U.K., Canada and Australia - all to neutral and all for essentially the same reason. There was not a compelling enough case to expect any of the central banks in those countries to move interest rates before year-end, in either direction, given the lack of sustainable inflation pressures and mixed messages on growth. With policymakers stuck on hold for the foreseeable future, keeping our recommended bond weightings at benchmark was the logical (albeit unexciting) choice. Even the mixed messages sent by our own bond indicators highlight the difficulty in making a decisive market call at the moment. Our Central Bank Monitors for Canada and Australia have recently flipped into the "tighter policy required" zone, joining the U.K. Monitor which has been there for some time (Chart 2).1 This would suggest moving to an underweight stance in anticipation of tighter monetary policy in those countries that is currently not priced into money market curves (bottom panel). Yet the best performing bond market of the three over the past two years has been the U.K. - a trend that started before last year's Brexit vote when the U.K. economy was in relatively good shape and the Bank of England (BoE) was starting to send hawkish messages. Gilts now look the most overvalued judging by the current negative real yields on offer (Chart 3), yet our U.K. Central Bank Monitor is showing signs of topping out, further adding to the confusion. Chart 2Markets Don't Expect Anything From BoE/BoC/RBA Chart 3Gilts Look Most Expensive Having mixed directional signals, however, does not imply that there are not trade opportunities within these markets. Even if the BoE, the Bank of Canada (BoC) and the Reserve Bank of Australia (RBA) are not in a hurry to begin hiking interest rates, domestic growth and inflation pressures are building at a different pace within these economies, creating potential cross-market trade opportunities. Economic Growth: Canada has the strongest leading economic indicator, manufacturing PMI and consumer sentiment, but the softest business confidence (Chart 4) - perhaps because of concerns over the future protectionist trade policies of U.S. President Donald Trump. In the U.K., a combination of falling real wage growth and persistently high levels of political uncertainty after Brexit are weighing on consumer sentiment, yet business confidence is the strongest of the three countries. Meanwhile, overall confidence in Australia is the weakest, even with manufacturing in a strong upturn. Most worryingly, real consumer spending is slowing rapidly in all three countries, although it is holding up relatively better in Canada. Inflation: The differences in price pressures are less pronounced (Chart 5). Inflation rates are similar among the three economies as Australian core CPI inflation appears to have finally bottomed out in the first quarter of this year after falling steadily since 2014. All three countries are witnessing decelerating wage growth, however, even with solid job growth in Canada over the past year. Spare capacity measures like the output gap and unemployment gap show the U.K. economy being closest to full employment (Chart 6). Spare capacity is steadily being absorbed in Canada, although the BoC attributes this to a slower pace of potential GDP growth, according to last month's BoC Monetary Policy Report (MPR).2 Chart 4Canadian Economic Data Looks Strongest Chart 5No Major Inflation Differences Home Prices & Debt: The housing markets remain an issue in Canada and Australia, where home prices look severely overvalued with household debt at elevated levels (Chart 7). The governments in both countries are trying to use regulatory and macro-prudential solutions to cool red-hot housing demand, but rapid growth in housing wealth remains a source of stimulus for consumers at the moment. The situation is different in the U.K., where home valuations and debt levels are nowhere near as elevated as in the other two countries (although London homeowners may disagree). Chart 6No Spare Capacity In The U.K. Chart 7Household Debt A Concern In Canada & Australia Exports: Each country is also exposed to a different major economy via the export channel. The OECD leading economic indicators for the U.S., Euro Area and China (the largest export markets for Canada, the U.K. and Australia, respectively) are all ticking higher, suggesting that export demand should pick up for Canada, the U.K. and Australia in the near term (Chart 8). However, Australian exports to China have already expanded at a 60% annual rate and our Emerging Market and China strategists are expecting some cooling of Chinese growth in the latter half of this year; slower export growth should be expected. Chart 8An Unsustainable Surge In Aussie##BR##Export Demand From China After adding up all the pieces, it is still difficult to select one government bond market over the others in absolute terms. The U.K. would appear to have the least bond-friendly backdrop, with higher inflation and very low real interest rates. Yet the BoE is worried about many factors - Brexit uncertainties on trade and business confidence, declining real household income growth - that should prevent them from shifting to a less accommodative monetary stance before year-end that would involve reduced Gilt purchases and/or outright interest rate hikes. Conversely, Australia seems to have the most bond-bullish climate - a still-negative output gap, plunging consumer confidence, very low inflation and the heaviest exposure to a Chinese economy that is set to cool off. Yet while core inflation remains low at 1.5%, it appears to be bottoming out and the RBA is currently forecasting that its preferred measure of underlying inflation will move up to 2% - the low end of its 2-3% target range - by early 2018, according to their just-released Statement on Monetary Policy.3 In Canada, the BoC continues to take a very cautious view on Canadian growth, despite the robust 4% real GDP growth seen in the first quarter of this year. Sluggish growth in exports and capital spending is expected to be a drag on growth this year, according to the April BoC MPR. Yet the central bank is now "decidedly neutral" and is no longer considering a rate cut as it was earlier this year according to BoC Governor (and BCA alumnus) Stephen Poloz.4 Given all the various factors pushing and pulling on these three economies and central banks, it is perhaps no surprise that yield moves have been highly correlated across these bond markets over the past several months (Chart 9). The most attractive near-term risk/reward opportunities now appear to be in relative yield curve trades rather than directional allocations or cross-country spread trades. Specifically, we see an opportunity to play for a steeper Gilt curve, and a relatively flatter Canadian government bond curve, via a 2-year/30-year box trade. Given the strong readings on current and leading economic indicators in Canada, combined with our view that the recent patch of slower U.S. growth will prove to be temporary, we see the greatest potential for upside growth surprises in Canada. The BoC is likely to wait before delivering rate hikes until there is decisive evidence of accelerating inflation, especially given the potential economic risks deriving from the Canadian housing bubble. However, better-than-expected growth will exert more flattening pressure on the Canadian yield curve than the U.K. or Australian curves, where downside growth risks are greater. Already, the very front end of the Canadian curve is starting to disengage from the U.K. and Australian curves, with the 2-year/5-year flattening modestly in Canada and the other markets showing steepening curves at similar maturities (Chart 10, top panel). We expect that relative flattening pressure to exert itself further out the yield curve for Canadian government debt over the latter half of 2017. Chart 9Yields Are Highly Correlated... Chart 10...Curve Slopes, Slightly Less Correlated In the U.K., the long end of the Gilt curve has rallied to very rich levels, with the 10-year/30-year slope now trading near the bottom of the range that has prevailed since 2014 (bottom panel). Much of that has been driven by a decline in longer-term inflation expectations that has accompanied the more stable British Pound. While the uncertainty surrounding the upcoming Brexit negotiations with the European Union will likely weigh on business confidence and investment spending in the U.K., the immediate impact of the robust Euro Area economy on U.K. exports should provide a boost to U.K. economic growth. Coming at a time when the U.K. is at, or even beyond, full employment, this should put some mild upward pressure on inflation expectations further out the curve, leading to steepening pressures on a relative basis to Canada. This can already be seen in looking at the 2-year/30-year yield curve box between the Canada and the U.K. in Chart 11. In all three panels, we show the steepness of the Canadian bond curve minus that of the Gilt curve, alongside the differentials in actual inflation, and market-based inflation expectations from the index-linked markets, between Canada and the U.K. As can be seen in the top two panels, the Canadian curve looks too steep relative to the U.K. curve given the higher rates of headline and core inflation in the U.K. The bottom panel shows that the 2-year/30-year box is in line with the relative inflation expectations within the two countries. We see this as a sign that U.K. inflation expectations are too low relative to actual U.K. inflation, leaving the Gilt curve too flat relative to the Canadian curve. While this would appear to argue for a relative trade between inflation-linked bonds in Canada and the U.K., the poor liquidity of the small Canadian linker market makes this a difficult trade for most investors to put on. We prefer to express the view via yield curves, particularly with the 2-year/30-year Canada-U.K. box currently priced in the bond forwards to move sideways over the rest of the year (Chart 12). This means that betting on a steeper Gilt curve relative to Canada does not incur negative carry - important for a trade with a more medium-term horizon like this. Chart 11Gilt 2/30 Curve Too Flat Relative To Canada Chart 12Enter A 2/30 Canada-U.K. Box Trade This week, we are adding this 2-year/30-year Canada-U.K. position to our strategic model portfolio at -7bps. The initial target is for the box to return to -50bps - the bottom of the range that has prevailed since 2015. A deeper decline would occur if the BoC begins to signal a rate hike in Canada at some point that puts even more flattening pressure on the Canadian curve, although that is not our base case expectation over the rest of 2017. The risk to the trade would come from a deceleration of U.K. inflation that eliminates the current divergence between realized and expected inflation. What about Australia? We anticipate that there will be an opportunity to move to an eventual overweight position in Australian bonds in the coming months to position for the slowing of Chinese growth, and the related demand for Australian exports, that we expect. We are choosing to stay neutral for now, however, given the current uptick in Australian inflation that muddies the water on any call on RBA monetary policy. Bottom Line: Economic data, as well as our bond market indicators, are giving conflicting signals for the outlook for yields in the U.K., Canada & Australia. Our analysis of the relative growth and inflation dynamics in the three countries leads us to recommend a 2-year/30-year yield curve box trade, positioning for a flatter curve in Canada and a steeper curve in the U.K. Tactical Overlay Housekeeping: Cutting Losses On Portugal Shorts One of our long-held positions in our Tactical Overlay trade portfolio has been a short position in Portugal 10-year government bonds versus a long position in 10-year German Bunds. We put the trade on last summer as part of a broader allocation at the time out of Peripheral European sovereign debt into core European debt. The logic was straightforward - the combined stress of decelerating economic growth and struggling banking systems in the Periphery (made worse by the ECB's negative interest rate policies) would result in some spread widening in Italy, Spain and Portugal. While that story remains true in Italy, both leading economic indicators and measures of financial sector risk like credit default swap (CDS) spreads for senior banks have a decline in Spain and Portugal. While we have already upgraded our recommended allocation to Spanish debt in our model portfolio, we had been reluctant to consider a similar move in Portugal given our concerns about its economy and, more importantly, its banking system. But with leading economic indicators starting to perk up and bank CDS spreads in Portugal falling sharply, and with German Bund yields rising alongside growing market nervousness of a potential ECB taper, Portugal-Germany spreads have tightened sharply. We are belatedly cutting our losses on this position this week and closing out the position at a loss of -1.6%. We plan on publishing a deeper dive on Portugal in the coming weeks to update our views on the country and its bond markets. Bottom Line: Improving growth indicators, and declining measures of banking sector risk, in Portugal have resulted in a sharp narrowing of government spreads versus Germany. We are exiting our short 10-year Portugal/long 10-year Germany Tactical Overlay trade this week, at a loss of -1.6%. 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 Special Report, "BCA Central Bank Monitor Chartbook", dated March 28 2017, available at gfis.bcaresearch.com. 2 http://www.bankofcanada.ca/wp-content/uploads/2017/04/mpr-2017-04-12.pdf 3 http://www.rba.gov.au/publications/smp/2017/may/pdf/statement-on-monetary-policy-2017-05.pdf 4 https://www.bloomberg.com/news/articles/2017-04-12/poloz-sees-faster-canada-return-to-full-capacity-key-takeaways The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Fed: The Fed is likely to lift rates in June, which could roil markets if economic data do not improve between now and then. Municipal Bonds: Weak state & local government revenue growth reflects the fall-out from the mid-2014 commodity price collapse. Now that energy sector capex has recovered, state & local government revenues will soon follow. Economy & Inflation: Consumer confidence remains elevated, and this should lead to a snapback in consumer spending in the second quarter. Stronger growth and a tight labor market should also cause core inflation to soon resume its uptrend, driven by accelerating wage growth. Feature How stubborn are Fed policymakers? This is an important question for markets at the moment. The Fed has clearly articulated that its base case economic outlook will result in two more rate hikes before the end of 2017, and even traditionally dovish Chicago Fed President Charles Evans said he "could be fine with two more rate hikes this year."1 Meanwhile, broad indexes of financial conditions suggest that markets can absorb another rate increase (Chart 1). Everything appears to be set up for the FOMC to lift rates by another 25 basis points when it meets next month, and this remains our expectation. The only problem is that the flow of economic data has turned decisively negative (Chart 2). Most recently, core CPI disappointed expectations by increasing only 0.1% in April, causing the year-over-year growth rate to fall to 1.9%. It was only three months ago that core CPI was growing 2.3% year-over-year. True to form, President Evans also noted last week that "downside risks [to inflation] still predominate". Chart 1Green Light From Financial Conditions Chart 2Red Light From Data Surprises The risk from a market point of view is that the Fed holds true to its promise and lifts rates in June, despite the fact that recent data have disappointed and inflation remains well below target. In that scenario, it is possible that markets come to the conclusion that the Fed is running an overly tight policy, resulting in a bear-flattening of the yield curve and a near-term sell-off in spread product. Chart 3Stay Positioned For Higher Yields As we have highlighted numerous times in the context of our Fed Policy Loop,2 with inflation below target, the Fed will be quick to adopt a more dovish stance when faced with a sharp tightening of financial conditions. This will put a floor under risk assets. Further, as was discussed in last week's report,3 negative data surprises are not likely to persist for much longer. But until that turnaround occurs, there is a heightened risk of a near-term widening in credit spreads if the Fed sticks to its guns. Ultimately, the Fed will continue to support credit spreads, and we remain overweight spread product on a 6-12 month investment horizon. Our 6-12 month outlook for Treasury yields is also unchanged, even though recent yield movements reflect the "hawkish Fed" scenario described above. The nominal 10-year yield has risen in recent weeks, driven entirely by real yields that have moved higher alongside increasingly hawkish rate hike expectations (Chart 3). The compensation for inflation protection has actually declined, in reaction to disappointing inflation data and perceptions of a more hawkish Fed. Even in the event that financial conditions tighten and the Fed is forced to adopt a more dovish policy stance, we would expect the decline in real yields to be offset by an increase in the cost of inflation compensation, which still has considerable upside (see section titled "The Consumer Is Strong, But Where's The Inflation?" below). We therefore continue to recommend a below-benchmark duration stance. Finally, futures market positioning is now solidly net long, suggesting that yields are biased higher during the next three months (Chart 3, bottom panel). Bottom Line: Risk assets could sell off in the near-term if economic data do not turn around and the Fed proceeds with a June hike. However, Fed policy will ultimately encourage tighter credit spreads and a higher cost of inflation compensation on a 6-12 month horizon. Remain at below-benchmark duration and overweight spread product. Municipal Bonds: Not Just About Taxes The uncertain outlook for fiscal policy is the immediate concern in municipal bond markets. While we expect some sort of tax bill will make its way through Congress before the end of the year, as of now, we don't have much clarity on what that bill will include. Lower corporate and individual tax rates seem likely, and the administration has also expressed a desire to curb deductions. Unfortunately, for now that's about all we can say for certain. Lower tax rates would be negative from the perspective of municipal bond investors, but fewer deductions would increase demand for munis, assuming the municipal bond tax exemption is not scrapped altogether. We haven't even mentioned the potential replacement of Obamacare and a possible federal infrastructure bill! For now, the muni market seems content to shrug off this uncertainty. Muni / Treasury (M/T) yield ratios are approaching their post-crisis lows across the entire curve (Chart 4), though longer maturity yield ratios remain elevated compared to pre-crisis levels (Chart 5). We recently recommended that investors favor long over short maturities on the Aaa muni curve.4 Chart 4Yield Ratios At Post-Crisis Lows Chart 5More Value In Long Maturities As for tax reform, although nothing is known for certain, we do expect that the administration's desire for increased infrastructure investment will keep the muni tax exemption in place. We also anticipate lower corporate and individual tax rates. How much of an impact will lower tax rates have on M/T yield ratios? Even that is hard to pin down, although we note that historically there has only been a loose relationship between yield ratios and the top marginal income tax rate (Chart 6). Chart 6The Municipal Treasury Yield Ratio & Tax Rates Further, elevated yield ratios since the financial crisis are much more driven by concerns about credit quality than changes in tax policy. With the potential for municipal bankruptcy more present than ever in investors' minds, as long as the muni tax exemption is not repealed, we think that trends in state & local government balance sheet health will continue to drive yield ratios. On that latter point, there is growing reason for optimism. Revenue Growth Ready To Rebound Periods of rising state & local government net savings have historically coincided with tightening M/T yield ratios, and vice-versa. Net savings increases when revenue growth exceeds expenditure growth. However, expenditure growth has been outpacing revenue growth since early 2015 and net savings have declined as a result (Chart 7). Unsurprisingly, state & local governments have reduced their pace of hiring in an effort to protect budgets (Chart 7, panel 3). Ratings downgrades have also spiked, but the message from our Municipal Health Monitor is that they will soon subside (Chart 7, bottom panel).5 We concur, and in fact believe that state & local government revenue growth has reached an inflection point and is poised to head higher. Breaking out the different sources of state & local government revenue we see that the recent deceleration has been concentrated in income tax and sales tax revenues (Chart 8). Property tax growth has been steady, if unspectacular. Transfers from the federal government have also decelerated since early 2015, but have been flat recently. Transfer revenue is at risk of falling if the federal government is able to pass a healthcare bill that includes the block-granting of Medicaid payments. But there is still a long road ahead before any proposed healthcare bill becomes law, and a lot can change in the interim. Chart 7A Setback In State & Local Savings Chart 8State & Local Revenue By Source What seems clear at the moment is that personal income growth is heading higher and consumer spending is firm (please see the following section of this report, titled "The Consumer Is Strong, But Where's The Inflation?", for a discussion of the outlook for income and consumer spending growth). Both suggest that income and sales tax revenue growth have bottomed for the time being. Chart 9State & Local Revenue By State Using data from the Rockefeller Institute, we can also examine state & local government revenue by state. Then, if we split out the nine states that are most heavily dependent on the energy and mining sectors,6 we observe that commodity-dependent states have dragged overall state & local government revenue growth lower since commodity prices collapsed in mid-2014 (Chart 9). Further, we see that revenue growth in commodity-dependent states is heavily influenced by nonresidential investment in the energy and mining sectors (Chart 9, bottom panel). Now that commodity prices have recovered from the 2014 bust and energy sector investment is coming back on line, we would expect state & local revenue growth to follow with a lag. Investment Implications Although we expect state & local government revenue growth to accelerate from here, yield ratios already reflect quite a lot of good news. Also, heightened policy uncertainty means there is an increased risk that yield ratios will widen sharply in the coming months. For now, we recommend only a neutral allocation to Municipal bonds within U.S. fixed income portfolios. However, an interesting opportunity could lie in focusing municipal bond exposure on those aforementioned commodity-dependent states, where revenues are likely to grow more quickly as energy capex rebounds, and whose bonds might still trade at a discount because of lower current revenues. Looking at Charts 10 & 11, we notice that the General Obligation (GO) bonds of energy-dependent Texas offer a yield advantage of 15 bps versus the overall Aaa muni curve at the 10-year maturity point. This is close to the same yield advantage offered by Massachusetts GO bonds, even though Massachusetts is rated Aa1 and Texas carries a Aaa rating. Other Aaa-rated states (Virginia, Georgia, Maryland, North Carolina, South Carolina and Tennessee) trade at much lower yields. Not only that, but Texas has also seen the strongest population growth during the past 12 months of all the states in our sample (Chart 11), and employment growth in Texas should continue to rebound alongside rising oil prices (Chart 12). Our Commodity & Energy Strategy service maintains a $60/bbl year-end oil price target.7 Chart 10Grab The Premium In Texas GOs Part I Chart 11Grab The Premium In Texas GOs Part II Chart 12Texas Bouncing Back Bottom Line: Weak state & local government revenue growth reflects the fall-out from the mid-2014 commodity price collapse. Now that energy sector capex has recovered, state & local government revenues will soon follow. Commodity-dependent states should benefit disproportionately. Texas GOs in particular look attractive on a risk/reward basis. The Consumer Is Strong, But Where's The Inflation? Consumer Spending Chart 13Consumer Spending Looks Solid The post-election surge in consumer confidence does not look as though it's about to reverse. At least not according to the University of Michigan Consumer Sentiment Survey, which was released last week. The expectations component of that survey, which closely tracks real consumer spending (Chart 13), rose from 87 in April to 88.1 in May, suggesting that weak first quarter consumer spending will prove to be nothing more than a blip. We like to think about consumer spending as a combination of income growth and the savings rate. On income growth, survey measures are also pointing to an imminent acceleration (Chart 13, panel 2). Meanwhile, the savings rate will likely remain elevated compared to pre-crisis levels, but is unlikely to move meaningfully higher from here. In our February 21 report,8 we noted that while tightening bank lending standards correlated with a higher savings rate prior to the financial crisis, that relationship has since completely broken down (Chart 13, panel 3). Since the housing bust, the supply of credit is no longer the chief constraint on consumer borrowing. Households are now much more concerned with maintaining the health of their own balance sheets. For this reason, we do not view the recent tightening of consumer lending standards as a meaningful impediment to consumer spending. Similarly, we do not think the recent decline in demand for consumer credit (according to the Fed's Senior Loan Officer Survey) will soon translate into much weaker consumer spending. In prior cycles, we see that loan demand tended to fall several years prior to the next recession, while the savings rate did not spike until the recession actually hit (Chart 13, bottom panel). Inflation & TIPS As was mentioned above, the Consumer Price Index for April was also released last week. Not only was the core CPI print disappointing, but the decline was broad based across the four major components of core CPI: shelter, core goods, core services excluding shelter, and medical care (Chart 14). The tick lower in shelter inflation is not surprising, and in fact should continue now that rental vacancies have put in a bottom. We would also expect core goods inflation to stay low, given that the U.S. dollar remains in a bull market. More worrisome is the large drop in core services inflation excluding shelter (Chart 14, panel 3). This component of core inflation correlates most closely with wage growth, and we would expect this component to drive core inflation higher as the labor market tightens and wage growth accelerates. It is worth noting that while wage growth has also weakened during the past few months, leading wage growth indicators are still trending up (Chart 15). Pipeline measures of inflationary pressures, such as the core Producer Price Index and the Supplier Deliveries and Prices Paid components of the ISM Manufacturing index, are the other bright spots in the inflation outlook (Chart 16). While the 10-year TIPS breakeven rate has fallen all the way to 1.85% from its post-election high of 2.08%, these pipeline measures suggest the decline will prove fleeting. Chart 14Core CPI By Major Component Chart 15Wage Growth Will Recover Chart 16Pipeline Measures Still Positive We continue to expect that the 10-year TIPS breakeven inflation rate will reach 2.4% to 2.5% by the time that core PCE inflation returns to the Fed's 2% target, sometime near the end of this year. Bottom Line: Consumer confidence remains elevated, and this should lead to a snapback in consumer spending in the second quarter. Stronger growth and a tight labor market should also cause core inflation to soon resume its uptrend, driven by accelerating wage growth. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.bloomberg.com/news/articles/2017-05-12/evans-says-risks-to-fed-inflation-outlook-still-on-the-downside 2 Please see U.S. Bond Strategy Weekly Report, "Caught In A Loop", dated September 29, 2015, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, "Past Peak Pessimism", dated May 9, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Reflation Window Still Open", dated April 4, 2017, available at usbs.bcaresearch.com 5 For further details on our Municipal Health Monitor, please see: U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 6 These states are: Alaska, Louisiana, Montana, New Mexico, North Dakota, Oklahoma, Texas, West Virginia and Wyoming. 7 Please see Commodity & Energy Strategy Weekly Report, "Oil: Be Long, Or Be Wrong", dated May 11, 2017, available at ces.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "The Odds Of March", dated February 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Duration: U.S. growth expectations have become overly pessimistic. A Q2 rebound will lead to higher global bond yields and a steeper U.S. Treasury curve. UST / Bund Spread: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. USD Hedging Costs: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Feature Chart 1Global Recovery Will Persist The synchronized global recovery that took hold in the second half of 2016 has stalled so far this year. Measures of economic sentiment, such as the Global ZEW survey and our own Boom/Bust Indicator, have rolled over from high levels and global bonds have clawed back some of last year's lost returns (Chart 1). Year-to-date, the Bloomberg Barclays Global Government Bond index has returned +3%, after having lost more than 9% between the July trough in the Global ZEW index and the end of last year. In our view, a repeat of early 2016's global growth slowdown and bond market rally, which saw the Global ZEW index fall below zero and the Global Government Bond index return 11.6% in 2016H1, is not in the cards. The global economy is on much firmer footing than at this time last year. U.S. Growth: Past Peak Pessimism First quarter U.S. GDP growth was a disappointing 0.7%, but is poised to bounce back strongly in Q2. The volatile inventories component subtracted 0.9% from overall Q1 growth, harsh weather wreaked havoc on the March employment report and there continue to be problems with residual seasonality depressing first quarter GDP data.1 The outlook is much brighter moving forward. The latest employment report showed that the U.S. economy added a healthy 211k jobs in April and our model is pointing toward a further acceleration (Chart 2). Economic growth can be thought of as a combination of aggregate hours worked and labor productivity (Chart 3). With aggregate hours worked growing at 1.7% year-over-year and labor productivity growth having averaged 0.6% (annualized) per quarter since 2012, real U.S. GDP growth of around 2.3% seems like a reasonable forecast. Chart 2Labor Market Still Strong Chart 3Look For Above 2% Growth There is even some reason to suspect that labor productivity could strengthen during the next few quarters. A recent IMF paper2 attributed weak post-crisis productivity growth to a combination of structural and cyclical factors, but also noted that weak investment in physical capital may be responsible for lowering total factor productivity growth by nearly 0.2 percentage points per year in advanced economies during the post-crisis period. With leading indicators pointing to still further gains in fixed investment (Chart 3, bottom panel), we would not be shocked to see productivity growth enjoy a modest late-cycle rebound. Chart 4Stronger Productivity = Steeper Curve All else equal, a late-cycle rebound in productivity growth would slow the increase in unit labor costs. Unit labor costs are a combination of wages (compensation-per-hour) and productivity (output-per-hour), and have historically tracked changes in the slope of the U.S. yield curve (Chart 4). Faster wage growth tends to coincide with Fed tightening, and slower wage growth with Fed easing. For this reason, all wage measures perform reasonably well tracking changes in the yield curve. But unit labor costs perform best because they also incorporate productivity growth, and low productivity growth can flatten the yield curve by pulling down long-dated yields. Rapid increases in compensation-per-hour and muted productivity growth have combined to give the yield curve a strong flattening bias during the past several years. Any increase in productivity growth would slow the uptrend in unit labor costs relative to other wage measures, allowing the yield curve to steepen. In fact, we continue to recommend that investors position for a steeper U.S. yield curve by going long the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This trade produces positive returns when the 2/10 slope steepens (Chart 4, panel 3), but has also returned +19 bps since we initiated the position last December, even though the curve has flattened since then. The reason for the trade's strong performance in an unfavorable curve environment is that the 5-year yield had been unusually elevated compared to the rest of the curve. Our model of the 2/5/10 butterfly spread versus the 2/10 slope showed that the 5-year note was one standard deviation cheap on the curve as recently as mid-March (Chart 4, bottom panel). This undervaluation has mostly dissipated and the 5-year note now appears only slightly cheap. For our curve trade to outperform from here, it will likely require the 2/10 slope to steepen.3 Bottom Line: With weak Q1 GDP now in the rearview mirror, we are likely past the point of peak pessimism on U.S. growth. Expect global bond yields to rise and the U.S. yield curve to steepen as the economic data start to reflect an environment of above-trend growth, in the neighborhood of 2% - 2.5%. European Growth & The Risk From China While the U.S. data have disappointed in recent weeks, as evidenced by the U.S. Economic Surprise Index having dipped below zero (Chart 5), the European economy has consistently bested expectations (Chart 5, panel 2). As a result, the Treasury / Bund spread has narrowed from high levels during the past few months. In practice, economic surprise indexes tend to mean revert because positive data surprises beget increasingly optimistic expectations. Eventually, overly optimistic expectations become too high a hurdle and the data start to disappoint. In our view, U.S. expectations have become unduly pessimistic while the Eurozone surprise index appears overdue for a correction. Against this back-drop, we expect the Treasury / Bund spread to widen in the near term as the large divergence between the U.S. and European surprise indexes starts to narrow. Further making the case for a wider Treasury / Bund spread is the recent performance of the Chinese economy. Our Foreign Exchange Strategy service recently observed that growth differentials between the U.S. and Europe are highly correlated with indicators of Chinese growth.4 This should not be overly surprising since Europe trades more with China and other Emerging Markets than does the United States. Along those lines, the IMF has calculated that a 1% growth shock to Emerging Markets impacts European growth by nearly 40 basis points, while it impacts U.S. growth by only 10 basis points.5 The worry at the moment is that Chinese monetary conditions have started to tighten, and China's Manufacturing PMI is rolling over alongside weaker commodity prices. These trends usually coincide with the underperformance of Europe relative to the U.S. (Chart 6). Chart 5Surprise Indexes Will Converge Chart 6Look To China To Trade UST / Bund Spread Our China Investment Strategy service highlights the importance of the trade-weighted RMB as a driver of Chinese growth.6 The RMB's 30% appreciation between 2012 and 2015 applied a massive deflationary force to China's economy, while its more recent depreciation helped boost producer prices, enhance profit margins and reduce the real cost of funding (Chart 7). Chart 7Monetary Conditions ##br##Still Fairly Stimulative More recently, the pace of the RMB's depreciation has slowed and this likely explains the weakness in China's Manufacturing PMI and commodity prices. Our China strategists are quick to note that while the pace of RMB depreciation has slowed, it is still not appreciating, and real interest rates deflated by the producer price index remain negative. In other words, monetary conditions have become somewhat less stimulative, but they should still be supportive of further economic growth. Although the Chinese economic data are likely to moderate in the coming months, barring the major policy mistake of aggressive tightening, Chinese growth will avoid a collapse and remain reasonably buoyant. Similarly, we would also expect European growth expectations to soften in the coming months, but growth is very likely to remain above trend and the ECB is still on track to adopt a less accommodative policy stance over the next year. In the most likely scenario, a few hints will be given at the June ECB meeting, and then an announcement that asset purchases will be tapered in 2018 will be made at the September meeting. The market will correctly assume that rate hikes will follow the taper, and this re-pricing of rate expectations will open up a window in the second half of this year when the Treasury / Bund spread can tighten. However, it is still too soon to adopt this position. Bottom Line: The extreme divergence between the European and U.S. economic surprise indexes is not sustainable, especially in the face of weakening Chinese economic data. The Treasury / Bund spread is biased wider in the near term, though could tighten in the second half of this year as the ECB shifts to a less accommodative policy. U.S. Bond Investors Should Expand Their Borders Divergences that have opened up between U.S. short-term interest rates and short-term rates in other developed countries mean that U.S. bond investors now face much lower currency hedging costs. In addition, increasingly negative cross-currency basis swap spreads have become a permanent feature of the post-crisis investment landscape, and unless significant regulatory changes occur, we expect they are here to stay. Combined, both of these factors make it incredibly attractive for U.S. bond investors to swap their U.S. dollars for foreign currencies and invest in foreign government bonds. In this week's report we explain why this is an attractive trade for U.S. investors and why it will likely remain so for quite some time. What Is The Basis Swap Spread? An excellent definition of the cross-currency basis comes from the Bank for International Settlements (BIS) who define it as "the difference between the direct dollar interest rate in the cash market and the implied dollar interest rate in the [currency] swap market".7 In essence, the existence of a negative basis swap spread should mean that there is an opportunity to arbitrage the difference between interest rates in the cash market and implied interest rates in the currency swap market. However, post-crisis regulatory constraints on bank balance sheets appear to have made this arbitrage prohibitive. Banks are either unable or unwilling to arbitrage the basis swap spread back to zero, and this increases the cost of U.S. dollars in FX swap markets. As a quick example, we can calculate the 10-year German Bund yield hedged into U.S. dollars using currency forwards. Hedged yield = Unhedged yield - Cost of hedging Where: Cost of hedging = forward exchange rate / spot exchange rate In this case, we define the exchange rates as euros per 1 U.S. dollar. By covered interest rate parity, we can also calculate the cost of hedging as: Cost of hedging = (1 + euro interest rate + basis swap spread) / (1 + USD interest rate) Using current 3-month interest rates, this means that the cost of hedging from euros into U.S. dollars is: Cost of hedging = (1 - 0.36% - 0.3%) / (1 + 1.18%) = -1.82% This means that the 10-year German Bund yield rises from 0.42% to 2.24%, from the perspective of a U.S. dollar investor, after hedging the currency on a 3-month horizon. In other words, U.S. investors can significantly increase the average yield of their portfolios by lending U.S. dollars over short time horizons and investing the proceeds into non-U.S. bonds. In Chart 8 we show the difference this currency hedging makes for German, Japanese and French 10-year government bonds. Current hedged 10-year yields for all the major bond markets are also shown on page 13 of this report. But for how long can this trade continue? In short, it can continue for as long as U.S. short-term interest rates increase relative to non-U.S. short-term interest rates and for as long as basis swap spreads move further into negative territory. At the moment there is no widespread agreement on what drives the day-to-day fluctuations in the basis swap spread. The BIS has posited a model where dollar strength weakens the capital positions of bank balance sheets, causing them to back away from providing liquidity to the FX swap market, and leading to increasingly negative basis swap spreads (Chart 9, top panel). Chart 8Higher Yields Via Currency Hedging Chart 9Basis Swaps, Reserves And The Dollar Meanwhile, Zoltan Pozsar from Credit Suisse has identified a link between basis swap spreads and reserves on the Fed's balance sheet (Chart 9, bottom panel).8 Specifically, as the Fed winds down its balance sheet it will be draining cash reserves from the banking system and replacing them with Treasury securities. This could cause money to leave the FX swap market and flow into Treasuries. The result is less liquidity in the FX swap market and increasingly negative basis swap spreads. Interestingly, the run-up to the debt ceiling in the U.S. has presented a test of this view. To stay under the debt ceiling the U.S. Treasury department has drawn down its cash account at the Fed and removed T-bill supply from the market. The result has been a temporary increase in reserve balances. As the theory would have predicted, basis swap spreads have moved closer to zero as reserves have increased. Going forward, the Fed is very likely to start winding down its balance sheet later this year. In all likelihood this will serve to pressure basis swap spreads even further below zero. Meanwhile, short-term interest rates in the U.S. will probably continue to rise more quickly than in most other developed markets. This means that the cost of hedging should become increasingly negative for U.S. investors. In Chart 10 we show that as the cost of hedging becomes more negative, total returns from a USD-hedged position in German bunds tend to outpace total returns from a position in U.S. Treasuries. Similarly, Chart 11 shows that USD-hedged Japanese government bonds (JGBs) also tend to outperform U.S. Treasuries when the cost of hedging falls. Chart 10Hedging Costs & Bond Returns: Germany Chart 11Hedging Costs & Bond Returns: Japan We should note that the relationships between hedging costs and relative total returns shown in Charts 10 & 11 are not perfect, and there will be instances when Treasuries can outperform even if hedging costs continue to decline. However, in the long run, as long as short-term U.S. interest rates continue to rise more quickly than short-term interest rates in the Eurozone or Japan, and especially if the Fed's upcoming balance sheet contraction leads to more deeply negative basis swap spreads, then U.S. investors should continue to boost their yields by lending dollars and investing in bunds and JGBs. Bottom Line: Declining hedging costs driven by interest rate differentials and negative basis swap spreads make international bond investment very attractive for U.S. investors. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our U.S. Investment Strategy service took up the issue of residual seasonality in a recent report. Please see U.S. Investment Strategy Weekly Report, "Spring Snapback?", dated April 24, 207, available at usis.bcaresearch.com 2 IMF Staff Discussion Note, "Gone with the Headwinds: Global Productivity", https://www.imf.org/en/Publications/Staff-Discussion-Notes/Issues/2017/04/03/Gone-with-the-Headwinds-Global-Productivity-44758 3 Our outlook for the U.S. yield curve was discussed in detail in a recent report. Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com 5 IMF Multilateral Policy Issues Report: 2014 Spillover Report https://www.imf.org/external/np/pp/eng/2014/062514.pdf 6 Please see China Investment Strategy Weeky Report, "Has China's Cyclical Recovery Peaked?", dated May 5, 2017, available at cis.bcaresearch.com 7 http://www.bis.org/publ/work592.pdf 8 https://ftalphaville.ft.com/2017/04/13/2187317/where-would-you-prefer-your-balance-sheet-banks-or-the-federal-reserve/ Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The global credit impulse is 4 months into a mini-downswing, and it is too soon to position for the next mini-upswing. The euro area economy will remain one of the better performers in a global growth pause. Underweight German bunds in a global bond portfolio. Stay long the euro, especially euro/yuan. Go long euro area Financials versus U.S. Financials, currency unhedged, as a first foray into a beaten-up sector. Feature First the good news: the ECB's latest bank lending data indicate that the euro area 6-month bank credit impulse is stabilizing after a modest but clear decline in recent months (Chart I-2). Now the bad news: the global bank credit impulse continues to weaken. The upshot is that the euro area economy - even with 1.5% growth - will remain one of the better performers in what is now a very clear global growth pause. Chart of the WeekThe Global Bond Yield Has Shown ##br##A Regular Wave Like Pattern Chart I-2The 6-Month Credit Impulse Has Stabilized In The ##br##Euro Area... But Not In The U.S. Or China How To Play The Euro Area's Economic Outperformance In a global growth pause, the best way to play euro area economic outperformance is through relative positions in the bond markets and through currencies. Specifically, underweight German bunds in a global bond portfolio but stay long the euro, especially euro/yuan. The implication for euro area equities is more ambiguous. The Eurostoxx50 has a very low exposure to Technology, which tends to perform defensively in a growth pause. Conversely, the Eurostoxx50 has a high exposure to Financials, whose relative performance reduces to a play on the bond yield (Chart I-3). Given that the global credit impulse is still weakening, it is premature to expect a sustained absolute rally in Financials anywhere. Therefore, the strong knee-jerk absolute rally in European banks after the French election first round is unlikely to last. That said, with the euro area economy likely to outperform in a global growth pause, and euro area Financials still near a 50-year relative low versus U.S. Financials, euro area bank equities can now outperform banks in other markets (Chart I-4). Chart I-3Global Bond Yield = ##br##Financials Vs. Market Chart I-4T-Bond/German Bond Spread Compression =##br## Euro Area Financials Outperform U.S. Financials As a first foray into a beaten-up sector, go long euro area Financials versus U.S. Financials, currency unhedged. (Caveat: all of this assumes that Emanuel Macron beats Marine Le Pen to the French Presidency on Sunday, as we expect.) Don't Rely On Year On Year Comparisons Nature provides many of our units of time. The earth's orbit around the sun gives us a year; the moon's orbit around the earth gives us a month; the earth's rotation on its axis gives us a day. But there is absolutely no reason why economic and financial cycles should follow nature's cycles. Yet most analysts persist at looking for patterns and cycles in economic and financial data using yearly, monthly, or daily rates of change. Unfortunately, by focusing on years, months and days, they risk completely missing some of the strongest patterns and cycles in the economy and markets. Think about a clock pendulum. If you look at it once a second, it will always seem to be in the same position, motionless. You will miss the cycle. Likewise, if an economy regularly accelerates for 6 months and then symmetrically decelerates for 6 months, the yearly rate of change will be a constant, giving the false appearance that nothing is happening. It will miss the cycle. It turns out that the global economy does indeed regularly accelerate and decelerate - and that each half-cycle averages about 8 months. The strongest evidence of this very clear oscillation comes from the remarkably regular wave like pattern in the global bond yield, illustrated in the Chart of the Week and Chart I-5 and Chart I-6. Chart I-5The Global Bond Yield Has Shown A ##br##Regular Wave Like Pattern... Chart I-6...Which Is Easier To See ##br##When Detrended Furthermore, the acceleration and deceleration of bank credit flows - as measured in the global credit impulse - also exhibits a remarkably regular wave like pattern, with each half-cycle lasting about 8 months. But crucially, a half-cycle length of less than a year means that a year on year analysis would miss this very clear oscillation. Hence, our analysis always uses the 6-month credit impulse (Chart I-7). Chart I-7The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern Mini Half-Cycles Average Eight Months It is not a coincidence that the bond yield and bank credit impulse exhibit near identical half-cycle lengths. The bond yield and credit impulse cycles are inextricably embraced in a perpetual feedback loop. A higher bond yield will initiate a mini down cycle. All else being equal, the higher cost of credit will weigh on credit flows. This will slow economic growth, which will then show up in GDP (and other hard) data. The bond yield will respond by readjusting down. In turn, a lower bond yield will then initiate a mini up cycle. And so on... But each stage in the sequence comes with a delay. For a change in the cost of credit to register with households and firms and fully impact credit flows, it clearly takes time. The credit flows do not generate instantaneous economic activity either. Fully spending the credit flows also takes time. Once you accept these assumptions of internal regulating feedback combined with delays in economic response, the economy has to be a naturally-oscillating system whose half-cycle length depends on the delays in economic response. And the important point is that these delays have little connection with nature's cycles. For those who are mathematically inclined, Box I-1 shows the differential equations which define the economic mini-cycle and its half-cycle length. Box 1The Mathematics Of Mini-Cycles Still, some commentators counter that credit flows don't just depend on the cost of credit. They also depend on so-called "animal spirits" - optimism or pessimism about the future. These commentators point to sentiment and survey data which show that animal spirits have soared. Our response is yes, for credit flows, heightened animal spirits in isolation are indeed a tailwind. But any rise in the cost of credit is a headwind. It follows that the net impact on credit flows depends on the relative strengths of the tailwind from heightened animal spirits and the headwind from the higher cost of credit. It is the net effect on the 6-month credit impulse - rather than heightened animal spirits per se - that determines the cyclical direction of the economy. We would suggest that the tailwind from heightened animal spirits has been countered by an even stronger headwind - the sharpest proportional rise in borrowing costs for at least 70 years (Chart I-8). Chart I-8The Sharpest Proportional Rise In Borrowing Costs For At Least 70 Years! As anticipated in our 16th February report The Contrarian Case For Bonds, incoming GDP data from the world's largest economies - the U.S., U.K. and France - now confirm this. First quarter growth (at annualised rates) sharply decelerated to 0.7%, 1.2% and 1.0% respectively. And this is not just about so-called first quarter "residual seasonality" as 6-month growth rates have also lost momentum. The global credit impulse is 4 months into a mini-downswing; the global bond yield is 2 months into a mini-downswing. Previous half-cycles have averaged 8 months, with the shortest at around 5 months. Hence, we feel it is somewhat premature to position for the next mini-upswing. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* The rally in Portuguese sovereign bonds appears technically overextended. Go short Portuguese sovereign 10-year bonds versus Spanish sovereign 10-year bonds with a profit target and stop loss of 2.5% . 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-9 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights ECB: The ECB is still on track to move to a less accommodative policy stance over the next year. Hints of this will be given at the June policy meeting, while a 2018 asset purchase taper announcement will be made at the September meeting. Rate hikes will follow the taper, unless core inflation surges faster than expected. Position for steeper core Euro Area government curves now, and a narrowing of the U.S. Treasury-German Bund spread in the second half of this year. France-Germany Spreads: France-Germany bond spreads are now too narrow relative to the probability-weighted outcomes of this Sunday's final round of the French presidential election. Even with a Macron victory highly likely, we do not recommend long positions in French OATs versus German Bunds. Feature Investors have navigated a minefield of political headline risks over the past few weeks. From French politics to North Korean missile launches, from Donald Trump's tax cuts to Theresa May's snap U.K election, uncertainty abounds. Yet risk assets remain unscathed. That can be mostly be chalked up to the strength of the global cyclical economic upturn, which has boosted corporate profits in the developed world and lifted equity and credit market valuations. The continued accommodative monetary stance of the major central banks is also helping investors see through the political noise, although the winds there are shifting (Chart of the Week). Chart of the WeekCyclical Upturn Remains Intact In the U.S., financial conditions have eased since the Fed's "dovish hike" in March, and too few rate increases are now discounted with leading indicators pointing to a reacceleration of growth after the soft Q1 print. Across the Atlantic, the European Central Bank (ECB) is having an increasingly open debate about the ongoing need for an exceptionally dovish policy stance given the robust (by European standards) economic expansion. A lack of inflation will keep the Bank of Japan in hyper-easy mode for longer, but the data is presenting a more mixed message for other developed economy central banks like the Bank of Canada and the Bank of England. We continue to see the current level of global bond yields as priced too low given the ongoing cyclical growth and inflation pressures. A pro-growth fixed income investment stance, with below-benchmark portfolio duration and overweight allocations to corporate credit versus sovereign debt (favoring the U.S.), is still appropriate. ECB Outlook: Language Change Coming In June, Policy Change Coming In September Last week's ECB meeting offered few surprises, on the surface. The official statement sounded a cautious note, discussing downside risks to the Euro Area economy from global factors (i.e. trade policy vis-à-vis the U.S. and U.K., geopolitical uncertainty), and that there is still not enough evidence suggesting that inflation was sustainably on course to return to the ECB's 2% target. In the post-meeting press conference, however, the questions aimed at ECB President Mario Draghi turned into an almost farcical dissection of every word in the official statement. Like this exchange, taken directly from the press conference transcript:1 Question: If I got it right, there's one sentence missing in the statement, and this is the sentence, "There are no signs yet of a convincing upward trend in underlying inflation." What is the reason? No? Have I got it wrong? Draghi: No, you're right in a sense that there is one sentence less, but this one is there. On page 2 you have: "Moreover, the ongoing volatility in headline inflation underlines the need..." Constâncio: "...yet to show a convincing upward trend." Draghi: "...convincing upward trend." If you read the end of page 1, beginning of page 2... Question: So there is no change in your assessment of the underlying inflation trend? That was finally the question. Draghi: That is there. No, the one that is not equal exactly like in the last statement is the balance of risks sentence, which repeated twice that the risks remained tilted on the downside in the last statement, and you can find it only once on the second page. That's the difference. Chart 2ECB Policies Are Working... It is clear that the ECB Governing Council is now stuck in a very difficult position. The domestic Euro Area economic data continues to show a very solid pace of expansion that is soaking up spare capacity, supported by the highly accommodative ECB monetary policies of large-scale asset purchases and rock-bottom interest rates (Chart 2). Yet both wage growth and core inflation remain subdued, suggesting that there is no rush to send any signal that a shift in monetary policy settings is on the horizon - even though the market is aware that the current ECB asset purchase program is set to expire at year-end. The political calendar is playing a role here, as the ECB has not wanted to create additional market volatility by discussing any potential tapering of asset purchases or interest rate hikes during the French election campaign. But with the pro-euro candidate now well-placed to win the French Presidency this Sunday, the market's focus will shift away from ''President Le Pen" disaster scenarios towards timing the ECB's next policy move. The latest round of Euro Area inflation data, released last Friday, showed that the sharp drop in inflation in March was a statistical aberration. Headline HICP inflation (on a year-over-year basis) rose to 1.9% in April from 1.5%, while core inflation jumped to 1.2% from 0.7% - the highest level in almost four years. An acceleration in core inflation now would be consistent with the evidence seen in the Euro Area jobs data, with the unemployment rate steadily falling towards the "full employment" level of 8% (Chart 3). This also fits with the ECB's latest projections that show core inflation returning to just under 2% by 2019. Already, markets are starting to get more jittery about a potential change in the ECB's policy stance in the coming months. Realized bond volatility at the front-end of the German yield curve has risen to the highest level since 2013, although our "months-to-hike" measure is still at 25 months, suggesting that the next ECB rate hike will not occur until 2019 (Chart 4). That pricing makes sense, in our view, as the ECB is likely to taper its asset purchases before considering any interest rate increase. Chart 3...Perhaps Now Too Well? Chart 4Tightening Pressures Building Draghi and other senior members of the ECB (like Chief Economist Peter Praet) have reiterated that exact forward guidance of sequencing - tapering before rate hikes - in recent weeks, citing a desire to not cause an unwanted tightening of financial conditions too soon. That sounds to us like code language for "we do not want to hike rates and cause the euro to appreciate sharply", which is more likely to happen, with greater magnitude, after an increase in policy rates than a taper of bond purchases. We continue to expect that the ECB will move toward a less accommodative monetary stance over the next year, starting with a tapering of asset purchases followed by rate hikes. The initial signal for that will come at the June meeting where a new set of ECB staff economic projections will be prepared, followed by an announcement in September that tapering will begin in early 2018. Rate hikes will not begin until after the tapering ends, likely not until late 2018 or early 2019. This sequencing could change, however, if core inflation was to rise more rapidly than the ECB currently projects, with a rate hike happening sooner in that case. In terms of bond strategy, we recommend curve steepeners in core European government bond markets as an initial way to position for a less accommodative ECB. We anticipate moving to an underweight allocation stance to core Europe (both Germany and France) at some point before the June ECB meeting. We would like to see higher U.S. Treasury yields before making that change, as we expect Treasury-Bund spreads to narrow as the ECB tapers. With the market not pricing in enough rate hikes into the U.S. curve, in our view, we see the Treasury-Bund spread moving wider first as Treasuries reprice, before narrowing after the ECB taper is announced. Bottom Line: The ECB is still on track to move to a less accommodative policy stance over the next year. Hints of this will be given at the June policy meeting, while a 2018 asset purchase taper announcement will be made at the September meeting. Rate hikes will follow the taper, unless core inflation surges faster than expected. Position for steeper core Euro Area government curves now, and a narrowing of the U.S. Treasury-German Bund spread in the second half of this year. OAT-Bund Spreads Are Now Fairly Valued Last week, we closed our recommended long 10-year French OAT vs. 10-year German Bund Tactical Overlay trade following the first round of the French presidential election, at a profit of 1.3%.2 While we view the chances of Marine Le Pen winning this Sunday's run-off vote versus Emmanuel Macron as remote, betting on additional spread tightening from the current level of 53bps does not offer an attractive risk/reward opportunity. To judge this, we performed a scenario analysis to determine a probability-adjusted level of the OAT-Bund spread under the two tail events of a Macron or Le Pen victory. In the first scenario, we assigned a 15% probability to Le Pen winning the election, as currently indicated by online betting markets (Chart 5). In the second, we increased the probability to a more pessimistic 40%, which is Le Pen's current level of support in head-to-head opinion polls. We then came up with OAT-Bund spread projections for a victory by either candidate. If Le Pen were to pull off the upset and win the presidency, this would re-ignite fears of a potential Eurozone breakup given her anti-euro stance. Fears of a "Frexit" would likely push the OAT-Bund spread up to at least the same level (around 190bps) reached during the peak of the Euro debt crisis in late 2011 when euro breakup risk was at extreme levels. Even that spread level, however, may not adequately compensate for France's worsening fiscal backdrop, with France's debt/GDP ratio now 40% larger, relative to Germany's, than during the Euro debt crisis (Chart 6). Chart 5Macron Is The Favorite To Win Chart 6No Value In Staying Long France Vs Germany As a simple way to account for this, we increased the spread target for a Le Pen victory scenario by 1.4 times to account for the increased stock of French sovereign debt, which is all denominated in euros, that would be at risk of default if France was to pull out of the euro. This gives an upside spread target for a Le Pen victory of 266bps. In the event that the poll numbers prove correct, as they did in the first round of the election, and Macron wins as expected, this market-friendly result would prompt the OAT-Bund spread to decline further. Our estimate for a downside spread target after a Macron win is 36bps, which is the average level during 2015-2016 before the rise in uncertainty surrounding the elections. Again, this is adjusted upward in order to reflect changes in the relative debt-to-GDP ratios for France and Germany, with the former nearly 10% higher versus the latter over the past two years. Table 1Probability-Weighted OAT-Bund ##br## Spread Scenarios Using these spread targets and our base case election odds (85% chance of a Macron victory), we come up with a probability-adjusted spread of 71bps (Table 1). Using the head-to-head probabilities from the polling data (60% chance of a Macron win), the expected spread is 128bps. With the current OAT-Bund spread at 53bps, well below either projection, we conclude that the potential reward of holding onto a long OAT/short Bund position for a Macron victory does not adequately compensate for the non-zero probability that Le Pen pulls out the win this Sunday. Bottom Line: France-Germany bond spreads are now too narrow relative to the probability-weighted outcomes of this Sunday's final round of the French presidential election. Even with a Macron victory highly likely, we do not recommend long positions in French OATs versus German Bunds. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Global Fixed Income Strategy patrick@bcaresearch.com 1 https://www.ecb.europa.eu/press/pressconf/2017/html/ecb.is170427.en.html 2 Please see BCA Global Fixed Income Strategy Weekly Report "Global Bond Yields On The Move, Higher", dated April 25, 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns