United States

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The first month of this year continues to see economic growth moderating around the world. However, it remains well above trend. There is a tentative growth rotation from the US to other G10 economies. The market expects five interest rate hikes from the Fed this year, but our bias is that they will underwhelm market expectations. A surge in eurozone inflation suggests that many central banks (including the ECB) will gently catch up to the Fed. We were stopped out of our long AUD/USD trade for a small profit and are reinstating this trade via a limit-buy at 0.70. The Dollar Is Flat In 2022, Despite A Hawkish Fed Recommendation Inception Level Inception Date Return Long AUD/NZD  1.05 Aug 4/21 1.72% Long AUD/USD 0.7 Feb 3/22 -     Bottom Line: The US dollar will continue to fight a tug of war between a hawkish Federal Reserve, which will boost interest rate differentials in favor of the US and tightening financial conditions that will sap US growth, and trigger a rotation from US stocks. Feature Chart 1The Dollar Has Been Flat In 2022 The dollar was volatile in January. The DXY started the year on a weakening path, surged last week on the back of a hawkish Federal Reserve, and is now relapsing anew. Year to date, the dollar index is flat. Remarkably, emerging market currencies such as the CLP, BRL, and ZAR, which are very sensitive to the greenback and financial conditions in the US, have been outperforming (Chart 1). Incoming economic data continues to be robust, but there has been a slight rotation in favor of non-US growth. The economic surprise index in the US has fallen below zero, while it is surging in other G10 countries (Chart 2). Manufacturing PMIs continue to roll over around the world, but remain robust, even in places like the euro area, which is more afflicted by the energy crisis, and the potential for military conflict in its backyard (Chart 3). Chart 2A Growth Rotation Away From The US Chart 3APMIs Are Rolling Over Globally Chart 3BPMIs Are Rolling Over Globally In this week’s report, we go over a few key data releases in the last month and implications for currency markets. Our take is that a growth rotation from the US to other economies is underway, and that will ultimately support a lower greenback (Chart 4). That said, near term risks abound, including geopolitical tensions, the potential for more hawkish surprises from the Federal Reserve, and the potential for a policy mistake in China. Chart 4The IMF Expects A Growth Rotation From The US This Year US Dollar: In A Tug Of War The dollar DXY index is flat year to date. Economic growth continues to moderate in the US, from very elevated levels. According to the IMF, the US should see robust growth of 4% this year, from 5.6% last year. This is quite strong by historical standards, and in fact argues for less accommodative monetary policy. The caveat is that financial conditions in the US are tightening quite quickly, which could accentuate the slowdown the IMF expects. There have been a few key data releases over the last month. The payrolls report was underwhelming, with only 199K jobs added in December, versus a consensus of 450K. Friday’s number will likely also be on the weaker side. That said, with the unemployment rate now at 3.9%, average hourly earnings growing at 4.7%, and headline CPI inflation at 7%, the case for curtailing monetary accommodation in the minds of the FOMC remains compelling. Last week, the FOMC opened the window for a faster pace of a rate hikes than the market was anticipating. Fed fund futures now suggest around five interest rate increases this year. In our view, the Fed could underwhelm market expectations for a few reasons. Sentiment has begun to deteriorate. The University of Michigan survey saw its sentiment index fall from 70.6 to 67.2. The expectations component fell from 68.3 to 64.1. These also came in below expectations. Both the Markit and ISM purchasing managers’ indices are rolling over. The services PMI in the US is sitting at 50.9, a nudge above the boom/bust level. The goods trade balance continues to hit a record deficit, at -$101bn in December, suggesting the dollar is too strong for the US external balance. In a nutshell, the economic surprise index in the US has turned firmly negative, at a time when market participants are pricing in a very hawkish pace of interest rate increases. A tighter Fed is what the US needs, but the perfect calibration of monetary policy could prove difficult to achieve. As such, we believe the Fed will slightly underwhelm market expectations of five rate hikes. With speculative positioning in the dollar close to record highs, this will surely deal a blow to the greenback. Chart 5AUS Dollar Chart 5BUS Dollar The Euro: War And Inflation The euro is up 0.6% year to date. Economic data in the eurozone has been resilient, despite a surge in the number of new COVID-19 cases, rising energy costs and the potential for military conflict between Ukraine and Russia. On the data front, inflation continues to surge. HICP inflation came in at 5.1% on the headline print and 2.3% on the core measure in January. This followed quite strong prints in both Germany and Spain earlier this week, where the latter is seeing inflation at 6.1%. Meanwhile, the unemployment rate continues to drift lower, falling to 7% in December for the entire eurozone, and as low as 5.1% for Germany. House prices are also surging across the monetary union. This begs the question of how long the ECB can remain on a dovish path and maintain credibility on its inflation mandate. Our favorite forward-looking measures for eurozone activity continue to point towards improvement. The Sentix investor confidence index rose from 13.5 to 14.9 in January, well above expectations. The ZEW expectations survey surged from 26.8 to 49.4 in January. The manufacturing PMI remained at a healthy 58.7 in January.  The ECB continues to maintain a dovish stance, keeping rates on hold and reiterating that inflation should subside in the coming quarters. According to their analysis, inflation is stickier than anticipated, but will ultimately head lower. This could prove wrong in a world where inflation is sticky globally and driven by supply-side factors. Ultimately, if inflation does prove transitory, then the hawkish pivot by other central banks will have to be reversed, in a classic catch-22 for the euro. Most of the above analysis suggests that investors should be buying the euro on weaknesses. However, the potential conflict in Ukraine raises the prospect that energy prices could stay elevated, which will hurt European growth. This will weaken the euro. Also, speculators are only neutral the currency according to CFTC data. As such, we are standing on the sidelines on EUR/USD and playing euro strength via a short cable position.  Chart 6AEuro Chart 6BEuro The Japanese Yen: The Most Undervalued G10 Currency The Japanese yen is flat year to date. The number of new COVID-19 infections continues to surge in Japan, which has led to various restrictions across the region and constrained economic activity. This has split the recovery on the island, where domestic activity remains constrained, but the external environment continues to boom. Inflation remains well below the Bank of Japan’s long-run target, coming in at 0.5% for the core measure, and -0.7% for the core core measure (excluding fresh food and energy) in January. The Jibun Bank composite PMI was at 48.8 in January, below the 50 boom/bust level, even though the manufacturing print is a healthy 55.4. The labor market continues to heal, with the unemployment rate at 2.7% in December, but the jobs-to-applicants ratio at 1.16 remains well below the pre-pandemic high of 1.64. This is 30% lower. As a result, wage growth in Japan has been rather anemic.   The external environment continues to perform well. Machine tool orders rose 40.6% year on year in December, following strong machinery orders of 11.6% year on year in November. Exports also rose 17.5% year on year in December. That said, the surge in energy prices and a weak yen continues to be a tax on Japanese consumers. We have been constructive on the yen, on the back of a wave of pent-up demand that will be unleashed as Omicron peaks. The Bank of Japan seems to share this sentiment. While monetary policy was kept on hold at the January 17-18 meeting, the BoJ significantly upgraded its GDP growth forecasts. 2022 forecasts were upgraded from 2.9% to 3.8%. This dovetailed with the latest IMF release of the World Economic Outlook, where Japan was the only country to see improving growth from 2021 in the G10. In short, bad news out of Japan is well discounted, while any specter of good news is underappreciated. The bull case for the yen remains intact over a longer horizon in our view. From a valuation standpoint, it is the cheapest G10 currency. It is also one of the most shorted. And as we have witnessed recently, it will perform well in a market reset, given year-to-date appreciation. Should the equity market rotation from expensive markets like the US towards cheaper and cyclical markets like Japan continue, the yen will also benefit via the portfolio channel. Chart 7AJapanese Yen Chart 7BJapanese Yen The British Pound: A Hawkish BoE The pound is up 0.5% year to date. The Bank of England raised interest rates to 0.5% today. According to its projections, inflation will rise to 7.25% in April before peaking. The BoE also announced it will start shrinking its balance sheet, via selling £20bn of corporate bonds and allowing a run-off from maturing government bonds. The Bank of England is the one central bank caught between a rock and a hard place. Inflation in the UK is soaring, prompting the governor to send a letter to the Chancellor of the Exchequer, explaining why monetary policy has allowed inflation to deviate from the BoE’s mandate of 2%. Headline CPI for December was at 5.4% and core CPI at 4.2%. The retail price index rose 7.5% year on year in April. At the same time, the UK is facing an energy crisis that is hitting consumer spending, ahead of a well-telegraphed tax hike in April. The labor market continues to heal. The ILO unemployment rate fell to 4.1% in November. This was better than expectations and below most estimates of NAIRU. As such, the UK runs the risk of a wage-price spiral, that will corner the BoE in the face of tighter fiscal policy. Average weekly earnings rose 4.2% year on year in November, pinning real wages in negative territory. Nationwide house prices also continue to inflect higher, accelerating much faster than incomes. This will lead to demand for much higher wages in the UK, in the coming months. The Sonia curve is currently pricing four or more interest rate hikes this year. This is despite Omicron cases in the UK surging to new highs and tighter fiscal policy. Should the BoE tighten aggressively ahead of a pending economic slowdown, this will hurt the pound. PMIs remain relatively well behaved – the manufacturing PMI was 57.3 in January, above expectations, while the services PMI was a healthy 53.3, but this could turn quickly should financial conditions tighten significantly. The political situation in the UK remains volatile, especially with Prime Minister Boris Johnson facing a scandal domestically, while lingering Brexit tensions continue to hurt the trade balance. As such, portfolio flows are likely to keep the pound volatile in the near term. An equity market correction, especially on the back of heightened tensions in Ukraine, will also pressure cable. That said, more political stability domestically and internationally will allow the pound to continue its mean reversion rally. Given the above dynamics, we are long EUR/GBP in the short term but are buyers of sterling over the longer term.  Chart 8ABritish Pound Chart 8BBritish Pound Australian Dollar: RBA Watching Inflation And Wages The Australian dollar is down 1.7% year to date. The Reserve Bank of Australia kept rates on hold at its February 1 meeting, even though it ended quantitative easing. The two critical measures that the RBA is focusing on are the outlook for inflation, especially backed by an increase in wages. In our view, a more hawkish outcome is likely to materialize over the course of 2022. On the inflation front, key measures are above the midpoint of the central bank’s target. In Q4, headline inflation was 3.5%, the trimmed mean measure was 2.6%, and the median print was 2.7% year on year. In fact, the increase in Q4 prices took the RBA by surprise and was attributed to rising fuel prices. The RBA expects inflationary pressures to remain persistent in 2022, but to ultimately fall to 2.75% in 2023. This will still be at the upper bound of their 1-3% target range. The employment picture in Australia is robust, barring lackluster wage growth. The unemployment rate fell to 4.2% in December from 4.6%, which, according to most measures, is below NAIRU. The RBA expects this rate to dip towards 3.75% next year. Admittedly, wage growth is still low by historical standards, but it is also true that the behavior of the Phillip’s curve at these low levels of unemployment is uncertain. Ergo, we could see an unexpected surge in wage growth. House prices are rising at a record 32% year-on-year in Sydney. This is a clear indication that monetary policy remains too easy, relative to underlying conditions. In the very near term, COVID-19 continues to ravage Australia, which will keep the next set of economic releases rather underwhelming. Combined with the zero-COVID policy in China (Australia’s biggest export partner), the outlook could remain somber in the very near term. This will keep the RBA dovish. On the flip side, a dovish RBA has softened the currency and allowed the trade balance to recover smartly. Meanwhile, it has also led to a record short positioning on the AUD. Our expectation going forward remains the same – as China eases policy, Australian exports will remain strong. A simultaneous peak in the spread of Omicron will also allow a domestic recovery, nudging the RBA to roll back its dovish rhetoric, relative to other central banks. Ergo, investors will get both a terms-of-trade and interest rate support for the AUD. We are reintroducing our limit but on AUD/USD at 70 cents, after being stopped out for a modest profit. Chart 9AAustralian Dollar Chart 9BAustralian Dollar New Zealand Dollar: Up Versus USD, But Lower On The Crosses The New Zealand dollar is down 2.3% year to date, the worst performing G10 currency. The Reserve Bank of New Zealand has been among the most hawkish in the G10. This has come on the back of strengthening economic data. In Q4, inflation in New Zealand shot up to a 32-year high of 5.9%. The labor market continues to heal, with the unemployment rate at a post-GFC low of 3.2% in Q4, well below NAIRU. Meanwhile, house prices continue to inflect higher, with dwelling costs in Wellington up over 30%. The trade balance continues to print a deficit but has been improving in recent quarters on the back of rising terms of trade. Meanwhile, given New Zealand currently has the highest G10 10-year government bond yield in the developed world, and bond inflows have been able to finance this deficit. In a nutshell, we expect the RBNZ to stay hawkish, but also acknowledge that is being well priced by bond markets. Overall, the kiwi will appreciate versus the US dollar, but will lag AUD, which is much more shorted and has a better terms-of-trade picture. As such, we are long AUD/NZD. Chart 10ANew Zealand Dollar Chart 10BNew Zealand Dollar Canadian Dollar: A Terms-Of-Trade Boom The CAD is down 0.3% year-to date. The Bank of Canada kept rates on hold at its January 26 meeting. This was a surprising outcome for us, as we expected the BoC to raise interest rates, but was in line with market expectations. Taking a step back, all the conditions for the BoC to raise interest rates are in place. The widely viewed Business Outlook Survey showed improvement in Q4, especially vis-à-vis wage and income growth. This is on the back of very strong inflation numbers out of Canada. The headline, trim and median inflation prints were either at or above the upper bound of the central bank’s target at 4.8%, 3.7% and 3%. On the labor front, employment levels in Canada are back above pre-pandemic levels, with the unemployment rate at 5.3%, close to estimates of NAIRU, while the participation rate has also recovered towards pre-pandemic levels. House price inflation is also prominent across many cities in Canada, which argues that monetary policy is too loose for underlying demand conditions. Longer term, the key driver of the CAD remains the outlook for monetary policy, and the path of energy prices. We remain optimistic on both fronts. On monetary policy, we expect the BoC will continue to monitor underlying conditions but will ultimately have to tighten policy as Omicron peaks. Among the G10 countries, Canada is one of the only countries where infection rates have peaked and are falling dramatically. Oil prices also remain well bid, as the Ukraine/Russia conflict continues to unfold. Should we reach a diplomatic solution in Ukraine, while Omicron also falls to the wayside, travel resumption will bring back a meaningful source of oil demand. From a positioning standpoint, speculators are only neutral the CAD. That said, we are buyers of CAD over a 12–18-month horizon given our analysis of the confluence of macro factors.  Chart 11ACanadian Dollar Chart 11BCanadian Dollar Swiss Franc: Sticking To NIRP The Swiss franc is down 0.8% year to date. The Swiss economy continues to hold up amidst surging COVID-19 infections. Economic wise, inflation is inflecting higher, the unemployment rate has dropped to 2.4%, and wages are rising briskly. This is lessening the need for the central bank to maintain ultra-accommodative settings. House price inflation also suggests that monetary conditions remain too easy relative to underlying demand. The Swiss National Bank remains committed to its inflation mandate, and inflation in Switzerland is among the lowest in the G10. As such, it will likely lag the rest of other developed market central banks in raising rates, with currently the lowest benchmark interest rate in the world. On the flip side, Switzerland runs a trade surplus that has been in structural appreciation, underpinning the franc as a core holding in any FX portfolio. In the near term, rising interest rates are negative for the franc. We are long EUR/CHF on this basis, as we believe the ECB will begin to react to rising inflation pressures. That said, we were long CHF/NZD on the prospect of rising volatility in the FX market and took 4.6% profits on January 14. In the near term, this trade could continue to perform well.  Chart 12ASwiss Franc Chart 12BSwiss Franc Norwegian Krone: Higher Rates Ahead The NOK is up 1.1% year-to-date. The Norges Bank kept the policy rate unchanged at 0.5% at its January meeting and reiterated that rate increases in March are likely. In their view, rising prices, low unemployment, and an easing of Covid-19 restrictions will give way to policy normalization, barring a persistence in Omicron infections. With as many as four rate hikes expected in 2022, the central bank is among the most aggressive in the G10. Headline CPI rose to 5.3% in December, spurred by record high electricity prices, while the core inflation came in at 1.8%. The unemployment rate dropped to 3.4% in Q4, the lowest since 2019. The manufacturing PMI rolled over slightly in January but at 56.5 remains well above the long-term average. Daily Covid-19 cases continue to hit record highs, but hospitalizations remain low, and the government has already scaled back most restrictions after a partial lockdown in December. This will contribute to an economic upswing and aid a recovery in retail sales that were down 3.1% month on month in December.  Norway’s trade balance shot up to record highs in December, driven by surging oil and natural gas export prices. A surging trade surplus supports the krone. Meanwhile, in a rising rate environment, portfolio flows into the cyclical-heavy Norwegian stock market could provide further support for the NOK. In a nutshell, the krone is undervalued according to our PPP models and appears attractive on a tactical and cyclical basis.  Chart 13ANorwegian Krone Chart 13BNorwegian Krone Swedish Krona: Lower Now, Strong Later The SEK is down 0.5% year-to-date. The Swedish economy continued to strengthen in Q4 with GDP growth rising 1.4% quarter-on-quarter, exceeding expectations. In December, the unemployment rate fell to 7.3%, the lowest since the onset of the pandemic, and household lending edged higher to 6.8% year on year. In other data, the manufacturing PMI increased to 62.4 in January. Headline inflation adjusted for interest rates rose to 4.1%, highest since 1993, well above the Riksbank’s 2% target. This has raised doubts on whether the central bank will be able to hold off raising rates until 2024 as it had previously announced. However, excluding energy prices the CPI declined slightly to 1.7%. In short, the Riksbank faces the same conundrum as the ECB, on the persistence of higher inflation, driven by high energy costs. The Omicron variant continues to spread at record pace in Sweden, but recent numbers suggest some moderation. This was probably due to stricter measures in Sweden, in contrast to its Scandinavian neighbors. The cost of this stringency has been softer business and consumer confidence, which are down to multi-month lows. Retail sales also fell by 4.4% in December from the previous month. Taking a step back, Sweden is a small open economy very sensitive to global growth conditions. As such, a rebound in global and Chinese economic activity will hold the key to a rebound in SEK. In our models, the SEK is also undervalued. Chart 14ASwedish Krona Chart 14BSwedish Krona   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary

2022 has surprised investors with the out-of-the-gate market correction, accompanied by a sharp underperformance of Growth vs. Value as part of repricing of the long-duration assets in the context of the tighter monetary policy. As such, $60 billion more has been allocated towards value than growth mutual funds over the past month – the highest amount since 2002 (top panel). Mean reversion is certainly a risk. A big question is whether there is a significant amount of cash sitting on the sidelines or parked in fixed income mutual funds, waiting to be redeployed into equities?  To answer this question, we looked at the net flows into all money markets, retail money fund deposits, and net flows into equities vs. bonds (middle and bottom panels). While YTD’s sharp market correction produced only a small uptick in flows into the money market funds or retail deposits, reallocation from equities into fixed income mutual funds has been running its course throughout 2021. Recently, this trend has started to reverse, with net outflows from equities decelerating. This supports the thesis that market correction was a Growth into Value rotation, without much cash leaving equities. Once a new tighter monetary regime gets priced in, money may flow back into equities from the fixed income mutual funds as There Is (still) No Alternative (TINA) in the environment of rising rates. In addition, it appears that there is plenty of cash sitting in retail money funds that could potentially be redeployed. Bottom Line: It appears that retail investors stayed in equities throughout the correction. However, there is plenty of dry powder sitting on the sidelines in the money market, and bond and income mutual funds, ready to be redeployed into equities, supporting their continued outperformance even in the face of tighter monetary policy.

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. In lieu of next week’s report, I will be presenting the quarterly Counterpoint webcast series ‘Where Is The Groupthink Wrong?' I do hope you can join. Executive Summary Spending on goods is in freefall while spending on services is struggling to regain its pre-pandemic trend.  If spending on goods crashes to below its previous trend, then there will be a substantial shortfall in demand. The good news is that the freefall in goods spending is leading inflation. With spending on goods now crashing back to earth, inflation will also crash back to earth later this year. Underweight the goods-dominated consumer discretionary sector, and underweight semiconductors versus the broader technology sector. Sell Treasury Inflation Protected Securities (TIPS) and other overbought inflation hedges such as commodities that have not yet corrected. Overbought base metals are particularly vulnerable. Fractal trading watchlist: We focus on nickel versus silver, add tobacco versus cannabis, and update bitcoin, biotech, CAD/SEK, and EUR/CZK. As Spending On Goods Crashes Back To Earth, So Will Inflation Bottom Line: As spending on goods crashes back to earth, so will inflation, consumer discretionary stocks, semiconductors, and overbought commodities. Feature The pandemic has unleashed a great experiment in our spending behaviour. After a binge on consumer goods, will there be a massive hangover? We are about to find out. The pandemic binge on consumer goods, peaking in the US at a 26 percent overspend, is unprecedented in modern economic history. Hence, we cannot be certain what happens next, but there are three possibilities: We sustain the binge on goods, at least partly. Spending on goods falls back to its pre-pandemic trend. There is a hangover, in which spending on goods crashes to below its previous trend. The answer to this question will have a huge bearing on growth and inflation in 2022-23. After The Binge Comes The Hangover… The pandemic’s constraints on socialising, movement, and in-person contact caused a slump in spending on many services: recreation, hospitality, travel, in-person shopping, and in-person healthcare. Nevertheless, with incomes propped up by massive stimulus, we displaced our spending to items that could be enjoyed within the pandemic’s confines; namely, goods – on which, we binged (Chart I-1). Chart I-1Spending On Goods Is In Freefall Gradually, we learned to live with SARS-CoV-2, and spending on services bounced back. At the same time, we made some permanent changes to our lifestyles – for example, hybrid office/home working and more online shopping. Additionally, a significant minority of people changed their behaviour, shunning activities that require close contact with strangers – going to the cinema or to amusement parks, using public transport, or going to the dentist or in-person doctors’ appointments. The result is that spending on services is levelling off well short of its pre-pandemic trend (Charts I-2-Chart I-5). Chart I-2Spending On Recreation Services Is Far Below Its Pre-Pandemic Trend Chart I-3Spending On Public Transport Is Far Below Its Pre-Pandemic Trend Chart I-4Spending On Dental Services Is Far Below Its Pre-Pandemic Trend Chart I-5Spending On Physician Services Is Far Below Its Pre-Pandemic Trend Arithmetically therefore, to keep overall demand on trend, spending on goods must stay above its pre-pandemic trend. Yet spending on goods is crashing back to earth. The simple reason is that durables, by their very definition, are durable. Even nondurables such as clothes and shoes are in fact quite durable. Meaning that are only so many cars, iPhone 13s, gadgets, clothes and shoes that any person can binge on before reaching saturation. Indeed, to the extent that our bingeing has brought forward future purchases, the big risk is a period of underspending on goods. Countering The Counterarguments Let’s address some counterarguments to the hangover thesis. One counterargument is that some goods are a substitute for services: for example, eating-in (food at home) substitutes for eating-out; and recreational goods substitute for recreational services. So, if there is a shortfall in services spending, there will be an automatic substitution into goods spending. The problem is that the substitutes are not mirror-image substitutes. Spending on eating-in tends to be much less than on eating-out. And once you have bought your recreational goods, you don’t keep buying them! A second counterargument is that provided the savings rate does not rise, there will be no shortfall in spending. Yet this is a tautology. The savings rate is simply the residual of income less spending. So, to the extent that there is a structural shortfall in services spending combined with a hangover in goods spending, the savings rate must rise – as it has in the past two months. A third counterargument is that the war chest of savings accumulated during the pandemic will unleash a tsunami of spending. Well, it hasn’t. And, it won’t. Previous episodes of excess savings in 2004, 2008, and 2012 had no impact on the trend in spending (Chart I-6). Chart I-6Previous Episodes Of Excess Savings Had No Impact On Spending The explanation comes from a theory known as Mental Accounting Bias. This points out that we segment our money into different ‘mental accounts’. And that the main factor that establishes whether we spend our money is which mental account it resides in. The moment we move money from our ‘income’ account into our ‘wealth’ account, our propensity to spend it collapses. Specifically, we will spend most of the money in our ‘income’ mental account, but we will spend little of the money in our ‘wealth’ mental account. Hence, the moment we move money from our income account into our wealth account, our propensity to spend it collapses. Still, this brings us to a fourth counterargument, which claims that even though the ‘wealth effect’ is small, it isn’t zero. Therefore, the recent boom in household wealth will bolster growth. Yet as we explained in The Wealth Impulse Has Peaked, the impact of your wealth on your spending growth does not come from your wealth change. It comes from your wealth impulse, which is fading fast (Chart I-7). Chart I-7The 'Wealth Impulse' Has Peaked Analogous to the more widely-used credit impulse, the wealth impulse compares your capital gain in any year with your capital gain in the preceding year. It is this change in your capital gain – and not the capital gain per se – that establishes the growth in your ‘wealth effect’ spending. Unfortunately, the wealth impulse has peaked, meaning its impact on spending growth will not be a tailwind. It will be a headwind. As Spending On Goods Crashes Back To Earth, So Will Inflation, Consumer Discretionary Stocks, And Overbought Commodities In the fourth quarter of 2021, US consumer spending dipped to below its pre-pandemic trend and the savings rate increased. Begging the question, how did the US economy manage to grow at a stellar 6.7 percent (annualised) rate? The simple answer is that inventory restocking contributed almost 5 percent to the 6.7 percent growth rate. In fact, removing inventory restocking, US final demand came to a virtual standstill in the second half of 2021, growing at just a 1 percent (annualised) rate. Growth that is dependent on inventory restocking is a concern because inventory restocking averages to zero in the long run, and after a massive positive contribution there tends to come a symmetrical negative contribution. If, as we expect, spending on services fails to catch up to its pre-pandemic trend while spending on goods falls back to its pre-pandemic trend, then there will be a demand shortfall. And if there is a hangover, in which spending on goods crashes to below its previous trend, then the demand shortfall could be substantial. As inflation crashes back to earth, so will overbought commodities. The good news is that the freefall in durable goods spending is leading inflation. In this regard, you might be surprised to learn that the US core (6-month) inflation rate has already been declining for five consecutive months. With spending on goods now crashing back to earth, inflation will also crash back to earth later this year (Chart I-8). Chart I-8As Spending On Goods Crashes Back To Earth, So Will Inflation Sell Treasury Inflation Protected Securities (TIPS) and other overbought inflation hedges such as commodities that have not yet corrected. Given that the level (rather than the inflation) of commodity prices is irrationally tracking the inflation rate, the likely explanation is that investors have piled into commodities as a hedge against inflation. Hence, as inflation crashes back to earth, so will overbought commodities (Chart I-9). Overbought base metals are particularly vulnerable. Chart I-9Overbought Commodities Are Particularly Vulnerable Fractal Trading Watchlist This week we focus on nickel versus silver, add tobacco versus cannabis, and update bitcoin, biotech, CAD/SEK, and EUR/CZK. To reiterate, overbought base metals are vulnerable, and the 70 percent outperformance of nickel versus silver through the past year has reached the point of fractal fragility that signalled previous major turning-points in 2014, 2016, 2018, and 2020 (Chart I-10). Accordingly, this week’s recommended trade is to go short nickel versus silver, setting the profit target and symmetrical stop-loss at 20 percent.  Chart I-10Short Nickel Versus Silver A Potential Switching Point From Tobacco Into Cannabis Bitcoin's 65-Day Fractal Support Is Holding For Now Biotech Approaching A Major Buy CAD/SEK Approaching A Sell EUR/CZK At A Bottom Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations 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      

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The US midterm elections will bring another round of intense polarization and policy uncertainty this year, though the overall stock market today appears well prepared for the most likely result: a GOP victory in House and Senate. Yet our quantitative Senate election model is “too close to call.” It expects Democrats to retain 50 seats in the Senate and hence the thinnest possible majority. We doubt it, subjectively, but the important point is that the Senate will be stymied either way. Indeed, the only way investors could truly be surprised would be if Democrats made a comeback and retained control of both chambers, but this outcome is very unlikely.  Voters make up their minds early in the year during midterm elections, so Democrats may not benefit from any softening of inflation later this year. Still, gridlock ensures that domestic policy uncertainty will rise as well as foreign policy uncertainty. The  dollar will be resilient, favoring a tactically defensive positioning. Quant Model For US Senate Election Bottom Line: While we expect Republicans to win both the House and the Senate in 2022, our quant model says the Senate is too close to call. Value has bottomed on a structural time frame but the coming months will be challenging and we recommend growth stocks tactically. Feature This report updates our quantitative models for the 2022 Senate and 2024 presidential elections (Chart of the Week). As always, we use the quantitative modeling as a complement to our qualitative analysis. Formal modeling helps to question our assumptions and views. It is not a substitute for empirical analysis and good judgment, whether in economics or politics. Our qualitative analysis utilizes the geopolitical method, a method based on realist political theory, in which we analyze the concrete checks and balances (constraints) that prevent policymakers from achieving their objectives. We then assign scenario probabilities and compare with BCA Research macro and market views to identify investment risks and opportunities. Advantage Republicans In Midterm Elections Our base case for the midterm election is a Republican victory in both the House of Representatives and the Senate. This outlook is consensus in online betting odds (Chart 1). However, the consensus may be underestimating the Democrats in the Senate election. The Senate is still in play and that is where investors should focus this year. However, the only true risk to expectations would be Democrats keeping the House and Senate. Every other scenario involves different shades of gridlock. Democrats can only hold onto both chambers if a shock event occurs that massively upsets expectations. Such a shock would have to be devastating for the Republicans, as it would go against long-established political cycles and current trends. The implication would be a rare chance to pass major legislation on partisan lines: corporate tax hikes and social programs cut out of the current “Build Back Better” planning. Online betters currently give this Democratic scenario a 10% probability: it is essentially a “black swan” and would be inflationary on the margin. Chart 1Midterm Election Odds Favor Republicans Other scenarios are more or less disinflationary as Republicans in the opposition will attempt to rein in government spending: If Republicans win both chambers, then they will have an impetus to pass legislation and it is more likely that they will do so, as President Biden could find common ground (a la Bill Clinton after 1994). But if Republicans win only the House, then they will only be capable of obstruction and brinksmanship, a la the “Tea Party” Republicans of 2010-16. This scenario would be disinflationary and would heighten political risks such as the risk of a national debt default over a refusal to raise the debt ceiling in 2023. Bottom Line: The only midterm election outcome that could surprise US markets in a major way in 2022 would be a Democratic victory in both houses of Congress. But the consensus is right to put the odds of that at 10%. Otherwise the midterm scenarios are just different shades of gridlock, albeit with higher policy uncertainty under a split Congress. Republicans Highly Likely To Take The House We have not yet unveiled our House Election model but here we can make some preliminary predictions. The opposition party has gained seats in the House in 90% of the midterm elections since 1862 (incumbent party gained seats four out of 40 times). Exceptions are rare (e.g. 1902, 1934, 1998, and 2002) and not applicable to the 2022 context so far.1 About 47 seats in the House are thought to be competitive this year, compared to around 75 in 2018, 81 in 2010, and 38 in 2002. Of the 47 competitive seats, 30 are especially competitive, with 18 Democratic and 12 Republican. Four Democratic seats are wide open to competition, i.e. lacking an incumbent, the same as four Republican seats. However, more Democrats (29) are stepping down than Republicans (13), a sign that Democratic incumbents recognize cyclical patterns turning against them.2 President Biden has a net negative approval rating (53% disapprove while 42% approve), similar to President Trump in 2018, when Republicans lost 42 seats in the House. Presidential approval has a significant correlation with House losses for the president’s party since the end of World War II. This is especially true when taking the average of presidential approval and his party’s support in the generic congressional ballot. By this measure Democrats are lined up to lose 40 House seats, whereas they only need to lose a net of five to lose control. The nation’s woes are unlikely to improve significantly in time for the election: Inflation is surging and real wages are collapsing (Chart 2). Even if economists observe inflation rolling over before the election, voter inflation expectations will lag, and will be brought into the ballot box. Americans are the unhappiest they have been since the 1970s, as a consequence of the pandemic, the economy, toxic society and politics, and other factors (Chart 3). Chart 2Consumers Facing Rising Prices Amid Declining Incomes Chart 3Unhappiness Reaches New High A rebound in consumer confidence is not enough to save Biden’s party from losses at the ballot box, as President Obama learned in 2010 and 2014 (Chart 4). Similarly a big drop in confidence can hurt the president in the midterms even if confidence recovers in time for the vote, as happened to Republicans in 2018. Biden has another foreign policy crisis on his hands (Russia), after losing trust on his handling of Afghanistan, and may have more crises to deal with by November (Iran, Latin America). If a crisis hits the oil price, as with Russia or Iran, then prices at the pump will go higher, as we discussed in “Biden’s External Risks.” As for the immigration surge, while it will not concern the business community during a time of labor shortage and inflation, it will concern voters, especially in border states like Arizona (Chart 5). The current surge is historic and may come back to haunt the Democrats. Chart 4Lackluster Consumer Confidence Won't Help Democrats Chart 5Immigration Crisis Looms On Southern Border Republicans will benefit slightly from the post-2020 congressional redistricting. Democrats will probably not make substantial gains as a result of Republican infighting in the primaries, though it could make a big difference in the Senate. We will revisit the latter two issues in future reports (redistricting and Republican primaries) but they only matter if Democrats make a significant comeback in opinion. Otherwise the general swing of public opinion will swamp these marginal effects in the House elections. Worst of all for Democrats, evidence shows that voters tend to make up their minds early in the year. That is when the correlation is strongest between the generic congressional opinion poll and the vote share of elections, though for Democrats in particular late-year polling is equally significant (Chart 6). Chart 6AMidterm Voters Mostly Decided At The Start Of The Year Chart 6BMidterm Voters Mostly Decided At The Start Of The Year What could lift the Democrats’ odds? The following factors: The relevance of the Covid-19 pandemic will wane. The economy, while slowing, will continue expanding and unemployment will be very low (Chart 7). Democrats are still somewhat likely to pass a reconciliation bill with the most popular parts of their “Build Back Better” agenda. Democrats will use social “wedge issues” to mobilize their political base. A racialized battle over the Supreme Court nomination and any conservative Supreme Court ruling on abortion may mobilize African Americans and women. It is possible, not likely, that a foreign policy crisis could generate a lasting patriotic backlash against foreign insults, as we discussed last week. This dynamic is relevant given our Geopolitical Strategy’s 75% odds of new Russian military action in Ukraine. A lot can change in nine months during rapidly changing and highly polarized contests in which every marginal vote matters. Bottom Line: While Republicans are highly likely to retake control of the House, the Senate is still in competition. Chart 7Economy Will Slow, Unemployment To Remain Low The Senate Leans GOP But Still In Play The Senate is more competitive than the House in this year’s election, as 20 Republican seats are up for grabs versus only 14 Democratic seats. About nine of these seats are truly competitive, compared to 13 in 2018, 11 in 2010, and 15 in 2002.3 Only one Democrat is stepping down, in the very blue state of Vermont, whereas five Republicans are stepping down, three of which from competitive states. Hence Democrats have a better chance of picking up Republican seats in North Carolina and Pennsylvania than otherwise. However, even here, Democrats only have a one-seat margin of safety. A net loss of a single seat will yield control of the chamber. Our quantitative model relies on the following six variables: State-level economic health Incumbent party margin of victory in state’s previous Senate race (i.e. 2020) The incumbent president’s net average approval rating Average net support rate of incumbent party in generic congressional ballot A dummy variable for the generic ballot, for statistical purposes A “time for change” penalty for any party that has controlled the Senate for six or more years The model’s results are shown in Chart 8. Currently the model says the status quo will hold, with a 50/50 split in the Senate. Democrats lose Georgia but gain Pennsylvania and hence the balance of power stays the same, as Vice President Kamala Harris casts any tie-breaking vote. Chart 8Senate Quant Election Model Points To Even Split Specifically the model says: Arizona is a toss-up but leans Democratic, with 55% odds. Pennsylvania is a toss-up but switches to the Democrats with 54% odds. North Carolina is a toss-up but leans Republican with 47% odds. Georgia switches to the Republican side and is no longer viewed as a toss-up at 43% odds. Looking at the change in these election probabilities since November 2020, North Carolina has seen the biggest drop for the Democrats, followed by Arizona (Chart 9). Democratic odds are worsening in four states, while Republican odds are worsening in three states. Since North Carolina and Pennsylvania are losing their Republican incumbents, this change in odds is a problem for the GOP. By contrast, Democrats are running incumbents in the four states where they are vulnerable. The problem for Democrats, again, is that voters make up their minds early. The closest correlation between the generic party polling and the incumbent party’s performance in the Senate in a midterm election occurs in February at 94% (Chart 10). Chart 9Senate Model: Change In Predicted Probability Senate elections, like all American elections, are increasingly nationalized.4 This is evident in the 75% correlation we find between the generic polls and the performance of the incumbent party in the Senate (Chart 10 again). So, for example, while one might view Senator Mark Kelly of Arizona as likely to win given the incumbent advantage and the fact that he is a former astronaut and US Navy captain, and he may indeed win, nevertheless a national wave of anti-incumbent feeling could overwhelm his re-election bid. Still, state effects could matter. To examine these from a macro perspective we look at each state’s Misery Index (inflation plus unemployment) compared to the national average in Chart 11. Here are the notable takeaways: Chart 10Midterm Voters Mostly Decided At The Start Of The Year Chart 11AState Level Miseries Point To Risks For Democrats In GA And AZ… Chart 11B… And To Republicans In PA And WI Misery in Arizona, Georgia, and Pennsylvania is higher than average and rising – negative news for Democrat Kelly, Democrat Raphael Warnock, and the yet-to-be-decided Republican candidate in Pennsylvania. Misery in Florida is also slightly above the national average and rising, though Senator Marco Rubio is likely secure. Wisconsin misery is lower than national average and rising (possibly hurting Republican incumbent Senator Ron Johnson). North Carolina misery is lower than national average and falling (helping the yet-to-be-decided Republican candidate). In other words, Misery Indexes support our model’s findings, yet suggest that Democrats face a headwind in Arizona – where our model is also flagging an important risk for Democrats. In sum, our model’s direction of change suggests Democrats will lose another seat and thus the Senate. Going forward, the key moving parts are the economy and the president’s and his party’s approval ratings. There is a chance that these variables will bottom early in the year and improve later, which underscores that the Senate will remain competitive. What investors can be certain about is that Democrats are extremely unlikely to make significant seat gains in the Senate. So even if they retain control, it will be with the thinnest of possible majorities, and hence the Senate will only be capable of passing bipartisan Republican-authored House bills – or vetoing Republican House bills to save the president from having to veto them. It is also certain that Republicans will fall far short of the 67 votes they would need to remove Biden from office, if House Republicans find or invent a reason to impeach him. Bottom Line: The Senate outcome is too close to call but subjectively we doubt Democrats will pull it off given the negative macro trends cited above. Our Senate election model gives 51% odds that Democrats will retain a de facto majority with 50 seats. 2024 Presidential Vote: Odds Favor Democrats For Now The US presidential election is 34 months away. Investors need to be prepared for any outcome, including another contested election. But it is important to have a base case – especially because a Republican (or Democratic) victory in both House and Senate in 2022 would open up the prospect of single-party control in 2025, which has much bigger policy implications than various shades of gridlock. As a rule of thumb, investors should think of presidential elections as a referendum on the incumbent party, not the president’s person, for the prior four years of material performance. Thus Democrats are currently favored to keep the White House. Voters will feel better than they did in 2020, which suffered a triple crisis of pandemic, recession, and unrest. Significant changes must occur to alter this trajectory – such as a recession, Biden’s stepping down, or a humiliating foreign policy defeat.5 Our quantitative model supports this view: it currently gives a 55.2% chance of Democratic victory in the Electoral College (Chart 12). Chart 12US Election 2024: Quant Model Tips Dems Our model relies on the following four variables: State economic health Incumbent party margin of victory in the previous election A penalty for parties that have held the White House for two terms (not applicable in 2024) The president’s approval rating (level) Interestingly our model produces 308 electoral votes for Biden, compared to his actual 306 in 2020, except that some states trade places: Democrats win Florida while Republicans take back Arizona and Georgia. Specifically the model says: North Carolina is a toss-up state but leans Republican. Wisconsin is a toss-up state but just slightly leans Democratic. Florida and Pennsylvania have moved above toss-up range into the Democratic camp. Arizona and Georgia have slipped beneath the toss-up range into the Republican camp. Looking at the change in each state’s odds of voting for the incumbent, Democrats’ chances are falling in eight states while Republicans chances are falling in three states (Chart 13). Wisconsin and Arizona are seeing the most substantial drops, followed by Pennsylvania. Thus the current direction of change is negative for Democrats as one would expect. Biden’s thin margin of victory in 2020 and weak approval ratings make him vulnerable, so the economic performance will largely determine the model’s results going forward. If Biden avoids a recession, that may be enough to retain the White House according to the model. Florida is an interesting case. The model gives a 59% chance it will go to the Democrats. We are suspicious of this outcome but it suggests investors should not take a Republican victory there for granted. Consider: Chart 13Presidential Model: Change In Predicted Probability While we gave President Trump 45% odds of winning in 2020, we predicted he would win Florida due to the state’s partisan leaning.6 That leaning has probably not changed much, although Governor Ron DeSantis’s latest approval rating is only at 45%. However, the six-month change in Florida’s coincident economic indicator has fallen 0.6% since November 2020 and the Misery Index is rising above the national average, as noted above. If Biden loses Florida but the rest of our model is correct, Democrats will retain the White House with 279 electoral college votes. That would leave Wisconsin as the decisive battleground. Yet Wisconsin is very tenuously in their camp today, so any change in the model that gives Florida back to the Republicans would likely give them Wisconsin as well … The result of Biden losing Arizona, Georgia, and Wisconsin (among other combinations) would be a 269-269 tie in the electoral college, in which each state’s delegation to the House of Representatives would have a single vote. A Republican win in the House in 2022 would thus result in a Republican White House in another explosive contested election. But let’s not get ahead of ourselves, 2024 is more than two years away. Bottom Line: Our presidential model gives a 55% chance that Democrats will retain the White House in 2024. Subjectively we agree. A Democratic defeat in 2022 will not rule out a Democratic victory in 2024, especially if Biden is alive and kicking, given the incumbent advantage. But economic factors will largely determine how the model evolves over the next 34 months. Our model also suggests the Electoral College math will be close and that another contested election is possible. Investment Takeaways Based on the current stock market correction, financial markets have priced a fair amount of policy uncertainty already. And this report suggests the midterms merely offer different shades of gridlock. However, Biden’s external risks – namely conflict with Russia – could cause further risk-off moves. And uncertainty will increase as midterms get closer. US policy uncertainty is falling relative to the rest of the world (Chart 14). This is positive for King Dollar, at least over a tactical time frame. The Fed’s interest rate liftoff is also positive for the dollar. Chart 14Lower US Uncertainty In The Near Future Supports The DXY Hence on a short-term basis, the stock-to-bond ratio can fall further and cyclicals can fall further relative to defensives. Tactically we recommend going long growth versus value stocks (Chart 15). Value has surged in the New Year and the dollar and rate hikes will counteract that, as well as any global energy shock that kills demand. Chart 15Tactically Go Long Growth Versus Value However, this is a tactical call. Otherwise, we remain in line with the BCA House View, which favors stocks over bonds and a weaker dollar over the next 12 months.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Guy Russell Research Analyst guyr@bcaresearch.com   Footnotes 1     Brookings Institution, “Losses by the President’s Party in Midterm Elections, 1862-2014,” Vital Statistics on Congress, February 8, 2021, www.brookings.edu. 2     For the number of competitive seats, see Cook Political Report, cookpolitical.com, and Fair Vote, fairvote.org.  3    See footnotes 1 and 2 above. In addition see the Green Papers, “General Election 2002 – Contests to Watch,” October 25, 2002, thegreenpapers.com, and Ken Rudin, “2010 Senate Ratings: 11 Seats Seen As Tossups; GOP With At Least 3 Pickups,” NPR, July 9, 2010, npr.org. 4    See Joel Sievert and Seth C. McKee, “Nationalization in U.S. Senate and Gubernatorial Elections,” American Politics Research 47:5 (2019), pp. 1036-1054. 5    Our qualitative presidential election framework relies heavily on the work of Professor Allan Lichtman, American University. See our updated Lichtman-style checklist in BCA US Political Strategy, “Biden Is Underwater But His Legislation Will Float,” September 8, 2021, bcaresearch.com. 6    See BCA Research Geopolitical Strategy, “Upgrading Trump’s Odds of Re-Election,” October 26, 2020, bcaresearch.com. See also my interview on Bloomberg’s The Tape Podcast, “Full Blue Sweep Will Push Biden To Left,” July 13, 2020, Bloomberg.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets

With 184 S&P 500 companies having reported Q4-2021 earnings, it’s time to take a tab of the interim results. So far, the blended earnings growth rate is 26%, while the actual reported growth rate is 33%. The blended sales growth rate is 13%, while the actual reported rate is 19%. Blended earnings and sales, excluding energy, currently stand at 17% and 9% respectively. Analysts expect Q4-2021 earnings to be 2.4% below the Q3-2021 level. The majority of the companies reporting have easily exceeded analysts’ forecasts: 79% of companies delivered a positive earnings surprise (the long-term average is 66% and the prior four-quarter average is 84%), with Comm Services, Industrials, and Technology leading the pack. In terms of the magnitude of the EPS beats, the overall number currently stands at 4% with Tech in the avant-garde. While this number is strong by historical standards, it appears low compared to recent history: From Q3-2020, earnings surprises were in double digits, ranging from 10% to 22%. The big theme for the current earnings season remains inflation and rising costs. Last week, despite delivering a 19% earnings surprise, CAT shares gapped lower as the company warned about a hit to its margins even as sales climbed. The other S&P 500 members have also guided lower with 59 negative and 34 positive pre-announcements, resulting in an N/P ratio of 59/34=1.7 (Q3-2021 N/P ratio was 0.8).  Negative guidance is a key reason for the ubiquitous negative returns following the earnings reports.  Clearly, the growth slowdown and margin compression, which we flagged back in October, are only now being priced in by the market. In terms of Q1-2022 earnings expectations, growth is expected to slow to 7%. On a sector level, earnings of Consumer Discretionary, Financials, and Communication Services sectors are expected to contract. Bottom Line: This earnings season results are consistent with our theme of earnings growth and profitability coming off the high levels and normalizing. The market is currently pricing in this new normal under a new “tighter” monetary regime.

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary Cyclical UST Curve Flattening, But With Unusually Low Rate Expectations The US Treasury curve is unusually flat given high US inflation and with the Fed not having begun to raise interest rates. The dichotomy between deeply negative real interest rates and a flattening yield curve is not only evident in the US, but in other major developed countries like Germany and the UK. A low term premium on longer-term US Treasury yields is one factor keeping the curve so flat, but the term premium will likely rise as the Fed begins to hike rates. An overly flat US Treasury curve more likely reflects a belief that the neutral real fed funds rate (r-star) is actually negative. This is consistent with markets pricing in a very low peak in the funds rate for the upcoming tightening cycle, despite the current high inflation and tight labor market. Bottom Line: The Fed will hike by less than the market expects in 2022 and longer-term Treasury yields remain too low versus even a moderate 2-2.5% peak in the fed funds rate. Stay in US curve steepeners, as the Treasury curve is already too flat and will not flatten as much as discounted in forward rates this year. Feature Last week’s FOMC meeting essentially confirmed that the Fed will begin lifting rates in March and deliver multiple rate hikes this year. This was considered a hawkish surprise as the Fed signaled imminently tighter monetary policy even with the elevated financial market volatility seen so far in 2022. Fed Chair Jerome Powell noted that the US economy was in a stronger position compared to the 2016-18 tightening cycle, justifying a faster pace of hikes – and an accelerated pace of QE tapering – this time around. Markets have responded to the increasingly hawkish guidance of the Fed by pushing up rate expectations for 2022, continuing a path dating back to last September’s FOMC meeting when the Fed first signaled that QE tapering was imminent (Chart 1). There are now 163bps of Fed rate hikes by year-end discounted in the US overnight index swap (OIS) curve. Some Wall Street investment banks are calling for the Fed to hike as much as 6 or 7 times in 2022. We see this as much too aggressive. Chart 1Fed Hawkishness Pushing Up Rate Expectations For 2022/23 - But Not Beyond That Our base case scenario calls for the Fed to lift rates “only” 3-4 times this year. The persistently high inflation that is troubling the Fed is likely to peak in the first half of 2022, taking some heat off the FOMC to move as aggressively as discounted in markets this year. Although inflation will remain high enough, and the labor market tight enough, to keep the Fed on a tightening path into 2023. The US Treasury Curve Looks Too Flat What is unique about the upcoming Fed tightening cycle is that it is starting with such a flat US Treasury curve. The spread between the 2-year and 10-year yield now sits at 61bps, the lowest level since October 2020. This dynamic is not unique to the US, as yield curves are quite flat in other major countries where policy rates are near 0% and inflation remains relatively high, like the UK and Germany (Chart 2). In the US, the modest slope of the Treasury curve is notably unusual given a growth and inflation backdrop that would be more consistent with much higher bond yields: The US unemployment rate fell to 3.9% in December, well within the range of full employment estimates from FOMC members (Chart 3, top panel) Chart 2Bond Bearish Yield Curve Flattening In The US & UK US labor costs are accelerating; the wages and salaries component of the Employment Cost Index for Private Industry Workers rose to a 38-year high of 5.0% on a year-over-year basis in Q4/2021 (middle panel) Chart 3Challenges To The Fed's Inflation Fighting Credibility​​​​​​ Higher inflation is becoming more embedded in medium term consumer inflation expectations measures like the University of Michigan 5-10 year ahead series that climbed to 3.1% last month (bottom panel). Importantly, market-based measures of inflation expectations have pulled back, even with little sign of inflation pressures easing. The 5-year TIPS breakeven, 5-years forward has fallen 35bps from the October 2021 peak of 2.41%. The bulk of that decline occurred in January of this year, alongside a rising trend in real TIPS yields as markets began pricing in a faster pace of Fed rate hikes. TIPS breakevens can often be something of a “vote of confidence” by the markets in the appropriateness of the Fed’s policy stance; rising when policy appears overly stimulative and vice versa. Thus, the decline in the TIPS 5-year/5-year forward breakeven, which climbed steadily higher since the Fed introduced massive monetary easing in March 2020 in response to the pandemic, can be interpreted as a sign that markets agree with the Fed’s recent hawkish turn. However, while the move in TIPS breakevens is sensible, the flatness of the Treasury curve appears unusual. In Chart 4, where we look at the previous times since 1975 that the 2-year/10-year US Treasury spread flattened to 70bps (just above the current level). In past cycles, the Treasury curve would be flattening into such a level after the Fed had already hiked rates a few times, which is obviously not the case today. Also, US unemployment was typically approaching, or falling through, the full employment NAIRU when the 2/10 Treasury curve fell to 70bps, suggesting diminished spare economic capacity and rising inflation pressures – similar to the current backdrop. Chart 4The UST Curve Is Unusually Flat Right Now Chart 5UST Curve Too Flat Relative To Inflation Pressures In those past cycles, the funds rate was rising at a faster pace than that of core inflation, suggesting that the Fed was pushing up real interest rates. The backdrop looks very different today, with US realized inflation soaring and the real funds rate now deeply negative. In the top panel of Chart 5, we show a “cycle-on-cycle” chart of the 2/10 Treasury curve versus an average of the previous five instances where the curve flattened to 70bps. The green line is the median outcome of all the cycles, while the shaded region represents the range of all the outcomes. In the other panels of the chart, we show US economic variables (the Conference Board leading economic index and the ISM Manufacturing index) and US inflation variables (the wages and salaries component of the Employment Cost Index and the US Congressional Budget Office estimate of the US output gap). The panels are all lined up so that the vertical line in the middle of the chart represents the date that the 2/10 curve falls to 70bps. The conclusion from Chart 5 is that the US economic variables shown are currently at the high end of the range of past curve flattening episodes, but the inflation variables are well above the high end of the historical range. In other words, the current modest slope of the 2/10 Treasury curve is in line with US growth momentum but is too flat relative to US inflation trends. So Why Isn’t The US Treasury Curve Steeper? There are a few possible reasons why the US curve is as flat as it is before the Fed has even begun tightening amid above-trend US growth and very high US inflation: Fears of a deeper financial market selloff The Fed believes strongly in the role of financial conditions in transmitting its monetary policy into the US economy. That often means that, during tightening cycles, the Fed hikes rates “until something breaks” in the financial markets, like a major equity market downturn or a big widening in corporate credit spreads. Such moves act as a brake on US growth through negative wealth effects for investors and by raising the cost of capital for businesses – reducing the need for additional Fed tightening. If bond investors thought that a major market selloff was likely before the Fed could successfully lift rates back to neutral (or even restrictive) levels during a tightening cycle, then they would discount a lower peak level of the funds rate. This would also lower the expected peak level of longer-term Treasury yields, resulting in a flatter Treasury yield curve. Given the current elevated valuations on so many asset classes – like equities, corporate credit and housing – it is likely that the relatively flat Treasury curve incorporates some believe that the Fed will have difficulty delivering a lot of rate hikes in this cycle. However, it should be noted that the US financial conditions remain quite accommodative, even after the recent equity market turbulence (Chart 6), and represent no impediment to US growth that reduces how much tightening the Fed will need to do. Longer-term bond term premia are too low A relatively flat yield curve could reflect a lack of a term premium on longer-maturity bonds. That is certainly the case when looking at the slope of the 2/10 government yield curve in the US, as well as in the UK and Germany (Chart 7).1 Chart 6US Financial Conditions Are No Impediment To US Growth​​​​​​ Chart 7Flatter Yield Curves? Or Just Lower Bond Term Premia?​​​​​ The term premium is the defined as the extra yield that investors require to commit to own a longer-maturity bond instead of the compounded yield from a series of shorter-maturity bonds. The latter can also be expressed as the “expected path of short-term interest rates”, which is often proxied by an average expected path of the monetary policy rate over the life of the longer-maturity bond. So the term premium on a 10-year US Treasury yield is the difference between the actual 10-year Treasury yield and the expected (or average) path of the fed funds rate over the next ten years. The term premium can also be thought of as a risk premium to holding longer-term bonds. On that basis, the term premium should correlate to measures of bond risk, like bond price volatility or inflation volatility. That is definitely true in the US, where the 10-year Treasury term premium shows a strong correlation to the MOVE index of Treasury market option-implied volatility or a longer-term standard deviation of headline CPI inflation (Chart 8). Estimated term premia can also rise during periods of slowing economic growth momentum, but that is typically due to a rapid decline in the expected path of interest rates rather than a rise in bond risk premia (in this case, this is probably more accurately described as a rise in bond uncertainty). Currently, a low term premium on US Treasury yields is justified by the relatively low level of bond volatility and solid US growth momentum. However, the term premium looks far too low compared to the more volatile US inflation seen since the start of the COVID-19 pandemic. With the Fed set to respond to that higher inflation with rate hikes, rising real interest rate expectations could also give a lift to the Treasury term premium. Our favorite proxy for the market expectation of the peak/terminal real short-term interest rate for the major developed market economies is the 5-year/5-year forward OIS rate minus the 5-year/5-year forward CPI swap rate. That “real” 5-year/5-year forward rate measure is typically well correlated to our estimates of the 10-year term premium in the US, Germany and the UK (Chart 9). This correlation likely reflects the level of certainty bond investors have over the likely future path of real interest rates. When there is more uncertainty about how high rates will eventually go to in a tightening cycle, a higher term premium is required. The opposite is true during periods of very low and stable interest rates. Chart 8Drivers Of US Term Premia Pointing Upward​​​​​​ Chart 9Bond Term Premia Positively Correlated To Real Rate Expectations​​​​​​ Chart 10Global Yield Curves Are Too Flat Versus Real Policy Rates Currently, the estimated 10-year US term premium is increasing alongside a rising market-implied path for the real fed funds rate. We anticipate these trends will continue as the Fed lift rates over the next couple of years, boosting longer-term Treasury yields and potentially putting some steepening pressure on the US Treasury curve (or at least limiting the degree of flattening as the Fed tightens). Markets believe that the neutral real rate (r*) is negative Historically, yield curve slopes for government bonds were well correlated to the level of real interest rates, measured as the central bank policy rate minus headline inflation. That relationship has broken down in the US, with the Treasury curve flattening in the face of soaring US inflation and an unchanged fed funds rate (Chart 10). Similar dynamics can also be seen in the German and UK yield curves. The most plausible reason for such a dramatic shift in the relationship between curve slopes and real policy rates is that bond investors now believe that the neutral real interest rate, a.k.a. “r-star”, is negative … and perhaps deeply so. The New York Fed has produced estimates of the US r-star dating back to the 1960s. The gap between the real fed funds rate and that r-star estimate has typically been fairly well correlated to the slope of the Treasury curve (Chart 11). When the real fed funds rate is below r-star, indicating that the policy is accommodative, the Treasury curve is usually steepening, and vice versa. Under this framework, the recent flattening trend of the Treasury curve would indicate that policy is actually getting tighter, despite the falling, and deeply negative, real fed funds rate of -5.4% (deflated by core inflation). Chart 11UST Curve Slope Is Positively Correlated To The 'Real Policy Gap' The last known estimate of r-star from the New York Fed was 0%, but no update has been provided for almost two years. Blame the pandemic for that. The sharp lockdown-fueled collapse in US GDP growth in 2020, and the rapid recovery in growth as the economy reopened, made it impossible to estimate the the “neutral” level of real interest rates given such massive swings in demand that were not related to monetary policy. One way to try and “back out” the implicit pricing of r-star currently embedded in US Treasury yields is to estimate a model linking the gap between the real fed funds rate and r-star to the slope of the Treasury curve. We did just that, with the results presented in Chart 12. This model estimates the “Real Policy Gap”, or r-star minus the real fed funds rate, as a function of the 2/10 Treasury curve slope. In other words, the model shows the Real Policy Gap that is consistent with the current slope of the curve. Chart 12Current UST Yield Curve Makes Slope Sense ... If The Fed Followed The Taylor Rule With 7% Inflation The model estimates that the current 2/10 curve slope is consistent with a Real Policy Gap of 96bps. With US core CPI inflation currently at 5%, and assuming r-star is still 0% as per the last New York Fed estimate, the fed funds rate would have to rise to 4% to justify the current slope of the 2/10 curve. While that may sound like an implausibly large increase in the funds rate, similar results are produced using straightforward Taylor Rules.2 We can also use our Real Policy Gap model to infer the level of inflation that is consistent with a Gap of 96bps, for various combinations of the funds rate and r-star. Those are shown in Table 1. Assuming the funds rate rises in line with current market expectations to 1.7% and r-star remains close to 0%, the current slope of the 2/10 Treasury curve suggests a fall in US inflation to just around 3% - still above the Fed’s inflation target - from the current 5%. Table 1The UST Curve Slope Has Already Discounted A Big Drop In US Inflation We see this as the most plausible reason for the relatively flat level of the 2/10 US Treasury curve. Markets expect somewhat lower US inflation and a moderate rise in the funds rate over the next couple of years, making the real funds rate less negative but not pushing it above a negative r-star expectation. This would suggest upside risk for US Treasury yields, and potential bearish steepening pressure, as markets come to realize that the neutral real fed funds rate is actually positive, not negative. Fight The Forwards, Stay In US Treasury Curve Steepeners While it may sound counter-intuitive with the Fed set to begin a rate hiking cycle, we continue to see better value in tactically positioning in US Treasury curve steepening trades. Specifically, we are keeping our recommended trade in our Tactical Overlay on page 19, where we are long a 2-year Treasury bullet versus a duration-neutral barbell of cash (a 3-month US Treasury bill) and a 10-year Treasury bond. The trade is currently underwater, but we see good reasons to expect the performance to rebound over the next few months. The front end of the curve now discounts more hikes than we expect will unfold in 2022, which should limit further increases in the 2-year Treasury yield. At the same time, the 10-year yield looks too low relative to the expected cyclical peak for the fed funds rate (Chart 13). One way we can assess this is by comparing 5-year/5-year forward Treasury rates to survey estimates of the longer run, or terminal, fed funds rate. The median FOMC forecast (or “dot”) for the terminal funds rate is 2.5%, the median terminal rate forecast from the New York Fed’s Survey of Primary Dealers is 2.25% and the median terminal rate forecast from the New York Fed’s Survey of Market Participants is 2%. This sets a range of estimates of the longer-run terminal rate of 2-2.5%, in line with the current expectations of the BCA Research bond services. The current 5-year/5-year forward Treasury rate is 2.0%, at the low end of that range. We see those forwards rising to the upper part of that 2-2.5% range by the end of 2022, which will push the 10-year Treasury yield toward our year-end target of 2.25%. Chart 13The 5-Year/5-Year UST Forward Rate Is Too Low​​​​​​ Chart 14Stay In UST Curve Steepeners, Even With Fed Liftoff Imminent​​​​​​ Some of our colleagues within the BCA family see the longer-term neutral funds rate as considerably higher than survey estimates, perhaps as high as 3-4%. We are sympathetic to that view, but it will take signs of US economic resiliency in the face of rate hikes before bond investors – and more importantly, the Fed – arrive at that conclusion. This would make steepening trades more attractive on a strategic, or medium-term, basis as the market realizes that the Fed is further behind the policy curve (i.e. the funds rate even further below a higher terminal rate) than previously envisioned. For now, we do not see the US Treasury curve flattening at the pace discounted in the Treasury forward curve over the next 3-6 months (Chart 14, top panel). However, this will be more of a carry trade by betting against the forwards over time. A bearish steepening of the Treasury curve with a swift upward move in the 10-year Treasury yield is less likely with bond investor/trader positioning already quite short (bottom two panels).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com       Footnotes 1      The term premium estimates shown here are derived from our own in-house framework. For those familiar with the various term premium estimates on the 10-year US Treasury yield produced by the Fed, our estimates are currently in line with those produced by the ACM model and the Kim & Wright model. 2     A fun US Taylor Rule calculator, which can be used to generate Taylor Rules under a variety of assumptions, is available on the Atlanta Fed’s website here. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. 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