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Highlights The political theater in Washington has caused the last inning of the dollar correction to materialize. The U.S. economy remains at full employment, growth will stay above trend, and the Fed will be capable of hiking rates by more than the 66 basis points priced into the OIS curve over the next 24 months. It is time to buy the DXY. Investors are too optimistic on the euro and too negative on the CAD, short EUR/CAD as a tactical bet. The Swedish economy continues to improve. Yet, the SEK has limited upside as the Riksbank continues to find excuses to justify its dovishness. The downside for EUR/SEK is limited to 9.3. Feature Chart I-1Trump Rally Is Gone Four weeks ago, we wrote that the U.S. dollar correction was entering its last inning and recommended investors should wait a few more weeks before betting on renewed dollar strength.1 We think the time to bet on this rebound is now. To begin with, the dollar index has now erased all the gains accumulated since Trump's electoral victory, suggesting that all the hope of fiscal stimulus, deregulation, and tax cuts have now been priced out of the greenback (Chart I-1). In fact, at this point in time we think too many risks have been priced into the dollar. For one, the market is overemphasizing the likelihood of a Trump impeachment. While our Geopolitical Strategy group does think the likelihood of an impeachment procedure is near 100% if the democrats win the House in 2018, the likelihood remains much lower in 2017.2 Simply put, Trump remains a very popular president among republican voters (Chart I-2). Most problematic for many republicans that would like to see Trump out of office, is that his popularity is particularly strong among the "Tea Party" districts and voters (Chart I-3). Chart I-2Trump Still Popular With Republicans Chart I-3Trump Is Popular In Tea Party Territory Second, the chance that tax cuts are part of the upcoming budget negations is high. Tax cuts are espoused by the entire GOP caucus. Additionally, Republicans know that in order to avoid losing the Senate or the House of Representatives, or both, they have to do something popular with voters. Tax cuts definitely fit the bill. This simple political assessment points toward a likely passage of stimulus in the coming quarters despite Trump's personal woes. Finally, if Trump were to be stabbed in the back by the GOP establishment, what would the impact be on the dollar? Would the U.S. default? No. Would the economy enter a recession? No. Would the Fed become dovish? Neither. If anything, a potential removal of Trump from the oval office reduces the risk that he appoints a super-dove at the helm of the Fed, a risk that would have been very negative for our positive dollar cyclical stance. Regarding the economics behind the dollar rally, our positive cyclical stance on the USD predates the election of Trump, and in fact relied on the underlying shifts in the U.S. economy.3 These dynamics are still intact: While wage growth remains anemic, this partly reflects the fact that the long-term determinant of wage growth, productivity growth, is low. When this is taken into account, productivity-adjusted wage growth is in line with levels that in the past have prompted the Fed to tighten policy in order to combat potential inflationary dynamics (Chart I-4). Nonetheless, the risk is that wages begin accelerating going forward. The labor market is at full employment, with the U-3 unemployment rate standing 0.3 percentage points below the Fed's estimate of the neutral unemployment rate. Additionally, hidden labor market slack has also greatly dissipated (Chart I-5), with the U-6 unemployment rate, the number of workers in part-time jobs for economic reasons, and the amount of workers outside of the labor force but that would still like to have a job if economic conditions warranted it all back to levels where historically wage growth has gained momentum. Chart I-4Without Productivity Gains, Current Wage##br## Growth Is Enough For A Tighter Fed Chart I-5U.S. Labor Market##br## Is Tight Moreover, the outlook for consumption remains sturdy. Overall household income growth remains supported by elevated levels of job creation, and our indicator for real household disposable income growth continues to point up. Additionally, Federal income tax withholdings are accelerating, a sign of more robust consumption to come (Chart I-6). With consumer confidence at 17-year highs, positive income developments are likely to be translated into consumption. The outlook for capex is also bright. CEO confidence and capex intentions have all rebounded sharply, moves whose genesis predate Trump's election (Chart I-7). Moreover, elements are in place for these positive feelings to be catalyzed into actual investment. On the back of rebounding revenue growth, thanks to nominal GDP growth exiting levels historically associated with recessions, profit growth will receive a fillip, which should boost capex in the current context (Chart I-8). Chart I-6Income Tax Receipts Points ##br##To Healthy Consumption Chart I-7Capex Intentions Point ##br##To Higher Growth Chart I-8Revenue Growth Exiting ##br##Recessionary Levels Finally, when all major indicators are aggregated, real GDP growth looks set to accelerate. BCA's Beige Book diffusion index, based on the distribution of positive and negative mentions about the state of the economy in the Fed's Beige Book, is pointing to an acceleration in activity (Chart I-9). This suggests that the collapse in U.S. economic surprises may be toward its tail end. With this in mind, we continue to expect the Fed to increase rates more than the 66 basis points currently anticipated in the OIS curve over the next two years, as such, this supports our bullish stance on the dollar. In terms of tactical developments, the recent selloff has brought the DXY toward the levels congruent with the end of the correction.4 Additionally, based on our Intermediate-term timing model, the USD is now cheap enough to justify taking a long bet on the currency. The deeply oversold levels reached by our Intermediate-term momentum oscillator supports this message (Chart I-10). Finally, the Swedish Krona seems to be confirming these signposts. USD/SEK has historically displayed one of the strongest betas to the trade-weighted dollar's movements. The fact that this pair has not been able to break down below a long-term upward slopping trend line put in place since 2014, and that it also managed to stay above its 2015 peaks, gives us more confidence that the dollar correction is likely to have run its course (Chart I-11). Chart I-9BCA's Beige Book Monitor ##br##Improves Growth Will Strengthen Chart I-10Dollar Is ##br##Oversold Chart I-11USD/SEK Giving A Hopeful##br## Signal For DXY Bottom Line: The dollar has taken a beating in the wake of the scandals emerging out of the White House. In our view, these developments were only the catalyst that crystalized the last leg of the USD correction that begun in late 2016/early 2017. Ultimately, the bull case for the dollar predates Trump and rests on the dissipating slack in the U.S. economy. These developments are intact, even with Trump's fiascos in the foreground. Tactically, the dollar is now cheap enough and oversold enough to justify investors buy the DXY again. We are opening a long DXY trade this week. We remain long the dollar against most commodity currencies and EM currencies. The yen may continue to benefit if the budding weaknesses in the EM space gather further momentum. EUR/CAD Is A Short At this juncture, it would be natural for us to begin shorting the EUR against the USD. In fact, we believe the recent spike in the EUR has created a good shorting opportunity against the European currency. While we worry investors are becoming too pessimistic on the U.S., we believe investors are too optimistic regarding the capacity of the ECB to increase rates. Investors moved away from deep short positions on the euro and are now net long this currency. Also, while in July 2016 investors expected the first ECB rate hike to materialize in more than five years' time, they are now expecting the first repo rate hike to happen in just 24 months (Chart I-12). This looks premature. For comparison's sake, in the U.S. we are only seeing the early signs of labor market tightness, despite the last recession ending in the summer of 2009. Europe was victim to a double-dip recession, the last leg of which ended in 2013. This decreases the likelihood of Europe being at full employment today. More concretely, there remains plenty of hidden labor market slack in the euro area. In Europe, the main form of slack exists among workers hired under contracts, contracts that do not offer the same level of benefits and protections as regular employment. The euro area increasingly has a dual labor market, a condition that has weighed on wage growth for more than two decades in Japan. Today, as a result of such dynamics, the level of labor underutilization in Europe is still very elevated, which will continue to limit wage growth going forward (Chart I-13). Hence, core inflation dynamics in Europe are likely to prove disappointing and they will keep the ECB on a more dovish path than investors currently appreciate. Chart I-12Investors Too Optimistic On The ECB Chart I-13Labor Market Slack In The Euro Area Remains High For now we are electing to profit from this view by tactically shorting the euro against the CAD. We do believe there are problems in Canada, a topic we discussed a few weeks ago.5 But at this juncture, these worries seem well digested by markets. The Home Capital Group debacle has been front page news for weeks, but the aggregate banking sector remains strong, especially as loses on the mortgage holdings of Canadian banks will ultimately be passed on to the government through the insurance provided by the Canadian Mortgage and Housing Corporation. Additionally, in the wake of the deepening trade dispute on softwood lumber, the fears of a disintegration of NAFTA have hit Canada especially violently, with the CAD falling 16% against the peso since January 2017. Chart I-14EUR/CAD Is Toppy Tactically, the pieces are falling into place to favor the CAD over the EUR. Our Commodity and Energy group remains positive on the outlook for oil prices. The continuation of the output controls by OPEC and Russia remains binding as oil producers want to further curtail elevated oil inventories. Therefore, oil prices have little downside and may even experience further upside, helping the CAD in the process. Additionally, investor positioning is very skewed. Investors are massively short the CAD, especially when compared to the euro, which historically has provided a signal to short EUR/CAD (Chart I-14). This is re-enforced by our Intermediate-term technical indicator which shows EUR/CAD as massively overbought. Shorter-term momentum measures such as the RSI or the MACD have also been forming negative divergences with actual prices in recent days. Bottom Line: The euro is likely to suffer if the USD correction is indeed finishing. Hidden labor market slack remains a much deeper problem in Europe than in the U.S. and will limit the capacity of the ECB to increase rates in the next two years, as investors are currently expecting. For now, we are electing to short the euro against the CAD instead of against the USD. The Canadian dollar is oversold and oil prices have limited downside from here as supply adjustments remain positive. Moreover, investors are at record shorts on the CAD, especially when compared to the euro. Sweden Is Strong, But The Riksbank Still Haunts The SEK The long-term outlook for both Sweden and the Swedish krona remain bright but the ultra-dovish stance of the Riksbank remains a potent short-term hurdle. To begin with, the SEK offers great value. Not only is it trading at 24% and 8% discounts to its PPP fair value against the USD and the EUR, respectively, but the trade-weight SEK is also trading at a near one-sigma discount against our long-term fair value models (Chart I-15). Chart I-15SEK Is Cheap... But Is It Enough? Additionally, Sweden's net international investment position has moved back in positive territory in 2014, and now stands 16.4% of GDP (Chart I-16). This is not only a reflection of the weakness in the SEK since 2014, but is first and foremost the end-result of more than two decades of accumulated current account surpluses. This development is crucial. Not only does the positive income balance generated by assets in excess of international liabilities put a floor under the current account; historically, currencies with positive and growing net international investment positions tend to exhibit an upward bias. In terms of economic developments, employment growth in Sweden remains steady. Unemployment has been in a protracted downtrend, falling 2.9 percentage points since 2008 (Chart I-17). Yet, despite being well into full employment territory, wage growth has been absent. To a large degree, this reflects entrenched deflationary pressures in the Swedish economy. However, deflationary forces are abating. Chart I-16A Long-Term Driver Pointing North Chart I-17Swedish Labor Market At Full Employment To begin with, Sweden's output gap has recently entered positive territory, which historically has been a reliable indicator of inflationary pressures in this country (Chart I-18). Also, monetary aggregates, M1 in particular, continue to point toward higher inflation in Sweden. This means that with the employment market being at full capacity, the conditions for higher inflation in Sweden are emerging. Our expectation of an upcoming upturn in the Swedish credit impulse - which until now has been contracting and exerting deflationary forces on the economy - reinforces confidence in our inflation view. Credit growth tends to lag industrial activity, but our industrial production model for Sweden is perking up. Improving industrial variables suggest that credit will move from depressing demand back to supporting demand, further rekindling inflationary forces (Chart I-19). Chart I-18Swedish Inflation Is Set To Pick Up Chart I-19Swedish Credit Impulse Will Rebound With this positive backdrop for prices, should investors buy the SEK right now? The Riksbank continues to represent a great hurdle for SEK bulls. The Swedish central bank has one of the strongest dovish biases amongst global monetary guardians. Against expectations, it recently increased the duration of its asset purchase program, giving markets a strong signal that it is unlikely to increase rates soon. This means that the Riksbank is unlikely to tighten policy until it sees the "whites of inflation's eyes". While we are moving in the right direction, we are not there yet. Officially, the Riksbank targets CPIF, which currently clocks in at 2%. Yet, the emphasis of the central bank on domestic price dynamics implies that adjustment away from dovishness will only occur when core inflation itself moves to 2% (Chart I-20). This means that gains in the SEK will be limited. To begin with, EUR/SEK does have downside, and our view that the euro is getting overextended highlights that EUR/SEK could fall toward 9.3. However, beyond this level, gains should prove limited as Sweden is a small open economy and EUR/SEK plays a big role in tightening monetary conditions for that country. As a result, any move in EUR/SEK below 9.3 is likely to be unwelcomed by the Riksbank until core inflation moves closer to 2%. Versus the USD, it will be even more difficult for the SEK to rally. Historically, the SEK has been one of the most sensitive currencies to the dollar's trend, implying that strength in DXY could be magnified in USD/SEK. In fact, the absence of breakdown in USD/SEK in the face of violent dollar selling pressures this week suggests that the SEK could be a serious casualty of a rebounding dollar. Additionally, real rate differentials continue to move in favor of the U.S. dollar, with U.S. 2-year real rates now 180 basis points above that of Sweden (Chart I-21). With the Intermediate-term technical indicator for USD/SEK now hitting oversold levels, the downside for USD/SEK is very limited, further supporting the idea that any rebound in DXY could lead to significant weaknesses in SEK. Chart I-20Core Inflation Needs To Rise Chart I-21Rates Differentials Support A Lower SEK Bottom Line: The Swedish economy has adjusted and several factors are pointing toward a pickup in core inflation in the coming quarters. However, the Riksbank has maintained a strong dovish bias. We need to see an actual pick up in core inflation itself before the central bank moves away from its dovish bias. While EUR/SEK could weaken toward 9.3, more gains for the krona against the euro will prove elusive until the Riksbank sees firmer inflation. USD/SEK is a buy at current levels. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant HaarisA@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled “The Last Innings Of The Dollar Correction”, dated April 21, 2017, available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Special Report titled “Break Glass In Case Of Impeachment”, dated May 17, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report titled “Dollar: The Great Redistributor”, dated October 7, 2016, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report titled “The Last Innings Of The Dollar Correction”, dated April 21, 2017, available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report titled “AUD and CAD: Risky Business”, dated March 10, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The past week has been quite eventful for the greenback, slipping almost 2.3%. Most of the downside is owed to markets revising down rate expectations, on the basis of weak growth numbers and political scandals. The 10-year yield dropped, gold rose, and equities fell. There was also a large sell-off in EM currencies and a sharp appreciation in the yen. Furthermore, the soft patch in U.S. data continued as housing starts and building permits came in especially weak in April: 1.172 million and 1.229 million respectively, both underperforming consensus. Nevertheless, markets calmed after the release of stronger employment numbers with initial and continuing jobless claims beating expectations. The upswing in the Philly Fed index also helped revive sentiment. The dollar picked up Thursday morning following these releases. Interestingly, the DXY is at pre-election levels, which suggests that the dollar is nearing its bottom. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro has enjoyed significant upside as a result of Macron's victory and the dollar's drubbing. Weak data in the U.S. caused markets to revise growth expectations, pressuring the dollar downwards and the euro up. Further lifting the euro were comments by ECB President Mario Draghi, who highlighted that growth in the euro area is performing well. However, he also reiterated that "it is too early to declare success". These forces have lifted the euro to expensive levels on a tactical basis, suggesting the path of least resistance is most likely down as the ECB will find it hard to tighten policy and the dollar resumes its bull market. Data in the euro area has been mixed as of late without too much disappointment, and inflationary pressured remain unchanged. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 After coming slightly above 114, USD/JPY has plunged by more than 3%, as a result of the market pricing increasing odds that president Trump will get impeached. Although we believe that the correction of the dollar has run its course, the end of the Trump trade might have triggered the sell-off we have been expecting in emerging markets. Thus we like to play this risk off period by shorting NZD/JPY. On the data side, news have mostly been negative: Machinery orders contracted by 0.7% YoY, underperforming expectations. Consumer confidence came in lower than last month at 43.2. Bank lending grew by a measly 3% YoY underperforming expectations. However, real GDP for Q1 came in at 0.5% QoQ, beating expectations. This was dampened by the weak GDP deflator, which contracted by tk%. We continue to be yen bears on a cyclical basis, as the fed will raise rates more than the markets expects, while the BoJ will continue anchoring 10-year yields around zero. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K has been mixed: Industrial Production growth came in at 1.4%, underperforming expectations. However retail sales and retail sales ex-fuel growth came in at 4% and 4.5% respectively, both outpacing expectations. Crucially, both core and headline inflation came above expectations at 2.4% and 2.7% respectively. This surge in inflation is important as it raises the odds of a BoE hike this year, especially as the economy remains resilient. Moreover, as long term inflation expectations continue to be well anchored consumption is likely to continue to surprise as households are looking through the inflation caused by the depreciation in the pound. Overall, we continue to be positive on GBP against all other currencies but the U.S. dollar, given that the British economy will likely stay more resilient than investors are anticipating. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA shed some light on the Australian economy through its most recent Minutes, highlighting that monetary policy needs to remain accommodative to support economic trends. It noted the negative hit to terms of trade as a result of Cyclone Debbie curtailing coking coal exports. China's housing market was also identified as a risk to Australia's exports and terms of trade. Nevertheless, this week the AUD was buoyant, helped by a weaker greenback. However, the factors above paint a bleak picture for the AUD's future. The very important employment figures depicted a similar trend to that of last year, with full-time employment in fact contracting while part-time employment picked up. Unemployment also declined by 0.2% to 5.7%, however, wages remain subdued. This corroborates the weaker core CPI measure of 1.5%, while the strong headline figure of 2.1% is likely to be transitory when the recent commodity-prices weakness kicks in. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The RBNZ continues to much more accommodative than warranted. The monetary policy report highlighted that the recent surge in inflation is mainly attributable to tradables, and that non-tradable inflation is bound to increase very gradually. We continue to believe that the RBNZ is understating the inflationary pressures in the economy, as core inflation is already higher than 2%. Additionally, retail sales are growing at 10-year high and nominal GDP growth has skyrocketed to 7.5%, by far the highest in the G10. Right now, the market expects the first rate hike to come in 9 months. We believe that a rate hike at this point would be the bare minimum for the RBNZ to avoid an overheating in the economy. Thus expectations have nowhere to go than up and the NZD now has considerable upside against the AUD. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has been somewhat weaker this past week as oil prices rebounded and the dollar fell. Oil prices are likely to see further upside as OPEC and Russia are likely to agree to another supply cut to support oil prices. Domestically, the economy is improving as unemployment is declining and PMIs are perking up. The BoC also identified the output gap to close earlier than expected in its last meeting. The almost 4% depreciation in the CAD in the past month has made the oil-based currency considerably cheap. When looking at EUR/CAD, the depreciation has been around 7.5%. With the euro now sitting in expensive territory, the ECB is unlikely to change its stance any time soon as inflation has not yet rooted itself, while peripheral economies' inflation remain weak. The CAD, however, is likely to see further upside on the back of increasing oil prices and a strengthening economy. These factors warrant a short EUR/CAD trade. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 And CAD: Risky Business -AUD March 10, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Following the election of Emmanuel Macron as the new president of France EUR/CHF skyrocketed, coming close to hitting 1.1. At this point EUR/CHF is a very attractive short, given that good news for the euro are likely to tapper now that the French election is behind us. When it comes to inflation, the ECB will likely focus on the lowest denominator, because in spite of higher inflation in some countries like Germany or Austria, inflationary pressures remain muted in most other economies. This will prevent the ECB from tightening monetary policy as fast as the market expects. Meanwhile, the possibilities that the SNB takes the floor off EUR/CHF at the end of this year or the beginning of 2018 are rising given that inflation and economic activity are slowly coming back to Switzerland. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has depreciated in the past weeks thanks to the fall in the dollar as well as rising oil prices. Additionally, the fall in inflation is slowing down, with core and headline inflation coming in at 1.7% and 2.2% respectively. Is it time to become bullish on the NOK against the U.S. dollar? We do not believe this is the case. While inflation might be close to bottoming it is unlikely to surpass the Norges Bank target in the coming years, given that inflationary pressures remain muted in Norway. Furthermore, given that USD/NOK is more sensitive to real rate differentials than oil prices, the effect of a dovish Norges Bank on USD/NOK will be much stronger than the impact of rising oil prices. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 We expect the SEK to experience limited upside in the next 3-6 months. The Greenback is bottoming and we expect USD/SEK to pick up on the back of the dollar bull market. Furthermore, EUR/SEK has limited downside as the RIksbank wants to keep monetary conditions easy. Indeed, the Swedish central bank is also planning to officially target CPIF instead of the CPI. While both of these measures are near 2%, the behavior of the Riksbank suggests that it is in fact targeting core inflation. Core inflation itself is still somewhat depressed, as consumer activity remains weak. However, we expect core inflation to pick up on the back of a higher credit impulse and money supply growth, which should help the Riksbank exit its dovish tilt later this year. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Duration: The opposing forces currently pulling on global bonds - softer growth and core inflation readings vs. tightening labor markets - are keeping yields locked into narrow trading ranges. We expect the strength of the global upturn to reassert itself, leading to higher government bond yields and corporate credit outperformance over the balance of 2017. U.K./Canada/Australia: Economic data, as well as our bond market indicators, are giving conflicting signals for the outlook for yields in the U.K., Canada & Australia. Our analysis of the relative growth and inflation dynamics in the three countries leads us to recommend a 2-year/30-year yield curve box trade, positioning for a relatively flatter curve in Canada and a relatively steeper curve in the U.K. Portugal Trade Update: Improving growth indicators, and declining measures of banking sector risk, in Portugal have resulted in a sharp narrowing of government spreads versus Germany. We are exiting our short 10-year Portugal/long 10-year Germany Tactical Overlay trade this week, at a loss of -1.6%. Feature Chart of the WeekMarket Volatility Is Low For A Good Reason What was once a fairly straightforward narrative for global bond markets earlier this year is now being challenged. Growth data has cooled a bit in the U.S. and China, while commodity prices have fallen, suggesting that the global economy may be losing steam even with leading indicators still rising and the European economy looking robust. At the same time, core inflation measures have ticked lower despite the signs of tighter labor markets throughout the developed world. These moves on the margin have stalled the upturn in global bond yields, resulting in lower fixed income market volatility that is likely playing a role in keeping realized equity market volatility at depressed levels (Chart of the Week). We continue to see the recent pullback in U.S. data as being temporary in nature. The economy should improve in the coming months given the still-solid trends in U.S. corporate profits and household income and the still-low level of interest rates. The signs of a building China slowdown are potentially more worrisome, especially on the inflation front given how much Chinese demand has boosted commodities and overall traded goods prices over the past year. Although we are not expecting a major Chinese downturn that could spill over more broadly to the world economy, it is likely that the next leg up in inflation in the developed economies will come from diminished spare capacity and rising core inflation, rather than a commodity-driven reacceleration of headline inflation. We continue to recommend a strategic underweight overall portfolio duration stance, as we expect the Fed to deliver on its planned rate hikes before year-end and the European Central Bank (ECB) to soon begin signaling a tapering of its asset purchases next year. We continue to favor corporate credit over sovereign debt, particularly in the U.S., given the strength of the current global upturn, but staying up in credit quality (i.e. focusing on Investment Grade and higher-rated credit tiers in High-Yield). Stuck On Neutral: Considering Trades Between Canada, Australia & The U.K. Over the past few months, we have upgraded our stance on government bond exposure in the U.K., Canada and Australia - all to neutral and all for essentially the same reason. There was not a compelling enough case to expect any of the central banks in those countries to move interest rates before year-end, in either direction, given the lack of sustainable inflation pressures and mixed messages on growth. With policymakers stuck on hold for the foreseeable future, keeping our recommended bond weightings at benchmark was the logical (albeit unexciting) choice. Even the mixed messages sent by our own bond indicators highlight the difficulty in making a decisive market call at the moment. Our Central Bank Monitors for Canada and Australia have recently flipped into the "tighter policy required" zone, joining the U.K. Monitor which has been there for some time (Chart 2).1 This would suggest moving to an underweight stance in anticipation of tighter monetary policy in those countries that is currently not priced into money market curves (bottom panel). Yet the best performing bond market of the three over the past two years has been the U.K. - a trend that started before last year's Brexit vote when the U.K. economy was in relatively good shape and the Bank of England (BoE) was starting to send hawkish messages. Gilts now look the most overvalued judging by the current negative real yields on offer (Chart 3), yet our U.K. Central Bank Monitor is showing signs of topping out, further adding to the confusion. Chart 2Markets Don't Expect Anything From BoE/BoC/RBA Chart 3Gilts Look Most Expensive Having mixed directional signals, however, does not imply that there are not trade opportunities within these markets. Even if the BoE, the Bank of Canada (BoC) and the Reserve Bank of Australia (RBA) are not in a hurry to begin hiking interest rates, domestic growth and inflation pressures are building at a different pace within these economies, creating potential cross-market trade opportunities. Economic Growth: Canada has the strongest leading economic indicator, manufacturing PMI and consumer sentiment, but the softest business confidence (Chart 4) - perhaps because of concerns over the future protectionist trade policies of U.S. President Donald Trump. In the U.K., a combination of falling real wage growth and persistently high levels of political uncertainty after Brexit are weighing on consumer sentiment, yet business confidence is the strongest of the three countries. Meanwhile, overall confidence in Australia is the weakest, even with manufacturing in a strong upturn. Most worryingly, real consumer spending is slowing rapidly in all three countries, although it is holding up relatively better in Canada. Inflation: The differences in price pressures are less pronounced (Chart 5). Inflation rates are similar among the three economies as Australian core CPI inflation appears to have finally bottomed out in the first quarter of this year after falling steadily since 2014. All three countries are witnessing decelerating wage growth, however, even with solid job growth in Canada over the past year. Spare capacity measures like the output gap and unemployment gap show the U.K. economy being closest to full employment (Chart 6). Spare capacity is steadily being absorbed in Canada, although the BoC attributes this to a slower pace of potential GDP growth, according to last month's BoC Monetary Policy Report (MPR).2 Chart 4Canadian Economic Data Looks Strongest Chart 5No Major Inflation Differences Home Prices & Debt: The housing markets remain an issue in Canada and Australia, where home prices look severely overvalued with household debt at elevated levels (Chart 7). The governments in both countries are trying to use regulatory and macro-prudential solutions to cool red-hot housing demand, but rapid growth in housing wealth remains a source of stimulus for consumers at the moment. The situation is different in the U.K., where home valuations and debt levels are nowhere near as elevated as in the other two countries (although London homeowners may disagree). Chart 6No Spare Capacity In The U.K. Chart 7Household Debt A Concern In Canada & Australia Exports: Each country is also exposed to a different major economy via the export channel. The OECD leading economic indicators for the U.S., Euro Area and China (the largest export markets for Canada, the U.K. and Australia, respectively) are all ticking higher, suggesting that export demand should pick up for Canada, the U.K. and Australia in the near term (Chart 8). However, Australian exports to China have already expanded at a 60% annual rate and our Emerging Market and China strategists are expecting some cooling of Chinese growth in the latter half of this year; slower export growth should be expected. Chart 8An Unsustainable Surge In Aussie##BR##Export Demand From China After adding up all the pieces, it is still difficult to select one government bond market over the others in absolute terms. The U.K. would appear to have the least bond-friendly backdrop, with higher inflation and very low real interest rates. Yet the BoE is worried about many factors - Brexit uncertainties on trade and business confidence, declining real household income growth - that should prevent them from shifting to a less accommodative monetary stance before year-end that would involve reduced Gilt purchases and/or outright interest rate hikes. Conversely, Australia seems to have the most bond-bullish climate - a still-negative output gap, plunging consumer confidence, very low inflation and the heaviest exposure to a Chinese economy that is set to cool off. Yet while core inflation remains low at 1.5%, it appears to be bottoming out and the RBA is currently forecasting that its preferred measure of underlying inflation will move up to 2% - the low end of its 2-3% target range - by early 2018, according to their just-released Statement on Monetary Policy.3 In Canada, the BoC continues to take a very cautious view on Canadian growth, despite the robust 4% real GDP growth seen in the first quarter of this year. Sluggish growth in exports and capital spending is expected to be a drag on growth this year, according to the April BoC MPR. Yet the central bank is now "decidedly neutral" and is no longer considering a rate cut as it was earlier this year according to BoC Governor (and BCA alumnus) Stephen Poloz.4 Given all the various factors pushing and pulling on these three economies and central banks, it is perhaps no surprise that yield moves have been highly correlated across these bond markets over the past several months (Chart 9). The most attractive near-term risk/reward opportunities now appear to be in relative yield curve trades rather than directional allocations or cross-country spread trades. Specifically, we see an opportunity to play for a steeper Gilt curve, and a relatively flatter Canadian government bond curve, via a 2-year/30-year box trade. Given the strong readings on current and leading economic indicators in Canada, combined with our view that the recent patch of slower U.S. growth will prove to be temporary, we see the greatest potential for upside growth surprises in Canada. The BoC is likely to wait before delivering rate hikes until there is decisive evidence of accelerating inflation, especially given the potential economic risks deriving from the Canadian housing bubble. However, better-than-expected growth will exert more flattening pressure on the Canadian yield curve than the U.K. or Australian curves, where downside growth risks are greater. Already, the very front end of the Canadian curve is starting to disengage from the U.K. and Australian curves, with the 2-year/5-year flattening modestly in Canada and the other markets showing steepening curves at similar maturities (Chart 10, top panel). We expect that relative flattening pressure to exert itself further out the yield curve for Canadian government debt over the latter half of 2017. Chart 9Yields Are Highly Correlated... Chart 10...Curve Slopes, Slightly Less Correlated In the U.K., the long end of the Gilt curve has rallied to very rich levels, with the 10-year/30-year slope now trading near the bottom of the range that has prevailed since 2014 (bottom panel). Much of that has been driven by a decline in longer-term inflation expectations that has accompanied the more stable British Pound. While the uncertainty surrounding the upcoming Brexit negotiations with the European Union will likely weigh on business confidence and investment spending in the U.K., the immediate impact of the robust Euro Area economy on U.K. exports should provide a boost to U.K. economic growth. Coming at a time when the U.K. is at, or even beyond, full employment, this should put some mild upward pressure on inflation expectations further out the curve, leading to steepening pressures on a relative basis to Canada. This can already be seen in looking at the 2-year/30-year yield curve box between the Canada and the U.K. in Chart 11. In all three panels, we show the steepness of the Canadian bond curve minus that of the Gilt curve, alongside the differentials in actual inflation, and market-based inflation expectations from the index-linked markets, between Canada and the U.K. As can be seen in the top two panels, the Canadian curve looks too steep relative to the U.K. curve given the higher rates of headline and core inflation in the U.K. The bottom panel shows that the 2-year/30-year box is in line with the relative inflation expectations within the two countries. We see this as a sign that U.K. inflation expectations are too low relative to actual U.K. inflation, leaving the Gilt curve too flat relative to the Canadian curve. While this would appear to argue for a relative trade between inflation-linked bonds in Canada and the U.K., the poor liquidity of the small Canadian linker market makes this a difficult trade for most investors to put on. We prefer to express the view via yield curves, particularly with the 2-year/30-year Canada-U.K. box currently priced in the bond forwards to move sideways over the rest of the year (Chart 12). This means that betting on a steeper Gilt curve relative to Canada does not incur negative carry - important for a trade with a more medium-term horizon like this. Chart 11Gilt 2/30 Curve Too Flat Relative To Canada Chart 12Enter A 2/30 Canada-U.K. Box Trade This week, we are adding this 2-year/30-year Canada-U.K. position to our strategic model portfolio at -7bps. The initial target is for the box to return to -50bps - the bottom of the range that has prevailed since 2015. A deeper decline would occur if the BoC begins to signal a rate hike in Canada at some point that puts even more flattening pressure on the Canadian curve, although that is not our base case expectation over the rest of 2017. The risk to the trade would come from a deceleration of U.K. inflation that eliminates the current divergence between realized and expected inflation. What about Australia? We anticipate that there will be an opportunity to move to an eventual overweight position in Australian bonds in the coming months to position for the slowing of Chinese growth, and the related demand for Australian exports, that we expect. We are choosing to stay neutral for now, however, given the current uptick in Australian inflation that muddies the water on any call on RBA monetary policy. Bottom Line: Economic data, as well as our bond market indicators, are giving conflicting signals for the outlook for yields in the U.K., Canada & Australia. Our analysis of the relative growth and inflation dynamics in the three countries leads us to recommend a 2-year/30-year yield curve box trade, positioning for a flatter curve in Canada and a steeper curve in the U.K. Tactical Overlay Housekeeping: Cutting Losses On Portugal Shorts One of our long-held positions in our Tactical Overlay trade portfolio has been a short position in Portugal 10-year government bonds versus a long position in 10-year German Bunds. We put the trade on last summer as part of a broader allocation at the time out of Peripheral European sovereign debt into core European debt. The logic was straightforward - the combined stress of decelerating economic growth and struggling banking systems in the Periphery (made worse by the ECB's negative interest rate policies) would result in some spread widening in Italy, Spain and Portugal. While that story remains true in Italy, both leading economic indicators and measures of financial sector risk like credit default swap (CDS) spreads for senior banks have a decline in Spain and Portugal. While we have already upgraded our recommended allocation to Spanish debt in our model portfolio, we had been reluctant to consider a similar move in Portugal given our concerns about its economy and, more importantly, its banking system. But with leading economic indicators starting to perk up and bank CDS spreads in Portugal falling sharply, and with German Bund yields rising alongside growing market nervousness of a potential ECB taper, Portugal-Germany spreads have tightened sharply. We are belatedly cutting our losses on this position this week and closing out the position at a loss of -1.6%. We plan on publishing a deeper dive on Portugal in the coming weeks to update our views on the country and its bond markets. Bottom Line: Improving growth indicators, and declining measures of banking sector risk, in Portugal have resulted in a sharp narrowing of government spreads versus Germany. We are exiting our short 10-year Portugal/long 10-year Germany Tactical Overlay trade this week, at a loss of -1.6%. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "BCA Central Bank Monitor Chartbook", dated March 28 2017, available at gfis.bcaresearch.com. 2 http://www.bankofcanada.ca/wp-content/uploads/2017/04/mpr-2017-04-12.pdf 3 http://www.rba.gov.au/publications/smp/2017/may/pdf/statement-on-monetary-policy-2017-05.pdf 4 https://www.bloomberg.com/news/articles/2017-04-12/poloz-sees-faster-canada-return-to-full-capacity-key-takeaways The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights The headwinds against commodity currencies are still brewing, the selloff is not over. Global liquidity conditions are deteriorating and EM growth will disappoint. The valuation cushion in commodity currencies and EM plays is not large enough to compensate for the red flags emanating from financial markets. The euro is peaking. A capitulation by shorts is likely early next week. A move to 1.12 should be used to sell EUR/USD. Feature Commodity currencies have had a tough nine weeks, weakening by 5% in aggregate, helping boost our short commodity currency trade returns to 3.8%. At this juncture, the key questions on investors' minds is whether or not this trend will deepen and if this selloff will remain playable. We believe the answer to both questions is yes. A Less Friendly Global Backdrop When observed in aggregate, the past 12 months represented a fertile ground for commodity currencies to perform well as both global liquidity and growth conditions were on one of the most powerful upswings in the past two decades, lifting risk assets in the process (Chart I-1). Chart I-1The Zenith Is Passing Global Liquidity Is Drying When we look at the global liquidity picture, the improvement seems to be over, especially as the Fed, the key anchor to the global cost of money, is more confidently embracing its switch toward a tighter monetary policy. It is true that U.S. Q1 data has been punky at best; however, like the Fed, we think this phenomenon will prove to be temporary. Recently, much ink has been spilled over the weakness in the auto sector. However, when cyclical spending is looked at in aggregate, the picture is not as dire and even encourages moderate optimism. Driven by both corporate and housing investment, cyclical sectors have been growing as a share of GDP (Chart I-2). This highlights that poor auto sales may have been a sector specific development and do not necessarily provide an accurate read on the state of household finances. Chart I-2Autos Do Not Paint The Full Picture For The U.S. Cyclical Spending Is Firm... Moreover, the outlook for household income is still positive. Our indicator for aggregate household disposable income continues to point north (Chart I-3). As we have highlighted in recent publications, various employment surveys are suggesting that job growth should improve in the coming months.1 Also, this week's productivity and labor cost report showed that compensation is increasing at a nearly 4% annual pace. This healthy outlook for household income, combined with the consumer's healthy balance sheets - debt to disposable income stands near 14 year lows while debt-servicing ratios are still near 40 year lows - and elevated confidence suggests that house purchases can expand. With the inventory of vacant homes standing at 11 year lows, this positive backdrop, along with the improving household-formation rate, is likely to prompt additional housing starts, lifting residential investment (Chart I-4). Chart I-3Bright U.S. Household ##br##Income Prospects Chart I-4As Households Get Formed,##br## Housing Starts To Pick up For the corporate sector, the strength in survey data is also likely to result in growing capex (Chart I-5). Not only have "soft" data historically been a good leading indicator of "hard" data, but the outlook for profit growth has also improved substantially. Profit growth is the needed ingredient to realize the positive expectation of business leaders embedded in "soft" data. Profit itself is very often dictated by the trend in nominal revenue growth. The fall in profits in 2016 mostly reflected the fall in nominal GDP growth to 2.5%, which produced a level of revenue growth historically associated with recessions (Chart I-6). As such, the recent rebound in nominal GDP growth, suggests that through the power of operating leverage, profit should also continue to grow, supporting capex in the process. Chart I-5Business Confidence Points ##br##To Better Growth And Capex... Chart I-6...Especially As A Key Profit##br## Driver Is Improving With the most cyclical sector of the U.S. economy still on an upswing, the Fed will continue to increase rates, at least more aggressively than the 45 basis points of tightening priced into the OIS curve over the next 12 months. With liquidity being sucked into the U.S. economic machine, international dollar-based liquidity, which is already in a downtrend, is likely to deteriorate further (Chart I-7). Moreover, global yield curves, which were steepening until earlier this year, have begun flattening again, highlighting that the tightening in global liquidity conditions is biting (Chart I-8). This will represent a continuation of the expanding handicap against global growth, and EM growth in particular. Chart I-7Global Dollar Liquidity Is Already Poor Chart I-8A Symptom Of The Tightening In Liquidity Global Growth Conditions Are Also Past Their Best, Especially In EM Global growth conditions are already showing a few troubling signs, potentially exerted by the tightening in global liquidity. To begin with, while our global leading economic indicator is still pointing north, its own diffusion index - the number of nations with improving LEIs versus those with deteriorating ones - has already rolled over. Normally, this represents a reliable signal that growth will soon peak (Chart I-9). For commodity currencies, the key growth consideration is EM growth. Here too, the outlook looks precarious. The impulse to EM growth tends to emerge from China as Chinese imports have been the key fuel to boost exports, investments, and incomes across a wide swath of EM nations. Chinese developments suggest that Chinese growth, while not about to crater, may be slowing. Chinese monetary conditions have been tightening abruptly (Chart I-10, top panel). Moreover, this tightening seems to be already yielding some results. The issuance of bonds by smaller financial firms has been plunging, which tends to lead the growth in aggregate total social financing (Chart I-10, bottom panel). This is because the grease in the shadow banking system becomes scarcer as the cost of financing rises. Chart I-9Deteriorating Growth##br## Outlook Chart I-10Chinese Monetary Conditions ##br##Are Tightening This situation could continue. Some of the rise in Chinese interbank rates to two-year highs reflects the fact that easing capital outflows have meant that the PBoC can tighten monetary policy through other means. However, the recent focus by the Beijing and president Xi Jinping on financial stability and bubble prevention, suggests that there is a real will to see tighter policy implemented. This means that the decline in total credit growth in China should become more pronounced. As a result, this will weigh on the country's industrial activity, a risk already highlighted by the decline in Manufacturing PMIs (Chart I-11). Additionally, this decline in credit growth tends to be a harbinger of lower nominal GDP growth, and most importantly for EM and commodity producers, a foreboding warning for Chinese imports (Chart I-12). Chart I-11China Industrial ##br##Growth Worry Chart I-12Slowing Chinese Credit Impulse ##br##Will Weigh On EM Growth Financial markets are already flashing red signals. The Canadian Venture exchange and various coal plays have historically displayed a tight correlation with Chinese GDP growth.2 Today, they are breaking below key trend lines that have defined their bull markets since the February 2016 troughs (Chart I-13). This message is corroborated by the recent weakness in copper, iron ore, and oil prices. Additionally, the price of platinum relative to that of gold is also breaking down. While the VW scandal has a role to play, this breakdown is also a symptom of the pain on growth created by the tightening in global liquidity conditions. In the past, the message from this ratio have ultimately been heeded by EM stock prices, suggesting that the recent divergence is likely to be resolved with weaker EM asset prices (Chart I-14). Confirming this risk, the sectoral breadth of EM equities has also deteriorated, and is already at levels that in the past have marked the end of stock advances (Chart I-15). At the very least, the narrowing of the EM bull market should prompt investors in EM-related plays to pause and reflect. Chart I-13Two Worrisome Breakdowns##br## On Chinese Plays Chart I-14Platinum's Dark##br## Omen For EM Chart I-15The Falling Participation ##br##In The EM Rally This moment of reflection seems especially warranted as EM assets do not have much cushion for unanticipated growth disappointment. The implied volatility on EM stocks is near cycle lows, so are EM sovereign CDS and corporate spreads (Chart I-16). This picture is mimicked by commodity currencies. Even after the recent bout of weakness, the aggregate risk-reversal in options points to a limited amount of concern, and therefore, a growing risk of negative surprises (Chart I-17). Chart I-16Little Cushion##br## In EM Assets Chart I-17Commodity Currency Options##br## Turn Optimistic As Well If commodity currencies have already depreciated in the face of a slightly soft dollar and perky EM asset prices, we worry that further weaknesses will emerge if the dollar strengthens again and EM assets self-off on the back of less liquidity and more EM growth disappointment. If the price of platinum relative to that of gold was a signal for EM assets, it is also a good indicator of additional stress in the commodity-currency space (Chart I-18). Chart I-18Platinum Raises Concerns ##br##For Commodity Currencies As Well We remain committed to our trade of shorting a basket of commodity currencies. AUD is the most expensive and most exposed to the Chinese tightening of the group, but that doesn't mean much. The Canadian housing market seems to be under increased scrutiny thanks to the combined assault of rising taxes on non-residents and growing worries about mortgage fraud, which is deepening the underperformance of Canadian banks relative to their U.S. counterparts. If this two-front attack continues, the housing market, the engine of the domestic economy, may also prove to weaken faster than we anticipated. Finally, the New Zealand dollar too is expensive even if domestic economic developments suggest that its fair value may be understated by most PPP metrics. Bottom Line: The outlook for the U.S. economy remains good, but this will deepen the tightening in global liquidity. When combined with the tightening of monetary conditions in China, this suggests that global industrial activity and EM growth in particular could disappoint, especially as cracks in the financial system are beginning to appear. Moreover, EM assets and commodity currencies do not yet offer enough of a valuation cushion to fade this risk. Stay short commodity currencies. Macron In = Buy The Euro? The euro has rallied a 3.6% since early April, mostly on the back of Emmanuel Macron's electoral victories. Obviously, the last big hurdle is arriving this weekend with the second round. The En Marche! candidate still leads Marine Le Pen by a 20% margin. Wednesday's bellicose debate is unlikely to overturn this significant lead. The Front National candidate's lack of substance seems to have weighed against her in flash polls. If anything, her performance might have prompted some undecided Mélanchon voters to abstain or cast a "vote blanc" this weekend instead of picking her. This was her loss, not Macron's win. Does this mean that the euro has much upside? A quick rally toward 1.12 early next week still seems reasonable. New polls are beginning to show that En March! might perform much better than anticipated in the legislative election. Also, the center-right Les Républicains should also perform very well, resulting in the most right wing, pro-market Assemblée Nationale in nearly 50 years. While these polls are much too early to have any reliability, they may influence the interpretation by traders of Sunday's presidential election. However, we would remain inclined to fade any such rally. As we highlighted last week in a Special Report, our EUR/USD intermediate-term timing model shows that the euro is becoming expensive tactically, and that much good news is now in the euro's prices (Chart I-19).3 Additionally, investors have been excited by the rebound in core CPI in the euro area, a development interpreted as giving a carte-blanche to the ECB to hike rates sooner than was anticipated a few months ago. Indeed, currently, the first hike by the ECB is estimated to materialize in 27 months, versus the more than 60 months anticipated in July 2016. We doubt that market participants will bring the first rate hike closer to the present, a necessary development to prompt the euro to rally given our view on the Fed's tightening stance. We expect the rebound in the European core CPI to prove transient. Not only does European wage dynamics remain very poor outside of Germany, our country-based core CPI diffusion index has rolled over and points to a decelerating euro area core CPI (Chart I-20). Chart I-19EUR/USD: ##br##Good News In The Price Chart I-20European Core CPI Rebound ##br##Should Prove Transient Additionally, as we argued four weeks ago, tightening Chinese monetary conditions and EM growth shocks weigh more heavily on European growth than they do on the U.S.4 As such, our EM view implies that the euro area's positive economic surprises might soon deteriorate. Therefore, the favorable growth differential between Europe and the U.S. could be at its zenith. Shorting the euro today may prove dangerous, as a violent pop next week is very possible if the last euro shorts capitulate on a positive electoral outcome. Instead, we recommend investors sell EUR/USD if this pair hits 1.12 next week. Moreover, for risk management reasons, despite our view on the AUD, we are closing our long EUR/AUD position at a 6.9% gain this week. Bottom Line: Emmanuel Macron's likely victory this weekend could prompt a last wave of euro purchases. However, we are inclined to sell the euro as economic differentials between the common currency area and the U.S. are at their apex. Moreover, European core CPI is likely to weaken in the coming quarters, removing another excuse for investors to bid up the euro. Close long EUR/AUD. A Few Words On The Yen The yen has sold-off furiously in recent weeks. The tension with North Korea and the rise in the probability of a Fed hike in June to more than 90% have been poisons for the JPY. We are reluctant to close our yen longs just yet. Our anticipation that EM stresses will become particularly acute in the coming months should help the yen across the board. That being said, going forward, we recommend investors be more aggressive on shorting NZD/JPY than USD/JPY. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled “The Last Innings Of The Dollar Correction”, dated April 21, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report titled "Healthcare Or Not, Risks Remain", dated March 24, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report titled "Updating Our Intermediate Timing Models", dated April 28, 2017, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report titled "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The Fed decided to keep the federal funds rate unchanged at the 0.75% - 1% range. The Committee highlighted the Q1 GDP weakness as transitory, as the labor market has tightened more since their last meeting, inflation is reaching its 2% target, and business investment is firming. Continuing and initial jobless claims both beat expectations; However, ISM Manufacturing PMI came in less than expected at 54.8; PCE continues to fluctuate around the 2% target, coming in at 1.8% from 2.1%; ISM Prices Paid came in at 68.5, beating expectations. Furthermore, the Committee expects that "near-term risks to the economic outlook appear roughly balanced", and that "economic activity will expand at a moderate pace". The market is now pricing in a 93.8% probability of a hike. We therefore expect the dollar to continue its appreciation after the French elections. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Macron's lead over Le Pen has risen after the heated debate between the two rival candidates. We believe these dynamics were a key bullish support for the euro in the run up to elections as the possibility of a Le Pen victory is being completely priced out. Adding to this optimism is a plethora of positive data from Europe. Business and consumer confidences have both pick up. German HICP came in at 2% yoy; Overall euro area headline CPI came in at 1.9%, and core at 1.2%. Nevertheless, labor market data in the peripheries, as well as the overall euro area, was disappointing. We believe this highlights substantial slack in the economy, and will keep the ECB from increasing rates any time soon. We expect the euro to climb in the short run, but the longer-run outlook remains bleak. Look to short EUR/USD at 1.12. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Economic data in Japan has been positive this past week: The unemployment rate went down to 2.8%, outperforming expectations. Retail trade annual growth came in 2.1%, also outperforming expectations. The jobs offer-to-applicants ratio came in at 1.45. This last number is significant, as this ratio has reached it 1990 peak, and it provides strong evidence that the Japanese labor market is very tight. Eventually, this tight labor market will exert pressures on wage inflation. In an environment like Japan, where nominal rates are capped, rising inflation would mean a collapse in real rates and consequently a collapse on the yen. Thus, we are maintaining our bearish view on the yen on a cyclical basis. On a tactical basis, we continue to be positive on the yen, given that a risk-off period in EM seems imminent. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 In spite of the tougher rhetoric coming from Brussels recently, the pound has maintained resilient and has even gain against the U.S. dollar. Indeed, recent data from the U.K. has been positive: Markit Services PMI came in at 55.8, outperforming expectations. Meanwhile, Markit Manufacturing PMI came in at 57.3, crushing expectations. Additionally, both consumer credit and M4 money supply growth also outperformed. Overall we continue to be positive on the pound, particularly against the euro, as we believe that expectations on Britain are too pessimistic, while the ability for the ECB to turn hawkish limited given that peripheral economies are still too weak to sustain tighter monetary conditions. Against the U.S. dollar the pound will have limited upside from now, given that it has already appreciated substantially. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA left its cash rate unchanged at 1.5%. The Bank also stated that its "forecasts for the Australian economy are little changed." It remains of the opinion that the low interest rate environment continues to support the outlook. This will also be a crucial ingredient to generate a positive outcome in the labor market in the foreseeable future. This past month has been very negative for the antipodean currency, with copper and iron ore prices displaying a similar behavior, losing almost 10% and 25% of their values since February, respectively. With China tightening monetary policy, and dissipating government spending soon to impact the Chinese economy, we remain bearish on AUD. In brighter news, the Bank's trimmed mean CPI measure increased by 1.9% on an annual basis, beating expectations of 1.8%. This is definitely a positive, but economic slack elsewhere could limit this development. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Data for New Zealand was very positive this week: The participation rate came in at 70.6%, outperforming expectations. Employment growth outperformed expectations substantially in the first quarter of 2017, coming in at 1.2%. The unemployment rate also outperformed coming in at 4.9% This recent data confirms our belief that inflationary pressures in New Zealand are stronger than what the RBNZ would lead you to believe. Indeed, non-tradable inflation, which measures domestically produced inflation is at its highest since 2014. Eventually, this will lead the RBNZ to abandon its neutral bias and embrace a more hawkish one, lifting the NZD in the process, particularly against the AUD. Against the U.S. dollar the kiwi dollar will likely have further downside, as the tightening in monetary conditions in China should weigh on commodity prices. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The oil-based currency has once again succumbed to fleeting oil prices, depreciating to a 1-year low. U.S. crude inventories have recently been declining by less than expected and production in Libya has been increasing. Moreover, headline inflation dropped 0.5% from its January high of 2.1%. The Bank of Canada acknowledged the weak core CPI data in its last monetary policy meeting, but instead chose to focus on stronger economic data to change their stance to neutral. As the weakness in oil prices proves temporary due to another likely OPEC cut, headline inflation should pick up again. However, labor market conditions and economic activity remain questionable based on the weakness of recent data: retail sales are contracting 0.6% on a monthly basis, and the raw materials price index dropped 1.6%. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 AUD And CAD: Risky Business - March 10, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Real retail sales growth came in at 2.1%, crushing expectations. However, Aprils PMI underperformed coming in at 57.4 against expectations of 58.3. Additionally, the KOF leading indicator came in at 106, al coming below expectations. EUR/CHF now stands at its highest level since late 2017 and while data has not been beating expectations it still very upbeat. We believe that conditions are slowly being put into place for the SNB to abandon its implied floor, given that core inflation is approaching its long term average. Therefore, once the French elections are over, EUR/CHF will become an attractive short, given that the euro will once again trade on economic fundamentals rather than political risks. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The krone continues to depreciate sharply. This comes as no surprise given that oil is now down 13% in 2017. Overall we expect that oil currencies will outperform metal currencies given that oil prices will have less sensitivity to EM liquidity and economic conditions. That being said, it is hard to be too bullish on oil if China slows anew, even if one believe that the OPEC deal will stay in place . This means that USD/NOK could have additional upside. On a longer term basis, there has been a slight improvement in Norwegian data, as nominal retail sales are growing at a staggering 10% pace, while real retail sales are growing at more than 2%, which are a 5-year and a 2-year high respectively. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The April Monetary Policy meeting delivered an unexpected decision, with members deciding to extend asset purchases till the end of the year, while delaying the forecast for a rate hike to mid-2018. Recent inflationary fluctuations and weak commodity prices support the Riksbank's actions. Forecasts for both inflation and the repo rate were lowered for 2018 and 2019. The Riksbank highlighted that "to support the upturn in inflation, monetary policy needs to be somewhat more expansionary", and is prepared to be more aggressive if need be. This increasingly dovish rhetoric by the Riksbank contrasts markedly with the FOMC's hawkish tilt, a dichotomy that will prove bearish for the krona relative to the greenback. Implications for EUR/SEK are a little more blurred, as the ECB will also remain dovish for the foreseeable future. However, Sweden's attentive and cautious stance on its currency's strength will cap any downside in EUR/SEK. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The level of Fed interest rates, in absolute or relative terms, has been a poor determinant of dollar bull markets. A more useful marker has been the relative performance of U.S. assets as well as relative growth rates. The U.S. economy should continue to outperform the rest of the G10 on a cyclical basis, suggesting that the USD could rise further on a 12-18 months basis. April is seasonally the cruelest month for the USD. Once this hurdle is passed, the likelihood grows that the dollar correction will be over. The conditions are slowly falling into place for the SNB to abandon the floor under EUR/CHF. Bank of Canada: Bye-bye easing bias, hello neutrality. Feature One of the great paradox of modern finance is the relationship between the dollar and the Fed. Contrary to a priories, rising U.S. interest rates are not synonymous with a rising dollar (Chart I-1). In fact, since 1975, out of seven protracted Fed tightening campaigns, the greenback fell four times. Obviously, one could argue that domestic interest rates per say are irrelevant, what matters should be the trend of U.S. interest rates relative to the rest of the world. Here again, the evidence is rather inconclusive. As Chart I-2 illustrates, since 1975, out of the eight episodes where U.S. policy rates rose relative to the rest of the advanced economies, the dollar was down or flat five times. Chart I-1The Fed Is Not An All-Weather Friend Chart I-2Rate Differentials Are Also A Fickle Ally This modern Gordian knot is not as intractable as it seems. In fact, we would argue that focusing on the Fed misses some key drivers of flows inside the U.S. economy. What really matters for the U.S. dollar is not just what the Fed does, but in fact, how U.S. assets are performing relative to the rest of the world. It's Not Just The Fed, It's Everything Simple interest rate differentials have a poor long-term track record explaining the U.S. dollar. However, one factor does seem to work better: the relative performance of a portfolio of U.S. stocks, bonds, and money market securities relative to the rest of the world. This does make sense. Investors who want to buy the USD do so because they expect to receive higher returns on their U.S. assets, independently of whether these assets are cash, stocks or bonds. As Chart I-3 shows, the ups and down of the USD have been contemporaneous with the gyrations of a U.S. portfolio invested 40% in stocks, 30% in bonds, and 30% in cash relative to the same portfolio in the euro area (and its predecessor national markets), Japan, the U.K., and Canada. However, there is a problem with this observation. It is expected returns that should drive the inflows into a currency, not the ex-post returns like the one used in the previous chart. But this forgets a key factor influencing asset returns: the momentum effect. As Chart I-4 illustrates, playing momentum continuation strategies has historically been one of the best performing investment philosophies, a fact not lost on investors.1 As such, there is a very rational reason for previously outperforming markets to attract funds by virtue of their previous outperformance. This would also explain why peaks and troughs in the relative U.S. / global portfolios tend to lead the turning points in the dollar itself. Chart I-3It's All About Returns Chart I-4Don't Get Against The Crowd The same dynamics are prevalent when one looks at bilateral pairs. This is particularly true of the EUR/USD, which has a 58% weight in the dollar index vis-à-vis major currencies. As Chart I-5 illustrates, as was the case with the dollar against the majors, EUR/USD dynamics are a function of the relative performance of a European portfolio of various assets against a similar U.S. portfolio. As an aside, it is true that the secular trend in the dollar is not nearly as well explained by the dynamics in the asset markets. On longer time horizons, other factors dominate currency returns. While the most well know long-term exchange rate determinant has been relative inflation rates (the PPP effect), our research has corroborated well-known academic findings that relative productivity differentials and net international investment positions (NIIP) also play important roles.2 While U.S. productivity growth has been equal or superior to that of the other nations comprised in the dollar index against the majors, the other variables have forced the long-term fair value of the dollar downward. Relative to Europe and Japan (the crucial weights in the dollar index), the U.S. NIIP grows each year more deeply into negative territory, and the U.S. has also experienced structurally more elevated inflation than these currency blocs (Chart I-6). Going back to the cyclical moves in the dollar, another factor has had a very strong explanatory power for the USD: Relative trend growth (Chart I-7). The 5-year moving average of real growth rate differentials - when GDP is measured at PPP, thus eliminating some currency effects - has mimicked the moves in the greenback. In the context of portfolio flows, this also makes sense. Ultimately, a faster growing economy should be able to generate higher rates of returns than slower growing ones, and thus attract more funds. Chart I-5EUR/USD And Asset Returns Chart I-6Secular Drags On The USD Chart I-7Growth Is Paramount What do these observations mean for the future path of the dollar? Despite continued noise by President Trump, we think the outlook for the dollar remains bright. First, the dollar is still not nearly as expensive as it has been at the peak of previous cyclical bull markets, which raises the likelihood that the USD has yet to hit the historical pain thresholds of the U.S. economy (Chart I-8). Further reinforcing this probability, U.S. employment in the manufacturing sector represents 10% of the working population today, versus 15% in 2001 and more than 22% in 1985 (Chart I-9). Not only does this mean that the sector of the U.S. economy most exposed to the pain created by a strong dollar is much smaller than at previous dollar peaks - raising the resilience of the U.S. economy to the tightening created by a strong dollar - the share of employment in that sector today remains much lower in the U.S. than it is in Japan and Europe. Chart I-8Valuations Have Yet To Bite Chart I-9The U.S. Is More Resilient To XR Moves Second, on a multi-year basis, the U.S. economic outlook remains more exciting than what the majority of the rest of the G10 has to offer. Most obviously, even if Trump changes immigration laws, the U.S. demographic outlook still outshines that of other nations (Chart I-10). Also, the U.S. benefits from being much more advanced than the rest of the G10 in its deleveraging cycle. As Chart I-11 illustrates, U.S. non-financial private debt to GDP fell from 170% of GDP to a low of 146% of GDP, while outside of the U.S., the same ratio has plateaued at 175%. This means that debt is likely to represents a greater ceiling on growth outside than inside the United States. Chart I-10A Structural Help To The U.S. Chart I-11Lower Deleveraging Pressures In The U.S. Third, U.S. markets can continue to attract funds. For one, most of the net inflows in the U.S. since 2015 has been driven by a surge in U.S. funds repatriation. Foreign investors remain timid buyers of U.S. assets (Chart I-12). This phenomenon is most pronounced in the equity space, where investors have been net sellers of U.S. equities (Chart I-13). Additionally, if the U.S. continues to grow faster than most other large advanced economies, FDIs inflow into the U.S. are likely to improve further, something that could be reinforced by Trump's hard-nosed trade negotiations with the rest of the world (Chart I-14). Chart I-12Foreigners Still Have Room To Buy Chart I-13Big Deficit In U.S. Stock Purchases Chart I-14FDI Inflows In The U.S. Can Grow More Finally, when it comes to money markets, the U.S. continues to hold the advantage. As we have argued, U.S. rates are likely to remain in the top of the G10 distribution. While the level and direction of rate differentials between the U.S. and the rest of the world has been a poor predictor of the USD's trend, how high U.S. rates rank globally has been a better explanatory variable of the greenback (Chart I-15). This means that money markets in the U.S. are likely to remain more attractive to investors needing to park liquidity than money markets outside the U.S. We are currently still positioned negatively on the U.S. dollar against European currencies and the yen on a tactical basis. We expect this phenomenon to be toward its tail end. First, when it comes to seasonality, April is historically the weakest month for the dollar (Chart I-16). Second, Trump's comments on Wednesday regarding the dollar's strength were enough to prompt a vicious sell-off in the dollar. Yet, this seems overdone. Unlike Reagan in 1985, Trump has little levers to force a strong re-evaluation of the euro and the yen. Moreover, his endorsement of Janet Yellen implies that the Fed is less likely to lose its independence in the near future, suggesting that U.S. rates will continue to be tightened if the economy improves. Thus, a plunge in U.S. real rates relative to the rest of the world prompted by a too easy Fed is less of a risk, reducing the probability of the re-emergence of the 1970s.3 Chart I-15Being The Leader Of The Pack Is What Matters Chart I-16April Is The Cruelest Month Bottom Line: On a cyclical basis, more than simple interest rate differentials between the U.S. and the rest of the world, what matters for the dollar's trend is the return on U.S. assets vis-à-vis the rest of the world as well as the growth rate of the U.S. compared to other nations. On this front, relative growth rate differentials continue to be the best factor pointing toward further USD outperformance. Tactically, the USD is in the midst of its seasonally weakest month, suggesting another down leg in DXY is likely in the coming weeks. However, it may soon be time to start buying the USD once again. EUR/CHF: Getting Closer To The End Recent data in Switzerland have shown great improvement. The PMIs are at their highest levels in six years and CPI has moved back into positive territory. This raises the specter of the end of the Swiss National Bank floor under EUR/CHF (Chart I-17). Chart I-17The SNB Floor Lives On While we think this peg might be in its final innings, its end is not imminent. However, we think that if Swiss data continues to improve, late 2017 will be a more supportive environment for the SNB to bury this strategy. What key signals are we looking for? First, inflation may be in positive territory, but it remains very low by recent standards. Most specifically, core CPI stands at a low 0.1%, well below the 0.8% average experienced from 1999 to 2010, an era when the euro already existed, but when the euro area crisis was still outside of investors' lexicons. As well, wage dynamics continue to underwhelm. Swiss wages are growing at a 2.4% rate compared to 3.3% from 1999 to 2010. Growth conditions also remain weak. Swiss real GDP is growing at 1%, half of the average that existed before the euro area crisis. Nominal GDP growth is undershooting the mark by an even greater margin, standing at 0.7% versus an average of 3%. What does this mean for the SNB? We would expect these datasets to move closer to their historical average before the SNB adjusts its policy stance. The main reason for this is 2015. In late 2014, just before the SNB tentatively let the CHF float, nominal and real GDP growth were outperforming current readings, yet the Swiss economy was not strong enough to handle a stronger franc. While Europe and the global economy are in a better place than in these days, risk management and precaution are likely to dictate a more careful approach by the central bank, especially as the ECB has eased monetary policy since that period, potentially causing another slingshot move in the franc if the SNB lets it float once again. In terms of strategy, we would expect the SNB to manage any appreciation in the franc following a lifting of the floor. We expect a move more akin to that of the PBoC in 2005, when the yuan, after an original 2% move, was allowed to increase progressively to minimize disruptions. We think this type of strategy is also currently being employed by the Czech central bank, and that EUR/CZK will continue to depreciate over time. This means that we would use any rebound in EUR/CHF to 1.08 to begin shorting this cross, knowing that the timing of an SNB policy change will be uncertain, but that the conditions are falling into place. Bottom Line: Even if it is still too early to bet on an imminent fall in EUR/CHF, Swiss data is moving in the right direction to expect a lift of the EUR/CHF floor later this year. As such, with the large amount of uncertainty surrounding such a decision, we would use any rebound in EUR/CHF to 1.08 to implement some short positions on the cross to bet on the eventuality of a policy change in Switzerland. Bank Of Canada: Less Dovish But Far From Hawkish The Bank of Canada this week officially removed its dovish bias. Canadian data has been very strong, with recent housing starts coming in at 254 thousand, a 10-year high. Additionally, recent employment data has been strong and so have purchasing managers index and business surveys. As a result, the BoC used this meeting as an opportunity to increase its growth expectation for the year - albeit a move heavily based on a stronger Q1 - and also brought forward in time its expectation of the closing of the output gap to early 2018. Chart I-18Canadian Surprises: More Likely##br## To Roll-Over Than Not Despite this more upbeat picture, the Bank of Canada also highlighted heavy risks to the Canadian economy. Obviously, the risks from the potential for a U.S. border adjustment tax and renegotiations of NAFTA were seen as crucial. The housing market too continues to be a big worry for the Bank of Canada, with affordability being extremely poor. Moreover, the BoC also decreased its estimate of the neutral rate and observed that monetary conditions are not as accommodative as was believed in January. Going forward, we think that the upside for the CAD remains limited. Canadian economic surprises are stretched and are very likely to rollover in the coming months (Chart I-18). This suggests that further upgrades to the Canadian economic outlook may take some time to emerge. As such, we continue to expect rate differentials between the U.S. and Canada to continue to support a higher USD/CAD, especially as Canadian money markets are already pricing in a full rate hike by Q1 2018. Bottom Line: The Bank Of Canada abandoned it dovish bias, but it is still far away from moving toward a hawkish bias. While a rate hike in 2018 is now much more likely, the market already anticipates this. As such, since the Canadian surprise index is very elevated, the likelihood of a move downward in interest rate expectations grows as surprises are likely to roll over. Stay long USD/CAD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a discussion on why momentum continuation strategies may have worked, see the April 24, 2015 Global Investment Strategy Special Report titled "Investing In Style" available at gis.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled "A Guide To Currency Markets (Part I)", dated April 8, 2016, and the Foreign Exchange Strategy Special Report titled "Assessing Fair Value In FX Markets", dated February 26, 2016, both available at fes.bcaresearch.com 3 For a more detailed discussion of the 1970s stagflation, please see Foreign Exchange Strategy Special Report titled "Trump: No Nixon Redux", dated December 2, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 President Trump, once again, delivered dollar-nuking remarks, after saying it was "getting too strong". The dollar dropped 0.7% on the news, while other currencies appreciated. The dollar has since regained most of its losses, but further upside remains questionable in the coming weeks. The market has already priced-in large amounts of monetary tightening, and recent producer price figures disappointed expectations: PPI increased at a 2.3% annual pace and contracted 0.1% monthly; core PPI increased at a 1.6% annual pace, and did not grow at a monthly pace. Additionally, in the past 5, 10 and 26 years, April has been the weakest month for the dollar. Upside is most likely limited until after the French elections. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Healthcare Or Not, Risks Remain - March 24, 2017 USD, Oil Divergences Will Continue As Storage Draws - March 17, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent movements in the euro remain largely a function of the dollar. Even after the Trump-induced dollar gyrations, the euro appreciated this week. The ZEW Survey for Economic Sentiment and Current Situation both outperformed expectations, however weak industrial production figures were also evident, which contracted by 0.3% on a monthly basis, and grew at less than expectations at 1.2%. Peripheral economies are also showing strength, with inflation outperforming expectations in Italy and Greece. Nevertheless, the outlook for the euro this month remains decent, as April is notorious for dollar weakness. Moreover, Melanchon's rising popularity is a double-edge sword: while it increases the risk that yet another euro-sceptic becomes the French president, if it grows further it is likely to take away potential voters from Le Pen. In fact, with the chances of Macron winning remaining elevated, this election could ultimately could provide further support to the euro. Report Links: ECB: All About China? - April 7, 2017 Healthcare Or Not, Risks Remain - March 24, 2017 Et Tu, Janet? - March 3, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 USD/JPY continues to fall rapidly, and now stands at 109. However, we believe the yen could still have more upside. Indeed, EM assets continue to struggle with a technical resistance, and a down leg seems imminent, given the tightening in liquidity conditions that China is currently experiencing. As evidenced by the events of early 2016, such as sell off of EM assets could supercharge yen rallies. On the data side the Japanese economy continues to show mixed signs: Labor cash earning underperformed expectations, growing by a paltry 0.4% from a year ago. However domestic corporate goods prices outperformed expectations, growing by 1.4% year on year. Overall Japanese economic activity continues to be too tepid for the BoJ to have a shift from its ultra-dovish policy. This makes us yen bears on a 12 to 18 month basis. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data from the U.K. has been mixed this week: Industrial production growth underperformed coming in at 2.8% The goods trade balance also underperformed coming in at -12.46 billion pounds. However, average hourly earnings including bonus outperformed coming in at 2.3%, while core inflation come in at 1.8%, below expectations. This last point bodes well for consumption as it would limit the downside to real income caused by the inflationary shock resulting from the depreciation of the pound. Moreover, long term inflation expectations remain relatively stable, which means that British households are looking past the temporary nature of the inflation caused by the pound sell-off. Both of these factors should help the British economy outperform expectations, and ultimately help the GBP rally against the EUR. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The ConqueringDollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 An unfortunate tropical storm, Cyclone Debbie, ravaged through the state of Queensland at the end of March. Queensland is known for its agriculture and mining industries, which suffered heavily during the hurricane. March and April export figures are likely to weaken as output was destroyed and reparations may delay production. Exacerbating this weakness is the risk of faltering import demand from China, which is the most likely the reason behind the current weakness in industrial metal prices. As this trend continues, the AUD is likely to suffer for the remainder of the year. On the bright side, the labor market has regained some vigor as full-time employment outperformed part-time employment in two consecutive months, with full-time job growing at a 30-year-high pace. However, a durable trend needs to be apparent for the labor market to fully strengthen. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 After positive import and export data out of China, the kiwi rallied strongly. The market interpreted this data as evidence that global growth is on a solid footing and that it will continue to surprise to the upside. Although we agree with the first point we disagree with the second one, as outperformance in global growth amid a sharp tightening in Chinese monetary conditions, a slowdown in Chinese shadow banking credit and a deceleration in Chinese house prices, is highly unlikely. Thus, carry currencies like the NZD are likely to underperform against the dollar. Against other commodity currency the picture is more nuanced, as strong PMI numbers of 57.8 as well as solid credit and employment numbers are evidence that the kiwi economy is better equipped to deal with a Chinese shock than Australia. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The BoC left its overnight rate unchanged at 0.5%, citing recent stronger than expected economic activity and a sooner-than-previously-anticipated closure of the output gap. The gains in the energy sector are unlikely to provide as much of a tailwind as earlier this year as the base effects from rising oil prices prove transitory on inflation and exports. The Bank highlighted labor market slack as a key factor which may contribute to the brevity of this growth impulse, as well as the business sector being hampered by low investment aimed at maintenance rather than expansion. Similarly strong data are needed to keep growth rate high enough for the Bank to become hawkish. For the time being, employment data still remains mixed. Although employment increased by 19,400, the unemployment rate ticked up to 6.7%. With only 38% of firms planning to add jobs over the next 12 months, job gains could be modest and slack could remain. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 After a short rally in early March, EUR/CHF cross is once again at 1.066, very close to the SNB's implied floor of 1.065. This sell-off is most likely the result of risk-off flows caused by the French presidential elections. However, we believe these fears are overstated, as Macron seems primed to win the election. Once these political fears dissipate, and economic fundamentals take over, EUR/CHF would likely be at a point where it would become an attractive short, given that there are some early signs that inflation is slowly coming back to the alpine country and that the franc has strong structural forces pushing up its value. While an abandonment of the SNB's floor in unlikely until the end of the year, investors could still begin positioning themselves for this eventuality given that a rally in EUR/CHF beyond the French election should be limited. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The relationship between the NOK and oil prices continues to be a strange one, as the NOK has depreciated this last month even in the face of a strong rally in oil prices. Plummeting inflation and inflation expectations in Norway are probably the main culprit, as it entrenches the Norges Bank dovish bias. All this being said, there are some faint signs that the economy is starting to recover as manufacturing PMI is at 5 year highs while consumer confidence keeps creeping up and is now at its highest point since early 2015. While we are still NOK bears, we will continue to monitor these developments, as the NOK could become an attractive buy against other commodity currencies. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent inflation numbers corroborate downside risk to the krona. Headline inflation dropped by 0.5% to 1.3% on an annual basis; Core inflation dropped by 0.3% to 1%. This is most likely a follow-through of February's producer prices contraction. This may justify the Riksbank's fear over deflationary risks, as inflation remains tamed despite increased economic activity. However, it is likely that this proves to be a temporary phenomenon, as manufacturing new orders expanded at 12% in February, while industrial production expanded at 4.1%. Given that the next monetary policy meeting is in July, it is too early to tell if the Riksbank will further pursue its dovish stance: inflation will need to be consistently underperform further for that to happen, which is still not our base case. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The global economy has turned the cap and is on a sustainable uptrend. Yet, the AUD and CAD have over-discounted the improvements and are at risk of suffering a disappointment if global manufacturing activity remains firm but does not accelerate much. Moreover, the Australian and Canadian domestic economies remain too weak to justify rates moving in line with the Fed. Rate differentials will continue to weigh on both currencies. While the CAD is cheaper than the AUD and warrants an overweight position versus the Aussie, we are adding it to our short commodity currency basket trade. The ECB will not ease further, but it will not tighten this year either. Feature Since their February highs, the Australian and Canadian dollars have declined by 2.7% and 3.6% respectively. In May 2016, we wrote that commodity currencies could continue to perform well, but that ultimately, this strong performance would only prove transitory and that the AUD and the CAD would once again resume their downtrends.1 Is this recent weakness the beginning of a more pronounced selloff? We believe the answer is yes. How Great Is The Global Backdrop? Much ink has been spilled regarding the improvement in the global industrial sector. Global PMIs have perked up the world over, semi-conductor prices have been booming, metal prices have been on a tear, and Chinese excavator sales have been growing at a 150% annual rate (Chart I-1). It would seem that the world economy is out of the woods. This is true, but asset markets are not backward looking, they are forward looking. The improvement in global economic conditions that we have witnessed has driven the impressive rally in stocks, EM assets, commodity, and commodity currencies in 2016. But what matters for future asset markets' performance, and especially growth sensitive currencies like the AUD and the CAD, is future global growth. Where do we stand on that front? We do not expect an economic relapse like in 2015 and early 2016. Some key elements have changed in the global economy, suggesting it is not as hampered by deflationary forces as it once was: DM industrial capacity utilization has improved (Chart I-2). Also our U.S. composite capacity utilization indicator that incorporates both the manufacturing and service sectors has now moved into "no slack" territory. This suggests that deflationary forces that have so negatively affected the DM economy in 2015 and 2016 are becoming tamer. Chart I-1Signs Of An Economic Rebound Chart I-2Improving Global Capacity Utilization Commodity markets are much more balanced than in 2015-2016. Not only has excess capacity in the Chinese steel and coal sector been drained, but the oil market has moved from being defined by excess supply to a surplus of demand (Chart I-3). This suggests that commodities are unlikely to be the same deflationary anchors they were in the past two years. The global contraction in profits is over. Profits are a nominal concept, and in 2015 and 2016, U.S. nominal growth hovered around 2.5%, in line with the levels registered in the 1980, 1990, and 2001 recessions (Chart I-4). As a residual claim on corporate revenues, profits display elevated operating leverage. Thus, nominal GDP growth moving from 2.5% to 4% on the back of lessened deflationary forces will continue to support profits. Chart I-3Oil: From Excess Supply To Excess Demand Chart I-4Last Year Was A Nominal Recession This also means that the rise in capex intentions that began to materialize last summer is likely to genuinely support capex growth and the overall business cycle in the coming quarters, especially in the U.S. (Chart I-5). Additionally, the inventory cycle that has weighed on EM and DM economies is now over (Chart I-6). While growth is likely to be fine based on these factors, for the AUD and CAD to move higher, growth needs to accelerate further. The problem is that based on our Nowcast for global manufacturing activity, things are as good as they get now (Chart I-7). Chart I-5Improving DM ##br##Capex Outlook Chart I-6Inventories: From ##br##Drag To Boost Chart I-7If Global Industrial Activity Doesn't ##br##Improve, CAD and AUD Are Toast In China, which stands at the crux of the global manufacturing cycle, we see the following factors hampering further improvements: The Chinese fiscal impulse has rolled over. Fiscal stimulus does impact the economy with some lags. The peak in the Chinese boost was reached in November 2015, with government expenditures growing at a 24% annual rate, but today, they are growing at a 4% rate. The deleterious effect on growth of this tightening may soon be felt. Chinese liquidity conditions have deteriorated. Interbank borrowing rates are already rising (Chart I-8), and the PBoC has drained an additional RMB 90 billion out of the banking system this week alone. These dynamics could be aimed at cooling down the real estate bubble in the country. Falling activity in that sector would represent a significant drag on the industrial and commodity sectors globally. Chart I-8Tightening Chinese Liquidity Conditions Chart I-9The NZD Weakness Should Be A Bad Omen The fall in Chinese real rates may have reached its paroxysm in February. Commodity price inflation may have hit its peak last month, suggesting the same for Chinese producer prices. A slowing PPI inflation will raise real borrowing costs in that economy and further tighten monetary conditions. Corroborating these risks, Kiwi equities, a traditional bellwether of global growth continue to buckle down. In fact, the New Zealand dollar is offering the same insight. Being the G10 currency most sensitive to the combined effect of wider EM borrowing spreads and commodity prices, its recent fall may presage some problems in these spaces (Chart I-9). To be clear, we are not expecting a wholesale collapse in growth. Far from it, but an absence of acceleration or a mild deceleration, could have troubling effects on commodities. The case of oil this week is very telling. Inventories have been going up, but the frailty of the oil market was mostly a reflection of the extraordinary bullish positioning of investors (Chart I-10, left panel). The same is true for copper, investors are very long and thus, vulnerable to mild growth disappointments (Chart I-10, right panel). Chart I-10AInvestors Are Bullish Industrial Commodities Chart I-10BInvestors Are Bullish Industrial Commodities Oil is not the only commodity experiencing a large accumulation in inventories. China, the key consumer of metals, is now overloaded with large inventories of both iron ore and copper (Chart I-11). This combination of high bullishness and rising inventories represents a risk for metals, especially if the positive growth impulse in China slows somewhat from here. Chart I-11China Has ##br##Hoarded Metals Chart I-12Can Growth And Reflation Surprises Increase##br## As Policy Becomes Less Easy? Adding to these risks is the Fed. The Fed is on the path to increase rates a bit more aggressively than was recently anticipated by markets. U.S. real rates are responding in kind, and key gauges like junk bonds, gold, or silver are also highlighting that global liquidity conditions may begin to deteriorate at the margin. While this tightening is not a catastrophe, it is still happening in an environment of elevated global leverage and potentially decelerating growth. This is not the death knell for risk assets, but it does represent a risk for the asset classes that are not pricing in any potential rollover in the elevated level of global surprises and reflation (Chart I-12). Commodity currencies are not ready for this reality. To begin with, positioning on the key commodity currencies has rebounded substantially, and risk reversals on these currencies as well as EM currencies are at levels indicative of maximum bullishness amongst investors. Also, the Australian dollar is expensive relative to its fundamentals, including the terms of trade. This makes the Aussie very vulnerable to small shocks to metal or coal prices (Chart 13, left panel). The CAD is not as pricey as the AUD, but nonetheless, it has lost its previous valuation cushion (Chart I-13, right panel). It also faces its own set of risks. Chart I-13ANo Valuation Cushion In CAD And AUD Chart I-13BNo Valuation Cushion In CAD And AUD This set of circumstance highlights that the room for disappointment in these currencies is now large. Bottom Line: While 2016 was a dream come true for investors in commodity currencies, 2017 may prove to be a tougher environment. Global growth is not about to plunge, but for commodity currencies to rally more, global manufacturing activity needs to accelerate further. Here the hurdle is harder to beat. Not only is the Chinese reflationary impulse slowing exactly as the global manufacturing sector hits exceptional levels of strength, but the Fed is also marginally tightening its stance. This means that expensive currencies like the BRL and AUD, as well as the cheaper but still vulnerable CAD could suffer some downside if industrial growth temporarily flattens, an event we judge more likely than not. Domestic Considerations Chart I-14We Build Houses In Canada When it comes to the AUD and the CAD, global risk is skewed to the downside, but what about domestic considerations? Here again, signs are not as great as one might hope. When it comes to Canada, the capacity to withstand higher rates is limited. The elephant in the room is the risk posed by the U.S. border adjustment tax. BCA thinks that this tax could be implemented in a diluted form, one were apparels, food, energy, etc. are exempt from the deal. However, the industries representing the American "rust-belt" are likely to be fully covered. This means that machinery and cars in particular could be the key targets of the BAT. This is a huge problem for Canada. Take the car industry as an example. Canada exports C$80 billion in vehicles and parts to the U.S., or 15% of its merchandise exports, nearly 4% of GDP. The potential hit from this tax on the country could be large. Also, the Canadian economy is even more levered to house prices that the Australian one. As Chart I-14 illustrates, the share of residential investment in Canada is much higher than in Australia, despite the slower growth of the population in Canada than in the Australia. Additionally, Canadian consumption is much more geared to housing than in Australia. Canadian households are experiencing slower nominal and real wage gains than their Australian counterparts. Yet their consumption per head growth is similar to that of Australia, and their confidence is substantially higher, reflecting a stronger wealth effect in Canada than in Australia (Chart I-15). Furthermore, despite the rebound in commodity prices and profits in 2016, Canadian and Australian credit growth have been slowing sharply (Chart 16, top two panels); however, Canada suffers from a higher level of debt service payment than Australia, despite the fact that the Canadian household debt to disposable income is 170% versus 185% in Australia (Chart I-16, bottom panel). These factors amplify the negative potential of higher interest rates in Canada relative to Australia. But Australia also suffers from its own ills. Total hours worked continue to deteriorate in that country and job growth is even more heavily geared to the part-time sector than in Canada. Additionally, while Canada will benefit from a small amount of fiscal expansion in the coming years, Australia is tabled to experience a large degree of fiscal austerity (Chart I-17). In this context, it will be difficult for the Australian labor market to outperform that of Canada. Chart I-15Canadian Households Are ##br##More Levered To Housing Chart I-16Slowing Credit Growth In ##br##Canada And Australia Finally, while the Canadian core CPI is elevated at 2.1%, this largely reflects pass-through from the previous collapse in the CAD, and this is expected to dissipate as wage growth remains tepid at 1.2%. But the Australian situation is even more troubling. Australia has been incapable of generating much inflation, and the fall in hours worked suggests that the labor market may be easing, not tightening. With the 10% increase in the AUD from its trough in 2016, inflation is unlikely to rise enough to prompt the RBA to become much more hawkish in the coming months. Thus, we think that both Canadian and Australian rates will continue to lag U.S. ones, putting more downward pressures on the CAD and the AUD versus the USD, despite the recent improvement in trade balances in both nations. (Chart I-18). Moreover, even if the decline in Australian interest rate differentials relative to the U.S. were to be less pronounced than in Canada, the AUD is much more misaligned with differentials than the CAD, adding to the Aussie's vulnerability. Chart I-17Fiscal Policy: Canada Eases, ##br##Australia Tightens Chart I-18Rate Differentials Will Continue##br## To Help The USD Bottom Line: Domestic conditions remains challenging for Australia and Canada. In both nations, debt service payments are already elevated, suggesting it will be hard for the central bank to increase rates without prompting accidents. While Australia seems less geared to the housing sector than Canada, its labor market dynamics are poorer, it faces a more austere fiscal policy, and it has trouble generating any inflation. We expect rate differentials to continue to move against both the CAD and the AUD versus the USD. Investment Conclusions At this point, the CAD and AUD are essentially entering an ugly contest. For both of these currencies, the global backdrop could prove to be more difficult in 2017 than in 2016. Moreover, both these currencies are handicapped by fundamental domestic issues that will further prevent rates to rise vis-à-vis the U.S. As such, we are now adding the CAD to our short commodity currency basket trade against the USD. AUD/USD may move toward 0.65-0.60 and USD/CAD may rally toward 1.40-1.45. Comparatively, both the AUD and CAD suffer from different but equally important handicaps. The only thing that would put the CAD at the nicer end of the ugly contest are its valuations. Our PPP model augmented for productivity differentials continues to show that the CAD is cheap against the AUD, corroborating the message of our long-term fair value models (Chart I-19). Also, as we highlighted above, CAD is more in line with its IRP-implied fair value than the AUD. We therefore recommend investors overweight the CAD vis-à-vis the AUD. A Few Words On The ECB Yesterday, Draghi struck a cautious tone in Frankfurt. While he acknowledged that deflationary risks in the euro area have decreased relative to where they stood last year, the governing council still thinks downside risks, even if of a foreign origin, slightly overshadow upside risks to its forecast. While the ECB feels that there is less of a need to implement additional support to the economy in the future, it judges the current accommodative setting to still be warranted. We agree. It is true that headline inflation in Europe has moved to 2%, but core inflation, which strips the very important base effect in energy prices that has lifted HICP, remains flat at low levels. Moreover, wage growth in the euro area remains tepid, confirming the lack of persistent domestic inflationary pressures in Europe (Chart I-20). Thus, the ECB elected to maintain asset purchases to the end of December at EUR60 billion per months. Rates are also unlikely to rise until after the end of the purchase program. In this environment, while the trade-weighted euro may move higher, the cyclical outlook continue to be negative for EUR/USD as monetary policy divergences between the U.S. and Europe will grow as time passes. On a 3-month basis, if we are correct that global growth may not accelerate further, the potential for a correction in EM and commodity plays could provide a temporary fillip to the euro. As markets currently priced in less rate hikes from the ECB than the Fed, the scope for pricing out the anticipated rate hikes is lower in Europe than in the U.S. if risk assets experience a correction within a bull market. This means that DXY may weaken or stay flat even if the trade-weighted dollar rises during that time frame. Chart I-19AUD / CAD Is Expensive Chart I-20The ECB's Dilemma Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Pyrrhic Victories" dated April 29, 2016 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The U.S. economy continues to show resilience with the ADP employment change crushing expectations by 108,000. Although the USD did not react proportionately to this specific news, this is only a firmer signal of the confirmation for a rate hike next week. With the market pricing in almost a 100% probability of a hike, the Fed is unlikely to disappoint. What matters now is the messaging around the hike. In this regard, Trump's aggressive fiscal stance and the economy's consistent resilience is making a good case for the Fed to remain supportive of its forecasts. On a technical basis, the MACD line for the DXY is above the signal line, while also being in positive territory. Momentum is therefore pointing to a strong upward trend for the dollar in the short term. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The ECB left its policy rates and asset purchase program unchanged. Although President Draghi acknowledged the euro area's resilience as risks have become "less pronounced", he also noted that risks still "remain tilted to the downside". In the press release, the Governing Council continued to highlight that they continue to expect "the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of the net asset purchases". The message is therefore mixed. Growth is expected to remain resilient in the euro area, but significant domestic slack and global factors have forced the ECB to remain cautious. Cyclical risks to the euro are more to the downside than to the upside in the current environment. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent Japanese data has been mixed: Machine tool orders yearly growth came in at 9.1%, the highest level since the third quarter of 2015. Labor cash earnings yearly growth came above expectations at 0.5%. However GDP growth was disappointing, coming in at 1.2% against expectations of 1.6%. We continue to be bearish on the yen on a cyclical basis. Although there has been some improvement, economic data has still been too tepid for the Bank of Japan to even consider rolling back some of its most radical policies. After all, the BoJ has established that they now have a price level target instead of an inflation target, which means that inflation would have to overshoot 2% for a significant period of time in order to switch from their easing bias. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 After the vote in the House of Lords, Theresa May has been dealt yet another blow to her Brexit hopes as the upper house of the U.K. voted for giving parliament veto power over the final exit deal of Britain from the European Union. This news have been positive for the pound at the margin, as the perception of softer Brexit increases. The prime minister will now appeal this decision to the House of Commons. If she is defeated here, the pound could rally significantly. On the economic side, recent data has been disappointing: Market Services PMI not only went down from the previous month but also underperformed expectations, coming in at 53.3. Halifax house prices yearly growth came in at 5.1%, underperforming expectations. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 As expected, the RBA left its cash rate unchanged at 1.5%. The currency was little changed from this announcement. However, following last week's depreciation, the AUD followed through with further depreciation on Wednesday due to a strengthening greenback. This affected the AUD twofold: the appreciating dollar added pressure on the AUD, and on commodity prices which further exacerbated the AUD's decline - copper prices are down more than 4% and iron ore futures are down almost 3%. Risks are to the downside for the AUD: declining copper and iron ore prices foretell that the AUD's decline may continue; China's regulation on coal imports and energy production will further damage Australia's export market. On a shorter-term basis, the MACD line is below the signal line and indicates negative momentum. Additionally, the MACD line has breached negative territory, adding further downward momentum. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi continues to fall, and has now lost all of the gains from earlier this year. The outlook for the NZD against other commodity currencies is puzzling: on the one hand the NZD is very sensitive to emerging market spreads, which means that it would be the primary victim of the dollar bull market, as a rising dollar drains liquidity from EM and hurts fixed income instruments in these countries. On the other hand, domestic factors provide a tailwind for the NZD as strong inflationary pressures are emerging in the kiwi economy and New Zealand continues to be the star performer amongst its commodity peers. Overall, we are inclined to be tactically more bullish on the NZD against the AUD, as the NZD/USD has reached oversold levels, while AUD/USD has been firmer amidst the rally in the U.S. dollar. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Following up from last week's depreciation is an even weaker CAD this week. USD/CAD appreciated greatly amidst a large decline in oil prices after crude oil stocks increased by around 7 mn bbl more than the previous change and the consensus amount. This trend is likely to continue as rig counts continue to increase. A rising USD is likely to exacerbate the decline in the CAD as it will continue to weigh on oil prices. We have previously noted that the CAD will stay very affected by U.S. trade relations and rate differentials. This trend is likely to continue. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been encouraging: Unemployment continues to be very low at 3.3%. Headline inflation came in at 0.5%. At this level inflation now stands at its highest since 2011. Although these developments are positive, the SNB will continue to aggressively intervene in the currency and prevent further appreciation. The SNB has been keen on keeping their unofficial floor of 1.065 in EUR/CHF, even on the face of risk-off flows coming into Switzerland due to the European election cycle. In fact, the SNB reserves surged at the highest pace since December 2014, which indicates that the central bank has been having its hands full. For now the SNB will continue with this policy, however, we will continue to monitor Swiss data to assess whether a change in policy by the SNB is possible. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK rallied sharply following the 5% plunge in oil prices, as the rise in inventories came at almost 7 million barrels above expectations. The risk profile for the NOK is the opposite of the NZD. External factors should help the Norwegian economy vis-à-vis other commodity currencies, as oil should outperform industrial metals given that it has a lower beta to China and Emerging markets. On the other hand, the domestic situation has deteriorated. Nominal GDP is contracting, the output gap stands around -2% of potential GDP, and the credit impulse continues to be negative. Meanwhile, inflation is starting to recede, as the effect of the depreciation of the NOK on 2015 is dissipating. All of these factors should support a dovish bias from the Norges Bank, hurting the NOK going forward. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The krona will resume its cyclical downward trend as the USD continues to climb, being one of the currencies with the highest betas to the dollar. Our bullish case for the krona is weakened by the Riksbank's extremely cautious tone which, so to speak, stopped the krona in its tracks. EUR/SEK stopped its depreciation abruptly in the beginning of February and has since appreciated. Momentum, however, does seem to be slowing down for this cross as the Swedish economy remains inherently resilient. As a large proportion of Sweden's exports to the euro area are re-exported to EM, additional risks may emanate from China as any potential slowdown in the world's second largest economy could provide a risk to Sweden's industrial sector. This could add deflationary pressures to the economy, which can solidify the Riksbank's dovish stance even further. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights In February, the model underperformed global equities and the S&P 500 in USD and local-currency terms. For March, the model slightly increased its allocation to stocks and cut its weighting in bonds (Chart 1). Within the equity portfolio, the allocation to Europe was increased. The model boosted its weightings to French and Australian bonds at the expense of Canadian and Swedish paper. The risk index for stocks, as well as the one for bonds, deteriorated in February. Feature Performance In February, the recommended balanced portfolio gained 2.1% in local-currency terms, and 0.2% in U.S. dollar terms (Chart 2). This compares with a gain of 3% for the global equity benchmark and a 3.3% gain for the S&P 500. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we provide suggestions on currency risk exposure from time to time. The high allocation to bonds continued to hold back the model's performance. Chart 1Model Weights Chart 2Portfolio Total Returns Weights The model increased its allocation to stocks from 53% to 57%, and cut its bond weighting from 47% to 43% (Table 1). Table 1Model Weights (As Of February 23, 2017) The model increased its equity allocation to Dutch and Swedish equities by 4 points each, Germany and New Zealand by 2 points each, and France and Emerging Asia by 1 point each. Weightings were cut in Italy by 4 points, Latin America by 3 points, Spain by 2 points, and Switzerland by 1 point. In the fixed-income space, the allocation to Australia was boosted by 8 points, France by 6 points, and Germany by 4 points. The model cut its exposure to Swedish bonds by 9 points, Canadian bonds by 6 points, U.S. and U.K. bonds by 3 points each, and Kiwi bonds by 1 point. Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The most recent bout of dollar depreciation was halted in February. Our Dollar Capitulation Index is below neutral levels. However, it is not extended, meaning that it does not preclude renewed dollar weakness in the near term. That said, assuming no major negative economic surprises, a relatively more hawkish Fed versus its peers should provide support for the dollar (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators The risk index for commodities was little changed in February. The model continues to avoid this asset class (Chart 4). The risk index for global equities rose to its highest level since early 2010, mostly on the back of deteriorating value. Despite this, the model slightly increased its allocation to equities (Chart 5). Chart 4Commodity Index And Risk Chart 5Global Stock Market And Risk The rally in U.S. stocks - driven by optimism about the economic outlook - pushed the value component of the risk index into expensive territory. The model kept a small allocation in U.S. equities. A change in the perception about the ability of the new U.S. administration to boost growth remains a risk for this market (Chart 6). The risk index for euro area equities continues to deteriorate. However, it remains lower than its U.S. counterpart. The continued flow of solid economic data and a weaker currency should bode well for euro area stocks, although political uncertainty is a potential headwind (Chart 7). Chart 6U.S. Stock Market And Risk Chart 7Euro Area Stock Market And Risk All three components of the risk index for Dutch equities are close to neutral levels. As a result, despite the recent deterioration in the overall risk index, it remains one of the lowest among the markets the model covers (Chart 8). The risk index for Swedish stocks worsened. However, the model increased its allocation to this bourse. Swedish equities would be a beneficiary of the continued risk-on environment (Chart 9). Chart 8Netherlands Stock Market And Risk Chart 9Swedish Stock Market And Risk The momentum indicator for global bonds is less stretched in February. Meanwhile, despite its latest decline, the cyclical indicator continues to signal that the positive global economic backdrop is firmly bond-bearish. Taken all together, the risk index for bonds deteriorated in February, although it still remains in the low-risk zone (Chart 10). U.S. Treasury yields moved sideways in February as investors await more guidance from the Fed on the timing of the next hike. A bond-negative cyclical indicator coupled with the unwinding of oversold conditions - as per the momentum measure - led to a deterioration in the risk index for U.S. Treasurys. The latter is almost back to neutral levels. The model trimmed the allocation to this asset class (Chart 11). Chart 10Global Bond Yields And Risk Chart 11U.S. Bond Yields And Risk The momentum indicator remains the main driver of the risk index for Canadian bonds. As a result, the less extreme momentum reading translated into an increase in the risk index for this asset class. (Chart 12). The risk index for Australian bonds moved lower in February, reflecting improvements in all three of its components. The model included the relatively high-yielding Aussie bonds in the portfolio. (Chart 13). Chart 12Canadian Bond Yields And Risk Chart 13Australian Bond Yields And Risk The cyclical indicator for euro area bonds is near expensive levels, and the momentum indicator shows heavily oversold conditions. These two measures are offsetting the cyclical one that is sending a bond-bearish message. While the overall risk index for euro area bonds is in the low-risk zone, the country allocation is concentrated in French paper (Chart 14). The risk level for French bonds is seen as low thanks to oversold momentum. French presidential elections are probably the most important political event in Europe this year. Whether the models' heavy allocation to this asset pans out hinges to a certain extent on the reduction of investor anxiety about this political risk (Chart 15). Chart 14Euro Area Bond Yields And Risk Chart 15French Bond Yields And Risk The 13-week momentum measure for the dollar broke below the zero line, and is currently sitting on its upward-sloping trendline, drawn from the 2010 lows, that has been broken only once before. Meanwhile, the 40-week rate of change measure is still suggesting that the dollar bull market has more legs on a cyclical horizon. Monetary divergences should lend support to the dollar over the cyclical horizon, although the new administration's attempts to talk down the dollar as well as heightened policy uncertainty could translate into more volatility (Chart 16). The weakening trend in the yen hit a snag two months ago, as the 13-week momentum measure reached the lows that previously foreshadowed a consolidation phase after sharp depreciations. This short-term rate-of-change measure has bounced smartly this year reaching a critical level. Meanwhile, the 40-week rate-of-change measure is not warning of a major change in the underlying trend which remains dictated by BoJ's dovish bias (Chart 17). EUR/USD has been gravitating towards 1.05 over the course of February. The short-term rate-of-change measure seems to be holding at the neutral level, while the 40-week rate-of-change measure is in negative territory, but hardly stretched. Political uncertainty has the potential to drive the euro in near term, but the longer-term outlook is mostly a function of the monetary policy divergence between the ECB and the Fed (Chart 18). Chart 16U.S. Trade-Weighted Dollar* Chart 17Yen Chart 18Euro Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com