Euro Area
Highlights Persistent QE, ZIRP and NIRP have severely distorted the valuation relationship between equities and bonds on a global scale. Hence, the risk is that financial market distortions will infect the economy, not the other way round. A global mini-downturn in the first half of 2018 is now all but guaranteed. High conviction equity sector recommendation: underweight the major cyclical equity sectors: specifically, Banks, Materials and Energy; but overweight Airlines. High conviction currency recommendation: yen first; euro second; pound third; dollar fourth. Feature Stock markets ascend by walking up the stairs, but they descend by jumping out of the window. Unfortunately, investors often misinterpret the low volatility of a market ascent as a sign that equity risk has diminished. In fact, the low volatility just tells us that walking up the stairs is a slow and dull process (Chart I-2). It tells us nothing about equity risk. Chart of the WeekA Global Mini-Downturn In H1 2018 Is Now All But Guaranteed Chart I-2Stock Markets Climb Up The Stairs, And Then Jump Out Of The Window The risk of equities, as we have just seen, is that they do periodically jump out of the window. Meaning that equities have the potential to suffer much more intense short-term losses than short-term gains. This ratio of potential losses to potential gains is technically known as negative skew. For a reminder why equity returns have this unattractive asymmetry, please revisit our Special Report 'Negative Skew': A Ticking Time-Bomb.1 That said, equity returns always possess negative skew, so there is nothing new about stock markets jumping out of the window, as they have this week. Persistent QE, ZIRP And NIRP Have Created A Severe Financial Distortion The much bigger story is that persistent QE, ZIRP and NIRP2 have imparted negative skew on bond returns too. Central banks accept that there is a 'lower bound' for policy interest rates - perhaps slightly negative - below which there would be an exodus of bank deposits. The limit also marks the lower bound for bond yields. Approaching this lower bound for yields, bond prices have diminishing upside with increasing downside (Chart I-3). So at low bond yields, mathematics necessarily forces bond markets also to walk up the stairs and then jump out of the window (Chart I-4 and Chart I-5). Chart I-3Approaching The Lower Bound For Yields, Bond Prices ##br##Have Diminishing Upside With Increasing Downside Chart I-4In A Low Yield Era, Bond Markets ##br##Also Climb Up The Stairs... Chart I-5... And Then Jump Out ##br##Of The Window As the risk of owning 10-year bonds has increased to become 'equity-like', it has removed the requirement for an excess return, a risk premium, on equities. In other words, persistently ultra-accommodative monetary policy has diminished the prospective 10-year annual return on global equities to become 'bond-like', collapsing from 9% in 2012 to 1.5% today - exactly the same rate of return that is now offered by the global 10-year bond (Chart I-6). In effect, persistent QE, ZIRP and NIRP have severely distorted the valuation relationship between equities and bonds. Chart I-6Equities' Prospective Returns##br## Have Become 'Bond-Like' However, as we explained last week in Beware The Great Moderation 2.0,3 the nose-bleed valuation of the world stock market is justified only as long as bond yields stays low. Above a 2% yield, the payoffs offered by bonds gradually lose their negative skew and thereby become less risky than those offered by equities. So equities must once again compensate by offering an excess prospective return, necessitating a derating of today's elevated valuations. Specifically, we wrote that the big threat to equity valuations "comes from the global 10-year bond yield rising to 2% - broadly equivalent to the German 10-year bund yield rising to 1% or the U.S. 10-year T-bond yield rising to 3%." To which one client responded "markets do not respect round numbers... if the trigger-point is 3%, then you must act well before that." Wise words indeed. The U.S. 10-year T-bond yield got as far as 2.88% before triggering a reversal in equity valuations. Financial Distortions Threaten The Real Economy Chart I-7Financial Conditions 'Easiness' Is Just ##br##Tracking The Stock Market Many people naturally assume that the economy drives the financial markets. This may be true some of the time, or even most of the time. But in the last three downturns, the causality ran the other way round - financial market distortions dragged down the economy. The bursting of the dot com bubble triggered the downturn in 2001; the large-scale mispricing of U.S. mortgages caused the Great Recession in 2008; and the explosive widening of euro area sovereign credit spreads resulted in the euro area recession in 2011. Which begs the question: is there a financial distortion or mispricing that could once again drag down the economy? The answer is an emphatic yes. To repeat, six years of persistent QE, ZIRP and NIRP have severely distorted the valuation relationship between equities and bonds on a global scale, compressing the prospective 10-year annual return on world equities from 9% to 1.5%.4 Thereby, equity returns which would have accrued in the future have been brought forward to the here and now in the form of elevated capital values. But if higher bond yields correct the severely distorted valuation relationship between equities and bonds, the effect will be to move these returns from the present back to the future, depressing capital values today. Now note that while world GDP is worth around $80 trillion, the combination of equities and correlated risk-assets such as corporate and EM debt is worth double that, around $160 trillion, and real estate is worth $220 trillion. If returns from these richly valued asset-classes are redistributed from the present back to the future, through lower capital values today, there is a very real risk that current spending could take a hit. Supporting this broad thesis, central bank measures of 'financial conditions easiness' just track tick for tick the level of the stock market (Chart I-7). What To Do Now The upturn in bond yields which started last summer threatens to impact activity through two separate channels. As just discussed, the first is the financial market channel via a setback to global risk-asset capital values. The second is the bank credit channel. Changes in the bond yield very clearly and reliably lead changes in credit flows, the credit impulse, by 6 months. Therefore, the rise in bond yields is only now starting to pull down the credit impulse - and thereby the global activity mini-cycle, which is the all-important driver of mainstream European investments. It follows that a global mini-downturn in the first half of 2018 is now all but guaranteed (Chart of the Week). And that the higher that bond yields go from here, the more marked this mini-downturn will be. This reinforces two high conviction investment recommendations. First, it is now appropriate to underweight cyclical equity sectors: specifically, Banks, Materials and Energy. Against this, the one cyclical sector to upgrade to overweight is Airlines, given the sector's negative correlation with the oil price. Second, the payoff profile for exchange rates is just tracking expected long-term interest rate differentials (Chart I-8). This means that when the expected interest rate is close to the lower bound, the currency possesses a highly attractive payoff profile called positive skew. In essence, for any central bank already at the realistic limit of ultra-loose policy - such as the BoJ and ECB - the direction of policy rate expectations cannot go significantly lower. Conversely, tightening expectations for the Federal Reserve are approaching a magnitude that threatens either risk-asset prices and/or economic growth. So these expectations cannot go significantly higher (Chart I-9). Chart I-8Exchange Rates Are Tracking Long-Term ##br## Interest Rate Differentials Chart I-9Expected Interest Rates In The Euro Area And ##br##U.S. Will Converge One Way Or The Other On this basis, we reiterate our high conviction pecking order for currencies in 2018. Yen first; euro second; pound third; dollar fourth. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report 'Negative Skew: A Ticking Time-Bomb', July 27 2017 available at eis.bcaresearch.com. 2 Quantitative Easing, Zero Interest Rate Policy and Negative Interest Rate Policy. 3 Please see the European Investment Strategy Weekly Report, 'Beware The Great Moderation 2.0', February 1 2018 available at eis.bcaresearch.com. 4 This 1.5% forecast comes from regressing the world equity market to GDP multiple through 1998-2008 with subsequent 10-year returns, observing a very tight relationship, and then using the same relationship on current world equity market cap to GDP. Fractal Trading Model* This week's recommended trade is to go long utilities versus the market. The profit target is 3.5% outperformance with a symmetrical stop-loss. It was an excellent week for our other trades with short palladium hitting its 6% profit target, while underweight Japanese energy and long USD/ZAR are both in comfortable profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights The dollar seems to have entered a cyclical bear market, which suggests that EUR/USD is in a multi-year bull market. While the euro performs well in the late stages of the business cycle, it has moved ahead of long-term fundamentals. A correction is growing increasingly likely. The euro's rally has been a reflection of hope that the ECB will tighten policy in excess of the Fed's in the coming years. This leaves the euro vulnerable to short-term disappointments on both the inflation front and the global growth front. The trade-weighted pound has downside from current levels as the BoE will be handcuffed by a fall in inflation, courtesy of a diminishing pass-through. Feature Two weeks ago, we explored the confluence of forces facing the euro. We concluded that in all likelihood, the euro had embarked on a new cyclical bull market that could push EUR/USD well above 1.30 over the course of the coming few years. We also highlighted some tactical risks that were present for the euro.1 This week, we delve into how the cyclically positive outlook for the euro is interacting with the more cautious, short-term view, especially in the wake of the U.S. dollar's recent wave of weakness that has pushed the euro above 1.25. The probability of a correction has grown only further. This could represent a shorting opportunity for tactical players, as well as an occasion to deploy more funds into the euro for agents with a longer investment horizon. It's A Bull Market, But... The body of evidence is growing that the U.S. dollar has entered a bear market, which would support the view that the dollar's antithesis - the euro - has entered a bull market. To begin with, my colleague Harvinder Kalirai, who runs BCA's Daily Insights service, has noted that the dollar has been following an interesting pattern since the end of the Bretton Woods era: It tends to depreciate for roughly 10 years, and then rally for five to six years (Chart I-1). Admittedly, there is a small set of bull and bear markets here, but this begs the question: Was the 2011-2016 bull market the heyday for the dollar this decade? Chart I-1USD: Times Up? To answer this question, it helps to understand where we stand in the current business cycle. BCA believes that while a U.S. recession is not imminent, we are nonetheless entering the last two innings of this cycle. Interestingly, as Chart I-2 illustrates, the euro tends to appreciate during the last two years of U.S. economic upswings. This is because historically, European growth begins to outperform U.S. growth in the late stages of the economic cycle. This observation resonates with today's environment. Chart I-2The Euro Rallies Late In The Business Cycle There is a glaring exception to this phenomenon: the period from 1999 to 2000. However, we view this particular interval as rather exceptional. First, the euro had just entered into force, and was still untested. Second, the U.S. basic balance was in a large surplus as M&A waves and the tech bubble were sucking in capital from all over the world. Third, the U.S. was experiencing the apex of its peace dividend, resulting in fiscal surpluses that gave comfort to investors. Beyond the ebullience of U.S. tech stocks, the parallels with this era are limited. The tendency for the European economy to boom late into the cycle also has implications for monetary dynamics. We, as most commenters, have been puzzled by the euro's divorce from interest rate differentials, especially at the short end of the curve. Even indicators that historically have been extremely reliable such as the spread between the European and U.S. 1-year/1-year forward risk-free rate have lost their explanatory power. However, late into the cycle, the European economic boom tends to lift expectations of future European Central Bank policy tightening faster than these same expectations in the U.S. As a result, the European yield curve steepens in contrasts to that of the U.S. We built a simple three-factor model to capture these dynamics. These factors are: real 2-year yield differentials between the euro area and the U.S., to grab the effect of current policy; the euro area minus the U.S. 10/2-year yield curve slope, to incorporate changes in perception of how fast the ECB will hike in coming years compared to the Federal Reserve; and the price of copper relative to lumber, to capture how U.S. growth dynamics - as represented by the price of lumber - are evolving relative to the rest of the world, as represented by the price of copper. Chart I-3 shows the model's results. Over the long run, this model explains nearly 70% of EUR/USD's variations, and most importantly, the significance of the three factors is stable over various samples. Three points are worth noting: Chart I-3A 3-Factor Model To Explain The Euro First, the euro was very undervalued from 2015 to 2017. It was not as cheap as in 1985 or 2000, but the narrative behind the dollar's strength this cycle was the perception that the USD was the "cleanest dirty shirt." This is not the same optimism as what prevailed during former U.S. President Ronald Reagan's Imperial Cycle of the 1980s, or the New Economy boom / unipolar moment for the U.S. in the late 1990s. Second, the euro's fair value has stopped falling as global growth has caught up to the U.S., and as the European yield curve has steepened relative to the U.S. thanks to the reappraisal by investors of the future path of the ECB's terminal policy rate this cycle. Third, the euro is now trading at an 8% premium to its fair value. This last point raises the question of a euro correction. Are we seeing conditions fall into place for the euro to experience a pullback toward its fair value of roughly 1.15? A move to this level would bring the euro straight back into its 38-50% retracement levels, based on the low recorded in late 2016. Bottom Line: It appears as if the dollar has begun a cyclical bear market. As a corollary, this implies that the euro has begun a cyclical bull market that could last many years. The main reason relates to where we stand in the current business cycle: An ageing business cycle is associated with a stronger euro - a result of the euro area's economic outperformance toward the end of the cycle. Despite this positive, it would seem the euro has overshot fundamentals factors that try to capture these dynamics. ... The Correction Is Nigh Conditions are still too precarious to call for a correction in the euro, but some facts need to be kept in mind as they highlight growing short-term risk. Dollar Dynamics From a technical perspective, the dollar is much oversold. Last week we illustrated how our Capitulation Index was inching closer to a buy signal. The "buying" threshold was hit this week. Confirming this message, the Dollar's RSI and 13-week rate of change are also at levels consistent with a dollar rebound (Chart I-4). To be sure, many FX investors have become enthralled by the "twin deficit" narrative. Since 2011, when worries about a growing combined fiscal and current account deficit spike, this tends to represent dollar buying opportunities for the next three to six months (Chart I-5). Chart I-4Oversold Dollar Chart I-5Because The Narrative Is Scary Blood In The Street? When it comes to the twin deficit narrative, at this point it is a very nice-sounding story, but it still lacks substance. For one, while a growing U.S. economy tends to be associated with a growing current account deficit, the U.S. is increasingly morphing from an oil importer to an oil exporter. As Chart I-6 illustrates, net oil imports for the U.S. have collapsed from 13.5 million bbl/day in 2005 to 3.8 million today, as oil production recently hit a 47-year high. Matt Conlan, who runs BCA's Energy Sector Strategy service, anticipates that within the next two to three years the U.S could even become a net exporter of oil. Thus, the expansion of the current account deficit is not baked in the cake. The fiscal deficit may also not widen as much as many fears over the next year or two. As Chart I-7 illustrates, the gyrations in the U.S. 30-year swap spread have been linked to fluctuations in the velocity of money in the U.S. As banks faced the imposition of higher capital ratios, Dodd-Frank, rising supplementary leverage ratios, and so on, they decreased their participation in the swap market. As the supply of funds fell in that market, swap spreads collapsed, punishing the receivers of the 30-year swap rate. But recently, with the growing likelihood that the supplementary leverage ratio rules will be softened, banks are coming back to the market, and the swap spread is rising again. Banks are also easing their credit standards on most things from C&I loans to mortgages. This suggests credit growth could pick up further, lifting money velocity. Chart I-6A Support For The U.S. Current Account Chart I-7Money Velocity To Pick Up Why does this matter? Simply put, the rise in velocity portends to an acceleration in nominal GDP growth. Rising nominal expansion is historically associated with narrowing budget deficits. This cycle is a prime example. The main reason why the U.S. deficit fell from 8% of GDP to 3.5% of GDP this cycle is because activity recovered, which lifted government revenues and narrowed the deficit. To be clear, we do not want to sound overly sanguine. The chickens will come home to roost. If the budget deficit does not blow out as much as many fear over the next two years, it will catch up to these dire expectations once GDP growth slows. Euro Dynamics In a mirror image to the DXY, the euro's 13-week week rate of change and RSI oscillator are also flagging overbought conditions. But more interesting developments are happening that highlight the elevated correction risk for the euro. As Chart I-8 shows, the correlations between EUR/USD and the relative euro area/U.S. yield curve slope as well as the real interest rate gap tends to swing widely over time. Most interestingly, when the euro correlates closely with the relative yield curve slope and ignores real rate differentials, this tends to be followed by a reversal of the previously prevailing trend in the euro. This seems to tell us that when investors are more focused on the potential for an adjustment in relative policy between the euro area and the U.S. instead of current real rate differentials, they expose themselves to surprises - surprises that cause the trend to change. Today, the euro correlates massively with anticipated policy changes - not the current situation - highlighting the risk of a correction if anything dashes hopes of higher European rates in future. Chart I-8Euro: Future Versus Present In terms of potential culprits, inflation expectations rise to the top of the list. Since mid-2016, when euro area CPI swaps began to weaken relative to the U.S., this has typically been followed by a correction in EUR/USD (Chart I-9). Simply put, sagging relative inflation expectations prompt investors to question whether or not they should continue to anticipate a tightening by the ECB relative to the Fed in the years ahead. Additionally, EUR/USD has historically traded as a function of global export growth, reflecting the euro area's greater leverage to global trade than the U.S.'s. However, as Chart I-10 highlights, the euro has overshot the mark implied by global trade growth. Chart I-9Inflation Expectations Point To A Correction Chart I-10Euro Is Stronger Than Global Trade Warrants In of itself, this is a weak signal. After all, the decoupling can be solved by a rebound in global trade. However, the decline in manufacturing production evident across EM Asia suggests this will not be the case, as global trade is dominated by shipments of manufacturing goods (Chart I-11). If these waves were to affect Europe, it could spur a period where investors begin questioning the path for the ECB's policy rate. Some European indicators already highlight this risk. Sweden's economy is very sensitive to global trade growth, as exports represent nearly 50% of Sweden's economy. Moreover, Sweden exports a lot of intermediary goods to Europe. This place within the European supply chain suggests that if any weakness in global trade emerges, it is likely to be felt in Sweden before it is felt in the rest of Europe. Today, while European PMIs are still near record highs, Swedish Manufacturing PMI have been falling significantly after hitting 65 last year (Chart I-12, top panel). This suggests the first ripples of the manufacturing slowdown in Asia are hitting Europe's shores. Chart I-11A Headwind For Global Trade Chart I-12The Slowdown Will Come To Europe In the same vein, Switzerland is a large exporter of machinery and chemicals. Its exports are therefore also sensitive to the global manufacturing cycle. Swiss export orders have been nosediving in recent months, which has historically pointed to periods of vulnerability for EUR/USD (Chart I-12, bottom panel). Finally, as Chart I-13 shows, for the past year, rises in the FX market's implied volatility have been followed by periods of weaknesses in EUR/USD. This also suggests that at the very least, the euro will need to digest its recent strength for another while before rallying anew. At worst, a correction could emerge in the first quarter of 2018. Meanwhile, Chart I-14 illustrates that EUR/JPY could also suffer downside in the wake of a rise in currency implied volatility. We were stopped out of this trade for now, but it remains a high conviction all for the first half of 2018. Chart I-13Higher FX Vol: A Risk For EUR/USD... Chart I-14...And EUR/JPY Bottom Line: The time is nigh for a euro correction to begin. From the dollar's perspective, not only is it oversold, but stories of a 'twin deficit" tend to be associated with selling pressures hitting their paroxysm, at least on a three- to six-month basis. Meanwhile, the euro is not only overbought but is also trading in line with hopes for a rise in policy rates vis-à-vis the U.S. while ignoring the current situation in terms of real rate differentials - a situation that historically has only lasted so long without a reversal, even if temporary. Moreover, European inflation expectations are weakening and Asia's manufacturing cycle is slowing, heightening the risk that investors temporarily curtail their hopes for the ECB and move back to focusing on current real rate spreads. A Few Words On The Pound The Bank Of England is meeting next week. BoE Governor Mark Carney made some hawkish noise this week, highlighting that the impact of the Brexit shock is passing, and that the BoE can narrow its focus on inflation dynamics. This of course begs the question of what the outlook is for inflation dynamics. As Chart I-15 illustrates, inflation across a broad swath of components is likely to slow sharply in the coming months as the trade-weighted pound has stopped depreciating as sharply as it did in 2016. Thus, the pass-through from a lower exchange rate is beginning to dissipate. Moreover, in terms of growth, Brexit risk may have receded, but the British economy continues to face important hurdles. For one, real consumption, which constitutes 63% of the British economy, could decelerate further (Chart I-16). Real disposable income growth is negative and household confidence is declining. Additionally, the savings rate has no downside left, especially as household credit growth is beginning to weaken. The weakness in house prices, especially in London, will not dissipate anytime soon, as the RICS survey is still displays poor showings. Chart I-15U.K.: Less Pass-Through Chart I-16The British Consumer Is Feeling The Pinch On the capex front, the picture is not much brighter. Strength in the global economy along with weakness in the pound have lifted export growth. However, corporate investments have failed to follow. In fact, private credit growth is flagging anew (Chart I-17). The market is currently pricing in 36 basis points of interest rate hikes in the U.K. for 2018, with the first one anticipated in September. Rob Robis, our Chief Global Fixed Income Strategist, does not believe the current economic situation will let the BoE actually follow this lead. Carney's recent emphasis on inflation may actually turn out to be a double-edged sword: If today's inflationary strength justifies higher rate, tomorrow's anticipated weakness will not. Thus, a potentially hawkish BoE next week will probably have to be faded, not heeded. In terms of currency markets, the trade-weighted pound is testing the upper bound of its post-Brexit trading range (Chart I-18). The economics currently at play in the U.K. make it unlikely that it will be able to punch above this line yet, especially as the U.K.'s basic balance is once again dipping as FDI is drying out. Chart I-17Private Credit Growth Is Slowing Chart I-18GBP: Stuck In A Rut Bottom Line: British inflation is set to slow, and the economy remains on a weak footing. The BoE will find it difficult to tighten policy much this year. With the trade-weighted pound at the top end of its post-Brexit range, a correction is likely over the coming weeks. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "The Unstoppable Euro?" dated January 19, 2018 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data has been decent: Initial jobless claims declined to 230,000, while continuing jobless claims increased to 1.953 million; ISM Manufacturing index beat expectations of 58.8, coming in at 59.1; ISM Prices paid also beat expectations at 72.7; However, the employment subcomponent decelerated sharply; Chicago PMI beat expectations of 64.1, coming in at 65.7; While the Fed stayed pat in this week's FOMC monetary policy meeting, there is a 99% probability currently being priced in that New Chairman Powell will begin his leadership with a hike. This is in line with our own expectations. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed this week: Consumer confidence, service sentiment, business climate and overall economic sentiment all failed to meet expectations; 2017 Q4 GDP grew at a 2.6% annual pace, implying that the euro area's growth in 2017 once again beat that of the U.S.; German headline inflation came in at 1.4%, less than the expected 1.6%; German unemployment rate decreased to 5.4%, beating expectations; Overall European inflation (headline and core) both outperformed consensus at 1.3% and 1% respectively. However, PMIs remain strong. The overall sentiment on the euro remains very bullish. We are likely seeing the beginning of a protracted cycle of appreciation in the euro as markets align the ascent of the currency with its growth prospects. However, the relationship against the greenback may be blurred as the Fed is hiking faster than the ECB. Report Links: From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Unstoppable Euro? - January 19, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The jobs/applicant ratio outperformed expectations, coming in at 1.59. This measure is now at 44 year-highs. Moreover, retail trade yearly growth outperformed expectations, coming in at 3.6%. It also increased from 2.1% the previous month. However, consumer confidence underperformed expectations, coming in at 44.7. Additionally, the unemployment rate also surprised negatively, coming in at 2.8%. It also increased from 2.7% the previous month. After falling precipitously last week, USD/JPY has been flat this week as Japanese policy makers increase purchases and talked down the yen. In the coming 3 months, we expect EUR/JPY to have significant downside, as financial conditions have tighten significantly in Europe relative to Japan. Moreover, rising volatility, particularly from such depressed levels will also weigh on this cross. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Net lending to individuals monthly growth outperformed expectations, coming in at 5.2 billion pounds. This measure also increased from last month's 4.9 billion pound reading. Moreover, nationwide house price yearly growth also surprised to the upside, coming in at 3.2%. This measure also increased from 2.6% last month. However, mortgage approvals underperformed expectations, coming in at 61 thousand. Finally, manufacturing PMI underperformed expectations, coming in at 55.3. GBP/USD has rallied by roughly 0.6% this week. Overall, we expect the ability of the BoE to hike more than once this year to be limited, given that the sharp appreciation that the pound has experienced in recent months should weigh on inflation. This means that cable is unlikely to have much upside from here on. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data this week surprised to the downside: NAB Business Confidence and Conditions came in lower than expected at 11 and 13 respectively; Headline CPI disappointed at 1.9% yoy, while the trimmed mean CPI also failed to perform as expected, coming in at 1.8%; Building permits contracted heavily in monthly terms at 20%, even contracting in yearly terms at a 5.5% rate; The RBA Commodity Index in SDR terms contracted by 0.6%, which was still better than the expected 8.9% contraction; These data support our view that substantial slack remains in the Australian economy. The RBA will need to consider the lackluster inflation figures at their next meeting, and are likely to maintain an easy policy setting this year. Report Links: From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: The trade balance outperformed expectations, coming in at -2.840 billion. It also increased from -3.480 billion the previous month. Moreover, exports for December came in at 5.5 billion, increasing from the November reading of 4.61 billion. NZD/USD appreciated by 1.2% this week. Overall the kiwi has upside against the Australian dollar, given that a negative fiscal impulse and decreased investment will likely weigh on Australia's economic outlook. Moreover the NZD would be less sensitive than the AUD to a potential slowdown in Chinese industrial activity caused by the PBoC tightening. These factors will likely weigh on AUD/NZD. That being said, if a Chinese slowdown does occur, NZD/JPY could have significant downside. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was decent: GDP grew at a 0.4% monthly rate, in line with expectations; Raw material prices, however, contracted by 0.9%; Markit Manufacturing PMI increased to 55.9 from 54.7, beating expectations of 54.8; The Canadian economy is still booming alongside a stellar labor market. Higher oil prices and higher wages will add to inflationary pressures this year, prompting the BoC to tighten in line with expectations. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: The trade balance underperformed expectations, coming in at 2.6 billion. However it increased from the previous month reading. The KOF indicator also underperformed expectations, coming in at 106.9 However the SVME PMI outperformed expectations, coming in at 65.3 EUR/CHF has depreciated by about 0.75% this week, as risk-on assets have lost ground due to the perception that a correction in the markets might be overdue. Overall, while Swiss inflation is on the rise, it is not yet high enough to cause the SNB to abandon its current dovish tilt. Thus, unless global markets weaken meaningfully, downside to EUR/CHF will likely be limited. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Retail sales growth surprised to the downside, coming in at -1%. This measure also declined from 2.1% on the previous month. However, Norway's credit indicator outperformed expectations, coming in at 6.3%. USD/NOK has fallen by roughly 0.8% this week, as the fall in the dollar continues to weigh on this cross. Overall, we expect the krone to have upside against the Canadian dollar, as the market is pricing 3 rate hikes in the next 12 months for the BoC, while only pricing 27 basis points for the Norges Bank. While it is true, that the recovery is much more advanced in Canada than in Norway, given the surge in oil prices, the gap in rate expectations should narrow. This will weigh on CAD/NOK. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish Manufacturing PMI surprised to the downside, coming in at 57 compared to the expected 60. Manufacturing PMI in Sweden has been declining since April last year. However, inflation has been in line with the target thanks to higher energy prices and the weakness of the cheapness of the SEK. This year, the Riksbank also seems to be slowly moving away from its dovish stance. This has allowed the SEK to recoup some of its 2017 losses against the euro. We may see a stronger SEK this year as the Riksbank is likely to turn hawkish quicker than the ECB. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Watch Inflation Expectations How much longer can this go on? Global equities were up 6% in January alone (the 15th consecutive month of positive returns), and investors are increasingly asking how much further this bull market has to run. There are no signs we can see that suggest it will end imminently. Our watch-list of key recession indicators (decline in global PMIs, inverted yield curve, rise in credit spreads - Chart 1) is sending no warning signals. U.S. GDP growth was a little weaker than expected in Q4, at 2.6% QoQ annualized, but this was mainly due to inventories and strong imports: final private demand, a better guide to future growth, was strong at 4.3%. Fed NowCasts for Q1 growth point to 3.1-4.2%. The euro zone grew even faster than the U.S. last year, and even Japan probably saw 1.8% GDP growth. Corporate earnings expectations have accelerated sharply over just the past few weeks - particularly in the U.S. as a result of the tax cuts (Chart 2) - with analysts now expecting 16% EPS growth for the S&P 500 this year. BCA U.S. Equity Strategy service's earnings models suggest that this forecast may still be too cautious (Chart 3). Recommended Allocation Chart 1No Recession Signals Flashing Chart 2A Dramatic Rise In Earnings Forecasts... Chart 3...But Forecasts May Still Be Too Cautious While it is true that equity valuations are stretched, particularly in the U.S. (with BCA's Composite Valuation Index having just tipped into the "Extremely Overvalued" zone - Chart 4), valuations are not usually a good timing tool. Investor euphoria seems not yet to have reached the extremes that usually characterize a bull-market peak. The message we hear consistently from wealth managers is that their clients who missed last year's rally are now looking to get into risk assets. The American Association of Individual Investors' latest weekly survey shows 45% bulls to 24% bears - not especially optimistic by past standards (Chart 5). Flows into equity funds have started to accelerate, but have been weaker than bond flows over the past year (Chart 6). Chart 4U.S. Equities Now 'Extremely Overvalued' Chart 5Investors Are Not Particularly Bullish Chart 6Flows Into Equities Starting To Accelerate Chart 7Key: Inflation Expectations Getting to 2.5% We think the key to timing the top lies in inflation expectations. With the U.S. economy at full capacity and unemployment at 4.1%, well below the NAIRU of 4.6%, the Fed believes that a pick-up in inflation is just a matter of time - an analysis we agree with. The market has started to come round to this view too, with implied inflation rising by about 40 BPs over the past two months (Chart 7). The market has now priced in a 65% probability of the Fed's projected three rate hikes this year, and even a 27% probability of four. Inflation expectations hitting 2.5% (which would be compatible with the Fed's 2% PCE inflation target - CPI inflation is typically 50 BPs higher) could be the tipping-point. This is because it would remove the Fed put - with inflation expectations elevated, the Fed would no longer be able to back off from tightening in the event of a global risk-off event such as a stock-market correction or a slowdown in China. Such a rise in inflation expectations would also push the 10-year U.S. Treasury yield above 3%, which would increase the attraction of fixed income, and represent a threat to highly indebted borrowers, especially in emerging markets. This is how bull markets typically end: with the Fed having to raise rates to choke off inflation, and either making a policy mistake or tightening monetary policy enough to slow growth. But all this is probably quite a few months away. We expect to turn more defensive perhaps late this year, ahead of a recession that we have for some time now penciled in for the second half of 2019. Given how advanced the cycle is, conservative investors primarily concerned with capital preservation might look to dial down risk or hedge exposure now. But investors focused on quarterly performance should ride the bull market until some of the warning signals mentioned above begin to flash. For now, therefore, we continue to recommend an overweight in equities relative to bonds on the 12-month investment horizon, and mostly pro-risk and pro-cyclical tilts. Equities: We continue to prefer developed over emerging equities. EM will be hurt by the slowdown likely in China (where money supply and credit growth have fallen in response to the authorities' tighter policies - Chart 8), rising U.S. interest rates, sluggish productivity growth, and valuations that are no longer particularly cheap (Chart 9). Within DM, we are overweight euro zone and Japanese equities, which should benefit from their higher beta, more cyclical earnings, still accommodative monetary policy, and cheaper valuations than the U.S. Our sector bets are tilted to late-cycle value sectors such as financials, industrials and energy. Chart 8Tighter Monetary Conditions in China Chart 9EM No Longer Cheap Fixed Income: Rising inflation expectations should push the 10-year U.S. Treasury bond yield up to 3% this year, with German Bunds rising by a similar amount. We recommend an underweight on duration, and a preference for inflation-linked over nominal bonds, in these markets. In the U.K. and Australia, however, central banks are unlikely to tighten as quickly as futures markets have priced in and so we prefer their government bonds. While the expansion continues, spread product should continue to outperform in the fixed-income bucket. The default-adjusted spread on U.S. high-yield bonds remains over 200 BP and, though we see little further spread contraction, carry alone makes this attractive. Currencies: BCA was correct last year to predict a widening of interest-rate differentials between the U.S. and the euro zone, but wrong to conclude that this would lead to a stronger dollar (Chart 10). The drivers of currencies can undergo regime shifts, and it seems now that valuation (both the euro and yen are cheap compared to their purchasing power parity, 1.32 and 99 to the U.S. dollar respectively), current account surpluses (3.3% for the euro zone and 3.7% for Japan), and other factors have become more important. Tactically, the euro, in particular, looks very overbought. Speculative investors are very long euros, the ECB is likely to remain dovish relative to the Fed, and the strong euro could put some downward pressure on growth in the short-term. However, if the dollar were to rebound by 5% or so we would be likely to end our dollar bull call. Chart 10Rate Differentials No Longer Moving Currencies Chart 11Oil Supply To Increase In 2019 Commodities: Oil prices have risen on the back of strong global demand, OPEC discipline, and a lag in the response of U.S. shale oil producers. We forecast an average of $67 a barrel for Brent crude this year, with spikes to as high as $80 in the event of disruptions in producer countries such as Venezuela. However, with one-year forward crude prices around $62, shale producers (whose marginal costs average about $52 a barrel) are likely to pick up production soon. OPEC, too, should be happy with crude around $50-60. Our energy team forecasts a pick-up in supply next year (Chart 11), which should bring the crude price down to an average of $55 in 2019. Industrial commodities are a product of Chinese demand, global growth, and the U.S. dollar. These drivers look likely to be mixed over the coming months and so we remain neutral. Gold has risen, in the face of rising interest rates, because of the weak dollar - it remains an excellent hedge against inflation, recession, and geopolitical risks and so should be a modest part of any balanced portfolio. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com GAA Asset Allocation
Highlights The German 10-year bund yield rising to 1%, or the U.S. 10-year T-bond yield rising to 3% would be a trigger to downgrade equities and upgrade bonds... ...especially as the blue sky expectations for global growth in H1 2018 will turn out to be overly-optimistic. On a 6-9 month horizon, upgrade Airlines to overweight. Downgrade Banks to underweight. Upgrade Germany (DAX) to neutral. Downgrade Italy (MIB) and Spain (IBEX) to underweight. Feature Where has the equity market cycle gone? Since 2012, the stock market's 6-month returns have generated an unprecedented consistency, with only a brief breakdown - at the end of 2015 - into negative territory (Chart of the Wesk and Chart I-2). Chart of the WeekSince 2012, The Equity Market ##br##Cycle Has Disappeared Chart I-2Much Less Cyclicality In Equities ##br##Than In Commodities The disappearance of the equity market cycle brings to mind the concept of the "Great Moderation", a term coined in 2002 to describe the big drop in business cycle volatility during the 1990s. In 2004, Ben Bernanke suggested that "improvements in monetary policy, though certainly not the only factor, probably were an important source of the Great Moderation." Today's Great Moderation 2.0 refers to the equity market cycle - or rather, its disappearance. And in finding a reason for the Great Moderation 2.0, Bernanke's attribution to monetary policy might be right on the money. Stick With TINA, Or Flirt With TIA? For many years, ultra-accommodative monetary policy has provided a consistent and substantial uplift to world stock market valuations. Since 2012, our preferred measure of equity market valuation - world stock market capitalisation to GDP - has almost doubled. This inexorable and relatively trouble-free rise has even spawned its own acronym: TINA - There Is No Alternative (to owning equities.) However, the uplift to stock market valuations has happened in a less obvious way than you might realise. Based on the excellent predictive power of stock market capitalisation to GDP, the prospective 10-year annualised return from world equities has collapsed from 9% in 2012 to 1.5% now (Chart I-3). Over the same period, the global 10-year bond yield has compressed from 3% to 1.5%. Hence, the collapse in prospective equity returns is not due to the decline in bond yields per se. It has happened mostly because the excess return offered by equities over bonds - the so-called 'equity risk premium' has compressed from 6% to zero (Chart I-4). Chart I-3World Equity Market Cap To GDP Implies##br## A Feeble Prospective 10-Year Return Chart I-4Prospective Equity Returns ##br##Have Become 'Bond Like' Ultra-accommodative monetary policy has caused the disappearance of the equity risk premium. The simple reason is that at low bond yields, the risk of owning bonds becomes similar to the risk of owning equities. Chart I-5Below A 2% Yield, 10-Year Bonds Have ##br##More Negative Skew Than Equities When bond yields approach their lower bound, bond prices have little upside but they have a lot of downside. This ratio of an investment's potential losses relative to its potential gains is the risk that most frightens investors,1 and is known as negative skew. At yields below 2%, bond returns become as negatively skewed as equity returns, or even more negatively skewed than equities (Chart I-5). As the risk of bonds increases to become 'equity-like', the prospective return from equities must compress to become 'bond-like'. Which is to say, equity valuations become substantially richer. All well and good - so long as the global 10-year bond yield stays low. Above a 2% yield, the negative skew on bond returns disappears, and equities once again require an excess prospective return over bonds. More colloquially, investors would dump TINA and start flirting with TIA (There Is an Alternative). In essence, a big threat to the Great Moderation 2.0 comes the global 10-year bond yield rising to 2% - broadly equivalent to the German 10-year bund yield rising to 1%, or the U.S. 10-year T-bond yield rising to 3%. Any moves towards these thresholds would be a trigger to downgrade equities and upgrade bonds - especially as we now explain why the blue sky expectations for global growth in H1 2018 will turn out to be overly-optimistic. The Equity Sector Cycle Is Alive And Well For the stock market in aggregate, the cycle has been moribund. But for equity sector relative performance, the cycle is very much alive and well. In The Cobweb Theory And Market Cycles 2 we showed and explained the existence of mini-cycles in economic and financial variables. To summarise, a lag between the demand for credit and its supply necessarily creates mini-cycles in both the price of credit (the bond yield) and the quantity of credit (the global credit impulse). Thereby it also creates mini-cycles in GDP growth. The useful point is that these cycles are very regular with half-cycles averaging 6-8 months. Which makes their turning points and phases predictable. Given that the global credit impulse cycle has been in a mini-upswing phase since last May, it is highly likely to turn into a mini-downswing phase through the first half of 2018. The latest data point, showing a tick down, seems to corroborate such a turning point. From an equity sector perspective, Banks versus Healthcare has closely tracked the phases of the credit impulse mini-cycle (Chart I-6). In all five of the last five mini-downswings, Banks have underperformed Healthcare, and we would expect no difference in the next mini-downswing. Hence, on a 6-9 month horizon, downgrade Banks to underweight. Unsurprisingly, exactly the same pattern applies to Basic Materials (and Energy) versus Healthcare (Chart I-7). Hence, on a 6-9 month horizon, stay underweight Basic Materials and Energy versus Healthcare. Also unsurprisingly, the performance of European Airlines is a mirror-image of the oil price cycle, given that aviation fuel comprises the sector's main variable cost (Chart I-8). As an aside, this also somewhat insulates the European Airlines against a strengthening euro, given that this variable cost is priced in dollars. Hence, on a 6-9 month horizon, upgrade European Airlines to overweight. Chart I-6Banks Vs. Healthcare Tracks The ##br##Credit Impulse Mini-Cycle Chart I-7Materials Vs. Healthcare Tracks The##br## Credit Impulse Mini-Cycle Chart I-8European Airlines Relative Performance Is A##br## Mirror-Image of The Oil Price Cycle Country Allocation Just Drops Out Of Sector Allocation Our core philosophy of investment reductionism teaches us that for most stock markets, the sector (and dominant company) skews swamp any effect that comes from the domestic economy. For example, the defining skew for Italy's MIB and Spain's IBEX is their large overweighting to banks. So unsurprisingly, MIB and IBEX relative performance reduces to: will banks outperform the market? (Chart I-9 and Chart I-10). Chart I-9Italy = Long Banks Chart I-10Spain = Long Banks Therefore, the key consideration for European equity country allocation is always: how to allocate to the vital few equity sectors that feature most often in the skews: Banks, Healthcare, Energy and Materials. To reiterate, our 6-9 month recommendation is to underweight Banks, Materials And Energy versus Healthcare, and to overweight Airlines versus the market. Then to arrive at a country allocation, combine the cyclical view on the vital few sectors with the country sector skews shown in Box I-1. Even if you disagree with our sector views, the sector-based approach is the right way to pick European equity markets. If you agree with our sector views, the result is the following updated European equity market allocation: Box I-1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands. Underweight: Italy, Spain, Sweden and Norway. In terms of change, it means upgrading Germany (DAX) to neutral and downgrading Italy (MIB) and Spain (IBEX) to underweight. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report "Are Bonds A Greater Risk Than Equities", January 28, 2018 available at eis.bcaresearch.com. 2 Please see the European Investment Strategy Weekly Report "The Cobweb Theory And Market Cycles", January 11, 2018 available at eis.bcaresearch.com. Fractal Trading Model* There is a lot of optimism already priced into the South African rand, making it vulnerable to a countertrend reversal. Therefore, this week's recommended trade is to go long USD/ZAR with a profit-target of 6% and a symmetrical stop-loss. In other trades, short S&P500/long Eurostoxx50 hit its stop-loss, while short Japanese energy and short palladium moved comfortably into profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations
Highlights Duration Checklist: Our Duration Checklists continue to point to a bearish backdrop for global bond yields. A continued below-benchmark overall portfolio duration stance is warranted. There is not enough of a difference between the U.S. & European portions of the Checklist to suggest a big imminent move in the U.S. Treasury-German Bund spread is in the cards. UST-Bund Spread: A big cyclical turn in the Treasury-Bund spread is coming, but not before the ECB begins to seriously signal an end to its asset purchases and the Fed delivers a few more rate hikes. There will be better levels to move to a long Treasury/short Bund position by the summer. Feature Chart of the WeekUST-Bund Gap Still##BR##Reflects Policy Differences With the 10-year yield on both U.S. Treasuries and German Bunds hitting new cyclical highs on an intraday basis yesterday (2.72% and 0.70%, respectively), it is clear that the backdrop for global government bond markets is still bearish. The yield differential between the two markets remains quite wide, however, with the cyclical European economic performance rapidly catching up to that in the U.S. This is raising the odds that European Central Bank (ECB) will have to soon begin signaling a move to a less accommodative policy stance that will raise European bond yields further away from historically low levels. The continued strength of the Euro versus the U.S. dollar is a sign that investors are already expecting a big compression in U.S. bond yields versus European equivalents (Chart of the Week). Should investors position now for an eventual tightening of the Treasury-Bund spread? Or is it possible that the spread widens even further, thus providing a better entry point to profit from a spread tightening move? In this Weekly Report, we investigate the drivers of the Treasury-Bund spread to provide some clues as to its future direction. Our conclusion is that, from a medium-term strategic perspective, a narrowing of the Treasury-Bund spread is highly probable, but there is still potential for widening in the next few months. Checking In On Our Duration Checklist: Still Bearish, But With No Big Signal For U.S.-German Spreads In early 2017, we introduced a list of indicators to monitor in order to determine if our strategic below-benchmark duration stance on U.S. Treasuries and German Bunds should be maintained.1 This list, which we dubbed our "Duration Checklist", contained elements focused on economic growth, inflation, central bank policy biases, investor risk appetite and bond market technicals. The vast majority of indicators in the Checklist have accurately pointed to a cyclical backdrop for rising yields throughout the past year, despite the surprising drop in global inflation witnessed in 2017 (Table 1). Table 1The Message From Our Duration Checklist Is Still Bearish For Both USTs & Bunds With bond yields hitting fresh cyclical highs this week, it is a good time to provide another update of our Duration Checklist to see how conditions have changed since our last update in September. Specifically, we are looking for any differences in the individual U.S. and European components of the Checklist that can inform our view on the UST-Bund spread. Global growth momentum is accelerating to the upside. The global leading economic indicator (LEI) continues to climb steadily higher, even with global growth already in a solid uptrend (Chart 2). The global ZEW index, measuring investor sentiment towards growth in the major developed economies, has started to accelerate. The Citigroup Global Data Surprise index is at the highest level since 2004 (!), while our global credit impulse indicator has picked up sharply - both of which should keep global bond yields under upward pressure. We are giving a "check" to all these elements of our Duration Checklist, indicating that a defensive stance on overall duration exposure should be maintained. The only indicator in the "global" section of our Duration Checklist that is not pointing to higher bond yields is our global LEI diffusion index, which has fallen to just below the 50 line. This suggests a potential narrowing of the breadth of the current global upturn, which warrants an "x" in the Checklist. Domestic economic growth in both the U.S. and Euro Area remains solid. Manufacturing PMIs in both the U.S. (the ISM index) and Europe remain high and are rising, as is consumer and business confidence on both sides of the Atlantic (Charts 3 & 4). Corporate profit growth is solid both in the U.S. and Europe, with our models suggesting that earnings should expand at a double-digit pace again in 2018. All these indicators earn a "check" in our Duration Checklist. Chart 2Majority Of Global Growth Indicators##BR##Still Pointing To Higher Yields Chart 3U.S. Growth##BR##Remains Solid Chart 4A Booming European##BR##Economy Is Bearish For Bunds Inflation signals are mixed both in the U.S. and Europe. This remains the portion of our Checklist that has the greatest number of conflicting signals. While the rapid rise in oil prices over the past several months is putting upward pressure on headline U.S. inflation (Chart 5), the equally fast increase in the EUR/USD exchange rate is helping offset much of that increase in the Euro Area (Chart 6). Unemployment is below the OECD's estimate of the full employment NAIRU rate in the U.S., yet both Average Hourly Earnings growth and the Atlanta Fed Wage Tracker are decelerating. Unemployment in the Euro Area is now back to the OECD'S NAIRU level for the first time since the Great Recession, but wage inflation has only risen modestly. Chart 5U.S. Inflation Still Subdued,##BR##Despite Higher Oil & Low Unemployment Chart 6A Puzzling Lack Of##BR##Euro Area Core Inflation For the U.S. inflation side of our Checklist, we are giving a "ü" to the accelerating oil price (in U.S. dollar terms) and the unemployment gap, but an "x" to decelerating wage inflation. In the Euro Area, we give a "check" to the unemployment gap and a weak "check" to wage inflation which is in a mild uptrend. The stable momentum in the Euro-denominated Brent oil price earns an "x" in the Checklist, however. Both the Fed and ECB Are Looking To Tighten Monetary Policy. The Fed remains in a tightening cycle and with U.S. growth strong, core inflation bottoming out and the labor market still tight, there is no reason why the Fed should not deliver on its projected three rate hikes in 2018. The ECB just reduced the size of its monthly asset purchases in response to the robust Euro Area economic growth and modest pickup in inflation. The latest comments from various ECB officials suggests that, if core inflation rebounds after the recent unusual dip, then additional moves to less accommodative monetary policy (tapering first, rate hikes later) should be expected. So for both the U.S. and Europe, we place a "check" in this portion of the Duration Checklist. Investors risk appetite remains strong. The surge in global stock markets seen so far in 2018 has definitely played a role in the backup in global bond yields, as investors have been allocating out of fixed income into equities. Within our Duration Checklist framework, a bearish signal for bonds occurs if the percentage deviation of equity indices from their 200-day moving average is positive but is not yet at 10% - a stretched level that has typically preceded significant equity corrections. The S&P 500 index is now 14% above its 200-day average, and thus earns an "x" in that element of the Duration Checklist. The other parts of the U.S. side of the Checklist - tight corporate bond spreads and a low level of the VIX volatility index - both warrant a "check" as an indication of intense investor risk appetite that lessens the appeal of government bonds (Chart 7). In the Euro Area, the Stoxx 600 index is only 4% above its 200-day moving average, but with tight credit spreads and a low level of the VStoxx volatility index (Chart 8). All these elements earn a "check" in our Duration Checklist. Chart 7High Risk Appetite In the U.S.,##BR##But Risk Assets Look Stretched Chart 8Still A Pro-Risk Bias##BR##Among Euro Area Investors Bond market momentum is not overly stretched, although short positioning is an issue. In the U.S., the 10-year Treasury yield is only 35bps above its 200-day moving average, well below the 90-100bps levels seen at previous yield peaks (Chart 9). Price momentum for the 10-year is right on the zero line, suggesting no stretched extreme that would precede a reversal. Both of those indicators earn a "check" in the Checklist. Positioning is a problem in the U.S., however, with the CFTC data on Treasury futures showing a net short position on the 10-year contract among speculators. From the point of view of our Duration Checklist, a big net short is a bullish signal for bonds from a contrarian perspective. Thus, positioning warrants an "x" in the U.S. side of the Checklist. In Europe, the 10-year Bund yield is now 22bps above its 200-day moving average. This is below the previous peaks around the 50bps level. Price momentum is also hovering just above the zero line and is no impediment to a move higher in yields (Chart 10). Both of these pieces of the Duration Checklist score a "check". Note that due to a lack of available data, we do not include a positioning component on the European side of the Checklist. Chart 9USTs Not Oversold,##BR##But Positioning Getting Stretched Chart 10Bunds Not Yet At##BR##Oversold Extremes The net conclusion from our Duration Checklist is that the majority of indicators continue to point to upward pressure on U.S. Treasury and German Bund yields. Thus, a below-benchmark duration stance is still warranted for both markets. There are only a few potentially bullish signals in the Checklist. The overshoot in U.S. equity markets and the large net short position in Treasury futures are both sending a more positive signal for Treasuries, while the more stable momentum in the Euro denominated oil price is also a positive for Bunds. None of those is enough to prompt a change in our recommended below-benchmark duration stance. At the same time, there is not enough of a difference between the U.S. and European sides of the Checklist to provide a signal for the future direction of the Treasury-Bund spread. For that, we must dig a bit deeper into the drivers of that spread, which we cover in the next section. Bottom Line: Our Duration Checklists continue to point to a bearish backdrop for global bond yields. A continued below-benchmark overall portfolio duration stance is warranted. There is not enough of a difference between the U.S. & European portions of the Checklist to suggest a big imminent move in the U.S. Treasury-German Bund spread is in the cards. How To Play The Treasury-Bund Spread - Tactically Wider, Structurally Narrower The Treasury-Bund spread, like most cross-country bond yield spreads, is driven mostly by economic growth and inflation differentials. In the past, the U.S. and European economic cycles have rarely been in sync, which creates gaps in growth, inflation and monetary policy between the two regions. This usually leads to the Fed and ECB (and the Bundesbank before it) rarely having interest rates at similar levels, or moving at a similar pace, thus creating large cyclical swings in the Treasury-Bund spread. At the moment, however, the 200bp gap between 10-year Treasuries and German Bunds mostly reflects the 4.6 percentage point gap between the unemployment rates in the U.S. and Europe. The spread has been far less correlated to the difference in inflation rates between the two economies. Reported headline inflation in the U.S. is only 30bps above the same measure in Europe, with core inflation only 60bps higher in the U.S. (Chart 11). The latter may be more critical for the future direction of the Treasury-Bund spread, however. The dip in Euro Area core inflation back below the 1% level at the end of 2017 was a surprise given the strength of European growth last year, with real GDP reaching a well-above potential pace of 2.8%. Core inflation must rise from the current 0.9% level for the ECB to consider any move to a tighter monetary policy stance, as this would give the central bank confidence that its 2% inflation target would be reached in the medium-term. The markets seem to be pricing in a recovery of Euro Area core inflation in the coming months. Our Euro Area months-to-hike indicator, which measures the number of months until the first full 25bp rate hike is priced into the EUR Overnight Index Swap (OIS) curve, is now down to 17 months. As the interest rate markets have pulled forward the date of the next ECB rate hike to June 2019, the currency markets have followed suit with the euro rallying to a 3-year high last week (Chart 12). Chart 11Big Gaps Between Yields & Unemployment,##BR##Small Gaps In Inflation Chart 12Markets Are Acting Like##BR##Core Inflation Will Rebound In Europe A rebound in Euro Area core inflation is the first step towards seeing a convergence of the Treasury-Bund spread. The key is how the ECB responds to that move. Looking across the full spectrum of maturities, the moves in the yield gap between U.S. Treasuries and German government bonds have historically occurred alongside changes in relative inflation expectations (Chart 13). This makes sense, as to the extent that inflation expectations were climbing at a faster rate in the U.S. than in Europe, the market would price in a higher future Fed funds rate relative to European policy rates and, thus, widen the Treasury-Bund spread (and vice versa). That correlation between relative inflation expectations and the Treasury-Bund spread has broken down in recent years. The specific timing of that breakdown can be traced back to the August 2014 speech given by Mario Draghi at the Fed's Jackson Hole conference, marked by the vertical line in Chart 13. In that speech, Draghi introduced the idea that the ECB could begin buying government bonds to fight deflation pressures in Europe. That sent a powerful signal to the markets not to expect any movement in European policy rates for some time - the typical response seen in recent years to an announcement by a central bank that it was ramping up asset purchases. If Euro Area core inflation begins to rise in the coming months, the ECB's "forward guidance" can start to work in reverse. The ECB will be forced to signal further reductions in its asset purchases, likely all the way to zero in a full taper scenario. Markets will then begin to price in both higher inflation expectations and ECB rate hikes, resulting in a normalization of the Treasury-Bund spread through higher Bund yields. Until that inflation upturn happens in Europe, however, it will be difficult to get much of a tightening of the Treasury-Bund spread. In Chart 14, we present the spread versus the difference between policy rates in the U.S. and Europe (top panel), the ratio of the U.S. and Euro Area unemployment rates (middle panel), and the gap between U.S. and European headline inflation (bottom panel). At the moment, the Treasury-Bund spread is being held at an elevated level by the relative unemployment rates, with the spread looking wide versus the inflation differential. The much lower U.S. unemployment rate, which is driving the Fed to continue slowly hiking interest rates while the ECB keeps policy rates near zero, is preventing any meaningful decline in the Treasury-Bund spread. Chart 13UST-Bund Spread Has Divorced##BR##From Inflation During ECB QE Chart 14UST-Bund Spread Reflects Policy##BR##& Unemployment Differentials We have combined these three variables into a simple econometric model to explain the Treasury-Bund spread (Chart 15). We also added the size of the balance sheets of the Fed and ECB as separate variables, to account for the impact of bond purchases from each central bank. This model shows that a) the predicted value of the spread continues to steadily rise and b) the current spread is below one standard deviation away from that predicted value - a level equal to 237bps on the spread. That implies that there is still room for Treasury yields to climb higher versus Bunds before the spread becomes "too wide". Additional spread widening will be much harder to come by in the near-term, however. The gap between data surprise indices between the U.S. and Euro Area - which correlates well to the momentum in the Treasury-Bund spread - is relatively stretched, at a time when U.S. bond managers are already very underweight duration exposure (Chart 16). Yet with the forward curves already pricing in some mild tightening over the next year (top panel), betting on Treasury-Bund spread widening is a positive carry trade. One final point in favor of a wider Treasury-Bund spread is that the spread momentum is not yet close to the extremes seen in previous cycles (Chart 17). The big cyclical peaks in the spread typically occur when spreads are 50bps above the 200-day moving average, which is well above current levels. Chart 15Our New Model Suggests##BR##UST-Bund Spread Not Overstretched Chart 16Relative Data Surprises & UST##BR##Positioning May Limit Additional Spread Widening Chart 17UST-Bund Spread Momentum##BR##Not Yet At Stretched Extremes Our conclusion after looking at all these indicators is that the major cyclical peak in the Treasury-Bund spread is not yet on the immediate horizon, but is likely to unfold later this year - after one final move higher in Treasury yields versus Bunds. Bottom Line: A big cyclical turn in the Treasury-Bund spread is coming, but not before the ECB begins to seriously signal an end to its asset purchases and the Fed delivers a few more rate hikes. There will be better levels to move to a long Treasury/short Bund position by the summer. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "A Duration Checklist For U.S. Treasuries & German Bunds", dated February 15th 2017, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights EUR/USD is in a blow off phase. Treasury secretary Mnuchin's comments added fuel to a fire already lit by worries of twin deficits and the inherent responsivity of the dollar to momentum. It is dangerous to short EUR/USD when momentum is so strong; while we expect EUR/USD to correct over the next three months, it is safer to short the euro against the yen. The rebound in Australia's national income will peter off, this will hurt inflows into the country. The RBA will not surprise markets to the upside in 2018. Most of the drivers of AUD/USD point south. Stay short the AUD against the CAD and NZD, shorting AUD/JPY is attractive. Feature By somewhat abandoning the "strong dollar policy" in Davos, U.S. Treasury Secretary Steve Mnuchin sent the dollar in yet another tailspin this week.1 The weakness was further compounded by the seeming lack of concern vis-à-vis the euro's strength expressed by European Central Bank President Mario Draghi during the European Central Bank's press conference in Frankfurt yesterday. Mnuchin's comments rightfully worried investors, as they echoed President Trump's own rhetoric from a year ago that a strong dollar was negative for the U.S. economy, at least in terms of trade competitiveness. However, it is important to remember that words are only words, and for these utterances to have any durable impact, they need to be backed by policy instruments. The 1985 Plaza Accord was able to drive down the dollar not just because finance ministers said that the greenback was too strong, but also because the Federal Reserve cut interest rates in half between July 1984 and October 1986. This drove 2-year yield differentials between the U.S. and Japan, the U.K., and Germany down by 454 bps, 630 bps and 407 bps, respectively. Compounding this punch, the USD was trading at prodigiously expensive levels in early 1985. Today, the Fed is not cutting interest rates, it is raising them. In fact, BCA expects at least three rate hikes this year. The current weakness in the dollar is also easing U.S. financial conditions further, which is giving more ammunition for the Fed to tighten policy. Meanwhile, President Draghi reiterated that the ECB was very unlikely to increase rates in 2018; thus rate differentials between the U.S. and the euro area are widening, not narrowing. There is also the nagging question of the twin deficit in the U.S. The Trump stimulus package is expected to increase the fiscal deficit, and also feed through to a higher current account deficit. We have sympathy for this view. While such a twin deficit was associated with a weakening USD at the beginning of the millennium, in the first half of the 1980s it was not. Thus a twin deficit is no guarantee of a weaker dollar. The behavior of the Fed is likely to once again dominate. In the early days of the millennium, the Greenspan Fed was easing policy aggressively. In the early 1980s, while the Fed was cutting rates, it was cutting rates at a slower pace than had been anticipated because it realized that President Ronald Reagan's tax cuts and increased military spending were inflationary. Volcker wanted to make sure inflation expectations would stay well anchored, and not spike up. It thus seems that once again, the behavior of U.S. inflation is paramount. If U.S. inflation picks up as we expect (Chart I-1), the dollar is likely to appreciate as the Fed will hike. If U.S. inflation stays moribund, the twin deficit will likely tank the dollar. What to do practically? We have posited that the expected terminal rate spread between the euro area and the U.S. has been the interest rate spread driving EUR/USD rate over the past 12 months. Yet, even by this metric, the move in the euro to 1.25 is out of bound, as the euro has completely diverged from the recent trends in terminal rate differentials (Chart I-2). This suggests the euro is vulnerable at current levels. Chart I-1U.S. Inflation Will Pick Up Chart I-2Mind The Gap! It is also important to remark that the dollar's weakness is generalized. Moreover, the dollar is oversold and likely to experience a rebound (Chart I-3). However, timing this rebound is a made harder by the nature of the greenback. As we highlighted in a Special Report in December, the U.S. dollar is one of the two currencies exhibiting the strongest response to momentum factors.2 This is because the dollar is a very important macro variable, which is both responsive to global growth but also a key input to global growth. As global growth strengthens, this tends to weigh on the USD, but the USD's weakness tends to also boost global growth, as it eases global financial conditions. This creates a strong feedback loop that favors momentum trades in the USD. Chart I-3The Time To Bet On A Rebound Is High The greenback is currently entangled in such dynamics. Global growth improved after China massively stimulated its economy in 2015 and early 2016, which hurt the dollar. The weakness in the dollar is now helping global growth, which further hurts the dollar. It is thus a mugs game trying to time a reversal in the USD. As a result, even if we think EUR/USD is likely to experience a sharp correction in the coming weeks, we prefer shorting EUR/JPY. EUR/JPY is expensive, and positioning is just as extreme. However, by shorting the euro against the yen, we are not as exposed to the dollar cycle, and if global growth were to weaken in response to increasing tightening in Chinese policy, the yen would benefit in this environment. As such, the risk-reward ratio for this trade is higher. Bottom Line: Mnuchin comments on the USD were only an excuse for the dollar to sell off. The true culprit for the dollar's weakness is the greenback's own extreme sensitivity to momentum. As a result, timing a dollar reversal is nearly impossible. Only once the dollar begins to turn around can we begin betting on a tactical USD rally, even if it dooms us to miss the early parts of the move. Shorting EUR/JPY continues to offer a more attractive risk-reward tradeoff than shorting EUR/USD. Feature: Hard Times Ahead For The AUD The Australian dollar has rallied by a stunning 18.3% since its February 2016 trough. Improvement in global trade, surging Chinese stimulus, the resurgence in commodity prices, the rally in EM stocks, and the fall in the U.S. dollar have all aligned to transform the AUD into a high flyer. Not only have these factors encouraged risk-taking, creating an environment that is helping high-beta Australian assets perform well, they also have had a direct positive outcome on the Australian balance of payments, thus creating real improvements in the AUD's fundamentals as well. With AUD/USD now back above the key 0.80 threshold, it is important for investors to ask themselves: Can the AUD continue on its upward trajectory or is it time to bet against it? While the short-term outlook remains clouded by the USD's downward momentum, the AUD is likely to weaken on a cyclical basis. Playing AUD weakness against the NZD, CAD, and JPY seems like safer bets at the current juncture. Australian Economic Developments Australia's real GDP growth has slowed from 2.8% in Q3 2016 to 2.2% in Q3 2017, and currently stands below the lows recorded in 2015. However, this hides some very significant improvements, as nominal GDP growth has surged - from 1.4% in Q3 2015 to 6.5% in Q3 2017 (Chart I-4). Consumption has not been the crucial source of variations in Australia's economic activity. Instead, the source of change has emanated from net exports, which have moved from slicing off nearly 2% to GDP growth in late 2015 to adding more than 3% in the most recent quarter. The fluctuations in Australian growth have in large part reflected the dynamics in commodities prices. Australia has undergone massive fluctuations in its terms-of-trade as iron ore, copper and coal prices experienced a bust, followed by a subsequent boom that has pushed base metals prices up by 76% since their nadir. These movements in commodity prices not only explain past gross domestic product performance, they also explain the swings in both national income and corporate profits (Chart I-5). Chart I-4Australian Growth Decomposition Chart I-5The Positive Shock: Commodities In response to the improvement in national income and profits since the winter of 2016, the basic balance of Australia has surged from a deficit of 3% of GDP to a surplus of 3% (Chart I-6). While higher commodities prices contributed to higher exports, lifting the current account, portfolio flows moved up by more than 4% of GDP. This was simply because the surge in Australian corporate profits also made investing in Australia much more attractive for investors around the world. This combination caused a lot of investors to buy Australian dollars in the process, generating a severe upward bias in favor of the AUD. But how these trends are likely to evolve remains uncertain. To begin with, the rate of change of the Reserve Bank of Australia's commodity index has already rolled over, plunging from a high of 47% six months ago to -1% today. The historical lead times of this variable on GDP, GNI and profits suggests that each of these three variables are set to decelerate meaningfully in the coming quarters. This could weigh on inflows into Australia. China too plays a key role. Exports to China were subtracting 0.5% from Australia's growth as of the end of 2016 and are now adding 1.5%. Swings in Chinese activity could amplify the impact of the rollover in commodities price inflation. In fact, the slowing Li Keqiang index already paints this exact picture (Chart I-7). The growth rate of railway freight, one of the index's components, has already collapsed from 20% in August 2017 to 1%, and iron ore stockpiles in Chinese ports are hitting record highs. The tightening of the monetary and fiscal screws in China are therefore likely to exert a negative impact on Australia's national income, and thus on inflows that have been so important in supporting the AUD. Chart I-6From Income Shock To ##br##Balance Of Payment Shock Chart I-7China's Boost Is Dissipating ##br##The Boost To Trade Is Dissipating But what about real economic activity? Here again, the picture does not shine particularly bright. Fiscal policy has been a drag on GDP since 2011, and 2018 will be no exception, as the fiscal thrust will be -0.3% of potential GDP (Chart I-8). A potential rollover in aggregate profits could limit corporate capex in 2018. Mining projects in Australia are expected to continue to decline as a share of GDP in 2018, thus mining capex will remain a drag on growth (Chart I-9). Moreover, imports of capital goods have been a leading indicator of Australian capex, and they too have rolled over after a recent surge, suggesting that non-mining capex growth will also experience limited upside. The Australian consumer is also unlikely to come and save the day. To begin with, the savings rate has additional upside. As net worth has increased, Australian households have curtailed their savings rate to 3% of disposable income (Chart I-10). Moreover, debt levels have increased significantly, rising to an eye-opening 200% of income. The problem is that Australian housing is now much overvalued (Chart I-11). While this does not guarantee a fall in house prices, it is highly unlikely that net worth will continue to increase at its heady pace. Thus, with high debt loads and a limited wealth effect, the probability is high that the savings rate will increase. Chart I-8Fiscal Policy: Still Contractionary ##br## Fiscal Policy Is Still A Drag Chart I-9Mining Capex##br## Still Falling Chart I-10Households Savings ##br##Rate Should Rise Put together, the Australian economy is unlikely to accelerate this year. As Chart I-12 illustrates, business confidence has been weakening throughout the year, new orders are at high levels but are rolling over, and real consumer spending has not been able to gain any traction - despite job growth reaching a 3.8% annual pace. Job growth is unlikely to accelerate from such high levels, limiting the potential for household income growth to undo the damage of a rising savings rate. Chart I-11House Price Gains Will Slow Chart I-12No Boost To Real GDP Growth Bottom Line: The Australian dollar has benefitted from a major nominal improvement in the economy. As terms of trade rebounded, so did nominal GDP, national income and profits. This caused a surge in inflows into the country. However, the best of the positive terms-of-trade shock is ebbing, and the slowdown in Chinese industrial activity also points to weakening national income growth. In terms of real activity, the Australian fiscal drag continues unabated, capex will not accelerate, and households are likely to increase their savings rate, which will weigh on consumption. While Australia is not on the verge of recession, it will not experience much of a boom either. But How Fast Can The RBA Hike Anyway? Chart I-13The RBA Is Limited By Economic Slack The RBA is also still facing a tough environment. On one hand, job creation was very robust in Australia last year, and core CPI has accelerated. However, wage growth remains depressed at 2%. Even more disturbing is the fact that Australian wages have decoupled from a reliable driver: exports to China (Chart I-13). This underscores the extremely large degree of slack present in the Australian labor market. As the middle panel of Chart I-13 displays, the underemployment rate remains near twenty five-year highs and is congruent with the current level of wage growth. Moreover, Australia's output gap is still -2% of GDP and is not expected to close until after 2020. Thus, the underemployment rate will continue to act as an anchor on policy (Chart I-13, bottom panel). The strength in the AUD since 2016 will play into these dynamics. The lack of traction on wages is likely to be compounded by the tightening in monetary conditions resulting from an expensive AUD. As such, we would expect core CPI to weaken again in the coming quarters, which will comfort the RBA that its dovish stance remains appropriate. Finally, the high indebtedness of Australian households along with the fact that house price appreciation has slowed also suggests that household balance sheets are not capable of withstanding much of an increase in interest rates right now. The RBA is unlikely to toy with such a deflationary risk while the output gap is still negative and labor utilization is so low. The market is currently pricing in 40 basis points of hikes in 2018. A hike in 2018 is possible, as the global economy has healed from its deflationary nadir of 2016, but the economic backdrop of Australia will not let the RBA test the waters more than once this year. We thus anticipate that the RBA will continue to lag the Bank of Canada and the Federal Reserve - two central banks we expect to raise rates three times in 2018. The RBA will also most likely lag behind the RBNZ. Bottom Line: The Australian economy is replete with excess capacity, which is limiting the ability of the RBA to push up its policy rate. Moreover, the elevated indebtedness of Australian households suggests the RBA is loath to generate a deflationary shock while the output gap is already negative. The RBA will therefore lag the Fed, the BoC and the RBNZ. Implications For The AUD AUD/USD is currently trading at a 15% premium to its purchasing power parity equilibrium versus the U.S. dollar, making it one of the rare currencies expensive against the still-pricey greenback (Chart I-14, top panel). Moreover, Australia's real effective exchange rate also trades above its long-term average (Chart I-14, bottom panel). While the AUD is not wildly expensive, its current premium to fair value does suggest it would not be immune to adverse cyclical dynamics. What do the cyclical drivers currently say about the AUD? As we have highlighted, Australian national income and profit growth are likely to decelerate sharply in 2018, which is likely to undo some of the improvement that has materialized in the basic balance and thus remove one of the key supports that has underpinned the AUD. In this optic, the fact that the AUD has been able to strengthen despite a significant deceleration in Australian exports of iron ore to China raises a yellow flag against the AUD's strength (Chart I-15). Chart I-14No Valuation Cushion In AUD Chart I-15AUD Disconnect However, when investors expect strong growth from EM economies, the AUD does well. Thus, if the outlook for EM growth remains healthy, current weaknesses in commodities shipments can be safely ignored. Under this framework, the recent sharp upgrade by global investors of long-term earnings growth of EM equities sheds light on the AUD's strength, despite slowing iron ore exports (Chart I-16). Yet, this growth expectation is now the highest on record. This suggests the expectation hurdles in EM are very elevated. Even if EM growth does not crater, any disappointment could leave the AUD in a vulnerable position. The rollover in the annual performance of EM/JPY carry trades point to a growing risk of such disappointments.3 Financial markets are also sending interesting signals. Australian equities are underperforming global indices in local currency terms, suggesting the growth outlook for Australia is weakening relative to the rest of the world. These developments are true even when financial stocks are removed from the equation. Moreover, AUD/USD has historically traded in line with the relative performance between Australian and U.S. equities. Not only is the AUD currently quite above the level implied by the relative stock performance, but also the underperformance of Aussie stocks is deepening. This is another poor omen for AUD/USD (Chart I-17). Chart I-16Investors Love EM, ##br##This Helps The Aussie Chart I-17Listen To Equities If stocks are sending a message regarding the path of the Australian economy vis-à-vis the U.S., and thus about the outlook for AUD/USD, so are various key drivers of policy. First, AUD/USD normally broadly tracks the gap in the five-year moving average of nominal GDP growth between Australia and the U.S. This growth differential is moving in the opposite direction of AUD/USD, and based on the IMF's forecast, it is only expected to widen. AUD/USD has also been responsive to the relative utilization of labor, as measured by the spreads between the U.S.'s U-6 unemployment rate and Australia's labor underemployment measure (Chart I-18). Currently, this spread is not ratifying the rally in AUD/USD - and is pointing toward a much more hawkish Fed than RBA. This too paints a somber picture for the Aussie. This picture is echoed by the trend in Australia's employment-to-population ratio for prime age workers relative to the U.S. Again, Australia's large labor market excess supply points to a weaker AUD (Chart I-19, top panel). What's more, Australia's employment-to-population ratio is set to fall further vis-à-vis the U.S. This relative labor utilization measure has tracked the share of investment as a percent of Chinese GDP. This is because the investment-heavy period of development that China has undergone over the past 30 years has been very commodities intensive, forcing full labor utilization in Australia. However, based on the IMF's forecast, the role of investment in the Chinese economy is set to decline further (Chart I-19, bottom panel). Chart I-18Labor Market Slack Points To Weak AUD Chart I-19Labor Market And China Additionally, Xi Jinping's reforms are about decreasing pollution and leverage while increasing the role of consumption and services in the economy. This points to a risk of an even greater fall in the share of capex in China's economy. This would deepen the decline in labor utilization in Australia relative to the U.S., and thus increase downside risk for the AUD. Another risk emanates from U.S. financial markets themselves. The AUD tends to perform well when volatility in financial markets is on the decline, or at very low levels. This describes the current state of financial markets. On the other hand, a higher VIX is associated with a declining AUD. The VIX's current low level is not enough to flash an imminent sell signal, but the risk of a spike in risk aversion increases significantly if the spot VIX is low and the VIX futures curve is "too flat." Since there is a strong inverse relationship between the VIX futures curve slope and the spot VIX, the curve is "too flat" when its steepness is below the degree implied by the line of best fit linking the slope to spot VIX. As Chart I-20 shows, when the slope of the VIX is below this implied fair value, the subsequent 12 months of returns in the AUD/USD have been negative 84% of the time. The current reading in this relationship suggests that the AUD could depreciate by a large amount over the coming year. Chart I-20Flat VIX Term Structure = Lower AUD In 12 Months Bottom Line: Australia's national income growth is set to decline, and the RBA is unlikely to increase rates more than is currently priced into the curve. Moreover, the Australian dollar is trading on the expensive side. These factors point to vulnerability for the AUD. Moreover, key variables are suggesting this vulnerability could materialize into actual weakness: investors are pricing in too much growth in the EM space, Australian equities point to growth underperformance, labor market utilization measures suggest relative policy will hurt the AUD, China's long-term policy tilt is becoming increasingly AUD-negative, and any spike in asset volatility would hurt the Aussie. Strategy Considerations The arguments highlighted above all point to a weakening AUD. However, the picture is never that clear-cut. In fact, there is one major risk to our view: commodities prices and the USD itself. As Chart I-21 illustrates, commodities prices have a stronger inverse relationship with the USD than they have a positive link to Chinese economic conditions. Thus, if the greenback were to weaken further, the AUD could delay its moment of reckoning even further. This suggests that playing AUD weakness on its crosses, while potentially less rewarding, is a safer strategy. Our long-term valuation models continue to highlight the positive risk/reward tradeoff to shorting AUD/NZD: Not only is the New Zealand economy less exposed to shifting away from investment in the Chinese economy, AUD/NZD is trading at valuation levels that are historically followed by periods of pronounced weakness (Chart I-22). Moreover, the Kiwi economy is displaying a much higher level of resource utilization than Australia, suggesting there is more scope for the RBNZ to increase rates than there is for the RBA. Chart I-21Risk To The View: The Weak USD Chart I-22Improve Your Reward To Risk: Short AUD/NZD The same can be said about AUD/CAD. AUD/CAD also trades at a significant premium to its fair value. As we argued two weeks ago, like New Zealand, labor and capacity utilization in Canada are both very tight, thus we foresee three BoC rate hikes this year, which is at least two more than we anticipate in Australia. Additionally, our commodity strategists continue to like energy more than they like metals. Thus, terms-of-trade dynamics will play in favor of the CAD. That being said, this trade is much more correlated with the movements in AUD/USD than the AUD/NZD bet is. Shorting AUD/JPY is also an attractive trade right now. AUD/JPY is trading at a 30% premium to purchasing power parity, and the risk represented by a potential removal of over-exuberance currently evident in the pricing of growth in EM markets would likely be amplified in this cross. Additionally, as we highlighted two weeks ago, the risk of a tactical rally in the JPY is growing significantly. Bottom Line: The outlook is negative for AUD/USD, but if the USD's bear market can gather force from current levels, this would dampen the attractiveness of shorting the Aussie. While potentially less profitable but also considerably less risky, shorting AUD/NZD and AUD/CAD remain attractive expressions of our negative AUD bias. We also like going short AUD/JPY as it plays both on our positive tactical view on the JPY and on the risks of a slowdown in EM earnings growth expectations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Even if he somewhat retracted his comments later during the day. 2 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets," dated December 8, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert: EM/JPY Carry Trades," dated December 1, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed: The Chicago Fed National Activity Index underperformed expectations of 0.44, coming in at 0.27; The Richmond Fed Manufacturing Index came in at 14, well below the expected 19; Manufacturing PMI came in at 55.5, above the consensus of 55; Existing Home Sales contracted by 3.6% on a monthly pace; New Home Sales contracted by 9.3% on a monthly pace; Continuing jobless claims underperformed at 1.937 million, while initial jobless claims outperformed expectations at 233,000. The greenback has experienced notable downside this week owing to a slew of disappointing data and significant technical breakdowns. Treasury Secretary Steven Mnuchin's comments concerning a weaker dollar being beneficial for growth only added fuel to the fire. We have a neutral view on the greenback against the euro as emerging inflation in the U.S. later in the year should help alleviate some of the gains in the euro. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data this week was stellar: German Current Situations and Economic Sentiment ZEW Surveys came in at 95.2 and 20.14, outperforming the expected 89.8 and 17.8; Overall euro area Economic Sentiment ZEW Survey came in at 31.8, outperforming the expected 29.7; European consumer confidence also beat expectations of 0.6, coming in at 1.3; German IFO Business Climate and Current Assessment outperformed expectations, while the Expectations survey underperformed; German Gfk Consumer Confidence came in at 11, also surpassing expectations of 10.8. Mario Draghi affirmed his positive outlook on European growth and inflation. However, we believe that the most recent move to 1.25 is unsustainable as the euro continues to decouple from relative terminal rates. We believe that signs of weakening global growth should translate into a weaker euro in the short term. Report Links: The Unstoppable Euro - January 19, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Even if they decelerated relative to the previous month, imports yearly growth surprised to the upside, coming in at 14.9%. Moreover, the Nikkei Manufacturing PMI also outperformed expectations, coming in at 54.4. The All Industry Activity Index month-on-month growth also outperformed, coming in at 1%. However, exports yearly growth, surprised to the downside, coming in at 9.3%. The Bank of Japan left the reference rate unchanged at -0.1%. In their Outlook for Economic Activity and Prices, the BoJ stated that it expects inflation to reach the 2% target by 2019. Moreover, the committee highlighted that the output gap will move further into positive territory in 2018 and 2019. Overall, we expect for the yen to appreciate in coming months, particularly against the Euro, given that financial conditions have tightened much more in Europe than in Japan. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Retail sales and retail sales ex-fuel yearly growth both underperformed expectations, coming in at 1.4% and 1.3% respectively. Both of these measures also declined relatively to last month. Moreover, the claimant count change surprised negatively, coming in at 8.6 thousand. However, average earnings excluding bonus yearly growth outperformed expectations, coming in at 2.4%. This number also increased from 2.3% last month. GBP/USD has surged by almost 4% this week, partly due to the fall in the dollar. However the pound has also rallied against the euro, with EUR/GBP falling by almost 2%. Overall, the ability for the BoE to raise rates relative to other central banks will be limited, as the strengthening currency should create a drag on inflation and the economy displays underlying weaknesses. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The Australian dollar has benefitted from last year's stellar growth period, now above the crucial 0.80 level. Slowing Chinese industrial activity and a domestic fiscal drag will handicap Australian growth this year. We believe the AUD is expensive amongst various metrics and the RBA is unlikely to hike any time soon given the negative output gap. Additionally, substantial labor market slack remains as the concentration of employment has been in part-time growth. We believe markets are overpricing hikes at 40 bps, and the AUD will suffer once this becomes priced in. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data In New Zealand has been mixed: The ANZ Activity Outlook was unchanged from last month, coming in at 15.6%. However, headline inflation surprised to the downside, coming in at 1.6%. It also declined significantly from last month's 1.9% value. Intraday, the kiwi fell by almost 1.5% following the weak inflation number. However even amid this drop NZD/USD has rallied by almost 1% this week, as the dollar has weakened to its lowest level in 3 years. Overall, we are positive on this cross relatively to the AUD, given that Australia is more sensitive to a slowdown in China than New Zealand. However, the New Zealand dollar will likely have downside against the yen. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data out of Canada was mixed: Wholesale sales monthly growth missed expectations of 1%, coming in at 0.7%; Headline retail sales missed expectations of 0.7%, coming in only at 0.2% on a monthly basis; Core retail sales (ex. Autos) outperformed the expected 0.8% greatly, coming in at 1.6% month-on-month; We remain bullish on CAD as strong employment and higher wages will augur well for inflation this year. Higher oil prices will continue to power the Canadian economy and help close the output gap in line with expectations. The Bank will therefore continue to tighten policy. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has fallen this week by almost 0.5% even as the euro has rallied. Nevertheless, as long as the SNB continues with its ultra-dovish monetary stance, upside for the franc is limited, as the Swiss National Bank will continue to intervene in the currency markets. Indeed, on Monday SNB president Thomas Jordan once again reiterated that he believed that the franc was "Highly Valued". As of now, while inflation is slowly picking up, wage growth and house price growth are too anemic for the SNB to have a significant change in their monetary stance. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has depreciated by 2.2% this week, as it has been struck by a double whammy of higher oil prices and a very weak dollar. Meanwhile, on Wednesday, the Norges Bank decided to keep its key interest rate unchanged at 0.25%. The bank decided that monetary policy should stay accommodative for the foreseeable future, as inflation is likely to stay under target. Furthermore they stated that inflation, the economy, and the currency were evolving according to their December 2017 expectations. Overall, we expect the krone to appreciate relative to the Canadian dollar, as the BoC is fully priced this year, while the Norwegian interest rates could still have some upside amid rising oil prices. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Data out of Sweden was mixed: Consumer confidence decreased to 107.2 from 107.7, under expectations of 107.4; The unemployment rate increased to 6% from 5.8%, but beat expectations of 6.1%; Producer prices increased in December at a 1.6% monthly pace, and a 2.3% yearly pace. The SEK has appreciated noticeably given the recent hawkish comments by Riksbank officials about the policy path. While the consensus does seem to be changing in the Bank, we remain cautious given Ingves' dovish leanings. SEK could weaken against EUR for the rest of the year given Europe's stellar growth momentum. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Dear Client, In addition to this abbreviated Weekly Report, I am sending you a Special Report co-authored by Mark McClellan, Managing Editor of the monthly Bank Credit Analyst, and Brian Piccioni of Technology Sector Strategy. Mark and Brian argue that the deflationary impact of robot automation will not prevent inflation from rising as the labor market tightens. I hope you will find their report interesting and informative. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights Our cyclically overweight stance on global equities/underweight stance on bonds is working. Stick with it. U.S. Treasury Secretary Mnuchin's comments about the dollar are unlikely to have any lasting effects. EUR/USD has decoupled from terminal rate expectations since the start of this year. Tactical trade recommendation: Go short EUR/USD while simultaneously going long 30-year U.S. Treasurys/short 30-year German bunds. Feature Global Equities Enter A Blow-Off Phase Valuations do not matter on the way up, but they sure do matter on the way down. Once the market reaches that Wile E. Coyote moment - the one where the poor sap runs off the cliff, pauses in mid-air, looks down, and sees the ground below - all hell will break loose. On every valuation measure, U.S. stocks, and increasingly global stocks, have become very expensive (Chart 1). Chart 1AU.S. Stocks Are Expensive... Chart 1B...While Global Stocks Are Getting There That moment, however, is unlikely to arrive until the global economy and earnings growth begin to stall out. As we have argued in past reports, this probably will not happen until late next year. Historically, it has not paid to get defensive until six months before the start of a recession (Table 1). This suggests that stocks could continue to rally right through 2018. Beep beep. Table 1Too Soon To Get Out Granted, the timing of our recession call could turn out to be wrong, which is why we are watching a wide number of leading variables for signs that a slowdown is around the corner (Chart 2). In the U.S., these include credit spreads, the slope of the yield curve, financial conditions, business and consumer confidence, ISM new orders minus inventories, building permits, core capital goods orders, and initial unemployment claims. We have consolidated these variables and dozens of others into our MacroQuant model. The model is still pointing to a reasonably rosy cyclical outlook for stocks (Chart 3). Chart 2Leading Cyclical Data Still Strong Chart 3Cyclical Outlook For Stocks Is Still Rosy The Dollar Takes A Pounding While our cyclical bullish view on stocks and bearish view on bonds has paid off this year, our expectation that the dollar would recoup some of last year's losses has not worked out. Time will tell if December 2016 marked the beginning of a secular dollar bear market. The dollar tends to suffer when global growth accelerates. This happened last year. The dollar also tends to weaken when the composition of growth shifts away from the United States. That also happened in 2017. The remainder of this year could be different. We expect global growth to remain solidly above-trend in 2018, but ease from the torrid pace of 2017. This is already being foreshadowed by the decline in our Global LEI diffusion index to below 50%, a slowdown in Korean and Taiwanese exports, a deceleration in the Chinese Li Keqiang Index, and the loss of momentum in EM carry trades (Chart 4). Meanwhile, the composition of global growth should shift back in favor of the U.S. The fact that the U.S. Economic Surprise index has recovered in recent months relative to other economies suggests that this reversal of fortunes is already underway (Chart 5). The end result for asset markets could be slightly reminiscent of the late 1990s, a period when both equities and the dollar rallied. Chart 4Global Growth Will Remain Above-Trend ##br##But Ease From Blistering Pace Chart 5Composition Of Global Growth Will Shift ##br##Back In Favor Of The U.S. Talk Is Cheap Chart 6Trade-Weighted Dollar No Longer Pricey We do not put much weight on the remarks concerning the dollar made by Treasury Secretary Steven Mnuchin at Davos this week. While Mnuchin did say that "obviously a weaker dollar is good for us as it relates to trade and opportunities," he added that "longer term, the strength of the dollar is a reflection of the strength of the U.S. economy and the fact that it is and it continues to be the primary currency in terms of the reserve currency." More importantly, history suggests that verbal interventions in currency markets are only effective beyond the near term when backed by a supporting change in monetary policy. Many people remember the success that then-Treasury Secretary James Baker had in driving down the dollar following the Plaza Accord in 1985, but what is often forgotten is that the Federal Reserve steadily cut rates from 11.8% in July 1984 to 5.8% in October 1986. As a result, the 2-year interest rate differential fell by 454 bps against Japan, 630 bps against the U.K., and 407 bps against Germany over this period. It is also worth noting that the Fed's real broad trade-weighted dollar index is now 27% below its 1985 peak and 3% below its long-term average (Chart 6). This makes any effort to talk down the dollar all the more difficult. ECB Sending Mixed Messages About The Euro Chart 7Market Has Brought Forward ECB Rate Hikes ECB officials continue to send mixed messages about the resurgent euro. Earlier this month, ECB Vice President Vitor Constâncio and Bank of France Governor François Villeroy both expressed concern about the euro's strength, as did Ewald Nowotny, the fairly hawkish President of Austria's central bank. In contrast, Mario Draghi refused to wade into the debate during yesterday's press conference. The lack of angst in his tone sent the euro higher. Draghi's reluctance to say anything concrete about the euro was partly motivated by the desire to avoid the sort of "beggar thy neighbor" criticism that greeted Mnuchin's remarks. Like other central banks, the ECB gives a lot of weight to financial conditions in setting monetary policy. A stronger currency has tightened euro area financial conditions. This is something that must concern the ECB, at least behind closed doors. Ultimately, any effort by the ECB to knock down the euro will only work if it convinces the market to soften its expectations about the future pace of rate hikes. The likelihood of such an outcome is certainly higher now than it was in 2016. Our "months to hike" measure for the ECB has plummeted from over 60 months in mid-2016 to 19 today (Chart 7). Given that the ECB has made it clear that it intends to delay raising rates for some time after asset purchases end later this year, it is hard to see the central bank hiking rates before the summer of 2019. That is not far from where market pricing now stands. In contrast, if euro area growth were to surprise meaningfully on the downside or if core inflation in the peripheral economies continues to fall - it is already close to zero in Italy - the ECB could be forced to bide its time longer than the market currently expects. A Safer Way To Short EUR/USD Chart 8EUR/USD And Rate Decoupling ##br##Will Not Last Long Still, the euro has a lot going for it. Unlike the U.S., the euro area is running a current account surplus. This means the region does not need to attract foreign capital for there to be excess demand for euros. All it needs to do is keep net capital outflows roughly below 3% of GDP. The ability of the euro area to retain and attract fresh capital has become easier as political risk has ebbed and the ECB's pledge to do "whatever it takes" to preserve the euro has solidified. The euro's share of global central bank reserves currently stands at 20%, well below the 60% share enjoyed by the U.S. dollar. If capital continues to gravitate towards the region, the euro could strengthen further. All this makes shorting the euro a risky bet. With that in mind, investors should consider hedging short EUR/USD positions by wagering that the terminal rate spread between the euro area and the U.S. will narrow. Chart 8 shows that the spread in expected policy rates ten years out has decoupled from EUR/USD since the start of the year. The same is true for the 30-year spread between Treasurys and bunds - another good proxy for the terminal rate spread. While spreads have widened in favor of the dollar, the greenback has nonetheless plunged. Such decoupling rarely lasts long, which makes this a highly attractive trade. With that in mind, we are going short EUR/USD as a tactical trade while hedging the risk of a stronger euro by going long 30-year Treasurys/short 30-year bunds (a bet on further spread compression). Given that the first leg of the trade is more volatile than the second, we are scaling up the latter by a factor of 1.5. We will aim to close the trade for a gain of 5% (EUR/USD of about 1.18), assuming no change in the current spread of 160 bps. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades