Economy

Highlights US labor-market disappointments notwithstanding, the global recovery being propelled by real GDP growth in the world's major economies is on track to be the strongest in 80 years. This growth will fuel commodity demand, which increasingly confronts tighter supply.  Higher commodity prices will ensue, and feed through to realized and expected inflation.  Manufacturers will continue to see higher input and output prices. Our modeling suggests the USD will weaken to end-2023; however, most of the move already has occurred.  Real US rates will remain subdued, as the Fed looks through PCE inflation rates above its 2% target and continues to focus on its full-employment mandate (Chart of the Week). Given these supportive inflation fundamentals, we remain long gold with a price target of $2,000/oz for this year.  We are upgrading silver to a strategic position, expecting a $30/oz price by year-end.  We remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to steepen backwardations in forward curves, and long the Global Metals & Mining Producers ETF (PICK). Global economic policy uncertainty will remain elevated until broader vaccine distributions reduce lockdown risks. Feature The recovery of the global economy catalyzed by massive monetary accommodation and fiscal stimulus is on track to be the strongest in the past 80 years, according to the World Bank.1 The Bank revised its growth expectation for real GDP this year sharply higher – to 5.6% from its January estimate of 4.1%. For 2022, the rate of global real GDP growth is expected to slow to 4.3%, which is still significantly higher than the average 3% growth of 2018-19. DM economies are expected to grow at a 4% rate this year – double the average 2018-19 rate – while EM growth is expected to come in at 6% this year vs a 4.2% average for 2018-19. The big drivers of growth this year will be China, where the Bank expects an unleashing of pent-up demand to push real GDP up by 8.5%, and the US, where massive fiscal and monetary support will lift real GDP 6.8%. The Bank expects other DM economies will contribute to this growth, as well. Growth in EM economies will be supported by stronger demand and higher commodity prices, in the Bank's forecast. Commodity demand is recovering faster than commodity supply in the wake of this big-economy GDP recovery. As a result, manufacturers globally are seeing significant increases in input and output prices (Chart 2). Chart of the WeekUS Real Rates Continue To Languish Chart 2Global Manufacturers' Prices Moving Higher These price increases at the manufacturing level reflect the higher-price environment in global commodity markets, particularly in industrial commodities – i.e., bulks like iron ore and steel; base metals like copper and aluminum; and oil prices, which touch most processes involved in getting materials out of the ground and into factories before they make their way to consumers, who then drive to stores to pick up goods or have them delivered. Chart 3Commodity Price Increases Reflected in CPI Inflation Expectations These price pressures are being picked up in 5y5y CPI swaps markets, which are cointegrated with commodity prices (Chart 3). This also is showing up in shorter-tenor inflation gauges – monthly CPI and 2y CPI swaps. Oil prices, in particular, will be critical to the evolution of 5-year/5-year (5y5y) CPI swap rates, which are closely followed by fixed-income markets (Chart 4). Chart 4Oil Prices Are Key To 5Y5Y CPI Swap Rates Higher Gold Prices Expected CPI inflation expectations drive 5-year and 10-year real rates, which are important explanatory variables for gold prices (Chart 5).2 In addition, the massive monetary and fiscal policy out of the US also is driving expectations for a lower USD: Currency debasement fears are higher than they otherwise would be, given all the liquidity and stimulus sloshing around global markets, which also is bullish for gold (Chart 6). Chart 5Weaker Real Rates Bullish For Gold Chart 6Weaker USD Supports Gold All of these effects, particularly the inflationary impacts, are summarized in our fair-value gold model (Chart 7). At the beginning of 2021, our fair-value gold model indicated price would be closer to $2,005/oz, which was well above the actual gold price in January. Gold prices have remained below the fair value model since the beginning of 2021. The model explains gold prices using real rates, TWIB, US CPI and global economic policy uncertainty. Based on our modeling, we expect these variables to continue to be supportive of gold, bolstering our view the yellow metal will reach $2000/ oz this year. Unlike industrial commodities, gold prices are sensitive to speculative positioning and technical indicators. Our gold composite indicator shows that gold prices may be reflecting bullish sentiment. This sentiment likely reflects increasing inflation expectations, which we use as an explanatory variable for gold prices. The fact that gold is moving higher on sentiment is corroborated by the latest data point from Marketvane’s gold bullish consensus, which reported 72% of the traders expect prices to rise further (Chart 8). Chart 7BCAs Gold Fair-Value Model Supports 00/oz View Chart 8Sentiment Supports Oil Prices Investment Implications The massive monetary and fiscal stimulus that saw the global economy through the worst of the economic devastation of the COVID-19 pandemic is now bubbling through the real economy, and will, if the World Bank's assessment proves out, result in the strongest real GDP growth in 80 years. Liquidity remains abundant and interest rates – real and nominal – remain low. In its latest Global Economic Prospects, the Bank notes, " The literature generally suggests that monetary easing, both conventional and unconventional, typically boosts aggregate demand and inflation with a lag of 1-3 years …" The evidence for this is stronger for DM economies than EM; however, as the experience in China shows, scale matters. If the Bank's assessment is correct, the inflationary impulse from this stimulus should be apparent now – and it is – and will endure for another year or two. This stimulus has catalyzed organic growth and will continue to do so for years, particularly in economies pouring massive resources into renewable-energy generation and the infrastructure required to support it, a topic we have been writing about for some time.3 We remain long gold with a price target of $2,000/oz for this year. We are long silver on a tactical basis, but given our growth expectations, are upgrading this to a strategic position, expecting a $30/oz price by year-end. As we have noted in the past, silver is sensitive to all of the financial factors we consider when assessing gold markets, and it has a strong industrial component that accounts for more than half of its demand.4 Supportive fundamentals remain in place, with total supply (mine output and recycling) falling, demand rising and balances tightening (Chart 9). Worth noting is silver's supply is constrained because of underinvestment in copper production at the mine level, where silver is a by-product. On the demand side, continued recovery of industrial and consumer demand will keep silver prices well supported. In terms of broad commodity exposure, we remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to continue to draw down inventories – particularly in energy and metals markets – which will lead to steeper backwardations in forward curves. Backwardation is the source of roll-yields for long commodity index investments. Investors initially have a long exposure in deferred commodity futures contracts, which are then liquidated and re-established when these contracts become more prompt (i.e., closer to delivery). If the futures' forward curves are backwardated, investors essentially are buying the deferred contracts at a lower price than the price at which the position likely is liquidated. We also remain long the Global Metals & Mining Producers ETF (PICK), an equity vehicle that spans miners and traders; the longer discounting horizon of equity markets suits our view on metals. Chart 9Upgrading Silver To Strategic Position Chart 10Wider Vaccine Distribution Will Support Gold Demand Global economic policy uncertainty will remain elevated until broader vaccine distributions reduce lockdown risks. We expect the wider distribution of vaccines will become increasingly apparent during 2H21 and in 2022. This will be bullish for physical gold demand – particularly in China and India – which will add support for our gold position (Chart 10).       Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish The US EIA expects Brent crude oil prices to fall to $60/bbl next year, given its call higher production from OPEC 2.0 and the US shales will outpace demand growth. The EIA expects global oil demand will average just under 98mm this year, or 5.4mm b/d above 2020 levels. For next year, the EIA is forecasting demand will grow 3.6mm b/d, averaging 101.3mm b/d. This is slightly less than the demand growth we expect next year – 101.65mm b/d. We are expecting 2022 Brent prices to average $73/bbl, and $78/bbl in 2023. We will be updating our oil balances and price forecasts in next week's publication. Base Metals: Bullish Pedro Castillo, the socialist candidate in Peru's presidential election, held on to a razor-thin lead in balloting as we went to press. Markets have been focused on the outcome of this election, as Castillo has campaigned on increasing taxes and royalties for mining companies operating in Peru, which accounts for ~10% of global copper production. The election results are likely to be contested by opposition candidate rival Keiko Fujimori, who has made unsubstantiated claims of fraud, according to reuters.com. Copper prices traded on either side of $4.50/lb on the CME/COMEX market as the election drama was unfolding (Chart 11). Precious Metals: Bullish As economies around the world reopen and growth rebounds, car manufacturing will revive. Stricter emissions regulations mean the demand for autocatalysts – hence platinum and palladium – will rise with the recovery in automobile production. Platinum is also used in the production of green hydrogen, making it an important metal for the shift to renewable energy. On the supply side, most platinum shafts in South Africa are back to pre-COVID-19 levels, according to Johnson Matthey, the metals refiner. As a result, supply from the world’s largest platinum producer will rebound by 40%, resulting in a surplus. South Africa accounts for ~ 70% of global platinum supply. The fact that an overwhelming majority of platinum comes from a nation which has had periodic electricity outages – the most recent one occurring a little more than a week ago – could pose a supply-side risk to this metal. This could introduce upside volatility to prices (Chart 12). Ags/Softs: Neutral As of 6 June, 90% of the US corn crop had emerged vs a five-year average of 82%; 72% of the crop was reported to be in good to excellent condition vs 75% at this time last year. Chart 11 Chart 12 Footnotes 1     Please see World Bank's Global Economic Prospects update, published June 8, 2021. 2     In fact, US Treasury Inflation-Indexed securities include the CPI-U as a factor in yield determination.  3    For our latest installment of this epic evolution, please see A Perfect Energy Storm On The Way, which we published last week.  It is available at ces.bcareserch.com. 4    Please see Higher Inflation Expectations Battle Lower Risk Premia In Gold Markets, which we published February 4, 2021. It is available at ces.bcareserch.com.     Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights As commodity inflation subsides, so will broader inflation. As broader inflation subsides, so will inflation expectations – because inflation expectations just follow realised inflation. Overweight US T-bonds versus TIPS. Overweight UK gilts versus index-linked gilts. Within equities, sell the reflation trades: specifically, go underweight basic materials and industrials. Underweight commodity currencies, such as the Canadian dollar, South African rand, and Norwegian krone. Fractal trade shortlist: ZAR/USD, HUF/USD, AMC Entertainment. Feature Chart of the WeekThe Inflation Bubble Will Burst In the past few weeks, most commodity prices have undergone healthy corrections. Relative to recent peaks, the lumber price has plunged by 30 percent, while wheat, iron ore, and DRAM (semiconductor) prices are almost 15 percent lower. The price of copper, together with other industrial metals, is also down, albeit by a more modest 5 percent (Chart I-2). Chart I-2Most Commodity Prices Have Corrected Oil is the only major commodity that has not corrected (yet), but even here, the 1-year inflation rate has plummeted. This is highly significant, as the oil inflation rate feeds straight into the headline CPI inflation rate. Hence, we can say with reasonable conviction that the inflation bubble will soon burst (Chart I-1). What drove the spike in inflation? The answer is that as industries reconfigured for the end of lockdowns, supply bottlenecks in some commodities and services led to understandable surges in their prices. These price surges unleashed fears about inflation, causing investors to pile into inflation hedges. This drove up commodity prices further and more broadly… which added to the inflation fears…which added more fuel to the mania in inflation expectations. And so, the indiscriminate rally in commodities continued. The indiscriminate rally in commodity prices is ending. But supply bottlenecks eventually ease, at which point the price spike corrects – in some cases violently – and the indiscriminate rally in commodity prices ends. This is what we are witnessing now. As commodity inflation subsides, so will broader inflation. And as inflation subsides, so will inflation expectations – because inflation expectations just follow realised inflation. The Markets Are Lousy At Predicting Inflation We now come to a profound question. Why do inflation expectations just follow realised inflation? (Chart I-3) After all, the chances are low that inflation in the future will be the same as it was in the past (Chart I-4). Chart I-3Inflation Expectations Just Follow Realised Inflation Chart I-4AThe Markets Are Lousy At Predicting Inflation Chart I-4BThe Markets Are Lousy At Predicting Inflation The answer comes from our insensitivity to changes in low inflation rates. We cannot perceive changes in the broad inflation rate between -1 and 3 percent, a range we just perceive as ‘price stability’. For example, if a loaf of bread costs £1.50 today, most people cannot perceive the difference between it costing £1.44 two years ago (2 percent inflation) or £1.47 pence (1 percent inflation). Quality improvements compound the perception difficulty. If the loaf used to cost £1.47 pence but the ingredients and nutritional quality are 5 percent better today, then the quality-adjusted price has gone down. The inflation rate is -1 percent! Inflation rates within a low range just feel the same to us, so it is impossible to fine-tune our inflation expectations. As inflation rates within a low range just feel the same to us, it is impossible to fine-tune our inflation expectations. Therefore, when asked to quantify our inflation expectation, we just anchor on the latest realised number. Which explains why inflation expectations just follow realised inflation. Unfortunately, central banks persist in thinking of inflation as a linear phenomenon which they can nail to one decimal place, as if the decimal point means something! But, to repeat, we cannot perceive much difference between low rates of inflation. The entire range of low inflation just feels like price stability. Therefore, within this range, our behaviour stays unchanged. And if our behaviour is unchanged, what is the transmission mechanism to fine-tune inflation within the -1 to 3 percent range? In fact, inflation is a non-linear phenomenon, with two phases: price stability and price instability. Hence, policymakers can undoubtedly take an economy from price stability into price instability – and often do, as witnessed recently in Argentina, Venezuela, and Turkey (Chart I-5). Chart I-5The Choice Is Price Stability Or Price Instability But if a major developed economy tried to take the road to price instability, the ensuing collapse in asset prices would unleash a massive deflationary impulse, as we explained in The Road To Inflation Ends At Deflation. Time To Sell The Reflation Trades Our insensitivity to small changes in low inflation rates contrasts with our very finely-tuned sensation of changes in low nominal interest rates. For example, if your UK floating mortgage rate was tied to the Bank of England policy rate, and the Bank hiked the policy rate to 0.25 percent, your monthly mortgage payment would double. Which would really hurt!1  Contrast this with an alternative situation in which the UK inflation rate fell by 0.25 percent from, say, 0.1 percent to -0.15 percent. In this case, the real interest rate would double. Yet you would barely notice it. Proving again that changes in low inflation rates are imperceptible. All of this has important implications for how we should interpret real interest rates. An ex-post (historical) real interest rates is reliable because it is the true historical nominal interest less the true historical inflation rate. However, an ex-ante (expected) real interest rate is unreliable because it is the true prospective nominal interest less the predicted inflation rate. The problem is that the predicted inflation rate will almost certainly turn out to be wrong. Inflation expectations are too high. In short, if commodity inflation is rolling over, then inflation expectations are too high. The upshot is that the ex-ante real interest rate, as priced by Treasury Inflation Protected Securities (TIPS) and UK index-linked gilt yields is too low – at least, relative to nominal yields. Which leads to the following investment conclusions: 1. Overweight US T-bonds versus TIPS. 2. Overweight UK gilts versus index-linked gilts. 3. Within equities, it is time to sell the reflation trades: specifically, go underweight basic materials and industrials – which are just a proxy for inflation expectations (Chart I-6). Chart I-6Basic Materials And Industrials Are Just Tracking Inflation Expectations 4. Underweight commodity currencies, such as the Canadian dollar, South African rand, and Norwegian krone. In fact, CAD/USD is just a very tight play on inflation expectations. Nothing more, nothing less (Chart I-7). Moreover, the fragile fractal structures for CAD/USD and ZAR/USD confirm that both commodity currencies are vulnerable to correction (Chart I-8). Chart I-7CAD/USD Is Just Tracking Inflation Expectations Chart I-8ZAR/USD Is Vulnerable To Correction 5. In addition, HUF/USD is also vulnerable to correction given that a sharper rise in Hungarian inflation expectations have already driven up the currency cross (Chart I-9). A recommended trade is to short HUF/USD, setting the profit target and symmetrical stop-loss at 3 percent. Chart I-9HUF/USD Is Vulnerable To Correction Fractal Analysis Of ‘Meme’ Stocks Finally, several clients have asked if the use of fractal analysis can be extended from indexes and asset-classes to individual stocks. The answer is an emphatic yes. Fractal analysis works by identifying when the time horizons of investors setting the investment’s price has become dangerously skewed to short-term horizons. At this point, as longer-term value investors are missing from the price setting process, the price becomes unmoored from the longer-term valuation anchor. Eventually though, when the longer-term investors re-enter the price setting process, the price snaps back towards the valuation anchor. This makes fractal analysis particularly suitable for identifying when ‘meme’ stock rallies – fuelled by aggressive trend-following – are most susceptible to correct. Right now, the recent 700 percent rally in the meme stock, AMC Entertainment, is at such a point of vulnerability (Chart I-10). Chart I-10AMC Entertainment's Aggressive Rally Is At A Point Of Vulnerability On this basis, a recommended trade is to short AMC, setting the profit target and symmetrical stop-loss at 100 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 In this illustrative example, we assume that the mortgage rate equals the base rate plus 0.1 percent. Hence, if the base rate rose from 0.1 percent to 0.25 percent, the mortgage rate would rise from 0.2 percent to 0.35 percent, a near doubling. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- 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  

Highlights The Fed’s independence from politics is illusory. President Biden has the potential to reshape the Fed’s Board of Governors through three personnel picks, two of which are due by January 2022. While monetary policy could only get marginally more dovish, the Democratic Party’s goals would be furthered by new appointments. If Biden retains Powell then he is convinced that Powell is fully committed to today’s ultra-dovish monetary policy strategy. If he does not, then the new Fed chair will be still more dovish. Nevertheless the excessive expansion of the US money supply is reminiscent of the Arthur Burns era and suggests that any Fed chair faces a sea of troubles from 2022-26. For now stay long TIPS, infrastructure plays, cyclicals, and value stocks. Feature I do not recall a single instance where somebody in the political realm said, “We need to raise rates, they’re too low.”                         -Alan Greenspan, CNBC, October 18, 2018 Just before the 2020 election I held a call with a client in New York and the question arose of whether the expected winner, then candidate Joe Biden, would reappoint Federal Reserve Chairman Jerome Powell when his term expired on January 31, 2022. I argued that the odds of Biden keeping Powell in place were higher than one might think. After all, Powell reversed his stance on rate hikes in the winter of 2018-19 and then oversaw the Fed’s adoption of a new monetary policy strategy that deliberately targets an inflation overshoot. Powell would be a reliable dove for a president who would seek economic recovery above all things. The client drily responded, “There is no way that is going to happen.”   We still do not know what President Biden will decide with seven months before the decision is due. Personnel appointments are a matter of information and intelligence, not political or macroeconomic analysis. From a macro point of view all that can be said is that Biden does not face the situation President Trump faced: Biden has entered early in the business cycle, under a new, ultra-easy average inflation targeting regime at the Fed. Trump entered in the middle of a business cycle, while the Fed was hiking rates (Chart 1). Chart 1Biden's and Powell's Context Almost any new Fed chair will be largely constrained by the policy consensus on the Federal Open Market Committee (FOMC). Biden is an establishment player whose appointments so far suggest that he is unlikely to nominate a maverick capable of bucking the entire FOMC. But personalities can still make a difference at critical junctures. Nobody should be surprised if Biden opts to replace Powell with a candidate who is marginally more committed to keeping rates lower for longer.   Investors should bet on dovish surprises for three reasons. First, the Fed as an institution has reached a consensus on its current policy framework, which is geared toward an inflation overshoot. Second, Powell may wish to retain his job. Third, the aforementioned client could be right and Biden may replace Powell with a more fervent proponent of ultra-easy policy. The takeaway is bullish for the time being. The Dependency Of Central Banks Central banks are part of the political bureaucracy of the nation state. Insofar as they achieve policy autonomy, or independence, it is at the forbearance of the executive or legislative branch. The ability to contain personal influences shows institutional maturity but institutions can never be fully independent. Fiscal policy is controlled by the ruling party, which will legislate in its interest. The “political business cycle” is an empirical phenomenon in which policymakers attempt to manipulate fiscal policy ahead of elections either to help or hurt the incumbent. A “political monetary cycle” also exists but its prevalence is debatable. It is more widely observed in developing countries.1 Politics in the developed world are more democratic and institutionalized so central banks have achieved considerable autonomy. In many cases their independence is enshrined in law, although the legal basis is often questionable and exaggerated.2  Not only are there checks and balances but they are reinforced by asynchronous cycles between the institutions. Term limits constrict politicians as much as or more so than monetary policymakers. Federal Reserve chairmen William McChesney Martin, Arthur F. Burns, and Jerome H. Powell were not immune to political influence but were able in their own ways to “wait out” the tenure of manipulative presidents Lyndon B. Johnson, Richard M. Nixon, and Donald J. Trump. Still, the latter examples highlight that developed markets cannot claim to be purely rationalist in their conduct of monetary policy. President Trump publicly asked, “Who is our bigger enemy, Jay Powell or Chairman Xi?” Yet this was mild compared to the treatment that Nixon gave Burns and especially that Johnson gave Martin. Johnson physically shoved Martin around a private room demanding policy easing and accused him of not caring about the lives of young American soldiers dying in Vietnam. Martin held his ground and hiked rates in 1966 despite the war.3 Arthur Burns was subjected to a relentless campaign of public and private verbal abuse by Nixon and his staffers. Nixon was convinced that he lost the 1960 election because of overly tight Fed policies and was determined not to let it happen again in 1972. Greenspan kept rates low during the Iraq war and inflated the housing bubble. Plenty of unsavory examples of political influence and interference can be drawn from other developed markets.4 All governments and monetary systems are built and run by humans and therefore fallible. Even aside from individuals and anecdotes, structural forms of central bank manipulation within the developed world include: (1)  Debt accommodation: Central banks face an inexorable pressure to provide liquidity to governments running irresponsible fiscal deficits. The consequences if they refused could be devastating (Chart 2). Chart 2The Fed's Biggest Political Constraint: Debt (2)  Appointments: Presidents and executives appoint and remove leaders. In the US, the tendency for members of the Board of Governors to resign often gives the president substantial influence even aside from picking the Fed chairman, who can indeed be removed at will.5 (3)  Bureaucracy: Administrative structures exert a powerful influence over the personnel, policy frameworks, and behavior of central bank leadership and staff. The candidates for top positions are heavily filtered – and once they achieve high office, their options are constrained.6 Today’s Federal Reserve supports these three points: it is highly accommodative toward the US’s soaring federal debt and its leadership consists of a tight coterie of experts and academics who share a robust consensus regarding the appropriate theory and practice of monetary policy. The outstanding question stems from item number two, appointments, where President Biden has the opportunity to influence the Fed’s board. But the third point mostly controls the available personnel. Still, the choice of the Fed chair could prove decisive under unforeseen circumstances. Historical accounts of the Fed show that the chairman exerts substantial influence over monetary policy decisions.7 Most investors know from experience that individuals and leaders can still exert an outsized influence at critical junctures. For example, premature monetary tightening occurred with negative consequences in the US in 1937, Japan in 2000, and Europe in 2011. Investors are safest to bet on institutions rather than individuals. But the choice of the Fed chair can hardly be ignored. The current context features an extraordinary expansion of the money supply, and “excess money supply,” comparable only to the inflationary 1970s (Chart 3). The Fed chair in the coming years faces an unstable and difficult sea of troubles to navigate.  Chart 3Excess Money Supply Unseen In Modern Memory Fed Chairs Care About Their Careers But Not Midterm Elections Political influence over monetary policy is measurable. A substantial body of academic literature reveals not only the above structural political factors but also that ideological affiliation – i.e. the political party whose president appointed the Fed chair – influences interest rates. So do elections and the career interests of Fed chairmen. Consider the following findings:  Abrams and Iossifov show evidence of abnormally expansionary monetary policy if the president and the chair are affiliated with the same political party.8 Gamber and Hakes show evidence of a lowered federal funds rate if the Fed chair stands for reappointment in the two years following a national election – i.e. Fed chairmen accommodate political pressures in the latter part of term to increase odds of reappointment.9 Dentler shows that while the Fed funds rate does not fall in advance of elections to help presidents in general, it is found to fall when the Fed chair and president have the same partisan affiliation, especially when the Fed chair’s reappointment is looming. Also the Fed funds rate is abnormally high before elections if the Fed chair hails from the opposite party of the incumbent president.10 Dentler shows specifically that Fed chair career motivations matter. If you omit career considerations, then it is not so much partisan affiliation as partisan opposition that can influence monetary policy. In effect, there is a potential increase in policy rate before elections. Dentler calls this a “reverse political monetary policy cycle.”11 In essence, a Fed chair is more likely to lean into his partisan affiliation as an incumbent president seeks reelection. It is hard to prove this behavior is partisan because it conforms with the idea of a staunchly independent central bank. Now let us look at the data first hand. In the following analysis we focus on the nominal Fed funds rate alongside (1) the headline consumer price index and (2) an implied policy rate following a simple Taylor Rule using potential GDP, the core PCE deflator, and the unemployment rate.12 We chose the nominal Fed funds rate and headline consumer price index because they should provide an indication of how the US president and public perceived interest rates and inflation. These factors are critical for the president’s decisions as to whether to reappoint or replace sitting Fed chairmen. However, we also use the Taylor Rule as a proxy for the correct or appropriate policy rate at the time, recognizing that headline CPI is insufficient. We observe the following: Burns worked closely with President Nixon and his tenure has always been controversial. The simple evidence shown here suggests that he accommodated Nixon in 1972 but did not accommodate President Ford’s bid for the presidency in 1976. He might have stayed easy a bit longer than necessary in 1977 ahead of President Carter’s decision on whether to reappoint him (Chart  4).  Chart 4AArthur Burns As Fed Chair Chart 4BArthur Burns As Fed Chair Miller’s tenure was marred by stagflation. He did not accommodate the Democrats during the 1978 midterm election and probably could not have done so. Carter promoted him to Treasury Secretary as a way of removing him from the Fed chair. The episode is a reminder that the president can remove the Fed chair – as the best constitutional studies show – but he may need to get creative about how to do it to avoid a political storm (Chart 5). Volcker may have accommodated Carter somewhat but not entirely in 1980. His actions are debatable around Reagan’s election in 1984. But Volcker laid inflation low and his reappointment by Reagan in 1983 makes sense in the context of that triumph (Chart 6).  Chart 5William Miller As Fed Chair Chart 6Paul Volcker As Fed Chair Greenspan cannot really be said to have accommodated Bush in 1992 though rates fell. He cracked down on inflation regardless of the 1994 midterm election, which turned out badly for President Clinton and the Democrats. But Clinton did not hold it against him – inflation had been brought down without a recession. Greenspan was tame during Clinton’s reelection bid in 1996 despite rising inflation – he hiked rates immediately thereafter. Clinton reappointed him in the midst of a rate-hike cycle justified by rising inflation, regardless of any risk to the Democratic bid in the 2000 election (Chart 7).   Chart 7AAlan Greenspan As Fed Chair Chart 7BAlan Greenspan As Fed Chair Bernanke’s tenure was dominated by the subprime mortgage crisis and Great Recession. He cannot be said to have accommodated the Republicans in 2008, though they were doomed anyway. President Obama’s decision to reappoint him in 2009 was a clear example of an urgent need to maintain policy continuity. Obama announced his replacement in 2013, after the crisis had passed (Chart 8). Chart 8ABen Bernanke As Fed Chair Chart 8BBen Bernanke As Fed Chair Yellen’s decision to pause hiking interest rates in 2016 is debatable and can be said to have accommodated the Democratic Party that year. She was replaced by President Trump in the midst of a rate-hike cycle justified by conditions (Chart 9). Powell hiked rates four times in 2018 despite the onset of a trade war with China. Powell cannot be said to have accommodated the Republicans in the 2018 midterm election. His behavior in 2020 was dominated by the COVID-19 crisis (Chart 10). Chart 9Janet Yellen As Fed Chair Chart 10Jerome Powell As Fed Chair The point is not to claim that politics is the driving factor behind monetary policy but rather to observe the cruxes in which personal and political motivations are at least mixed with technocratic and institutional decisions. Incidentally our observations largely corroborate the relevant academic literature.  If there is one solid rule that emerges from this analysis, it is that Fed chairmen and chairwomen do not accommodate midterm elections. There are no exceptions in the data shown here. If anything they are more hawkish. At the same time, it is true (though sometimes exaggerated) that rate hikes tend to be put on pause during presidential election years. And this tendency is observable not only during times in which a crisis makes rate hikes impossible. Furthermore a close examination of these charts supports the contention that Fed chairs tend to avoid or delay rate hikes prior to the president’s decision whether to reappoint them. There are exceptions but the charts do not disconfirm the hypothesis, which is intuitive because it fits with the central banker’s self-interest.  Biden Faces Zero Risk From A New Chair Or Some Risk From Powell A flat application of the rules of thumb in the previous section would suggest that Powell will push for easier policy than necessary ahead of Biden’s decision whether to reappoint him. It would also suggest that, if reappointed, Powell will not make any special accommodation for the Democrats in the critical 2022 midterms or in 2023. Obviously the reality might work out differently this time. But it is legitimate to suggest that retaining Powell poses a risk to the Democrats’ control of the economy ahead of the 2024 elections, even though we know we will get hate mail for saying it. Investors should not assume that there is a powerful norm in favor of the president’s retaining the sitting Fed chair in the name of continuity and “doing no harm.” The modern period of the Federal Reserve begins with the Fed-Treasury Accord in 1951. There have been seven changes of the Fed chair since that time and three of them occurred because of a change of political party in the White House (Martin to Burns, Burns to Miller/Volcker, and Yellen to Powell). While President Obama retained Bernanke, the reappointment came in early 2009, in the midst of a historic crisis. Biden has much greater flexibility than that today. And while Clinton retained Greenspan, the above analysis suggests that Democrats may warn Biden against doing the same. Most importantly Biden is president at a period of peak polarization in the US, when most of his Democratic Party and the US political establishment believe that democracy itself is at risk of dying at the hands of the Trumpist populism that is overtaking the Republican Party. If this is the view then even marginal risks to Democratic election prospects over the next four years should not be willingly taken. Biden’s dilemma can be illustrated easily by game theory. If he retains Powell he runs some risk of a hawkish surprise, however small, whereas if he replaces Powell he can avoid that risk. Powell regains some individual discretion if he is reappointed and therefore a hawkish surprise cannot be ruled out. The game theory implies that Biden will opt to remove Powell, but obviously that is up to Biden. Note that there is no stable equilibrium as Powell’s decision is shown as data-dependent and indifferent to the outcome (which may not truly be the case) (Diagram 1).   Diagram 1Game Theory: Will The President Reappoint The Fed Chair? Biden must also choose a replacement for Vice Chair Richard Clarida, whose term expires in January 2022. Later, in June 2023, John Williams’s tenure on the board will expire (Diagram 2). With three new appointments Biden would be able to remake the board both slightly more dovish and considerably more diverse. Diversity and inclusiveness in top government positions are key aspects of Biden’s and the Democrats’ overall agenda.  Diagram 2Biden Could Replace At Least Three Fed Governors The history of the Fed shows that leaders tend to be captured by the institution. Powell is fully absorbed into the new Fed consensus and his personal legacy depends on executing the new ultra-dovish monetary policy strategy that he himself ushered into being. While Modern Monetary Theory (MMT) has made great strides, it is not easy for Biden to get a true believer confirmed in the Senate. In this sense, it does not matter whether Biden replaces Powell – the result will be largely the same and in line with the Fed’s current policy framework. We have a lot of sympathy with this argument. It emphasizes the checks and balances on the individual policymaker, which is the method we use to analyze US politics. The Fed has given very explicit criteria for lifting rates off the zero lower bound that are tied to specific economic outcomes. They have removed a lot of the discretion from that decision. Anyone qualified to take up the Fed chair would understand that it would be very risky to deviate from that specific guidance: the Fed would lose a lot of credibility. It would have to be a very non-mainstream pick to do that. That is not likely to happen. But again – personalities can matter at inflection points. Some would argue that Biden will not be able to find any credible candidates who can pass Senate confirmation and still be significantly more dovish than Powell (the Senate being divided equally between the two parties). However, Lael Brainard, Raphael Bostic, and Neel Kashkari are all Fed insiders who would be likely to pass the Senate and marginally more dovish than Powell, albeit supporters of the current policy framework. They would also advance the diversity agenda in different ways. They are more likely nominees than other potential candidates (Table 1).   Table 1Potential Successors To Powell As Fed Chair Note that the focus on inclusiveness is not only about personnel but also about the inclusiveness of the economy and hence it could affect monetary policy decisions. Inclusiveness as well as climate change and inequality are concerns outside of the Fed’s official mandate, where monetary policy will have a limited effect, but any influence of these issues whatsoever would point to dovish surprises. Biden can advance this agenda without legislative change through appointments.   Investment Takeaways The Fed chair appointment is a misleading win-win situation for markets. If Biden retains Powell, it is because Powell has proved thoroughly committed to the Fed’s new ultra-dovish monetary policy strategy, whereas if Biden replaces him, the replacement will be ultra-dovish. However, this win-win is misleading because beyond the near term the Fed will have to normalize policy. The Fed will ultimately remain data-dependent and the rapid closing of the output gap combined with a historic increase in excess money supply will push up inflation and require Fed responses regardless of the future chairman or chairwoman (Chart 11). Our US Bond Strategist Ryan Swift emphasizes that the Fed’s policy framework is very explicit. In order to normalize policy it needs to see inflation above the 2% target, the economy at maximum employment, and a convincing inflation overshoot (Table 2). The first goal is already met, with 12-month PCE inflation above target. An inflation overshoot will necessarily follow from the first goal combined with the second goal. Therefore the focal point for investors should be the second goal, “maximum employment,” i.e. the unemployment rate and labor participation rate (Chart 12). Positive data surprises on the employment front will accelerate the time frame. Chart 11Output Gap To Close Rapidly Table 2Checklist For Fed Liftoff Chart 12Charting The Checklist For Fed Liftoff For now we remain long TIPS relative to duration-matched nominal Treasuries in expectation of dovish policy surprises. We may modify this trade in the near future. The upside is limited now that ten-year breakevens and five-year/five-year forward breakevens have reached the point where they are consistent with the Fed’s goal of well-anchored inflation expectations. But the above analysis supports this trade. Of course, the Fed’s actions should be taken into context with fiscal policy as well as external events and the US dollar. In the near term we continue to advise a cautious approach given that the US dollar is resting at a critical juncture, around 90 on the DXY. If the dollar breaks down beneath this level then it could fall substantially further. From a macro perspective this is what we would expect given the standing of budget deficit and real interest rates. Today’s historic combination of loose fiscal, loose monetary policy is dollar-bearish (Chart 13). The implication is positive for equities, especially cyclical and value sectors, so we maintain our current positioning.  Chart 13Loose Monetary, Loose Fiscal Policy Threaten The Dollar Our sister Geopolitical Strategy highlights China among other foreign policy challenges to the bearish dollar view and global risk appetite. This summer should provide some clarity on whether global policy uncertainty will rise and reinforce the dollar’s floor (Chart 14).     Chart 14Geopolitical Risk And Policy Uncertainty Put Floor Under Dollar? Biden is still highly likely to pass an infrastructure bill this year (80% subjective odds). Any failure of bipartisan talks with Republicans will simply result in an all-Democratic bill via budget reconciliation. West Virginia Senator Joe Manchin will not prevent the passage of a bipartisan infrastructure bill and/or Biden’s next reconciliation bill (the American Jobs Plan). Manchin’s current tensions with the Democratic caucus center on the so-called “For The People” voting rights bill and the Senate filibuster, not the question of infrastructure and corporate tax hikes. Indeed Manchin may be forced to accept a higher corporate tax rate than his preferred 25% if he wants to make peace with his party. It is not inconceivable that he could defect from his party – the Republicans lost a 50-seat majority in the Senate this way as recently as 2001. But we have long argued that Manchin will support Biden’s signature legislative achievement. The market may be temporarily disappointed by stimulus hiccups but we view the infrastructure bill as a “buy the rumor, sell the news” dynamic for US cyclicals. While a fiscal policy weak spot will develop late in 2021 and early 2022, after the American Rescue Plan Act’s provisions expire but before new funds arrive from the American Jobs Plan, nevertheless the recovery of the private economy both at home and abroad should provide a bridge. The implication of the above analysis is to stay invested in the stock market and maintain a constructive outlook over the cyclical (12-month) time horizon while exercising near-term caution due to the dollar and geopolitical risk.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1USPS Trade Table Table A2Political Risk Matrix Table A3Political Capital Index Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets   Footnotes 1     For political monetary cycles see Edward N. Gamber and David R. Hakes, “The Federal Reserve’s response to aggregate demand and aggregate supply shocks: Evidence of a partisan political cycle,” Southern Economic Journal 63:3 (1997), 680-91. For developed versus developing market political monetary cycles, see S. Alpanda and A. Honig, “The impact of central bank independence on political monetary cycles in advanced and developing nations,” Journal of Money, Credit and Banking 41:7 (2009), 1365-1389. 2     In the US, the Fed’s independence rests on dubious constitutional and legal supports but is nevertheless well-established in legal and political practice. See Peter Conti-Brown, “The Institutions of Federal Reserve Independence,” Yale Journal on Regulation 32 (2015), 257-310. 3    Lawrence Bauer and Alex Faseruk, “Understanding Political Pressures, Monetary Policy, and the Independence of the Federal Reserve in the United States from 1960-2019,” Journal of Management Policy and Practice 21:3 (2020), 41-63. 4    Kuttner and Posen (2007) demonstrate that financial markets respond to newsworthy developments with central bankers across the developed world. See footnote 7 below. 5    See Conti-Brown, footnote 2 above. See also Kelly H. Chang, Appointing Central Bankers: The Politics of Monetary Policy in the United States and European Union (Cambridge: CUP, 2003). 6    See Alexander W. Salter and Daniel J. Smith, “Political economists or political economists? The role of political environments in the formation of Fed policy under Burns, Greenspan, and Bernanke,” The Quarterly Review of Economics and Finance 71 (2019), 1-13. 7     See Dentler, 241. See also Ellen E. Mead, “The FOMC: Preferences, Voting, and Consensus,” Federal Reserve Bank of St. Louis Reivew 87:2 (2005), 93-101; Kenneth N. Kuttner and Adam S. Posen, “Do Markets Care Who Chairs the Central Bank?” National Bureau of Economic Research, Working Paper 13101 (May 2007), nber.org.  8    B. A. Abrams and P. Iossifov, “Does the Fed contribute to a political business cycle?” Public Choice 129 (2006), 249-62. 9    Gamber and Hakes, “The Taylor rule and the appointment cycle of the chairperson of the Federal Reserve,” Journal of Economics and Business 58 (2006), 55-66. 10   Alexander Dentler, “Did the Fed raise interest rates before elections?” Public Choice 181 (2019), 239-73. 11    Dentler, 259, characterizes the Fed chairs as follows: “We believe that Martin was more susceptible to political infuences than his colleagues, but he never worked in opposition to a president in our sample period. Neither did Arthur Burns; however, we find him to be a moderating force with respect to ideological biases, though he appears to have been vulnerable to threats regarding his career. We find Volcker to respond more strongly than most other chairs to ideological motives and career incentives. Greenspan, on the other hand, did not fall prey to biased behavior that characterizes the other chairs. Bernanke’s tenure is probably the most difficult to interpret.” 12    Real Potential GDP Growth + Core PCE Deflator + 0.5 * (Core PCE Deflator – 2% Target) - 0.5 * (Unemployment Rate – NAIRU). We prefer real potential GDP to estimates of the real neutral rate because it is simpler and more transparent.  

Highlights In the near term, the RMB against the US dollar has ceased to be a one-way bet. Market sentiment will re-focus on economic fundamentals, which are less supportive of further RMB appreciation.  In the longer term, the RMB still has some upside potential, but the pace of its growth should be much slower than in the past 12 months. The sharp rise in the trade-weighted RMB index is starting to threaten China’s export sector and has exacerbated the tightening of domestic monetary conditions. Barring a monetary policy reset by Chinese authorities, even a small increase in the broad-RMB index would heighten the risk of a contraction in corporate profit growth in the coming 12 months. We remain risk adverse to Chinese stocks for the next 6 months. Feature Chart 1The RMB Back On A Fast Ascending Path After a brief pause in March, China’s currency versus the US dollar extended its steep upward trend began in mid-2020 (Chart 1). Chinese policymakers recently ramped up their strong-worded statements warning against speculating on the RMB. Regulators have also taken steps to stem the rise. Questions we have recently been getting from our clients about the RMB can be summarized as follows: After a 10% appreciation since its trough a year ago, does the RMB have more upside in 2021 and beyond? If the RMB continues to appreciate, what would be the impact on China’s economy and corporate sector? What can the PBoC do to slow the pace of the currency’s appreciation? One could argue that the US dollar will continue to weaken, but we see substantial headwinds to the RMB within the year. A weaker US dollar would support global stock prices outside of the US and foreign inflows have driven the recent rally in China’s onshore stocks. However, we think China’s domestic macro policy and economic conditions pose more downside risks on a cyclical basis. How Far Can The RMB Go? A continued upswing in the CNY relative to the USD can no longer be taken for granted. In the coming months, there is a strengthening case for the RMB to fall against the greenback as factors supporting a strong RMB in the past year start to abate. Economic fundamentals will no longer prop up the RMB’s rise going into 2H21. China’s growth momentum is softening due to significant tightening in the monetary environment in the second half of last year and a rapid deceleration in credit growth this year (Chart 2). Meanwhile, the massive rollouts of COVID-19 vaccines in North America and Europe have successfully reduced new infections and hospitalization rates, allowing these countries to reopen their economies. The economic growth gaps between China and the developed markets (DMs) will narrow more significantly in the coming months (Chart 3). Chart 2Chinese Economic Fundamentals Will Start To Weaken Chart 3China's Growth Gap Relative To DMs Will Narrow Chart 4Global Consumption Recovery In Services Will Likely Outpace Goods China’s large current account surplus will likely start narrowing. It has been driven by strong global demand for goods, which is unlikely to be sustained as the pent-up demand for services in DMs will outpace the consumption for goods (Chart 4). Emerging countries (EMs), many of which are China’s export competitors, lag far behind DMs and China on inoculation rates and some have resurging COVID cases (Chart 5). However, EMs will likely benefit from meaningful expansions in global vaccine production in the second half of the year.1 A catchup in vaccinations in these countries will reduce China’s export-sector advantage, reversing the RMB’s gains over other Asian currencies in the past month. Chart 5China's Asian Neighbors Have Been Hit By Resurging COVID Cases The future trend of the USD also matters to the USD/CNY exchange rate. The recent strength of the CNY vis-à-vis the dollar was the mirror image of USD weakness, which has been due to low real rates in the US and recovering economic momentum outside the US (Chart 6). However, the broad dollar index is sitting at a critical technical level that could either breakout or breakdown (Chart 7). When the Fed announces the slowing of asset purchases, which our BCA US Bond Strategy expects before the end of 2021, it could lead to higher US real yields and reverse the trend of hot money flows into China. Chart 6The Sharp Rise In The RMB In The Past Two Months Has Been Dollar-Driven Chart 7The Dollar Index: Breakout or Breakdown? Furthermore, the financial market does not seem to have priced in unstable US-China relations, which could undermine global risk appetite (Chart 8). Recent actions by US President Joe Biden – from expanding the investment ban on 59 blacklisted Chinese tech companies to calling for the US intelligence community to investigate the origins of COVID-19 – point to risks for escalating tensions between the two nations. Longer term, the RMB is at about one standard deviation below its fair value, which suggests that it still has more upside potential (Chart 9). Based on our BCA’s Foreign Exchange Strategist’s real effective exchange rate (REER) model, the RMB’s fair value mostly climbed in the past three decades, driven by higher productivity in China relative to its trading partners. However, part of the RMB’s appreciation since mid-2020 has been a catch up to its pre-trade war value and its valuation gap has rapidly narrowed. From the current valuation levels, the pace of RMB appreciation should be much slower going forward. Chart 8Geopolitical Surprises Could Spook The Market Chart 9Valuation Gap Has Rapidly Narrowed We also expect China’s real interest rates relative to the US to dwindle in the next three to five years. Demographic headwinds in China herald lower real rates while the Fed is primed to start rate liftoffs within the next two years. Bottom Line: The RMB still has some upside potential in the long run, but the pace of its appreciation should be much slower than in the past 12 months. In the near term, odds are high that economic fundamentals will not boost the RMB any further.  How Does A Stronger RMB Affect China’s Economy? Historically, a stronger RMB relative to the dollar has not had a significant impact on China’s economy. However, if the CNY appreciates considerably versus the greenback so that it pushes up the trade-weighted RMB index, then China’s corporate profits will be negatively affected (Chart 10). Chart 10Strengthening Broad-RMB Index Has Historically Led To Weaker Corporate Profit Growth... Chart 11...And Could Significantly Raise Prob Of A Earnings Contraction In 12 Months Our earnings growth recession probability model confirms our view. If all else is equal, a 3% rise in the trade-weighted RMB index from its current level would more than double the probability of a contraction in earnings growth in the coming 12 months (Chart 11, Scenario 1). On the other hand, all else will not be equal if the broad RMB index goes up by 3%. A quick increase in the RMB’s value against the currencies of its trading partners will impede China’s export growth and tighten domestic monetary conditions. Chart 12Moving Into Restrictive Territory For Chinese Exports Chart 12 shows the impact on export growth from the speed of the RMB’s appreciation; we calculate the rise in an export-weighted RMB index relative to its highs and lows in the past few years. The metric implies that the acceleration in the RMB’s value has reached levels that should be restrictive for exports. The nominal export-weighted RMB index has been significantly above the median value since 2015 and it is approaching the peak reached in that year. Clearly, the strong RMB is linked to a recent weakness in the PMI surveys on export orders. A 3% increase in the trade-weighted RMB from the current level, coupled with a drop in export growth and further deceleration in credit impulse would prop up the earnings contraction probability to more than 50% (Scenario 2 in Chart 11 above). Bottom Line: Our metrics suggest that the RMB’s recent sharp rise is starting to threaten the export sector. An additional 3% appreciation in the broad RMB index would cause a meaningful increase in the probability of a corporate earnings growth contraction in the coming 12 months. What Can The PBoC Do To Halt The RMB Rally? We break this question into two parts: the willingness and the capability of the PBoC to intervene in the currency market.  On the first aspect, the PBoC in recent years has largely refrained from draconian intervention measures in the currency market. Allowing a more market-based currency exchange rate regime is a crucial part of China’s RMB internationalization process. The PBoC seems to be mostly sticking to this long-term goal. Chart 13New FX Regime Began In 2015 Has Significantly Lowered USD Weight In The Broad-RMB Index... Importantly, the new exchange rate regime that the PBoC switched to at end-2015 has greatly weakened the link between the USD and the broad RMB trend (Chart 13). Since then China has continuously cut the weighting of the USD in the CFETS currency index basket, which has reduced the impact of dollar moves on the index. Therefore, the PBoC has mostly ignored short-term volatilities in the CNY/USD exchange rate. The central bank tends to intervene only when swings in the CNY/USD exchange rate are large enough and/or the market forms a unilateral view on the Chinese currency to drive sustained movements in the broader RMB index.  For example, the RMB value rose at a much faster rate against the USD compared with its other trading partners in the second half of 2020. However, this year, the pace of growth in the broad RMB index has caught up with that of the CNY/USD appreciation. Moreover, even when the RMB depreciated against the USD in March, the CFETS index basket kept rising and is now breaching its previous peak in April 2018 (Chart 14). As discussed in the previous section, a sharp jump in the trade-weighted RMB would be more detrimental to China’s corporate profits than an increase in the CNY/USD. Chart 14...But The Massive Appreciation In The CNY/USD Of Late Has Pushed The RMB Index To A Three-Year High Chart 15The PBoC Has Been Trying To Guide Market Expectations Lower On The RMB On the second aspect, the PBoC is unlikely to alter its monetary policy trajectory to tame the RMB’s appreciation. A looser monetary environment would encourage more asset price bubbles domestically and jeopardize policymakers’ ongoing progress in financial and property-market de-risking. If the CFETS strengthens further, Chinese authorities will probably use tools such as managing market expectations and various capital controls to mop up excess FX liquidity generated from capital inflows. In the near term, the PBoC may set a weaker fixing rate against the dollar to dampen market expectations for more RMB growth (Chart 15). An increase in the FX deposit reserve requirement ratio (RRR) rate, announced by the PBoC last week, is another example of the central bank trying to prevent a one-sided expectation by market participants. However, the previous three FX deposit RRR hikes –all taken place more than a decade ago—did little to alter the path of the CNY exchange rate; the pace of USD/CNY depreciation actually accelerated following the May 2007 RRR hike.  The two-percentage point bump in the FX deposit RRR rate will drain China’s domestic FX liquidity by about US$20 billion. Its effect on domestic FX liquidity and FX loan rates is rather limited – FX inflows to Chinese financial institutions since 2H20 were more than US$20 billion a month –more than offsetting the tightening from a RRR rate hike.  The PBoC can further loosen outward capital controls to release some pressure on the RMB’s increase. In a report from November last year we wrote that Chinese policymakers attempted to slow the pace of appreciation in the RMB through a build-up in strategic FX assets by commercial banks and other financial institutions . Since August last year, China has relaxed outbound investment regulations and increased quotas to help channel domestic money into offshore financial markets. China’s commercial banks significantly ramped up their FX assets last year (Chart 16). In Q1 this year, commercial banks enriched their FX asset holdings by US$518.5 billion, a record high in the past five years.  Bottom Line: The PBoC is willing to allow more volatility in the USD/CNY exchange rate, but a sharp jump in the RMB’s value against a basket of other currencies would warrant further policy actions. Chart 16Chinese Banks Ramped Up FX Asset Holdings Chart 17Chinese Onshore Stocks Propped Up By Foreign Investors Investment Conclusions A tightened monetary and credit environment has created headwinds for Chinese equities since early this year. However, the domestic market appears to have found support at a key technical level of late (Chart 17). The recent rebound in China’s onshore stocks on the back of a sharp CNY appreciation and accelerated foreign capital inflows, in our view, are unsustainable on a cyclical basis. Despite buoyant global economic growth, investors should consider deteriorating cyclical conditions in China when judging the appropriate allocation for Chinese equities. While policy tightening has brought multiples closer to earth than last year, the upside in Chinese stock prices will be capped by subsiding stimulus and slower profit growth ahead. As such, a decisive breakout to the upside in Chinese stock prices will require major reflationary catalysts, and it is the reason we are still risk adverse on Chinese equities (Chart 18). Meanwhile, we continue to favor onshore consumer discretionary stocks relative to the broad A-share market. A strong RMB can be a booster to domestic discretionary spending. We initiated this trade in May last year and it has largely outperformed China’s onshore broad market (Chart 19). We will close the trade when the CNY loses its strength and Chinese domestic demand starts to falter. Chart 18Cyclical Performance In Chinese Stocks Is Still Driven By Economic Fundamentals Chart 19Keep A Long CD Position, But On A Short Leash   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1The UN estimates that as many as 15 billion vaccine doses could be produced by the second half of 2021, enough to inoculate most of the world’s population. Cyclical Investment Stance Equity Sector Recommendations