Developed Countries

Listen to a short summary of this report     Executive Summary On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall without much loss in production or employment. Skeptics will argue that such benign disinflations rarely occur, pointing to the 1982 recession. But long-term inflation expectations were close to 10% back then. Today, they are broadly in line with the Fed’s target. Equities will recover from their recent correction as headline inflation continues to fall and the risks of a US recession diminish. Go long EUR/USD on any break below 0.99. Contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted Bottom Line: The US economy is entering a temporary Goldilocks period of falling inflation and stronger growth. The latest correction in stocks will end soon. Investors should overweight global equities over the next six months but look to turn more defensive thereafter.   Dear Client, I will be attending BCA’s annual conference in New York City next week. Instead of our regular report, we will be sending you a Special Report written by Mathieu Savary, BCA’s Chief European Strategist, and Robert Robis, BCA’s Chief Fixed Income Strategist, on Monday, September 12. Their report will discuss estimates of global neutral interest rates. We will resume our regular publication schedule on September 16. Best Regards, Peter Berezin, Chief Global Strategist The Hawks Descend On Jackson Hole Chart 1Markets Still Think The Fed Will Start Cutting Rates Next Year Jay Powell’s Jackson Hole address jolted the stock market last week. Citing the historical danger of allowing inflation to remain above target for too long, the Fed chair stressed the need for “maintaining a restrictive policy stance for some time.” Powell’s comments were consistent with the Fed’s dot plot, which expects rates to remain above 3% right through to the end of 2024. However, with the markets pricing in rate cuts starting in mid 2023, his remarks came across as decidedly hawkish (Chart 1). While Fedspeak can clearly influence markets in the near term, our view is that the economy calls the shots over the medium-to-long term. The Fed sees the same data as everyone else. If inflation comes down rapidly over the coming months, the FOMC will ratchet down its hawkish rhetoric, opting instead for a wait-and-see approach. The Slope of Hope Could inflation fall quickly in the absence of a deep recession? The answer depends on a seemingly esoteric concept: the slope of the aggregate supply curve. Economists tend to depict the aggregate supply curve as being convex in nature – fairly flat (or “elastic”) when there is significant spare capacity and becoming increasingly steep (or “inelastic”) as spare capacity is exhausted (Chart 2). The basic idea is that firms do not require substantially higher prices to produce more output when they have a lot of spare capacity, but do require increasingly high prices to produce more output when spare capacity is low. Chart 2The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted When the aggregate supply curve is very elastic, an increase in aggregate demand will mainly lead to higher output rather than higher prices. In contrast, when the aggregate supply curve is inelastic, rising demand will primarily translate into higher prices rather than increased output. In early 2020, most of the developed world found itself on the steep side of the aggregate supply curve. The unemployment rate in the OECD stood at 5.3%, the lowest in 40 years (Chart 3). In the US, the unemployment rate had reached a 50-year low of 3.5%. Thus, not surprisingly, as fiscal and monetary policy turned simulative, inflation moved materially higher. Goods inflation, in particular, accelerated during the pandemic (Chart 4). Perhaps most notably, the exodus of people to the suburbs, combined with the reluctance to use mass transit, led to a surge in both new and used car prices (Chart 5). The upward pressure on auto prices was exacerbated by a shortage of semiconductors, itself a consequence of the spike in the demand for electronic goods. Chart 3The Pandemic Began When The Unemployment Rate In The OECD Was At A Multi-Decade Low Chart 4With Supply Unable To Meet Demand, Goods Prices Surged During The Pandemic The supply curve for labor also became increasingly inelastic over the course of the pandemic. Once the US unemployment rate fell back below 4%, wages began to accelerate sharply. The kink in the Phillips curve had been reached (Chart 6). Chart 5Car Prices Went On Quite A Ride During The Pandemic Chart 6Wage Growth Soared When The Economy Moved Beyond Full Employment Chart 7Job Switchers Usually See Faster Wage Growth Faster labor market churn further turbocharged wage growth. Both the quits rate and the hiring rate rose during the pandemic. Typically, workers who switch jobs experience faster wage growth than those who do not (Chart 7). This wage premium for job switching increased during the pandemic, helping to lift overall wage growth. A Symmetric Relationship? All this raises a critical question: If an increase in aggregate demand along the inelastic side of the aggregate supply curve mainly leads to higher prices rather than increased output and employment, is the inverse also true – that is, would a comparable decrease in aggregate demand simply lead to much lower inflation without much of a loss in output or employment? If so, this would greatly increase the odds of a soft landing. Skeptics would argue that disinflations are rarely painless. They would point to the 1982 recession which, until the housing bubble burst, was the deepest recession in the post-war era. The problem with that comparison is that long-term inflation expectations were extremely high in the early 1980s. Both consumers and professional forecasters expected inflation to average nearly 10% over the remainder of the decade (Chart 8). To bring down long-term inflation expectations, Paul Volcker had to engineer a deep recession. Chart 8Long-Term Inflation Expectations Are Much Better Anchored Now Than In The Early 1980s Chart 9Real Long Terms Bond Yields Are Currently A Fraction Of What They Were Four Decades Ago Jay Powell does not face such a problem. Both survey-based and market-based long-term inflation expectations are well anchored. Whereas real long-term bond yields reached 8% in 1982, the 30-year TIPS yield today is still less than 1% (Chart 9). The Impact of Lower Home Prices Chart 10Supply-Side Constraints Limited Home Building During The Pandemic, Helping To Push Up Home Prices While falling consumer prices would boost real incomes, helping to keep the economy out of recession, a drop in home prices would have the opposite effect on consumer spending. As occurred with other durable goods, a shortage of building materials and qualified workers prevented US homebuilders from constructing as many new homes as they would have liked during the pandemic. The producer price index for construction materials soared by over 50% between May 2020 and May 2022 (Chart 10). As a result, rising demand for homes largely translated into higher home prices rather than increased homebuilding.  Real home prices, as measured by the Case-Shiller index, have increased by 25% since February 2020, rising above their housing bubble peak. As we discussed last week, US home prices will almost certainly fall in real terms and probably in nominal terms as well over the coming years. Chart 11Despite Higher Home Prices, Households Have Not Been Using Their Homes As ATMs How much of a toll will falling home prices have on the economy? It took six years for home prices to bottom following the bursting of the housing bubble. It will probably take even longer this time around, given that the homeowner vacancy rate is at a record low and reasonably prudent mortgage lending standards will limit foreclosure sales. Thus, while there will be a negative wealth effect from falling home prices, it probably will not become pronounced until 2024 or so. Moreover, unlike during the housing boom, US households have not been tapping the equity in their homes to finance consumption (Chart 11). This also suggests that the impact of falling home prices on consumption will be far smaller than during the Great Recession. Inelastic Commodity Supply While inelastic supply curves had the redeeming feature of preventing a glut of, say, new autos or homes from emerging, they also limited the output of many commodities that face structural shortages. Compounding this problem is the fact that the demand for many commodities is very inelastic in the short run. When you combine a very steep supply curve with a very steep demand curve, small shifts in either curve can produce wild swings in prices.  Nowhere is this problem more evident than in Europe, where a rapid reduction in oil and gas flows has caused energy prices to soar, forcing policymakers to scramble to find new sources of supply.  Europe’s Energy Squeeze At this point, it looks like both the UK and the euro area will enter a recession. In continental Europe, the near-term outlook is grimmer in Germany and Italy than it is in France or Spain. The latter two countries are less vulnerable to an energy crunch (Spain imports a lot of LNG while France has access to nuclear energy). Both countries also have fairly resilient service sectors (Spain, in particular, is benefiting from a boom in tourism). The good news is that even in the most troubled European economies, the bottom for growth is probably closer at hand than widely feared. Despite the fact that imports of Russian gas have fallen by more than 60%, Europe has been able to rebuild gas inventories to about 80% of capacity, roughly in line with prior years (Chart 12). It has been able to achieve this feat by aggressively buying gas on the open market, no matter the price. While this has caused gas prices to soar, it sets the stage for a possible retreat in prices in 2023, something that the futures market is already discounting (Chart 13). Chart 12Europe: Squirrelling Away Gas For The Winter Chart 13Natural Gas Prices In Europe Will Come Back Down To Earth Europe is also moving with uncharacteristic haste to secure new sources of energy supply. In less than one year, Europe has become America’s biggest overseas market for LNG. A new gas pipeline linking Spain with the rest of Europe should be operational by next spring. In the meantime, Germany is building two “floating” LNG terminals. Germany has also postponed plans to mothball its nuclear power plants and has approved increased use of coal-fired electricity generators. Chart 14The Euro Is Undervalued France is seeking to boost nuclear capacity. As of August 29, 57% of nuclear generation capacity was offline. Electricité de France expects daily production to rise to around 50 gigawatts (GW) by December from around 27 GW at present. For its part, the Dutch government is likely to raise output from the massive Groningen natural gas field. All this suggests that contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The euro, which is 30% undervalued against the US dollar on a purchasing power parity basis, will rally (Chart 14). Go long EUR/USD on any break below 0.99. Investment Conclusions Chart 15Falling Inflation Should Boost Real Wages And Buoy Consumer Confidence On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall with little loss in production or employment. Will this be the end of the story? Probably not. As inflation falls, US real wage growth, which is currently negative, will turn positive. Consumer confidence will improve, boosting consumer spending in the process (Chart 15). The aggregate demand curve will shift outwards again, triggering a “second wave” of inflation in the back half of 2023. Rather than cutting rates next year, as the market still expects, the Fed will raise rates to 5%. This will set the stage for a recession in 2024. Investors should overweight global equities over the next six months but look to turn more defensive thereafter. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on            LinkedIn & Twitter   Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores      

Next week, on September 7-8, is the BCA New York Conference, the first in-person version since 2019. I look forward to seeing many of you there, and if you haven’t already booked your place, you still can! (a virtual version is also available). As such, the next Counterpoint report will come out on September 15. Executive Summary The 2022-23 = 1981-82 template for markets is working well. If it continues to hold, these are the major investment implications: Bonds: The 30-year T-bond (price) will trend sideways for the next few months, albeit with a potential correction that lifts the yield to 3.5 percent. However, bond prices will enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Stocks: A coordinated global recession will depress profits, causing the S&P 500 to test 3500. However, once past the worst of the recession, a strong rally will lift it through 5000 later in 2023. Sector allocation: Longer duration defensive sectors (such as healthcare) will strongly outperform shorter duration cyclical sectors (such as basic resources) until mid-2023, after which it will be time to flip back into cyclicals. Industrial metals: A tactical rebound in copper could lift it to $8500/MT after which the structural downtrend will resume, taking it to sub-$7000/MT in 2023. Oil: Just as in 1981-82, supply shortages will provide near-term support. But ultimately, demand destruction will dominate, depressing the price to, at best, $85, though our central case is $55 in 2023.  If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price Bottom Line: The 2022-23 = 1981-82 template for markets is working well, and should continue to do so. Feature History doesn’t repeat, but it does rhyme. And the period that rhymes closest with the current episode in the global economy and markets is 1981-82, a rhyming which we first highlighted four months ago in Markets Echo 1981, When Stagflation Morphed Into Recession, and then developed in More On 2022-23 = 1981-82, And The Danger Ahead. In those reports, we presented three compelling reasons why 2022-23 rhymes with 1981-82: 1981-82 is the period that rhymes closest with the current episode in the global economy and markets. First, the simultaneous sell-off in stocks, bonds, inflation protected bonds, industrial commodities, and gold in the second quarter of 2022 is uniquely linked with an identical ‘everything sell-off’ in the second quarter of 1981. It is extremely rare for stocks, bonds, inflation protected bonds, industrial commodities, and gold to sell off together. Such a simultaneous sell-off has happened in just these 2 calendar quarters out of the last 200. Meaning a ‘1-in-a-100’ event conjoins 2022 with 1981 (Chart I-1 and Chart I-2). Chart I-1A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... Chart I-2...And The 'Everything Sell-Off' In 1981 Second, the Jay Powell Fed equals the Paul Volcker Fed. Now just as then, the world’s central banks are obsessed with ‘breaking the back’ of inflation. And now, just as then, the central banks are desperate to repair their badly battered credibility in managing inflation. Third, the Russia/Ukraine war that started in February 2022 equals the Iraq/Iran war that started in September 1980. Now, just as then, a war between two commodity producing neighbours has unleashed a supply shock which is adding to the inflation paranoia. To repeat, it is a 1-in-a-100 event for all financial assets to sell off together. This is because it requires an extremely rare star alignment. Inflation fears first morph to stagflation fears and then to recession fears. Leaving investors with nowhere to hide, as no mainstream asset performs well in inflation, stagflation, and recession. So, the once-in-a-generation star alignment conjoining 2022 with 1981 is as follows: Inflation paranoia is worsened by a major war between commodity producing neighbours, forcing reputationally damaged central banks to become trigger-happy in their battle against inflation, dragging the world economy into a coordinated recession. September 2022 Equals August 1981 If 2022-23 = 1981-82, then where exactly are we in the analogous episode? There are two potential synchronization points. One potential synchronization is that the Russia/Ukraine war which started on February 24, 2022 equals the Iraq/Iran war which started on September 22, 1980. In which case, September 2022 equals April 1981. But given that inflation is public enemy number one, a better synchronization is the Fed’s preferred measure of underlying inflation, the US core PCE deflator. Aligning the respective peaks in core PCE inflation, we can say that February 2022 equals January 1981. Meaning that our original report in May 2022 aligned with April 1981, and September 2022 equals August 1981 (Chart I-3 and Chart I-4). Chart I-3The Peak In Core PCE Inflation In ##br##February 2022 Chart I-4...Aligns With The Peak In Core PCE Inflation In ##br##January 1981 In which case, how has the template worked since we introduced it on May 19th? The answer is, very well. The template predicted that the long bond price would track sideways, which it has. The template predicted that the S&P 500 would decline from 4200 to 4000, which it has. The template predicted that the copper price would decline from $9250/MT to $8500/MT. In fact, it has fallen even further to $8200/MT. In the case of oil, the better synchronization is the starts of the respective wars. This template predicted that the Brent crude price would decline sharply from a knee-jerk peak in the $120s, which it has. Not a bad set of predictions! If 2022-23 = 1981-82, Here’s What Happens Next Assuming the template continues to hold, here are the major implications for investors: Bond prices will enter a sustained rally in 2023. Bonds: The 30-year T-bond (price) will trend sideways for the next few months, albeit with a potential tactical correction that takes its yield to 3.5 percent. However, bond prices will enter a sustained rally in 2023 in which the 30-year T-bond yield will fall to sub-2.5 percent (Chart I-5). Chart I-5If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices Stocks: A coordinated global recession will depress profits, causing the S&P 500 to test 3500 in the coming months. However, once past the worst of the recession, a strong rally will lift it through 5000 later in 2023 (Chart I-6). Chart I-6If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices Sector allocation: Longer duration defensive sectors (such as healthcare) will strongly outperform shorter duration cyclical sectors (such as basic resources) until mid-2023, after which it will be time to flip back into cyclicals (Chart I-7). Chart I-7If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation Industrial metals: A tactical rebound in copper could lift it to $8500/MT after which the structural downtrend will resume, taking it to sub-$7000/MT in 2023 (Chart I-8). Chart I-8If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price Oil: Just as in 1981-82, supply shortages will provide near-term support. But ultimately, demand destruction will dominate, depressing the price to, at best, $85 (Chart I-9) though our central case is $55 in 2023.  Chart I-9If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price But What If 2022-23 Doesn’t = 1981-82? And yet, and yet…what if the Jay Powell Fed doesn’t equal the Paul Volcker Fed? What if central banks lose their nerve before inflation is slayed? Long bond yields could gap much higher, or at least not come down, causing a completely different set of investment outcomes. In this case, the correct template would not be 1981-82, but the 1970s. If central banks lose the stomach to slay inflation, then the consequent housing market crash will do the job for them. However, there is one huge difference between now and the 1970s, which makes that template highly unlikely. In the 1970s, the global real estate market was worth just one times world GDP, whereas today it has become a monster worth four times world GDP, and whose value is highly sensitive to the long bond yield. In the US, the mortgage rate has surged to well above the rental yield for the first time in 15 years. Simply put, it is now more expensive to buy than to rent a home, causing a disappearance of would be homebuyers, a flood of home-sellers, and an incipient reversal in home prices (Chart I-10). Chart I-10If Bond Yields Don't Come Down, Then House Prices Will Crash Hence, if long bond yields were to gap much higher, or even stay where they are, it would trigger a housing market crash whose massive deflationary impulse would swamp any inflationary impulse. The upshot is that the 2022-23 = 1981-82 template would suffer a hiatus. Ultimately though, it would come good, because a crash in the $400 trillion global housing market would obliterate inflation. In other words, if central banks lose the stomach to slay inflation, then the consequent housing market crash will do the job for them. Fractal Trading Watchlist As just discussed, copper’s tactical rebound is approaching exhaustion. This is confirmed by the 130-day fractal structure of copper versus tin reaching the point of extreme fragility that has consistently marked turning-points in this pair trade (Chart I-11). Chart I-11Copper's Tactical Rebound Is Exhausted Hence, this week’s recommendation is to short copper versus tin, setting the profit target and symmetrical stop-loss at 12 percent.   Chart 1Expect Hungarian Bonds To Rebound Chart 2Copper Is Experiencing A Tactical Rebound Chart 3US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started To Reverse Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 11The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 12A Potential Switching Point From Tobacco Into Cannabis Chart 13Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Dear Clients, Next week we will attend the BCA Investment Conference in New York. Therefore we will not publish our regular report. We will resume regular publication in the week of September 12. We apologize in advance for any inconvenience. Thank you, Matt Gertken, Senior Vice President US Political Strategy Executive Summary Top Issues On Voters’ Minds President Biden has a foreign policy but not yet a foreign policy doctrine.  The Biden Doctrine will emerge after critical tests. These tests are likely to be imminent, signaling more volatility and negative surprises for global investors. The three key foreign policy tests are: the Russia-EU energy crisis, the Iran nuclear crisis, and the fourth Taiwan Strait crisis. Of these, only Iran is looking like it could become a win for Biden – and a boon for markets – but even there deal is not yet confirmed. Biden’s foreign policy is domestically focused given the looming midterm elections. The result is likely to be high or higher volatility in the short run. Recommendation (Tactical) INITIATION DATE Return Long DXY (Dollar Index) Feb 23, 2022 13.1% Bottom Line: Stay defensive and long US dollar in the short run. The fourth quarter could be a turning point but for now political risk remains negative for risk assets. Feature Successful US presidents establish a foreign policy doctrine. The doctrine should not be defined by ideas and ideals but rather by the test of reality and experience – i.e. the decisions the president makes during crises. The Biden administration has a foreign policy and it has been tested in Ukraine. The focal point is to strengthen US alliances – even if that means deferring to allies’ interests on critical points. For example, while the US wanted to sell natural gas to Europe at the expense of Russia, Biden approved of Germany’s decision to finish building and operate the Nord Stream 2 pipeline to Russia in summer 2021. He condoned this decision even though Russia was already threatening Ukraine with invasion. Once Russia invaded, Germany froze the pipeline. The US had given its ally a choice, the choice ended badly, and now the ally is more certain that its interest lies with the United States. Bottom Line: The Biden administration’s foreign policy aims to restore US alliances and thus looks for the common denominator among allies. Biden’s Reactive Foreign Policy Biden’s foreign policy is fundamentally defensive, not offensive like that of the Trump administration. Trump initiated a trade war with China and others, revoked several international deals, tried to build a wall on the Mexican border, and imposed “maximum pressure” sanctions on Iran. By contrast, Biden, who entered office with a weak grip on Congress and a rebellion at the capitol, preferred to focus on domestic politics and social issues. He preferred to be reactive rather than proactive abroad, slapping sanctions on Russia only after it invaded Ukraine and so far avoiding major new sanctions on Iran or China. Biden’s foreign policy has also been reactive in the sense that it aims to win the approval of his domestic audience. Biden is a first-term US president, he faces midterm elections and the potential for re-election in 2024 – and the odds for him and his party are not great (Chart 1). Elections encourage him to maximize domestic legislation and minimize risks on the international scene. Chart 1Midterm Election Odds From The Street The second term – when the president is no longer eligible for re-election and could become a “lame duck” – is opportune for prioritizing national interests over partisan interests and taking risks abroad. The 2022 midterm election fits into this rubric: Biden’s foreign policy this year has been domestically focused and will continue to be through November. Biden’s goal must be balanced: to pursue his foreign policies but avoid worsening the Democratic Party’s difficulties at the voting booth. Our quantitative election models show that Democrats are likely to lose 21 seats in the House of Representatives (Table 1) and two seats in the Senate (Chart 2), thus losing control of all Congress to Republicans. The Senate is uncertain but the House is not. Given that the Senate is highly competitive, Biden must tread carefully to avoid worsening the economy or suffering a policy humiliation. Table 1BCA’s US House Election Quant Model Chart 2BCA’s US Senate Election Quant Model Hence while sanctions on Russia have pushed up energy prices and given ammunition to critics at home, Biden has encouraged Europe to take a pragmatic and gradual approach so as to soften the blow. The EU agrees for its own reasons and the oil embargo will not fully kick in until December 5, after the midterm election. Bottom Line: The Biden administration’s foreign policy is focused on its domestic audience, which means that midterm elections will continue to drive US foreign policy this year. Taking Risks Before The Midterms Since May we have observed that the Ukraine war and Biden’s midterm woes have stirred the administration into taking greater risks in its foreign policy. If American interests are asserted, Biden will look stronger at home. If a crisis erupts, Americans will rally around the flag. For example, Biden agreed to sell long-range artillery rockets (HIMARS) to Ukraine and provide higher value targeting intelligence to Ukraine. Biden expanded export controls on China and agreed to send legislators and eventually a new arms package to Taiwan. The current crisis in the Taiwan Strait arose because of the Biden administration’s initiatives – House Speaker Nancy Pelosi’s trip. Similarly Biden has not, as of August 31, provided Iran with the concessions necessary to clinch a nuclear agreement, raising the risk of rising tensions across the Middle East. He has slightly expanded sanctions, though, to be fair, the odds of an Iran deal are not low.1 We are contrarians on this issue and have put the odds of a deal at 40%, but rumors are swirling in the news media that a deal is at hand. In short, with his job approval rating falling to a net negative 13 percentage points (net negative 18 percentage points on his handling of the economy), Biden is increasingly willing to take foreign policy risks. The domestic focus of foreign policy is overwhelming its initial defensiveness. Biden’s policy is becoming more offensive, albeit still not to the same degree as the Trump administration’s. This shift in foreign policy does not line up well with what voters want. Voter priorities for the midterms are shaping up as follows: Economy: Voters are far more concerned about the economy than anything else (Chart 3, first panel). Biden’s foreign policy actions – sanctions on oil producers like Russia and Iran and tariffs on manufacturers like China – add to inflation, which is the top concern for voters within the economic sphere. Society: Voters are concerned about a range of social grievances such as gun policy, health care, crime, the electoral system. Abortion access and gun rights have become more important over the year, while foreign policy and energy policy have become less important (Chart 3, second panel). Foreign Policy: True, Biden’s foreign policy can tap into unfavorable views of Russia, Iran, and China (Chart 3, third panel). But voters are not demanding a more hawkish foreign policy in this election, so Biden’s decision to take more foreign policy risks this year must come from somewhere else. That somewhere else is the need to respond to foreign events, such as Russian invasions, but there is also the political expediency of stirring up nationalism, as is clear in the case of China. Chart 3Top Issues On Voters’ Minds Bottom Line: Voters are focused on the economy and social issues but Biden must respond to international challenges. In doing so, Biden is increasingly willing to take risks as the Democrats could benefit from any crisis that leads to an outburst of nationalism and patriotism. Biden’s Foreign Policy And Anti-Inflation Drive Back in June the Biden administration unveiled an anti-inflation plan that consisted of (1) Fed rate hikes (2) a reconciliation bill (3) budget discipline. We pointed out that the first option was the only one that would truly reduce inflation – but that it would also bring recession within a year or two. Once the reconciliation bill passed, we showed how the Inflation Reduction Act would increase budget deficits and inflation, especially when taken along with other new legislation like the Chips and Science Act. More recently Biden’s $500 billion plan for student debt forgiveness has underscored the continuing inflationary bent of his policies. Gasoline prices have come down slightly over the summer but not to the extent that Democrats can declare victory (Chart 4). Midterm voters will feel the year-on-year increase in headline inflation. Chart 4Prices At The Pump Market-based inflation expectations are rising again and consumers still report very high expectations for the one-year period, which is most relevant this fall (Chart 5). This brings us to Biden’s three foreign policy options for reducing inflation: reduce tensions with Russia, lift sanctions on Iran, and lift tariffs on China. Back in June we doubted that any of these would come to fruition. Now Biden faces a series of tests that will define his foreign policy doctrine: Chart 5Inflation Expectations Unabated   European Energy Crisis: Biden faces a European energy crisis stemming from Russia’s clash with NATO. Biden is providing Ukraine with extensive support in the form of money and weapons. That will continue in the short run as the Ukrainians are launching a counter-offensive against Russia. There are some signs of Russia signaling a willingness to negotiate but until Russia defeats the new counter-offensive it is highly unlikely to offer any serious concessions, or to relieve the pressure on Europe. The Biden administration has not yet accepted Russia’s broader demands, namely on the topic of NATO enlargement and whether NATO will ever try to station military bases in Finland or Sweden when they join the alliance (Table 2). Russia’s reaction to western policy is to constrict Europe’s energy supply further – namely shutting down the Nord Stream 1 pipeline – which will also tighten American energy supply via exports and exacerbate energy price inflation and expectations (Chart 6). Table 2US Response To Russia’s Demands On Finland, Sweden  Biden can allow slippage on sanction enforcement prior to the midterm but still his Russia policy will be a source of both conflict and inflation. Chart 6Russia Squeezes Europe Harder   Iranian Nuclear Crisis: Biden faces an Iranian nuclear crisis but it could be resolved quickly through a return to the 2015 nuclear deal. Apparently Biden is closer to clinching a deal. But the US and Iran do not trust each other, as shown in Chart 3 above. Biden could unilaterally relieve sanctions and allow Iranian their oil exports to pick up substantially (Chart 7). He can overcome Congress after a 30-day delay. But any deal will alienate the Saudi Arabians, who are threatening to cut oil production and reverse the oil price drop that Biden is seeking on behalf of US voters. So Iran is an option for Biden but it is not very compelling: the oil can be traded regardless of any deal. Biden’s capitulation would hurt politically without helping much economically. However, the failure of a deal poses a greater risk of instability in the Middle East and inflationary energy price shocks. So Biden faces an immediate and critical foreign policy test on this issue. Chart 7Iranian Oil Exports By Destination Fourth Taiwan Strait Crisis: Biden also faces a crisis in relations with China over the One China Policy and the status quo in the Taiwan Strait. This is the fourth such crisis since 1954. In previous crisis the US sent aircraft carriers through the strait, including in 1995-96. But it is not clear that Biden will do so given that China’s capabilities are much greater today (Map 1). The crisis probably will not be resolved before the midterm election since China will remain firm given its own domestic concerns this fall. Recently there emerged a tentative deal on the US auditing Chinese firms that list on US stock exchanges and an attempt to restart talks on climate change cooperation. The US and China are still talking despite tensions. But Biden has ruled out the option of reducing tariffs … which would only marginally have reduced inflation anyway. Map 1US Aircraft Carriers Suggest Taiwan Risk Is Substantial Bottom Line: Biden faces three foreign policy crises that threaten to exacerbate inflation. In each case he will likely uphold US security interests at the expense of higher inflation expectations in the short run. Investment Takeaways The Biden administration has a foreign policy but it does not yet have a foreign policy doctrine. The Biden Doctrine will be forged in the crucible of experience. The critical tests look to be coming soon. It will be difficult for Biden to pass the tests without fanning inflation expectations, at least in the short run. While bold action on Iran will not reduce oil prices as much as the consensus holds, a deal could avoid a worse scenario in which the Middle East destabilizes and energy shocks multiply. Investors should brace for more volatility, at least through the November 8 midterm election. Investors will need to see US-Russia, US-China, and US-Iran relations improve concretely and verifiably before determining that the geopolitical and macroeconomic backdrop are turning more favorable for risk assets.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com       Footnotes 1     See Ivana Saric, “Biden administration ramps up Iran sanctions as nuclear talks falter,” Axios, June 16, 2022, axios.com; Ellen Nakashima, “Biden administration slaps export controls on Chinese firms for aiding PLA weapons development,” Washington Post, April 8, 2021, washingtonpost.com; see also Karen Freifeld, “Biden administration reviewing China chip export policies, official says,” Reuters, July 14, 2022, reuters.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model  Table A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets 

Executive Summary Low-Yielding Countries Facing High USD Hedging Costs The US dollar will remain strong alongside continued Fed rate hikes. Interest rate differentials will remain positive for the greenback, alongside other USD-positive factors like slowing global growth and rising investor risk aversion. Relatively high US interest rates have made hedging away US currency risk very expensive for some of the largest holders of US Treasuries like Japan. US Treasury yields, on an FX-hedged basis, look unattractive relative to local currency denominated bonds across the developed world. Increased foreign demand for US Treasuries evident in the US TIC data appears to reflect a re-establishment of positions unwound by global hedge funds and mutual funds dating back to the 2020 “dash for cash” in global financial markets. UST yields must rise even further versus non-US yields to attract more fundamental buyers like Japanese and European institutional investors, given elevated volatility in both US Treasury prices and the dollar. Bottom Line: Global investors should continue to underweight US Treasuries in global bond portfolios, on both a currency-unhedged and USD-hedged basis. Feature Dear Client, The schedule for the next two Global Fixed Income Strategy reports will be impacted by the upcoming Labor Day holiday and next week’s BCA’s annual conference in New York (I hope to see you there!). This Friday, September 2, we will be publishing a joint report with our colleagues at Foreign Exchange Strategy discussing Japan. On Monday, September 12, we will be publishing another joint report with our colleagues at European Investment Strategy, covering estimates of global neutral interest rates. -Rob Robis The title of our report from four weeks ago was “Dovish Central Bank Pivots Will Come Later Than You Think.” This could have also been the title for Fed Chair Jerome Powell's Jackson Hole speech. He reiterated the Fed’s commitment to tighten policy further and “keep at it” until the US economy slows enough to bring down inflation. Other central bankers who spoke at the conference had a similar tone to Powell, talking up an ongoing inflation fight that will require much slower growth and higher unemployment. Related Report  Global Fixed Income StrategyRecent USD Strength Is Not Bond Bullish By quickly and bluntly dispensing any notion that the Fed could soon pause its rate hiking cycle, Powell poured ice cold water on the risk asset rally that boosted the S&P 500 by nearly 17% between mid-June and mid-August. The S&P 500 plunged 3.4% after Powell’s speech, a tightening of US financial conditions that was likely welcomed by the Fed, as it helps their goal of slowing the US economy. Minneapolis Fed President Neil Kashkari even said he was “happy” to see the negative market reaction to Powell’s speech. Powell, Kashkari and the rest of the FOMC are probably happy over the strength of the US dollar, which is also helping tighten US financial conditions – while also having a major impact on global bond returns and currency hedging decisions for investors. A Collision Of A USD Bull Market & Global Bond Bear Market Chart 1A Big Move In The USD The current strength of the US dollar is becoming increasingly broad-based. The EUR/USD exchange rate has fallen below parity, while USD/JPY continues to flirt with the 140 level (Chart 1). The British pound is trading at a 2-year low versus the US dollar, many important emerging market (EM) currencies are struggling, and the Chinese renminbi is set to retest the 7.0 level. The strength of the US dollar is no recent phenomenon. The current uptrend dates back to the start of 2021, with the DXY dollar index up 21% since then. The dollar bull market has been supported by several factors, most critically rising US interest rates. The 2-year US Treasury yield started 2021 just above 0% and now sits at 3.4%. Higher US interest rates have raised the benefit of hedging currency risk into US dollars for global bond investors. The Bloomberg Global Aggregate Bond Index in USD-hedged terms has outperformed the unhedged version of the index by 6.3% over the past year, one of the largest such increases dating back to 2000 (Chart 2). This means that global bond investors have been paid handsomely to simply swap non-US bond exposures into US dollars – in some cases, making low-yielding assets like Japanese government bonds (JGBs), hedged from yen into dollars, comparable to US Treasury yields. Chart 2Big Gains From Hedging Global Bond Exposure Into USD This wedge between USD-hedged and unhedged bond returns is unlikely to reverse soon, as the fundamental drivers of the dollar remain biased to more dollar strength. The US dollar is not only supported by more favorable interest rate differentials versus other currencies (both in nominal and inflation-adjusted terms), but is also benefitting from its safe haven status at a time of considerable uncertainty on the future of the global economy (Chart 3). Global growth expectations are depressed and showing no signs of turning around anytime soon, particularly in Europe and the UK where electricity and gas prices are climbing at a record pace. The dollar not only typically appreciates during periods of slowing growth, but also during episodes of investor risk aversion. Investors remain cautious, according to indicators like the US equity put/call ratio which shows greater demand for downside protection via puts – an outcome that also typically coincides with a stronger US dollar. In this current environment of broad-based US dollar strength, the gap between hedged and unhedged bond returns has varied widely depending on the base currency of the investor. For a euro-based investor, the performance gap between the unhedged Global Aggregate index and the EUR-hedged index has been 6% over the past year (Chart 4). Chart 3USD Strength Supported By Key Fundamental Drivers​​​​​​ Chart 4FX Hedging Decisions Mean Everything In A Global Bond Bear Market​​​​​ Chart 5Low-Yielding Countries Facing High USD Hedging Costs The gap has been even larger for yen-based investors, with the unhedged index beating the JPY-hedged index by a whopping 13% over the past twelve months. Although Japanese fixed income investors are not typically known for taking unhedged currency risk on foreign bond holdings, doing so would have turned an awful year of global bond returns into a great year, simply due to yen weakness. When looking at current levels of interest rate differentials versus the US, which are the main determinant of currency hedging costs, the low yielding currencies like the euro, yen and Swiss franc see the greatest gain on returns versus the high-yielding US dollar (Chart 5). Hedging euros into dollars results in an annualized pickup of 252bps, while hedging yen into dollars produces an even bigger gain of 327bps. At the same time, the USD-hedging gains for relatively higher yielders are much lower. Hedging Australian dollars into US dollars only produces an annualized gain of 48bps, while hedging Canadian dollars into US dollars produces an annualized loss of -18bps. These varying hedging costs matter for global bond investors, as they impact the attractiveness of an individual country’s bond yields, depending on the investor’s base currency. We show the unhedged yield levels, and currency-hedged yield levels for six main developed market base currencies (USD, EUR, JPY, GBP, CAD, AUD) in the tables on the next two pages. Table 1 shows 2-year government bond yields, Table 2 shows 5-year government bond yields, Table 3 shows 10-year government bond yields and Table 4 shows 30-year government bond yields. Unsurprisingly, hedging into euros and yen, where short-term interest rates are the lowest, produces the smallest yields. Meanwhile, hedging into higher-rate currencies like US dollars and Canadian dollars generates the highest yields. Table 1Currency-Hedged 2-Year Government Bond Yields Table 2Currency-Hedged 5-Year Government Bond Yields Table 3Currency-Hedged 10-Year Government Bond Yields Table 4Currency-Hedged 30-Year Government Bond Yields We take the analysis a step further in the next set of tables on pages 9-11. Here, we take the hedged yields for each currency and compare them to the yields of the base currency. For example, in Table 5, it can be seen that a 2-year US Treasury yield of 3.4%, hedged into euros, produces a yield of 0.82% that is -17bps below the 2-year German yield (which is obviously denominated in euros). In other words, from the point of view of a euro-based investor who wants to hedge away the currency risk in a global bond portfolio, he gets paid a bit more to own a German bond over a US Treasury. Table 5Currency-Hedged 2-Year Govt. Bond Yield Spreads Similar results are shown in the subsequent tables for 5-year yields (Table 6), 10-year yields (Table 7) and 30-year yields (Table 8). From these tables, we can make the following broad conclusions: Table 6Currency-Hedged 5-Year Govt. Bond Yield Spreads Table 7Currency-Hedged 10-Year Govt. Bond Yield Spreads Table 8Currency-Hedged 30-Year Govt. Bond Yield Spreads For USD-based bond investors, all non-US markets except Canada have a yield pickup over US Treasuries on an FX-hedged basis For EUR-based investors, all non-euro area markets except Australia produce yields lower than those of Germany on an FX-hedged basis For GBP-based investors, all non-UK bond markets except the US and Canada have yields greater than those of Gilts for maturities from 5-30 years (the results are more mixed across countries for 2-year yields) For JPY-based investors, euro area and Australian bonds are clearly more attractive than JGBs on an FX-hedged basis, while US Treasuries, UK Gilts and Canadian government bonds offer FX-hedged yields below puny JGB yields. This is true up to the 10-year maturity point, as 30-year JGB yields – which are not targeted by the Bank of Japan in its yield curve control program – are much higher than those on the rest of the JGB curve For CAD-based investors, hedging virtually all non-Canadian bonds into CAD results in yields that are higher than Canadian government bond yields, with the largest hedged yield advantage for euro area and Australian bonds For AUD-based investors, only euro area bonds offer a consistent yield pickup over Australian government bonds on an FX-hedged basis. Broadly speaking, government bonds in the euro area and Australia offer consistently attractive FX-hedged yield pickups over the unhedged bonds for all currencies shown in the tables. On the other hand, Canadian government bonds have consistently less attractive FX-hedged yields across all currencies shown. Perhaps most importantly, US Treasuries look unattractive on an FX-hedged basis to all but CAD-based investors – a result that has meaningful implications for the potential of foreign buying to help stem the rise of US bond yields. Bottom Line: The US dollar bull market is having a huge influence on global bond returns. US Treasury yields, on an FX-hedged basis, look unattractive relative to most local currency denominated bonds across the developed world. Who Are The Foreign Buyers Of US Treasuries? When simply looking at currency-unhedged yield spreads, US Treasury yields offer particularly inviting yields over low-yielding (and low “beta” to US yields) markets like Germany and Japan. The unhedged 10-year US-Germany spread is now 160bps, while the unhedged US-Japan spread is up to 286bps (Chart 6). Meanwhile, among high-beta markets, the US-Canada 10-year spread is flat on an FX-unhedged basis, while an unhedged Australian 10-year bond yields 56bps more than a 10-year US Treasury. Chart 6UST Yields Only Look Attractive In FX-Unhedged Terms Yet after factoring in the currency hedging costs shown earlier, US Treasuries look consistently unattractive versus the other major developed economy bond markets. Chart 7UST Yields Look Unattractive After Hedging Out USD Exposure​​​​​ A 10-year US Treasury hedged into euros now yields -77bps less than a 10-year German bund, at the low end of the historical range for this spread dating back to 2000 (Chart 7). A 10-year Treasury hedged into GBP and JPY also offers lower yields versus 10-year UK Gilts (-11bps) and 10-year JGBs (-50bps), respectively. The 10-year hedged US-Australia spread (with the US yield hedged into AUD) is also at a stretched negative extreme at -114bps (Chart 8). Despite these broadly unattractive hedged US yield spreads, the US Treasury market has seen significant foreign inflows this year, according to the US Treasury Department’s capital flow (TIC) data. Total net purchases of US Treasuries by foreign buyers accelerated to $470bn (on a 12-month rolling total basis) as of the latest data for June (Chart 9). When broken down by type of buyer, private buyers bought a net $619bn, while official buyers were net sellers to the tune of -$149bn. Chart 8No Compelling Yield Advantage To Owning FX-Hedged USTs When looking at the TIC data by country, China was an important net seller of -$18bn of Treasuries. This is consistent with the reduced demand for US dollar assets from China, where policymakers are actively targeting a weaker renminbi. Chart 9TIC Data Shows USTs Seeing Foreign Buying (Ex-China)​​​​​ There was also net selling from many EM countries that have seen reduced trade surpluses and, hence, fewer US dollars to recycle into Treasuries. Chart 10Even Higher UST Yields Needed To Entice Japanese & European Buyers The largest net buying (Chart 10) was seen from the UK (+$306bn) and Cayman Islands (+$154bn) – the latter being a large source of Treasury buying through hedge funds and offshore investment funds located there. Those two countries accounted for almost all of the net foreign inflows into Treasuries, despite the fact they only hold a combined 12% of all foreign US Treasury holdings. There was modest net buying from the euro area (+$37bn) and small net selling by the country with the largest stock of US Treasury holdings, Japan. The relatively subdued inflows from Europe, and lack of inflows from Japan, are consistent with the unattractive hedged US-Europe and US-Japan yield spreads shown earlier, particularly at a time of elevated US bond yield volatility. The huge inflows from the UK and Cayman Islands are harder to explain on a fundamental basis, but are likely due to a continued normalization of Treasury market liquidity after the spring 2020 “dash for cash”. In a report published back in January, Fed researchers analyzed foreign demand for US Treasuries around the worst of the COVID pandemic shock in 2020. The report concluded that the huge collapse in private inflows into Treasuries – from a peak of +$238bn at the start of 2020 to a trough of -$373bn at the end of 2020 – was the result of aggressive net selling by hedge funds and global mutual funds. These are exactly the types of investors that would be domiciled in the Cayman Islands and UK (London). Specifically, the Fed report noted that: “In short, two prominent reasons for the large sales are the unwind of the Treasury basis trade by hedge funds (including foreign-domiciled funds) and the sudden, massive investor outflows from mutual funds that caused these funds to sell their most liquid assets, U.S. Treasury securities, to meet these redemptions.” The “basis trade” mentioned likely involved buying cash Treasuries versus selling Treasury futures, attempting to exploit unsustainable price differences between the two. As market liquidity conditions dried up in the spring of 2020 during the first wave of global lockdowns, leveraged bond investors needed to frantically unwind positions. For Treasury basis trades, that would have involved selling cash Treasuries, which was likely what is being picked up in the TIC data from the Cayman Islands which showed a huge plunge in net buying in 2020. The mutual fund outflows were likely a global phenomenon, but given the large fund management presence in London, the huge net selling of Treasuries from the UK in 2020 were almost certainly related to global fund managers, not purely UK investors. As Treasury market liquidity conditions normalized in 2021 and 2022, those large sellers in the UK and Cayman Islands (and other offshore investment locations) have likely turned into big net buyers, as evidenced from the TIC data. However, the modest inflows from Europe, and outflows from Japan, tell a more important story about the fundamental demand for US Treasuries. Treasury yields must rise further, widening both currency-hedged and unhedged spreads versus non-US government bonds to more historically attractive levels, to entice more foreign buying. Bottom Line: UST yields must rise even further versus non-US yields to attract more fundamental buyers like Japanese and European institutional investors, given elevated volatility in both US Treasury prices and the dollar. Global investors should underweight US Treasuries in global bond portfolios, on both a currency-unhedged and USD-hedged basis.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Tactical Overlay Trades