Europe
Highlights The neutral real rate of interest, R*, is low in most economies, and will only rise gradually over the coming years. Currency movements tend to dampen differences in neutral rates across countries. The fact that R* is higher in the U.S. will limit further downside risk for the dollar. While a variety of structural forces will cap the increase in the neutral real rate, the neutral nominal rate could rise more briskly as inflation picks up. As such, investors should reduce duration risk and increase exposure to inflation-linked securities. We are closing our long GBP/JPY trade for a gain of 9.9% and opening a new trade going short EUR/GBP. EUR/USD will trade in a range of $1.10-to-$1.20 over the next 6-to-9 months before moving lower in the second half of next year. Feature Where Is Neutral? As the global economy continues to recover, central banks are increasingly turning to the question of how to best normalize monetary policy. A key issue in this debate concerns the level of the neutral real rate of interest, commonly referred to as R*. If central banks raise rates too far above the neutral rate, growth could stall. If they don't raise rates enough, inflation could accelerate. The concept of the neutral rate is somewhat difficult to grasp, and we apologize in advance that this report is more abstract than what we are normally accustomed to writing. However, we think that readers who stick with the logic of the piece will be well rewarded with the practical implications that it provides. A Conceptual Framework In thinking about the neutral rate, it is worthwhile to recall the familiar macro identity which states that the difference between what a country saves and what it invests is equal to its current account balance.1 Since one country's current account surplus is another's deficit, globally, the current account balance must equal zero. This, in turn, implies that globally, savings must equal investment. What happens when desired global savings exceed desired investment? The answer is that interest rates will fall.2 Lower rates will incentivize firms to undertake more investment projects, while discouraging household savings. Investment will rise and savings will decline by just enough to ensure that the global savings-investment identity is satisfied. The discussion above aptly captures what happened to the global economy after the financial crisis. The desire of households to boost savings and firms to cut capital spending led to a sharp and sustained drop in the neutral rate. Those who understood this point back in 2010, when the 10-year Treasury yield briefly hit 4%, made a lot of money by being long bonds when most others were fretting about the inflationary effects of QE and large government budget deficits. The Exchange Rate As A Mitigating Force The ability of countries to export their excess savings abroad by running current account surpluses implies that the neutral rate has a large global component. To appreciate this point, consider a simple thought experiment. Suppose the global trading system completely breaks down and every country ends up with a trade balance of zero. For the sake of argument, let us ignore the immense economic dislocations that this would cause and focus simply on the arithmetic impact that this would have on aggregate demand. The U.S. trade deficit currently stands at $567 billion (3% of GDP). Getting rid of it would add about six million jobs. This would likely cause the economy to overheat, forcing the Fed to raise rates. In contrast, the German economy would fall into a deep recession if its €224 billion (7.1% of GDP) trade surplus vanished. The ECB would not be able to raise rates for years. Thus, in the absence of trade, the neutral rate would be higher in the U.S. and lower in the euro area. This simple thought experiment illustrates why the neutral rate partly depends on the value of a country's currency.3 If a country's currency strengthens, all things equal, its neutral rate will fall. The extent to which the currency appreciates will depend on how long the forces causing neutral rates to diverge across countries are expected to persist. In general, if the forces are more structural than cyclical in nature, currencies will adjust to a greater degree (Chart 1).4 Chart 1The Longer The Interest Rate Gap Persists, The Bigger The Exchange Rate Overshoot The discussion above helps make sense of currency movements over the past three years. A key reason the dollar began to strengthen against the euro in the second half of 2014 is that investors became convinced that the neutral rate in the U.S. would exceed that of the euro area for a very long period of time. The rally in the euro this year largely reflects a reappraisal of that view. Stronger euro area growth has convinced many investors that the neutral rate in the region may not be as low as previously imagined. The Outlook For The Neutral Rate The savings-investment balance provides a useful framework for thinking about how the neutral rate will evolve over the coming years. With this framework in mind, let us consider the various forces affecting the neutral rate and how they might change over time. The Debt Supercycle Today, almost 60% of Americans want to save more money according to a recent Gallop poll; before the financial crisis, that number was less than 50% (Chart 2). A slower pace of debt accumulation implies less spending and more desired savings. It is possible that households will become more willing to take on debt as the memories of the Great Recession fade. However, a return to the reckless lending standards of the pre-crisis period is unlikely. Thus, while the end of the deleveraging cycle in the U.S. will push up R*, it will remain low by historic standards. Globally, efforts to reduce leverage have been more halting. In fact, in many emerging markets, debt levels are higher today than in 2008 (Chart 3). This will weigh on R*. Chart 2Return To Thrift Chart 3EM Debt At All-Time Highs The "Amazonification" Of The Economy Chart 4Savings Heavily Skewed Towards Top Earners Technological progress is nothing new, but unlike past inventions which typically replaced man with machine, many of today's innovations appear to be reducing the need for both labor and physical capital.5 Companies like Amazon are laying waste to America's retail sector. Uber and Airbnb are providing ways to use the existing stock of capital more efficiently. Fewer shopping malls, taxis, and hotels means less investment, and less investment means a lower neutral rate. Inequality One of the distinguishing features of the "Amazon economy" is that it is dominated by a few winner-take-all firms. This has generated huge payoffs for their owners, but paltry returns for everyone else. While this is not the only trend fueling income inequality, it has certainly exacerbated it. Rising inequality redistributes income from households that tend to live paycheck-to-paycheck to those who save a lot (Chart 4). This increases aggregate desired savings, leading to a lower neutral rate. However, rising inequality may also generate a political backlash. Donald Trump's ability to take over the Republican party was partly driven by the disillusionment of Republican voters over the GOP's pro-business positions on issues such as immigration and trade. Historically, populism has been associated with larger budget deficits. To the extent that budget deficits soak up savings, they lead to a higher neutral rate. Rising populism could also lead to stronger calls for anti-trust policies. Our sense is that we are slowly moving in this direction. Slower Population Growth Demographic shifts can be tricky to assess because they affect savings and investment in offsetting ways and over different time horizons (Chart 5). A decrease in the growth rate of the population will reduce the incentive to expand capacity. Less investment means a lower neutral rate. Slower population growth may also lead to higher savings for a while, as a larger fraction of the population enters its peak saving years (ages 30-to-50). This also means a lower neutral rate. Eventually, however, aging will push more of the population into retirement, increasing the number of people who are dissaving rather than saving. Rising government spending on health care and pensions could also lead to larger fiscal deficits, further depleting national savings. We may be approaching this outcome. Chart 6 shows that the global "support ratio" - defined as the number of workers relative to the number of consumers - has peaked globally and will start falling sharply over the coming years. Chart 5An Aging Population Eventually Pushes Up Interest Rates Chart 6The Ratio Of Workers To Consumers Have Peaked Slower Productivity Growth As with population growth, slower productivity growth is likely to depress R* at first, but could raise R* over time (Chart 7). Initially, slower productivity growth will prompt firms to curb investment spending. It could also lead to less consumer spending, as households react to the prospect of smaller gains in real incomes. All this implies a lower neutral rate. Eventually, however, chronically weak income growth is likely to deplete national savings, leading to a higher neutral rate. The U.S. and a number of other economies may be getting increasingly close to that inflection point (Chart 8). Chart 7A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Chart 8Weak Supply Growth Has Narrowed Output Gaps Lower Commodity Prices Swings in commodity prices may also generate offsetting pressures on the neutral rate that manifest themselves over different time horizons. At the outset, lower commodity prices tend to depress investment spending in the resource sector. This implies a lower neutral rate. Over time, however, lower commodity prices may generate new investment opportunities in downstream industries that use fuel as an input. Lower commodity prices also put money into the pockets of poorer households who are likely to spend it. This raises the neutral rate. Investment Implications Given the conflicting forces affecting R*, it is difficult to have much certainty over how it will evolve. Our best guess is that R* will increase over the next few years, as the scars from the financial crisis recede, deleveraging headwinds abate, fiscal deficits in some economies widen, and population aging and lower productivity growth make more of a dent in national savings. However, the rise in R* is likely to be gradual and from what is currently a very low base. Where we do have greater conviction is on two points: First, the neutral nominal rate will rise more quickly than the neutral real rate, as inflation picks up in most economies. As discussed last week, central banks have a strong incentive to try to engineer more inflation in situations where the economy needs a low real rate to maintain full employment.6 Getting inflation up has been a struggle ever since the financial crisis began, but now that spare capacity around the world is dissipating, central banks are likely to gain more traction over monetary policy. As such, investors should reduce duration risk and increase exposure to inflation-linked securities. Second, the forces pushing down R* outside the U.S. will remain more pronounced than those in the U.S. This, in turn, will provide some support to the beleaguered U.S. dollar. Investors, in particular, may be getting too optimistic about the ability of the ECB to engineer a full-fledged tightening cycle. The euro area is further behind the U.S. in the deleveraging process, suggesting that desired private-sector savings will remain higher there. The overall stance of fiscal policy is also much tighter in the euro area. The IMF estimates that the euro area's structural primary budget surplus currently stands at 0.7% of GDP, compared to a deficit of 1.9% in the U.S. Thus, fiscal policy is currently adding 2.6% of GDP more to aggregate demand in the U.S. than in the euro area. The Fund expects this relative contribution to increase to nearly 4% of GDP by the end of the decade (Chart 9). Furthermore, investment spending has more scope to fall in the euro area. According to the OECD, gross fixed capital formation is actually higher in the euro area than in the U.S. as a share of GDP, despite the fact that potential GDP growth is slower in the euro area (Chart 10). Chart 9Fiscal Policy Is More Stimulative In The U.S. Chart 10Euro Area Investment Spending: Higher Than In The U.S. The appreciation of the euro has led to a tightening in euro area financial conditions in recent weeks, whereas U.S. financial conditions have continued to ease (Chart 11). This will cause relative growth to shift back in favor of the U.S. later this year. Chart 11Diverging Financial Conditions##br## Favor U.S. Over The Euro Area Chart 12The Neutral Rate Is Lowest In The Euro Area The 30-year U.S. Treasury yield is currently 95 basis points higher than the 30-year GDP-weighted euro area government bond yield. This gap in yields does not strike us as being especially large considering that both the neutral rate and long-term inflation expectations are lower in the euro area. We expect EUR/USD to trade in a range of $1.10-to-$1.20 over the next 6-to-9 months before moving lower in the second half of 2018, by which time the Fed will be forced to pick up the pace of rate hikes. The resurgent euro has approached all-time highs against the pound, abetted by a somewhat more dovish-than-expected BoE meeting this week. Yet, with U.K. inflation above target and the unemployment rate at the lowest level since 1975, the Bank of England may need to deliver more than the mere 36 basis points in rate hikes the market is expecting over the next two years. Holston, Laubach and Williams estimate that R* is 1.6 percentage points higher in the U.K. than in the euro area (Chart 12). As such, the balance of risks now favor a stronger pound over a cyclical horizon of 12 months. With that in mind, we are closing our long GBP/JPY trade for a gain of 9.9% and opening a new short EUR/GBP position (Note: The returns of all closed trades are displayed at the back of this report). Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 The difference between what a country saves and what it invests is also equal to the difference between what it earns and what it spends. To see this, note that S=Y-C-G where S is national savings, Y is national income, C is personal consumption, and G is government spending. Hence, the identity S-I=CA can be re-written as Y-(C+G+I)=CA where CA is the current account balance. 2 An obvious question is what happens if desired savings exceed desired investment, but interest rates are already equal to zero. In that case, income will contract. Workers will lose their jobs, making it impossible for them to save. Firms will suffer lower profits or even incur losses in the face of flagging demand. Governments will see tax revenues dry up and spending on welfare programs escalate. This means that household, corporate, and government savings will all decline. Of course, since firms are likely to reduce investment in response to slower growth, this could usher in a vicious cycle where falling demand leads to higher unemployment and even less spending - in other words, a recession or even a depression. 3 Suppose, for example, that the interest rate in Country A were to rise above that of Country B for a period of say, ten years. Country A's currency would appreciate. This would reduce net exports in Country A, leading to a decline in aggregate demand. This, in turn, would prevent the neutral rate in Country A from rising as much as it otherwise would. On the flipside, the cheapening of Country B's currency would push up its neutral rate. 4 In the extreme case where the structural forces are expected to last forever, currencies will adjust to the point where the neutral rate across countries is equalized. Intuitively, this must happen because it is impossible for currency-hedged, risk-adjusted interest rates to be lower in one country than in another for an indefinite amount of time. 5 From a neoclassical economics perspective, one might imagine a "production function" that includes labor, physical capital, and digital capital. Many of today's innovations are raising the return on digital capital relative to those on labor and physical capital. This generates outsized rewards to the owners of this particular form of capital (i.e., internet companies), while potentially undercutting the income of workers and owners of physical capital. 6 Please see Global Investment Strategy Weekly Report, “A Secular Bottom In Inflation,” dated July 28, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The euro area's growth prospects, adjusted for population, are no different to any other major developed economy. If the euro area continues its recovery to just the mid-point of its long-term relative growth cycle... ...the yield spread between long-dated bonds in the euro area and the U.S. will compress to around -50 bps from today's -150 bps... ...and euro/dollar will eventually rally to over 1.30. Stay overweight euro area Financials and Retailers versus U.S. Financials and Retailers. Feature ChartThe Euro Area Has Surged Because Expectations ##br##For The Euro Area's 'Terminal' Interest Rate Have Surged Feature The latest GDP releases confirm that the euro area has comfortably outperformed other major developed economies this year. Yet among mainstream equity indexes the Eurostoxx50, which is up 6%, has comfortably underperformed both the MSCI World index1 and the S&P500, which are up 9% and 11%. Why? One clue comes from the technology-heavy NASDAQ 100, which is up 21%. Whereas euro area equities have a negligible exposure to technology, the S&P500 has more than a quarter of its market capitalization in the strongly performing tech and biotech sectors (Chart I-2). Then there is the effect of the surging euro. The largest euro area companies are multinationals earning dollars. In dollar terms, euro area profit growth2 has indeed outperformed U.S. profit growth by about 10%. But converted back into euros - the base currency of the Eurostoxx50 - the outperformance has become an underperformance (Chart I-3). Chart I-2When Technology Outperforms, The Eurostoxx50 Underperforms Chart I-3Euro Area Profits Have Outperformed In Dollars, ##br##But Not In Euros Play Relative Economic Performance Through Bonds And Currencies Chart I-4Euro Area Banks Have Outperformed U.S. Banks The salutary lesson is that sector and currency effects always swamp relative economic performance in predicting or explaining the relative performance of mainstream equity indexes. To play the euro area's economic outperformance, global equity investors must drill down to the more domestically driven euro area sectors, financials and retailers. An overweight position in these two domestic sectors versus their equivalents in, say, the U.S. has outperformed this year, and should continue to do so (Chart I-4). But the best way to play relative economic performance is through other asset classes. Focus not on equities, but on government bonds and currencies. In line with the euro area's superior economic performance this year, the spread between long-dated bond yields in the euro area and U.S. has compressed by 45bps, and euro/dollar is up 12%. The good news is that these trends can ultimately run much further. He That Is Without Structural Problem, Cast The First Stone... Chart I-5For American Men, Labour Force ##br##Participation Rate Is Collapsing The obvious pushback to the longer-term narrative is: what about the euro area's much discussed structural difficulties? To which our response is yes, the euro area does face undoubted long-term challenges. Integrating 19 disparate nations into the confines of an ever closer financial, economic, and ultimately political union is a task that comes with difficulties and risks, especially in the political dimension. Having said that, the euro area is not the only major economy contending with major financial, economic and political challenges in the coming years. To paraphrase the Bible, "he that is without structural problem among you, let him cast the first stone at the euro area." The United Kingdom will spend the next few years struggling to define and redefine the meaning of Brexit, then trying to negotiate it, and then grappling to implement it - whatever 'it' ends up being. The whole process is fraught with financial, economic and political challenges and dangers. Looking West, the United States is suffering a major structural downtrend in its labour participation rate; for American men especially, the participation rate is collapsing (Chart I-5), which creates its own political problems. Looking East, Japan is suffering a chronically low and declining birth rate. And China must wean itself off a decade long addiction to debt-fuelled growth. We could go on... Seen in this light, are the euro area's structural challenges really any harder (or easier) than those faced by the other major economies? The Euro Area Is An Economic Equal One important differentiator across the major developed economies is population growth. A population that is growing boosts headline output. On the other hand, it also adds to the number of people who must share the economy's income and resources. Conversely, a population that is shrinking weighs on headline output, but it reduces the number of people who must share the income and resources. Therefore, what matters for standards of living - and the consequent political implications - is the evolution of GDP per head. In a similar vein, a growing population means that a firm will see rising sales. But absent a rise in productivity, the firm will have to employ more staff and capital to deliver those increased sales - in other words, issue more shares. Therefore, what matters for earnings per share is the evolution of productivity, which once again means GDP per head. Some people consider a shrinking population as a particular problem. They argue that when a population is shrinking, the economy needs to shed workers and capital, which can be hard to do. But a growing population can also create disruptions and pains: specifically, resources such as housing and public services might struggle to keep pace with rapidly rising demand. Consider the United Kingdom. In the 1980s and 90s, the population grew at a very sedate 2% per decade. But since the millennium, population growth has almost quadrupled to 7.5% per decade. The resulting strain on housing and public services was a major factor behind the vote for Brexit - which of course, now carries its own disruptive consequences. Chart I-6The Euro Area Is An Economic Equal Therefore, population shrinkage or growth is a problem only if it is sudden or extreme. More modest changes in either direction are neither good nor bad per se. But to assess progress in living standards and indeed equity market profitability, it is crucial to measure economic growth adjusted for population change. On this population adjusted basis, the structural growth prospects of the euro area are not meaningfully different to other developed economies such as the U.K. and the U.S. The euro area is an equal, and recently it has been the first among equals. Over the longer term, the euro area and the U.S. have generated identical growth in real GDP per head (Chart I-6). Within the bigger picture, the euro area has underperformed through multi-year periods encompassing around half the time; and it has outperformed through the multi-year periods encompassing the other half. Seen in this light, the post-2008 phase of poor performance was the impact of back to back recessions separated by an unusually short gap, with the second of the two recessions the direct result of policy errors specific to the euro area. In other words, the euro area's 2008-14 economic underperformance was not structural; it was cyclical. Prospects For Bond Yield Spreads And The Euro If the euro area continues its recovery to just the mid-point of its long-term relative cycle, then recent investment trends ultimately have much further to run. Unsurprisingly, relative interest rate expectations closely follow relative real GDP per head. Relative interest rate expectations 2 years out between the euro area and United States have compressed from -230 bps last December to -185 bps today. Relative interest rates expectations 5 years out have compressed more, to -150 bps today (Feature Chart). This makes perfect sense. Clearly, the ECB will not hike interest rates any time soon, but expectations for the long-term 'terminal' rate have correctly gone up from overly-pessimistic levels. Nevertheless, to reach the mid-point of its long-term cycle, the gap between euro area and U.S. interest rate expectations must ultimately get to around -50 bps (Chart I-7). The implication is that the yield spread between long-dated bonds in the euro area3 and the U.S. will also compress to around -50 bps (Chart I-8). Therefore, on a 2-year horizon, stay underweight euro area bonds - especially German bunds - in a European and global bond portfolio. This also carries repercussions for euro/dollar, given that it closely tracks relative interest rate expectations. The mid-cycle gap of -50 bps equates to euro/dollar at over 1.30 (Chart I-9). And an overshoot to the top of the cycle implies over 1.50. Chart I-7Relative GDP Per Head Leads Relative Interest Rate Expectations Chart I-8...And Bond Yield Spreads Chart I-9Relative Interest Rate Expectations Drive Euro/Dollar But trends do not unfold in straight lines. They are punctuated by regular setbacks. The recent surge in euro/dollar has taken its 65-day fractal dimension towards its lower limit, which suggests excessive short-term herding. That said, we could now be at the mirror-image turning point in ECB policy to that of the summer of 2014. Then, Draghi pre-announced QE; now, he may pre-announce its demise. In which case, fundamentals will override the 65-day fractal signal just as they did three years ago (Chart I-10). Nonetheless, we would not be surprised if euro/dollar first revisited the 1.10-1.15 channel before resuming its long march upwards. Chart I-10Excessive Short-Term Herding In Euro/Dollar, But... Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In local currency terms. 2 Based on 12 month forward earnings per share. 3 Euro area average over 10-year sovereign yield, weighted by sovereign issue size. Fractal Trading Model* This week's trade is to position for an underperformance of Chinese shares versus the emerging markets benchmark. Target a 2.5% profit target and stop-loss. 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 * 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. 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. 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 - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Feature Recommended Allocation When Central Banks Turn Hawkish It seems almost as though, when central bank governors gathered in Portugal for the ECB's annual confab in late June, they agreed to start sounding more hawkish. ECB President Mario Draghi's speech included the line: "The threat of deflation is gone and reflationary forces are at play." Bank of Canada Governor Stephen Poloz went ahead and on July 12 announced Canada's first rate hike in seven years. Indeed, BCA's Central Bank Monitors (Chart 1) suggest that, with the exceptions of Japan and possibly the euro area, all major developed central banks need to tighten monetary policy. Does this matter for risk assets, such as equities? Historical evidence suggests not, as long as the central bank is tightening because it is confident about the outlook for growth and unconcerned about financial risks (rather than, for example, reacting to a sharp rise in inflation). Equity markets typically move up in the early stages of a tightening cycle (Chart 2); it is only when the central bank tightens excessively (usually later in the cycle) that risk assets start to anticipate that this will trigger a recession. Even in the U.S. which, after four rate hikes since December 2015, is the furthest advanced in tightening, the real effective Fed Funds Rate is still -0.3%, below the 0.3% that the Fed believes to be the neutral real rate at the moment (Chart 3). The Fed expects the neutral rate to rise to 1% in the longer run. Chart 1Most Central Banks Need To Tighten Chart 2Equities Usually Rise During Rate Hike Cycle Chart 3Fed Policy Is Still Accommodative But the order in which central banks tighten will be a major driver of currencies (as has been clear with the sharp appreciation of the CAD and AUD in recent weeks). Our current asset recommendations are based on the belief that the market has become too complacent about the speed at which the Fed will tighten (with futures pricing only 26 bp of hikes over the next 12 months), and too nervous about the ECB (Chart 4). As the market starts to understand that the Fed has fallen a little behind the curve, and that the ECB will remain cautious (given continuing weakness in peripheral economies, and a lack of underlying inflationary pressures), we expect to see the dollar begin to appreciate again. A key to all this is whether the recent softness in U.S. inflation data (core PCE inflation has fallen from 1.8% YoY to 1.4% since January) proves to be temporary. A rebound in inflation would allow the Fed to continue to hike without bringing the real rate close to the neutral level yet. It is worth remembering that inflation is a lagging indicator: the recent weakness is largely a reflection of last year's soggy GDP growth (Chart 5), as well as some transitory technical factors (particularly drug and wireless data prices). The recent dollar depreciation should also boost inflation via the import price channel over the coming months (Chart 6). Chart 4Markets Views On Fed And ECB Have Diverged Chart 5Inflation Lags GDP Growth Chart 6Dollar Deprecation Will Raise Prices However, with global equities having produced a total return of 35% since their recent bottom in February last year, and 17% year to date, valuations are unattractive and, on some measures, sentiment is quite optimistic (Chart 7). What catalysts are there left to give risk assets further upside? We see two. First, earnings. The Q2 U.S. results season has seen 77% of S&P 500 companies surprising on the upside at the sales line, with EPS rising 7% compared to the same quarter in 2016. Most of our indicators suggest that earnings have further to rise this year (Chart 8), yet the consensus EPS forecast for 2017 as a whole remains at just over 10%, where it has been since January. Strong earnings momentum is likely to remain a positive at least through the end of the year. Second, tax cuts. Our Geopolitical Strategy service1 remains optimistic that the U.S. Congress will pass tax legislation to come into effect in early 2018. The failure to repeal Obamacare means that the Republican Party will need a big legislative win going into the mid-term elections in November 2017. Tax cuts (which the market is no longer pricing in - Chart 9) is one policy on which there is little disagreement within the GOP. Chart 7Are Investors Getting Too Optimistic? Chart 8Earnings Can Still Surprise On Upside Chart 9No One Expects Tax Cuts Any More None of the recession indicators we highlighted in our most recent Quarterly 2 (global PMIs, the shape of the yield curve, or credit spreads) are pointing to a downturn in the next 12 months. So, given the environment described above, we are happy to remain overweight equities versus bonds, and to maintain our pro-risk and pro-cyclical tilts. But we continue to warn of the risk of a recession in 2019 - probably triggered by the Fed needing to tighten more aggressively - and might look to lower our risk profile in the first half of next year. Equities: We favor DM equities over EM. An appreciating dollar, rising interest rates, weak industrial metals prices this year and uncertain growth prospects for China all represent headwinds for EM equities. Our strong dollar view points to an overweight in U.S. equities in USD terms but, in local currencies, our preference is for euro area and Japanese equities. Both are relatively high-beta, have strongly cyclical earnings momentum, and central banks that are likely to stay dovish. In Japan, the falling popularity rating of the Abe administration might compel it to ramp up fiscal spending to boost the economy, which would help the Bank of Japan in its efforts to rekindle inflation. Chart 10Everyone Has Turned Bullish On The Euro Fixed Income: Our macro outlook, with faster rate hikes and rebounding inflation in the U.S., is very negative for rates. We are underweight government bonds, short duration and prefer inflation-linked bonds to nominal ones. Valuations in credit are no longer particularly attractive but, with a 100 bp spread for U.S. investment grade bonds and a 230 bp default-adjusted spread for high-yield, returns are likely to be satisfactory as long as the economic cycle continues to improve. Currencies: Our fundamental view of the dollar is that relative monetary policy and interest rates point to further appreciation, especially against the yen and euro. The timing of the dollar's rebound, though, is harder to pinpoint. The euro could rise further over the next couple of months. However, given speculators' large net long positions in the euro - a big turnaround from the start of the year (Chart 10) - the likely announcement by the ECB in September or October of a reduction in its asset purchases might be the catalyst for a reversal (as a classic "buy the news, sell the rumor" event), particularly if Mario Draghi dresses it up as a "dovish tapering." Commodities: Oil inventories have begun to draw down in line with our expectations (Chart 11). Continued discipline by OPEC producers until next March, combined with a slowdown in the growth of U.S. shale production (reflecting the weaker crude price this year) should bring inventories down further (despite production increases in such countries as Libya and Iran), and push the price of WTI above $55 a barrel by year end. Industrial commodity prices have rebounded somewhat in the past six weeks, mainly on the back of moderately brighter economic data out of China (Chart 12). But, given uncertain prospects about the sustainability of this growth, especially beyond the Communist Party Congress in the fall, and amid some signs of weakness in Chinese monetary and credit aggregates,3 we remain cautious about the outlook for metals prices over the next 12 months. Chart 11Oil Inventories Will Draw Down Further in Chart 12Tick-Up In Chinese Data? Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bca.research.com. 2 Please see BCA Global Asset Allocation, "Quarterly Portfolio Review," dated July 3, 2107, available at gaa.bcaresearch.com. 3 Please see BCA Emerging Markets Strategy Weekly Report, "Follow The Money, Not The Crowd," dated July 26, 2017, available at ems.bcaresearch.com. Recommended Asset Allocation
Highlights Structural Bond Backdrop: The secular global bond market outlook is slowly deteriorating on the margin. The structural forces that have driven down bond yields over the past few decades are in the process of stabilizing or even slowly reversing. With central banks moving away from "emergency" stimulative monetary policies that were designed to fight imminent deflation risks that are no longer needed, the path of least resistance for global bond yields is up. Central Bank Liquidity & Volatility: The current low volatility backdrop is a function of solid global economic growth and accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but monetary policies will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds for the rest of 2017. Feature The End Of The Bond Bull Market, One Year Later In July of last year, BCA put its flag in the ground and declared the end of the 35-year global bond bull market.1 This was not a view that a new fixed income bear market was about to immediately unfold. Rather, we concluded that all the bond-bullish factors of the past few decades - aging populations, anemic productivity growth, structurally declining global inflation rates - were more than fully reflected in the level of bond yields seen after the shocking result of the U.K. Brexit referendum. Even in the most pessimistic of future scenarios for the global economy, a 10-year U.S. Treasury yield at 1.37% or a 10-year German Bund yield at -0.18% (the intraday lows seen immediately after the Brexit vote) discounted an awful lot of bad news. Chart of the WeekA Less Market-Friendly##BR##Backdrop On The Horizon? We believed that central bankers would likely respond to the uncertainties created by the growing wave of political populism evidenced by Brexit (and, later, Trump) by keeping monetary settings as loose as possible for as long as possible. Overly accommodative policy would provide a reflationary tailwind to global growth - especially if governments also looked to placate voter uprisings with looser fiscal policy. Coming at a time when many of the powerful structural factors that have acted to suppress bond yields in recent decades were starting to lose potency, the risks were tilted toward a cyclical rise in yields that could turn into something longer lasting. Roll the tape forward one year, and some parts of our prediction have already come to fruition. The major developed economy central banks have generally leaned on the dovish side. Policy rates have been kept well below "equilibrium" - in some cases, below zero. Only the U.S. Federal Reserve has been able to raise interest rates a handful of times, and even then while still maintaining a bloated balance sheet left over from the QE era. More importantly, the European Central Bank (ECB) and the Bank of Japan (BoJ) have continued with asset purchase programs that have added a combined $3.5 trillion in monetary liquidity over the past two years. That massive dose of money printing has helped keep global bond yields low while supporting a coordinated economic recovery that has underwritten equity and credit bull markets worldwide (Chart of the Week). The structural aspects of our long-term call on global bonds are less evident in the current economic data, but we are even more convinced that the tide is turning. This week, we are including a pair of additional Special Reports, recently authored by BCA's Chief Global Strategist, Peter Berezin, and Mark McClellan, Chief Strategist for our flagship publication, The Bank Credit Analyst. Mark discusses how many of the secular drivers of the current low level of global bond yields - aging populations; excess global savings, especially from China; the absorption of low-cost labor from the emerging world; globalization of world trade and supply chains - are waning or may even be reaching an inflection point. Peter takes an even more provocative stand in his report, laying out a case for why the current backdrop of low global productivity growth will eventually lead to higher real interest rates and faster inflation. In this Weekly Report, we tackle the more immediate issue of the shifting outlook for central bank policies and what it implies for the current state of low market volatilities. The growth rate of the "G-3" aggregate balance sheet has already peaked which, combined with early warning signs on future growth signaled by measures like our diffusion index of global leading economic indicators, suggests that a turning point in the current low volatility, pro-risk backdrop may start to unfold in the months ahead - but not before government bond yields move higher on the back of rebounding inflation and central bank tightening actions. Are Central Banks To Blame For Low Volatility? Perhaps the hottest topic among investors at the moment is what to make of the exceptionally low levels of market volatility. The so-called "fear gauge" - the U.S. VIX index - fell into single digits last month to the lowest level since 1993. This is not the only measure of market volatility that is probing historic lows, however. In Chart 2, we show the range of realized total return volatilities for major global asset classes dating back to 1999. The current volatilities all sit very close to the low end of the historical range, from bonds to equities to currencies to commodities. Part of this can simply be chalked up to the broad-based acceleration of global growth seen over the past year, which has supported stable earnings-driven equity bull markets. Chart 2It's Not Just The VIX ... All Market Volatilities Are Historically Low The slow response of central banks to this upturn is an even bigger factor, helping keep bond volatility depressed. Low rates of realized inflation, and restrained levels of expected inflation, have allowed policymakers to maintain accommodative monetary policies and not engineer slower growth to cool overheating economies. Corporate profits have enjoyed a cyclical boost as a result, to the benefit of equities and corporate credit. For the VIX index, which is based on option-implied volatilities for the S&P 500, the current low level is consistent with a more stable environment for economic growth and corporate profits. The standard deviations of the growth rates of U.S. real GDP and reported S&P earnings have fallen to the lowest levels seen since 1990 (Chart 3). Against this backdrop, it is no surprise that the realized volatility of the S&P 500 is also depressed (bottom panel). The previous dovish biases of central bankers have also played a role in helping keep volatility low. Interest rates been kept at low levels relative to policymakers' own estimates of "neutral". Asset purchase programs in Europe and Japan have acted as a signaling mechanism to markets to delay expectations of future interest rate increases, helping suppress bond yield levels and bond price volatility. This has acted to boost risk-seeking behavior among investors seeking adequate investment returns given rock-bottom risk-free interest rates. In the U.S., policymakers still have strong memories of the mid-2000s period where predictable monetary policy, even during a tightening cycle, led to an extended period of low market volatility and encouraged risk-taking behavior fueled by excessive leverage. A greater focus on "financial stability" issues has likely played a hand in the timing of the Fed's rate hikes earlier this year, given that growth and inflation data were not rapidly accelerating (especially prior to the June rate hike). In other words, the Fed was seeing soaring equity prices, tightening credit spreads and a weaker U.S. dollar as an easing of financial conditions that could set the stage for more rapid economic growth, and more "frothy" investor behavior, down the road. The Fed can take some comfort in the fact that some signs of speculative excesses in the U.S. corporate bond market are not at levels seen during the credit boom of the prior decade. Our preferred measure of corporate balance sheet leverage, debt less cash relative to the EBITD measure of earnings, is rising but remains below prior peaks despite the current lower level of corporate borrowing rates (Chart 4). Inflows into corporates from foreign buyers are far below the levels seen in the mid-2000s, while domestic retail buying of corporate bond funds is within historic norms (middle panel). Some signs of excess are appearing, however, with the share of leveraged loan issuance taken up by so-called "covenant-lite" deals offering reduced protection for lenders soaring to a record high earlier this year (bottom panel). Chart 3A Low VIX Reflects More Stable Growth & Earnings Chart 4Not At 2000s Credit Bubble Levels...Yet The Fed will never explicitly say that monetary policy is being tightened to cool off booming financial markets. However, numerous Fed officials have mentioned signs of stretched market valuations in their public speeches in recent months. This suggests that there is growing concern about leaving monetary policy too accommodative for too long and potentially fueling future asset bubbles. We remain of the view that faster growth and rebounding inflation will prompt the next wave of Fed rate hikes over the next year - which is not currently discounted in financial markets, leading us to maintain a below-benchmark recommended duration stance in the U.S. Yet the very easy level of financial conditions will also play a role in the Fed's next move. In many ways, the current backdrop is similar to 2014. Realized U.S. inflation was falling rapidly then, but financial conditions were easing and leading economic indicators were rising, even as the Fed was tapering its QE purchases to zero (Chart 5). At the beginning of the Fed's tapering process in the spring of 2014, there was barely one 25bp rate hike priced into the Overnight Index Swap (OIS) curve. As the Fed began to taper its bond buying, even while inflation was falling, investors got the hint that the Fed was serious about becoming less accommodative and began to price in more future rate hikes (bottom panel). Chart 52014 Revisited? Chart 6The ECB Will Taper Next Year We see a similar dynamic playing out in Europe in the coming months as the markets begin to more seriously price in a slower pace of ECB bond purchases in 2018, which the central bank is likely to formally announce next month (Chart 6). In Japan, the BoJ has already been buying bonds at a slower pace this year after shifting to a bond yield target from a quantitative purchase target last September (Chart 7). Combined with the additional Fed hikes that are likely to come, in addition to the Fed beginning to "normalize" the size of its swollen balance sheet (Chart 8), the central bank liquidity backdrop is about to become much less friendly for financial markets. Chart 7The BoJ Has Already Tapered Chart 8Let The Fed Runoff Begin We have seen the lows in market volatility for this business cycle. This will become a bigger issue for risk assets after monetary policy becomes even less accommodative and economic data begins to slow in response, likely sometime in the first half of 2018. Until then, the current healthy pace of global growth will put more upward pressure on bond yields than downward pressure on equity or credit market valuations over the rest of the year. Bottom Line: The current low volatility backdrop is a function of solid global economic growth with accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but the monetary policy backdrop will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds over the rest of 2017. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Investment Strategy Third Quarter 2016 Strategy Outlook, "The End Of The 35-Year Global Bond Bull Market", dated July 8th 2016, available at gis.bcaresearch.com. Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Structural Bond Backdrop: The secular global bond market outlook is slowly deteriorating on the margin. The structural forces that have driven down bond yields over the past few decades are in the process of stabilizing or even slowly reversing. With central banks moving away from "emergency" stimulative monetary policies that were designed to fight imminent deflation risks that are no longer needed, the path of least resistance for global bond yields is up. Central Bank Liquidity & Volatility: The current low volatility backdrop is a function of solid global economic growth and accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but monetary policies will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds for the rest of 2017. Feature The End Of The Bond Bull Market, One Year Later In July of last year, BCA put its flag in the ground and declared the end of the 35-year global bond bull market.1 This was not a view that a new fixed income bear market was about to immediately unfold. Rather, we concluded that all the bond-bullish factors of the past few decades - aging populations, anemic productivity growth, structurally declining global inflation rates - were more than fully reflected in the level of bond yields seen after the shocking result of the U.K. Brexit referendum. Even in the most pessimistic of future scenarios for the global economy, a 10-year U.S. Treasury yield at 1.37% or a 10-year German Bund yield at -0.18% (the intraday lows seen immediately after the Brexit vote) discounted an awful lot of bad news. Chart of the WeekA Less Market-Friendly##BR##Backdrop On The Horizon? We believed that central bankers would likely respond to the uncertainties created by the growing wave of political populism evidenced by Brexit (and, later, Trump) by keeping monetary settings as loose as possible for as long as possible. Overly accommodative policy would provide a reflationary tailwind to global growth - especially if governments also looked to placate voter uprisings with looser fiscal policy. Coming at a time when many of the powerful structural factors that have acted to suppress bond yields in recent decades were starting to lose potency, the risks were tilted toward a cyclical rise in yields that could turn into something longer lasting. Roll the tape forward one year, and some parts of our prediction have already come to fruition. The major developed economy central banks have generally leaned on the dovish side. Policy rates have been kept well below "equilibrium" - in some cases, below zero. Only the U.S. Federal Reserve has been able to raise interest rates a handful of times, and even then while still maintaining a bloated balance sheet left over from the QE era. More importantly, the European Central Bank (ECB) and the Bank of Japan (BoJ) have continued with asset purchase programs that have added a combined $3.5 trillion in monetary liquidity over the past two years. That massive dose of money printing has helped keep global bond yields low while supporting a coordinated economic recovery that has underwritten equity and credit bull markets worldwide (Chart of the Week). The structural aspects of our long-term call on global bonds are less evident in the current economic data, but we are even more convinced that the tide is turning. This week, we are including a pair of additional Special Reports, recently authored by BCA's Chief Global Strategist, Peter Berezin, and Mark McClellan, Chief Strategist for our flagship publication, The Bank Credit Analyst. Mark discusses how many of the secular drivers of the current low level of global bond yields - aging populations; excess global savings, especially from China; the absorption of low-cost labor from the emerging world; globalization of world trade and supply chains - are waning or may even be reaching an inflection point. Peter takes an even more provocative stand in his report, laying out a case for why the current backdrop of low global productivity growth will eventually lead to higher real interest rates and faster inflation. In this Weekly Report, we tackle the more immediate issue of the shifting outlook for central bank policies and what it implies for the current state of low market volatilities. The growth rate of the "G-3" aggregate balance sheet has already peaked which, combined with early warning signs on future growth signaled by measures like our diffusion index of global leading economic indicators, suggests that a turning point in the current low volatility, pro-risk backdrop may start to unfold in the months ahead - but not before government bond yields move higher on the back of rebounding inflation and central bank tightening actions. Are Central Banks To Blame For Low Volatility? Perhaps the hottest topic among investors at the moment is what to make of the exceptionally low levels of market volatility. The so-called "fear gauge" - the U.S. VIX index - fell into single digits last month to the lowest level since 1993. This is not the only measure of market volatility that is probing historic lows, however. In Chart 2, we show the range of realized total return volatilities for major global asset classes dating back to 1999. The current volatilities all sit very close to the low end of the historical range, from bonds to equities to currencies to commodities. Part of this can simply be chalked up to the broad-based acceleration of global growth seen over the past year, which has supported stable earnings-driven equity bull markets. Chart 2It's Not Just The VIX ... All Market Volatilities Are Historically Low The slow response of central banks to this upturn is an even bigger factor, helping keep bond volatility depressed. Low rates of realized inflation, and restrained levels of expected inflation, have allowed policymakers to maintain accommodative monetary policies and not engineer slower growth to cool overheating economies. Corporate profits have enjoyed a cyclical boost as a result, to the benefit of equities and corporate credit. For the VIX index, which is based on option-implied volatilities for the S&P 500, the current low level is consistent with a more stable environment for economic growth and corporate profits. The standard deviations of the growth rates of U.S. real GDP and reported S&P earnings have fallen to the lowest levels seen since 1990 (Chart 3). Against this backdrop, it is no surprise that the realized volatility of the S&P 500 is also depressed (bottom panel). The previous dovish biases of central bankers have also played a role in helping keep volatility low. Interest rates been kept at low levels relative to policymakers' own estimates of "neutral". Asset purchase programs in Europe and Japan have acted as a signaling mechanism to markets to delay expectations of future interest rate increases, helping suppress bond yield levels and bond price volatility. This has acted to boost risk-seeking behavior among investors seeking adequate investment returns given rock-bottom risk-free interest rates. In the U.S., policymakers still have strong memories of the mid-2000s period where predictable monetary policy, even during a tightening cycle, led to an extended period of low market volatility and encouraged risk-taking behavior fueled by excessive leverage. A greater focus on "financial stability" issues has likely played a hand in the timing of the Fed's rate hikes earlier this year, given that growth and inflation data were not rapidly accelerating (especially prior to the June rate hike). In other words, the Fed was seeing soaring equity prices, tightening credit spreads and a weaker U.S. dollar as an easing of financial conditions that could set the stage for more rapid economic growth, and more "frothy" investor behavior, down the road. The Fed can take some comfort in the fact that some signs of speculative excesses in the U.S. corporate bond market are not at levels seen during the credit boom of the prior decade. Our preferred measure of corporate balance sheet leverage, debt less cash relative to the EBITD measure of earnings, is rising but remains below prior peaks despite the current lower level of corporate borrowing rates (Chart 4). Inflows into corporates from foreign buyers are far below the levels seen in the mid-2000s, while domestic retail buying of corporate bond funds is within historic norms (middle panel). Some signs of excess are appearing, however, with the share of leveraged loan issuance taken up by so-called "covenant-lite" deals offering reduced protection for lenders soaring to a record high earlier this year (bottom panel). Chart 3A Low VIX Reflects More Stable Growth & Earnings Chart 4Not At 2000s Credit Bubble Levels...Yet The Fed will never explicitly say that monetary policy is being tightened to cool off booming financial markets. However, numerous Fed officials have mentioned signs of stretched market valuations in their public speeches in recent months. This suggests that there is growing concern about leaving monetary policy too accommodative for too long and potentially fueling future asset bubbles. We remain of the view that faster growth and rebounding inflation will prompt the next wave of Fed rate hikes over the next year - which is not currently discounted in financial markets, leading us to maintain a below-benchmark recommended duration stance in the U.S. Yet the very easy level of financial conditions will also play a role in the Fed's next move. In many ways, the current backdrop is similar to 2014. Realized U.S. inflation was falling rapidly then, but financial conditions were easing and leading economic indicators were rising, even as the Fed was tapering its QE purchases to zero (Chart 5). At the beginning of the Fed's tapering process in the spring of 2014, there was barely one 25bp rate hike priced into the Overnight Index Swap (OIS) curve. As the Fed began to taper its bond buying, even while inflation was falling, investors got the hint that the Fed was serious about becoming less accommodative and began to price in more future rate hikes (bottom panel). Chart 52014 Revisited? Chart 6The ECB Will Taper Next Year We see a similar dynamic playing out in Europe in the coming months as the markets begin to more seriously price in a slower pace of ECB bond purchases in 2018, which the central bank is likely to formally announce next month (Chart 6). In Japan, the BoJ has already been buying bonds at a slower pace this year after shifting to a bond yield target from a quantitative purchase target last September (Chart 7). Combined with the additional Fed hikes that are likely to come, in addition to the Fed beginning to "normalize" the size of its swollen balance sheet (Chart 8), the central bank liquidity backdrop is about to become much less friendly for financial markets. Chart 7The BoJ Has Already Tapered Chart 8Let The Fed Runoff Begin We have seen the lows in market volatility for this business cycle. This will become a bigger issue for risk assets after monetary policy becomes even less accommodative and economic data begins to slow in response, likely sometime in the first half of 2018. Until then, the current healthy pace of global growth will put more upward pressure on bond yields than downward pressure on equity or credit market valuations over the rest of the year. Bottom Line: The current low volatility backdrop is a function of solid global economic growth with accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but the monetary policy backdrop will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds over the rest of 2017. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Investment Strategy Third Quarter 2016 Strategy Outlook, "The End Of The 35-Year Global Bond Bull Market", dated July 8th 2016, available at gis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
Highlights EUR/USD is likely to correct over the course of the coming weeks, however, the picture remains too murky to be aggressive. The dollar move since 2015 is still in line with previous sideways consolidations. Economic developments suggest that the USD is more likely to break out than breakdown over the next 12 months. Inflation will hold the keys to the next big trend. The RBA is hampered by a high degree of labor underutilization, and the roll-over in the Chinese Keqiang index bodes poorly for the AUD. Feature The euro's recent strength has been nothing short of stunning. Abandoning our "dollar correction" stance at the end of May was clearly a mistake.1 Now that EUR/USD has punched back above its 2015 high, it is time to reflect whether this year's dollar decline was indeed a correction or whether the euro's bear market is over, in which case EUR/USD could move back above its PPP fair value of 1.33. A Dollar Move Chart I-1The Dollar Is Weak Against Everything The rally in EUR/USD has been more than just a period of euro strength: it has been reflective of a broad-based decline in the USD. As Chart I-1 illustrates, the plunge in the dollar's advance/decline line indicates the greenback has been weak against pretty much everything out there. While the White House's failures and its lack of action on the fiscal stimulus front have played a role in explaining the dollar's weakness, the Federal Reserve's absence of credibility among market participants has been an even greater factor. Weak U.S. inflation, with core CPI at 1.7% and core PCE at 1.4%, implies that the Fed is not achieving its 2% inflation target. Thus, the probability of another rate hike in December has now fallen below 50%, and the OIS curve only anticipates one interest rate hike per year for the next two years. We can add color by looking at specific contracts. At the end of 2016, the December 2019 Eurodollar futures sported a nearly 2.6% implied rate. Today, the same contract trades below 2%. This seems too complacent. For one, U.S. financial conditions have massively eased in response to the collapse in the dollar and the rally in risk assets. This suggests U.S. growth should perk up toward 3% for the remainder of 2017 (Chart I-2). Chart I-2Financial Conditions Will Support Growth Moreover, this is not happening in a vacuum. The official U.S. output gap is more or less closed, and our Composite Capacity Utilization Gauge - which incorporates both the traditional capacity utilization measure along with the unemployment gap - has now moved decisively into "no slack" territory. Under such circumstances, accelerating growth is likely to put heightened pressures on existing resources, raising the risk of a resumption in inflation. Also, in and of itself, this indicator has historically displayed long leads on inflation. Based on this measure, inflation should bottom during the third quarter of 2017 (Chart I-3). With the narrative that inflation is low forever well-entrenched in the market, an inflation surprise in the fall is a growing threat that would prompt a violent repricing of the Fed's path toward something closer to the "dots." This would support a rebound in the DXY. Would this rebound be playable? Our bias is to say yes. The U.S. labor market is still much tighter than the rest of the G10. The U.S. unemployment remains 2.7 percentage points below its 10-year moving average, versus 0.3 percentage points for the rest of the G10 (Chart I-4). Hence, U.S. rates have more upside relative to other advanced economies. This suggests that peak monetary divergences have yet to be seen. Moreover, from a technical perspective, it is far from clear that the dollar bull market is over. While the dollar A/D line has swooned, it has yet to break down - a pattern reminiscent of the second half of the 1990s, when the dollar bull market also experienced a long pause before powering ahead again (Chart I-5). Chart I-3The Trough In Inflation Is Coming Chart I-4The U.S.: In A Tighter Spot Chart I-5Too Early To Tell If The Greenback Is Dead Bottom Line: The euro's strength has been a reflection of generalized weakness in the USD. So far, the USD's weakness in 2017 continues to look and smell like a correction, similar to the action in the late 1990s. However, we cannot be dogmatic: the USD will remain under the thralls of inflationary dynamics in the U.S. The easing in U.S. financial conditions, along with the elevated level of resource utilization, suggests U.S. inflation will pick up this fall, which should prompt a repricing of the Fed's path by investors. The Euro Specifics When it comes to that specifics of the euro, the economic fundamentals are in favor of the dollar right now. First, it is undeniable the euro area inflation has been surprising to the upside relative to that of the U.S. However, this is principally a reflection of the lagging stimulative impact of the 25% collapse in the euro from April 2014 to March 2015. Its 12% appreciation since then points to a reversal of this dynamic (Chart I-6). Second, aggregate relative financial conditions (FCI) tell a similar story. The tightening in euro area FCI relative to the U.S. also points to a slowdown in relative growth in favor of the U.S. Most crucially though, this tightening in relative FCI also portends a change in relative inflation dynamics. As Chart I-7 illustrates, the change in relative FCI has been a reliable leading indicator of comparative inflation dynamics. At this juncture, it argues that inflation in Europe should slow down relative to the U.S. Chart I-6Inflation Surprises Will Move##br## From Europe To The U.S. Chart I-7FCIs Point To A Reversal ##br##Of Inflation Fortunes This makes sense. The U.S. has had trouble generating much inflation despite the U6 unemployment rate standing at 8.5% - a level at which wages and inflation accelerated in previous cycles. Meanwhile, the euro area's labor underutilization remains very high, especially outside Germany. This suggests that euro area inflation could be vulnerable to the tightening in financial conditions that has materialized in the wake of the euro's rally. In other words, the euro's strength is doing the ECB's job while the dollar's weakness is undoing some of the Fed's tightening. Third, the trading action around the release of the German Ifo survey this past Tuesday was very interesting. The Ifo came in at 116, another record reading and substantially above market expectations, yet the euro fell on the news until it was rescued by the Fed. What is fascinating is that, while the German Ifo is near record highs, the Belgian Business Confidence (BCC) survey has begun to sag (Chart I-8). Because Belgium is a logistical center deeply intertwined within European supply chains, the BCC has been an even better leading indicator of European growth trends than the Ifo. The current extreme gap between the Ifo and the BCC confirms that Europe owes a lot of its current health to Germany's boom - and indicates that the rest of the euro area is already suffering blowbacks from the euro's rally. Fourth, euro area equities have eradicated all of their gains for the year relative to U.S. equities. This is happening exactly as the euro area economic surprise index has rolled over against its U.S. counterpart (Chart I-9). This corroborates the economic risks created by the tightening of FCI in Europe versus the U.S. Fifth, the EUR/USD is trading at its greatest premium to our preferred intermediate-term fair value measure since December 2009 (Chart I-10). This measures incorporate real rate differentials at both the short end and long end of the curve, global risk aversion, and commodity prices, suggesting that the EUR/USD has dissociated from most reasonable guides.2 Chart I-8European Growth Is About Germany Chart I-9Stocks Are Sending A Dark Omen For The Euro Chart I-10Euro And Fair Value Bottom Line: European financial conditions have tightened considerably, especially relative to the U.S. This suggests European inflation will once again lag that of the U.S. Moreover, the pain of tighter FCIs is rearing its head: European stocks are once again underperforming the U.S., and the relative economic surprise index has markedly rolled over. We are thus experiencing a euro overshoot. Timing Chart I-1Skewed Positioning In EUR/USD These fundamental considerations do point to a weaker EUR/USD, but they provide little guidance in terms of timing the end of the euro bull run. Most metrics we follow are in fact pointing to trouble ahead. As we highlighted, euro longs are at all-time highs, while euro shorts have been massively purged. This suggests that chasing any further gains in the euro could be a high-risk proposition (Chart I-11). Additionally, the euro's fractal dimension is fully indicative of massive groupthink, and warns that both short-term and long-term investors are both positioned on the long side of the trade (Chart I-12). While the paucity of willing sellers in the market has been a key ingredient bidding up the euro, this also makes the currency vulnerable to a buying exhaustion phase as potential future buyers are already in the market, and will not be there to support it in the coming months. However, because of this very scarcity of sellers, only a few new buyers are necessary to bid up the euro further. Therefore, with the euro having broken above its 2015 high, a rally toward 1.2 could materialize in the blink of an eye. Because of this risk, we have been shorting the euro through the EUR/SEK, EUR/CAD, and EUR/NOK pairs, a strategy that has paid off. This week, for traders with greater liquidity needs, we recommend a tactical speculative short EUR/USD bet, with a tight stop at 1.182 and a target 1.12. Chart I-12Groupthink In Action Bottom Line: The euro is displaying signs of massive groupthink on the long side. Moreover, speculators are excessively long. Our preferred strategy is still to play a euro correction on its crosses, where the risk reward ratio seems more attractive. However, we are opening a tactical short EUR/USD bet this week with a tight stop. The Almighty AUD In a Special Report published four weeks ago, we positioned Australia in the middle of the pack within G10 central banks in terms of hiking sequence.3 Essentially, while Australia does not suffer from as much slack as the euro area and Switzerland, and from as much uncertainty as the U.K., or as severely entrenched inflation expectations as Japan, it still suffers from much more labor underutilization than Canada, Sweden, or New Zealand. As Chart I-13 illustrates, labor underutilization in Australia is still hovering near 20-year highs, underpinning low wage growth and policy rates. This weakness in wages is likely to continue to weigh on core inflation (Chart I-14). Chart I-13The Root Cause Of The RBA's Dovishness Chart I-14Wages Continue To Weigh On Core CPI Furthermore, while being deeply embedded in the Asian business cycle has helped Australia avoid a recession since 1991, this also means that Australian inflation has been greatly influenced by regional dynamics. Thus, based on recent trends, Aussie headline inflation could endure another down leg, especially as the AUD has rallied 16% since January 2016 (Chart I-15). This means that on all fronts, Australian inflationary pressures will remain muted. The recent speech by Governor Philip Lowe focusing on the flatness of the Australian Philips curve highlights that all these concerns are at the forefront of the Reserve Bank of Australia's mind. As a result, we continue to expect Australian interest rates to lag those in the U.S. As Chart I-16 illustrates, when the unemployment gap - as measured by the difference between unemployment and its 10-year moving average - is greater in Australia than in the U.S., the RBA lags the Fed. This also highlights that the AUD is at risk of a sharp correction once the broad USD rally resumes, especially as its recent strength is completely out of line with policy differentials. Chart I-15The Asian Inflation Anchor Chart I-16The Labour Market Points To A Weaker AUD Beyond the USD's own weakness, the rebound in the Chinese economy has been the main reason behind the Australian dollar's rally - despite the continued dovish bias of the RBA. Australian exports expressed in U.S. dollar terms have surged in response to the Chinese mini boom in late 2016/early 2017 (Chart I-17). However, this positive for the Australian economy and Australian profits is dissipating: the Chinese Keqiang index has rolled over, and Beijing is likely to continue to limit speculative excesses in Chinese real estate - a key source of demand for Australian exports. Chart I-17China's Boost Is Dissipating Moreover, the Australian dollar is trading 10% above its PPP, has moved out of line with interest rate differentials, and investors are massively long this currency; yet Australia still sports a negative international investment position of 60% of GDP. This combination makes the Aussie's strength untenable. When EM stocks break, a view espoused by our Emerging Market Strategy sister service, the AUD should prove the greatest victim within the G10 FX space. Bottom Line: Inflationary pressures in the Australian economy remain muted as labor underutilization remains plentiful. As a result, the RBA is likely to keep a dovish tone at least until the end of the year. The rebound in Chinese activity has been the key factor that has supported the AUD this year. However, the recent rollover in China's Keqiang index indicates this pillar of support to growth and profits is vanishing. The AUD will prove the greatest victim of any EM weakness or risk-off event. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Bloody Potomac", dated May 19, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled, "In Search Of A Timing Model", dated July 22, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy and Global Alpha Sector Strategy Special Report titled, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. Dollar U.S. data was somewhat mixed recently: Continuing and initial jobless claims both came in higher than expected; New home sales also increased at a lesser-than-anticipated pace, with home prices also fairing worse than investors hoped for; However, durable goods increased by very solid 6.5%; Building permits and housing starts, however, are also growing robustly. The DXY has hit a crucial point. It has given up all of its gains since 2015 and even from mid-2016. The greenback has previously fared well at this level, and a buying opportunity should emerge when U.S. inflation picks up as positioning is skewed against the dollar. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Data in core Europe is still firm, although it is becoming increasingly mixed: Headline inflation is staying at the consensus figure of 1.3% and core inflation came in higher than expected at 1.2%; PPI is increasing at a 2.4% pace annually; The IFO survey was robust, with the current assessment, business climate and expectations all beating expectations; However, ZEW survey was weaker than expected; PMIs were also weaker across the board. The recent strength in the euro was also compounded by weakness in the U.S. The euro has failed to appreciate nearly as much against commodity currencies due to higher global growth. Given its much lofty momentum, we are reluctant to bet on more euro upside. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Japanese trade balance worsened as exports and imports grew at 9.7% and 15.5% respectively; However, the all-industry activity index declined by 0.9% in May; The Leading Economic Indicator increased by only 0.4 to 104.6; The Coincident Index, however, declined to 115.8 from 117.1; USD/JPY has been declining recently due to softer U.S. data and lower bond yields. However, we remain yen bears as the absence of inflation remains the key challenge facing the Japanese economy. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Data out of the U.K. was mixed: Real retail sales expanded at a 2.9% annual pace, with the 'ex-Fuel' measure expanding at 3%; PPI managed to increase by 2.9%; However, CPI came in at 2.6%, falling short of the 2.9% expected. GBP/USD has managed to appreciate close to 10% since the beginning of the year, while depreciating around 5% against EUR in the same time period. We still believe the pound has more short-term downside against the euro, and longer-term downside against the greenback. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The economic data flow in Australia saw a somewhat softer patch this week: RBA trimmed-mean CPI increased at a 1.8% pace, in line with consensus but below the previous data point; Headline CPI, however, increased by 1.9%, which was less than expected; Both the export price index and the import price index contracted 5.7% and 0.1% quarterly. Weaker data from the U.S. is helping the AUD sustain its gains, however, external pressures from China are proving to be even more paramount to the Aussie's strength. Domestically, however, the Australian economy remained challenged by persistent underemployment. We therefore believe the RBA is unlikely to follow the Bank of Canada in 2017. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Data out of New Zealand has been mixed: Visitor Arrivals increased at a 17.3% annual pace; The trade balance improved slightly, and both exports and imports also increased; The Global Dairy Trade price index increased by 0.2%; However, CPI came in at 1.7%, disappointing consensus by 0.2%, and falling short of the previous 2.2% figure. While the NZD has strengthened against the USD, it has lagged the euro and the rest of the commodity currency complex. WHile the RBNZ is better placed than the RBA to increase rates, it will continue to lag the BoC and the Fed this year. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The Canadian economy continues to exhibit signs of strength: Wholesale sales increased at a 0.9% monthly pace in May; Manufacturing shipments increased at a 1.1% monthly pace; Foreign portfolio investment in Canadian securities also increased to USD 29.46 bn; The CAD has experienced an unbelievable couple of months, appreciating more than 9% in the process. Weak U.S. data, a hawkish BoC, and somewhat stronger oil, have all added to the CAD's gains. We believe that the BoC will stay hawkish and Saudi Arabia will remain adamant in reducing oil inventories to their 5-year average by the end of the year. While these factors will limit the CAD downside this year, it is now vulnerable to a short-term pullback. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Swiss data has been mixed: Trade balance disappointed at 2,813 mn; UBS Consumption Indicator improved to 1.38 from 1.32; However, the ZEW Survey's Expectations increased to 34.7 from 20.7. EUR/CHF has appreciated more than 2% this past week, while USD/CHF has also been strong. This weakness is welcomed by the SNB, but more softness is needed before durable inflation trend can emerge in the Alpine Confederation. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Norway's recent labor force survey showed that the unemployment rate fell to 4.3%, better than the consensus 4.5%. Along with rebounding oil prices, this has been a key source of support for the NOK. BCA Energy Strategists continue to believe that oil inventories will be reduced to their 5-year average by the end of the year, which should warrant a healthy degree of downside for EUR/NOK. Against the dollar, the picture will become less positive once U.S. inflation picks up again. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 This week's data in Sweden has been somewhat weak: PPI increased at a 4.8% annual pace, less than the previous 7.2%; Consumer confidence decreased to 102.2, below the expected 103.1, and less than the previous 102.6; Unemployment rate increased to 7.4% from 7.2; However, the trade balance increased by 4.2 bn from the previous month. These explain the recent softness in the krona in recent days, however, we doubt that this represents the end of the period of weakness in EUR/SEK. The SEK's appreciation has been the result of an aggregate strengthening in Swedish data, especially on the inflation front, which has prompted a hawkish switch in the Riksbank's rhetoric. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades