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Your feedback is important to us. Please take our client survey today. Highlights The dollar remains at risk of a countertrend bounce in the near term. The DXY could rise to 94-96 before working off oversold conditions. Nonetheless, the long-term outlook for the greenback remains bearish. The Scandinavian currencies are best positioned for outperformance over the next 12 months. Stay short USD/JPY as a core holding for now. Remain long silver relative to gold. Sterling volatility will remain elevated in the near term, but short EUR/GBP positions should provide handsome gains over the longer term. Feature The US election is just a week away. The market consensus is that a “blue wave” will usher in significant fiscal stimulus which will boost stock prices, buffet bond yields and drive down the dollar. The rationale behind these anticipated market moves is that the Democrats have been more aggressive in their demand for bigger government. Fiscal spending will widen the US twin deficits as aggregate demand rises. In anticipation of higher inflation, foreign bond investors are likely to continue fleeing the US market, driving down the dollar in the process. Fiscal spending will widen the US twin deficits as aggregate demand rises. We sympathize with this view, but it is unlikely to pan out smoothly. More specifically, a number of indicators suggest that the dollar is at risk of a countertrend bounce. This could lead to an air pocket for dollar-short positions in the near term. Our bet is that the DXY could rise to 94-96 before working off oversold conditions. The Case For A Countertrend Bounce A number of indicators suggest that conditions may be ripe for a countertrend bounce in the dollar. The velocity of money (V) is collapsing around the world (Chart I-1A and Chart I-1B). At a minimum, this suggests that realized inflation is bound to remain tame in the very near term. The dollar is a countercyclical currency, and tends to do well when global inflation is decelerating. In the case of the US, a temporary dip in inflation expectations will boost real rates, and encourage flows back into US fixed-income assets. In a general sense, V can be viewed as the interest rate required by the underlying economy (the neutral rate), since it is measured using economic variables. Once economic agents start to increase the turnover of money in the system as activity improves, it is an endogenous sign that the economy has escaped a liquidity trap and can handle higher rates. Chart I-1ADownside Risks To US Inflation Chart I-1BDownside Risks To Euro Area Inflation ​​​​The balance sheet impulse of the Federal Reserve could peak soon, relative to a few other countries (Chart I-2). This will especially be the case if other G10 countries step up the pace of their quantitative easing. This is already occurring in Canada and could soon happen in Australia. Remarkably, long-term US interest rates have started rising faster compared to its G10 peers. This was bound to happen as we stepped into a world of competitive devaluations. For most of the post-2008 period, the EUR/USD exchange rate oscillated with the relative balance sheet impulse between the Fed and the European Central Bank. The story in Japan was similar after the Fukushima crisis in 2011 and the subsequent adoption of Abenomics. In short, central bank QE becomes an important driver at the lower bound, since it is the key signaling mechanism on the future path of interest rates. Chart I-2The Dollar And Balance Sheet Impulse Currencies are about relative growth trends. Remarkably, relative growth tends to play a crucial role in currency dynamics even over the short term. For example, the upside growth surprise between the euro area and the US has started to reverse after a sharp V-shaped recovery (Chart I-3). Correspondingly, the euro has been consolidating its gains since August. On a broader scale, the OECD leading economic indicator for the US has picked up relative to its G10 peers (Chart I-4). Chart I-3EUR/USD And Relative Growth Chart I-4The Dollar And Relative Growth The exchange rate that best signals whether we are in a reflationary/deflationary environment is the AUD/JPY rate (Chart I-5). The AUD/JPY cross has consistently bottomed at the key support zone of 72-74. This defensive line notably held during the European debt crisis, China’s industrial recession, and the global trade war. This Maginot Line was clearly breached during the March drawdown, but we have since re-entered the safe zone. In recent trading sessions, however, AUD/JPY has been edging lower and could soon punch below the 74 level. Inflows into US equities are rising sharply (Chart I-6). Currencies tend to move in sync with the relative performance of their equity bourses. Correspondingly, non-US equity markets have relapsed relative to the US. Similarly, cyclical stocks have been underperforming defensive ones of late. The dollar tends to weaken when non-US equity markets, with a much higher concentration of cyclical stocks in their bourses, are outperforming. This is usually a clear sign that the marginal dollar is rotating outside of the US. Speculators are very short the dollar. Whenever the percentage of leveraged funds and overall speculators that are short the dollar is at or below 20%, a meaningful rally ensues (Chart I-7). Chart I-5AUD/JPY: Watch The 72-24 Zone Chart I-6Strong Inflows Into US Equities Chart I-7Many Dollar Bears In a nutshell, the market has been ignoring clear bullish signals for the dollar such as the drop in money velocity and the relapse of global interest rates relative to the US. Meanwhile, the consensus is overwhelmingly bearish on the dollar, which could make any bounce or advance go much further than most expect. The catalyst in the near term could be a market reset, given uncertainty around the US presidential elections, the resurgence in COVID-19 cases and Brexit. Meanwhile, unless animal spirits are rekindled by an invisible hand, perhaps in the form of a vaccine, then the outperformance of cyclical stocks, which is needed to boost the aggregate market index higher, is not a sure bet. Similarly, the outperformance of non-US stocks, specifically those in Europe and Japan, is also needed to confirm the dollar bear market remains intact. Positive Catalysts Chart I-8Lumber Versus Copper Despite our concerns of a near-term bounce in the dollar, there are still many signs that it will not be a durable one. Therefore, investors should use any dollar rally to establish fresh short positions. Lumber has started to underperform Dr. Copper. Lumber benefits greatly from a pickup in housing activity in the US and is very closely correlated to US domestic variables, while copper is strongly linked to Chinese and global industrial cycles. The dollar also tends to underperform higher-beta currencies when lumber is underperforming copper, as is the case now (Chart I-8). Similarly, the copper-to-gold ratio has bottomed and is heading higher from deeply oversold levels. Together with the stabilization in government bond yields, it signifies that the liquidity-to-growth transmission mechanism might be working. This is usually dollar bearish, as rising global growth leads to capital outflows from the US (Chart I-9). The gold/silver ratio (GSR) has rolled over following the recent bounce (Chart I-10). The GSR provides important information on the battleground between easing financial conditions and a pickup in economic (or manufacturing) activity. Gold benefits from plentiful liquidity and very low real rates, while silver benefits from rising industrial demand. Therefore, the GSR usually peaks as we exit a recession. The bond-to-gold ratio, as measured by the ratio of the US bond ETF (TLT)-to-gold ETF (GLD) remains below the key technical level of 0.90, which is bearish for the dollar (Chart I-11). The ratio measures the shift in confidence between the dollar and alternatives to the fiat reserve currency. The upside for the 10-year Treasury is much more capped than the upside is for gold, suggesting that this confidence measure will remain dollar bearish for the near future. Finally, currency volatility is high, suggesting that currency traders are no longer complacent. Usually, high volatility signals a more balanced and healthy market rotation. Over the last three episodes where volatility rose from these oversold levels, the dollar has benefitted (Chart I-12). Should volatility drop from current levels, especially in early 2021, pro-cyclical currencies will benefit. Chart I-9The Copper/Gold Ratio Leads The Dollar Chart I-10The Gold/Silver Ratio Has Relapsed Chart I-11Watch The Bond-To-Gold Ratio Chart I-12Currency Volatility Is Rolling Over In summary, many cyclical drivers still point to a lower ultimate resting spot for the dollar. Nonetheless, the character of any equity shakeout over the coming weeks will be worth monitoring. If cyclical and value stocks that are already at historically bombed-out levels start to outperform, it will signal an equity market leadership change – something that is required for the dollar bear market to resume. Investment Implications Chart I-13Sell EUR/GBP Chart I-14Place Stops On Short GSR At 80 The investment implications are straightforward. Maintain a basket of the cheapest currencies, together with some safe-havens. Also, focus on trades at the crosses. Specifically: Stay long the Japanese yen, which sports an attractive real rate relative to the US. Focus on relative value at the crosses rather than outright dollar bets. We are short the NZD/CAD and EUR/GBP as a play on relative fundamentals. We also went short CAD/NOK a fortnight ago. EUR/GBP is at risk of a significant selloff if we get a Brexit deal (Chart I-13). We already have limit orders on a few currencies, including a Nordic currency basket, AUD/NZD and EUR/CHF. We are long petrocurrencies versus the euro, and will use any tactical bounce in the dollar to shift to USD shorts. Remain short gold/long silver with a target of 50, but tighten the stop loss to 80 (Chart I-14).   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been positive: The preliminary Michigan consumer sentiment index climbed up from 80.4 to 81.2 in October. Retail sales increased by 1.9% month-on-month in September. This was a significant beat, relative to expectations of a 0.8% rise. Housing starts increased by 1.9% month-on-month in September. Building permits also increased by 5.2% month-on-month, overtaking pre-pandemic levels. Initial jobless claims increased by 787K for the week ending on October 16th. Claims have consistently come under 1000K since August 28. The DXY index fell by 0.8% this week. It remains evident from incoming data that the US economy is holding up well, relative to its trading partners. Bond yields have also moved in favor of the US dollar. While this could catalyze a countertrend bounce in the DXY, our bias is that it is not likely to be a durable one.   Report Links: Does The US Save Too Much Or Too Little? - October 16, 2020 Tail Risks In FX Markets - October 2, 2020 The Message From Dollar Sentiment And Technical Indicators - Sept. 25, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been positive: The seasonally adjusted trade surplus increased from €19.3 billion to €21.9 billion in August. This lifted the current account balance from €16.95 billion to €19.94 billion. Both headline and core inflation remained unchanged at -0.3% and 0.2% year-on-year, respectively, in September. Consumer confidence has been rolling over, but much better than you would expect given the resurgence in COVID-19 cases in Europe. The euro increased by 0.7% against the US dollar this week. The critical barometer for the euro outlook is the economic impact from the second wave of the pandemic. During an interview this week, ECB president Christine Lagarde said that the recovery could be “running out of steam.” Economic surprise indices in Europe are also rolling over, relative to the US. This sets the euro up for some indigestion before the bull market resumes. Report Links: Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan have been mixed: The adjusted trade surplus significantly widened from ¥248 billion to ¥675 billion in September. Exports fell by 4.9% year-on-year in September, up from a 14.8% decrease the previous month. Imports continued to fall by 17.2% year-on-year. The Japanese yen appreciated by 0.7% against the US dollar this week. Sluggish imports reflect weakness in Japanese domestic demand, which is putting upward pressure on real rates. Meanwhile, Suga-san’s push to continue pressuring telecoms to drop prices does not bode well for the BoJ’s inflation target. As such, the yen remains a very attractive currency when real rates are compared across the G10. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been robust: Rightmove house prices surged by 5.5% year-on-year in October. Headline inflation increased from 0.2% to 0.5% year-on-year in September. Core inflation also ticked up from 0.9% to 1.3% year-on-year. CBI trends continue to improve in terms of both orders, selling prices and business optimism. The British pound increased by 0.7% against the US dollar this week. Sterling action will continue to be dictated by the evolution of Brexit. The UK public sector has no choice but to step in as a spender of last resort amid the twin economic and health crises. In fact, net borrowing surged to £35 billion from £29 billion in September, which was more elevated than expected. Rising public debt has pushed Moody’s to downgrade the UK’s sovereign credit rating, warning that Britain “effectively has no fiscal anchor.” That said, positive action on the pound this week reflects the market’s laser focus on the terms of the UK’s withdrawal from the EU, and nothing else. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data from Australia have been soft: The Westpac Leading Index declined from 0.49 to 0.22 in September.  Retail sales declined by 1.5% month-on-month in September. The Australian dollar appreciated by 0.4% against the US dollar this week. The RBA meeting minutes released this week implied further easing from the central bank, which might include further rate cuts and some expansion in its QE program. Interestingly, softness in the AUD, particularly against the NZD is setting the stage for a nice entry point. AUD/NZD slipped by 0.7% on the dovish RBA minutes. Over the longer-term, our fundamentally bullish bias on the AUD is based on strong relative terms of trade, and a currency that remains undervalued. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There has been scant data from New Zealand this week: NZIER business confidence fell by 40% quarter-on-quarter in Q3. Credit card spending fell by 9.9% year-on-year in September, but is a marked improvement from the 48.6% drop earlier this year. The New Zealand dollar surged by 1% against the US dollar this week. Prime minister Jacina Ardern’s election sweep over the weekend has boosted confidence on a more fluid government in New Zealand. That said, our updated PPP models shows that the New Zealand dollar is currently close to its fair value, while other major DM currencies, with the exception of the US dollar, are significantly undervalued. While NZD could rise against the US dollar in the near term, it should underperform at the crosses. We are short on NZD/CAD in our portfolio and it’s 2.5% in the money. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada have been positive: Headline inflation jumped from 0.1% to 0.5% year-on-year in September. Most measures of core inflation have held steady, but still came in below the midpoint of the BoC’s 1-3% band. The core median CPI came in at 1.9%, similar to last month, in line with expectations. Retail sales continued to increase by 0.4% month-on-month in September, but came in below the expected 1.1% rise. Teranet/National Bank House Prices increased by 6.7% year-on-year in September. The Canadian dollar appreciated by 0.3% against the US dollar this week. The most important release for Canada this week was the Business Outlook Survey, which showed a notable improvement in Quebec, Alberta, and the other Prairies. The pickup in September’s inflation figures also lowered the possibility of further rate cuts when the BoC meets next week. We remain positive on the CAD, expecting it to touch 82 cents versus the dollar over a cyclical horizon. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data from Switzerland have been positive: Exports increased from CHF 16.7 billion to CHF 18.7 billion in September and imports increased from CHF 13 billion to CHF 15.4 billion. As such, the trade surplus slightly narrowed from CHF 3.5 billion to CHF 3.3 billion. The Swiss franc increased by 0.2% against the US dollar this week. Since the March 19 lows, the franc has appreciated by nearly 10% against the US dollar. The unwanted strength in the Swiss franc has been a headache for the SNB. We believe the intervention from the SNB will limit how far the franc can rise, compared to other G10 currencies. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data from Norway have been negative: The unemployment rate rose from 5.2% to 5.3% in August. The participation rate dropped by 0.4% to 70.9% in Q3 compared with the same quarter last year. On a positive note, industrial confidence continues to rebound. The Norwegian krone soared by 1.2% against the US dollar this week. As we frequently highlight in our publications, the Norwegian krone is poised to benefit most from a weaker USD. Moreover, our PPP model shows that at 30% below its fair value, the krone is still the most undervalued DM currency. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 There has been no significant data release from Sweden this week. The Swedish krona fell by 0.6% against the US dollar this week. Reuters polls now suggest that the Swedish economy is expected to shrink by only 4% in 2020, rather than by 5% as was previously forecast. The Swedish krona is one of the cheapest currencies in the G10 and will benefit from a post-pandemic recovery. Kelly Zhong Research Analyst Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Your feedback is important to us. Please take our client survey today. Underweight In yesterday’s US Equity Sector Insight we highlighted why investors should stay on the sidelines when it comes to the defensive S&P household products index. But, with regard to the broader S&P consumer staples sector, our view remains that over the next 9-12 months this safe haven sector, which peaked in the depths of the COVID-19 recession, will continue to underperform. As the pandemic-induced recession disappears from the rear-view window, it no longer pays to favor stable cashflow growth staples companies. In fact, our relative macro earnings model paints a dark picture for this GICS1 sector (middle panel). Among other reasons, one of the factors that will drive relative earnings lower is the weaker US dollar. As a reminder, the S&P consumer staples sector derives approximately 32% of its sales from abroad, which is 10 percentage points lower than the S&P 500. As a consequence, on a relative basis staples stocks cannot benefit from positive currency tailwinds to the same extent as the overall market can. Bottom Line: We remain underweight the S&P consumer staples sector.  

Neutral We remain neutral the S&P household products index. A V-shaped economic recovery following a recession has historically been synonymous with this defensive industry underperforming (top panel). However, the uniqueness of the current recession must be taken into account. The US consumer continues to binge on household products, which are currently outpacing overall retail sales growth by 13% year-over-year (middle panel, relative consumer spending shown truncated). This trend is slated to continue until a vaccine arrives as the second wave of infections emerges. The same story holds for foreign consumers who also have an incentive to keep up their spending on US household products: a softer US dollar. A weaker US dollar will boost competitiveness of US exporters, which will translate into robust top line growth (bottom panel). Bottom Line: Given the strangeness of the current recession, we remain neutral the S&P household products index. The ticker symbols for the stocks in this index are: BLBG: S5HOPR – PG, CL, KMB, CLX, CHD.    

Informe especial

Highlights US Election & Duration: We estimate that there is an 80% probability of a US election result that will give a lift to US Treasury yields via increased fiscal stimulus. Those are strong enough odds to justify a move to a below-benchmark cyclical US duration stance on a 6-12 month horizon. US Treasuries: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Country Allocation: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to Canada and Australia. Stay neutral on the UK given the near-term uncertainties over the final Brexit outcome. Feature With the US presidential election just two weeks away, public opinion polls continue to show that Joe Biden is the favorite to win the White House. However, the odds of a “Blue Sweep” - combining a Biden victory with the Democratic Party winning control of both the US Senate and House of Representatives - have increased since the end of September according to online prediction markets. US Treasury yields have also moved higher over that same period (Chart 1), which we interpret as the bond market becoming more sensitive to the likelihood of a major increase in US government spending under single-party Democratic control. Chart 1A Blue Sweep Is Bond Bearish According to a recent analysis done by the Committee for a Responsible Federal Budget, President Trump’s formal policy proposals would increase US federal debt by $4.95 trillion between 2021 and 2030, while Biden’s plan would increase the debt by $5.60 trillion (Table 1).1 While those are both massive fiscal stimulus plans, there is a stark difference in the policy mix of their proposals that matters for the future path of US bond yields. Table 1A Comparison Of The Candidates' Budget Proposals Under Biden, spending is projected to increase by a cumulative $11.1 trillion, partially offset by $5.8 trillion in revenue increases and savings with the former vice-president calling for tax hikes on corporations and high-income earners. On the other hand, Trump’s plan includes $5.45 trillion of spending increases and tax cuts over the next decade, offset by $0.75 trillion in savings. Conclusion: Biden would increase spending by over twice that of a re-elected Trump, with much of that spending expected to be front-loaded in the early part of his first term. Outright spending is more reflationary than tax cuts because it puts more money in the pockets of consumers (spenders) relative to producers (savers). The Biden plan would be more stimulating for overall activity even if the increase in debt is about the same. Another analysis of the Biden and Trump platforms was conducted by Moody’s in September, based on estimates of how much of each candidate’s promises could be successfully implemented under different combinations of White House and Congressional control.2 The stimulus figures were run through the Moody’s US economic model, which is similar to the budget scoring model of the US Congressional Budget Office, to produce a year-by-year path for the US economy over the next decade (Chart 2). Chart 2The Biden Platform Is Highly Stimulative Moody’s concluded that the US economy would return to full employment in the second half of 2022 under a President Biden – especially if the Democrats win the Senate - compared to the first half of 2024 under a re-elected President Trump. Such a rapid closing of the deep US output gap that opened up because of the COVID-19 recession would likely trigger a reassessment of the Fed’s current highly dovish policy stance. The US output gap would close more rapidly under a President Biden, likely triggering a reassessment of the Fed’s current highly dovish policy stance.  At the moment, the US overnight index swap (OIS) curve discounts one full 25bp Fed hike by late 2023/early 2024, and two full hikes by late 2024/early 2025 (Chart 3). This pricing of the future path of interest rates has occurred even with the Fed promising to keep the funds rate anchored near 0% until at least the end of 2023. The likelihood of some form of increased fiscal spending after the election will cause the bond market to challenge the Fed’s current forward guidance even more, putting upward pressure on Treasury yields. Chart 3US Fiscal Stimulus Will Pull Forward Fed Liftoff Our colleagues at BCA Geopolitical Strategy see a Blue Sweep as the most likely outcome of the US election, although their forecasting models suggest that the race for control of the Senate will be much closer than the Biden vs Trump battle (there is little chance that control of the House of Representatives would switch back to the Republicans).3 Their scenarios for each of the White House/Senate combinations, along with their own estimated probability for each, are the following: Biden wins in a Democratic sweep: BCA probability = 45%. The US economy will benefit from higher odds of unfettered fiscal stimulus in 2021, although financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. Government bond yields should rise on the generally reflationary agenda. Trump wins with a Republican Senate: BCA probability = 30%. In this status quo scenario, a re-elected President Trump would still face opposition from House Democrats on most domestic economic issues, forcing him to tilt towards more protectionist foreign and trade policies in his second term. Fiscal stimulus would be easy to agree, though not as large as under a Democratic sweep. US Treasury yields would rise, but would later prove volatile due to the risk to the cyclical recovery from a global trade war, as Trump’s tariffs will not be limited to China and could even affect the European Union. Biden wins with the Senate staying Republican: BCA probability = 20%. This is ultimately the most positive outcome for financial markets - reduced odds of a full-blown trade war with China, combined with no new tax hikes. Bond yields would drift upward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators. The first such battle would start right after the election. Treasuries would remain well bid until financial market pressures forced a Senate compromise with the new president sometime in H1 2021. Trump wins with a Democratic Senate: BCA probability = 5%. This is the least likely scenario but one that could produce a big positive fiscal impulse. Trump is a big spender and will veto tax hikes, but will approve populist spending on areas where he agrees. The Democratic Senate would not resist Trump’s tough stance on China, however, thus keeping the risk of US-China trade skirmishes elevated. This is neutral-to-bearish for US Treasuries, depending on the size of any bipartisan stimulus measures and Trump’s trade actions. The key takeaway is that the combined probability of scenarios that will put upward pressure on US Treasury yields is 80%, versus a 20% probability of a more bond-neutral outcome. That is a bond-bearish skew worth positioning for by reducing US duration exposure now, ahead of the November 3 election. Of this 80%, 35 percentage points come from scenarios in which President Trump would remain in power. Hence his trade wars would eventually undercut his reflationary fiscal policy. This would become the key risk to the short duration view after the initial market response. Bottom Line: The most likely scenarios for the US election will give a cyclical lift to US Treasury yields via increased fiscal stimulus. This justifies a move to a below-benchmark US duration stance on a 6-12 month horizon. If Trump is re-elected, the timing of Trump’s likely return to using broad-based tariffs will have to be monitored closely. A Moderate Bear Market Chart 4Less Election-Day Upside Than In 2016 While our anticipated Blue Sweep election outcome will lead to a large amount of fiscal spending in 2021 and beyond, we anticipate only a modest increase in bond yields during the next 6-12 months. In terms of strategy, our recommended reduction in portfolio duration reflects the fact that fiscal largesse meaningfully reduces the risk of another significant downleg in bond yields and strengthens our conviction in a moderate bear market scenario for bonds. This does raise the question of how large an increase in US Treasury yields we expect during the next 6-12 months. We turn to this question now. Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart 4). For one thing, the Fed was much more eager to tighten policy in 2016 than it is today, and it did deliver a rate hike one month after the Republicans won the House, Senate and White House (Chart 4, bottom panel). This time around, the Fed has made it clear that it will wait until inflation is running above its 2% target before lifting rates off the zero bound and will not respond directly to expectations for greater fiscal stimulus. A complete re-convergence to long-run fed funds rate estimates would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. Second, 2016’s election result was mostly unanticipated. This led to a dramatic adjustment in market prices once the results came in. The PredictIt betting market odds of a “Red Sweep” by the Republicans in 2016 were only 16% the night before the election. As of today, the betting markets are priced for a 58% chance of a Blue Sweep in 2020. Unlike in 2016, bonds are presumably already partially priced for the most bond-bearish election outcome. A Slow Return To Equilibrium To more directly answer the question of how high bond yields can rise, survey estimates of the long-run (or equilibrium) federal funds rate provide a useful starting point. In a world where the economy is growing at an above-trend pace and inflation is expected to move towards the Fed’s target, it is logical for long-maturity Treasury yields to settle near estimates of the long-run fed funds rate. Indeed, this theory is borne out empirically. During the last two periods of robust global economic growth (2017/18 & 2013/14), the 5-year/5-year forward Treasury yield peaked around levels consistent with long-run fed funds rate estimates (Chart 5). As of today, the median estimates of the long-run fed funds rate from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers are 2% and 2.25%, respectively. In other words, a complete re-convergence to these equilibrium levels would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. We expect this re-convergence to play out eventually, but probably not within the next 6-12 months. In both prior periods when the 5-year/5-year forward Treasury yield reached these equilibrium levels, the Fed’s reaction function was much more hawkish. The Fed was hiking rates throughout 2017 & 2018 (Chart 5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart 5, bottom panel). The Fed’s new dovish messaging will ensure that the market reacts less quickly this time around. Also, continued curve steepening will mean that the 5-year/5-year forward yield’s 80 – 100 bps of upside will translate into significantly less upside for the benchmark 10-year yield. The 10-year yield and 5-year/5-year forward yield peaked at similar levels in 2017/18 when the Fed was lifting rates and the yield curve was flat (Chart 6). But, the 10-year peaked far below the 5-year/5-year yield in 2013/14 when the Fed stayed on hold and the curve steepened. Chart 5How High For Treasury Yields? Chart 6Less Upside In 10yr Than In 5y5y The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart 6, bottom panel).4 TIPS Versus Nominals We have seen that a full re-convergence to “equilibrium” implies 80 – 100 bps of upside in the 5-year/5-year forward nominal Treasury yield. Bringing TIPS into the equation, we have also observed that long-maturity (5-year/5-year forward and 10-year) TIPS breakeven inflation rates tend to settle into a range of 2.3 – 2.5 percent when inflation is well-anchored and close to the Fed’s target (Chart 7). The additional fiscal stimulus that will follow a Blue Sweep election makes it much more likely that the economic recovery will stay on course, leading to an eventual return of inflation to target and of long-maturity TIPS breakeven inflation rates to a 2.3 – 2.5 percent range. However, as with nominal yields, this re-convergence will be a long process whose pace will be dictated by the actual inflation data. To underscore that point, consider that our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate – a model that is driven by trends in the actual inflation data – has the 10-year breakeven rate as close to fair value (Chart 8).5 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart 7Overweight TIPS Versus Nominals Chart 8Real Yields Have Likely Bottomed All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart 8, bottom panel).6 Two More Curve Trades Chart 9Own Inflation Curve Flatteners And Real Curve Steepeners In addition to moving to below-benchmark duration, maintaining nominal yield curve steepeners and staying overweight TIPS versus nominal Treasuries, there are two additional trades that investors should consider in order to profit from the reflationary economic environment. The first is inflation curve flatteners. The cost of short-maturity inflation protection is below the cost of long-maturity inflation protection, meaning that it has further to run as inflation returns to the Fed’s target (Chart 9). In addition, if the Fed eventually succeeds in achieving a temporary overshoot of its inflation target, then we should expect the inflation curve to invert. Real yield curve steepeners are in some ways the mirror image of inflation curve flatteners. Assuming no change in nominal yields, the real yield curve will steepen as the inflation curve flattens. But what makes real yield curve steepeners look even more attractive is that increases in nominal yields during the next 6-12 months will be concentrated in long-maturities. This will impart even more steepening pressure to the real yield curve. Investors should continue to hold inflation curve flatteners and real yield curve steepeners. Bottom Line: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Government Bonds: Reduce Exposure To US Treasuries The mildly bearish case for US Treasuries that we have laid out above not only matters for our recommended duration stance, but also for our suggested country allocation within global government bond portfolios. Simply put, the risk of rising bond yields is much higher in the US than elsewhere, both for the immediate post-election period but also over the medium-term. Thus, the immediate obvious portfolio decision is to downgrade US Treasuries to underweight. The move higher in US Treasury yields that we expect is strictly related to spillovers from likely US fiscal stimulus. While other countries in the developed world are contemplating the need for additional fiscal measures, particularly in Europe where there is a renewed surge in coronavirus infections and growing economic restrictions, no country is facing as sharp a policy choice as the US with its upcoming election. The Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued. We can say with a fair degree of certainty that the US will have a relatively more stimulative fiscal policy stance than other developed economies over at least the next couple of years. This implies a higher relative growth trajectory for the US that hurts Treasuries more on the margin than non-US government debt. Chart 10The Fed Will Gladly Trade Less QE For More Fiscal Stimulus In addition, the likely path of relative monetary policy responses are more bearish for US Treasuries. As described above, the scope of the US stimulus will cause bond investors to further question the Fed’s commitment to keeping the funds rate unchanged for the next few years. That also applies to the Fed’s other policy tools, like asset purchases. The Fed is far less likely to continue buying US Treasuries at the same aggressive pace it has for the past eight months if there is less need for monetary stimulus because of more fiscal stimulus. According to the IMF, the Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued (Chart 10). If US Treasury yields are rising because of improving US growth expectations, fueled by fiscal stimulus, the Fed will likely tolerate such a move and buy an even lower share of Treasuries issued – particularly if the higher bond yields do not cause a selloff in US equity markets that can tighten financial conditions and threaten the growth outlook. The fact that US equities have ignored the rise in Treasury yields seen since the end of September may be a sign that both bond and stock investors are starting to focus on a faster trajectory for US growth. In terms of country allocation, beyond downgrading US Treasuries to underweight, we recommend upgrading exposure to countries that are less sensitive to changes in US Treasury yields (i.e. countries with a lower yield beta to changes in US yields). In Chart 11, we show the rolling beta of changes in 10-year government bond yields outside the US to changes in 10-year US Treasury yields. This is a variation of the “global yield beta” concept that we have discussed in the BCA Research bond publications in recent years. Here, we modify the idea to look at which countries are more or less correlated to US yields, specifically. A few points stand out from the chart: Chart 11Reduce Exposure To Bond Markets More Correlated To UST Yields All countries have a “US yield beta” of less than 1, suggesting that Treasuries are a consistent outperformer when US yields fall and vice versa. This suggests moving to underweight the US when US yields are rising is typically a winning strategy in a portfolio context. The list of higher beta countries includes Canada, Australia, New Zealand, the UK and Germany; although Canada stands out as having the highest yield beta in this group. The list of lower beta countries includes France, Italy, Spain, and Japan. In Chart 12, we show what we call the “upside yield beta” that is estimated only using data for periods when Treasury yields are rising. This gives a sense of which countries are more likely to outperform or underperform during a period of rising Treasury yields, as we expect to unfold after the election. From this perspective, the “safer” lower US upside yield beta group includes the UK, France, Germany and Japan. The riskier higher US upside yield beta group includes Canada, Australia, New Zealand, Italy and Spain. Chart 12Favor Bond Markets Less Correlated to RISING UST Yields Spain and Italy are less likely to behave like typical high-beta countries as US yields rise, however, because the ECB is likely to remain an aggressive buyer of their government bonds as part of their asset purchase programs over the next 6-12 months. We also do not recommend trading UK Gilts off their yield beta to US Treasuries in the immediate future, given the uncertainties over the negotiations over a final Brexit deal. Both sets of US yield betas suggest higher-beta Canada, Australia and New Zealand are more at risk of relative underperformance versus lower-beta France, Germany and Japan. In terms of government bond country allocation, we recommend reducing exposure to the former group and increasing allocations to the latter group. Bottom Line: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields, especially those with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to “higher-beta” Canada and Australia.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 2 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 3 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 4 For more details on this recommended steepener trade please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 5 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 6 For a detailed look at the implications of the Fed’s policy shift please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com