Equities

Highlights It is too early to conclude that the PBoC’s surprise rate cut last Friday to its reserve requirement ratio (RRR) marks the beginning of another policy easing cycle.  Historically it took more than a single RRR reduction to lower interest rates and to boost credit growth. Overall economic conditions do not yet suggest that Chinese policymakers will initiate a broad-based policy easing to spur demand. The end-of-July Politburo meeting will shed more light on whether there is a decisive turn in China’s overall policy stance. In previous cycles, consecutive RRR cuts led to bond market rallies, but were not good leading indicators for equities, which have been more closely correlated with cyclical swings in credit and business cycle. We recommend patience. Chinese onshore stocks are richly valued and their prices can still correct in Q3 when corporate profits and economic growth slow further. Feature The speed and magnitude of the PBoC’s 50-basis point trim in its RRR rate last week exceeded market expectations. The RRR rate drop, combined with June’s better-than-expected credit data, sparked speculation that China’s macroeconomic policy had shifted to an easier mode. A single RRR cut does not indicate that another policy easing cycle is underway. Rather, the PBoC’s intention is to prevent rising demand for liquidity in 2H21 from significantly pushing up interest rates. In addition, we do not expect that the credit impulse will decisively turn around until later this year. We will remain alert to any signs of additional policy easing, particularly because policymakers will face more pressure to maintain trend growth next year. The July Politburo meeting may provide more information on the direction of Chinese macro policy going forward. Meanwhile, investors should stay the course. In previous cycles there were long lags between the first RRR cut and sustained rallies in China’s onshore stock markets. We will continue to maintain an underweight stance towards Chinese stocks through the next three months, given that economic data and corporate profits will likely weaken further in Q3. Surprise, Surprise! The PBoC lowered the RRR rate only two days after the State Council mentioned the possibility, which exceeded the consensus. Historically, the PBoC has always made more than one RRR reduction during easing cycles, separated by about three months. Are more RRR cuts pending and does the initial decrease mark the beginning of another policy easing cycle? It is too early to conclude that a broad-based easing cycle has started, for the following reasons: First, economic fundamentals do not suggest an urgent need for policy easing. The economy is softening, but it is softening from a very elevated level (Chart 1). Importantly, production is weakening at a faster pace than demand and partially due to COVID-related idiosyncrasies. This supply-side issue cannot be solved by monetary easing.  For example, the production subcomponent of the manufacturing PMI fell in June while new orders increased (Chart 2). Since its trough in April last year, the gap between new orders and production has consistently narrowed for 11 of the past 15 months, highlighting that the demand-side recovery has been outpacing the supply-side. The recent resurgence in COVID-19 cases and local lockdowns in Guangdong province, which is China’s manufacturing and export powerhouse, may have curbed June’s manufacturing production and new export orders. Global supply shortages in raw materials and chips also add to the sluggishness in manufacturing production. Chart 1Chinese Economy Is Slowing, But Not Too Slow Chart 2Demand Not As Soft Compared With Production Similarly, China’s service PMI slipped notably in June and has closely tracked the country’s domestic COVID-19 situation. The decline is an issue that policy easing and boosting demand will not solve (Chart 3). Secondly, global supply chains are still impaired and commodity prices remain elevated. Even though China’s PPI on a year-over-year basis rolled over in June, it is at its highest level since 2008 (Chart 4). As such, spurring demand through monetary easing would only exacerbate inflationary pressures among producers. Chart 3Slow Recovery In Services Largely Due To Lingering COVID Effects Chart 4Producer Prices Remain Elevated Apart from COVID-related disruptions, the weakness in China’s economy this year has been driven by slower growth in infrastructure and real estate investment due to tightened regulatory oversights that were put in place late last year (Chart 5). Construction PMI declined sharply from its peak in March and both excavator sales and loader sales have plummeted since Q1 this year (Chart 5, bottom panel). However, regulatory tightening towards the housing market and infrastructure projects remain firmly in place, suggesting that policymakers are not looking to stimulate the old economy sectors to support growth. Lastly, despite weaker home sales, housing prices in tier-one cities continue to escalate (Chart 6). The rising prices will keep authorities vigilant about excessive liquidity in the market.    Chart 5It Has Been Chinese Policymakers' Intention To Slow The 'Old Economy' Sectors Chart 6Housing Market Mania Remains Authorities' Pressure Point Bottom Line: Supply-demand dynamics in the global economy and China’s domestic inflationary pressures suggest that it is premature to assume that the RRR cut marks the beginning of another policy easing cycle.  Why Now? Chart 7More 'Pain' Needed For Broad Easing The drop in the RRR highlights the PBoC’s determination to maintain a low interest-rate environment without any further easing, and does not indicate that the central bank has shifted its current policy setting framework. The PBoC has been reactive rather than proactive in the past as it typically waits for severe signs of economic weakness before broadly relaxing its policy (Chart 7). The PBoC cited two main reasons for the RRR cut. One is to ease liquidity pressures of small to medium enterprises (SMEs), which have been struggling with rising input prices and subdued output prices (Chart 8). This motive is consistent with the PBoC’s monetary position so far this year –the central bank has kept rates at historical low levels while scaling back credit creation (Chart 9).   Chart 8SMEs Under Elevated Pricing Stress Chart 9The PBoC Has Kept Rates At Historic Low Levels Demand for liquidity will rise meaningfully in the second half of the year due to an acceleration in local government bond issuance and the large number of expiring medium-term lending facility (MLF) loans and bonds. The liquidity gap could significantly push up interbank and market-based interest rates without the central bank’s intervention. The amount of maturing MLF and government bonds could be more than RMB1 trillion in July. Thus, the 50bp RRR cut, which the PBoC indicates will free up about RMB1 trillion of liquidity to the banking system, will ensure that interest rates remain stable. Chart 10Bank Lending Rates Have Not Declined With Policy Rates The PBoC also stated that it intends to keep down financing costs for both banks and SMEs. The statement is vague, but the PBoC may mean it plans to guide bank lending rates lower for SMEs and, at the same time, provide banks (particularly smaller banks) with enough liquidity to encourage lending to those enterprises. To achieve this goal, a broad-based RRR cut would be more effective than other monetary policy tools, such as open-market operations or MLF injections, which normally benefit large commercial banks more than their smaller counterparts. While interbank rates have been sliding since Q4 last year, the weighted average lending rates moved sideways and even ticked up slightly this year (Chart 10). As of Q1 2021, more than half of bank loans charged higher interest rates than the loan prime rate (LPR), highlighting a distribution matrix unfavorable to SMEs (Chart 11). Loan demand from SMEs, as shown in the PBoC survey, peaked much earlier and tumbled more rapidly than their large peers (Chart 12). Chart 11SMEs Face Rising Input And Funding Costs Chart 12Waning SMEs' Demand For Bank Credit Lowering lending rates for SMEs is usually at the cost of the banks by bearing higher default risks and lower profits. A RRR reduction, coupled with recent changes in banks’ deposit rate pricing mechanisms,1 are measures that can potentially reduce the banks’ liability costs. Bottom Line: The PBoC is using a RRR cut to avoid a sudden jump in interest rates from their low levels in 1H21, and to reduce funding costs for the SMEs and banks. What About Credit Growth? Chart 13Credit Numbers In June Beat Market Expectations Credit numbers beat the market’s expectations in June. Both credit growth and impulse rose slightly after a fast deceleration in much of 1H21 (Chart 13). We continue to expect the credit impulse to hover at a low level throughout Q3. Local government bond issuance will pick up in 2H21, but the acceleration will not necessarily lead to a reversal in credit growth (Chart 14). On a year-over-year basis, high base during Q3 last year will depress credit growth and impulse in the next three months. Moreover, in the past couple years, on average local government bonds account for only about 18% of annual total social financing. As such, the pace of bank loan expansion would need to substantially accelerate to reverse the slowdown in credit growth in the next three months. In previous cycles, on average it took more than one RRR cut and about two quarters for credit growth to turn around (Chart 15). Therefore, even if monetary policy is on an easing path, we expect credit growth to pick up in Q4 at the earliest. Chart 14LG Bonds Only A Small Part Of Total Credit Creation Chart 15Credit Growth Lags RRR Cuts By About Two Quarters Furthermore, policymakers are unlikely to deviate from targeting credit growth in line with nominal GDP this year. Based on our estimate, the target suggests that the overall credit impulse relative to 2020 will be negative this year (Chart 16). Chart 16Negative Credit Impulse In 2021 Relative To 2020 Chart 17The Credit Structure, Rather Than Volume, Will Improve In 2H21   Meanwhile, we think that the PBoC will focus on improving the structure of credit creation by continuing to encourage medium- to long-term lending, while scaling back shadow banking and short-term loans (Chart 17). Corporate bond financing improved slightly in June. However, room for further improvement in corporate bond issuance is small this year, given tightened financing reglations on local government financing vehicles. Downside potential for corporate bond yields is also limited in 2H21, when the economy slows and corporate bond default risks are rising (Chart 18).  Given elevated housing prices and tightened regulations to contain the property sector’s leverage, bank lending to real estate developers and mortgages will continue to trend down in the foreseeable future, regardless the direction of interest rates (Chart 19). Chart 18Limited Upsides For Corporate Bond Issuance In 2H21 Chart 19Bank Loans To Property Market Unlikely To Pick Up In 2H21 Bottom Line: Regardless changes in monetary policy, credit growth will not decisively bottom until later this year. Investment Implications Chart 20Chinese Stock Prices Failed To Break Out Chinese stocks in both onshore and offshore equity markets failed to reverse their trend of underperformance relative to global stocks (Chart 20). Investors should be patient in upgrading their allocation to Chinese stocks from underweight to overweight, in both absolute terms and within a global equity portfolio.  Historically, there has been a long lag between an initial RRR trim and a trough in Chinese onshore stock prices (Chart 21). Although prices moved up along with RRR cut announcements in the past, the price upticks were short lived. Stock prices in previous cycles troughed when the credit impulse and/or the economy bottomed. Given our view that a single RRR decrease does not indicate a broad-based policy easing and the credit impulse is unlikely to pick up until later this year, investors should wait for more price setbacks in Q3 before favoring Chinese stocks again.  Chart 21Long Lags Between First RRR Cut And Stock Market Troughs We are slightly more optimistic than last month about Chinese bonds because the RRR cut has reduced the possibility for any substantial rise in interest rates in 2H21. However, we maintain a cautious view on Chinese government and corporate bonds in Q3. In previous cycles, onshore bond yields often fluctuated sideways or even climbed a bit following the first RRR reduction. It often took several RRR drops, more policy easing signals and sure signs of economic weakening for the bond market to enter a tradable bull run (Chart 22). Therefore, we recommend investors stay on the sidelines for a better entry price point. Chart 22It Takes More Than One RRR Cut To Start A Bond Market Bull Run It is also unrealistic to expect the RRR cut will lead to significant and sustained devaluation in the RMB relative to the US dollar. We expect the dollar index to rebound somewhat in Q3 on the back of positive US employment data surprises which will push US bond yields higher. However, following previous RRR cuts, the RMB had sizeable depreciations only when geopolitical events (the US-China trade war in 2018/19) or drastic central bank intervention (the August 2015 de-pegging from the USD) coincided with the RRR cuts. These scenarios are not likely to play out in the next six months (Chart 23). As such, we maintain our view that the CNY will slightly weaken against the USD in Q3 but will end the year at around 6.4. Chart 23Expect Muted And Short-Lived Movements In The USDCNY From A Single RRR Cut   Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Footnotes 1The reform changes the way banks calculate and offer deposit rates. The upper limit is set on their deposit interest rates by adding basis points to the central bank’s benchmark deposit rates, rather than multiplying the benchmark rates by a specific number. Exclusive: Banks Prepare to Lower Deposit Rates as Rate Cap Reform Takes Effect (caixinglobal.com) Cyclical Investment Stance Equity Sector Recommendations

Earnings season is upon us again. Time just flies! This quarter, according to Refinitiv, Net Income is expected to increase by 64.9% YoY on Revenue growth of 18.5%. EPS growth is expected to be 68.1% - it is higher than income growth by 3.2% thanks to the projected share repurchases. BCA Model expects a 3.6% buyback yield. These numbers are truly spectacular, and yet a little suspicious. So what do we make of them? Similar to the inflation story, Q2-21 earnings season growth numbers look so high because they are dominated by the base effect: growth is computed against the worst quarter of the pandemic, Q2-20. To strip out the base effect, we calculated quarterly earnings growth with respect to Q2 of 2019 for the S&P 500 as well as its GICS1 sectors. Looking at the cleaner numbers reveals that SPX quarterly EPS growth sits at a respectable 12.2%. This number appears manageable, in sharp contrast to eyewatering growth calculated based on Q2-20 comparables.  Bottom Line: The implication is that once we take out the once in a lifetime pandemic effect, we observe that earnings growth is normalizing, and expectations are rather reasonable.  

Feature Since the end of the first quarter, the decline in Treasury yields has been the most important trend in global financial markets. It has contributed to the return of the outperformance of growth stocks relative to value stocks, the underperformance of Eurozone equities relative to the S&P 500, and the tepid results of cyclicals relative to defensive equities. This decline in yields is a temporary phenomenon, because the global economy continues to re-open and inventory levels remain so low that further restocking is in the cards. The cyclical picture is not without blemish; COVID-19 variants remain a concern. However, if these risks were to materialize into another delayed re-opening, then further reflationary efforts by both monetary and fiscal authorities would buoy financial markets. The greatest near-term worry for the global economy and markets comes from China. The Chinese credit impulse is slowing markedly and fiscal support has yet to come to the rescue. This phenomenon is the main reason why this publication maintains a cautious tactical stance on Eurozone cyclical stocks, even if we believe these sectors have ample scope to outperform over the remainder of the business cycle. As a corollary, we believe that yields will likely remain within range this summer and Eurozone benchmarks will lag behind the US. This week, we review key charts, organized by theme, highlighting some of these key concepts. As an aside, none covers inflation. Even if the balance of evidence suggests that any sharp increase in Eurozone inflation will be temporary, the proof will only become more visible by early 2022. The Opening Is On Track… The pace of vaccination across the major Eurozone economies has picked up meaningfully since the spring. Consequently, the number of doses distributed per capita is rapidly approaching that of the US, even as it still lags behind that of the UK (Chart 1). As a result of this improvement, the stringency of lockdown measures is declining, which is allowing European mobility to recover (Chart 2). While this phenomenon is evident around the world, EM still lag in terms of vaccination rates. However, the Global Health Innovation Center at Duke University expects 10 billion vaccine doses to be produced by the year’s end, which will be enough to inoculate most (if not all) the vulnerable people in the world by early 2022. Consequently, the re-opening of the economy will remain a potent tailwind behind global growth for three or four more quarters. Chart 1Vaccination Progress... Chart 2...Leads To Greater Activity   … But Near-Term Headwinds Remain The re-opening of the global economy will allow growth to stay well above trend for the upcoming 12 months, at least. Global industrial activity could nonetheless decelerate this summer. Input costs have risen. The two most important ones, oil and interest rates, are already consistent with a peak in the US ISM manufacturing and the global PMI (Chart 3). In this context, the decelerating Chinese credit impulse is concerning (Chart 4) because it portends a hit to global trade and industrial activity. The effect of this slowdown should be most evident in the third and fourth quarters of 2021. However, it will be temporary because Beijing only wants credit to grow in line with GDP, rather than an outright deleveraging. Thus, the credit impulse will stabilize before the year’s end, which will allow the positive effect of the global re-opening to be fully experienced once again. Chart 3Rising Input Costs... Chart 4...And China's Credit Slowdown Matter   Domestic Tailwind In Europe Despite the extreme sensitivity of the European economy to the global business cycle, Europe should continue to produce positive surprises. The supports to the domestic economy are strong. The NGEU funds means that Europe will suffer one of the smallest fiscal drag among G-10 nations next year. Moreover, the re-opening will support household income and allow the positive effect of the increase in the money supply to buoy consumption (Chart 5). Finally, rising consumer confidence, and the ebbing propensity to save will reinforce the tailwinds behind consumption (Chart 6). Chart 5Europe's Domestic Activity Chart 6...Will Improve Further   Higher Bond Yields Are Coming… The environment continues to support higher yields. Our BCA Pipeline Inflation Indicator is surging, which historically translates into higher global borrowing costs (Chart 7). Most importantly, our Nominal Cyclical Spending Proxy remains very robust, which normally leads to rising yields (Chart 8). While US inflation expectations at the short end of the curve already fully reflect current inflationary pressures, the 5-year/5-year forward inflation breakeven rates will have additional upside. Moreover, the term premium and real rates remain depressed, and policy normalization will cause these variables to climb higher over time. Chart 7Higher Yields Will Come... Chart 8...Later This Year   … But Not This Summer It could take some time before the bearish backdrop for bonds results in higher bond yields. First, bonds have yet to purge fully their oversold status created by the 125 basis-point surge that took place between August 2020 and March 2021 (Chart 9). This vulnerability is even more salient in an environment in which the Chinese credit impulse is decelerating. As Chart 10 illustrates, a slowing total social financing number reliably leads to bond rallies. While the chart looks dire for bond bears, it must be placed in context, in which global fiscal policy remains accommodative considering the decline in the private sector savings rate and in which Advanced Economies’ capex will stay strong. Thus, instead of betting on a large swoon in yields in the coming quarters, we expect US yields to remain stuck between 1.20% and 1.70% for a few more months before they resume their upward path once the Chinese economy stabilizes. Chart 9But Bonds Are Still Oversold... Chart 10...And Fundamentals Cap Yields For Now   A Positive Cyclical Backdrop For The Euro The near-term forces suggest that the euro will remain range bound over the summer, between 1.16 and 1.23. EUR/USD is a pro-cyclical pair, and so the near-term lack of upside to global growth will act as a temporary ceiling on this currency. Nonetheless, the 18-month outlook continues to favor the common currency. Investors have shed Eurozone exposure for more than 10 years and are structurally underweight this region (Chart 11). Hence, EUR/USD should benefit from any positive reassessment of the growth path in the Euro Area compared to that of the US. Additionally, the euro benefits from a structural current account surplus compared to the USD, which translates into a positive basic balance of payments (Chart 12). In an environment in which US real interest rates are low in relation to foreign ones and in which the Fed wants to maintain accommodative monetary conditions to achieve maximum employment, the capital account balance is unlikely to come to the rescue of the dollar. In this context, EUR/USD still possesses significant cyclical upside and is likely to move back above 1.30 by the year’s end of 2022. Chart 11Investors Underweight Eurozone Assets... Chart 12...And The BoP Favors The Euro   The Bull Market In Global Stocks Is Not Over The cyclical outlook for equities remains supportive. To begin with, in most years, equities eke out positive returns, as long as a recession is not around the corner; we do not expect a recession anytime soon. Moreover, while the balance of valuation risk and monetary accommodation is not as supportive of stocks as it was last year, it is not pointing to an imminent deep pullback either (Chart 13). The equity risk premium echoes this message. Our ERP measure adjusts for the expected growth rate of earnings as well as the lack of stationarity of the ERP. According to this indicator, equities are not an urgent buy, but they are not at risk of a bear market either (Chart 14). This combination does not prevent corrections, but it suggests that pullbacks of 10% are to be bought. Chart 13Equities Are Not A Screaming Buy... Chart 14...Nor A Screaming Sell   Europe’s Structural Underperformance Is Intact… Eurozone stocks have been underperforming their US counterparts since the GFC. As Chart 15 highlights, this subpar performance reflects the decline in European EPS relative to US ones. There is very little case to be made for this underperformance to end on a structural basis. Europe remains saddled with an excessive capital stock and ageing assets. This combination is weighing on European profit margins and RoE (Chart 16). To put an end to this structural underperformance, either European firms will have to consolidate within each industry (allowing cuts to the excess capital stock, to increase concentration, and to boost profit margins) or the regulatory burden must rise in the US to curtail rates of returns in relation to European levels. Chart 15Europe's Underperformance... Chart 16...Reflects Profitability Problems   …But The Window For A Cyclical Outperformance Remains Open Despite a challenging structural backdrop, European equities have a window to outperform US stocks, similar to the outperformance of Japan from 1999 to 2006, which only marked a pause within a prolonged relative bear market. European stocks beat their US counterparts when global yields rise (Chart 17). This is because European benchmarks underweight growth stocks relative to US markets. The effect of higher yields on the relative performance of the Euro Area is not limited to the impact of higher discount rates. Yields rise when global economic activity is above trend. As Chart 18 highlights, robust readings of our Global Growth Indicator correlate with an outperformance of the EPS of value stocks compared to growth equities. Thus, when rates rise, Europe should enjoy both a period of re-rating relative to the US and stronger profits. Chart 17Yields Drive European Stocks... Chart 18...And So Does Global Growth   Positives For Euro Area Financials Like the broad European market, the financials’ fluctuations are linked to interest rates. Moreover, Euro Area banks also move in line with EUR/USD (Chart 19). As a result, our positive view on both yields and the euro for the next 18 months or so should translate into an outperformance of financials in Europe. Additionally, European banks are inexpensive, embedding not just depressed long-term growth expectations, but also a wide risk premium. Europe’s structural problems mean that investors are correct to expect poor earnings growth from the region’s banks. However, the risk premium is overdone. Eurozone banks are much safer than they were 10 years ago. Banks now sport significantly higher Tier 1 capital adequacy ratios and NPLs have shrunk considerably (Chart 20). Moreover, governmental supports and credit guarantees implemented during the pandemic should limit the upside to NPL in the coming quarters. Finally, the so-called doom-loop that used to bind government and bank solvency together is not as problematic as it once was, because the ECB is a willing buyer of government paper and the NGEU programs create the embryo of fiscal risk sharing that limit these dynamics. As a result, investors should overweight this sector for the next 18 months. Chart 19Financials Have A Window To Shine... Chart 20...And Are Less Risky   A Tactical Hedge Our worries about the impact on the global economy of the Chinese credit slowdown are likely to prompt some downside in European cyclical equities relative to defensive ones. Moreover, cyclicals are still significantly overbought relative to defensives, while our relative Combined Mechanical Valuation Indicator confirms the near-term threat (Chart 21). A high-octane vehicle to play this tactical underperformance of cyclicals relative to defensives is to buy Euro Area telecom stocks relative to consumer discretionary equities. Not only are the discretionary stocks massively overbought and expensive relative to telecoms (Chart 22), they also offer a lower RoE. This backdrop makes the short discretionary / long telecoms bet a great hedge for portfolios with a pro-cyclical bias over one- to two-year horizons.  Chart 21Cyclicals Are Tactically Vulnerable... Chart 22...But This Risk Can Be Hedged Away   Currency Performance Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance  

Highlights Our sense remains that the dollar is undergoing a countertrend bounce, rather than entering a new bull market. The litmus test for this view is if the DXY fails to break above the 93-94 level that marked the March highs. Stay short USD/JPY. The drop in global bond yields should give this trade a welcome fillip. Short GBP/JPY positions also make sense. We are long CHF/NZD as a play on a potential increase in currency volatility. Look to rebuy a basket of Scandinavian currencies versus the USD and EUR at a trigger point of -2% from today’s levels. Remain long silver both in absolute terms and relative to gold. Our limit buy on EUR/USD was triggered at 1.18. Place tight stops given the potential for the dollar rally to continue for the next few weeks. We also believe the change in the ECB’s framework portends another bullish tailwind for the euro beyond the near term. Feature In our webcast last week, we made the case that the recent FOMC meeting (perceived as hawkish by market participants) has not altered the longer-term downtrend in the US dollar. This week, we are revisiting some of the sentiment and technical indicators that could help gauge how high the dollar can rise in the interim. Our view remains that three fundamental forces will continue to dictate currency market trends into the year end and beyond. First, the Federal Reserve will lag other central banks in raising rates amidst a shift in economic momentum from the US towards the rest of the world. This will boost short-term interest rates outside the US and provide a floor for procyclical currencies. Second, US inflation will prove stickier compared to other countries such as the eurozone or Japan. This will depress real interest rates in the US relative to the rest of the world, and curb bond inflows. And finally, an equity market rotation towards non-US stocks will improve flows into cyclical currencies. The transition could prove volatile in the coming month or so. Equity markets remain overbought, bond yields are falling, PMIs have stopped rising, and cyclical stocks are lagging growth stocks. More widespread infection from the Delta variant of Covid-19 will continue to reprice risk to the downside. As a countercyclical currency, the dollar will be a critical variable to watch. Sentiment and technical indicators make up an important component of our currency framework and are usually good at gauging significant shifts in financial markets. Our sense remains that the dollar is undergoing a countertrend bounce, rather than entering a new bull market. The litmus test for this view is if the DXY fails to break above the 93-94 level that marked the March highs. Momentum Indicators Our momentum indicators suggest that while the dollar is very oversold, the bear market remains very much intact. The dollar advance/decline line is sitting below its 200-day moving average (Chart I-1). Historically, bull markets in the dollar have been characterized by our advance/decline line breaking both above its 200-day and 400-day moving averages. This suggests a rally towards these critical resistance levels is in play but will constitute more of a countertrend bounce. Speculators are only neutral the dollar while, admittedly, leveraged funds are very short (Chart I-2). Historically, whenever the percentage of leveraged funds that are short the dollar has dipped near 40%, a meaningful rally has ensued. There are two important offsets to this. First, as Chart I-1 suggests, the dollar is a momentum currency. As such, during the bull market of the last decade, speculators were either neutral or long the dollar. If indeed the paradigm has shifted to a decade-long bear market, we expect speculators to be either short or neutral. Meanwhile, leveraged funds are a small subset of overall open interest, suggesting they are not the elephant in the room when it comes to dictating dollar movements. Leveraged funds were short the dollar during most of the bull market run last decade. Chart I-1The US Dollar Downtrend Is Intact Chart I-2Leveraged Funds Are Short The Dollar Carry trades are relapsing anew, suggesting the environment may be becoming unfavorable for high-yielding developed and emerging market currencies. The dollar has been negatively correlated with the Deutsche Bank carry ETF, DBV, since investors ultimately dump carry trades and fly to the safety of Treasurys on any market turbulence (Chart I-3). High-beta carry currencies such as the RUB, ZAR, MXN, and BRL have been consolidating recent gains. These currencies are usually good at sniffing out a change in the investment landscape, specifically one becoming precarious for carry trades. Our carry index tends to do well when the yield spread between US Treasuries and the indexes’ constituents’ is low. As such, there is some more adjustment underway, but one of limited amplitude (Chart I-4). Chart I-3The Carry Trade Rally Is Relapsing Chart I-4Carry Trades Have Hit An Air Pocket Chart I-5Currency Volatility Is Very Low Both expected and actual currency volatility are extremely depressed. Whenever currency volatility has been this low, the dollar has staged a meaningful rally. For example, the most significant episodes were the lows of 1996-1997, 2007-2008, and 2014-2015, and early 2020 (Chart I-5). Usually, low currency volatility is a sign of complacency, while higher volatility allows for a more balanced and healthy market rotation. The nature in which currency volatility adjusts higher this time around might be the same playbook as in previous episodes. The Asian crisis of the late 90s set the stage for the dollar bear market of the 2000s. The adjustment higher in the dollar during the Global Financial crisis jumpstarted the bull market the following decade. This time around, the Covid-19 crisis might have commenced a renewed dollar bear market. If this analogy is correct, then we should be selling the dollar on strength rather than buying on weakness. It is important to remember that the policy environment remains bearish for the dollar. These include deeply negative real rates, quantitative easing (which, admittedly, will soon end), generous liquidity swap lines to assuage any dollar funding pressures abroad (Chart I-6), and a global economy on the cusp of a renewed cycle. In our portfolio, we are long CHF/NZD since this cross has historically been a good hedge against rising currency volatility (Chart I-7). So is being short AUD/JPY. Being short the GBP/JPY cross might prove even more profitable, given that the UK has been a pandemic winner this year. Chart I-6The Fed Extended Its Swap Lines Chart I-7Buy CHF/NZD As Insurance Bottom Line: The message from our momentum indicators is that the bounce in the dollar was to be expected. We remain in the camp that believes the rally will be short-lived but are opportunistically playing what could be a more volatile environment. Equity Markets Signals A potential catalyst that could trigger further upside in the dollar is an equity market correction. Both the dollar and equities tend to be inversely correlated (Chart I-8). On this front, a few equity market indicators continue to flag that the rally in the dollar has a bit further to go.  Chart I-8The Dollar And Equities Move Opposite Ways Chart I-9Global Industrials Are Relapsing Anew The underperformance of cyclical stocks, especially global industrials, suggests equity markets could be entering a more volatile phase (Chart I-9). The dollar tends to strengthen when cyclical stocks are underperforming defensive ones. This is because non-US equity markets have a much higher concentration of cyclical stocks in their bourses. In more general terms, non-US markets are underperforming the US, a clear sign that the marginal dollar is rotating back towards the US (Chart I-10A and I-10B). Technology stocks have also been well bid in recent weeks, on the back of lower bond yields. These are all temporary headwinds for dollar weakness. Chart I-10ANon-US Stock Markets Are Underperforming Chart I-10BNon-US Stock Markets Are Underperforming Chart I-11US Relative Earnings Revisions Are High, But Rolling Over Earnings revisions continue to head higher across most markets, but US profit expectations are still higher compared to other countries (Chart I-11). Non-US bourses will need much higher earnings revisions to stimulate portfolio inflows, and for the dollar bear market to resume. On this front, both the euro area and emerging markets are showing only tentative improvement. The character of any selloff in equity markets will be worth monitoring. Cyclicals and value stocks are at historically bombed-out levels and could start to outperform high-flying stocks on any market reset.    Bottom Line: Whether a correction ensues, or the bull market continues, requires a change in equity market leadership from defensives to cyclicals. This is a necessary condition for the dollar bear market to resume. Commodities, Bonds, And The Dollar Commodity and bond prices give important cues about the health of the global economy. For example, rising copper prices and rising yields are a sign that industrial activity is humming, which in turn points to accelerating global growth. As a counter-cyclical currency, the dollar usually weakens in this scenario. Rising gold prices are generally a sign that policy settings remain ultra-accommodative, which also points to a weaker dollar. At the FX strategy service, we tend to focus more on the internal dynamics of commodity and bond markets, which can provide early warning signs. Chart I-12The Copper-To-Gold Ratio Is Consolidating Gains The copper-to-gold ratio is important since it indicates whether the liquidity-to-growth transmission mechanism is working. A rising ratio suggests policy settings are stimulating growth, while a falling ratio is a warning shot that the environment might be becoming deflationary. Correspondingly, this ratio has tended to track the dollar closely (Chart I-12). The copper-to-gold ratio is consolidating at very high levels. This is consistent with a healthy reset, rather than a reversal in the dollar bear market. The gold/silver ratio (GSR) tends to track the US dollar, and its recent price action also appears to be a welcome reset (Chart I-13). Like copper, silver benefits from rising industrial demand, especially in the electronics and renewable energy space. A falling GSR will be a sign that the manufacturing cycle is still humming. We are short the GSR with a target of 50, and a stop-loss at 71. The bond-to-gold ratio has bounced from very oversold levels. Both US Treasurys and gold are safe-haven assets and thus are competing assets. Remarkably, the ratio of the total return in US government bonds-to-gold prices has tracked the dollar pretty well since the end of the Bretton Woods system in the early ‘70s (Chart I-14). Gold has always been considered the perfect anti-fiat asset vis-à-vis the dollar, making the bond-to-gold ratio both a good short-term and long-term sentiment indicator. For now, the bounce in the ratio is not yet worrisome. We have noticed that inflows into US government bonds have risen sharply, while those into gold are falling. This should soon reverse with the fall in US rates, and the correction in gold prices. Chart I-13The Gold-To-Silver Ratio Is Consolidating Losses Chart I-14Competing Assets And The Dollar Bottom Line: The US is ultimately generating the most inflation in the G10, which is dampening real rates, and should curtail investor enthusiasm for gold relative to US Treasurys. The underperformance of Treasurys relative to gold will be a bearish development for the dollar. A Final Word On The Euro The strategic review from the European Central Bank had three key changes. The ECB now has a symmetric 2% inflation target. This is not a game changer, since it brings it in line with other global central banks, including the Bank of Japan. House prices will meaningfully begin to impact monetary policy, as the committee eventually includes owner’s equivalent rent (OER) in the HICP index (the ECB’s preferred inflation measure) for the euro area. This could be a game changer for the ECB’s price objective. Climate change was reiterated as important for price stability. Financial stability was also repeated as an important objective. As FX strategists, the second change was the most important. Shelter constitutes 17.7% of the euro area CPI basket, but it is 32.9% of the US CPI basket (Table I-1). Meanwhile, the shelter component of both the CPI basket in the US and euro area have tracked each other (Chart I-15). Table I-1Euro Area CPI Weights Chart I-15What Will Happen To Eurozone Inflation?   An adjustment in the weight of the shelter component in the euro area will boost the European CPI relative to the US and could trigger a major policy shift from the ECB in the coming years. This will especially be the in case if the current environment generates an inflationary shock. Bottom Line: The ECB will stay very accommodative in the next 1-2 years, but the change in its mandate could portend a bullish tailwind for the euro beyond the near term. Investment Implications We expect the current dollar rebound to be short-lived. As such, our strategy is as follows: Stay long other safe-haven currencies. Our preferred vehicle is the Japanese yen, which sports an attractive real rate relative to the US. Investors can also short GBP/JPY from current levels. Chart I-16The Euro, Yen And Real Rates Our limit-buy on EUR/USD was triggered at 1.18. Given our expectation that the dollar could rally in the near term, we are setting the stop-loss at the same level. However, the improvement in real rates in the euro area relative to the US could cushion any downside (Chart I-16). We are also long CHF/NZD, as a bet on rising currency volatility. Correspondingly, we are setting a limit buy on Scandinavian currencies relative to the euro and USD at a trigger level of -2%. Both gold and silver benefit from the current environment, but we prefer silver to gold, due to the former’s call option on continued improvement in global growth. We are short the gold/silver ratio from the 68 level. Overall, we expect the dollar to weaken towards the end of the year, as has been the case since the 1970s (Chart I-17). Chart I-17The Yen And Swiss Franc Are Usually Winners In H2   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies US Dollar USD Technicals 1 USD Technicals 2 The recent data out of the US have been robust: June non-farm payrolls showed an increase of 850K jobs, versus expectations of a 700K increase. The unemployment rate was relatively flat at 5.9% in June.  Factory orders came in at 1.7% year-on-year in May, in line with expectations. The US dollar DXY index is relatively flat this week, but with tremendous volatility. It was a relatively quiet week in the US, due to Independence Day, but the key theme remained a drop in US yields, with the 10-year yield moving from a high of near 1.8% this year to 1.3% currently. This move has catalyzed rallies in lower beta currencies, such as the yen and Swiss franc. The FOMC minutes released this week continue to suggest a Fed that will remain very patient in both tapering asset purchases and lifting interest rates.   Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro EUR Technicals 1 EUR Technicals 2 Recent data from the euro area were mixed: The PPI print for May came in at 9.6%, in line with expectations. Both the services and composite PMI were revised higher by 0.3 in June. At 59.2, the composite PMI is the highest in over a decade. ZEW expectations for the euro area fell sharply from 81.3 to 61.2. In Germany, there was a big decline in automotive surveys. The euro was flat this week against the dollar, despite gains overnight. The big news was the change in the ECB’s monetary policy objectives, which we discussed briefly in the front section of this report. The euro rallied on the news of three fundamental drivers in our view – real rate differentials are improving in favor of Europe, the ECB’s consideration for house price inflation could allow its price stability objective to be achieved sooner, and consideration for financial stability will be less favorable for negative interest rates.   Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021   The Yen JPY Technicals 1 JPY Technicals 2   Recent data from Japan remains subpar, but is improving: Labor cash earnings rose 1.9% in May, in line with expectations. Household spending rose 11.6% in May, in line with expectations. The Eco Watchers Survey for June came in at 47.6 from a May reading of 38.1. The outlook component rose from 47.6 to 52.4. The yen was up by 1.6% against the USD this week, the best performer. We argued a month ago that the yen is the most underappreciated G10 currency today. The catalyst that triggered yen gains were a drop in US real rates, that favored other safe-haven currencies. Going forward, further yen gains should materialize on the back of Japan successfully overcoming the pandemic like its Western counterparts. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021   British Pound GBP Technicals 1 GBP Technicals 2 There was scant data out of the UK this week: The construction PMI rose from 64.2 to 66.3 in June. House prices remain robust, with the RICS house price balance printing an elevated 83% in June. The pound was flat this week against the USD. The new delta variant of the COVID-19 virus is gaining momentum in the UK and will likely erode some of the dividends GBP had priced in from a fast vaccine rollout. As such, short GBP positions may pay off in the near term. Shorting GBP/CHF could be an attractive near-term hedge.   Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020   Australian Dollar AUD Technicals 1 AUD Technicals 2 There was scant data out of Australia this week: The Melbourne Institute of Inflation survey came it at 3% year on year in June, from 3.3%. The RBA kept interest rates unchanged at 0.1%, reiterating its commitment to stay accommodative until inflation and wages pick up meaningfully. The AUD was down by 0.4% this week against the USD. The RBA is decisively lagging other central banks in communicating less monetary accommodation in the coming years. This will create a coiled spring response for the AUD, because the RBA will have to eventually play catchup as the global economic cycle gains momentum.   Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021   New Zealand Dollar NZD Technicals 1 NZD Technicals 2 The was scant data out of New Zealand this week: ANZ commodity price index rose by 0.8% in June. The NZD was down 0.3% against the dollar this week. Our long CHF/NZD position paid off handsomely in this environment. We recommend holding onto this trade, as a reset in global rates hurts the hawkish pricing in the NZD forward curve. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020   Canadian Dollar CAD Technicals 1 CAD Technicals 2 Canadian data softened but remained robust: Building permits fell by 14.8% month on month in May. The Markit manufacturing PMI fell from 57 to 56.5 in June. The Canadian trade balance deteriorated from C$0.6bn to a deficit of -C$1.4bn in May. Business Outlook Survey indicator hit the highest level on record. As the Bank of Canada put it, improving business sentiment is broadening. The CAD fell by 0.8% against USD this week. The results of the BoC survey highlight that a reopening phase is categorically bullish for economic activity in general and financial prices. Until recently, the CAD was one of the best performing currencies in the G10. This is a sea change from a country that was previously a laggard in vaccination efforts. CAD should hold up well once the dollar rally fades, but other currency laggards such as SEK and JPY could do even better.   Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc CHF Technicals 1 CHF Technicals 2 The was scant data out of Switzerland this week: The unemployment rate was near unchanged at 3.1% in June, from 3.0%. Total sight deposits were unchanged at CHF 712 bn on the week of July 2. The Swiss franc was up by 1.1% this week against the USD. Falling yields improved the relative appeal of the franc that has bombed out interest rates. The franc is also benefiting from the rising bout of volatility as a safe-haven currency. On this basis, we are long CHF/NZD cross, which performed well this week. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020   Norwegian Krone NOK Technicals 1 NOK Technicals 2 Data out of Norway is improving: The unemployment rate fell from 3.3% to 2.9% in July. Industrial production growth came in at 2.1% year-on-year in May. Mainland GDP rose by 1.8% month on month in May. The NOK was down by 1.8% this week against the dollar, the worst performing G10 currency. The NOK is bearing the brunt of a reset in the US dollar, but our bias is that we are nearing a buy zone. NOK is cheap, would benefit from high oil prices and the economy is on the mend. We are looking to sell EUR/NOK and USD/NOK on further strength.   Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020   Swedish Krona SEK Technicals 1 SEK Technicals 2 Recent data from Sweden have been mildly positive: The Swedbank/Silf composite PMI fell from 70.2 to 66.9 in June. Industrial production came in at 24.4% year on year in May, after a rise of 26.4% in April. Household consumption jumped 8.8% year on year in April. The SEK was also up this week against the USD. Bombed-out interest rates in Sweden have also improved the appeal of the franc, given falling global bond yields. Meanwhile, the SEK remains one of the cheapest currencies in our models.   Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020   Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades