オーストラリア

特別レポート

Your feedback is important to us. Please take our client survey today. 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 II-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 II-1A Blue Sweep Is Bond Bearish Table II-1A Comparison Of The Candidates' Budget Proposals 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 II-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. 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. Chart II-2The Biden Platform Is Highly Stimulative 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 II-2). 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. 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 II-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 II-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 = 27%. 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 = 23%. 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 = 28%. 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 = 22%. 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 72%, versus a 28% 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 72%, 45 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 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. Chart II-4Less Election-Day Upside Than In 2016 Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart II-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 II-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. 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 II-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 II-5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart II-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 II-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 II-5How High For Treasury Yields? Chart II-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 II-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 II-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 II-8).5 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart II-7Overweight TIPS Versus Nominals Chart II-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 II-8, bottom panel).6 Chart II-9Own Inflation Curve Flatteners And Real Curve Steepeners Two More Curve Trades 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 II-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. 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. 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. Chart II-10The Fed Will Gladly Trade Less QE For 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 II-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 II-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 II-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 II-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 II-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

Highlights Global Duration: US Treasury yields have started to creep higher and the move is likely to continue in the coming months regardless of who wins the White House. Reduce overall global duration exposure to below-benchmark, focused on the US. Country Allocation: Based on our view that US Treasury yields have more upside, we are making the following changes to our recommended country allocations in the government bond portion of our model bond portfolio: downgrading the US to underweight, downgrading higher-beta Canada and Australia to neutral, and raising lower-beta Germany, France, Japan and the UK to overweight. Treasury-Bund Spread: We introduce a new trade in our Tactical Overlay to capitalize on our expectation of higher US bond yields and a wider Treasury-Bund spread: selling 10-year Treasury futures versus buying 10-year German bund futures. Feature In a Special Report jointly published last week with our colleagues at BCA Research US Bond Strategy, we laid out the case for why US Treasury yields have bottomed and should now begin to drift higher.1 We reached that conclusion for two reasons: 1) there will be a major US fiscal stimulus after the upcoming US election, especially so if Joe Biden becomes president and the Democrats take the Senate; and 2) the Fed’s shift to Average Inflation Targeting in late August represented the point of maximum Fed dovishness. The investment conclusions were to reduce duration exposure, while also downgrading our recommended allocation to US government bonds to underweight. We also advised cutting exposure to non-US government bond markets with relatively higher sensitivity to changes in US bond yields, while increasing allocations to countries with a lower “yield beta” to US Treasuries (Table 1). Table 1Updated GFIS Model Bond Portfolio Recommended Positioning In this follow-up report, we will further discuss the implications of our changed view on US yields for non-US developed market government bonds. This includes specific adjustments to the recommended country allocations in our model bond portfolio, as well as a new tactical trade to profit from a move higher in US yields that will not to be matched in Europe. Our Recommended Overall Duration Stance: Now Below-Benchmark The case for a future cyclical bottoming of global yields has been building for the past few months, even as yields have remained range-bound at very low levels across the developed economies. Our Global Duration Indicator, comprised of economic sentiment measures and leading economic indicators, bottomed back in March and has soared sharply since then (Chart of the Week). Given the usual lead time between peaks and troughs of the Indicator and global bond yields - around nine months, on average – that suggests yields should bottom out sometime before year-end. Chart of the WeekA Cyclical, US-Led Bottoming Of Global Bond Yields Chart 2UST Yields About To Break Out? In the US, we now think we are past that point, as we discussed last week. The 10-year US Treasury yield has been drifting higher during the month of October and is now bumping up against its 200-day moving average of 0.83% (Chart 2). This is only the first such attempt at a trend breakout in yields, and such a move is unlikely prior to US Election Day - or, more accurately, “US Election Is Decided Day” which may not be November 3! The case for a future cyclical bottoming of global yields has been building for the past few months, even as yields have remained range-bound. Outside the US, however, momentum of bond yields and potential trend breakouts paint a more mixed picture. German and French bond yields remain stable and generally trendless, with Italian and Spanish yields continuing to grind lower. At the same time, yields in the UK, Canada and Australia have started to perk up but remain just below their 200-day moving averages. Bond yields have not responded to the sharp cyclical rebound across the developed world, with large gaps between elevated manufacturing PMIs and stagnant bond yields (Chart 3). Low inflation, ample spare economic capacity and dovish monetary policies are all playing a role, with bond markets not expecting an imminent inflation surge that could drive up yields and fuel expectations of tighter monetary policy. By way of contrast, China - where domestic services sectors have improved at a rapid pace from the COVID-19 recession and where the central bank is not running an overly accommodative monetary policy – has seen a more typical positive correlation between government bond yields and the rising manufacturing PMI over the past several months (Chart 4). This suggests that developed market bond yields can begin to normalize if the domestic services side of those economies emerges more forcefully from the lockdown-induced downturn. Chart 3A Wide Gap Between Growth & Yields Chart 4Are Chinese Yields Sending A Message? The news on that front is more optimistic in the US compared in Europe. The Markit services PMIs for the euro area and UK have all weakened over the past few months, with headline inflation rates flirting with deflation (Chart 5). Similar data in the US has trended in the opposite direction, with stronger US services activity with rising inflation. Chart 5Deflation Risks In Europe, Not The US The pickup in new COVID-19 cases, and the degree of the response by governments to contain it, has been far stronger in Europe and the UK than in the US on a population-adjusted basis (Chart 6). Lockdowns have become more widespread across Europe to contain the second larger wave of the virus. The recent softer services PMI data in the euro area and UK are a reflection of those greater economic restrictions and weaker confidence. This gap between the US economy and non-US economies is only magnified by the fiscal stimulus measures proposed by both US presidential candidates.  In the US, governments have been far less willing to implement politically unpopular restrictions in an election year, while lockdown-weary consumers have been more willing to go about their lives rather than stay sheltered at home. The result is a healthier tone to the US data compared to other countries, even with the number of new US cases on the rise again. This gap between the US economy and non-US economies is only magnified by the fiscal stimulus measures proposed by both US presidential candidates. As we discussed in last week’s Special Report, both the Biden and Trump platforms are calling for major fiscal stimulus – between $5-6 trillion over the next decade, including tax changes – although the Biden plan has much more front-loaded direct government spending, only partially offset by tax increases, if fully implemented. This is the “Blue Sweep” scenario, with a Biden victory and Democratic Party control of the US Congress, that is most bearish for US Treasuries, as the outcome would eventually help reduce the expected 2021 US fiscal drag of -7.2% of GDP as estimated by the latest IMF Fiscal Monitor (Chart 7). Even a re-elected Trump, however, would also mean more US fiscal stimulus, although with a mix of tax cuts and spending increases. Chart 6The Latest COVID-19 Wave Is Hitting Europe Harder Combined with an improving services sector and rising inflation, this puts the US in a much different economic position than the major economies of Europe. Chart 7Post-Election US Stimulus Will Offset Fiscal Drag There, the IMF is also projecting some fiscal drag in 2021, but now with a much less healthy domestic economy due to the COVID-19 surge and where inflation is already near 0%. Our decision to reduce our recommended overall global duration stance to below-benchmark is largely driven by trends in the US that are more bond-bearish than in the rest of the developed world. There will likely be another round of fiscal measures to help combat virus-stricken economies in Europe and elsewhere, but the US election is bringing the issue to the forefront more quickly. In other words, the US will get a more bond-bearish fiscal stimulus before Europe does. Bottom Line: US Treasury yields have started to creep higher and the move is likely to continue in the coming months regardless of who wins the White House. Reduce overall global duration exposure to below-benchmark, focused on the US. Our Recommended Country Allocation: Downgrade US, Upgrade Lower-Beta Countries Net-net, our decision to reduce our recommended overall global duration stance to below-benchmark is largely driven by trends in the US that are more bond-bearish than in the rest of the developed world. This also has implications for our recommend country allocation in our model bond portfolio. First, are downgrading our recommended US Treasury allocation to underweight. We are also increasing our desired weighting in countries where government bond yields are less sensitive to changes in US Treasury yields – especially during periods when the latter are rising. We call this “upside yield beta”. The countries that have the highest such beta to US Treasuries are Canada, Australia and New Zealand, making them downgrade candidates (Chart 8). Similarly, lower upside beta countries like Germany, France, Japan and the UK are upgrade possibilities. Chart 8Favor Countries With Lower Yield Betas To USTs Already, we are seeing the widening of yield spreads between US Treasuries and non-US government markets – with more to come as US Treasuries grind higher over the next 6-12 months. We see the greatest upside for spreads between the US and the low upside yield beta countries – that means wider spreads for US-Germany, US-France, US-Japan and US-UK (Chart 9). Chart 9Expect More Underperformance From USTs Chart 10Fed QE Momentum Peaking, Unlike Other CBs Thus, this week are making significant changes to our strategic government bond country allocations (see page 15), as well as the country weightings in our model bond portfolio (see pages 13-14), based on our new view on US bond yields and non-US yield betas. Specifically, we are not only cutting our recommended US weighting to underweight, but we are also downgrading Canada and Australia from overweight to neutral. On the other side, we are upgrading UK Gilts to overweight from neutral, while also upgrading Germany, France and Japan to overweight. Importantly, we are maintaining our overweight stance on Italian and Spanish sovereign debt, as those markets are supported by greater European fiscal policy integration in the world of COVID-19 and, just as importantly, large-scale ECB asset purchases. More generally, the relative “aggressiveness” of central bank quantitative easing (QE) does play a role in our recommended country allocation. We expect the Fed to be more tolerant of higher Treasury yields if the move is driven by improving US growth and/or greater US fiscal stimulus – as long as the higher yields were not having a negative impact on equity or credit markets. We expect the Fed to be more tolerant of higher Treasury yields if the move is driven by improving US growth and/or greater US fiscal stimulus – as long as the higher yields were not having a negative impact on equity or credit markets. This means less expected QE buying of Treasuries by the Fed. Conversely, given how aggressive the Reserve Bank of Australia and Bank of Canada have been with expanding their balance sheet via QE (Chart 10), this makes us reluctant to shift to the underweight stance on those countries implied by their high beta to rising US Treasury yields. Therefore, we are only downgrading those two countries to neutral. Bottom Line: Based on our view that US Treasury yields have more upside, we are making the following changes to our recommended country allocations in the government bond portion of our model bond portfolio: downgrading the US to underweight, downgrading higher-beta Canada and Australia to neutral, and raising lower-beta Germany, France, Japan and the UK to overweight. A New Tactical Trade: A UST-Bund Spread Widener Using Futures This week, we are also introducing a new recommended trade in our Tactical Overlay portfolio on page 16 to take advantage of our view on US bond yields: a 10-year US-Germany spread widening trade using government bond futures. Chart 11A Tactical Opportunity For A Wider UST-Bund Spread This trade makes sense for several reasons: Germany has one of the lowest yield betas to US Treasuries during periods when the latter is rising, as shown earlier. Our US Treasury-German Bund fundamental fair value spread model – which uses relative policy interest rates, unemployment and inflation between the US and the euro area as inputs - suggests that the spread is now far too tight after the massive rally in US Treasuries in 2020 (Chart 11). The main reason why the spread looks so “expensive” is that the underlying fair value has risen with US inflation rising and euro area inflation falling (Chart 12, bottom panel). The UST-Bund yield differential is not stretched from a technical perspective, when looking at deviations of the spread from its 200-day moving average or the 26-week change in the spread; both measures suggest room for additional spread widening before reaching historical extremes (Chart 13). Also, duration positioning by US fixed income investors is only around neutral, according to the JP Morgan duration survey, suggesting scope to push yields higher if bond investors become more defensive. Chart 12Inflation Differentials Justify A Wider UST-Bund Spread Chart 13Technical Trends Favor A Wider UST-Bund Spread As a reference, we are initiating this trade with the cash bond 10-year US-Germany spread at +138bps, with a target range of +170-190bps over the 0-6 month horizon we maintain for our Tactical Overlay positions. Bottom Line: We introduce a new trade in our Tactical Overlay to capitalize on our expectation of higher US bond yields and a wider Treasury-Bund spread: selling 10-year Treasury futures versus buying 10-year German bund futures.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research US Bond Strategy Special Report, "Beware The Bond-Bearish Blue Sweep", dated October 20, 2020, available at usbs.bcaresearch.com and gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

特別レポート

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

Highlights While the bull market in the Australian dollar might pause temporarily, it will advance further this cycle. The key catalyst for the AUD is an improving balance-of-payments backdrop. Despite its explosive rise, the majority of our models still show the Aussie as relatively cheap. At the crosses, AUD/NZD, AUD/CAD, and AUD/CHF are attractive. Buy AUD/NZD if it drops to 1.05. Feature Chart I-1A V-Shaped Recovery The bounce in the Australian dollar has been remarkable. From a low of 55 cents, the Aussie is up over 30% from the March 19 lows, making it the best performing G10 currency over the period. In technical parlance, the Aussie has entered a bull market. More importantly, the performance of the AUD has been a mirror image of broad stock market indices, suggesting investors have been using both vehicles to reprice a global recovery (Chart I-1). The rise in the Aussie dollar raises a few questions. First, do conditions remain in place for continued appreciation in the exchange rate? Second, at what AUD levels does currency strength tighten domestic financial conditions significantly? Finally, what are the opportunities at the crosses that investors could leverage on? A Terms-Of-Trade Boom For over four decades, one of the key primary drivers of the AUD exchange rate has been the basic balance. For simplicity, our definition of basic balance is just the sum of the current account and long-term capital flows, such as foreign direct investment. Remarkably, Australia’s basic balance is making new secular highs, despite the fact that the commodity boom peaked almost a decade ago (Chart I-2). The big divergence between an improving basic balance and a relatively soft trade-weighted currency suggests room for mean reversion is substantive. Australia’s basic balance is making new secular highs, despite the fact that the commodity boom peaked almost a decade ago. There are three key drivers behind the improvement of Australia’s balance-of-payment dynamics. First, in terms of economic recovery, China has led the pack vis-à-vis other countries by simple virtue of the fact that the authorities started injecting stimulus much earlier on, which helped ease domestic financing conditions. Chart I-3 shows that Chinese domestic imports are tracking the easing in financial conditions we saw earlier this year. As a result, imports of key raw materials such as copper, iron ore, steel, and crude oil have been exploding higher. These have benefited Australian export volumes Chart I-2Improving Balance Of Payments Chart I-3Chinese Imports To Improve Further Remarkably, there have been notable improvements in recent months that suggest economic velocity in China may be picking up: Production of electricity and steel, which are inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production. If these leading indicators continue to advance, as we believe they will, it will suggest further upside in the Chinese industrial cycle (Chart I-4). Chart I-4Chinese End-Use Is Improving The second reason behind Australia’s improving balance-of-payment dynamics has been increasing relative competitiveness in the types of raw materials that China needs and wants. In recent months, both steel and iron ore prices have been soaring. Part of the reason is because Australian exporters produce higher-grade ore, which is more expensive, pollutes less and is in high demand in China. Going forward, Australia’s terms-of-trade improvement is likely to continue. This is because of another tectonic shift in China: an energy policy shift away from coal and towards natural gas (Chart I-5). Beijing’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix (Chart I-6). Given that reducing, if not outright eliminating, pollution is a long-term strategic goal in China, this will provide a multi-year tailwind. Already, Australian oil and gas stocks have been outperforming global bourses on the back of this tectonic shift. Such outperformance could help drive portfolio flows into Australia, further buffeting the currency (Chart I-7). Chart I-5A Tectonic Shift In Chinese Energy Policy Chart I-6Australia Is Becoming A Big LNG Player Chart I-7A Bull Market In Aussie Energy? Will Domestic Factors Derail The Aussie? The jobs report out of Australia yesterday was stellar. The economy added 111,000 jobs, pushing the unemployment rate down from 7.5% to 6.8%. This was within the context of a rise in the participation rate to 64.8%. This is an impressive feat given that Melbourne was effectively in complete lockdown in August (Chart I-8). The key takeaway is that as a manufacturing-oriented economy, the impact of social distancing and lockdowns in Australia are less severe than for service-oriented economies. This could be the story over the next year, allowing the AUD to outperform not just the USD but also other currencies with a higher share of services in their economies. Beijing’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix.  Monetary and fiscal policy have obviously played a big role as well. The Reserve Bank of Australia has cut interest rates to 0.25% and is doing yield-curve control on three-year maturities at 0.25%. The Liberal-National coalition government has also been very proactive, especially with the “Job Seeker” and “Job Keeper” scheme, which has provided a valuable cushion for domestic economic conditions (Chart I-9). With a very low government debt burden, there is obviously scope to expand the scheme further. Chart I-8The Employment Market Is Recovering Chart I-9A Big Fiscal Thrust The boost in confidence has helped engineer a meaningful recovery in Australian house prices (Chart I-10). More importantly, this recovery is driven by domestic concerns rather than by foreigners (Chart I-11). This suggests that at least at the margin, house prices are being driven by domestic demand/supply fundamentals. The key takeaway is that relative to its commodity-currency peers, Australia is well along its house-price adjustment path. This should favor Australian real estate and bank stocks relative to those in Canada (Chart I-12). Chart I-10A Housing Market Recovery Chart I-11Credit Is Flowing To Households, Not Foreigners/Investors Chart I-12Aussie Real Estate Relative To Canadia The economic recovery is already being priced in by the long end of the Australian bond curve. Long-term rates have collapsed in the US, relative to Australia, the latter offering a 40 basis point premium. Should US real rates move further into negative territory, this could continue to provide an interest-rate cushion for the AUD (Chart I-13). A further steepening in the Australian yield curve will be positive for banks, which have lagged the index, and could play catch up (Chart I-14). Chart I-13AUD Follows Long-Term Rates Chart I-14Australian Banks And The Yield Curve   How High Can The AUD Bounce? Usually, a rise in the AUD over a cycle goes uninterrupted until the cross becomes expensive. On this basis, the Australian dollar remains accommodative. Our purchasing power parity (PPP) models point to an 8% undervaluation in the Australian dollar. One of our favorite metrics for the Australian dollar’s fair value is its real effective exchange rate relative to its terms of trade. On this basis, the Aussie dollar is cheap by about 10% (Chart I-15). Our fundamental intermediate-term timing model, which uses real bond yield differentials and commodity prices, shows the Australian dollar as 5% cheap, or one standard deviation below the mean (Chart I-16). Chart I-15The AUD Is Cheap Chart I-16Our Timing Model Is Buying AUD Importantly, while our momentum indicators are stretched in the short term, speculators are still neutral the currency. Like the US dollar, the Aussie tends to be a momentum currency, with speculators that typically remain long over the cycle driving it to overvalued levels (Chart I-17). In terms of currency performance, the Australian dollar remains 10% below its 2018 peak and almost 35% below its 2011 peak, suggesting there is much scope for mean reversion. Chart I-17Speculators Are Not Yet Bullish Opportunities At The Crosses Long AUD/NZD and long AUD/JPY remain attractive bets. While our momentum indicators are stretched in the short term, speculators are still neutral the currency. As for AUD/NZD, our bias is that terms of trade in Australia will continue to outperform that in New Zealand. AUD/NZD and relative terms of trade tend to move together (Chart I-18). Meanwhile, the exchange rate is cheap on a historical basis. Furthermore, the Reserve Bank of New Zealand is likely to continue with more dovish forward guidance, relative to the RBA, which will favor AUD/NZD (Chart I-19). As a percentage of GDP, the RBNZ is more aggressive in terms of asset purchases. Buy the cross if it touches 1.05. Chart I-18AUD/NZD And Terms Of Trade Chart I-19AUD/NZD And Balance Sheet Policy AUD/JPY is a bet on a continued global economic recovery, and any drop below 74 is a buying opportunity. Interestingly, speculators remain short the cross despite a nice run-up from the March lows.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data from the US have been positive: Headline inflation increased from 1% to 1.3% year-on-year in August. Core inflation also edged up from 1.6% to 1.7% year-on-year. The NY Empire State Manufacturing Index jumped from 3.7 to 17 in September. Retail sales increased by 0.6% month-on-month in August. Initial jobless claims increased by 860K for the week ending on September 11. The DXY index increased by 0.3% this week. On Wednesday, the Fed kept interest rates unchanged and made a bold statement that they would keep rates low until inflation comes back to the 2% target. New economic projections show that most policymakers see interest rates on hold through at least 2023. Report Links: Addressing Client Questions - September 4, 2020 A Simple Framework For Currencies - July 17, 2020 DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area have been positive: The ZEW Economic Sentiment Index surged from 64 to 73.9 in September. The trade surplus widened from €16 billion to €20.3 billion in July, led by a faster decline in imports. Industrial production fell by 7.7% year-on-year in July, following a 12% contraction in June. Both headline inflation and core inflation remained flat at -0.2% and 0.4% year-on-year, respectively. The euro fell by 0.4% against the US dollar this week. While downside risk still looms for the euro area growth, we believe that the euro will continue to appreciate, as the structural growth rate of the euro area should improve relative to the US amid global economy recovery. 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 negative:  Industrial production plunged by 15.5% year-on-year in July. The total trade balance increased from ¥10.9 billion to ¥248.3 billion in August due to a steeper decline in imports. Exports fell by 14.8% year-on-year, while imports slumped by 20.8%. The Japanese yen appreciated by 1.5% against the US dollar this week. The BoJ kept interest rates steady this Thursday and upgraded its view on the economy outlook. Moreover, the governor Haruhiko Kuroda said that the Bank will not only monitor inflation trends but also the overall economy, including job growth, for future guidance. 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 from the UK have been mixed: The total trade surplus narrowed from £3.9 billion to £1.1 billion in July. The unemployment rate rose to 4.1% from 3.9% in July. Average earnings improved by 0.2% quarter-on-quarter for the three months to July. Headline inflation declined from 1% to 0.2% year-on-year in August. Core inflation slipped from 1.8% to 0.9% in August. The British pound appreciated by 0.8% against the US dollar this week. On Thursday, the BoE kept interest rates on hold at 0.1%. While recent data have been stronger than expected, multiple threats still loom, including a second wave of COVID-19, a no-deal Brexit, and the possibility of persistent high unemployment. The Bank is now considering all options, including negative interest rates, to support the economy. 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 positive: House prices fell by 1.8% quarter-on-quarter in Q2. However, this is a 6.2% increase compared with the same quarter last year. The Westpac Leading Index increased from 0.05% to 0.48% in August. On the labor market front, the unemployment rate fell from 7.5% to 6.8% in August. 111K jobs were added in August, including 74.8K part-time positions and 36.2K full-time positions. The Australian dollar has been flat this week. The RBA minutes released this week stated that the Bank will maintain its “highly accommodative settings” as long as required to further support the economy. Please refer to our front section this week for a more detailed analysis of the Aussie dollar. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data from New Zealand have been negative: GDP slumped by 12.2% quarter-on-quarter in Q2, or 12.4% year-on-year, the largest decline on record. The current account balance shifted to a surplus of NZ$1.8 billion in Q2 from a deficit of NZ$1.47 billion the same quarter last year, led by the sharp decline in domestic demand. The New Zealand dollar appreciated by 0.5% against the US dollar this week. The latest GDP release, while negative, was better than expectations. Goods industries, which make up 20% of the total economy, declined by 16.3% quarter-on-quarter in Q2. Services industries, which make up more than 50% of the economy, also fell by 10.9%. The path of the recovery will be highly contingent on COVID-19 developments. 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 mixed: Manufacturing sales increased by 7% month-on-month in July, following a 20.7% surge the previous month. Headline inflation was flat at 0.1% year-on-year in August, below market expectations of 0.4%. Core inflation edged up from 0.7% to 0.8% year-on-year in August. ADP employment recorded a loss of 205.4K jobs in the month of August. The Canadian dollar fell by 0.4% against the US dollar this week. The latest inflation report shows that gasoline prices were down 11.1% year-on-year in August, which has been a drag on inflation. On the other hand, prices of personal care services, including haircuts, have been increasing, as the cost to implement COVID-19 safety measures are being passed on to customers. With extremely low inflation, the BoC would most likely maintain interest rates low to support the economy recovery. 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: Total sight deposits increased from CHF 702.9 billion to CHF 704.1 billion for the week ending on September 11. Real exports increased by 2.9% month-on-month in August, while real imports fell by 1.3%. The trade surplus widened from CHF 3.3 billion to CHF 3.6 billion in August. PPI fell by 3.5% year-on-year in August. The Swiss franc depreciated by 0.3% against the US dollar this week, as the SNB continues to intervene in the currency market. Our bias is that the franc will fall against the euro but not so much against the US dollar. Moreover, holding the Swiss franc remains a good hedge, as Switzerland still sports the highest real rate in the G10 universe. 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 mixed: The trade deficit widened from NOK 1.8 billion to NOK 2.9 billion in August. Exports continued to fall by 13% year-on-year to NOK 57 billion in August due to lower sales of mineral fuels and related materials (-20.1%), chemical and related products (-9.3%), and food and live animals (-13.1%). Imports, on the other hand, remained unchanged at NOK 59.9 billion in August from a year earlier. The Norwegian krone fell by 0.5% against the US dollar this week. While the widening of the trade deficit seems to be bad news for the economy, the resilience of imports reflects a strong domestic demand, which bodes well for the Norwegian economy and the krone. 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 Recent data from Sweden have been positive: The seasonally-adjusted unemployment rate dropped from 9.2% to 9.1% in August. The Swedish krona depreciated by 0.3% against the US dollar this week. The better-than-expected data from the labor market suggests that the economic recovery is underway, which is bullish for the Swedish krona. 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   Kelly Zhong Research Analyst Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades