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Highlights The Fed & Yields: Positive U.S. growth and inflation momentum is maintaining the credibility of the Fed's 2017 rate hike plans. U.S. bond yields, in particular, and global yields, in general, will remain under upward pressure in this environment, despite the aggressive short positioning in the U.S. Treasury market. Maintain a below-benchmark portfolio duration stance. "Soft" vs. "Hard" Data: After a deep dive into the economic data for the major countries, both "hard" demand indicators and "soft" survey measures, we have little doubt that a tangible global growth acceleration is underway. This positive economic backdrop will continue to put upward pressure on government bond yields while boosting the relative return performance for corporate credit. Australia: The cyclical outlook Down Under has become murkier of late, even with the RBA starting to shift in a more hawkish direction. We are taking profits on our recommended pro-growth tilts in Australia. Feature The positive momentum on global growth continues to put upward pressure on bond yields, despite the large short positioning already in place in the government bond markets. The benchmark 10-year U.S. Treasury yield returned to 2.5% at one point last week, led by a rash of better-than-expected data on U.S. retail sales and inflation, combined with hawkish comments from numerous Fed officials (Chart of the Week). Markets started to more seriously consider a March Fed rate hike, although we still see June as the more likely date for the Fed's next tightening move. As we have discussed in several recent reports, it is a surge in global economic survey data that suggests that a broad-based upturn currently underway. While this is all good news for risk assets, there is some concern among investors that a pick-up in growth has been slow to appear clearly in the "hard" economic data related to final demand. Without a boost in actual economic activity, and not just "feel good" surveys, the pro-growth momentum currently embedded in equity and bond markets may melt away as rapidly as it was built up. Mark McClellan, the Chief Strategist at BCA's flagship publication, The Bank Credit Analyst, is releasing a report this week that digs into the differences between "soft data" (i.e. surveys) and "hard data" (i.e. employment and production).1 We present some excerpts from that report in the following section. Global Growth Pickup: Fact Or Fiction? Investors have taken some comfort from the fact that leading indicators are trending up across most of the developed and emerging economies. BCA's Global Leading Economic Indicator is moving higher and will climb further in the coming months given that its diffusion index is well above 50 (Chart 2). The Global ZEW indicator and the BCA Boom/Bust growth indicator are also constructive on the growth outlook. Chart of the WeekNo Bond-Bearish Data In The U.S. Chart 2A Consistent, Positive Message On Growth Consumers and business leaders are feeling more upbeat as well, both inside and outside of the U.S. (Chart 3). Importantly, the improvement in sentiment began before the U.S. election. Surveys of business activity, such as the Purchasing Managers Indices (PMI), are painting a uniformly positive picture for near-term global output in both the manufacturing and service industries. While this is all good news for risk assets, there is concern that a growth impulse has been slow to show up clearly in the "hard" economic data related to final demand. The good news is that there is more to the cyclical upturn than hope. The improved tone in the forward-looking data is now clearly showing up in some measures of final demand. The caveat is that there is no evidence yet that the cyclical mini up-cycle in 2017 is any less vulnerable to negative shocks than was the case in previous upturns since the Great Recession. The Hard Data First, we start with some bad news. There has been a worrying loss of momentum in job creation in recent months (Chart 4). While employment gains have accelerated in Japan, Canada and Australia, the payroll slowdown is mainly evident in the U.S. and U.K. This may reflect supply constraints as both economies are near full employment, but it is difficult to determine whether it is supply or demand-related. The good news is that the employment component of the global PMI has rebounded sharply following last year's dip, suggesting that the pace of job creation will soon turn up. Chart 3Surging Confidence, Production Following Suit Chart 4Global Employment Growth Cooling Off Also on the positive side, households are opening their wallets a little wider according to the retail sales data (Chart 5), where growth has accelerated sharply in all the major economies except U.K. and Australia (NOTE: we discuss the Australian bond outlook later in this Global Fixed Income Strategy report). Similarly, business capital spending is finally showing some signs of life following a rocky 2015 and early 2016. An aggregate of Japanese, German and U.S. capital goods orders2 is a good leading indicator for G7 real business investment (Chart 6). The acceleration of imported capital goods for our 20-country global aggregate corroborates the stronger new orders reports (bottom panel). Chart 5On Your Mark, Get Set, Shop!! Chart 6Global Capex Cycle Turning Positive Recent data on industrial production show that the global manufacturing sector is clearly emerging from last year's recession. Short-term momentum in production growth has accelerated over the past 3-4 months across all of the major advanced economies (Chart 7). Production growth has been particularly robust in the Eurozone, U.K. and Japan. Industrial output related to both household and capital goods is showing increasing signs of vigor in recent months (Chart 8). Chart 7A Global Manufacturing Upturn Chart 8A Broad-Based Acceleration At the moment, the upturn in manufacturing production is being driven by a broader pickup in business spending. The acceleration in production and orders related to consumer goods in the major countries suggests that household final demand is also showing increased vitality, consistent with the retail sales data. The Soft Data Chart 9Global GDP Growth Is Accelerating Notwithstanding the nascent upturn in the hard data, some believe that the soft data are sending an overly constructive signal in terms of near-term growth. The soft data generally comprise measures of confidence and surveys of business activity. One could discount the pop in U.S. sentiment as simply reflecting hope that President Trump's election promises to cut taxes, remove red tape and boost infrastructure spending will come to fruition. Nonetheless, improved sentiment readings are widespread across the major countries, which means that it is probably not just a "Trump" effect. Moreover, there is no reason to doubt the surveys of actual business activity. Surveys such as the PMIs, the U.K. CBI Business Survey, the German IFO current conditions index and the Japanese Tankan survey are all measures of activity occurring today or in the immediate future (i.e. 3 months). There is no reason to believe that these surveys have been contaminated by "hope" and are sending a false signal on actual spending. To test the reliability of the growth message from the "soft data", we employed these indicators in regression models for real GDP in the four major advanced economies and for the G7 as a group (Chart 9). The models predict that G7 real GDP growth will accelerate to 2½% on a year-over-year basis in the first quarter of 2017. We expect growth of close to 3% in the U.S. and a little over 2½% in the Eurozone, although the model for the latter has been over-predicting somewhat over the past year. Japanese growth should accelerate to about 2% in the first quarter based on these indicators. The implication is that the survey data are not sending a distorted message; underlying growth is accelerating even though it is only now showing up in the hard economic data. Turning for a moment to the emerging world, output is picking up on the back of an upturn in exports. However, we do not see much evidence of a domestic demand dynamic that will help to drive global growth this year. The main exception is China, where private sector capital spending growth has clearly bottomed. Stronger Chinese capital spending in 2017 will boost imports and thereby support activity in China's trading partners, particularly in Asia. Conclusions We have little doubt that a meaningful global growth acceleration is underway. Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. American CEOs appear to have more swagger these days. Since the start of the year there have been a slew of high-profile announcements of fresh capital spending and hiring plans from companies such as Amazon, Toyota, Walmart, GM, Lockheed Martin and Kroger. A return of animal spirits could prolong a period of stronger growth, even if President Trump's growth-boosting policies are delayed or largely offset by spending cuts or trade wars. This economic backdrop is positive for risk assets and bearish for government bonds. Bottom Line: After a deep dive into the economic data for the major countries, both "hard" demand indicators and "soft" survey measures, we have little doubt that a tangible global growth acceleration is underway. This positive economic backdrop will continue to put upward pressure on government bond yields while boosting the relative return performance for corporate credit. Australia: The Equation Gets More Complicated Two weeks ago, the Reserve Bank of Australia (RBA) unsurprisingly left its cash rate unchanged at 1.5%. The post-meeting statement by RBA Governor Philip Lowe was considered hawkish by economic analysts. Nonetheless, the market reaction has been relatively muted, with the Australian government bond yield curve steepening by only 5 bps, and the Aussie dollar remaining stable, since the meeting. Pricing in the OIS curve suggests that the RBA will probably remain on hold throughout 2017, but the implied odds of a rate hike are rising, standing now at 20%. The RBA's assessment of the current global economic backdrop was relatively constructive, pointing to above-trend growth expectations in a number of advanced economies. Domestically, the RBA foresees a boost to Australian export growth from the resource sector, an end to the decline in mining investment and a pick-up in non-mining capital spending.3 With such a tone, the central bank might have set up the market for some disappointments. The new forecast of economic growth around 3% for the next couple of years seems overly optimistic. This is higher than the median expectation of economists surveyed by Bloomberg, who foresee 2.5% and 2.8% growth for 2017 and 2018, respectively. The IMF does not expect growth to reach 3% until 2019. Granted, several parts of the economy have shown very robust performances of late. The service sector PMI has surged to pre-crisis levels. The NAB survey of business conditions also shot higher last week. Goods exports have exploded at a 40% annual growth rate, causing the December trade balance to jump to $3.5bn, nearly double the consensus $2.0bn estimate (Chart 10). Those jumps in activity are hard to ignore. From a big picture perspective, however, Australian economic data has not been surprising to the upside, unlike the trend in in the rest of the world over the past few months (Chart 11). This is intriguing, since an easy monetary policy, loose bank credit conditions, improving profit expectations and a reflationary impulse coming from China were all tailwinds that should have supported Australian growth; this was our view last year.4 Now, those favorable factors have started to reverse, raising the chances of a cyclical economic downturn. Chart 10Surging Numbers Chart 11Surprisingly Unsurprising Foremost, overall labor market conditions are uninspiring (Chart 12): Although the monthly employment change for January did positively surprise, at 13.3k versus an expected 10k, the pace of job creation remains under 1% year-over-year, which is low by historical standards. The diverging trend between plunging full-time and steady part-time job growth indicates a sub-optimal labor market. The labor force participation rate declined from 65.2 to 64.6 in 2016, suggesting an increasing amount of discouraged workers. Underemployment has not budged in the last two years and is stuck at historically high levels. As result, a rise in labor market slack poses a risk for the Australian consumer; wage growth has already been in a downtrend since 2011 (Chart 12, bottom panel). The construction sector further confirms our apprehensions on the true strength of the economy. Households believe that it is not a good time to buy a home, while building approvals for new dwelling units fell from bubbly levels at the end of last year. At the same time, speculative money, which was supposed to have been curbed by macroprudential policy measures, has returned to the housing market (Chart 13). Lower supply and increased speculation could push residential prices even higher, inflating debt burdens, and leaving households with fewer dollars to consume. Chart 12Consumption: Set To Deteriorate Chart 13The Foundations Are Shaking Externally, the Chinese reflationary mini-boom - which boosted the prices of iron ore and other commodities exported by Australia last year - will probably retreat to some extent in 2017. Although China's overall cyclical momentum remains solid, according to our GFIS China Checklist,5 government spending growth has severely relapsed, potentially signaling an end to last year's largesse (Chart 14). With that in mind, it has become difficult to envision a continuation of the positive effects from the terms of trade shock experienced by Australia in 2016. In a similar vein, but domestically-driven, Australia's credit growth has become a headwind. Between 2013 and 2015, business credit growth was expanding, creating a positive impulse for the economy. Unfortunately, this trend changed tack in 2016, with slowing credit growth now representing a negative economic force (Chart 15). With Australian banks having suffered declining profits and rising bad debt charges in the last few quarters, credit conditions could tighten going forward. This is especially worrisome since personal credit was already contracting in 2016. Chart 14China Mini-Boom Could Be Over Chart 15Negative Credit Impulse top of all this, the IMF is projecting that Australia's fiscal thrust - the change in the primary government budget balance - will be negative in each of the next five years (Chart 16). As such, this economy could run out of supporting impulses in the short to medium term. Summing it all up, we agree with the current market pricing of interest rates, given the economic uncertainties. The RBA will most likely remain on hold for the foreseeable future. The story remains the same; the central bank wants to depreciate the overvalued Aussie dollar, but excesses in the housing market prevent them from weakening the currency through interest rate cuts (Chart 17). Now, the declining cyclical outlook will only complicate the equation. Chart 16Negative Fiscal Impulse Chart 17The RBA Has Little Room To Maneuver Investment Implications Our updated and more balanced economic view of Australia leads us to neutralize our recommended pro-growth Australia bond tilts: Asset allocation. As discussed above, the previously favorable factors supporting the Australian economy are progressively reversing. This is not the case in most of the other bond markets where additional cyclical upward pressure on global yields is anticipated. To reflect this view, today we are upgrading our recommended Australian bond exposure to neutral, from below-benchmark, within global hedged bond portfolios. This underweight position produced +188bps of excess return versus the global benchmark since inception in June 2016. Duration. The 10-year Australian government bond yield, 1-year forward, is 3.04%, 25bps above the current yield of 2.79%. There is a good chance that yields will rise at a faster pace than implied by the forwards at times over the course of the year, given the improving global growth and inflation backdrop. However, these instances will be opportunities to extend duration within dedicated Australian fixed income portfolios. Current Australian government bond valuation has become very cheap and is now at a level that has been associated with the beginning of positive absolute performance in the past. Moreover, the 10-year inflation breakeven is already pricing in a fair amount of inflation increases; those expectations will be hard to surpass, especially considering the low starting point (Chart 18). Curve. In May 2016, we initiated an Australian butterfly curve trade, going long the 2-year/6-year barbell versus the 4-year bullet. At the time, the 2/4/6 part of the government bond yield curve was kinked, with the 4-year sector trading very expensive versus the 2-year and 6-year maturities, reflecting the perception of a dovish stance by the RBA. then, the market has priced out these rate cut expectations, as we expected, and this part of the curve has bear steepened (Chart 19). Today, we close this trade at a +36bps profit. The RBA's future potential actions - or, more likely, inaction - are now properly discounted in the curve and reflect our neutral stance on the RBA. Chart 18Time To Buy Australian Bonds Chart 19Taking Profits On Our 2/4/6 Butterfly Trade Credit trades. Developing economic uncertainties warrant more cautiousness towards Australian credit. In March 2016, we recommended going long Australian semi government debt versus federal government bonds as an initial way to play what was, at the time, a relatively constructive view on the Australian economy.6 Now, given the increased economic risks, we are closing this relative value trade with a +133bps profit. Mark McClellan, Senior Vice President markm@bcaresearch.com Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President rrobis@bcaresearch.com 1 Please see The Bank Credit Analyst, Section II, "Global Growth Pickup: Fact Or Fiction?," dated March 2017, available at bca.bcaresearch.com 2 Machinery orders used for Japan 3 http://www.rba.gov.au/media-releases/2017/mr-17-02.html 4 For details, please see BCA Global Fixed Income Strategy Weekly Report, "Last Minute Recommendations Before The Brexit Vote," dated June 21, 2016, available at gfis.bcaresearch.com 5 For details concerning this indicator, please see BCA Global Fixed Income Strategy Weekly Report, "How To Assess The "China Factor" For Global Bonds," dated November 11, 2016, available at gfis.bcaresearch.com 6 Please see BCA Global Fixed Income Strategy Special Report, "Australian Credit: Time To Test The Waters," dated March 29, 2016, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Feature The FX Market has a strange way of proving everyone wrong. Currently, we are finding ourselves uncomfortable with our cyclically bullish stance on the dollar as it has become a consensus view. A review of the rationale and risks to our view is in order. To begin with, let's review valuations. The dollar is overvalued by 8% at the current juncture. However, this overvaluation is still much more limited than the overvaluation of 22% registered in 1985 and of 17.7% recorded in 2002 (Chart I-1). Chart I-1Dollar Is Not Cheap, Yet It Can Get More Expensive This has two implications. First, we have always considered valuations as the ultimate measure of sentiment. After all, it is a reflection of how much people are willing to pay for an asset or currency, and therefore, how optimistically they view the prospects for that asset/currency. The USD's overvaluation being limited compared to previous instances suggests that investors' love affair with the greenback has yet to reach the exuberant heights reached in 1985 and 2002. In fact, at this point in time, the U.S. basic balance has improved considerably, especially vis-à-vis the euro area (Chart I-2). This suggests that investors are finding more attractive investments in the U.S. than in the euro area, and that so far, the strong dollar has not had a deleterious enough effect to hurt the perceived long-term earning power of the U.S. This can continue to weigh on EUR/USD, lifting DXY in the process. Second, the dollar has yet to represent the same drag on the U.S. economy that it did at its previous peaks. It is true that U.S. potential GDP growth is now lower than previously, dragged down by both lower labor force growth and lower trend productivity growth. However, manufacturing represents a much smaller share of employment than in these two instances, suggesting that the labor market should prove more robust in the face of the strong USD (Chart I-3). Chart I-2Basic Balance Dynamics Have ##br##Favored The USD Until Now Chart I-3The U.S. Dwindling ##br##Manufacturing Employment Thus, we continue to expect that the ongoing labor market tightening can run further. With the amount of slack in that market having now vanished, we are disposed to expect a quickening in wage growth in the coming quarters (Chart I-4). Additionally, we expect the U.S. labor market to promote a virtuous circle for the economy. As the job market tightens, wages and salary as a share of the economy rise. This skews the income distribution away from the top 1% of households - families who derive more than 50% of their incomes from profits, rents, and proprietors' incomes - toward the middle class. This redistribution effect should support consumption: middle class and poor households have marginal propensities to spend ranging between 90% and 100% while rich families have a marginal propensity to spend of around 60% Not only does household consumption represent nearly 70% of the U.S. economy, but also 70% of this consumption goes toward services. Services are principally domestically sourced and are a sector of the economy where productivity is hard to come by. As a result, we expect the boost in household consumption to be a key mechanism that will support employment and wage growth. Additionally, the strength of wages and salaries as a share of gross national income, coupled with the high degree of consumer confidence, could be a harbinger of a revival in capex. Historically, when these two measures of household health are behaving as they currently do, investment in the economy increases (Chart I-5). A few factors can explain this relationship: First, this strength in households boosts residential investment; Second, it also gives confidence to the business sector that final domestic demand is durable, a key factor boosting domestic producers willingness to invest; Third, the boost to residential investment lifts investment in the sectors of the economy linked to consumer durable goods. Moreover, the stabilization of U.S. profits, along with the narrowing of U.S. corporate spreads have boosted the capex intentions of businesses, a move that began even before Trump won the election. This has historically been a reliable leading indicator of both capex and the overall business cycle (Chart I-5). Chart I-4A Tight Labor Market ##br##Will Support Households... Chart I-5...And Households Support ##br##Domestic Businesses With U.S. trend GDP growth having fallen, lower growth is needed than in prior cycles to absorb the slack in the economy. In fact, our composite capacity utilization gauge currently shows an absence of slack (Chart I-6). Any further acceleration of growth would move the economy into "no slack" territory, an environment that has historically coincided with protracted Fed tightening campaigns. Chart I-6If The Fed Doesn't Heed The Message From Capacity Utilization, The Dollar Will Weaken However, if the Fed does let capacity move much above its constraint and does not react as much as it ought to, the inflationary outcome created by such a move would be devastating for the dollar: Rapidly rising U.S. price levels would hamper the USD's long-term PPP fair value; The process would also result in falling U.S. real yields, especially vis-à-vis nations with more signs of excess capacity, like the euro area, pushing down the greenback from a real interest-rate parity perspective; The easy Fed policy would ease global liquidity conditions, creating a shot in the arm for the global economy and EM in particular. Historically, an accelerating global economy hurts the dollar. We remain with the view that the Fed is unlikely to let such an outcome materialize. Yellen has gone out of her way to highlight that generating a "high-pressure" economy in the U.S. was a dangerous outcome that the FOMC wanted to avoid. In fact, the potential for Trump's fiscal stimulus, whenever it may be enacted, only raises the likelihood that the Fed leans against the inflationary under-current created by dissipating economic slack. The second risk to the dollar is the growing talk of a new Plaza Accord in the U.S. At this point, with Trump attacking China, the EU, and in fact, most trading partners, we think that the likelihood of moral suasion achieving its goal is low. However, we want to study this topic in more detail before coming to definitive conclusion. So where does this leave us with regard to our original discomfort with standing in the middle of the crowd? We continue to expect the dollar cycle to expand. However, we expect that the correction that begun after the December Fed meeting could run further before exhausting itself. This would be the key mechanism through which the stale longs that are accumulating will get shaken off. In fact, the current push-back against Trump by the political establishment, from both the republicans and the bureaucratic apparatus could raise doubts on Trump's ultimate capacity to achieve his fiscal policy goals. While we expect that these doubts will stay just that, doubts, and that Trump will ultimately make stimulus into law, this period of questioning could be enough to hurt a dollar still too loved by investors. Bottom Line: We are finding ourselves in the middle of the consensus with our cyclical dollar-bullish stance. However, U.S. economic fundamentals are still firmly bullish for the dollar and valuations are not yet potent enough to prompt the end of the dollar bull market. Short AUD/NZD After a long hiatus, inflation is making a comeback in New Zealand. Last week, inflation numbers for Q4 came in at 1.3%, marking the first time since 2014 that it exceeded 1%. This has significant implications for the RBNZ, given that persistently low inflation was the shackle that kept its dovish bias in place. As inflation starts to creep up, this should put upward pressure in rates and lift the NZD. Chart I-7Domestic Factor Points Will Help ##br##The Kiwi Outperform The Aussie Nevertheless, we are reticent to buy NZD/USD outright, as the dollar bull market should continue to weigh on the kiwi as well as on other commodity currencies. Instead we are expressing our view by shorting AUD/NZD. The outlook for these Oceanian countries could not be more different. New Zealand has been the best performing economy in the G10 with real GDP rising by 3.5% and employment growing at a staggering 6% pace, the highest level of the last 23 years. Meanwhile, Australia's real GDP growth has slowed down to 1.7% while employment growth is currently in negative territory. This contrast in economic performance is likely to dramatically increase inflationary pressures in New Zealand relatively to Australia, particularly if one considers that New Zealand's economy is growing at 2% above potential GDP while Australia's output gap is far from closed. Furthermore, growing divergences in housing and stock prices are also pointing to a widening in rate differentials (Chart I-7). These factors along with inflation should push kiwi rates up vis-à-vis Australian rates, and consequently weigh on AUD/NZD. The outlook for New Zealand's and Australia's main commodities (dairy products and iron ore respectively) also points to further downside in this cross. As previously highlighted, a weakening Chinese industrial sector and a tightening of global dollar liquidity should translate to an underperformance of base metals in the commodity space, given that China consumes roughly half of the world's industrial metals and that these commodities are highly sensitive to EM liquidity conditions. Meanwhile, although China is also the main consumer of dairy products, prices should hold up thanks to the recent loosening in the "One child" policy, which should increase demand for baby formula.1 This view is not without risks. The all-time low for AUD/NZD of 1.02 is not that far away, and could likely provide significant support to this cross. Indeed, one could argue that much of the widening in rate differentials is probably already priced in the cross. However, the difference in overnight rates between the central banks of these countries is a measly 25 basis points (with roughly another 25 basis points priced by the market until the end of 2017). Given the stark difference between the outlooks for these two economies we believe further widening could be warranted. Moreover, while it is true that the recent disappointment in kiwi unemployment numbers might provide fuel for the doves in the RBNZ for a bit longer, the markets have already reacted accordingly, with AUD/NZD rallying sharply since. Thus, we think that this recent rally provides a good entry point to short this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Assistant juanc@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "The OPEC Debate", dated November 24, 2016, available at ces.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The FOMC held the federal funds rate at 0.75%, as expected. The Committee highlighted that the economy is growing "at a moderate pace", also as expected. The labor market, consumer and business sentiment, and household spending all are improving. It is also expected that this trend continues and eventually leads to their 2% inflation target. Unlike the other G10 central banks, the FOMC sees near-term risks to the economic outlook as "roughly balanced", which may warrant a greenlight for their planned hikes. ISM Prices Paid, Manufacturing PMI, and the change in employment all beat expectations, confirming the economy's healthy path. The dollar will likely display limited movements, according to both seasonality and the economy developing as expected, and will likely remain relatively weak, in wait of fiscal policy information. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 Update On A Tumultuous Year - January 6, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Economic activity within the common market this week was mixed, however the overall euro area is accelerating: Confidence indicators (consumer, services, overall economic, and industrial) beat expectations across the board; Annual GDP growth outperformed at 1.8%; Unemployment came at better than expected at 9.6%; Most importantly, inflation was recorded at 1.8% - more or less in line with the ECB target. Nevertheless, core inflation remains at 0.9%, which is corroborated by the mixed performance of the major euro states - Germany, in particular, performed relatively poorly. The European Commission upgraded their forecasts for GDP, unemployment and inflation, however, highlighted that risks can emanate from emerging markets and the U.S, affecting financial markets and global trade. Report Links: GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data continues to show indications of a recovery in the Japanese economy: The jobs/applicants ratio beat expectations, and now stands at 1.43 The contraction in spending seems to be receding, with overall household spending falling by 0.3% vs a 1.5% contraction in November. December industrial production also outperformed expectations, growing by 0.5%. In their latest monetary policy report the BoJ took into account the good economic data that we have been highlighting as they have raised their forecast in GDP growth going forward. This should not be taken as a sign that the BoJ is starting to back off from its radical policies, as they project that inflation will reach 2% in 2018 (the target, as we have mentioned before lies above this level). Thus, the cyclical outlook for the yen remains bearish. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 In their monetary policy meeting yesterday, the BoE decided to keep their policy rate unchanged. While it is true that they raised their inflation forecast for the short term, they also decreased their forecast for inflation for the long term compared to their last meeting. More importantly they adjusted their equilibrium unemployment rate to 4.5% from 5%, a development which makes the BoE more dovish than otherwise. Markets have taken notice of this, as the pound has depreciated against all major currencies. Despite this development we continue to have a bullish bias towards the pound, as we still believe that both the BoE and the market are overestimating the negative effects that Brexit can have on the British economy. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Just as the dollar began to correct, AUD displayed an upbeat performance, appreciating 6.75% since then. The weak dollar has helped commodity prices rally, iron and copper prices have appreciated in anticipation of U.S. infrastructure spending, Chinese Manufacturing PMI beat expectations, and the trade balance also outperformed expectations. While it is possible that a weak dollar can help alleviate much of the pressure off AUD, we remain obstinate on the fundamental weakness of the AUD. The Australian economy is still haunted by the mining industry slump, with the labor market feeling much of the pain. As mentioned before, a longer-term bull market in the dollar, and Trump's expected policies, can have very adverse effects on EM, global growth, global trade, and thus commodity currencies. AUD is also approaching overbought RSI-levels, as well as an important resistance level, and is likely to see some downside soon. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 On Tuesday unemployment came in at 5.2%, significantly above the market expectation of 4.8%. This caused the NZD to fall off, particularly against its crosses. However we believe that the bullish story for the NZD is still intact. Immigration continues to increase, with visitor arrivals increasing by 11% YoY. This should continue to add fuel to the stellar kiwi economy. On the commodity side, in spite of a slowdown, dairy prices continue to grow at an astonishing 47% YoY pace. Moreover the relative robustness of dairy prices to EM liquidity conditions should help the NZD outperform the AUD, as base metals are more likely to bear the brunt of a shortage in EM liquidity triggered by a rising dollar. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 On Tuesday, USD/CAD fell below 1.30 for the first time since September, breaking through an important trend line, displaying newfound strength on the back of a weak greenback. As the USD continues its corrective phase, the strong CAD could hurt Canadian exports in the near future. Canada's exports represent 25% of its GDP, and 77% of its exports are to the U.S. An implementation of the Border-Adjustment Tax could have adverse consequences for this export-oriented economy. Although this tax will likely be bullish for the greenback, Trump has emphasized his view on the excessively strong dollar. The recent GDP monthly figure of 0.4% beat consensus due to the improving domestic economy. However, the aforementioned points can be a very real threat to this improvement, and should be monitored closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 After falling to an 18-month low, below 1.065, EUR/CHF has once again rallied and is now close to reaching 1.07. This is the third time that our recommendation of buying this cross whenever it falls below the crucial 1.07 level proves successful. We continue to reiterate that whenever EUR/CHF approaches this level, the SBN will not be shy to intervene, as a strong franc would accentuate the deflationary pressures that plague the Swiss economy. Recent data has been disappointing, and one should expect that the SNB will be more overzealous in its management of the franc: The KOF leading indicator stood at 101.7, falling from the previous month and underperforming expectations. SVME Manufacturing PMI also fell short of expectations and fell relative to November. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 This week, the Norwegian Krone built on its stellar 2017 rally. Indeed, USD/NOK has fallen by almost 5% since the start of the year. This rally in the krone has been particularly surprising, as it has happened in an environment where oil prices have stayed relatively flat. Thus, If OPEC cuts start to cause significant inventory drawdowns, the NOK could rally much further. Additionally it is worth reminding that Norwegian inflation is a unique case in the G10, as it is the only country which has an inflation level above their central bank target. A breaking point will eventually come, where the Norges Bank will have to choose between backing off their dovish bias and letting inflation run amok. Thus, we will continue to monitor inflation in Norway closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Sweden's economy continues to show strength. Producer prices increased at a 6.5% yearly pace, and a 2.1% monthly pace; Consumer confidence increased to 104.6 from last month's 103.2; Manufacturing PMI increased to 62; The monthly trade balance is positive for the first time since August. The data paints a positive picture of the economy: improving inflation, high consumer confidence, and a healthy industrial and export sector. Sweden's future for its exports seems hopeful on the back of an increasing manufacturing PMI and the lagged effects of a weak SEK. Additionally, Sweden is unlikely to be majorly affected by U.S. protectionism. Exports to the U.S. only account for 2% of GDP, and 7.7% of overall exports, whereas exports to the euro area account for 11% of GDP and 40.6% of exports. The risk of a strong SEK will be limited as the Riksbank monitors its pace of strength, and the USD will eventually resume its appreciation. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The U.S. growth outlook has improved but markets already reflect this reality. The U.S. dollar is losing momentum despite healthy economic releases, highlighting the risk of a pullback. EUR and JPY should be the prime beneficiaries of a dollar correction as commodity currencies are exposed to brewing Chinese risks. Short CAD/NOK and AUD/JPY. Happy New Year! Feature A defensive posturing seems increasingly appropriate for currency investors in the coming months. While we continue to expect U.S. growth to strengthen toward 3% this year, asset prices have already discounted a very positive economic outcome. As Chart I-1 illustrates, the ratio of metal to bond prices (adjusted for relative return volatilities) tends to be a good leading indicator of U.S. growth. However, this indicator clearly shows that investors are already positioned for solid growth. Chart I-1The Economic Outlook Has Improved, But Markets Are Aware Moreover, bond prices have uniformly discounted good news. Both our composite sentiment indicator and the bonds' fractal dimension - a measure of groupthink - highlight that investors are collectively positioned for a bearish Treasury outcome (Chart I-2). This raises the risk that even a good growth number out of the U.S. will disappoint investors. Lofty expectations are not confined to bonds and metals, however. DXY and the broad trade-weighted dollar are also displaying some groupthink, another troubling sign for dollar bulls like us (Chart I-3), who find our side of the ledger increasingly crowded. Chart I-2Buying Bonds Is A Contrarian Play Chart I-3Dollar Could Pull Back What does this all mean? In our 2017 outlook, we mentioned that while the risk of a dollar correction was rising, the dollar's momentum was too strong to fight at this point in time.1 Moreover, historically, January tends to be a strong month for the dollar (Chart I-4). A window of opportunity to get short may be opening up. For one, the dollar has been losing momentum in the past few weeks, shown by the divergence that is emerging between prices and momentum (Chart I-5). Additionally, net speculative positions on the dollar are near record highs but, more importantly, are not making new highs (Chart I-6). Chart I-4The Greenback Likes The New Year Chart I-5Dollar Momentum Is Weakening Chart I-6Long Dollar: A Crowded Trade Interestingly, the Swedish krona, the currency with the most negative beta to the dollar is now showing surprising signs of strength (Chart I-7). This is particularly remarkable as this week the Riksbank announced it would pursue currency-market interventions if it judges that a strong currency threatens its inflation target. Hence, if the krona's underperformance was a harbinger of dollar strength this past fall, the SEK's current resilience may foreshadow a correction in the greenback. In terms of the dollar's reaction to recent economic data, the greenback has been unable to rally on strong fundamentals this week. Instead, the dollar softened despite healthy readings from the ISM manufacturing survey, with the headline measure rising to 54.7 and the new orders component surging to 60.2. Relatively hawkish FOMC minutes couldn't even support DXY. In fact, European PMIs seem to have overshadowed U.S. economic data. The European Manufacturing PMI is at a six year high (Chart I-8). Even the French consumer is feeling perky, with the consumer confidence hitting a nine year high. Chart I-7SEK Upside Equals USD Downside Chart I-8Good Numbers In Europe The absence of U.S. dollar strength in response to strong economic news at a time of seasonal strength for the USD raises the risk of a dollar correction in the coming weeks. We expect the yen and the euro to be the prime beneficiaries of such moves. Commodity currencies, on the other hand, might be unable to take advantage of any dollar weakness. Too much good news have been priced in. Commodities have been lifted by the perception of stronger growth in the U.S., but also by the common refrain among investors that the Chinese authorities will continue to reflate the economy in the run up to the Communist Party Congress this autumn. We worry that China is likely to be a source of negative shock. Investors are increasingly likely to see their hopes of stimulus dashed, particularly since the Chinese economy does not look like it needs much stimulus right now. The Keqiang index - a comprehensive measure of industrial activity - is at post-2010 highs and real estate markets have become very frothy (Chart I-9). Moreover, the recent surge in bitcoin prices - despite a strong dollar - suggests that capital outflows out of China are intensifying despite tightening capital account restrictions (Chart I-10). Indeed, bitcoin prices started their recent ascent as talks of capital controls in China grew in late 2015. The result has been higher interest rates and a tightening of Chinese financial conditions. This also gives the authorities an impetus to let the RMB fall - representing another deflationary shock for EM economies and commodity producers. Chart I-9China Doesn't Need Reflation Chart I-10Symptoms Of Chinese Outflows In this environment, oil prices are likely to fare better than metal prices, one of the key themes we highlighted in our 2017 outlook, which should benefit our short AUD/CAD trade. In addition, we are reopening our short CAD/NOK position. CAD/NOK is trading 15% over its fair value (Chart I-11), and would benefit in the event of a USD correction. Moreover, the Canadian surprise index, which had surged relative to that of Norway has now rolled over, pointing toward weaknesses for this cross (Chart I-12). Chart I-11CAD/NOK Is Overvalued ##br##CAD/NOK Is Expensive Chart I-12Economic Momentum ##br##Moving Against CAD/NOK Another opportunity seems to be emerging in the yen. Speculators are massively short the yen and our yen capitulation index continues to hover near 22-year lows (Chart I-13). From current levels, the yen could easily move toward 110, especially if our view on the dollar and Chinese policy risks is correct. That being said, the more than 1% fall in USD/JPY yesterday suggests that investors may want a more attractive entry point. Investors should also consider shorting AUD/JPY. Not only is this cross very sensitive to movements in the yen, but it also provides a direct way to capitalize through the currency market on falling metal prices and rebounding bond prices (Chart I-14). Moreover, AUD is very sensitive to Chinese economic conditions, and tightening Chinese liquidity along with a falling RMB would do great damage to the Aussie. Chart I-13JPY Has ##br##Upside Chart I-14Short AUD/JPY Equal ##br##Short Metals / Long Bonds Bottom Line: Financial markets have priced in a lot of good news in a short amount of time. Investors are now vulnerable to a pullback in risk assets and a rebound in bond prices. This process is likely to support the European currencies and the yen against the dollar, but hurt commodity currencies. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, "Outlook: 2017's Greatest Hits", dated December 16, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The minutes from the December 14 FOMC meeting highlighted that Trump's fiscal proposal still lacks clarity, but the Fed's hawkish shift remains in place despite the tightening conditions brought about by a rising dollar. Anxiety about future growth may have resurfaced from this realization, prompting dollar bulls to close some of their bets: the DXY plunged 1.7% in just two days. Alongside this, Treasurys have rallied 1.7% and the 10-year yield has dropped 8 bps. Data from the U.S. in the past few months has been consistently positive, with this week also showing an uptick in Manufacturing PMI to 54.7 from 53.2, and prices paid increasing by 11 points to 65.5. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Party Likes It's 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The Euro Area ended the year on an up note, as manufacturing, service and composite PMIs all outperformed consensus and preceding figures for most of the major euro countries. The resulting effect was a pickup in CPI, as headline inflation for the Euro Area came in at 1.1% YoY, and core at 0.9%. The labor market continues to make steady progress as Germany recorded a decrease in unemployed people by 17,000, and Spain, a decrease of 86,800. It is too early to tell whether this data will affect the ECB's next monetary policy stance. However, what is evident is that EUR/USD is more likely to move on U.S. economic surprises than anything else. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 On December 20th the BoJ left rates unchanged and maintained its yield curve control program that keeps 10-year rates near 0%. In its statement, the bank admitted that it expects a moderate expansion on 2017 as Japan continues to recover. We are sympathetic to this view. With the yen and Japanese real rates falling, the economy should be able to get out of its deflationary trap. Indeed, recent data shows that things might be turning for Japan: Both Services and Manufacturing PMI increased last month and are now at 52.3 and 52.4 respectively. Retail trade growth came at 1.7% YoY, beating expectations. We maintain that the yen should see more downside on a cyclical basis, given that the BoJ will maintain their yield curve control program until inflation overshoots their 2% target. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Party Likes It's 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 The pound has remained relatively unchanged against the dollar since the start of the year. The decision by the Supreme Court will be a key event to watch as it will determine whether the U.K. parliament has authority in determining how Britain exits from the European Union. Aside from political risks, The British Economy has remained resilient despite the uncertainty unleashed by last year's referendum. Recent data confirms this: Markit Manufacturing PMI came in at 56.1 versus expectations of 53. Surprisingly, Markit Services PMI reached 56.2, marking the biggest expansion of the service sector in a year. Despite much fear about the effects that the fear of Brexit would have on property prices, house prices continue to rise at a healthy 4.5% pace, beating expectations. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 AUD/USD has enjoyed a recent rally on the back of the greenback's decline. Additionally, the Australian services sector has improved considerably with the AiG Performance of Services Index recording a 6.6 point increase in November to 57.7. Although this may have contributed to the AUD bump, it is important to not look too much into this data as the Australian economy looks questionable - something we have discussed on several occasions. Australia's mining sector, China and emerging market uncertainty, a bearish outlook for commodity currencies and a USD bull market are all factors which will put downward pressure on AUD in the future. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi reached its lowest level since June right before the New Year, dipping slightly below 0.69. Indeed some recent developments have proved negative for the NZD: Dairy prices have slowed down after their meteoric growth in the last half of 2016. GDP growth came at 3.5%, below expectations of 3.7%. Nevertheless structural forces appear to favor the Kiwi economy. First, permanent long-term migration in Auckland is at a 24-year high. Although, in the short term this should contain inflation as the supply of workers increases, in the long term the additional demand should boost the economy. Moreover, household credit growth continues to be healthy at almost 10% without being excessive, as it still is well below pre-2008 levels. These factors should boost the kiwi economy and provide long-term support for the NZD, at least compared to the AUD. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The Canadian dollar failed to appreciate against the dollar alongside rising oil prices after the Fed's December 14 monetary policy decision. For a moment, the Canadian dollar seemed to be more a function of the dollar than of oil. However, this decoupling is historically unprecedented and USD/CAD will soon revert back to its negative association with oil prices, especially due to the likely subdued movements in the dollar in the near future. A longer term outlook for CAD entails moderate downside. A dollar bull market will keep a lid on oil prices and be bullish for USD/CAD. Shorter-term momentum points to some strength in the CAD, with the MACD line surpassing the signal line and the 14-day RSI approaching oversold levels. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 USD/CHF should continue to mirror the behavior of the euro against the U.S. Dollar. While it is true that the euro area had strong data at the end of the year, continued dollar strength should cap any rally in the euro. Thus, USD/CHF should remain relatively unchanged. On the other hand, EUR/CHF is currently at 1.07, a level at which the SNB is very likely to intervene if it drifts any lower. The SNB has been very explicit that they will not tolerate any further currency appreciation, until deflationary pressures have started to dissipate. Given that inflation finished 2016 with a yearly growth of 0%, the SNB will not stop intervening any time soon. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 In a recent speech, Norges Bank Governor Oystein Olsen asserted that the economy has turned the corner, projecting real GDP growth of 1.5% in 2017 and above 2% in 2018 and 2019. He also pointed to the solid growth experienced by the non-oil sector. Wage growth, after falling for the past 8 years, also appears to have bottomed at around 2% and is now picking up. More importantly, leverage in the economy is very high and continues to grow, with debt as a percent of disposable income projected to reach close to 250% by the end of 2018. All of these factors could fortify already present inflationary pressures in the Norwegian economy. This will push the Norges Bank off its dovish bias, and consequently, thrust the NOK higher, particularly against its crosses. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Riksbank's monetary policy meeting on Wednesday concluded with an unexpected outcome -the board considered the option to be able to immediately intervene on the market if necessary. It is clear that Swedish officials are making an adamant attempt in achieving their inflation target, clearing out any obstructions that may slow down inflation. It must be highlighted however that Governor Martin Flodén is reticent on this policy in the current situation, suggesting that intervention risk is not looming for the time being. Nevertheless, it is important to note that this instrument has been added to their toolkit. This decision most likely stems from the 4.5% decline in EUR/SEK since November 8 of last year. Since Europe represents 82% of Sweden's imports, a risk of importing deflation exists. We believe a level of around 9.000 to 9.1000 for EUR/SEK seems like a potential intervention trigger. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Commodity prices and the dollar can occasionally rise together. The 1999-2001 and the 2005 experiences suggest a supply shock is required. If commodities were to rally alongside a strengthening dollar in 2017, this would be an oil-led move. Metals have very little potential upside as improving DM growth drains liquidity from EM economies. Favor petro currencies (CAD and NOK) relative to the antipodeans (AUD and NZD). Stay short AUD/CAD. USD/JPY is in a major bull market. However, near-term risks are to the downside. Feature It has become axiomatic among investors to assume that a dollar bull market is synonymous with a commodity bear market. While the relationships usually holds, there have been episodes where the narrow trade-weighted dollar and natural resource prices moved in tandem, not in opposite directions: 1982 to 1984, 1999 to 2001, and in 2005. The recent surge in base metals raises that possibility, but as DM economies suck in global liquidity away from EM ones, the prospect for a positive correlation between most commodities and the dollar is still remote. When Do Commodities And The Dollar Walk Together? Commodities and the dollar usually move in opposite direction. Since 1980, there has only been three episodes of consistent commodity strength despite dollar appreciation: 1982 to 1984, 1999 to 2001, and in 2005 (Chart I-1). What defines each of these episodes? In the early 1980s, the rally in commodities was concentrated outside of the energy complex. The U.S. economy was rebounding from the 1980s double-dip recession, and Japan was in the middle of its economic miracle. Their vigorous growth resulted in a large positive demand shock, boosting Japan and the U.S.'s share of global copper consumption from 34% to 37%. This undermined any harmful effect on metal prices from a rising dollar (Chart I-2). Chart I-1Commodities Can Rise ##br##Alongside The Dollar Chart I-2Early 1980s: U.S. Growth Was ##br##Able To Boost Metal Prices From 1999 to 2000, the rally in commodity was not broad based. In fact, it was concentrated in the energy sector (Chart I-3). It reflected three factors: After being decimated in 1997 and 1998, EM stock prices managed to stage a temporary rebound; one that mostly reflected bombed out equity and currency valuations. However, the muted response of non-oil commodities suggests that this rebound had little economic impact. Energy was buoyed by the vigorous growth in DM, with OECD oil consumption growing 1% annually between 1998 and 2001. Finally, as oil prices fell below US$10/bbl in late 1998 global oil production contracted sharply, plummeting by more than 4 million barrels, or 5% of total production. Not only could Saudi Arabia and Russia not withstand the pain of lower oil prices, but the latter was in the midst of a massive economic crisis that disrupted the local oil industry's ability to finance its operations. While most commodities in the 2005 episode experienced subtle upward drift, once again, energy was the true winner (Chart I-4). Supply disruptions in the Gulf of Mexico following the record-breaking 2004 and 2005 hurricane seasons contributed to removing slightly more than one million barrels from the market. Additionally, oil had captured investors' imagination, with the peak-oil theory being all the rage. This combination explains why oil was the primary beneficiary of Chinese and EM economic strength while base metals could not overcome the dollar's hurdle. Chart I-31999-2001: Commodity##br## Rally Was An Oil Rally Chart I-42005: Commodity##br## Rally Was An Oil Rally Bringing it all together, the dollar and commodities where able to rise as one in the 1980s because they responded to the same positive U.S. growth shock. However, during the 1999-2001 and 2005 commodity rallies in the face of strong dollar, the supply/demand imbalance in oil was paramount. Bottom Line: The dollar and commodity prices can occasionally move together. This happens when a supply shock affects a natural resource as important as oil, lifting its price despite the greenback hurdle. Outside of energy, in general prices still displayed little upside through these episodes. Giant Sucking Sound Our bullishness on the dollar is built on our positive outlook for U.S. growth and rates, a view only reinforced by Trump's electoral victory.1 This does not mean we expect the same boost to metal consumption that we saw in the early 1980s. Today, combined Japanese and U.S. copper consumption only accounts for 11% of global consumption. For iron ore, the U.S. represents only 4% of global consumption. Even if the U.S. were to spend $1trillion over five years on infrastructure (an extremely optimistic assumption), it will not constitute the same relative boost to global demand as the U.S. expansion during the 1980s did (Chart I-5). Additionally, metals will remain slightly oversupplied. In fact, inventories have been rising and more supply of iron ore is coming upstream in 2017, as additional Pilbara iron ore deposits are being unleashed on the markets. In the case of copper, our commodity specialists expect supply to continue to grow in the years ahead. But still, could EM lift the demand for metals enough to play the same role as the U.S. did in the early 1980s? We doubt it. When it comes to China, the current growth improvement is likely as good as it gets. The Keqiang index - a measure of industrial activity in the Middle Kingdom - is approaching post-2011 highs, but the demand for loans remains very depressed (Chart I-6). Moreover, the Chinese fiscal impulse - which has buoyed the country's economy for much of 2016 - has rolled over and is now in negative territory, suggesting that the Keqiang index will weaken in 2017. This will weigh on Chinese imports of machinery and raw materials, representing a deflationary shock for other EM. Chart I-5Metals Are About China, Not The U.S. Chart I-6China: The Best Is Behind Us At the current juncture, additional deflationary forces on EM would be an unwelcomed development. The structural headwinds plaguing EM economies are still in place. EM remain burdened by too much capacity, too much debt, and too little productivity (Chart I-7). More worryingly, strong DM growth will do very little to lift EM economies and assets out of their structural funk. Instead, DM strength is likely to hurt EM. As Chart I-8 shows, since 2009 improvements in DM leading economic indicators (LEIs) have led to falling EM LEIs. Chart I-7EM Structural Headwinds Chart I-8DM Hurting EM EM nations are not very dependent on DM as a source of growth. Intra EM trade has been responsible for most of the growth in EM exports as shipments to the DM economies and the U.S. now account for only 28% and 15% of EM total exports, respectively. While this explains why DM growth cannot lift EM growth, it still does not explain why DM growth leads to deteriorating EM activity. The glue binding this paradox is global liquidity. In a nutshell, when DM growth improves, DM economies suck in global liquidity, which results in a tightening of EM monetary and financial conditions. This combined constriction acts as a large brake on EM growth. Underpinning the relationship between liquidity and growth are a few relationships: First, DM real rates are a relatively clean measure of growth expectations. As Chart I-9 shows, U.S. real yields and the growth expectations embedded in U.S. stocks prices correlate closely with each other. Second, when DM real yields rise, EM reserve accumulation - a measure of high-powered liquidity - moves into reverse (Chart I-10). This suggests that rising DM real yields prompt investors to abandon EM markets, attracted by improving risk-adjusted returns in DM. Chart I-9Real Interest Rates: ##br##A Read On Expected Growth Chart I-10The Liquidity ##br##Channel Third, rising DM rates puts downward pressure on EM FX (Chart 10, bottom panel). Being associated with a reversal of carry trades this is another indication that capital is leaving EM economies. Additionally, falling EM exchange rates tighten EM financial conditions by hampering the financial viability of EM borrowers with foreign currency debt. Fourth, given that the exogenously-driven fall in liquidity already hurts EM growth, rising EM borrowing costs in response to increasing DM real rates amplify the economic drag. By causing the return on EM bonds to fall (Chart I-11), this generates further outflows from EM, and also tightens EM financial conditions. Finally, rising DM yields have been associated with underperforming EM equities relative to DM equities (Chart I-12), giving investors another reason to pull money out of EM. These dynamics have implications for commodity currencies. BCA's view is that DM real yields have upside from here, and therefore EM liquidity and financial conditions are set to tighten. Not only will this hurt EM assets, but a flattening BRICs yield curve should also lead to falling commodity currencies (Chart I-13). Chart I-11The Financial ##br##Channel Chart I-12EM/DM Stocks: A Function ##br##Of DM Real Rates Chart I-13Tightening EM Liquidity Conditions##br## Hurt Commodity Currencies However, differentiation is needed. Tightening EM liquidity and financial conditions are likely to hurt the metal market where there is no broad-based supply deficit. However, like in the late 1990s, oil could actually do well under a strong dollar scenario. For one, the OECD and the U.S. represent much larger shares of oil demand than they do for industrial metals (Chart I-14). In the context of robust U.S. economic growth and consumer spending, we could see continued upward momentum in global oil demand. This is crucial as the oil market is already in a deficit following the collapse in oil capex in 2015 and 2016 (Chart I-15). Additionally, our Commodity and Energy Strategy team argues that OPEC and Russia are very likely to cut production next week. Economic strains and the desire for asset sales in Saudi Arabia and Russia are creating the needed incentives.2 In this environment, oil currencies (CAD and NOK) should outperform antipodeans (AUD and NZD). The outlook for the AUD is the poorest. It is the currency most exposed to metals, the segment of the commodity market most aligned with EM growth. NZD could be at risk too. While it is not exposed to metals like the AUD, the kiwi is very exposed to EM spreads, a variable that is likely to suffer if DM yields continue to rise.3 Buying a basket of CAD and NOK relative to AUD and NZD makes sense here. In terms of our trades, we shorted AUD/CAD too early. However, the economic backdrop described above suggests that the economic rationale for this trade is growing ever more potent. In fact, from late December 1998 to January 2000, CAD rallied against the USD, while the AUD was flat. Additionally, technicals and positioning point to a favorable entry point at the current juncture (Chart I-16). Chart I-14Oil Is Still About The U.S. Chart I-15Favorable Supply/Demand Backdrop For Oil Chart I-16A Good Entry Point For Shorting AUD/CAD Bottom Line: In 2017, the relationship between commodity prices and the dollar is likely to resemble the 1999-2001 outcome. While tightening EM liquidity conditions could weigh on metals, supply concerns and a strong U.S. economy could lift oil prices. This environment would favor the CAD and the NOK relative to the AUD and the NZD. A Countertrend Bounce In The Yen? As we discussed last week, the move in USD/JPY makes sense based on the BoJ policy dynamics we analyzed in our September 23 report titled "How Do You Say "Whatever It Takes" In Japanese?". However, despite our bearish disposition toward the yen, we worry that a countertrend correction in USD/JPY is in the offing. USD/JPY is approaching a formidable resistance. The tell-tale sign of a USD/JPY bull market has been when the pair moves above its 100-week moving average (Chart I-17). We do expect such a move to ultimately materialize. However, with the 100-week MA currently at 114.8, this key indicator is a stone throw away from the present exchange rate of 113.39 and might prove to be a temporary resistance. Additionally, a congestion zone exists between 113 and 114.5, reinforcing this risk. Increasing the danger at the 114 level is the recent high degree of groupthink behavior displayed by this pair. As was the case for the U.S. bonds, the fractal dimension measure for USD/JPY is now below 1.25, highlighting the risk of a countertrend move (Chart I-18). Chart I-17USD/JPY: Key Resistance In Sight Chart I-18A Countertrend Move In USD/JPY Moreover, we agree with our U.S. Bond Strategy service and expect a pause in the U.S. bond sell-off.4 With the tight relationship between USD/JPY and 10-year Treasury yields fully alive, any rebound in bond prices would imply a rebound in the yen. Finally, our intermediate-term timing indicator shows that USD/JPY is 5% overvalued on a tactical time frame, a level where the likelihood of a temporary reversal is heightened. Based on the above observations, today we are opening a tactical short USD/JPY position at 113.39, with a target of 107 and a stop at 115.2. We are also closing our long NOK/JPY trade at a profit of 5.3%. Bottom Line: While the cyclical outlook for USD/JPY continues to point upward, tactically, USD/JPY is facing some downside risk. We are implementing a tactical short USD/JPY trade with a target at 107 and closing our long NOK/JPY trade. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Dollar: The Great Redistributor", dated October 7, 2016, and Foreign Exchange Strategy Weekly Report, "Reaganomics 2.0?", dated November 11, 2016, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report, "The OPEC Debate", dated November 24, 2016, available atces.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, "Global Perspective On Currencies: A PCA Approach For The FX Market", dated September 16, 2016, available at fes.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The dollar has crossed a crucial resistance level, and the DXY is now trading close to 102. Positive data this month have contributed to this rally. Durable goods orders came in at 4.8% for October, up from 0.4% in September. This has lifted manufacturing PMI for November to 53.9, showing strength in the supply side of the U.S. economy. Minutes from the November 1-2 FOMC meeting indicate a clear hawkish consensus for December's meeting. A probability of a hike is now fully priced in and is reflected in the almost 14-year high reached by the DXY following the release of the minutes. We should see some stability in the DXY coming up to the December meeting. Otherwise, the U.S. economy seems strong. Upcoming data should ultimately buoy the strength in the dollar, but short-term movements will be limited. Report Links: One Trade To Rule Them All - November 18, 2016 Reaganomics 2.0? - November 11, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Draghi remains resolute in his commitment to reach the inflation target. Easy monetary policy has helped support recent growth in the euro area. Low policy rates have increased credit supply, leading to higher lending volumes to households, NFCs and SMEs. Key indicators, such as this month's composite PMI which went up to 53.7, from 53.3, highlight continued decent growth in Europe. Nevertheless, core inflation remains weak at 0.75%, which entails a high likelihood for easy policy going forward. Persistently low rates and structural weaknesses will continue to weigh on bank profitability. Banks may eventually respond by limiting credit growth in the future and hampering overall activity. The short-run outlook for the Euro still remains solid against crosses. EUR/USD has hit a support level, but momentum indicates strong downward pressure against the dollar, so attention to this resistance level is warranted. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 USD/JPY has appreciated by more than 7% since the day Donald Trump was elected president. From 1990 up until the day Trump got elected, the yen depreciated at such a high rate in such a short time frame in only 4 occasions. We are taking a tactical short position in USD/JPY, because although we continue to be yen bears on a cyclical basis, the current sell-off seems overdone. USD/JPY has reached highly overbought technical levels and it is near its 100-week moving average of 114.8, which should act as a temporary resistance. More importantly, the sell-off in U.S. bond yields, a major driver of the recent plunge in the yen is likely to pause for the time being. USD/JPY will once again become an attractive buy at around 107. Report Links: One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 On Wednesday the Treasury released its Autumn Statement, outlining fiscal policy for the coming year. Philip Hammond, Chancellor of the Exchequer, offered no surprises as he vouched to continue to rebalance the budget, albeit at a slower pace. The fiscal impulse looks to increase slightly, yet stay negative for the next 4 years. Such a hawkish fiscal stance should be a drag on growth in an economy that cannot afford any setbacks as it prepares to exit the European Union. However, despite this grim outlook we are still monitoring the pound as an attractive buy, given that it is very cheap. In fact GBP/USD had very little movement after the announcement, which suggests that much of the risks for the U.K's economic outlook are already priced into the cable. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The Australian economy continues to encounter structural weaknesses from a deteriorating mining sector, for which the outlook remains pessimistic. An interesting observation is that the mining investment-cut is considerably mature, as RBA Assistant Governor Christopher Kent states "about 80% of the adjustment" is done. However, weak Asian EM fundamentals and a questionable outlook for China imply impending demand-side problems, which will weigh, not only on Australian terms of trade, but also the Australian economy, as emerging Asia represents 66% of Australia's total exports. An additional hurdle for the terms of trade is a rising USD, which could drag down commodity prices and the AUD. In the short run, the MACD line for AUD/USD also points to downside in the near future, as the currency approaches a possible resistance level at 0.72. Report Links: One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 We continue to hold a bearish stance towards NZD/USD, as the dollar bull market and weakness in Asian currencies will ultimately weigh on the kiwi. However, the outlook for the NZD against other commodity producers is not as clear. Prices for dairy products, which constitute over 30% of New Zealand exports, have skyrocketed and are now growing at 46% YoY. This trend is set to continue in the short term, as Chinese dairy imports continue to rebound, recording a 9.7% growth rate compared to last year. Furthermore, real GDP is growing at a 3.5% pace, the highest in the G10. That being said, we are reticent to be too bullish on this currency, as inflation remains very low and increasing migration is putting a lid on wages. However if inflation picks up, the NZD could become attractive relative to its commodity peers. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data has come out below expectations: Core CPI came in at 1.7%. Wholesale sales are contracting at -1.2%. Retail sales excluding autos are at 0%. These figures support the view that there is an underlying weakness in the Canadian economy which will keep the BoC from reaching its inflation target. However, as the U.S. continues to be the largest consumer of oil in the world, with around 20% of global consumption, stronger U.S. growth will support oil demand, which in conjunction with tighter supply, will support oil prices. This will support the CAD against other commodity producing currencies. Structural weaknesses and an upward trend in USD/CAD since May suggest that the CAD could experience more downside momentum against USD. Nevertheless, it is important to monitor next week's OPEC meeting, the outcome of which will dictate the CAD. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The decline in EUR/CHF appears to have subsided for the time being. Last week we mentioned that the SNB would not tolerate much more downside on this cross, and would not be shy to intervene if necessary. This view has shown to be valid, as EUR/CHF has found support around 1.07. This floor imposed by the SNB means that the performance of the franc against the dollar should mirror EUR/USD for the time being. This implies that USD/CHF should have limited upside in the short term, as EUR/USD has hit a major support level around 1.05 that has been in place for the last 2 years. On a cyclical basis, monetary divergences should continue to weigh against the euro, which makes us bullish on USD/CHF on this time frame. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The U.S. continues to be world's largest consumer of crude oil, with 20% of total consumption, while China leads in both the copper and nickel markets, accounting for nearly half of global consumption and consuming over 5 times as much as the U.S. in both markets. This divergence implies that if U.S. outperforms the rest of the world, and if the rising dollar continues to weigh on EM economies, oil should outperform base metals in the commodity space and consequently petro currencies like the NOK should outperform other commodity currencies. Additionally the NOK is supported by a current account surplus of 6%, and high inflation is prompting Norges Bank to back off from its dovish stance. While we like the NOK on its crosses, we are more bearish on the NOK versus the USD, as USD/NOK remains very sensitive to the dollar. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Swedish economy continues to show signs of strength. Recent data supports this view: Consumer confidence for November is at 105.8, compared to 104.8 for October. Producer Price Index came in at 2.2% annually for October. A strong consumer sector has lifted inflation expectations in Sweden. Strong PPI numbers validate this, as they foretell a potential rise in CPI as producers pass on their costs to consumers. Despite this strength, SEK may see limited upside. As mentioned last week, most of the movement in the SEK can be attributed to the USD. Rate hike expectations have now been fully priced in for the Fed, so it is likely that movements in the USD will be muted, and hence the SEK could find some support, at least for now. Report Links: One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The blistering dollar rally has mimicked the selloff in U.S. and global bonds. The dollar and bonds may have gotten ahead of themselves. A short-term reversal or a pause in the recent trend is becoming our base-case scenario for the rest of the year. If a dollar correction materializes, USD/CNY will also retreat, temporarily diminishing pressures on EM currencies. The yen weakness illustrates the importance of the September policy change by the BoJ. AUD/SEK is a short. We are re-introducing our back sections, but now covering all the G10 currencies. Feature In recent weeks, we have developed the view that a Trump victory would embolden our cyclically bullish stance on the dollar. We re-iterated this sentiment last week.1 Since then, we have received many questions about the very short-term outlook for FX markets. Our view is that from now to the end of the year, the dollar is likely to stabilize and may even weaken somewhat. This should create a buying opportunity for investors that have missed the dollar rocket. It's All About Bonds The dollar rally since Trump's election has been so torrid that the broad trade-weighted dollar has made new highs. DXY is now flirting with the top of the trading range established since March 2015 (Chart I-1). If the dollar can significantly punch above this resistance, or EUR/USD falls below 1.055, another violent dollar rally could ensue. While we do ultimately expect such a move to materialize, we do not expect it to happen just yet. The main reason for our skepticism is the bond market. Much of the appreciation in the dollar has been explained by the sharp rally in U.S. bonds, which has caused interest rates differentials to move massively in favor of the greenback (Chart I-2). For DXY to meaningfully punch above 100, bonds have to sell-off further. Chart I-1The Return Of The King Chart I-2Dollar And Bond Yields: Same Fight Our U.S. Bond Strategy service remains cyclically underweight duration, but the short-term outlook is murky. The move in bonds has been extremely one-sided. The bond market's behavior displays the hallmark of groupthink, where long-term and short-term traders have uniformly been selling Treasurys. The fractal dimension for bonds, a measure of groupthink developed by Dhaval Joshi, our European Chief Strategist, rests at 1.25, a level at which a trend reversal - even if a temporary one - tends to emerge (Chart I-3).2 Chart I-3Groupthink In The Bond Market Additionally, our composite sentiment indicator, based on the 13-week rate of change of prices, investor sentiment, and net speculative positions, is deeply oversold, highlighting the risk of a backup in prices (Chart I-4). Fundamentals also warrant a careful stance. A December Fed hike is fully priced in, and the expected Fed funds rates 12-months from now is already near the levels hit before the Fed raised rates in 2015 (Chart I-5). A catalyst is now needed to push rate expectations materially higher. Chart I-4Bond Sentimen##br##t Is Depressed Chart I-5Interest Rates Priced In A Lot##br## In A Short Time Span However, the recent backup in yields and the dollar has massively hit EM currencies (Chart I-6). EM currencies are falling because investors are taking funds out of these economies. Consequently, EM liquidity and financial conditions are tightening, a dark omen for economic activity in that space (Chart I-7). The more than 10% fall in gold prices since July 8, also paints a picture of deteriorating global liquidity conditions. Chart I-6Bond Yields Are Hurting##br## EM Financial Conditions Chart I-7A Dark ##br##Omen An EM correction may compel the Fed to worry about the short-term outlook. This development, along with the tightening in U.S. financial conditions resulting from the 7% back up in the broad trade-weighted dollar and 77 basis points in bond yields since mid-August, heighten the risk of a correction in risk assets. The Fed is aware of this and the market knows it. Chart I-8CPI Swaps Can Rebound More Additionally, U.S. 5y/5y forward CPI swaps have backed up 60 basis points from their lows to 2.4%, but they still remain below their historical norm of 2.5% to 3.3% (Chart I-8). The Fed probably wants to see them closer to these levels before aggressively ramping up its rhetoric and "dot-plot" forecasts. A Trump presidency will result in a large dose of fiscal stimulus, but we still have little clarity regarding the size of any packages, their composition, or their timing. Neither does the Fed. If there was any clarity, the Fed would likely be in a position to increase its "dot-plot" even without inflation expectations being in their normal range. Additionally, this week, the Bank of Japan put actions behind its words and announced an unlimited bond buying program at fixed prices, a process that should cap the upside on this anchor for global yields. Thus, in the very near term, the burden of proof is now elevated for rates to rise higher without the Fed's rhetoric becoming clearly more hawkish. While we expect this outcome to ultimately materialize, the next few weeks are not when we see it happening. This implies that the dollar's rip-roaring rally is likely to take a pause and even retrace some of its exceptional gains. However, a key risk remains, and that is China. Since Trump's victory, the Chinese RMB has accelerated its downward path, depreciating 1.7% in nine days. This move reflects the fear that Trump will impose large tariffs on Chinese-made goods. In the process, the fall in the yuan has dragged Asian currencies lower than the DXY appreciation would have warranted (Chart I-9). If these moves were to continue, EM currencies, the yen, and the AUD would fall further even without U.S. bond yields rising much. In the short-term this remains more a risk rather than a base-line scenario. While USD/CNY has rallied, the yuan has been stable relative to the currency basket targeted by the PBoC (Chart I-10). Therefore, if our view that the U.S. bond sell-off pauses temporarily is correct, the USD/CNY rally will also take a breather. Chart I-9Tariff Risk Weighing On Asian Forex Chart I-10Mind The Gap! The currencies most likely to benefit from any dollar bull-market pause are JPY, SEK, and EUR as they have become hyper-sensitive to U.S. bond yields. EM currencies too could see a temporary rally, especially if USD/CNY stops appreciating in line with the DXY. Bottom Line: The dollar bull market is intact. However, the tactical outlook points toward a pause in the greenback's upswing. In light of the fast repricing of the market's expectations for Fed policy, and the lack of clarity regarding Trump's plans, bond yields and interest-rate expectations have gotten ahead of themselves. Even the rally in USD/CNY, which has contributed to devaluation pressures on other Asian currencies, could pause if DXY stops rallying for a period of time. Why is the Yen So Weak? We have articulated a very bearish view on the yen since September 23.3 To our way of thinking, the Bank of Japan pegging 10-year JGB yields to 0% until Japanese inflation significantly overshoots 2% was a sea-change. However, we have been surprised by the violence of the recent yen sell-off. After all, wouldn't a selloff in EM currencies support the yen? A few factors have been at play. First, Japanese preliminary Q3 GDP numbers have come in at 2.2% on a year-on-year basis, handily beating expectations of 0.9%. Moreover, industrial production has picked up, and our model forecasts further acceleration, despite the recent strength in the yen (Chart I-11). With the employment market being tight - the unemployment rate stands at 3.1% and the active-job-openings-to-applicants ratio is at a 25-year high - this raises the risk that inflation begins to emerge. With nominal bond yields pegged at zero, this would weigh on Japanese real rates, and thus the yen, which continues to closely correlate with Japanese real rates differentials. Second, the recent global sell off in bonds has been an additional weight on the yen. In our communications with clients, we are often reminded how USD/JPY and bond yields are essentially one and the same, a heuristic borne by the facts (Chart I-12). Chart I-11Japanese IP Is ##br##Picking Up Chart I-12USD/JPY And Bond Yields ##br##Are One And The Same But right now, there is more to the relationship with bond yields than in previous episodes. The September promise of a cap on 10-year JGB yields is causing Japanese yield differentials to stand at mid-2015 levels, despite global yields being lower than they were then (Chart I-13). Also, the sell-off in global bonds has caused 10-year JGB yields to move slightly above 0%. However, having announced unlimited bond purchases at capped yields, the BoJ is about to begin purchasing JGBs to prevent yields from punching above 0% meaningfully. This will result in growing Japanese liquidity, compounding already existing JPY weaknesses. Chart I-13The BoJ Policy In Action Finally, the government is talking up fiscal stimulus. The third revision of the second supplementary budget has been passed, and the executive is already pushing for a third supplementary budget. Additionally, both Abe and Kuroda are ramping up their rhetoric regarding next year's wage negotiations, highlighting the growing risk that the government will implement wage policies in 2017.4 Short-term risks are skewed toward a yen rebound. When the BoJ announced its new policy in September, USD/JPY was 7% undervalued according to our short-term model. This is not the case anymore. Also, if global bond yields stop their ascension until year end, the BoJ will not purchase any bonds. Moreover, falling global bond yields will push Japanese rate differentials in favor of the yen, supporting the currency further. Finally, a continuation of EM stresses could prompt Japanese investors to repatriate funds into the country, putting upward pressures on the yen. Bottom Line: The extraordinary weakness in the yen reflects the improvement in Japanese economic activity. Also, the change in monetary policy executed earlier this year is limiting the upside for JGB yields, and the BoJ is now setting up an unlimited purchase program to back its words. However, a short term pull-back in USD/JPY grows increasingly likely if the global bond implosion takes a breather. Going Short AUD/SEK Shorting AUD/SEK here makes sense. To begin with, AUD/SEK is trading 16% above its long-term fair value as well as 5.2% above its short-term equilibrium (Chart I-14). Additionally, the current account differential is 9.4% of GDP in favor of Sweden. In terms of the economy, the Swedish consumer is displaying stronger resilience than the Australian one, powered by an outperforming Swedish labor market (Chart I-15). Additionally, Swedish house prices are growing 5% faster than in Australia. With Swedish consumer confidence outperforming that of Australia, and Swedish household credit overtaking Australian household credit growth, inflationary forces could emerge, resulting in a tightening of Swedish policymakers' rhetoric relative to Australia. On this front, the recent pick up in Swedish inflation is telling. Having rebounded to 1.2% annually, Swedish headline CPI is at a four-and-a-half-year high, suggesting that the emergency measures put in place by the Riksbank are beginning to outlive their usefulness. Meanwhile, Australia is moving away from its easing bias. But a move toward less accommodation is still not in the cards, especially as employment growth underperformed and total hours worked contracted at a 1% annual pace. Financial market dynamics also favor a weaker AUD/SEK. This cross has moved much ahead of nominal interest rate differentials, and real-interest-rate differentials have moved in the opposite direction, pointing to a lower AUD/SEK. Additionally, the Swedish broad market as well as financial equities have been outperforming Australian stocks. This suggests that Swedish financial conditions are too easy relative to Australia. Finally, technicals point to a negative short-term outlook for this cross. AUD/SEK is massively overbought on a 52-week-rate-of-change measure. On a shorter-term basis, the MACD indicates an overbought condition and is forming a negative divergence with prices, exactly as the stochastic indicator has broken down (Chart I-16). Chart I-14Poor Risk/Reward Tradeoff ##br##For Holding AUD/SEK Chart I-15The Swedish Labor ##br##Market Is On Fire Chart I-16AUD/SEK:##br## Poised For A Shakeout Bottom Line: The outlook for AUD/SEK is problematic. This cross is pricey and the Swedish consumer is outperforming that of Australia. This is happening exactly as the Riksbank may begin moving away from its hyper-accommodative stance, as inflation is hitting four-and-a-half year highs. Finally, financial market dynamics and currency technicals are flagging a short in this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Raeganomics 2.0?", dated November 11, available at fes.bcaresearch.com 2 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, "How Do You Say "Whatever It Takes" In Japanese?", dated September 23, 2016 available at fes.bcaresearch.com 4 Ibid. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Last week, equities and the dollar rallied as Trump's unexpected victory was taken as a positive for the U.S. economy in the hopes of promised fiscal stimulus. Both the market and Fed officials therefore remain tenacious on the prospects of a 25bps hike in December, with a 98% probability currently priced in. In a speech on Thursday, Yellen confirmed the gradual normalization of policy and acknowledged the strength of the U.S. labor market. Initial jobless claims declined to 235,000 from 254,000 and continuing jobless claims declined to 1.977 million from 2.043 million. This has further solidified our bullish stance on the dollar. On a technical basis, the DXY Index has hit a key resistance level of 100, which suggests a temporary halt to last week's surge. However, longer-term momentum is indicating a possible break-out from the key 100 level in the near future. Report Links: Reaganomics 2.0? - November 11, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The Euro continues to mirror the U.S. Dollar, losing more than 3% in a week since the U.S. Presidential Election. This move seems to be a function of the election only, as European data has come out reasonably strong this week: Economic sentiment from the ZEW Survey shot up to 15.8, beating expectations, while current conditions declined to 58.8 from 59.5. The trade balance increased by €8.2bn to €26.5bn. European GDP growth remains solid at 1.6%. Data points to EUR strength, so the Euro should remain somewhat neutral on a trade-weighted basis as its economy remains strong. Monetary policy divergence and technicals, however, should continue to weigh on EUR/USD in the short term, suggesting that cross-currency plays are the best way to capture any Euro strength. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 The yen has been one of the worst performing currencies in the G10 following Trump's election, with USD/JPY appreciating by about 5%. After this down-leg, we will not be surprised if the yen recovers some ground in the short-term. USD/JPY has already reached overbought technical levels and the sell-off in EM caused by the rising dollar may eventually trigger a risk-off period from which the yen will benefit. However, past the short term, we continue to be yen bears. Although the policies that the BoJ implemented in September did not seem as radical back then, a cap on Japanese 10-year rates takes a whole different meaning for the yen in the recent environment where interest rates are rising in the U.S, since it exerts considerable pressure on Japanese real rates vis-à-vis the rest of the world. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 An interesting trend has caught our attention: the British economy continues to be very resilient, beating not only market expectations but also projections by the BoE. Recent October data confirms this view: Retail sales and retail sales ex-fuel grew at an annual rate of 7.4% and 7.6% respectively, blowing past expectations. Additionally Markit Services PMI was 54.5, also beating expectations. This is particularly surprising given that the service sector is likely getting very little support from the weak pound. We are reticent to be bullish on the pound, at least on the short term, given that political risks continue to dominate the movements of this currency. Nevertheless, the cable is very cheap from a valuation standpoint, and if the British economy continues to beat expectations, the pound could become an attractive buy. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA left its cash rate unchanged at 1.5% at their November meeting, and clarified that their easing cycle has come to an end. Recent data, however, is showing signs of weakness in the Australian economy: the Westpac Consumer Confidence Index came in last week at -1.1%; wage pressures remain subdued at 1.9% yoy in Q3 from 2.1% in Q2; employment change was weaker than expected at 9,800 with the unemployment rate unchanged at 5.6% in October. Labor market slack remains a fundamental concern for the Australian economy, something the RBA also pointed out in their November statement. Inflationary pressures, if any, will likely emanate only from commodity prices, for which the outlook remains questionable due to a rising USD. Deteriorating consumer confidence and continued labor market slack will translate into deflationary tendencies, which will cap rates and add downward pressure on the AUD. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 In line with expectations, The RBNZ cut rates by 25 basis points to 1.75% at its latest policy meeting. Shortly after, a speech by Governor Wheeler lifted the NZD, as he appeared to signal that the RBNZ might be done easing by stating that "at this stage we think that we won't need another cut". We are unfazed by this change of rhetoric, and continue to be bearish on the kiwi. The NZD has formed a head-and-shoulders pattern which, along with fading momentum, foretells a downside leg for this antipodean currency. Moreover, a sell-off in Asian currencies and deteriorating financial conditions in Emerging markets following Trump's election should put further downward pressure on the kiwi, given that the NZD is the most sensitive currency to Asian spreads in the G10. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data points south for CAD: The merchandise trade deficit increased to CAD 4.1bn in September, with imports rising 4.7% to a record CAD 47.6 bn, and exports only up 0.1% to CAD 43.5 bn. The housing market continues to display warning signs as housing starts decreased in October to 192,900 and building permits declined by 7% in September from August, showing signs of supply decreases and rising prices. Although the labor market seems to be picking up, with net change in employment increasing by 43,900 and the participation rate at 65.8%, the setback in growth from the commodity slump and the Q2 Alberta wildfires will keep the BoC from raising rates. Nevertheless, we remain bullish on oil in the commodity space, and the CAD will likely display strength against the antipodeans. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The rally in USD/CHF should subside, at least in the short term. Not only has the swissie reached technical overbought levels, but the continued tightening in EM financial conditions caused by the rising dollar increased the probability of a risk off period where the CHF would rally. EUR/CHF on the other hand is likely to have limited downside from here on. Since August 2015, this cross had traded within a tight range of 1.075 to 1.110, breaking down only after the Brexit vote, when all risk-off assets rallied. However it has recently broken down again, an unwelcomed development for the SNB, who will likely intervene in the currency market in order to keep a rising franc from adding additional deflationary pressures to the Swiss economy. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Krone was another victim of Trump's election, with USD/NOK rising by 4%. Although we expect that the dollar bull market will ultimately weigh on the krone, we remain positive on the outlook for this currency compared to its commodity peers. Inflation is currently at 3.7%, significantly above the Norges Bank target. Additionally house prices are rising at almost 20%, while household debt as a percentage of disposable income has surpassed the 200% mark. The Norges Bank has not overlooked this developments, as their rhetoric has recently become more hawkish. All these factors along with rebalancing energy markets, should provide strong tailwinds for the NOK, particularly against its crosses. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Swedish economy looks strong according to recent data: Manufacturing PMI ticked up last month from 54.9 to 58.4. Industrial production increased in September by 1.5% annually. Inflation in October came in at 1.2% yoy. Inflation in the near future also looks quite upbeat, as per the uptick in 1-, 2-, and 5-year Prospera inflation expectation numbers to 1.4%, 1.7%, and 1.9% respectively. The Riksbank has therefore lifted their easing bias, which is also reflected by an increase in the 12-month market expectations of the repo rate to -0.4%. All is not perfect though. New orders decreased by 16.4% annually, indicating possible fragility in the manufacturing sector. Additional medium-term risk to the SEK will be dictated by bullish moves in the USD, as SEK remains one of the currencies with the highest sensitivity to the dollar. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
BCA will be holding the Dubai session of the BCA Academy seminar on November 28 & 29. This two-day course teaches investment professionals how to examine the economy, policy, and markets; and also makes links between these important factors. Moreover, it represents a great networking opportunity for all attendees. I look forward to seeing you there. Best regards, Mathieu Savary Highlights Donald Trump's victory represents a sea-change for U.S. politics as well as the economy. His expansionary fiscal policy, to be implemented as the labor market's slack evaporates, will boost demand, wages, and will prove inflationary. The Fed will respond with higher rates, boosting the dollar. EM Asian currencies will bear the brunt of the pain. Commodity currencies, especially the AUD, will also be significant casualties. EUR/USD will weaken in the face of a strong greenback, but should outperform most currencies. Key risks involve gauging whether the Fed genuinely wants to create a "high-pressure", economy as well as the potential for Chinese fiscal stimulus. Feature Trump's electoral victory only re-enforces our bullish stance on the dollar. A Trump presidency implies much more fiscal stimulus than originally anticipated. Therefore, the Fed will not be the only game in town to support growth. This strengthens our view that, on a cyclical basis, the OIS curve still underprices the potential for higher U.S. interest rates. In a Mundell-Fleming world, this suggests a much higher exchange rate for the greenback. Additionally, Trump's protectionist views are likely to hit EM economies - China in particular - harder than DM economies. We continue to prefer expressing our bullish dollar view by shorting EM and commodity currencies. Is Trump Handcuffed? Trump's victory reflects a tidal wave of anger and dissatisfaction with the current state of the U.S. economy. Most profoundly, his candidacy was a rallying cry against an increasingly unequal distribution of economic opportunities and outcomes for the U.S. population. As we highlighted last week, since 1981, the top 1% of households have seen their share of income grow by 11%. In fact, while 90% of households have seen their real income contract by 1% since 1980, the top 0.01% of households have seen their real income increase more than five-fold (Chart I-1). Chart I-1The (Really) Rich Got Richer In this context, Trump's appeal, more than his often-distasteful racial or gender rhetoric, has been his talk of protecting the middle class. But, by losing the popular vote, are his hands tied? Marko Papic, BCA's Chief Geopolitical Strategist, surmises in a Special Report1 sent to all BCA's clients that it is not the case. First, Trump's victory speech emphasized infrastructure spending, indicating that this is likely to be his first priority. As Chart I-2 illustrates, there is a lot of room for the government to spend on this front. At 1.4% of GDP, government investment is at its lowest level since World War II. Furthermore, according to the Tax Policy Institute, Trump's current plan includes $6.2 trillion in tax cuts over the next 10 years. Second, the Republican Party now controls Congress as well as the White House. Not only has the GOP historically rallied around the president when all the levers of power are in the party's hands, but also, the Tea party has been one of Trump's most ardent supporters. Hence, Trump's program is unlikely to be completely squelched by Congress. Third, the GOP is most opposed to government spending when Democrats control the White House. When Republicans are in charge of the executive, the GOP is a much less ardent advocate of government stringency, having increased the deficit in the opening years of the Reagan, Bush I, and Bush II administrations (Chart I-3). Chart I-2Room To Increase##br## Infrastructure Spending Chart I-3Republicans Are Fiscally Responsible ##br##When It Suits them Finally, international relations are the president's prerogative. While there are legal hurdles to renegotiate treaties like NAFTA, Trump can slap tariffs easily, rendering previous arrangements quite impotent. Though protectionism has not been highlighted in Trump's victory speech, the topic's popularity with his core electorate highlights the risk that trade policies could be impacted. Bottom Line: Trump has a mandate to spend and got elected because of his policies that support the middle class. His surprise victory represents a sea-change, a move the rest of the Republican establishment will not ignore. Therefore, we expect Trump to be able to implement large-scale fiscal stimulus. Economic Implications To begin with, Trump is a populist politician. While populism ultimately ends badly, it can generate a growth dividend for many years. Nowhere was this clearer than in 1930s Germany, where Hitler's reign yielded a major economic outperformance of Germany relative to its regional competitors (Chart I-4).2 Government infrastructure spending played a large role in this phenomenon. Also, the Reagan era shows how fiscal stimulus can lead to a boost to growth. From the end of the 1981-82 recession to 1987, U.S. real GDP per capita outperformed that of Europe and Japan, despite the dollar's strength in the first half of the decade. Fascinatingly, the U.S. GDP per capita even outperformed that of the U.K., a country in the midst of the supply-side Thatcherite revolution (Chart I-5). This suggests that the U.S's economic outperformance was not just a reflection of Reagan's deregulatory instincts. Chart I-4Populism Can Boost Growth Chart I-5Reagan Deficits Boosted Growth Too Unemployment is close to its long-term equilibrium, and the hidden labor-market slack has greatly dissipated. Additionally, one of the biggest hurdles facing small businesses is finding qualified labor. In the context of a tight labor market, we anticipate that Trump's fiscal stimulus will not only boost aggregate demand directly, but will also exert significant pressures on already rising wages (Chart I-6). Compounding this effect, if Trump does indeed focus on infrastructure spending, work by BCA's U.S. Investment Strategy service shows that this type of stimulus offers the highest fiscal multiplier (Table I-1).3 Chart I-6Stimulating Now Will Feed Wage Growth Table I-1Ranges For U.S. Fiscal Multipliers Additionally, a retreat away from globalization, and a move toward slapping more tariffs and quotas on Asia and China would be inflationary. Historically, falling inflation has coincided with falling tariffs as competitive forces increase. This time, with the output gap closing, and the tightening labor market, decreasing the trade deficit could arithmetically push GDP above trend, accentuating wage and inflationary pressures. Finally, for households, a combination of rising wages, elevated consumer confidence, and low financial obligations relative to disposable income could prompt a period of re-leveraging (Chart I-7). Moreover, the median FICO score for new mortgages has fallen from more than 780 in 2013 to 756 today, an easing in lending standard for mortgages. All the factors above suggest that U.S. growth is likely to improve over the next two years, driven by the government and households. It also points towards rising inflationary pressures. As we have highlighted before, the more the economy can generate wage growth to support domestic consumption, the more it becomes resilient in the face of a stronger dollar. The tyranny of the feedback loop between the dollar and growth will loosen. This environment would be one propitious for the Fed to hike interest rates as the economy becomes less dependent on lower rates for support. In the long-run, the Trump growth dividend is likely to require a payback, but this discussion is for another day. Bottom Line: Trump is likely to boost U.S. economic activity through fiscal stimulus, especially infrastructure spending. Since the slack in the economy is now small, especially in the labor market, this increases the likelihood that the Fed will finally be able to durably push up interest rates (Chart I-8). Chart I-7Household Debt Load Can Grow Again Chart I-8Vanishing Slack = Higher Rates Currency Market Implications The one obvious effect from a Trump victory is that it re-enforces our core theme that the dollar will strengthen on a 12 to 18-months basis as the market reprices the Fed's path. However, we expect Asian currencies to be viciously hit by this new round of dollar strength. For one, compared to the drubbing LatAm currencies received, KRW, TWD, and SGD are only trading 13%, 9%, and 15% below their post 2010 highs. Most importantly though, EM Asia has been the main beneficiary of 35 years of expanding globalization. Countries like China or the Asian tigers have registered world-beating growth rates thanks to a growth strategy largely driven by exports (Chart I-9). Chart I-9Former Winners Become Losers Under Trump We expect these economies and currencies to suffer the most from Trump's retribution and from a continued structural underperformance of global trade. China, Korea, and co. are likely to be hit by tariffs under a Trump administration. Also, under a Trump administration, the likelihood of implementation of new international trade treaties is near zero. Therefore, the continuous expansion of globalization of the previous decades is over, and may even somewhat reverse. Furthermore, a move toward a more multipolar world, like the interwar period, tends to be associated with falling trade engagement. Trump's desire to diminish the global deployment of U.S. troops would only add to such worries. Regarding the RMB, the picture is murky. On the one hand, the RMB is trading 4% below fair value and does not need much devaluation from a competitiveness perspective. However, Chinese internal deflationary pressures, courtesy of much overcapacity, remain strong (Chart I-10). Easing these pressures requires a lower RMB. Moreover, the offshore yuan weakened substantially in the wake of Trump's victory, yet the onshore one did not, suggesting that the PBoC is depleting its reserves to support the currency. This tightens domestic liquidity conditions, exacerbating the deflationary forces in the country. Chart I-10Plenty Of Excess Capacity In China This means that China is in a bind as a depreciating currency will elicit the wrath of president Trump. The risk is currently growing that China will let the RMB fall substantially between now and January 20. Such a move would magnify any devaluating pressures on other Asian exchange rates. While it is difficult to be bullish MXN outright on a cyclical basis when expecting a broad dollar rally, the recent weakness in MXN is overdone. Mexico has not benefited nearly as much from globalization as Asian nations. Also, after a 60% appreciation in USD/MXN since June 2014, even after the imposition of tariffs, Mexico will still be competitive. Even then, the likelihood and severity of any tariffs enacted on Mexico might be exaggerated by markets. In fact, President Nieto's invitation to Trump last summer may prove to have been a particularly uncanny political move. Investors interested in buying the peso may want to consider doing it against the won, potentially one of the biggest losers from a Trump presidency. Outside of EM, the AUD is at risk. Australia sits in the middle of the pack in terms of economic and export growth during the globalization era, but it is very exposed to Asian economic activity. Historically, the AUD has been tightly correlated with Asian currencies (Chart I-11). Adding insult to injury, Australia is a large metals producer, which means that Australia's terms of trade are highly levered to the Chinese investment cycle, the main source of demand for iron ore, copper, etc. (Chart I-12). With China already swimming in over capacity, unless the government enacts a new infrastructure package, Chinese imports of raw materials will remain weak. Chart I-11AUD Will Suffer If Asian Currencies Fall Chart I-12China Is The Giant In The Room The NZD is also likely to suffer against the USD. The currency's sensitivity to the dollar strength and EM spreads is very high. However, we expect AUD/NZD to remain depressed. The outlook for relative terms of trades supports the kiwi as ag-prices will be less impacted by a slowdown in Chinese capex than metals. Additionally, on most metrics, the New Zealand economy is outperforming that of Australia (Chart I-13). The CAD should beat both antipodean currencies. First, it is less sensitive to the U.S. dollar or EM spreads than both the AUD and the NZD, reflecting its tighter economic link with the U.S. We also expect some softer rhetoric and actions from Trump when it comes to implementing trade restrictions with Canada than with Asia. Finally, while we are very concerned for the outlook for metals, the outlook for energy is superior. Yes, a strong greenback is a headwind for oil prices, but a Trump presidency is likely to result in strong household consumption. Vehicle-miles-driven growth would remain elevated, suggesting healthy oil demand from the U.S. Meanwhile, our Commodity & Energy Strategy service expects the drawdown in global oil inventories to accelerate, particularly if Saudi Arabia and Russia can agree on a 1mm b/d production cut at the upcoming OPEC meeting at the end of the month, which is bullish for oil (Chart I-14). Chart I-13Stronger Kiwi Domestic Fundamentals Chart I-14Better Supply/Demand Backdrop For Oil We also remain yen bears. The isolationist stance of Trump is likely to incentivize Abe to double down on fiscal stimulus, especially on the military. Japan is currently massively outspent on that front by China (Chart I-15). With the BoJ pegging policy rates at 0% for the foreseeable future, the yen will swoon on the back of falling real yields. Moreover, if our bearish stance on Asian currencies materializes itself, this will put competitive pressures on the yen, creating an additional negative. For the euro, the picture is less clear. The euro remains the mirror image of the dollar, so a strong greenback and a weak euro are synonymous. Additionally, Trump stimulus, if enacted, will ultimately result in higher nominal and real yields in the U.S. relative to Europe, especially as the euro area does not display any signs of being at full employment (Chart I-16). That being said, the euro is currently very cheap, supported by a current account surplus, and the ECB might begin tapering asset purchases in the second half of 2017. Combining these factors together, while we remain cyclically bearish on EUR/USD - a move below parity over the next 12-18 months is a growing possibility - the euro will outperform EM currencies, commodity currencies, and even the yen. We are looking to buy EUR/JPY, especially considering the skew in positioning (Chart I-17). Chart I-15Japan Will Spend More On Its ##br##Military With Or Without Trump Chart I-16European Labor Market##br## Slack Is Evident Chart I-17EUR/JPY Has##br## Room To Rally Finally, the outlook for the pound remains clouded until we get a better sense of the High Court's decision on the government's appeal regarding the need for a Parliamentary vote on Brexit. We expect the court's decision to re-inforce the previous ruling, which means that the pound could strengthen as the probability of a "soft Brexit" grows. The resilience of the pound in the face of the recent dollar's strength points to such an outcome. Risk To Our View And Short-Term Dynamics The biggest risk to our view is obviously that Trump's fiscal plans never pan out. However, since our bullish stance on the dollar predates Trump's electoral victory, we would therefore remain dollar bulls, albeit less so. Nonetheless, limited fiscal stimulus would likely cause a temporary pullback in the dollar. Chart I-18A Mispricing Or A Signal? Another short-term risk is the Fed. Currently, inflation expectations in the U.S. have shot up. If the Fed does not increase rates in December - this publication currently thinks the FOMC will increase rates then - the dollar will fall as this move will put downward pressures on U.S. real rates. This is especially relevant as the 5-year/5-year forward Treasury yield stands at 2.8%, in line with the Fed's estimate of the long-term equilibrium Fed funds rates as per the "dots". A big risk for our EM / commodity currency view is China. China may not respond to Trump by aggressively bidding down the CNY before January 20. Instead, to counteract the negative effect of Trump on Chinese export growth, China might instigate more fiscal stimulus, plans that always have a large infrastructure component. The recent parabolic move in copper needs monitoring (Chart I-18). Bottom Line: A Trump victory is a massive boon for the dollar. However, because Trump represents a move away from globalization, the main casualties of the Trump-dollar rally will be Asian currencies and the AUD. The CAD and the NZD will also undergo downward pressures, but less so. Finally, while EUR/USD is likely to fall, the euro will outperform EM currencies, commodity currencies, and the yen. As a risk, in the short-term, an absence of Fed hike in December would represent the biggest source of weakness for the dollar. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications", dated November 9, available at gps.bcaresearch.com 2 To be clear, while we do find some of Trump comments over the past year highly distasteful, we are not suggesting that he is a re-incarnation of Hitler or that his presidency is doomed to end in a massive global conflict. It is only an economic parallel. 3 Please see U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability", dated November 7, available at usis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Policy Commentary: "We are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals. We're going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it." - U.S. President Elect Donald Trump (November 9, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Policy Commentary: "I'm very skeptical as far as further interest rate cuts or additional expansionary monetary policy measures are concerned -- over time, the benefits of these measures decrease, while the risks increase" - ECB Executive Board Member Sabine Lautenschlaeger (November 7,2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Policy Commentary: "In order for long-term interest rate control to work effectively, it is important to maintain the credibility in the JGB market through the government's efforts toward establishing sustainable fiscal structures" - BoJ Minutes (November 10, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Policy Commentary: "[The impact of a weak pound on inflation]... will ultimately prove temporary, and attempting to offset it fully with tighter monetary policy would be excessively costly in terms of foregone output and employment growth. However, there are limits to the extent to which above-target inflation can be tolerated" - BOE Monetary Policy Summary (November 3, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Policy Commentary: "Inflation remains quite low...Subdued growth in labor costs and very low cost pressures elsewhere in the world mean that inflation is expected to remain low for some time" - RBA Monetary Policy Statement (October 31, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Policy Commentary: "Weak global conditions and low interest rates relative to New Zealand are keeping upward pressure on the New Zealand dollar exchange rate. The exchange rate remains higher than is sustainable for balanced economic growth and, together with low global inflation, continues to generate negative inflation in the tradables sector. A decline in the exchange rate is needed" - RBNZ Governor Graeme Wheeler (November 10, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Policy Commentary: "We have studied the research and the theory behind frameworks such as price-level targeting and targeting the growth of nominal gross domestic product. But, to date, we have not seen convincing evidence that there is an approach that is better than our inflation targets" - BoC Governor Stephen Poloz (November 1, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Policy Commentary: "We don't have a fixed limit for growing the balance sheet; it's a corollary of our foreign exchange market interventions - which we conduct to fulfill our price stability mandate" - SNB Vice-President Fritz Zurbruegg (October 25, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Policy Commentary: "Banks' capital ratios have doubled since the financial crisis and liquidity has improved. At the same time, some aspects of the Norwegian economy make the financial system vulnerable. This primarily relates to high property price inflation combined with high household indebtedness" - Norges Bank Deputy Governor Jon Nicolaisen (November 2, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Policy Commentary: "...the weak inflation outcomes in recent months illustrate the uncertainty over how quickly inflation will rise. The Riksbank now assesses that it will take longer for inflation to reach 2 per cent. The upturn in inflation therefore needs continued strong support" - Riksbank Minutes (November 9, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Despite a tough week, the dollar bull market is intact. The U.S. economy's resilience to a strong dollar is growing. But, if Trump wins, the dollar could temporarily sell off against EUR, CHF, and JPY. Favor these currencies against EM and commodity currencies. Thanks to the High Court's Brexit ruling, the outlook for the pound is brightening. Wait for the appeal procedure to be over before implementing directional bets. Feature Despite this week's violent correction in the dollar, we remain dollar bulls. However, the recent reaction of the greenback to the rising probability of a Trump victory raises the need to hedge such an outcome. Still Bullish On The Dollar... The U.S. is unlikely to fall from its perch at the top of the distribution of G10 interest rates, a historically dollar-bullish environment (Chart I-1). Chart I-1Dollar Tailwinds The hidden slack in the U.S. labor market has dissipated. The amount of workers outside of the labor force who do want a job is at 6.2%, a level in line with the readings recorded between 2000 and 2007, when hidden slack was low (Chart I-2). Moreover, wages and salary continue to grow in the national income. Skewing the income distribution away from profits and rents is akin to a redistribution of income away from the top 1% of households, who derive nearly 50% of their income from profits. Importantly, middle-class households have a much higher marginal propensity to consume than rich ones. So great is the difference that since 1981, the 10% increase in the share of national income accruing to the top 1% of households has helped depress consumption by 3%. As a result, income redistribution will depress the U.S. savings rates going forward (Chart I-3). Since 70% of household consumption is geared toward the service sector, a component of the economy where productivity growth is hard to come by, increasing consumption is likely to directly result in job creation. Chart I-2U.S. Wages Can Rise Chart I-3The U.S. Savings Rate Has Downside With the unemployment gap being closed, consumption growth will cause wage growth to accelerate, further supporting consumption. Hence, the Fed can increase rates more aggressively than the 70 basis points priced into the OIS curve until the end of 2019. These kinds of dynamics have historically been very dollar bullish (Chart I-4). Moreover, the feedback loop linking the dollar and financial conditions to the economy is weakening. Not only is the economy increasingly driven by household expenditures, but the weight of commodity and manufacturing capex in the economy has collapsed in response to the dollar's strength (Chart I-5). Even if the sensitivity of these sectors to the dollar and financial conditions is unchanged, their impact on the broad economy has diminished. Chart I-4A Virtuous Circle##br## For The Dollar Chart I-5Lower Impact Of Manufacturing ##br##And Commodities Outside of the U.S. some key factors will prevent a normalization of policy rates in the major economies. Euro area rates will stay depressed for much longer. Conditions to generate inflation are absent. The output gap remains wide and negative, unemployment is significantly above NAIRU, and fiscal austerity, while diminished, is still de rigueur (Chart I-6). While the IMF pegs the output gap at 1.2% of GDP, the ECB estimates it to stand at 6% of GDP. Additionally, the European credit impulse is likely to roll-over. European bank stock prices have led European credit growth. They now point to slowing loan growth (Chart I-7). Even if loan growth were only to stabilize, this would imply a fall in the impulse. Chart I-6Inflationary Pressures##br## In Europe Chart I-7Downside Risk To The##br## Euro Area Credit Impulse These forces will weigh on the euro. The SNB floor under EUR/CHF remains credible and exercised. Therefore, USD/CHF will mostly stay a function of EUR/USD. For Japan, as we highlighted in the September 23 and October 28 reports, conditions are falling into place to see rising wages and inflation expectations. Rates being pegged at 0% until inflation greatly overshoots 2% will lower Japanese real rates along with the yen. Bottom Line: The 12-18 months outlook for the dollar remains bright. The resilience of U.S households will lead to stronger wage growth and an economy powered by consumption. The Fed will surprise markets with more rate hikes than anticipated. Meanwhile, European and Japanese real rates are unlikely to rise much if at all. ...But The Short-Term Outlook Is Bifurcated Yet, the short-term outlook is murky. BCA believes that a Trump presidency is likely to supercharge any dollar rally. Not only would his presidency imply huge infrastructure projects, his trade tactics should put upward pressure on wages and inflation, prompting an even more hawkish Fed than we anticipate. However, if recent dynamics are any clue, a Trump victory next week could also cause an immediate but temporary knee-jerk sell-off in the dollar. Since the FBI announced a re-examination of the Clinton emails affair, Trump's probability of winning has skyrocketed. While USD/MXN has rallied, so has EUR/USD, driven by a favorable move in interest rate differentials (Chart I-8). This raises the specter of a bifurcated move in the dollar over the next month or so. On the one hand, the dollar could rise against EM currencies and commodity producers, but suffer against EUR, CHF, and JPY. Why would the dollar rise against EM and commodity currencies? Cyclically and tactically, the stars are lining up against this set of currencies. The economic situation in EM and China is as good as it gets right now. The Keqiang index is near cyclical highs, suggesting that the upswing in Chinese industrial activity is unlikely to strengthen further, especially as loan demand remains tepid (Chart I-9). Chart I-8A Trump Indigestion Chart I-9China: As Good As It Gets Worryingly, Chinese fiscal stimulus is dissipating, which will act as a drag on the nation's investment and industrial activity. Chinese authorities panicked in 2015 as the Chinese economy was moving toward a hard landing. The government direct fiscal spending impulse surged (Chart I-10). Also, private-public partnerships originally expected to invest $1.2 trillion in infrastructure over three years were deployed in six months. As these tactics caused the economy to deviate from Beijing's stated goal to rebalance China away from investment, they are now being rolled back. Additionally, Chinese deflationary pressures are likely to resurface. Our bullish stance on the dollar implies a negative view on commodity prices. PPI will suffer if the dollar rallies given that Chinese producer prices are highly correlated with commodity prices (Chart I-11). This increases the likelihood that industrial activity in China will slow again. Chart I-10Vanishing Fiscal##br## Support Chart I-11Chinese PPI And Commodity Prices:##br## Brothers In Arms These risks are not priced in by EM assets and related plays. Risk reversals on EM currencies are priced in for perfection. Slowing Chinese growth would represent a negative surprise for EM debt, EM currencies, and commodity currencies (Chart I-12). An additional worry for EM currencies is momentum. A paper by the BIS shows that momentum continuation strategies are very profitable in EM FX.1 Hence, if EM currencies begin to fall, this fall will prompt further weaknesses. Finally, a Trump presidency is another headwind for EM and commodity currencies. In an earlier Special Report, we argued that a key factor that boosted the profitability of FX carry strategies was the rise of globalization (Chart I-13).2 This growing global trade mostly benefited small open economies, EM economies, and commodity producers, the so-called "carry-currencies". Trump's rhetoric promises a roll-back of this trend, a move that will disproportionally hurt such currencies. Compounding this risk, this cycle, the performance of FX carry trades has been inversely correlated to global bond yields (Chart I-14). BCA's underweight duration represents another problem for EM and commodity currencies. Chart I-12EM Plays Are Priced For Perfection Chart I-13Carry Trades Love Globalization Chart I-14Rising Yields Hurt Carry Currencies However, what could temporarily lift the euro, the Swiss franc, and the yen despite a negative cyclical outlook? Risk aversion and a global equity market correction prompted by a Trump victory. In short, a flight to safety amid uncertain times. These currencies are underpinned by current account surpluses ranging from 3% of GDP for the euro area to 10% for Switzerland. They therefore export investments abroad. This capital usually displays a strong home bias when global risks spike, and EUR, CHF, and JPY strengthen when global equities weaken. Finally, our current negative predisposition toward carry trades would also support funding currencies, currencies with deeply negative rates like EUR, CHF, or JPY. Bottom Line: In the direct aftermath of a Trump victory, the dollar could suffer from some temporary downward pressure against the EUR, CHF, and JPY. However, it will strengthen against EM and commodity currencies. On a cyclical basis, the USD will be stronger against these latter currencies than against European currencies. Key Investment Recommendations We are opening long EUR/AUD and short CAD/JPY positions. The EUR is less sensitive to EM downside than the AUD. Deteriorating EM currencies' risk reversals often coincide with a stronger EUR/AUD (Chart I-15). Also, the euro is cheaper than the Aussie, trading at a 5% discount to PPP. Additionally, EUR/USD could appreciate in the event of a Trump presidency, but its negative impact on EM economies and global trade will drag down AUD. The CAD/JPY position is primarily a Trump hedge. CAD will sell off if Trump wins as investors ponder the future of NAFTA. Meanwhile, the yen will benefit from safe-haven flows and from the eradication of any probability of MoF interventions (Chart I-16). Japan already meets two of the three criteria to be labeled a currency manipulator by the U.S. Treasury. Under a Trump presidency, such a label will have very real consequences. Chart I-15A Fall In EM Assets Would##br## Support EUR/AUD Chart I-16If Trump Wins, The MoF ##br##Will Not Intervene Moreover, CAD/JPY is also negatively affected by a deterioration of EM risk reversals. However, we are more worried for the JPY's long-term outlook than the EUR's. This is because of the more aggressive policy stance taken by the BoJ. Thus, this trade is more tactical than the EUR/AUD bet. Finally, investors wanting to play a Trump victory using European currencies should consider going long CHF/SEK. Sweden, a small open economy with deep trade links with EM, has been a key beneficiary of globalization. It will be a big loser if global trade shrinks. Meanwhile, CHF is likely to rally. Critically, this trade is for very nimble traders. At EUR/CHF 1.06, the SNB will intervene with all its might. The U.K.'s Über Thursday Yesterday, not only did the Bank of England announce its monetary policy decision and economic forecasts, but also, the High Court ruled that the Article 50 process preceding Brexit requires a vote from Parliament. While we expect Parliament to follow the popular vote and engage in Brexit, a parliamentary vote is much more likely to result in negotiating a "soft Brexit" rather than a "hard Brexit". In a "soft Brexit", the U.K. would retain access to the common market, and passporting of financial services would be allowed. However, freedom of movement would have to be maintained and the U.K. would have to contribute to the EU's purse. Unsurprisingly, the government is appealing the decision. Practically, this means it is still too early to aggressively bid up the pound. If the government wins its appeal, GBP/USD will move toward 1.10. If the government loses its appeal, FDI flows in the U.K. could regain some composure and help finance the large British current account deficit. This would lift GBP/USD toward 1.30 - 1.40. Probabilities are skewed toward the government losing its appeal. Economics, too, warrants caution. While the household sector's resilience has been a surprise to the Bank of England, it is unlikely to continue for long. First, the U.K. household credit impulse has rolled over and is now contracting at a GBP 1 billion pace, pointing to slowing growth. Second, in line with falling capex intentions, employers are paring their hiring intentions (Chart I-17). A slowdown in household nominal income growth should ensue. British households' real income will soon be squeezed, especially as the BoE increased it inflation forecast to 2.7% for 2018 due to the pass-through from the 15% fall in the trade-weighted GBP (Chart I-18). Additionally, the RICS survey points to further weakness in house prices. Chart I-17Deteriorating U.K. Labor Market Outlook Chart I-18Mechanics Of A Real Income Squeeze Hence, the BoE is on hold for a longer time than was anticipated in August. Moreover, Chancellor Hammond has made it clear that while the fall budget will loosen the fiscal austerity penciled in under the Osborne budgets, it is too early for investors to expect a large fiscal easing from the government. This suggests that risks remain tilted toward further easing by the "Old Lady." Bottom Line: Until we get clarity on the results of the government's appeal of yesterday's High Court Brexit ruling, we are inclined to fade strength in the pound. Any move above GBP/USD 1.25 would create a tactical shorting opportunity. A strangle with strikes at 1.27 and 1.15 and a January maturity makes sense for investors wanting to play the volatility around the ultimate ruling on the government's appeal. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Lukas Menkhoff, Lucio Sarno, Maik Schmeling and Andreas Schrimpf, "Currency Momentum Strategies", BIS Working Papers (2011). 2 Please see Foreign Exchange Strategy Special Report, "Carry Trades: More than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Policy Commentary: "The Committee judges that the case for an increase in the federal funds rate has continued to strengthen but decided, for the time being, to wait for some further evidence of continued progress toward its objectives" - FOMC Statement (November 2, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Policy Commentary: "[On ECB Stimulus]...the initial date set to end the buying program is March, but the most advisable action is that it be a process that's as slow as possible" - ECB Governing Council Member Luis Maria Linde (October 28, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Policy Commentary: "[On wether the BOJ would buy regional domestic bonds]..Regional domestic bonds are issued by the various local governments, and are traded separately. There are various factors that would make it difficult to consider them for monetary policy, but we will give the suggestion due consideration" - BoJ Governor Haruhiko Kuroda (November 2, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Policy Commentary: "...indicators of activity and business sentiment have recovered from their lows immediately following the referendum and the preliminary estimate of GDP growth in Q3 was above expectations. These data suggest that the near-term outlook for activity is stronger than expected three months ago" - BOE Monetary Policy Report (November 3, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Policy Commentary: "In Australia, the economy is growing at a moderate rate. The large decline in mining investment is being offset by growth in other areas, including residential construction, public demand and exports. Household consumption has been growing at a reasonable pace, but appears to have slowed a little recently" - RBA Statement (November 1, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Policy Commentary: "There are unconventional monetary policies that give us more room to maneuver than previously believed...These include pushing interest rates below zero or buying longer-term bonds to compress long-term yields" - BoC Governor Stephen Poloz (November 1, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Policy Commentary: "In Switzerland the negative interest rate is currently indispensable, owing to the overvaluation of the Swiss franc and the globally low level of interest rates" - SNB President Thomas Jordan (October 24, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Dear Client, This week, I am currently on the road visiting clients across Europe. We are sending you an abbreviated weekly report as well as a Special Report from our Geopolitical Strategy team entitled “U.S. Election: Final Forecast & Implications”. Not only does this report encompass a detailed analysis of the upcoming U.S. presidential election and its implications for the future of U.S. politics, it also introduces GPS’s poll-plus model, a model which currently forecasts a Clinton victory. I trust you will find this piece very informative. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights The U.S. dollar is consolidating its recent gains, but it offers more upside in the months ahead A Trump victory would supercharge any dollar strength, but is likely to hurt the dollar in the long-term. In Japan, no more fiscal drag and a tightening in the labor market will ultimately result in a lower yen, courtesy of higher inflation expectations and falling real rates. The Australian labor market points to weaknesses in the domestic economy. Any EM turmoil could launch an AUD bear phase. Feature The U.S. dollar continues to consolidate its recent gains. While the dollar is expensive, it still offers upside potential. Monetary divergences remain in favor of the U.S. economy. U.S. labor market slack is disappearing and the rising share of salaries and wages in the national income pie is likely to further support consumption. Shifting the distribution of economic gains toward workers signifies that the middle class is gaining ground relative to households at the summit of the income ladder. This process should help consumption because the middle class has a much higher marginal propensity to consume than the top 1% (Chart I-1). If consumption growth remains healthy, job creation is likely to fan additional wage pressures, creating a virtuous circle for U.S. households and consumption. This virtuous cycle is likely to help the Fed increase rates over the next two years, providing a source of support for the dollar (Chart I-2). Chart I-1Shifting Income To The Middle Class Will Support Consumption Chart I-2A Virtuous Cycle For The Dollar In terms of the presidential election outcome, the shift of the median voter to the left signifies that redistributionist policies are likely to become an ever growing part of the U.S. political discourse. This reality is likely to provide another source of support for the U.S. dollar, at least for now. While a Clinton victory will not halt these trends, a Trump victory would likely supercharge any dollar bull market. While vague in details, Trump's economic plan involves much more infrastructure spending financed with debt issuance, i.e. a large amount of fiscal stimulus that would remove the need for any dovish tilt to the Fed's stance. Moreover, by raising the specter of protectionism, a Trump victory could revive inflationary forces in the U.S. economy. Protectionism, while negative for profits, would decrease the trade deficit, temporarily lifting U.S. GDP. Since the supply side of the economy has been hampered by tepid levels of investment (Chart I-3), we could see a situation where demand is in excess of supply. This would prompt an even more hawkish Fed. However, although a Trump victory would be a dream for dollar bulls, caution is warranted. In the long-term, a Trump administration implies a falling fair value for the dollar. For one, by lifting inflation, a Trump victory would hurt the PPP value of the greenback. Second, a Trump victory would also ultimately lead to a degradation of the USD's role as the global reserve currency, making the -40% of GDP net international investment position of the U.S. more difficult to sustain (Chart I-4). Finally, by shielding the economy from the competitive pressures of globalization, a Trump victory would likely result in a deterioration of U.S. productivity vis-à-vis the rest of the world. Chart I-3Low Capital Stock Growth Would Crystalize The##br## Inflationary Effect Of A Trump Presidency Chart I-4The Dollar Needs Its ##br##Reserve-Currency Status Yen Signs pointing toward a strong wave of yen weakness are slowly coming together. In recent years, the yen has closely followed real rates differentials (Chart I-5). With the BoJ guaranteeing a limit on the upside for nominal rates, any improvement in the economy is likely to cause inflation expectations to increase, and thus real rates, to fall. What are the signals pointing toward higher inflation expectations and a lower yen? First, the labor market is tightening. The job-opening-to-applicants ratio is at a 15 year high and employment growth remains healthy (Chart I-6). Meanwhile, the participation rate of women in the labor force is at all-time highs, and at 73.5%, the employment-to-population ratio for prime-age women is already above U.S. levels. In fact, it is at similar levels to those experienced in the U.S. during the boom years of the late 1990s. Thus, the declining likelihood that more women will enter the labor force eliminates a wage-suppressing factor. Chart I-5USD/JPY: A Function Of##br## Real Rate Differentials Chart I-6Japan: Female Labor Participation Now Exceeds ##br##The U.S. Japanese Wages Can Now Rise Second, the Japanese shipment-to-inventory ratio is improving. Thanks to lean-inventory techniques, this ratio tends to be most elevated at the bottom of economic slowdowns, reflecting depressed sales rather than bloated inventories. Historically, growing shipments relative to inventories are associated with rising inflation expectations (Chart I-7). Third, the drag from fiscal policy is dissipating. Budget tightening is leveling off, lifting a big brake on domestic demand (Chart I-8). Moreover, we expect fiscal stimulus to gather momentum in 2017, especially in the form of wage policy. This provides an additional support for Japanese inflation expectations. If no further fiscal stimulus comes to fruition in Japan, we expect USD/JPY to rally toward 110-115 in the next 18-months. If aggressive fiscal stimulus and a wage policy are implemented, the upside for USD/JPY could be much greater, in the order of 120 or more. Chart I-7Japanese Shipment-To-Inventory##br## Ratio And CPI Expectations Chart I-8The Dissipating Japanese ##br##Fiscal Drag Yet, while the cyclical outlook for the yen is bearish, the shorter-term outlook is more nuanced. Any EM-selloff triggered by tightening global liquidity conditions could prompt downward pressures on Japanese inflation expectations. This would mechanically lift Japanese real rates and the yen. Hence, we recommend investors sell the yen on a long-term basis but hedge this position by buying JPY volatility over the next 3-6 months. Australian Dollar The Australian dollar is at a tricky spot. Technically, the AUD has been forming a tapering wedge, a pattern that often heralds a large move in this currency. How will this pattern resolve itself? We expect a bearish outcome. The domestic economy is displaying some worrying signs. Not only is full-time employment contracting, but so are total hours worked (Chart I-9). This is likely to weigh on household income and on consumption. This is especially problematic as Australian gross fixed capital formation continues to contract at a 4.5% annual pace. The result is that inflationary pressures in Australia will be kept at bay. In the process, the RBA could adopt a more dovish bias. Chart I-9Australian Domestic Conditions ##br##Are Deteriorating Chart I-10Australian Exports To ##br##China Are Still Falling... Additionally, despite a stabilization in Chinese growth, Chinese imports from Australia continue to contract (Chart I-10). Not only has this happened as iron ore prices have rebounded, but also, as economic conditions have improved in EMs that are highly levered to the Chinese cycle (Chart I-11). Our expectation is that the Chinese industrial sector is likely to experience a slowdown in the months ahead, courtesy of a falling fiscal impulse (Chart I-12), which begs a question: What does the future hold for Australian exports? Chart I-11...Despite Rising Taiwanese##br## Industrial Production Chart I-12Tightening Global Liquidity Is A Headwind##br## For EM Financial Conditions And Growth Finally, our bullish U.S. dollar stance is a tough hurdle for commodity prices to overcome (Chart I-13). Weakness in commodities would represent a negative terms-of-trade shock for Australia and the AUD. Moreover, the PBOC continues to use a lower RMB as an engine of reflation, and we stand by our bearish JPY forecast. Because of these two developments KRW, SGD, and TWD, are very likely to experience further downside. Historically, Asian currency weakness correlates closely with a weak AUD (Chart I-14). Chart I-13Commodities And The Dollar:##br## Joined At The Hip Chart I-14AUD Performs Poorly When ##br##Asian Currencies Sell Off We are already shorting AUD/USD in the context of a short commodity currencies trade. We are considering buying EUR/AUD, as the euro is less sensitive to the dollar, EM spreads, and commodity prices versus the AUD. Also, EUR/AUD is more attractive from a valuation perspective, trading 5% below its PPP fair value. This cross is also supported by a favorable balance-of-payments backdrop, with the euro area registering a 7.7% of GDP current-account differential relative to Australia. Buying EUR/AUD represents a way for investors to bet on a weaker AUD while decreasing their exposure to the U.S. dollar risk factor. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Policy Commentary: "There are risks of hanging around zero too long. And if the economy can withstand [a hike], I think it's appropriate to move" - Philadelphia Fed President Patrick Harker (October 26, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Policy Commentary: "In the euro area, we have a long way to go before we exhaust the productivity improvements that have already taken place in the U.S" - ECB President Mario Draghi (October 25, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Policy Commentary: "Since the employment situation has continued to improve, no further easing of monetary policy may be necessary... at any rate, I would like to discuss this thoroughly with other board members at our monetary policy meeting" - BoJ Board Member Yutaka Harada (October 12, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Policy Commentary: "Our judgment in the summer was that we could have seen another 400,000-500,000 people unemployed over the course of the next few years...So we're willing to tolerate a bit of overshoot in inflation over the course of the next few years in order to avoid that situation, to cushion the blow" - BOE Governor Mark Carney (October 14, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Policy Commentary: "We have never thought of our job as keeping the year-ended rate of inflation between 2 and 3 percent at all times...Given the uncertainties in the world, something more prescriptive and mechanical is neither possible nor desirable" - RBA Governor Philip Lowe (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Policy Commentary: ""Given the downgrade to our outlook, Governing Council actively discussed the possibility of adding more monetary stimulus at this time, in order to speed up the return of the economy to full capacity" - BoC Governor Stephen Poloz (October 19, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Policy Commentary: "We don't have a fixed limit for growing the balance sheet; it's a corollary of our foreign exchange market interventions - which we conduct to fulfill our price stability mandate" - SNB Vice-President Fritz Zurbruegg (October 25, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades