Economy

Highlights Inverted Curves & Recessions: While an inverted U.S. Treasury curve has been a reliable early indicator of past U.S. recessions, the current inversion appears “too soon” relative to the evolution of U.S. economic data today compared to past recessions. The Role Of The Term Premium: Term premia on U.S. Treasuries are negative at all maturities, much more so further out the yield curve, thanks to historically low economic and inflation volatility and, of late, greater investor risk aversion. This suggests that the economic signal from an inverted Treasury curve is somewhat distorted by unusually low bond risk premiums. The Stance Of Monetary Policy: Curve inversions that precede recessions are typically accompanied by tight monetary policy that trigger slowing growth expectations. On that front, the Fed’s current stance is roughly neutral based on measures like r* or the Taylor Rule. That does not, however, preclude the Fed from delivering rate cuts to offset the potential economic shock from escalating U.S. trade protectionism. Feature The rush into the safety of government debt accelerated rapidly last week, after another Trump Tariff Tweet targeted Mexican exports to the U.S. Investor confidence, already shaken by the escalation of the U.S.-China trade war, was further eroded by the news that the U.S. was willing to broaden the use of blunt economic tools like tariffs to deal with national security issues like illegal immigration. Global equity and credit markets sold off sharply, adjusting to both higher uncertainty and lower growth expectations. The biggest moves, however, came in the U.S. Treasury market. The 2-year Treasury yield fell -14bps to 1.92% after the Mexico tariff announcement and ended -34bps lower for the entire month of May – the largest monthly decline since November 2008 during the depths of the financial crisis. The 10-year Treasury yield fell -37bps on the month to 2.13%, below the fed funds target range of 2.25-2.5% and 22bps lower than the 3-month U.S. Treasury bill rate. This triggered the dreaded “inversion” signal that has preceded the majority of post-WWII U.S. recessions. The current Treasury curve inversion is not signaling an imminent U.S. recession – although it may signal a need for the Fed to ease policy to offset global growth uncertainties and below-target inflation. Given the well-known predictive properties of an inverted Treasury curve, investors are right to be more nervous about the outlook for U.S. economic growth and the potential for a recession. Multiple Fed rate cuts are now discounted in shorter-maturity Treasury yields. At the same time, the intense flight-to-quality bid for duration exposure has driven the term premium on longer-maturity Treasuries – and all other developed market government bonds – down to unprecedentedly negative territory (Chart of the Week). This can potentially alter the meaning of an inverted yield curve with regards to future economic growth and expected changes in monetary policy. Chart of the WeekUST Curve Inversion: A Too-Tight Fed Or A Too-Low Term Premium? In this Weekly Report, we discuss the typical drivers of yield curve inversions and conclude that the current Treasury curve inversion is not signaling an imminent U.S. recession – although it may signal a need for the Fed to ease policy to offset global growth uncertainties and below-target inflation. Could The Treasury Curve Be Wrong This Time? Chart 2This Is A GLOBAL Bond Rally The current sharp fall in government bond yields is not only occurring in the U.S. Treasury market. Yields are hitting new cyclical lows in many countries, with the 10-year German Bund yield ending May at an all-time low of -0.2%. Yield curves have bull-flattened during this move, with 10-year yields trading below 3-month Treasury bill rates not only in the U.S., but even in places like Canada and Australia (Chart 2). Global yields have been falling steadily since late in 2018, seemingly with little regard to the performance of risk assets in either direction. This suggests a more fundamental driver – like deteriorating growth expectations or perceptions of overly-tight monetary policy – rather than simple asset allocation decisions by investors. In July 2018, we published a Special Report discussing the drivers of yield curve shape in the major developed markets and the potential economic implications.1 For the U.S., we concluded that when the 10-year U.S. Treasury yield traded below the 3-month U.S. Treasury bill rate for an extended period of time (i.e. more than just a few days), the U.S. subsequently entered recession within twelve months, on average (Table 1). With the 10-year yield now trading below the 3-month rate, the clock may have already started counting down to a recession sometime in the next year. Table 1U.S. Curve Flattening, Inversions & Recessions Since 1960 Abstracting away from the yield curve, however, not all other U.S. economic data is behaving in line with past periods leading up to U.S. recessions. The New York Fed has a model that determines the probability of a U.S. recession one year ahead based on the slope of the 10-year/3-month Treasury curve.2 The current curve level translates into a 36% probability of a recession one year from now, which is in line with the probabilities seen before the three previous U.S. recessions (Chart 3). Chart 3New York Fed's Yield-Curve Based Recession Probability Model Flashing Red Abstracting away from the yield curve, however, not all other U.S. economic data is behaving in line with past periods leading up to U.S. recessions. In Chart 4, we show a “cycle-on-cycle” analysis of selected U.S. economic data series, comparing the current backdrop to past U.S. business cycles. For all panels, the solid line represents the current cycle, while the dotted line is the average of the past five U.S. business cycles. The data is lined up such that the vertical line in the chart represents the start date of past U.S. recessions as determined by the National Bureau of Economic Research. Shown this way, we can look how the data is evolving today and see how it compares to the way the data typically moves in the run-up to a recession. Based on the data, we can make the following conclusions: The current weakness in the U.S. manufacturing sector is in line with the start of past recessions, based on the depressed level of the ISM Manufacturing New Orders-to-Inventories ratio. The Conference Board’s U.S. leading economic indicator is usually contracting in the year prior to the onset of recession; today, the year-over-year growth rate is slowing but remains positive at 2.6%. The U.S. consumer is in much better shape today - initial jobless claims are not rising and consumer confidence is not falling, as typically happens in the run-up to an economic downturn. Non-financial corporate profits also typically start to contract about one year before a recession begins; today, profit growth has slowed from the tax cut fueled surge of 2018, but has not yet downshifted into negative territory on a year-over-year basis. We can apply the same cycle-on-cycle analysis to the U.S. Treasury curve to see how today compares to past pre-recessionary periods (Chart 5). Typically, the 2-year Treasury yield falls below the fed funds rate about one full year before the start of a recession, and ends up around 150bps below the funds rate when the downturn actually begins. In the current cycle, the 2-year dipped below the funds rate back in March of this year, and now sits 58bps below the funds rate. Both of those curve relationships, however, are influenced by the changing nature of the Treasury term premium. Chart 4Only A Manufacturing Recession Chart 5Mixed Messages From The Curve The New York Fed produces estimates of the Treasury term premium for all maturities, from one year up to ten years, which allows us to see how the term premium looks different today than prior to past U.S. recessions.3 As can be seen in the bottom two panels of Chart 5, the 10-year term premium has averaged between 100-150bps in the year prior to U.S. recessions, while the 2-year term premium has averaged between 25-50bps over the same period. Today, the term premia for 10-year and 2-year yields are now both deeply negative. This suggests that the current inversion of the 2-year/fed funds curve, and the 10-year/3-month curve, is likely giving too pessimistic a signal about future U.S. growth – a fact corroborated by the cycle-on-cycle analysis of U.S. economic data. Bottom Line: While an inverted Treasury curve has been a reliable early indicator of past U.S. recessions, the current inversion appears “too soon” relative to the evolution of U.S. economic data today versus past recessions. The Message From Depressed Bond Term Premia Today, the estimated term premium for 10-year Treasuries and 2-year Treasuries is -88bps and -70bps, respectively. This means that not only are bond investors willing to accept yields below the expected path of interest rates over the life of a bond (i.e. a negative term premium), they are accepting an even lower term/risk premium for bonds with longer maturities and durations – bonds that are more risky strictly in terms of price volatility. Why would that be? Typically, bond term premia are driven by the following factors: The volatility of inflation The volatility of bond yields and returns The volatility of economic growth Investor risk aversion Proxies for the first three factors are presented in Chart 6, alongside the estimate of the 10-year Treasury term premium dating back to the early 1960s. Broadly speaking, bond term premia have been higher when realized inflation is more volatile (second panel), unemployment is high (third panel) and Treasury yield volatility is elevated. Today, all of those factors are at, or very close to, the lowest levels seen over the past 50 years. No wonder term premia are so depressed. Chart 6Term Premia Are Depressed For Structural Reasons ... Today, while there has been some modest pickup in GDP volatility, the overall stability of growth and, more importantly, inflation is consistent with depressed bond term premiums. This is mildly exaggerating the pessimistic growth signal from an inverted Treasury curve.  Investor risk aversion does not exhibit the same type of broad multi-decade trends as growth and inflation, but it is safe to assume that investors become more risk averse when the economic backdrop is more uncertain. Periods of stable growth, categorized by low variability of U.S. nominal GDP growth or a rising trend in the global leading economic indicator, are associated with narrow term premiums and low measures of market-implied bond volatility like the MOVE index of U.S. Treasury option prices (Chart 7). Chart 7... And Cyclical Reasons This result does seem counter-intuitive – more economic uncertainty should make bonds safer, not riskier! The key to remember here is that it is only the term premium component of yields that rises during periods of greater volatility. Actual bond yields fall during those same periods, but because of more fundamental drivers like falling inflation expectations and a lower expected path of interest rates as the Fed eases policy. Today, while there has been some modest pickup in GDP volatility, the overall stability of growth and, more importantly, inflation is consistent with depressed bond term premiums. This is mildly exaggerating the pessimistic growth signal from an inverted Treasury curve. Bottom Line: Term premia on U.S. Treasuries are negative at all maturities, much more so further out the yield curve, thanks to historically low economic and inflation volatility and, of late, greater investor risk aversion. This suggests that the economic signal from an inverted Treasury curve is somewhat distorted by unusually low bond risk premiums. So Is The Fed Actually Running A Tight Monetary Policy? As we discussed in our yield curve Special Report last July, curve inversions typically occur during periods when monetary policy is considered restrictive. For example, every time the real fed funds rate (actual fed funds minus core PCE inflation) has been above the Fed’s estimate of the neutral r* real rate, the 10-year/3-month Treasury curve has inverted (Chart 8). Currently, the real funds rate is essentially equal to the Fed’s latest r* estimate, suggesting that monetary policy is neutral and not restrictive. Chart 8Too Soon For Sustained, Policy-Induced Yield Curve Inversion Other measures like the Taylor Rule can also provide an indication of whether monetary policy is too tight relative to real interest rates and measures of economic spare capacity. If policy was too restrictive, with a fed funds rate above the Taylor Rule, this would imply a more “fundamental” Treasury curve inversion. The Atlanta Fed’s interactive Taylor Rule tool provides estimates of a variety of Taylor Rules, using differing measures of the neutral real fed funds rate and measures of spare capacity.4 We show the results of those Taylor Rules in Table 2. Only one of twenty rules shown is currently producing a fed funds rate below the current 2.25-2.5% range, with fifteen rules indicating that a higher funds rate is still required. Table 2Taylor Rule Fed Funds Prescription Heat Map For 2019: Q2 Chart 9Our Fed Monitor Is Close To Calling For Rate Cuts Yet despite the more traditional indicators suggesting that the current level of the fed funds rate is not too high, that does not mean that there are not potential pressures on the Fed to cut rates. Our own Fed Monitor remains near the zero line, suggesting that no change in the Fed’s stance is warranted (Chart 9). Yet when looking at the individual components of the Fed Monitor, there has been enough softening of U.S. growth and inflation momentum to justify Fed rate cuts. Only the Financial Conditions component is preventing the overall Monitor from moving into the “easier policy required” zone. In other words, if equity and credit markets continue to sell off and the U.S. dollar continues to rally, a Fed rate cut becomes a higher probability outcome. Investment Conclusions Summing it all up, it does not appear that the current inverted Treasury yield curve is signaling a risk of a U.S. recession within the next 6-12 months. A very flat Treasury curve is appropriate with a Fed policy stance that is appropriately neutral. On a cyclical perspective, we still think that a small below-benchmark stance on overall portfolio duration for global bond investors is warranted, along with a modest underweight in U.S. Treasuries in currency-hedged global bond portfolios. On a more tactical basis, however, there is a growing chance that the Fed delivers an “insurance” rate cut or two before year-end in response to the increasing uncertainties over global growth and intensifying trade wars. Those cuts are largely discounted in the current level of yields, though. Our 12-Month Discounter now indicates that -75bps of rate cuts over the next year are priced into the U.S. Overnight Index Swap curve. A good tactical way to play for Fed cuts in 2019 is to implement a fed funds futures calendar spread trade to take advantage of possible near-term Fed actions. Investors should buy the August 2019 contract and sell the February 2020 contract – a position we are adding to our Tactical Overlay (see the table on page 15). The long position in the August contract will turn a profit if the Fed responds to market turmoil and cuts rates at the June or July meetings. Meanwhile, the short position in the February 2020 contract will only lose money if three or more rate cuts occur between now and then. On a more tactical basis, however, there is a growing chance that the Fed delivers an “insurance” rate cut or two before year-end in response to the increasing uncertainties over global growth and intensifying trade wars. We would expect our spread trade to return +45bps (unlevered) in a scenario where the Fed keeps rates flat until next March and +19bps (unlevered) in a scenario where there is one rate cut in June or July and another rate cut between September and January. The only scenarios where the trade loses money involve two or more rate cuts between September and January. Bottom Line: Curve inversions that precede recessions are typically accompanied by tight monetary policy that trigger slowing growth expectations. On that front, the Fed’s current stance is roughly neutral based on measures like r* or the Taylor Rule. That does not, however, preclude the Fed from delivering rate cuts to offset the potential economic shock from escalating U.S. trade protectionism. Go long an August 2019/February 2020 fed funds futures calendar spread trade to profit from near-term “insurance’ Fed rate cuts.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy/U.S. Bond Strategy Special Report, “Three Frequently Asked Questions About Global Yield Curves”, dated July 31, 2018, available at gfis.bcaresearch.com and usbs.bcaresearch.com. 2 Details of the NY Fed’s probit model of U.S. recession probability based on the slope of the Treasury curve can be found here: https://www.newyorkfed.org/research/capital_markets/ycfaq.html 3 There are several methodologies used to estimate term premia for government bond yields; the one used by the New York Fed is the Adrian, Crump and Moench (ACM) approach, details of which can be found here: https://www.newyorkfed.org/research/data_indicators/term_premia.html 4 The Atlanta Fed’s interactive Taylor Rule tool can be found here: https://www.frbatlanta.org/cqer/research/taylor-rule.aspx?panel=1 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature Markets have turned jittery in the past month. Global growth data have deteriorated further (Chart 1), with Korean exports, the German manufacturing PMI, and even U.S. industrial production weak. Moreover, trade negotiations between the U.S. and China appear to have broken down, with China threatening to retaliate against U.S. sanctions on Huawei by blocking sales of rare earths, and refusing to negotiate further unless the U.S. eases tariffs. BCA’s Geopolitical Strategists now give only a 40% probability of a trade deal by the time of the G20 summit at the end of June (Table 1). As a result, BCA alerted clients on 10 May to the risk of a further short-term 5% correction in global equities.1 Recommended Allocation Chart 1Worrying Signs? Table 1Chances Of A Trade Deal Fading Fast What is essentially behind the global slowdown, especially outside the U.S., is that both China and the U.S. last year were tightening monetary policy – China by slowing credit growth, the U.S. via Fed hikes. The U.S. economy was robust enough to withstand this, but economies in Europe, Asia, and Emerging Markets were not (Chart 2). The question now is whether the Chinese authorities and the Fed will come to the rescue and add stimulus that will cause a recovery in global growth. China has already triggered a rebound in credit growth since January (Chart 3). Chart 2U.S. Holding Up Better Than Elsewhere Chart 3China Stimulus Has Only Just Begun This has not come through clearly in Chinese – and other countries’ – activity data yet, partly because there is usually a lag of 3-12 months before this happens, and partly because Chinese authorities seemingly eased back somewhat on the gas pedal in April given rising expectations of a trade deal. But, judging by previous episodes such as 2009 and 2016, the Chinese will stimulate now based on the worst-case scenario. The risk is more that they overdo the stimulus than that they fail to do enough. Yes, China is worried about its excess debt situation. But this year they will prioritize growth – not least because of some sensitive anniversaries in the months ahead (for example, the 70th anniversary of the People’s Republic on October 1), and because the government is falling behind on its promise to double per capita real income between 2010 and 2020 (Chart 4). Chart 4Chinese Communist Party Needs To Prioritize Growth Chart 5U.S. Consumers Look In Fine State     In the U.S., consumption is likely to continue to buoy the economy. Wages are growing 3.2% a year and set to accelerate further, and consumer confidence is close to a 50-year high (Chart 5). It is easy to exaggerate the impact of even an all-out trade war. For China, exports to the U.S. are only 3.4% of GDP. A hit to this could easily be offset by stimulus leading to greater capital expenditure. For the U.S, most academic studies show that the impact of tariffs will largely be passed on to the consumer via higher prices.2 But even if the U.S. imposes 25% tariffs on all Chinese exports and all is passed on to the consumer with no substitutions for goods from other countries the impact, about $130 billion, would represent only 1% of total U.S. consumption. The question now is whether the Chinese authorities and the Fed will come to the rescue and add stimulus that will cause a recovery in global growth. But if China will bail out the global economy, we are not so convinced that the Fed will cut rates any time soon. The market has priced in two Fed rate cuts over the next 12 months (Chart 6). But we agree with comments from Fed officials that recent softness in inflation is transitory. For example, financial services inflation (mostly comprising financial advisor fees, linked to assets under management, and therefore very sensitive to the stock market) alone has deducted 0.4 percentage points from core PCE inflation over the past six months (Chart 7). The trimmed mean PCE (which cuts out other volatile items besides energy and food, which are excluded from the commonly used core PCE measure) is close to 2% and continues to drift up. Chart 6Will The Fed Really Cut Twice In 12 Months? Chart 7Soft Inflation Probably Is Transitory     Fed policy remains mildly accommodative: the current Fed Funds Rate is still two hikes below the neutral rate, as defined by the median terminal-rate dot in the FOMC’s Summary of Economic Projections (Chart 8). The market may be trying to push the Fed into cutting rates and could be disappointed if it does not. For now, we tend to agree with the Fed’s view that policy is about correct (Chart 9) but, if global growth does recover before the end of the year, one hike would be justified in early 2020 – before the upcoming Presidential election in November 2020 makes it less comfortable for the Fed to move. Chart 8Fed Policy Is Still Accommodative Chart 9Fed Doesn't Need To Move For Now     In this macro environment, we see global bond yields bottoming not far below their current (very depressed) levels, and equities eking out reasonable gains over the next 12 months. The risk of a global recession over the next year or so is not high, in our opinion. We, therefore, continue to recommend an overweight on global equities and underweight on bonds over the cyclical horizon.  We see global bond yields bottoming not far below their current (very depressed) levels, and equities eking out reasonable gains over the next 12 months. Fixed Income: Government bond yields have fallen sharply over the past eight months (by 110 basis points for the U.S. 10-year, for example) because of 1) falling inflation expectations, caused mostly by a weak oil price, 2) expectations of Fed rate cuts, 3) especially weak growth in Europe, which pulled German yields down to -20 basis points in May, and 4) global risk aversion which pushed asset allocators into government bonds, and lowered the term premium to near record low levels (Chart 10). If Brent crude rises to $80 a barrel this year as we forecast, the Fed does not cut rates, and European growth rebounds because of Chinese stimulus, we find it highly improbable that yields will fall much further. Ultimately, the global risk-free rate is driven by global growth (Chart 11). Investors are already positioned very aggressively for a further fall in yields (Chart 12). We would expect the U.S. 10-year yield to move back towards 3% over the next 12 months. We remain moderately positive on credit, which should also benefit from a growth rebound: U.S. high-yield spreads are still around 70 basis points for Ba-rated bonds, and 110 basis points for B-rated ones, above the levels at which they typically bottom in expansions; investment-grade bonds, though, have less room for spread contraction (Chart 13). Chart 10Term Premium Near Record Low Chart 11Global Rebound Would Push Up Yields   Chart 12Investors Very Long Duration Chart 13Credit Spreads Can Tighten Further     Equities:  We remain overweight U.S. equities, partly as a hedge against our overweight on the equity asset class, since the U.S. remains a relatively low beta market. Our call for the second half will be 1) when will Chinese stimulus start to boost growth disproportionately for commodity and capital-goods exporters, and 2) does that justify a shift out of the U.S. (which may be somewhat hurt short term by the Trade War) and into euro zone and Emerging Markets equities. Given the structural headwinds in both (the chronically weak banking system and political issues in Europe; high debt and lack of structural reforms in EM), we want clear evidence that the Chinese stimulus is working before making this call. We are likely to remain more cautious on Japan, even though it is a clear beneficiary of Chinese growth, because of the risk presented by the rise in the consumption tax in October: after previous such hikes, consumption not only slumped immediately afterwards but remained depressed (Chart 14). Chart 14Japan's Sales Tax Hike Is A Worry Chart 15Dollar Is A Counter-Cyclical Currency   Currencies:  Again, China is the key. The dollar is a counter-cyclical currency, and a pickup in global growth would weaken it (Chart 15). Any further easing by the ECB – for example, significantly easier terms on the next Targeted Longer-Term Refinancing Operations (TLTRO) – might actually be positive for the euro since it would augur stronger growth in the euro area. Moreover, long dollar is a clear consensus view, with very skewed market positioning (Chart 16). Also, on a fundamental basis, compared to Purchasing Power Parity, the dollar is around 15% overvalued versus the euro and 11% versus the yen. Chart 17Industrial Metals Driven By China Too Commodities: Industrial metals prices have generally been weak in recent months with copper, for example, falling by 10% since mid-April. It will require a sustained rebound in Chinese infrastructure spending to push prices back up (Chart 17). Oil continues to be driven by supply-side factors, not demand. With OPEC discipline holding, Iran sanctions about to be reimposed, political turmoil in Libya and Venezuela, BCA’s energy strategists continue to see inventories drawing down this year, and therefore forecast Brent crude to reach $80 during 2019 (Chart 18). Chart 18Oil Supply Remains Tight Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1       Please see Global Investment Strategy, Special Report, “Stay Cyclically Overweight Global Equities, But Hedge Near-Term Downside Risks From An Escalation Of A Trade War,” dated May 10, 2019, available at gis.bcaresearch.com 2      Please see, for example, Mary Amiti, Sebastian Heise, and Noah Kwicklis, “The Impact of Import Tariffs on U.S. Domestic Prices,” Federal Reserve Bank of New York Liberty Street Economics, dated 4 January 2019. Recommended Asset Allocation  

Highlights Monetary policy remains accommodative in Japan, but will tighten on a relative basis if the Bank Of Japan (BoJ) stands pat. The BoJ’s margin of error is non-trivial, since a small external shock could well tip the economy back into deflation. Historically, the BoJ has needed an external shock to act, suggesting the path towards additional stimulus could be lined with a stronger yen. Our bias is that USD/JPY could weaken to 104 in the next three to six months, especially if market volatility spikes further. We are carefully monitoring any shift in the yen’s behavior, in particular its role as a counter-cyclical currency. If global growth eventually picks up, the yen will surely weaken on its crosses, but could still strengthen versus the dollar. Feature The powerful bounce in global markets since the December lows is sitting at a critical juncture. With the S&P 500 at its 200-day moving average, crude oil and Treasury yields plunging and the dollar taking a bid, it may only require a small shift in market prices to change sentiment sharply. The yen has strengthened in sympathy with these moves, but the balance of evidence suggests the possibility of a much bigger adjustment. Should the selloff in global risk assets persist, the yen will strengthen further. On the other hand, if global growth does eventually pick up, the yen could weaken on its crosses but strengthen vis-à-vis the dollar. This places short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. BoJ: Out Of Policy Bullets For most of the 1990s, Japan was in a deflationary bust. In hindsight, the reason was simple: The structural growth rate of the economy was well below interest rates, which meant paying down debt was preferable to investing. Tight money also led to a structurally strong currency, reinforcing the negative feedback loop (Chart I-1). Chart I-1The Story Of Japan In One Chart Much farther down the road, the three arrows of ‘Abenomics’ arrived, ushering in a paradigm shift. Since 2012, Japan has enjoyed one of its longest economic expansions in recent history, having fine-tuned monetary policy each time private sector GDP growth has fallen close to interest rates. The result has been remarkable. The unemployment rate is close to a 26-year low, and the Nikkei index has tripled. But if the economy once again flirts with deflation, additional monetary policy options may be hard to come by, since there have been diminishing economic returns to additional stimulus. Chart I-2Stealth Tapering By ##br##The BoJ Chart I-32 Percent Inflation Equal Mission Impossible? The end of the Heisei era1 has brought forward the urgency of the above quandary. At its latest monetary policy meeting, the BoJ strengthened forward guidance, expanded collateral requirements for the provision of credit, and stated that it will continue to “conduct purchases of JGBs in a flexible manner so that their amount outstanding will increase at an annual pace of about 80 trillion yen.”2 But with the BoJ owning 46% of outstanding JGBs, about 75% of ETFs, and almost 5% of JREITs, this will be a tall order. The supply side obviously puts a serious limitation on how much more stimulus the central bank can provide. In recent years, the yen has become extremely sensitive to shifts in the relative balance sheets of the Federal Reserve and the BoJ. Total annual asset purchases by the BoJ are currently running at about ¥27 trillion, while JGBs purchases are running at ¥20 trillion. This is a far cry from the central bank’s soft target of ¥80 trillion, and is unlikely to change anytime soon. In recent years, the yen has become extremely sensitive to shifts in the relative balance sheets of the Federal Reserve and the BoJ. If the BoJ continues to purchase securities at its current pace, then the rate of expansion in its balance sheet will severely slow, and could trigger a knee-jerk rally in the yen (Chart I-2). The BoJ targets an inflation rate of 2%, but it is an open question as to whether it can actually achieve this. It pays attention to three main variables when looking at inflation: Core CPI, the GDP deflator, and the output gap. All indicators are pointing in the right direction, but the recent slowdown in the global economy could reverse this trend. It is always important to remember that the overarching theme for prices in Japan is a falling (and aging) population leading to deficient demand (Chart I-3). More importantly, almost 40% of the Japanese consumption basket is in tradeable goods, meaning domestic inflation is as much driven by the influence of the BoJ as it is by globalization. Even for prices within the BoJ’s control, an aging demographic that has a strong preference for falling prices is a powerful conflicting force. For example, over the years the government has been a thorn in the side of telecom companies, pushing them to keep cutting prices, given domestic pressures from its voting base. Transportation and telecommunications make up 17% of the core consumption basket in Japan, a non-negligible weight. This is and will remain a powerful drag on CPI (Chart I-4), making it difficult for the BoJ to re-anchor inflation expectations upward. On the other side of the coin, the importance of financial stability to the credit intermediation process has been a recurring theme among Japanese policymakers, with the health of the banking sector an important pillar. YCC and negative interest rates have been anathemas for Japanese net interest margins and share prices (Chart I-5). This, together with QE, has pushed banks to search for yield down the credit spectrum. Any policy shift that is increasingly negative for banks could easily tip them over. Chart I-4The Japanese Prefer Falling Prices Chart I-5Negative Rates Are Anathema To Banks Bottom Line: Inflation expectations are falling to rock-bottom levels in Japan, at a time when the BoJ may be running out of policy bullets. Meanwhile, the margin of error for the BoJ is non-trivial, since a small external shock could tip the economy back into deflation. The BoJ will eventually act, but it might first require a riot point. Go short USD/JPY. High Hurdle For Delaying Consumption Tax Since the late 1990s, every time Japan’s consumption tax has been hiked, the economy has slumped by an average of over 1.3% in subsequent quarters. For an economy with a potential growth rate of just 0.5-1%, this is a disastrous outcome. More importantly, similar to past episodes, the consumption tax is being hiked at a time when the economy is at the precipice of a major slowdown. Foreign and domestic machinery orders are slowing, employment growth has halved from 2% to 1%, and wages are inflecting lower (Chart I-6). This is especially worrisome since the labor market has been the poster child of the Japanese recovery.3 The consumption tax is being hiked at a time when the economy is at the precipice of a major slowdown. Why go ahead with the consumption tax then? The answer lies in the concept of Ricardian equivalence.4 Despite relatively robust economic conditions since the Fukushima disaster, Japanese consumption has remained tepid. By the same token, the savings ratio for workers has surged (Chart I-7). If consumers are caught in a Ricardian equivalence negative feedback loop, exiting deflation becomes a pipe dream. Chart I-6A Bad Omen Increased social security spending: This will be particularly geared towards child education. For example, preschool and tertiary education will be made free of charge. Promoting cashless transactions: Transactions made via cashless payments (for example, via mobile pay) will not be subject to the 2% tax increase for nine months. Cashless payments in Japan account for less than 25% of overall transactions – among the lowest of developed economies. This incentive should help lift the velocity of money. Chart I-7Strong Labor Market, Weak Consumption Construction spending: This will offset the natural disasters that afflicted Japan last year. Construction orders in Japan accelerated at a 66% pace in March. The Abe government’s strategy has so far been to offset the consumption tax hike with increased domestic spending. The thinking is that once in a liquidity trap, the fiscal multiplier tends to be much larger. Some of these outlays include: Chart I-8Japan Needs More Fiscal Stimulus The new immigration law will also help. Foreign workers were responsible for 30% of all new jobs filled in Japan in 2017. Assuming public aversion towards immigration remains benign, as is the case now (these are mostly lower-paying jobs in sectors with severe labor shortages), the government’s target to attract 350,000+ new workers by 2025 will be beneficial for consumption. To be sure, this may not be enough. The IMF still projects the fiscal drag in Japan to be 0.1% of GDP in 2019 and 0.6% in 2020 (Chart I-8). This puts the onus back on the BoJ to ease financial conditions. A combination of easier fiscal and monetary policy will be a headwind for the yen. This could happen if the U.S./China trade war escalates, and twists the arm of the finance ministry. But the hurdle is high for the government to roll back the consumption tax, given significant spending offsets. The Yen As A Safe Haven Correlations do shift from time to time, but one longstanding rule of thumb still holds for yen investors: Buy the currency on any market turbulence (Chart I-9). This is because with a net international investment position of almost 60% of GDP and net income receipts of almost 4% of GDP, volatility in markets tend to lead to powerful repatriation flows back to Japan. Real interest rates also tend to be higher in Japan in recessions as already-low inflation expectations fall further. Correlations do shift from time to time, but one longstanding rule of thumb still holds for yen investors: Buy the currency on any market turbulence. Some have suggested that the BoJ’s asset purchases are pushing investors out of Japan and weakening the safe-haven status of the yen. While plausible, our view is that other factors have been at play. First, tax changes led to repatriation of capital back to the U.S. in 2018. This unduly pressured foreign direct investment in Japan as well as other safe-haven countries like Switzerland. Second, Japan, by virtue of its current account surplus, runs a capital account deficit. This means that portfolio outflows are the norm. This is how it has managed to build the biggest net international investment position in the world. Only in times of severe flight to safety are those investments liquidated and brought home. More importantly, the time may now be very ripe for yen long positions, given rising suspicion towards the currency as a haven. To see why, one only has to return to late 2016. Back then, global growth was soft, the yen was very cheap and everyone was short the currency on the back of a dovish shift by the BoJ. Despite that backdrop, the yen strengthened by almost 10% from December 2016 to mid-2017, even as equity markets remained resilient. When the equity market drawdown finally arrived in early 2018, it carried the final legs of the yen rally. With U.S. interest rates having risen significantly versus almost all G10 countries in recent years, including Japan’s, the dollar has become a carry currency. It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions. As markets become volatile and these trades get unwound, this will be a powerful undercurrent for the yen (Chart I-10). Chart I-9The Yen Remains A Safe Haven Chart I-10The Yen Has Financed Carry Trades Bottom Line: Every diversified currency portfolio should hold the yen as insurance against rising market volatility. What If Global Growth Picks Up? The eventual bottom in global growth is a key risk to our scenario. However, inflows into Japan could accelerate, given cheap equity valuations and improved corporate governance that has been raising the relative return on capital (Chart I-11). The propensity of investors to hedge these purchases will dictate the yen’s path. The traditional negative relationship between the yen and the Nikkei still holds, but it will be important to monitor if this correlation shifts during the next equity market rally. Over the past few years, an offshoring of industrial production has been marginally eroding the benefit of a weak yen/strong Nikkei. If a company’s labor costs are no longer incurred in yen, then the translation effect for profits is reduced on currency weakness. USD/JPY and the DXY tend to have a positive correlation because the dollar drives the yen most of the time. Our contention is that the yen will surely weaken at the crosses, but could strengthen versus the dollar. USD/JPY and the DXY tend to have a positive correlation because the dollar drives the yen most of the time. Meanwhile, large net short positioning in the yen versus the dollar makes it attractive from a contrarian standpoint (Chart I-12). Chart I-11Japan: Better Governance, Higher ROIC Chart I-12Short USD/JPY: A Contrarian Bet Bottom Line: Short USD/JPY trades have entered into an envious “heads I win, tails I do not lose too much” position. Should the selloff in global risk assets persist, the yen will strengthen further. On the other hand, if global growth does eventually pick up later this year, the yen could weaken on its crosses but may actually strengthen versus the dollar. Housekeeping We are closing our short EUR/CZK position with a 4.7% profit. Interest rate differentials between the Czech Republic and the euro area have widened significantly, at a time when growth and labor market tightness could be fraying at the edges. Meanwhile, possible weakness in the dollar will be a risk to this position.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 The Heisei era refers to the period corresponding to the reign of Japanese Emperor Akihito from 1989 until 2019. 2 Please see “Minutes of the Monetary Policy Meeting,” Bank of Japan, dated May 8, 2019, p.27. 3 Sample changes last year make it more difficult to have an apples-to-apples comparison for wages. 4 Ricardian equivalence suggests in simple terms that public sector dissaving will encourage private sector savings. Currencies U.S. Dollar USD Technicals 1 USD Technicals 2 Recent data in the U.S. have been negative: Total durable goods orders decreased by 2.1% in April. On the housing front, FHFA house price growth fell to 0.1% month-on-month in March. MBA Mortgage applications fell by 3.3% in May. Conference Board consumer confidence index improved to 134.1 in May. Dallas Fed Manufacturing activity index fell to -5.3 in May. Annualized GDP came in at 3.1% quarter-on-quarter in Q1, revised from the previous 3.2% but higher than the consensus of 3%. Q1 headline and core PCE both fell to 0.4% and 1% quarter-on-quarter respectively. DXY index increased by 0.6% this week. In the long-term, we maintain a pro-cyclical stance, and continue to believe that the path of least resistance for the dollar in down. In the short-term however, there is more room for the trade-weighted dollar to rise before eventually reversing, amid global data weakness and political uncertainties. Report Links: President Trump And The Dollar - May 9, 2019 Take Out Some Insurance - May 3, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 The Euro EUR Technicals 1 EUR Technicals 2 Recent data in the euro area have shown improvement: Private loans increased by 3.4% year-on-year in April. Money supply (M3) increased by 4.7% year-on-year in April. Business climate indicator fell to 0.3 in May. Despite the weak business climate indicator, soft data in the euro area have generally improved in May: economic confidence rose to 104; industrial confidence increased to -2.9; services confidence climbed to 12.2. Lastly, the consumer confidence increased to -6.5. EUR/USD fell by 0.7% this week. During this weekend’s European Parliament election, the European People’s Party (EPP) won with 24% of the seats. However, 43 seats were lost compared with their last election result. The S&D party also lost 34 seats, together ending the 40-year majority of the center-right and center-left coalitions. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 The Yen JPY Technicals 1 JPY Technicals 2 Recent data in Japan have been negative: All industry activity index fell by 0.4% month-on-month in March. The leading index and coincident index both fell to 95.9 and 99.4 respectively in March. PPI services fell to 0.9% year-on-year in April, below the expected 1.1%. Labor market  and CPI data will be released after we go to press today. USD/JPY rose by 0.3% this week. BoJ Governor Haruhiko Kuroda has given two speeches this week, warning about the high degree of uncertainty, and potential downside risks worldwide. On the positive side, Kuroda thinks that EM capital outflows are less at risk than during recent financial crises, given a better framework for risk management. In the meantime, uncertainties remain regarding the U.S.-Japan trade disputes, especially vis-à-vis Japanese auto exports. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound GBP Technicals 1 GBP Technicals 2 Recent data in the U.K. continue to outperform: Total retail sales increased by 5.2% year-on-year in April, surprising to the upside. BBA mortgage a pprovals increased to 43 thousand in April. GBP/USD fell by 0.8% this week. The uncertainties of Brexit increased with the resignation of Prime Minister Theresa May last Friday. With a Brexit decision not due until October 31, 2019, the U.K. has participated in the recent EU election. The newly formed Brexit Party led by Nigel Farage, won with more than 31% of the votes. This reflects a growing dissatisfaction with traditional parties within U.K. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 Australian Dollar AUD Technicals 1 AUD Technicals 2 Recent data in Australia have been mostly negative: ANZ Roy Morgan weekly consumer confidence index increased to 118.6 this week. HIA new home sales fell by 11.8% month-on-month in April. Moreover, building permits decreased by 24.2% year-on-year. Private capital expenditure in Q1 fell by 1.7% quarter-on-quarter. Building approvals fell by 4.7% month-on-month in April. AUD/USD fell by 0.2% this week. As we argued in last week’s report, we favor the Aussie dollar from a contrarian point of view. Despite the negative data points on the surface, the recent election result and dovish shift by RBA all support the Australian economy in the long-term. Moreover, the robust job market, rising terms of trade, and Chinese stimulus will likely put a floor under AUD/USD. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar NZD Technicals 1 NZD Technicals 2 Recent data in New Zealand have been mixed: ANZ activity outlook increased by 8.5% in May, well above consensus. Building permits fell by 7.9% month-on-month in April. ANZ business confidence remained low at -32 in May. NZD/USD fell by 0.6% this week. The Financial Stability Report, released by RBNZ this week, highlighted the worrisome debt levels, particularly in the household and dairy sectors. Ongoing efforts are necessary to bolster system soundness and efficiency, according to RBNZ governor Adrian Orr. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar CAD Technicals 1 CAD Technicals 2 Recent data in Canada have been positive: Bloomberg Nanos confidence index improved to 55.7, from the previous 55.1. Current account deficit increased to C$17.35 billion from C$16.62 billion, but it is lower than the expected C$ 18 billion. USD/CAD increased by 0.4% this week. On Wednesday, the Bank of Canada (BoC) held interest rates steady at 1.75%, as widely expected. Despite the recent trade uncertainties, the BoC views the slowdown in late 2018 and early 2019 as temporary, and expects growth to pick up again in the second quarter this year, supported by recovering oil prices, stabilizing housing sector, robust job market and easy financial conditions. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc CHF Technicals 1 CHF Technicals 2 Recent data in Switzerland have been mixed: Q1 GDP came in higher-than-expected at 1.7% year-on-year, from the previous reading of 1.5%. Trade surplus reduced to 2.3 million CHF in April, mostly due to the decrease in exports. KOF leading indicator fell to 94.4 in May. ZEW expectations fell in May to -14.3. USD/CHF appreciated by 0.7% this week. We favor the Swiss franc as a safe haven when market volatility rises. In the longer term, the high domestic savings rate, rising productivity, and current account surplus should all underpin the franc. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone NOK Technicals 1 NOK Technicals 2 There is little data from Norway this week: Retail sales increased by 1.6% year-on-year in April. Credit expanded by 5.7% year-on-year in April USD/NOK increased by 0.9% this week. Our Commodity & Energy Strategy team believe that the energy market is underpricing the U.S. - Iran war risk, and overestimating the short-term effects of the trade war. In the long run, the Chinese stimulus, dollar weakness, and supply uncertainties should lift oil prices, which will support the Norwegian krone. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona SEK Technicals 1 SEK Technicals 2 Recent data in Sweden have been mostly negative: Producer price inflation fell to 4.9% year-on-year in April from 6.3% in March. Consumer confidence fell to 91 in May. Moreover, manufacturing confidence fell to 103.7 in May. Trade surplus fell from 6.4 billion to 1.4 billion SEK in April. Q1 GDP came in at 2.1% year-on-year, outperforming expectations but lower than the previous 2.4%. USD/SEK has been flat this week. Swedish exports, a reliable barometer for global business confidence, fell from 133.4 billion SEK to 128 billion SEK in April, which is a total decrease of 5.4 billion SEK in exports, implying that the global growth remains in a volatile bottoming process. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades