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An analysis on Ukraine is available below.   Highlights A number of liquidity and technical reasons have led us to give benefit of the doubt to the bullish market action and chase this EM rally. We still doubt that the US-China trade truce alone is sufficient to propel a cyclical recovery in global trade and manufacturing. However, it seems the market is operating on a “buy now, ask questions later” principle. Therefore, we are initiating a long position in the EM equity index as of today. Despite the potential for higher EM share prices in absolute terms, we are still reluctant to upgrade EM versus DM stocks. The basis is that EM corporate profits will continue lagging those in DM. Feature We could be in for a replay of the 2012-2014 DM equity rally, where EM stocks rebounded in absolute terms but massively underperformed DM on a relative basis. Chart I-1EM Share Prices: In Absolute Terms And Relative To DM EM share prices have spiked on the announcement of a trade truce between the US and China. As a result, our buy stop at 1075 on the EM MSCI Equity Index has been triggered, and we are initiating a long position in EM stocks as of today (Chart I-1, top panel). That said, we are still reluctant to upgrade EM versus DM stocks. Regardless of the direction of the market (bull, bear or sideways), EM share prices will likely underperform the global equity benchmark. As we discussed in our report, the primary risk to our view has been that EM share prices get pulled higher as a result of rallying DM markets. Nevertheless, our fundamental assessment remains that EM corporate profits will lag those in DM, heralding EM relative equity underperformance. In fact, we could be in a replay of the 2012-2014 DM equity rally where EM stocks massively underperformed (Chart I-1, bottom panel), as we elaborated in our November 28 report. In this report, we review the indicators that support a bullish stance, the ones that are inconclusive and those that are not confirming the current rally in China-plays in general and EM risk assets in particular. Bullish Liquidity And Technical Settings The following points have led us to give benefit of the doubt to recent market action and to chase this rally: The global liquidity backdrop appears to be conducive for higher share prices. Global narrow and broad money growth have accelerated (Chart I-2). That said, a caveat is in order: These money measures do not always strongly correlate with both global share prices and the global business cycle. There are numerous times when they gave a false signal or were too early or late at turning points. Chart I-2Global Narrow And Broad Money: A Useful But Not Always Reliable Indicator   The technical profile of EM equities is rather bullish. As shown on the top panel of Chart I-1 on page 1, EM share prices have found a support at their six-year moving average. When a market fails to break down below its long-term technical support line, odds are that a major bottom has been reached, and the path of the least resistance is up. The reason we look at these long-term (multi-year) moving averages is because they have historically worked very well for key markets like the S&P 500 and 10-year US Treasury bond yields (Chart I-3A & I-3B). Chart I-3AThe Reason Why We Use Multi-Year Moving Averages Chart I-3BThe Reason Why We Use Multi-Year Moving Averages   As another positive development, both EM share prices in local currency terms and the EM equity total return index in US dollar terms have bounced from their three-year moving averages (Chart I-4). Chart I-4A Bullish Chart Formation For EM Equities In addition, when a market does not drop below its previous top, this creates a bullish chart configuration (Chart I-4). This seems to be the case with EM share prices currently. Bottom Line: A number of liquidity and technical reasons have led us to give benefit of the doubt to the bullish market action and to chase this rally. Inconclusive Indicators It is rare that all types of indicators – directional market, business cycle, valuation and technical – all line up together to convey the same investment recommendation. Below we present the market indicators and signals that we have been watching to get confirmation of sustainability in the bull market in EM risk assets, commodities and global cyclical equity sectors. They are still inconclusive: The US broad trade-weighted dollar has recently sold off, but it has not broken down technically (Chart I-5). A decisive relapse below its 200-day moving average will signify that the greenback has entered a major bear market. The latter would be consistent with a sustainable and extended bull market in EM risk assets, commodities and global cyclical equity sectors.  Chart I-5The US Dollar Has Fallen But Not Broken Down Chart I-6Indecisive Signals From Commodities And Commodity Currencies   Even though copper prices have recently rebounded, they have not yet broken above their three-year moving average (Chart I-6, top panel). The latter can be viewed as the neckline of the head-and-shoulders pattern that has formed in recent years. The same holds true for the overall London Metals Exchange Industrial Metals Price Index, as well as our Risk-On/Safe-Haven currency ratio1 (Chart I-6, middle and bottom panels). Barring a decisive break above their three-year moving averages, the jury is still out on the durability of the rally in commodities prices and EM/China plays.   Finally, global industrial share prices and US high-beta stocks have advanced to their 2018 highs, but have not yet broken out (Chart I-7). The same is true for the euro area aggregate stock index in local currency terms (Chart I-8). A decisive breakout above these levels will confirm that global equities in general and cyclical segments in particular are in an enduring bull market. Chart I-7Decisive Breakouts Here Are Needed To Confirm The EM Rally Chart I-8European Share Prices Are At A Critical Juncture   Bottom Line: Several cyclical and high-beta segments of global financial markets are at a critical juncture. A decisive breakout from these key technical levels is required for us to uphold that EM risk assets and global cyclical plays are in a medium-term bull market. The Eye Of The Storm? There are a number of leading indicators and market signals that do not corroborate the common narrative of a sustainable improvement in global manufacturing/trade in general and China’s industrial cycle in particular: First, China’s narrow and broad money growth appear to be rolling over (Chart I-9). Notably, the money impulses lead the credit impulse, as illustrated in Chart I-10. Consequently, we expect the credit impulse – which is the main indicator currently portraying a revival in the Chinese economy as well as in the global business cycle – to roll over in early 2020. Chart I-9China: Narrow And Broad Money Growth Are Rolling Over Chart I-10China: Money Impulses Are Coincident Or Lead Credit Impulse   This entails that the recent tentative improvements in China’s manufacturing, its imports and global trade will not be sustained going forward. Crucially, China’s narrow money (M1) growth point to the lack of a cyclical upturn in EM corporate profits in H1 2020 (Chart I-11). In short, EM listed companies’ profit growth rate stabilizing at around -10% is not a recovery. Second, government bond yields in both China and Korea are not corroborating a revival in their respective business cycles (Chart I-12). Chart I-11EM Corporate Profit Growth To Remain Negative In H1 2020 Chart I-12Asian Rates Are Not Confirming A Recovery   Chinese onshore interest rates have been a reliable compass for both its business cycle as well as EM share prices and currencies as we illustrated in Chart 15 of the November 28 report. For now, the mainland fixed-income market is not predicting an upturn in China’s industrial economy (Chart I-12, top panel). In Korea, exports account for 40% of GDP. Hence, without a considerable export recovery, there cannot be a business cycle revival in Korea. In brief, the latest relapse in local bond yields could be sending a downbeat signal for global trade (Chart I-12, bottom panel). Third, the four-month rise in the Chinese Caixin manufacturing PMI can be partially explained by front-running production and shipments of smartphones, laptops, computers and other electronics ahead of the December 15 round of US tariffs on imports from China. Right after President Trump announced these tariffs in the summer, businesses likely did not take a chance to wait and see. In fact, whether or not these tariffs would have come into effect was unknown till December 13. Manufacturers and US importers of these electronic goods initiated orders, produced and shipped these goods to the US ahead of December 15. Chart I-13Caixin And Taiwanese PMIs Benefited From Front Running Given the focus on that particular round of tariffs was electronics, producers of these goods got a temporary but notable boost from such front-running. Smartphone and electronics manufacturers and their suppliers are predominantly located in Shenzhen and Taiwan. The Caixin manufacturing PMI is a survey of 500 companies, many of which are private enterprises located in Shenzhen. Not surprisingly, the Caixin manufacturing PMI index often fluctuates with Taiwan’s electronics and optical PMI (Chart I-13). In brief, there has been meaningful improvement in China’s and Taiwan’s tech manufacturing. Yet it can be attributed to front-running of production and shipments of electronic products to the US ahead of the December 15 tariff deadline as well as stockpiling of semiconductors by China. The odds are that these measures of manufacturing will slump in early 2020 as the front-running ends. Chart I-14Commodities Prices In China Finally, several commodities prices in China, that troughed in late 2015 ahead of the bottom in global and EM/Chinese equities in early 2016, continue to drift lower or exhibit only a mild uptick. Specifically, these include prices of nickel, steel, iron ore, thermal coal, coke, polyethylene and rubber (Chart I-14). They corroborate that there has been no broad-based amelioration in the mainland’s industrial sector. Bottom Line: In China, narrow and broad money growth has rolled over, onshore interest rates are subsiding and many commodities prices are weak. All of these signify the lack of sustainable growth revival in China in the coming months.  Putting It All Together EM risk assets have rallied on the consensus market narrative that the temporary truce between the US and China will lift global growth. We have written at length that China’s domestic demand – not its exports – has been the epicenter of and basis for the global slowdown over the past two years. Without Chinese domestic demand and imports, not exports, staging a material amelioration, global trade and manufacturing are unlikely to experience a cyclical upturn.   In short, we doubt that the US-China trade truce is alone sufficient to propel a cyclical recovery in global trade and manufacturing. Yet, when the majority of investors perceive things the same way and act on these perceptions, asset prices can move a lot. We continue to believe that China’s industrial sector, global trade, EM ex-China domestic demand and consequently EM corporate profits will continue to disappoint in the first half of 2020. Nevertheless, we presently concede that we need to give benefit of the doubt to markets. We still doubt that the US-China trade truce alone is sufficient to propel a cyclical recovery in global trade and manufacturing. It could be that the EM equity and currency market rallies are not driven by their fundamentals – i.e., corporate profits/exports do not matter. However, it is rather possible that this rally is only stoked by the worst-kept secret in the investment industry: the search for yield. If that is the case, then there is no dichotomy between our fundamental thesis – that EM/China profits/growth will disappoint in H1 2020 – and the rally in EM markets. It seems the market is operating on a “buy now, ask questions later” principle. We had thought that the ongoing and enduring contraction in EM corporate profits (please refer to Chart I-11 on page 8) amid various structural malaises would overwhelm the impact of the global search for yield. However, it seems the market is operating on a “buy now, ask questions later” principle. Overall, we are initiating a long position in the EM equity index as of today. Provided the high uncertainty over the outlook, we are also instituting a stop point at 1050 for the MSCI EM equity index, 5% below its current level. For global equity investors, we continue recommending favoring DM over EM stocks. Finally, our country equity overweights are Korea, Thailand, Russia, central Europe, Pakistan, Vietnam and Mexico. A basket of these bourses is likely to outperform the EM equity benchmark in any market scenario in terms of EM absolute share price performance. We have been and remain neutral on Chinese, Indian, Taiwanese and Brazilian equities. As always, our list of overweight, underweight and market weight recommendations for EM equities, local and US dollar government bonds and currencies are available at the end of our report on pages 17-18 and on our website.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Ukraine: Buy Local Currency Bonds EM fixed-income investors should buy Ukraine local currency government bonds as well as overweight Ukraine sovereign credit within an EM credit portfolio. The exchange rate is the key for EM fixed-income investors. The Ukrainian hryvnia will be supported by high real interest rates, improving public debt and balance of payment dynamics, as well as abating geopolitical risks. In turn, a stable currency will keep inflation at bay. In such an environment, investors should favor local currency government bonds, as local interest rates will continue falling.  Chart II-1Inflation Will Fall Further In turn, a stable currency will keep inflation at bay (Chart II-1). In such an environment, investors should favor local currency government bonds, as local interest rates will continue falling. The primary risk of owning Ukrainian domestic bonds is a major depreciation in the hryvnia stemming from a risk-off phase in EM. However, as a periphery country, Ukraine’s financial markets might not correlate with their EM peers. Besides, these bonds offer high carry, which protects them against moderate currency depreciation. Overall, the case for buying Ukraine local currency government bonds is based on the following: First, Ukraine satisfies the two prerequisites for public debt sustainability, namely (1) it runs a robust primary fiscal surplus and/or (2) the government’s borrowing costs are below nominal GDP growth. The public debt-to-GDP ratio stands at 56% and will continue to fall so long as the above two conditions are satisfied. The primary consolidated fiscal surplus currently amounts to 1.8% of GDP (Chart II-2). The recently approved 2020 budget projects the primary surplus to be above 1% of GDP and the overall fiscal deficit to be close to 2% of GDP.  Local currency interest rates are below nominal GDP growth (Chart II-3). In addition, public debt servicing is at 3.2% and 9% as a share of GDP and total government expenditures, respectively. According to the new budget, the government plans to use close to 12% of total spending for debt repayments in 2020. This will further help reduce the public debt load. Chart II-2A Healthy Fiscal Position Chart II-3Interest Rates Are Below Nominal GDP Growth And Are Falling Second, the central bank has more scope to cut interest rates because various measures of inflation will continue falling. Real (adjusted for inflation) interest rates are still very elevated. In particular, the prime lending rate is at 17% for companies and 35% for households, both in nominal terms. Provided core inflation is running at 6%, lending rates are extremely high in real terms. Not surprisingly, narrow and broad money growth are sluggish (Chart II-4). Commercial banks are undergoing major balance sheet deleveraging: their asset growth is in the low single digits in nominal terms, while their value is dropping relative to nominal GDP (Chart II-5). Chart II-4Money Growth Is Sluggish Chart II-5Deleveraging In The Banking Sector Meanwhile, tighter regulations are forcing banks to recognize bad assets and boost their capital. This has led to a sharp drop in the number of registered banks. Such a structural overhaul of the banking system is cyclically deflationary and warrants lower interest rates. Critically, these reforms are a positive for the exchange rate in the long run. Third, receding foreign funding pressures are helping the balance of payments dynamics and are supportive for the currency. Ukrainian exports have been outperforming global exports since 2017 (Chart II-6). Agricultural exports – which represent 40% of total exports – are an important source of foreign currency revenue for the country. Chart II-6Ukraine Exports Are Outperforming Global Trade Chart II-7Tight Fiscal And Monetary Policies Are Good For The Current Account Balance The current account deficit has been narrowing due to slowing domestic demand, arising from tight fiscal and monetary policies (Chart II-7). Foreign ownership of local currency government bonds is $4.6 billion and it makes only 12% of total outstanding amount. Consequently, risk of major foreign portfolio capital outflows due to a risk-off phase in global markets is low. Lastly, Ukraine’s foreign debt obligations – the sum of short-term claims, interest payment and amortization – have been declining and are presently well covered by exports. They comprise 34% of total exports. Finally, geopolitical risks will continue to subside over the coming months. Peace talks between Ukraine and Russia will continue. Importantly, two sets of constraints could force Ukraine and Russia towards resolving the conflict. Specifically: Russia is constrained by its commitment to be a reliable gas supplier to the EU. Half of its gas export capacity passes through Ukraine. European demand for Russian gas is falling and Gazprom gas revenues are decelerating. Cutting transit of gas through Ukraine could now severely jeopardize Russia’s relations with Europe. Therefore, as much as Europe is dependent on Russian gas, Russia is as dependent on European demand for its natural gas.   The EU’s support for Ukraine is contingent on reliable transits of Russian gas into EU countries. As such, President Zelensky is under pressure from Europe to assure transmission of Russian gas to Europe. This has led Zelensky into opening a dialogue with Russia and motivated him to seek a new gas transit deal with Gazprom. Given President Zelensky’s high popularity at home, he has political capital to pursue a rapprochement with Russia and attempt to find a resolution to end the conflict in the Donbass. All of these developments have been, and will continue to be, positively perceived by international investors, sustaining the recent stampede into Ukraine’s fixed-income markets. Investment Recommendation We recommend investors purchase 5-year local currency government bonds currently yielding 12%. EM fixed-income investors should also consider overweighting US dollar sovereign bonds in an EM credit portfolio on the back of improving public debt and balance of payments dynamics.   Andrija Vesic Research Analyst andrijav@bcaresearch.com     Footnotes 1    The Risk-On/Safe-Haven currency ratio is the average of high-beta commodity currencies such as the CAD, AUD, NZD, BRL, CLP and ZAR total return (including carry) indices relative to the average of JPY and CHF total returns (including carry). This ratio is dollar-agnostic. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights OPEC 2.0 production discipline and the capital markets’ parsimony in re funding US shale-oil producers will restrain oil supply growth. Monetary and fiscal stimulus will revive EM demand. These fundamentals will push inventories lower, further backwardating forward curves. Base metals demand will pick up as EM income growth revives. Demand also will get a boost from the ceasefire in the Sino-US trade war. Gold will remain range-bound for most of next year: A weaker USD and rising inflation expectations are bullish, but rising bond yields and reduced trade tensions will be headwinds. Grain markets will drift, although dry conditions in Argentina and the trade-war ceasefire could provide short-term price support, along with a weaker USD. Risk to our view: Continued elevated global policy uncertainty would support a stronger USD and stymie central bank efforts to revive global growth in 2020. Feature Dear Client, We present our key views for 2020 in this issue of Commodity & Energy Strategy. This will be our last publication of 2019, and we would like to take the opportunity to thank you for your on-going interest in the commodity markets and in our publication. It has been our privilege to serve you. We wish you and your loved ones all the best of this beautiful Christmas season and a prosperous New Year in 2020! Robert Ryan Chief Commodity & Energy Strategist Going into 2020, policy uncertainty again will be a key driver of commodity demand, the Sino-US trade-war ceasefire and UK election results notwithstanding.1 As uncertainty has increased, demand for safe havens like the USD and gold have increased. The principal impact of this uncertainty shows up in FX markets. As uncertainty has increased, demand for safe havens like the USD and gold has increased. Indeed, the Fed’s Broad Trade-Weighted USD index for goods (TWIBG) has become highly correlated with the Global Economic Policy Uncertainty index (GEPU). The three-year rolling correlation between these indexes reached a record high in November 2019 (Chart of the Week).2 Individually, the record for the TWIBG was posted in September 2019, while the GEPU record was hit in August 2019. Chart of the WeekGlobal Economic Policy Uncertainty Highly Correlated With USD A strong USD affects commodity demand directly, because it slows income growth in EM economies – the engine-house of commodity demand. A stronger USD raises the local-currency cost of consuming commodities – an important driver of EM demand – and reduces the local-currency cost of producing commodities. So, at the margin, demand is pressured lower and supply growth is incentivized – together, these effects combine to push prices lower. Economic policy uncertainty likely will diminish in early 2020, following the Sino-US trade-war ceasefire, the decisive UK election results and continued central-bank signaling – particularly from the Fed – that rates policy will remain accommodative for the foreseeable future. That said, the ceasefire does not mark the end of the Sino-US trade war, and many issues – ongoing US-China tensions, US election uncertainty, global populism and nationalism, rising geopolitical tensions in the Persian Gulf, ad hoc monetary policy globally – still are to be resolved. Terra Incognita The GEPU index does not measure uncertainty per se, as uncertainty per se cannot be measured.3 The index picks up word usage connected with the word “uncertainty.” So, it is more the perception of uncertainty that is being reported by Economic Policy Uncertainty in its data. Nonetheless, this is a good way to measure such sentiment, as research from the St. Louis Fed found: “Increases in the economic uncertainty index tend to be associated with declines (or slower growth) in real GDP and in real business fixed investment.” In past three years, increased policy uncertainty also has been fueling demand for safe havens, chiefly the USD and gold. This is a highly unusual coincidence – i.e., a rising USD accompanied by a rising gold price. Typically, a weaker USD puts a bid under gold prices. Indeed, this relationship is one of the primary drivers of our gold model, which suggests the effect of the heightened policy uncertainty dominates the USD impact on gold prices in the current environment (Chart 2). Chart 2Gold Typically Rallies When the USD Weakens The flip-side of the deleterious effects of higher economic policy uncertainty is its resolution: Growing cash balances and a higher capacity to lever balance sheets of households, firms and investor accounts means there is a lot of dry powder available to recharge growth in the real and financial economies globally.4 Chart 3BCA's Grwowth Gauges Indicate Global Economy Rebounding Our commodity-driven economic activity gauges are picking up growth impulses, most likely in response to the global monetary stimulus that has been deployed this year (Chart 3). In addition, systemically important central banks have given no indication they are going to be reversing this stimulus. A meaningful reduction in uncertainty could turbo-charge global growth prospects. Below, we provide our key views for each of the commodity complexes we cover. Oil Outlook Energy: Overweight. The oil market is poised to move higher on the back of OPEC 2.0’s deepening of production cuts to 1.7mm b/d, mostly because of actions by the Kingdom of Saudi Arabia (KSA) to cut output deeper, to a total of close to 900k b/d vs. its October 2018 production levels.5 Combined with the loss of ~ 1.9mm b/d of production in Iran and Venezuela due to US sanctions, the supply side can be expected to tighten next year (Chart 4). The Vienna meeting – which ended December 6, 2019 – demonstrated commitment to OPEC 2.0’s production-restraint strategy, and we expect member states will deliver. At least they will reduce the incidence of free riding at KSA’s expense – there were subtle hints from the Saudis they will not tolerate such behavior. KSA’s threats in this regard are credible, given its follow-through in 1986 when they surged production and briefly drove WTI prices below $10/bbl to send a message to free riders in the OPEC cartel. The Saudis acted similarly during the 2014 – 2016 market share war. US shale-oil production growth will slow next year to 800k b/d y/y, vs. the 1.35mm b/d we expect for this year. US lower 48 crude production will increase to 10.7mm b/d in 2020, taking total US production to 13.1mm b/d, a ~ 850k b/d increase y/y. On the demand side, we lowered our expectation for 2019 growth to 1.0mm b/d, given the continued downgrades of historical consumption estimates this year from the EIA, IEA and OPEC. Nonetheless, we continue to expect 2020 growth of 1.4mm b/d, on the back of continued easing of global financial conditions, led by central-bank accommodation. Given our view, we remain long oil exposures in several ways. First, we remain long WTI futures outright going into 2020; this position is up 30% from January 3, 2019 when it was initiated. Second, we recommended getting long 2H20 vs. short 2H21 Brent futures, expecting crude oil forward curves to backwardate further as tighter supply and stronger demand force refiners to draw inventories harder next year (Chart 5). Chart 4Markets Will Tighten In 2020 Chart 5Oil Inventories Will Draw Harder In 2020 We expect Brent crude oil to average $67/bbl next year, given the fundamentals outlined above. We also expect a weaker dollar to be supportive of demand ex-US. WTI will trade at a $4/bbl discount to Brent next year, based on our modeling (Chart 6). Chart 6Brent, WTI Will Trade Higher We remain overweight energy, crude oil in particular, given our expectation markets will tighten on the supply side and demand growth, particularly in EM economies, will revive. Bottom Line: We remain overweight energy, crude oil in particular, given our expectation markets will tighten on the supply side and demand growth, particularly in EM economies, will revive. This expectation will be challenged by continued economic policy uncertainty. On the flip side, however, a meaningful resolution to this uncertainty could turbo-charge growth as real economic activity picks up and the USD weakens. Base Metals Outlook Base Metals: Neutral. We remain strategically neutral base metals going into 2020, but tactically bullish, carrying a long LMEX and iron-ore spread position into the new year.6 The behavior of base metals prices – used by economists as proxies for EM growth – is indicating industrial demand is picking up (Chart 7). This aligns well with our proprietary indicators of commodity demand and global industrial activity (Chart 8). Base metals prices are more sensitive to changes in global growth than other commodities. For this reason, we use these prices to confirm the signals coming from the proprietary models we use to gauge EM growth. Chart 7Base Metals Prices Signaling EM Growth Revival The so-called phase-one agreement to reduce tariffs in the Sino-US trade war will support global demand at the margin for base metals. This is a ceasefire in the trade war not a resolution, so we are not expecting a surge in demand. Chart 8BCA Proprietary Indicators Also Signaling Growth Revival That said, base metals – aluminum and copper, in particular – have a tailwind in the form of global monetary accommodation by central banks. This was undertaken to reverse the negative effect on global financial conditions brought about by the Fed’s rates normalization policy last year and China’s 2017-18 deleveraging campaign. In addition, our China strategists expect modest fiscal and monetary stimulus from Beijing, which also will be supportive of demand.7 Aluminium and copper comprise 75% of the LMEX index. These are primary industrial markets, in which China accounts for ~ 50% of global demand, and EM ex-China demand remains stout. Even with a trade war raging for most of 2019, the supply and demand of aluminum and copper – the largest components of the LMEX index – was diverging: Consumption outpaced production – a multi-year trend – which forced inventories to draw hard (Charts 9A and 9B). Chart 9AGlobal Aluminum Markets Getting Tighter … Chart 9B… As Are Copper Markets Bottom Line: Inventories in industrial-metals markets have been drawing hard for years – particularly in aluminum – as metals' demand remained above supply. Given this, we are long the LMEX index: Even a marginal growth pick-up could rally prices. Precious Metals Outlook Precious Metals: Neutral. Going into 2020, gold’s outlook could be volatile – especially in 1H20 – as the metal’s key drivers will send conflicting signals (Table 1). Table 1Fundamental And Technical Gold-Price Drivers Gold prices are holding up above $1,450/oz. Our latest fair-value estimate indicates gold will hover around $1,475/Oz over the short-term (Chart 10). We break next year’s gold forecast into two parts: Phase 1: Growth revival and uncertainty respite. These two factors are closely intertwined; the magnitude of global growth’s rebound is conditional on a reduction of global economic policy uncertainty. We expect this relief will come from a ceasefire in the US-China trade war. Combined, accelerating economic activity – mainly driven by EM economies – and falling uncertainty will push the US dollar lower.8 For gold prices, this phase will be characterized by two contrasting forces: A falling USD (bullish gold) vs. lower safe-haven demand and rising US interest rates (bearish gold). US rates will increase early next year as global uncertainty is reduced and bond markets price-out Fed rates cuts. The current unusually high correlation between gold and US rates implies gold will face selling pressures during this period (Chart 11). Nonetheless, we expect the Fed will stay on hold and not start raising rates next year, which will cap price risks to gold. Chart 10High USD Correlation Throws Off Fair-Value Model Gold Prices Will Rise 4Q20 Chart 11US Rates Could Hurt Gold Prices In 1H20 Phase 2: EM wealth effect and inflation rebound. As income growth accelerates, EM households will slowly accumulate jewelry, coins, and bars – of which China and India are the largest consumers. Demand pressure from these consumers will manifest itself in 2H20, adding to buoyant central-banks purchases of gold. The upside in bond yields will be limited by major central banks’ dovish stance until inflation is well-established above target. Closely monitoring the evolution of inflation will become increasingly important in 2020, given inflation pressures are building in the US and globally (Chart 12). A lower USD – supporting stronger commodity demand – will magnify global inflation trends (Chart 13). There is a very real risk inflation shoots up in 4Q20, keeping real rates low. This differs from our BCA House view, which does not see inflation pressures building until 2021. Chart 12Inflationary Pressures Are Building Up In The US And Globally Political uncertainty likely will return ahead of the 2020 US election. A resurgence in popular support for one of the progressive Democratic candidates – Elizabeth Warren or Bernie Sanders – could disrupt US stock markets. Gold would advance in such an environment. Chart 13No Inflation Without A Weaker USD Progressive populists would lead to domestic policy uncertainty and larger budget deficits, yet would not remove the threat of trade protectionism. We expect the Fed will stay on hold and not start raising rates next year, which will cap price risks to gold. Bottom Line: Gold prices will move sideways in 1H20 and will drift higher in 4Q20 supported by depressed real rates, a lower dollar, and US election uncertainty. Silver Market Chart 14Silver Prices Will Move Higher With Gold Prices Silver prices have traded closely with gold since the Global Financial Crisis (GFC), moreso than with industrial metals (Chart 14). Prior to the GFC, silver traded like a base metal, owing to the high growth rates in EM economies undergoing rapid industrialization. Post-GFC, the evolution of silver’s price more closely tracked gold prices, following the massive injections of money and credit by central banks globally. Thus, we expect it will continue to follow the evolution of gold prices outlined above. Nonetheless, industrial applications still represent ~ 50% of silver’s physical demand and its supply-demand balance is estimated to have been tight this year. Silver likely will outperform gold next year as global growth and industrial activity rebound. PGM Markets The palladium market will remain tight in 2020. According to Johnson Matthey, the 10-year-long supply deficit is expected to widen massively this year, when all’s said and done. Prices surpassed $1,900/oz in December, forcing inventory liquidation (Chart 15). We believe the platinum-to-palladium ratio is at a level that would incentivize substitution in the pollution-control technology in gasoline-powered engines, and supports higher platinum content in diesel catalyzers (Chart 16).9 Nonetheless, swapping palladium for platinum is complex and requires a redesign of the production process. A lot will depend on how much the added cost of the more expensive palladium affects new-car buyers’ demand.10 To date, there are no signs car makers have already – or are willing to – initiate this process on a significant scale. Chart 15Palladium Inventories Are Depleted A few factors need to align to incentivize substitution of palladium for platinum. The price ratio between the two metals should reach extreme levels; the price divergence should be expected to last for a prolonged period of time, and concerns over supply security of platinum should be low. Chart 16Relative Inventory levels Drive The Palladium To Platinum Price Ratio In today’s context, this last condition could slow substitution. South African platinum supply – which represents close to 73% of the world primary supply – is projected to fall by close to 3% next year. Automakers need stable platinum supplies as they increase their demand for the metal and with persistent power-supply issues in South Africa – exacerbated by recent flooding – this condition will be hard to meet. No market has been harder hit by the Sino-US trade war than grains and ags generally. Thus, palladium holds an advantage over platinum on that front. Its supply sources are more diversified, and with 15% comes from stable North American countries and 40% comes from Russia. We believe substitution will commence, but this is a gradual process and will only slowly affect the metals’ price ratio.11 For 2020, we expect palladium prices to continue increasing due to stricter pollution regulation in China, India, and Europe.12 Ag Outlook Chart 17Sino-US Trade War, USD Hammer Grain Prices Ags/Softs: Underweight. The final form of the ceasefire in the Sino-US trade war – i.e., the “phase one” deal between China and the US to roll back tariffs – has yet to show itself. Last Friday, US Trade Representative Robert Lighthizer stated China has agreed to buy $32 billion – over the next two years – of US ag products as part of a “phase one” deal. This news moved corn, wheat and beans prices up 6.3%, 3.2%, and 3.4% respectively as of Tuesday’s close. Another positive news for US farmers was an announcement from the USDA that the final $3.6 billion of the $14.5 billion budgeted for farm subsidies this year to offset the trade war impact on US farmers most likely would be made in the near future by the Trump administration.13 No market has been harder hit by the Sino-US trade war than grains and ags generally. Severe weather across much of the US Midwest should have produced a rally, as offshore demand competed for available supply, which likely would have been lower at the margin last year absent a trade war. Instead, corn, wheat and beans are going into 2020 pretty much at the same price levels they went into 2019. In addition to the deleterious effect of the US-China trade war, ag markets have been particularly hard hit by the strong USD, which makes exports from the US expensive relative to alternative suppliers – e.g., Argentina and Brazil, which are posing serious challenges to US farmers (Chart 17).   Global inventories are, nonetheless, being whittled away, which is good news for farmers generally (Chart 18). And, this likely will continue in 2020, given the physical deficits expected this year (Chart 19). Chart 18GLOBAL GRAIN STOCKS BEING WHITTLED DOWN ... Chart 19... Physical Deficits Will Whittle Stocks Further Next Year Markets are still awaiting final details of the ceasefire in the Sino-US trade war. The deal is expected to be signed in the first week of January. 2020 could be the year the global ag markets come more into balance, with stocks-to-use levels falling and normal trade resuming. We are not inclined to take a view on this possibility and are therefore remaining underweight the ag complex. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1 Our outlook last year was entitled 2019 Key Views: Policy-Induced Volatility Will Drive Markets. It was published December 13, 2018, and is available at ces.bcaresearch.com. This year’s outlook again reflects our House view, which was published in the Bank Credit Analyst on November 28, 2019, entitled OUTLOOK 2020: Heading Into The End Game. It was sent to all clients last month and is available at bca.bcaresearch.com. 2 Uncertainty is measured using the Baker-Bloom-Davis Global Economic Policy Uncertainty (GEPU) index. GEPU is a monthly GDP-weighted index of newspaper headlines containing a list of words related to three categories – “economy,” “policy” and “uncertainty.” Newspapers from 20 countries representing almost 80% of global GDP (on an exchange rates-weighted basis) are scoured monthly to create the index. Please see Economic Policy Uncertainty for additional information. We use the Fed's USD broad trade-weighted index for goods (TWIBG) reported by the St. Louis Fed to track the USD. Please see the St. Louis Fed’s FRED website at Trade Weighted U.S. Dollar Index: Broad, Goods. 3In a June 2011 interview with the Minneapolis Fed, Ricardo Caballero, a professor of economics at MIT, provided a succinct description of risk and uncertainty, paraphrasing former US Defense Secretary under President George W. Bush Donald Rumsfeld: “(W)hen he talked about the difference between known unknowns and unknown unknowns. The former is risk; the latter is uncertainty. Risk has a more or less well-defined set of outcomes and probabilities associated with them. Uncertainty does not—things are much less clear.” Kevin L. Kliesen of the St. Louis Fed explores the link between rising uncertainty and slower economic growth in Uncertainty and the Economy (April 2013), observing, “If the business and financial community believes the near-term outlook is murkier than usual, then the pace of hiring and outlays for capital spending projects may be unnecessarily constrained, thereby slowing the overall pace of economic activity.” 4The Wall Street Journal reported investors have accumulated a $3.4 trillion cash position, a decade-high level; this is consistent with the risk aversion that can be expected when economic uncertainty is high. Please see Ready to Boost Stocks: Investors’ Multitrillion Cash Hoard, published by The Wall Street Journal November 5, 2019. 5 Accounting for Saudi Arabia's 400k b/d of additional voluntary cuts. 6 The LMEX no long trades on the LME, but we are using the index as a proxy for a position. In iron ore, we are long December 2020 65% Fe futures vs. short 62% Fe futures on the Singapore Exchange, expecting steelmakers will favor the high-grade material in the new mills they’ve brought on line. 7 Our China strategists expect “Chinese policymakers will roll out more stimulus to secure an economic recovery in 2020, and external demand will improve. But we expect growth in both the domestic economy and exports to only modestly accelerate.” Please see 2020 Key Views: Four Themes For China In The Coming Year, published by BCA Research’s China Investment Strategy December 11, 2019. It is available at cis.bcareserach.com. 8 The US dollar is a countercyclical – i.e. it is inversely correlated with the global business cycle – due to the fact that the US economy is driven more by services than manufacturing. 9 Palladium is used mostly in pollution-abatement catalysts in gasoline-powered cars, while Platinum is favored in diesel-engine cars (along with a small amount of palladium). Catalysts production represents close to 80% and 45% of palladium's and platinum's total demand. 10 Considering there’s ~ 3.5g of palladium in a new car and palladium trades at ~ $1,900/oz, close to $240 is added to the cost of a new gasoline-powered car by using this metal in pollution-abatement technology. 11 Please see South African Mines Grind To Halt As Floods Deepen Power Crisis, published by reuters.com on December 10, 2019. 12 Stricter emissions standards in the car industry – mainly in China where China 6 emissions legislation is taking effect – are increasing the PGMs loadings in each car, supporting demand growth. 13 Please see China May Agree to Buy U.S. Ag Exports, But a Final Tranche of Cash to Farmers is Still Likely, published by agriculture.com’s Successful Farming news service. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Trades Closed

  Overweight The large cap size bias is our sole hold out from last year’s high-conviction list despite getting stopped out and booking a handsome 9% profit. We recommend reinstating a large cap size bias. This call actually represents a slight hedge on BCA’s overall higher interest rates view for next year. Financials comprise 13% of the SPX, but the weight jumps to 18% in small cap indexes. Thus, if the rising interest view is off the mark, the large cap bias will provide an offset. Relative forward profit growth favors mega caps and by a wide margin. One key factor underpinning this increasing profit gap is the massive profit margin divergence. Tack on the fact that index providers omit negative forward profits from their index EPS calculations and the narrative that small caps have cheapened versus large caps falls flat on an adjusted basis. Why? Because a large number of small caps have negative forward EPS. Moreover, we recently created a relative employment proxy that is firing on all cylinders. Not only is the small business labor market crumbling according to the latest NFIB survey, but hard data also suggest that nonfarm private small business payroll employment has ground to a halt. Finally, small caps are debt saddled compared with large caps and small cap b/s have actually been degrading of late.

Informe especial

This is the final report of the year from BCA’s Global Fixed Income and US Bond Strategies. Our regular publication schedule will resume on January 7, 2020. We wish you a happy, healthy and prosperous new year.   Highlights Interest Rate Policy: The Fed’s next interest rate move will be a hike, but it probably won’t occur until 2021. It will not occur until either long-maturity TIPS breakeven inflation rates reach our target band of 2.3%-2.5% or financial asset valuations reach extreme levels. We provide several indicators to monitor to assess the timing of the next Fed hike. Balance Sheet Policy: The era of balance sheet shrinkage is over. The Fed will continue to grow its balance sheet in 2020, and will also tweak regulations to make banks more indifferent between holding Treasury securities and reserves. Strategic Review: The exact form of any new policy strategy is uncertain, but we expect the Fed to make an announcement in mid-2020 that makes it clear that it will explicitly target above-2% inflation for some unspecified period of time in order to re-anchor inflation expectations and make up for past inflation misses. Feature Last week, both our Global Fixed Income Strategy and US Bond Strategy services published their key fixed income views for 2020.1  Those reports presented investment ideas that we think will be profitable next year, but only discussed Fed policy to the extent that it informs those views. This Special Report delves into exactly what we expect to see from the US Federal Reserve in 2020. Specifically, we consider what the Fed will do with its interest rate and balance sheet policies in 2020, and also what might result from the Fed’s ongoing strategic review. Interest Rate Policy The final FOMC meeting of 2019 took place last week, and we learned that the Fed’s reaction function underwent a significant dovish shift between the September and December meetings. Currently, only 4 FOMC participants expect to lift rates in 2020 while the remaining 13 expect the funds rate to stay in its present range between 1.5% and 1.75% (Chart 1). Back in September, 9 participants thought the fed funds rate would be above 1.75% by the end of 2020. Chart 1Fed Will Stay On Hold In 2020, Market Still Priced For Cuts The yield curve is still discounting a slight decline in the funds rate next year, and the Fed will of course deliver more rate cuts if economic growth deteriorates. However, given our positive global growth outlook for 2020, we think rate cuts are unlikely.2 Rather, we expect a flat fed funds rate next year followed by rate hikes in 2021. The Fed’s reaction function underwent a significant dovish shift between the September and December meetings.  If our economic view pans out, then getting a sense of what will be required for the Fed to lift rates is the most pressing monetary policy issue. On that front, we continue to believe that inflation expectations and financial conditions are the two most important factors to monitor.3  Recent remarks from Fed officials have only strengthened our conviction in that view. Inflation Expectations & The Fed’s Phillips Curve Model Last week, when Chair Powell was asked what it will take to lift rates again, he said that he wants to see “a significant move up in inflation that’s also persistent”. This scripted response reveals a lot about the Fed’s reaction function in 2020, and about the importance of inflation expectations. To see why, let’s consider the Expectations-Augmented Phillips Curve, the typical model that the Fed uses to assess trends in inflation. An example of this sort of model, taken from a 2015 Janet Yellen speech, is presented in Box 1.4 Box 1The Fed's Inflation Model According to the Fed’s model, core inflation is determined by: (i) inflation expectations, (ii) resource utilization and (iii) relative import prices. But inflation expectations are especially important because they determine inflation’s long-run trend. As explained by former Chair Yellen: Chart 2The Importance Of Inflation Expectations … economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to deviate from its longer-term trend that is ultimately determined by long-run inflation expectations. This is what Chair Powell means when he says he wants to see a “persistent” move up in inflation. He wants to make sure that inflation expectations return to levels that are consistent with the Fed’s target in order to re-anchor inflation’s long-run trend. The widespread consensus that the “Phillips Curve is flat” makes inflation expectations even more important in the minds of Fed policymakers. When people say that the “Phillips Curve is flat”, they mean that there is very little relationship between resource utilization and inflation. In other words, the coefficient b4 in Box 1 is very small. Logically, if the relationship between resource utilization and inflation is weak, then expectations become an even more important driver of core inflation. As Fed Vice Chair Richard Clarida recently said:5 A flatter Phillips Curve makes it all the more important that inflation expectations remain anchored at levels consistent with our 2 percent inflation objective. Simply put, the Fed needs to see a re-anchoring of inflation expectations before it lifts rates. Our sense is that this will be achieved when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%. We are not yet close to those levels. The 10-year and 5-year/5-year forward TIPS breakeven rates currently sit at 1.71% and 1.79%, respectively (Chart 2). Meanwhile, household survey measures from the University of Michigan and the New York Fed also show very low inflation expectations (Chart 2, bottom 2 panels). With all this in mind, the big question for monetary policy is how long will it take for inflation expectations to rise back to “well anchored” levels? Will it occur next year, or not until 2021? How Long Until Inflation (And Inflation Expectations) Return To Target? Chart 3High Inflation No Longer A Worry We have long held the view that inflation expectations adapt only slowly to changes in the actual inflation data.6 In other words, inflation expectations are low today because actual inflation has been consistently below the Fed’s target for much of the past decade. This makes it very difficult for people to believe that inflation will be high in the future. In fact, when asked what CPI inflation is likely to average over the next 10 years, most forecasters think it will be in a range between 2% and 2.5%, consistent with the Fed’s target.7 This is similar to what forecasters thought in 2004 when TIPS breakeven rates were well-anchored within our target band (Chart 3). The main difference between 2004 and today is that in 2004 a sizeable minority thought inflation might average above 2.5% over the next 10 years. Now, almost nobody expects a significant overshoot of the Fed’s inflation target, and a sizeable minority think inflation will undershoot. The lesson we take from these survey responses is that in order for TIPS breakeven inflation rates to reach our 2.3%-2.5% target, more people need to expect a significant overshoot of the Fed’s 2% inflation target. This will only happen if actual inflation rises to the Fed’s target, or above, and stays there for a significant period of time. Long enough to bring the fear of high inflation back to the forefront of investors’ minds. To further quantify this notion, our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate pegs current fair value for the 10-year breakeven at 1.94% (Chart 4). The model’s fair value is primarily determined by the 10-year rate of change in core CPI, meaning that a prolonged period of year-over-year core inflation near (or above) the Fed’s target will be required before our model’s fair value pushes above 2.3%. So how long will it take before core inflation is sustainably running at, or above, the Fed’s target? While we expect core inflation to continue along its slow upward trend. It probably won’t be high enough to push long-maturity TIPS breakevens into our target range until 2021, or late-2020 at the earliest. Chart 4Adaptive Expectations Model Chart 5Trimmed Means Are Rising... At present, core PCE inflation is running at a year-over-year rate of 1.59%, considerably below the Fed’s 2% target. One point in favor of rising core inflation is that trimmed mean price measures are accelerating more quickly than core measures (Chart 5). This will tend to drag core inflation higher over time. However, there is still a long way to go before core inflation reaches the Fed’s target and many leading inflation indicators have moderated this year (Chart 6):   Chart 6...But Many Headwinds Remain Unit labor cost growth rebounded in the past few quarters, but has yet to break out of its post-crisis range (Chart 6, top panel). The New York Fed’s Underlying Inflation Gauge rolled over sharply in 2019 (Chart 6, panel 2). NFIB surveys of planned and reported price increases have also turned down (Chart 6, bottom 2 panels). Considering the main components of core inflation, we find that the strong month-over-month core inflation prints of June, July and August were driven mostly by accelerating goods prices (Chart 7). Goods inflation has reversed course since then, and should continue to be a drag on core inflation going forward. This is because core goods inflation follows import price inflation with a long lag, and some import price deflation is already baked in (Chart 8). Chart 7CPI Components Chart 8Expect Some Import Price Deflation On the flipside, we have also seen core services inflation (excluding shelter and medical care) inflect higher during the past six months (Chart 7, panel 4). Continued strength in this component is essential if overall core inflation is going to move up. Shelter is the largest component of core inflation and we expect it to trend sideways as we head into 2020. The rental vacancy rate has flattened off at a low level, and the Apartment Market Tightness Index is just barely in net tightening territory (Chart 9). Neither indicator is sending a strong signal in either direction. Chart 9Shelter Inflation Trending Sideways All in all, we see core inflation and TIPS breakeven rates moving slowly higher in 2020. But it will take some time before inflation is strong enough to push long-maturity breakeven rates into our target range of 2.3%-2.5%. Given the importance placed on re-anchoring inflation expectations, the Fed won’t hike rates again until our TIPS breakeven target is met. We don’t expect this to occur until 2021, or late-2020 at the earliest. The Financial Conditions Wildcard Chart 10The Importance Of Financial Conditions We mentioned above that the Fed’s interest rate policy will be determined by two factors: inflation expectations and financial conditions. In a perfect world, financial market valuations will stay at reasonable levels and inflation expectations will determine the timing of the next Fed rate hike. However, we must also consider what is likely to happen if it takes a very long time for inflation expectations to reach our target. The longer it takes, the longer that monetary conditions will be accommodative, and any extended period of easy money could lead to an asset bubble. Eventually, if valuations look bubbly enough, there may be a case for the Fed to sacrifice a bit on its inflation target and attempt to deflate a potentially de-stabilizing bubble in financial markets. This is not just a hypothetical situation. As Governor Lael Brainard remarked last December:8 The last several times resource utilization approached levels similar to today, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation. With greater focus on financial stability than in the past, it is conceivable that we could eventually see Fed tightening to head off an asset bubble. But we are not close to such bubbly conditions yet (Chart 10). The Financial Conditions component of our Fed Monitor is close to neutral, and while corporate bond spreads are tighter than average, they are well above the lows seen in the mid-2000s. Meanwhile, the S&P 500’s forward multiple is not yet back to its early-2018 level, let alone the highs of the late 1990s (Chart 10, bottom panel). Bottom Line: The Fed’s next interest rate move will be a hike, but it probably won’t occur until 2021. It will not occur until either long-maturity TIPS breakeven inflation rates reach our target band of 2.3%-2.5% or financial asset valuations reach extreme levels. Balance Sheet Policy 2019 was a tumultuous year for the Fed’s balance sheet policy. At the start of the year, the Fed was continuing the process of balance sheet shrinkage that started in October 2017. The goal was never to return the Fed’s balance sheet to its pre-crisis size. Policymakers had already decided that they would shift permanently to a floor system of monetary policy implementation. A floor system is one where the central bank supplies more reserves to the banking system than are demanded, pushing interest rates down toward a floor that is set by the Fed. In this case, the floor is the Fed’s overnight reverse repo facility (ON RRP). Using this facility, the Fed agrees to borrow any excess cash at the ON RRP rate in return for a security from the Fed’s balance sheet as collateral. To implement this policy correctly, the Fed’s balance sheet must remain large so that bank reserves are plentiful. The Fed thought that it was supplying more reserves than the banking system demanded, but banks found themselves hoarding liquidity for a few days in September. Everything was going smoothly until September when this strategy hit a snag. The Fed thought that it was supplying more reserves than the banking system demanded, but banks found themselves hoarding liquidity for a few days in September. The result was that the fed funds rate shot higher, and actually printed outside the Fed’s target band for one day (Chart 11).9 Chart 11The Fed Briefly Lost Control Of Rates In September Clearly, the Fed had actually not been supplying the banking system with more reserves than it wanted, otherwise overnight liquidity would have remained plentiful throughout September. Even more vexing is that surveys of primary dealers and market participants all showed that reserve supply was comfortably above demand (Chart 12), even though this turned out not to be the case. Chart 12The Fed Was Blindsided Though there are many questions that still need to be answered, the Fed quickly took action and intervened in the repo market to increase the daily reserve supply. It also re-started T-bill purchases at a rate of $60 billion per month, ending the period of balance sheet shrinkage. Then just last week, the Fed announced a program of term repo agreements that will increase overnight liquidity heading into the volatile year-end period. After all that, the Fed’s balance sheet is once again growing as we head into 2020. But there is much uncertainty about how the balance sheet will evolve during the next 12 months.  A Two-Pronged Strategy In 2020 the Fed will attack its balance sheet problems on two fronts. 1) Increase Reserve Supply First, it will purchase T-bills in order to increase the supply of reserves. Chart 13 shows how the Fed’s securities holdings and bank reserves will evolve in the first half of 2020, assuming that the Fed buys $60 billion of T-bills per month. We also assume that maturing MBS roll over into Treasury securities and that currency in circulation grows at a rate of 5% per year. Table 1 gives a breakdown of what the Fed’s balance sheet looks like today and what it will look like at the end of June, according to our assumptions. Chart 13The Fed's Balance Sheet Over Time But increasing the reserve supply will be a bit more difficult than that. For one thing, Table 1 shows that the Treasury Department’s General Account at the Fed is expected to grow by another $106 billion. All else equal, this will drain $106 billion of reserve supply. The Treasury depleted its cash holdings down to $130 billion in August, as it took extraordinary measures to stay under the debt ceiling. But now that the debt ceiling has been suspended until July 2021, the Treasury has been re-building its cash stores, targeting a level of $410 billion. Table 1Fed’s Balance Sheet: Projections Second, Table 1 assumes that Fed repos stay flat at $213 billion. But if the Fed decides to extricate itself from the repo market in the first half of 2020 then, all else equal, reserve supply will shrink by $213 billion. So far the Fed has provided very little guidance about its future presence in the repo market, but we expect it to err on the side of caution. That is, the Fed will not completely unwind its repo operations until it is confident that reserve supply is comfortably above demand. What we can say for certain is that the Fed will try to increase the reserve supply in early-2020. Then, at some point during the year, it will decide that the reserve supply is high enough and it will shift to purchasing only enough securities to keep pace with growth in non-reserve liabilities, holding reserve supply flat. It is unknown when that shift will occur, but whenever it does, the Fed’s balance sheet will still be growing, just more slowly. We can say decisively that the era of balance sheet shrinkage is over. At some point in 2020 the Fed will probably also introduce a standing repo facility. This will act as the mirror image of the current ON RRP, providing a ceiling on interest rates. The facility will promise to supply overnight cash at a stated rate in return for Treasury collateral. If reserve supply is sufficiently high, then the standing repo facility is irrelevant. It would merely be a safety measure in case of periods like last September when reserve demand spiked. 2) Decrease Reserve Demand Other than increasing reserve supply, the Fed will also take steps in 2020 to reduce the amount of reserves demanded by the banking sector. It will do this by tweaking some banking regulations that possibly encouraged banks to hoard reserves in September. The Liquidity Coverage Ratio is the regulation that requires banks to hold enough high-quality liquid assets (HQLA) to cover 30 days of cash outflows in a stressed scenario. Bank reserves and Treasury securities both count as HQLAs, as do other fixed income securities with a haircut. In theory, the Liquidity Coverage Ratio shouldn’t prevent banks from swapping reserves for Treasuries in the repo market. But banks also undergo frequent internal stress testing, in preparation for the Fed’s periodic stress tests, and those internal tests may place a premium on reserves over Treasuries. It is very likely that, in 2020, the Fed will take steps to make banks increasingly indifferent between holding reserves and Treasury securities. This should reduce overall reserve demand and make cash more freely available in the overnight repo market. Investment Implications With all that said, we place very little importance on the Fed’s balance sheet policy in terms of what it means for asset returns. Our longstanding view is that asset purchases were only an effective policy tool because they reinforced the Fed’s forward guidance about changes in the funds rate. In fact, any perceived correlation between changes in the size of the Fed’s balance sheet and financial asset prices is only because balance sheet policy was moving in the same direction as interest rate policy. That is, during the past few years, periods of Fed asset purchases have always coincided with easier interest rate policy and periods of balance sheet shrinkage have always coincided with tighter interest rate policy. It is the interest rate policy that determines movements in asset prices, not the balance sheet. Finally, in 2019, we witnessed a period when balance sheet policy diverged from interest rate policy and we were able to test our thesis. Between December 2018 and July 2019, the Fed was shrinking its balance sheet but also easing its forward rate guidance and preparing for rate cuts. Outstanding bank reserves fell by $124 billion, but the expected 12-month change in the fed funds rate fell from +11 bps to -88 bps. It is very likely that, in 2020, the Fed will take steps to make banks increasingly indifferent between holding reserves and Treasury securities. What happened during this period? Bond yields declined and the dollar depreciated (Chart 14). Meanwhile, risk asset prices shot higher (Chart 15). In other words, markets behaved as you would expect if the Fed were easing policy, clearly taking their cues from interest rate policy not the balance sheet. Chart 14Rates Policy Trumps Balance Sheet Part I Chart 15Rates Policy Trumps Balance Sheet Part II Bottom Line: The era of balance sheet shrinkage is over. The Fed will continue to grow its balance sheet in 2020, and will also tweak regulations to make banks more indifferent between holding Treasury securities and reserves. But more importantly, the Fed’s balance sheet policy is now completely de-linked from its interest rate policy. That being the case, investors should largely ignore trends in the Fed’s balance sheet and focus on interest rate policy as the main driver of asset returns. The Fed’s Strategic Review The Fed is currently undertaking a strategic review of its monetary policy strategy, tools and communications practices. Chair Powell has said that he expects the review to be completed by the middle of 2020, and it is likely that some important changes will be announced. According to the Fed, the review is taking place because “the US economy appears to have changed in ways that matter for the conduct of monetary policy.” Specifically, the Fed believes that the neutral fed funds rate – the rate consistent with stable inflation – is structurally lower. The Fed is concerned that this increases the risk of the fed funds rate being pinned at its effective lower bound (ELB), making it more difficult to consistently hit its inflation target. The review is about considering different strategies and tools that the Fed could use to more consistently hit its 2% inflation target in the future, but the 2% target itself is not up for discussion. The Fed has already decided that 2% inflation is most consistent with its price stability mandate. Policy Strategy Chart 16A Big Miss One thing that’s clear is that most Fed participants agree that some changes to policy strategy are necessary. There is widespread concern about the fact that the Fed has not hit its inflation target during the past decade. The Fed officially adopted a 2% target for PCE inflation in January 2012, but inflation has not come close to those levels since. Headline and core PCE have increased at average annual rates of only 1.3% and 1.6%, respectively, since 2012 (Chart 16). At the July and September FOMC meetings, the Fed discussed several different strategies that could make it easier to hit its inflation target. Most of the proposals fall into the category of “makeup strategies”, strategies where the Fed tries to make up for a period of below-2% inflation by targeting above-2% inflation for a stretch of time. In theory, most Fed members agree that such strategies make sense. From the September FOMC minutes:10 Because of the downside risk to inflation and employment associated with the ELB, most participants were open to the possibility that the dual-mandate objectives of maximum employment and stable prices could be best served by strategies that deliver inflation rates that over time are, on average, equal to the Committee’s longer-run objective of 2 percent. Promoting such outcomes may require aiming for inflation somewhat above 2 percent when the policy rate was away from the ELB, recognizing that inflation would tend to be lower than 2 percent when the policy rate was constrained by the ELB. The main problem with these sorts of makeup strategies is what Fed Governor Lael Brainard calls the time-inconsistency problem.11 For example, if inflation has been running well below – or above – target for a sustained period, when the time arrives to maintain inflation commensurately above – or below – 2 percent for the same amount of time, economic conditions will typically be inconsistent with implementing the promised action. In other words, when it comes time to deliver on its past promises, the Fed may not want to. But if it fails to deliver, it makes any future promises less impactful. Governor Brainard thinks that this problem can be mitigated by adopting a more flexible approach. That is, rather than following a strict rule that says that the Fed must aim for average inflation of 2 percent over a specific timeframe, it could simply opportunistically change its target inflation range based on the circumstances. She gives the following example: For instance, following five years when the public has observed inflation outcomes in the range of 1-1/2 to 2 percent, to avoid a decline in expectations, the Committee would target inflation outcomes in a range of, say, 2 to 2-1/2 percent for the subsequent five years to achieve inflation outcomes of 2 percent on average overall. We think it is very likely that something similar to Brainard’s plan will be announced when the review is completed in 2020. There is widespread consensus that the Fed should temporarily target an overshoot of its 2 percent inflation target to ensure that inflation expectations stay anchored near target levels. Opportunistically shifting the inflation target to 2%-2.5% on a temporary basis seems like the easiest way to communicate that goal. ELB Tools In addition to potential changes to policy strategy, the Fed has also been talking about potential policy tools that could be deployed the next time that interest rates reach the ELB. Policymakers took up this question in detail at the October FOMC meeting and generally agreed that the combination of forward guidance and asset purchases had been effective at delivering policy accommodation at the lower bound. Now that the committee is comfortable with these tools, we would expect them to be deployed very quickly the next time that the fed funds rate reaches zero. In all likelihood, if the funds rate reaches zero again, the Fed will quickly announce a round of asset purchases and pledge to keep rates on hold until some economic outcome – likely related to inflation – is met. The Fed also discussed the possibility of cutting rates into negative territory, but there is very little appetite for negative rates policy in the US. From the October FOMC minutes:12 All participants judged that negative interest rates currently did not appear to be an attractive monetary policy tool in the United States. Participants commented that there was limited scope to bring the policy rate into negative territory, that the evidence on the beneficial effects of negative interest rates abroad was mixed, and that it was unclear what effects negative rates might have on the willingness of financial intermediaries to lend and on the spending plans of households and businesses. If, during the next ELB phase, the combination of forward rate guidance and asset purchases does not appear to be working quickly enough, we think it’s most likely that the Fed will follow the Bank of Japan and simply extend these policies further out the yield curve. For example, the Fed would set a cap on some intermediate-maturity Treasury yield (say the 2-year yield), and pledge to buy as many securities as necessary to keep the yield below that cap. This potential tool was discussed at the October FOMC meeting, and it received a more favorable response than the negative rates policy. Results Of The Strategic Review The exact form of any new policy strategy is uncertain, but we expect the Fed to make an announcement in mid-2020 that makes it clear that it will explicitly target above-2% inflation for some unspecified period of time in order to re-anchor inflation expectations and make up for past inflation misses. This will make it even more important to use inflation expectations as our guide for detecting shifts in Fed policy, rather than the actual inflation data. In many ways, the Fed’s reaction function has already moved toward targeting expectations. The results of the 2020 strategic review will make that even more explicit. There is less urgency to announce any potential new tools for conducting policy at the ELB, and we do not expect much in that regard. Other than some ideas for further study.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Global Fixed Income Strategy Special Report, “2020 Key Views: Delay Of Reckoning”, dated December 10, 2019, available at gfis.bcaresearch.com and US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 2 For details on BCA’s economic outlook for 2020 please see The Bank Credit Analyst, “Outlook 2020: Heading Into The End Game”, dated November 22, 2019, available at bca.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 4  https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 5  https://www.federalreserve.gov/newsevents/speech/clarida20190926a.htm 6 Please see US Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 7 CPI inflation runs about 0.4%-0.5% above PCE inflation, so the Fed’s 2% PCE target translates to a 2.4%-2.5% target for CPI. 8  https://www.federalreserve.gov/newsevents/speech/brainard20181207a.htm 9 This September episode is discussed in detail in the US Bond Strategy Weekly Report, “What’s Up In US Money Markets?”, dated September 24, 2019, available at usbs.bcaresearch.com 10 https://www.federalreserve.gov/monetarypolicy/fomcminutes20190918.htm 11 https://www.federalreserve.gov/newsevents/speech/brainard20191126a.htm 12 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20191030.pdf

Overweight The expected price of credit, still pristine credit quality, and a looming reacceleration in credit growth all argue for including the S&P banks index in our high-conviction overweight list. Banks stocks troughed in mid-August, sniffing out a sell-off in the bond market. As the bond sell-off gained steam, the bank outperformance phase also caught on fire. BCA’s view for next year calls for a 50-75bps selloff in the 10-year Treasury yield, further boosting the allure of bank equities. Beyond the rising price of credit, credit growth is another key industry profit driver. Importantly, the latest Fed Senior Loan Officer Survey painted a bright picture on both the demand and supply of credit. In more detail, bankers reported that a rising number of credit categories reversed course and demand for loans slingshot higher. The upshot is that bank credit growth will likely reaccelerate in the first half of 2020. Finally, credit quality, the third key bank profit driver, is also emitting a positive signal. While a few loan categories have deteriorated recently in absolute terms, as percentage of loans outstanding, credit quality remains pristine. Despite all this enticing news, bank valuations remain anchored near rock bottom levels and a resurgent ROE is signaling that there is a long runway ahead for relative bank valuation. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC.