Financial Markets

Highlights Spread Product: The credit risk premium has shrunk considerably during the past 16 months. While we don’t foresee a period of significant spread widening any time soon, lower spreads mean lower excess corporate bond returns. We recommend three ways for investors to grab extra spread and increase their excess corporate bond returns: (i) move down in quality, (ii) extend maturity, (iii) favor high-DTS industry groups. Corporate Bond Sectors: High-DTS industry groups like Energy, Communications, Utilities and Basic Industry offer the best risk-adjusted spread pick-up within both investment grade and junk bonds. Consumer Noncyclicals and Transportation also look attractive within high-yield. Municipal Bonds: Investors can increase the average after-tax yield of their bond portfolios without taking greater credit or duration risk by favoring long-maturity tax-exempt municipal bonds (both GO and Revenue). EM Bonds: Investors can increase the average yield of their US bond portfolios by shifting out of investment grade US corporates and into USD-denominated EM Sovereign and Corporate bonds. Feature US bond yields have been on a wild ride since the pandemic struck in March 2020. The 10-year Treasury yield collapsed to 0.52% last year. It then rebounded to a high of 1.74% in March 2021 before falling back to its current 1.21%. But throughout all this volatility in rates markets, the steady outperformance of credit risk has been a constant. For the past 16 months, accommodative monetary policy has spurred a steady flow of investment into spread product, a trade that was amplified by the Fed’s extraordinary intervention in the corporate bond market. On March 23rd 2020, the Fed essentially announced a back-stop of the corporate bond market that gave investors the green light to pile into the sector. Since then, the investment grade corporate bond index has outperformed a duration-matched position in Treasury securities by 24% and the high-yield index has outperformed by 39%. Of course, the result of this consistent flow of funds into spread product has been a collapse in credit spreads. The average spread on the investment grade corporate bond index is only slightly below its post-1973 median, but it is at its tightest level since the mid-1990s (Chart 1). When we adjust for the fact that the index’s average duration has increased significantly since the 1970s, we find that the spread has only been tighter 13% of the time since 1973 (Chart 1, bottom panel). What’s more, this analysis doesn’t control for the fact that the average credit rating of the index has fallen significantly during the past few decades. In short, investment grade corporate bonds are extremely expensive and are quite possibly the most expensive they have ever been in risk-adjusted terms. Chart 1Investment Grade Corporate Bond Valuation Investment Grade Corporate Bond Valuation Investment Grade Corporate Bond Valuation How should bond investors proceed in this environment? Of course, tight credit spreads will cause us to exit our recommended spread product overweight earlier in the cycle than would otherwise be the case. But for the time being, we still see quite a bit of life left in credit markets. We showed in a recent report that corporate bond excess returns tend not to turn negative until the 3/10 Treasury slope is below 50 bps, even during periods when credit spreads are tight.1 At 88 bps, the slope still has a ways to go before breaching that threshold. In the meantime, we advise investors to run high levels of credit risk in their bond portfolios, grabbing attractive risk premiums where they can be found. As for what investors can do to find attractive risk premiums, we have a few suggestions. Move Down In Quality The most obvious way to add spread to a bond portfolio is to move down in quality. Charts 2A-2E show the extra spread that can be picked up by moving down one credit tier at a time. We show both the raw spread pick-up since 1995 and the spread pick-up after adjusting for duration risk (i.e. the 12-month breakeven spread). The additional spread on offer for moving out of Aa-rated bonds and into A-rated bonds is currently 17 bps, very low compared to history (Chart 2A). The extra compensation looks a little better after adjusting for duration risk (Chart 2A, bottom panel), but it is still well below its historical mean. Similarly, investors only earn an additional 38 bps by moving out of A-rated bonds and into Baa-rated bonds (Chart 2B). This is very low compared to history and it looks even worse in duration-adjusted terms (Chart 2B, bottom panel). A move down in quality within the investment grade space may still be worth it, even though the reward for doing so is meager in historical terms. However, investors can get much more bang for their buck by moving out of investment grade entirely and into junk bonds. The additional spread earned in Ba-rated bonds compared to Baa-rated bonds (130 bps) is below its historical average, but it has been much lower in the recent past (Chart 2C). This is also true in duration-adjusted terms (Chart 2C, bottom panel). A move out of Ba-rated bonds and into B-rated bonds looks even better (Chart 2D). Yes, the raw 116 bps spread pick-up in the B-rated index compared to the Ba-rated index is well below its historical mean, but after adjusting for the lower duration of the B-rated index we see that the duration-adjusted spread pick-up in B-rated bonds is above its average historical level (Chart 2D, bottom panel). Finally, we observe that investors earn an extra 159 bps by moving out of the B-rated sector and into the Caa-rated sector (Chart 2E). This is extremely low compared to history, but it looks considerably more appealing in duration-adjusted terms (Chart 2E, bottom panel). All in all, we think it makes sense for investors to grab extra spread by moving down the quality ladder. In particular, investors should favor high-yield bonds over investment grade and focus on the B-rated credit tier where the duration-adjusted spread is most attractive. Chart 2AA Versus Aa A Versus Aa A Versus Aa Chart 2BBaa Versus A Baa Versus A Baa Versus A Chart 2CBa Versus Baa Ba Versus Baa Ba Versus Baa Chart 2DB Versus Ba B Versus Ba B Versus Ba Chart 2ECaa Versus B Caa Versus B Caa Versus B Extend Maturity As an alternative to moving down in quality, investors can also increase the average spread of their credit portfolios by extending maturity within corporate bonds. Compared to history, we find that long maturity investment grade and junk bonds offer above-average compensation relative to their shorter-maturity counterparts (Chart 3A). Of course, implementing this trade means either taking more duration risk in your portfolio or offsetting the increased duration on the credit side by taking less duration risk within your government bond holdings. It’s also worth mentioning that extending maturity within corporate credit is rarely, if ever, an attractive proposition in risk-adjusted terms. The spread per unit of duration for long-maturity corporates is almost always below that of short-maturity corporates (Chart 3B). However, this risk-adjusted spread differential tends to be highest when overall corporate bond spreads are tight. In other words, it is during periods of expensive corporate bond valuations, like today, when it makes most sense to extend maturity within corporate bond portfolios. Chart 3ASpreads: Long Versus Short Spreads: Long Versus Short Spreads: Long Versus Short Chart 3BRisk-Adjusted Spreads: Long Versus Short Risk-Adjusted Spreads: Long Versus Short Risk-Adjusted Spreads: Long Versus Short Favor High-Beta Sectors Finally, investors can chase better returns within the corporate bond space by favoring those industry groups with the highest Duration-Times-Spread (DTS). DTS functions as a rough proxy for corporate bond excess return volatility. In other words, bonds with high (low) DTS tend to perform best during periods of spread tightening (widening) and worst during periods of spread widening (tightening). We can also look at the correlation between DTS and excess returns to get a sense of the excess return earned by taking an extra unit of DTS risk. For example, Chart 4A shows annualized excess returns for the 10 major investment grade industry groups relative to starting DTS for the period that ran from the March 23rd 2020 peak in spreads until the end of last year. The slope of the trendline is 79 bps, meaning that investors earned 79 bps of extra return for taking one extra unit of DTS risk. Notably, this credit risk premium fell to 35 bps per unit of DTS risk this year (Chart 4B), as tighter spreads led to a lower realized credit risk premium. Chart 4AInvestment Grade Credit Risk Premium: March 23 2020 To Dec 31 2020 The Collapsing Credit Risk Premium The Collapsing Credit Risk Premium Chart 4BInvestment Grade Credit Risk Premium: Year-To-Date The Collapsing Credit Risk Premium The Collapsing Credit Risk Premium Interestingly, we don’t observe the same declining credit risk premium in high-yield. Investors earned 95 bps per unit of DTS risk between March 23rd 2020 and Dec 31st 2020 (Chart 4C), but they have earned an even greater 98 bps per unit of DTS risk so far this year (Chart 4D). The steeper line is mostly due to the Energy sector that has delivered strong excess returns and that continues to offer an enticing spread in both absolute and risk-adjusted terms. Chart 4CHigh-Yield Credit Risk Premium: March 23 2020 To Dec 31 2020 The Collapsing Credit Risk Premium The Collapsing Credit Risk Premium Chart 4DHigh-Yield Credit Risk Premium: Year-To-Date The Collapsing Credit Risk Premium The Collapsing Credit Risk Premium The next section of this report dives into the relative attractiveness of different corporate bond industry groups. For now, we just want to stress that it makes sense for credit investors to increase their spread pick-up by favoring those industry groups with the highest DTS. Bottom Line: The credit risk premium has shrunk considerably during the past 16 months. While we don’t foresee a period of significant spread widening any time soon, lower spreads mean lower excess corporate bond returns. We recommend three ways for investors to grab extra spread and increase their excess corporate bond returns: (i) move down in quality, (ii) extend maturity, (iii) favor high-DTS industry groups. Sector Opportunities The previous section recommended three ways to increase the spread pick-up within a corporate bond portfolio. In this section, we identify sectors that offer attractive spreads in risk-adjusted terms. That is, we are looking for attractive spreads relative to other fixed income sectors with similar duration and credit rating. We specify three opportunities: 1. Corporate Bond Industry Groups Chart 5 plots a measure of risk-adjusted spread for each of the 10 major investment grade corporate bond industry groups relative to that industry group’s DTS. The risk-adjusted spread is the residual from a cross-sectional regression of sector spreads versus average credit rating and duration. The prior section noted that investors should favor high-DTS industry groups within investment grade corporate bonds, and Chart 5 reveals that those high-DTS sectors are also the most attractive in risk-adjusted terms. Energy, Utilities, Basic Industry and Communications all stand out as offering elevated risk-adjusted spreads. While the Transportation and Consumer Cyclical sectors offer low risk-adjusted spreads, the Airlines group within Transportation and the Lodging group within Consumer Cyclicals also stand out as being attractive.2 Chart 5Investment Grade Corporate Sector Valuation The Collapsing Credit Risk Premium The Collapsing Credit Risk Premium Chart 6 shows the results of the same analysis performed on high-yield industry groups. Once again, we see that the high-DTS sectors look best in risk-adjusted terms. Communications, in particular, offers an extraordinarily high risk-adjusted spread that is driven by issuers in the Media: Entertainment and Wirelines sub-sectors. Overall, high-DTS industry groups like Energy, Communications, Utilities and Basic Industry offer the best risk-adjusted spread pick-up within both investment grade and junk bonds. Consumer Noncyclicals and Transportation also look attractive within high-yield. Chart 6High-Yield Corporate Sector Valuation The Collapsing Credit Risk Premium The Collapsing Credit Risk Premium 2. Long-Maturity Municipal Bonds Another opportunity to add risk-adjusted spread to a US bond portfolio lies in tax-exempt municipal bonds. In particular, investment grade rated tax-exempt municipal bonds at the long-end of the curve. Chart 7A shows the yield offered by the Bloomberg Barclays Municipal General Obligation (GO) index at different maturity points alongside the US Credit index yield that has the same credit rating and duration. The average credit rating for GO maturity buckets ranges from Aa1/Aa2 to Aa3/A1. Chart 7B translates the yields shown in Chart 7A into breakeven tax rates. That is, it shows the tax rate that would make an investor indifferent between owning the GO muni and the US Credit index. While the breakeven tax rates are quite high at the front-end of the curve, they fall dramatically as maturity is extended. The breakeven tax rate falls to 29% for the 8-12 year maturity bucket, 13% for the 12-17 year bucket and a mere 3% for 17-year+ maturities. In other words, any investor faced with a tax rate above 3% would be better off owning a long-maturity GO muni than a long-maturity US corporate bond. Chart 7AGeneral Obligation Munis Versus US Credit: Yields The Collapsing Credit Risk Premium The Collapsing Credit Risk Premium Chart 7BGeneral Obligation Munis Versus US Credit: Breakeven Tax Rates The Collapsing Credit Risk Premium The Collapsing Credit Risk Premium Charts 8A and 8B show the results of the same analysis performed for Municipal Revenue bonds relative to the US Credit index. All Revenue Muni maturity buckets have an average credit rating of Aa3/A1. We find that Revenue bonds look even more attractive than GO bonds, though once again the attractive yields are found at the long-end of the curve. The negative breakeven tax rate shown for the 22-year+ maturity bucket means that the muni bond actually offers a before-tax yield pick-up compared to the corporate credit. Chart 8ARevenue Munis Versus US Credit: Yields The Collapsing Credit Risk Premium The Collapsing Credit Risk Premium Chart 8BRevenue Munis Versus US Credit: Breakeven Tax Rates The Collapsing Credit Risk Premium The Collapsing Credit Risk Premium USD-denominated Emerging Market Sovereigns and Corporates Chart 9EM Sovereign And Corporate Spreads The Collapsing Credit Risk Premium The Collapsing Credit Risk Premium Finally, as we noted in a recent report,3 USD-denominated Emerging Market (EM) Sovereign and Corporate bonds offer an attractive yield pick-up relative to US corporate credit. Chart 9 shows the spreads of both the EM Sovereign and EM Corporate indexes relative to duration and credit rating matched positions in the US Credit index. First, we observe that both indexes offer a significant yield advantage over the US Credit index across all investment grade credit tiers. Second, we also observe that EM Corporates look much more attractive than Sovereigns within the A and Baa credit tiers, but that Sovereigns have the advantage within the Aa credit tier. The elevated Aa Sovereign spread is the result of USD bonds issued by the UAE and Qatar that offer yields above 2%. Bottom Line: US bond investors can increase the average yield of their portfolios without taking greater credit or duration risk by focusing on high-DTS industry groups (Energy, Communications, Utilities, Basic Industry) within both investment grade and high-yield corporate bond indexes. This can also be achieved by shifting allocation into long-maturity tax-exempt municipal bonds (both GO and Revenue) and USD-denominated EM Sovereign and Corporate debt. Ryan Swift US Bond Strategist rswift@bcaresearch.com   Footnotes 1 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 2 A version of this chart with all 40 industry groups can be found in our monthly Portfolio Allocation Summary. Please see US Bond Strategy Portfolio Allocation Summary, “On Track For 2022 Liftoff”, dated July 6, 2021. 3 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. Recommended Portfolio Specification Other Recommendations The Collapsing Credit Risk Premium The Collapsing Credit Risk Premium Treasury Index Returns The Collapsing Credit Risk Premium The Collapsing Credit Risk Premium Spread Product Returns The Collapsing Credit Risk Premium The Collapsing Credit Risk Premium

Highlights The dollar smile theory was valid around the COVID-19 crisis but does not stand the test of time. A more useful framework for determining the long-term trend in the dollar is observing global business cycle dynamics. The 2000s experience could provide a useful roadmap for the dollar this coming decade. We remain dollar bears over a 9-to-12-month horizon, although the dollar could stage a short-lived rally in the interim. Feature The “dollar smile” theory1 is the premise that the dollar tends to rise when the US economy is either too strong or too weak. Only in the precise environment, when the US economy is neither too hot nor too cold would you experience a dollar decline (Chart I-1). Chart I-1The Dollar Smile Theory The Dollar Smile Theory The Dollar Smile Theory This theory particularly resonates with traders and financial speculators as each handle of the smile can be explained by economic theory. For example, when the US economy is running hot, this usually prompts the Federal Reserve to hike interest rates. This supports the dollar. When the US economy is entering a recession, this is generally accompanied by a flight to safety. Inflows into safe-haven US bonds and defensive sectors of the stock market would also tend to boost the dollar. The fact that the dollar can rise in these polarizing set of circumstances makes a long dollar view particularly attractive as the default position. The key questions therefore for investors are: First, how does this theory hold up in terms of evidence? and, second, how should FX portfolios be positioned in the current environment? The Evidence During the height of the COVID-19 crisis, the smile theory certainly proved correct. Chart I-2 shows that the DXY index tended to rise approximately 58% of the time when the S&P 500 was either up by 2% or down by 2%. However, when the sample size is broadened, even to a few years, the theory falls apart. From 2010-2020, the DXY index rose only 37% of the time when the S&P 500 was up 2%, while it rose almost 50% of the time when the S&P 500 was down 2% (Chart I-3). Meanwhile, this sample size is particularly biased since during that period, the dollar was in a bull market, and the US economy was quite strong. Chart I-2The Dollar Smile Around The 2020 Pandemic The Dollar Smile Theory The Dollar Smile Theory Chart I-3The Dollar Smile Around Full Business Cycles The Dollar Smile Theory The Dollar Smile Theory Chart I-4US Industrial Production And The Dollar: No Correlation The Dollar Smile Theory The Dollar Smile Theory In economic terms, we get a similar picture. The relationship between US industrial production and the greenback is weak at best, with little evidence of a smile (Chart I-4). For example, there was no discernable trend in the dollar when US industrial production was between 0-5%, or even 5-10%. Admittedly, the dollar does rise when US manufacturing is in recession. A More Useful Framework Chart I-5US Relative Growth And The Dollar: Linear Correlation The Dollar Smile Theory The Dollar Smile Theory While the dollar is a complex variable, explaining its longer-term trend boils down to two simple rules of thumb: Is the global economy recovering or contracting? And if so, is the US leading or lagging this recovery? Chart I-5 shows that the dollar tends to rise when US economic activity is picking up relative to the world, but tends to fall otherwise, albeit with a few outliers. Meanwhile, one of the reasons the US dollar has done well during recessions is that the US economy generally has had more shallow recessions than other advanced economies in recent years. Through this lens, the US performs comparatively better during global downturns (Chart I-6). Going forward, the IMF predicts that non-US growth should fare better than growth in the US over the next few years. We side with the IMF: The global economic recovery will remain intact and will rotate from the US to other economies. Chart I-6US Growth Usually Outperforms During Recessions The Dollar Smile Theory The Dollar Smile Theory Chart I-7Spectacular Recovery In Vaccinations Outside The US Spectacular Recovery In Vaccinations Outside The US Spectacular Recovery In Vaccinations Outside The US The primary rationale is that most G10 countries lagged the US in their vaccination campaigns in 2020 and earlier this year. That is starting to change now, as vaccinations in the rest of the G10 are ramping up (Chart I-7). Meanwhile, vaccinations are proving effective against death and hospitalizations for the Delta variant of the COVID-19 virus. A turnaround in the vaccination campaign would not only boost public opinion about the COVID-19 response but would also be a welcome fillip to much subdued consumer and business sentiment outside the US. Taking a step back, there is a strong case to be made that cyclically, both eurozone and Japanese growth could surprise to the upside due to pent-up demand. For the eurozone, the debt crisis from 2010-2012 was a severe blow to the recovery. In Japan, rolling crises from the Fukushima disaster in 2011 to the consumption tax hikes both in 2014 and 2019 were growth handicaps. Chinese monetary tightening in 2015 caused a sharp manufacturing recession that was a severe blow to non-US economies, including Japan and the eurozone. This time around, coordinated monetary and fiscal stimulus could allow for a few years of a genuine growth recovery. In a nutshell, the dollar smile that occurred around the pandemic last year was due to the uncertainty about the future path of growth, while the US was leading the world in both monetary and fiscal stimulus. The US also led in the vaccination campaign. As other economies adopt this template, the smile should fade, as has empirically been the case over time. Echoes From The 2000s The 2000s experience could provide a useful roadmap for the dollar in this coming decade (Chart I-8). US growth was underperforming the rest of the world during that time. The primary driver was a commodity boom driven by massive infrastructure spending in China. This time around, a concerted push towards green energy will sustain bull markets in metals such as copper, nickel, cobalt, aluminum, and silver, benefiting the economies of producer countries (Chart I-9). Leaders in building renewable energy infrastructure, such as Europe, could also see a boom as demand for their goods and services rise. Chart I-8A Roadmap For The Dollar In The Next Decade A Roadmap For The Dollar In The Next Decade A Roadmap For The Dollar In The Next Decade Chart I-9At The Cusp Of A New Commodity Super Cycle? At The Cusp Of A New Commodity Super Cycle? At The Cusp Of A New Commodity Super Cycle? The aftermath of the tech bubble bust created extremely easy policy settings for the US. The Federal Reserve cut interest rates to a low of 1% in 2003. Meanwhile, fiscal policy was much more accommodative than what was needed to close the output gap. The combination led to a massive expansion in the US twin deficits, a similar situation to today (Chart I-10). Chart I-10A 2000s Roadmap A 2000s Roadmap A 2000s Roadmap Chart I-11Real Yields: Now Versus Then Real Yields: Now Versus Then Real Yields: Now Versus Then Excess demand in the US started to create inflationary pressures, with headline inflation consistently between 2-4% from 2000-2008. Real rates in the US cratered, which hurt the dollar. This time around, inflation is rising fastest in the US (even if it is transitory). Meanwhile, The Fed is the only central bank that has an asymmetric inflation target. Other central banks (such as the Reserve Bank of New Zealand, the Bank of Canada or Norges Bank) have stated they will normalize policy, even though they also view their inflation as transitory. So real rates are and will be rising faster outside the US (Chart I-11). In short, most of the conditions that have usually characterized a dollar bear market for a decade or so are in place today. The Federal Reserve is committed to staying easy, US real rates are depressed, and growth should be stronger outside the US compared to within it, a similar template to what we saw in the 2000s. From A Dollar Shortage To An Avalanche The dollar smile theory works particularly well when there is a shortage of dollars, like in 2020. The lack of dollar liquidity was a tailwind behind the dollar bull market during the last decade. Today, the Fed’s balance sheet is still expanding, and the massive liquidity injection from quantitative easing has tremendously improved the global supply of dollars. One measure of global dollar liquidity is the sum of the Federal Reserve’s custody holdings together with the US monetary base. Every time this measure has severely contracted in the past, the shortage of dollars has exacerbated a blow-up somewhere, typically among other countries running twin deficits (Chart I-12). For example, since the global financial crisis, a deceleration in this measure coincided with the European debt crisis, the China slowdown, and more recently, the COVID-19 crisis, with steep depreciation in many procyclical currencies and a vicious rally in the dollar. Chart I-12An Explosion In The US Monetary Base An Explosion In The US Monetary Base An Explosion In The US Monetary Base Fast forward to today and it is difficult to imagine such a scenario playing out over the next 9-12 months. The Fed has swap lines with many foreign developed and emerging market central banks that can draw on dollar liquidity until the end of this year. These lines are likely to be extended if the economic environment deteriorates before year-end. Meanwhile, the lack of uptake from these lines suggests foreign central banks are flush with dollars (Chart I-13). The Federal Reserve’s custody holdings also argue that there is little shortage of dollars internationally, compared to 2008 or 2020 (Chart I-14). With the US current account deficit widening, outflows of US dollars will continue to keep global dollar liquidity flush. Chart I-13Swap Lines Are Not Being Tapped Swap Lines Are Not Being Tapped Swap Lines Are Not Being Tapped Chart I-14Custody Holdings Are Picking Up Custody Holdings Are Picking Up Custody Holdings Are Picking Up Cross-currency basis swaps are well contained, suggesting no US dollar funding pressures abroad. Chart I-15Rising Non-USD Debt Rising Non-USD Debt Rising Non-USD Debt It is important to note that euro- and yen-denominated debt are also expanding (Chart I-15). These are smaller in outstanding amounts than US-denominated debt but reflect the gradual shift in the allocation of currencies away from dollars. In a nutshell, the system is awash with both dollars and other international reserve currencies, limiting the negative feedback loop that dollar shortages have usually triggered. Concluding Thoughts We made the case last week that the dollar is experiencing a countertrend bounce, likely to continue over the next month or so. Beyond that, however, the dollar should depreciate towards the end of the year into next year. Meanwhile, our analysis suggests the dollar smile theory works best near recessions when the US economy is likely to outperform and the safe-haven status of US Treasuries is likely to buffet the greenback. Outside of these periods which represent only 5% of the last four decades, the dollar smile theory falls apart.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   Currencies US Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2   There were a few strong data releases out of the US: Inflation continues to inflect higher in the US. Headline CPI came out at 5.4% versus expectations of 4.9% in June. Core came in at 4.5% versus expectations of 4.0%. The PPI report was equally robust, with core prices rising well above expectations to the tune of 5.6%. The NFIB small business optimism survey jumped from 99.6 to 102.5. Empire manufacturing data for July was 43 versus 17.4 the prior month. The US dollar DXY index is up 0.4% this week. The big data release was the increase in US inflation but relative calm in bond markets seems to cement the view that financial participants consider it transitory. There is still scope for the US dollar to work off oversold conditions, but our bias is that it will be lower in the next 9-12 months.   Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2   There was scant data out of the eurozone this week: The Bloomberg GDP survey showed that both Q2 and Q3 GDP growth were revised higher. 2022 growth was also revised higher from 4.2% to 4.3%. In the same survey, there was no change expected in policy rates in the foreseeable future. CPI across eurozone countries was in line with expectations: 2.5% in Spain, 2.1% in Germany and 1.9% in France for the month of June. Over the weekend, in a Bloomberg interview, Christine Lagarde told us to expect a significant update to the eurozone’s monetary policy and forward guidance in the July 22 meeting. Our bias is that given the new symmetric inflation target, PEPP will be rolled over into a new program, revised asset purchases will be announced to accommodate for climate change, and possibly more forward guidance that gives us a window into when the ECB will exit negative rates. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2   There was some positive news out of Japan this week: Core machine orders rose 12.2% year on year in May, versus an expectation of a 6.3% increase. PPI came in at 5% year on year in June, in line with expectations. Machine tool orders rose 97% year on year in June. Importantly, domestic orders grew faster. The yen was down 0.14% against the dollar this week, after a stellar performance last week. The yen continues to sit in a sweet spot among G10 currencies. Falling nominal yields elsewhere are increasing the appeal of yen cash in real terms. Meanwhile, there is the upshot of cyclical improvement in Japan, which will benefit inflows into yen assets.   Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2   There was significant data out of the UK this week: The 3-month-on-3-month GDP release for May came in at 3.6%, below expectations. Industrial production growth for May was 20.6% year on year, below the 27.5% increase in April. The trade deficit improved from GBP 11bn to GBP 8.5bn. CPI was above target in June, with core at 2.3% and the RPI at 3.9%. The house price index rose 10% year on year in May. Employment increased 25K in May, which disappointed expectations of a 91K increase. The pound rose 0.5% against the US dollar this week. The market reacted positively to the upside surprise in inflation, suggesting the BoE might normalize policy sooner than expected.   Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020   Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2   There were a few important data releases out of Australia this week: NAB business conditions deteriorated. The conditions component fell from 37 to 24 in June, while the confidence component fell from 20 to 11. Westpac consumer confidence rose slightly to 108.8 from 107.2 in July. The employment report was better than expected. There were 29.1K jobs added in June, pushing the unemployment rate down to 4.9%. The mix was also great with 51.6K full-time jobs added versus a loss of 22.5K part-time jobs. The AUD was up 0.13% this week against the USD. Melbourne has joined Sydney in the lockdown, and so there is room for economic data to keep disappointing over the next few weeks. In hindsight, the RBA’s decisively dovish bias relative to other central banks seemed to be the appropriate strategy. In the end, if the COVID-19 crisis proves transient, it will create a coiled spring response for the AUD. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2   The was scant data out of New Zealand this week: REINZ house prices rose 6.2% year on year in June. Net migration for May was 1182 versus 1087 the prior month. The NZD was up 60bps versus the US dollar this week. While the RBNZ kept interest rates at 0.25%, it signaled QE will end on July 23, a full year ahead of schedule. Markets are now priced for a rate hike as early as August. Our long CHF/NZD position was offside in this environment. Our conviction on this trade has fallen given the hawkish shift from the RBNZ, but we recommend holding onto this trade, as a reset in global asset prices could increase currency volatility and hurt the pair. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2   Data out of Canada this week has been robust: The employment report was stellar. 231K new jobs were added in June. The unemployment rate fell from 8.2% to 7.8%. The participation rate also increased from 64.6% to 65.2%. The BoC kept interest rates on hold at 0.25% but cut its weekly asset purchases from C$3 billion to C$2 billion. The Bloomberg Nanos Confidence index held steady at 66.4. The CAD fell by 0.2% this week and was flat on the announcement. The loonie has softened since the bottom in the DXY index, as overbought conditions are being worked off. There was no new information out of the recent BoC meeting – the central bank is on pace to start lifting rates ahead of the Fed as long as Canada approaches full employment and inflation remains above target. This will limit downside on the CAD. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2   The was scant data out of Switzerland this week: Producer prices rose by 2.9% year on year in June. Total sight deposits were unchanged at CHF 712 bn for the week of July 9. The Swiss franc was down 0.3% this week, after a nice run-up last week. Falling yields will continue to improve the relative appeal of the franc, like the yen. The franc will also benefit from safe-haven inflows if equity markets correct. We are long the CHF/NZD cross on this basis and are sticking with this recommendation. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2   Data out of Norway is improving: June CPI came in at 2.9% as expected. Underlying CPI was also 1.4%. PPI came in at 37.1% year on year in June, driven by high oil prices. The trade balance improved from NOK 15.5bn to NOK 25bn in June. The NOK was down by 1.7% this week against the dollar. We have a limit-buy on the Scandinavian currencies at -1.4% from current levels, on expectation that the sell-off is short lived. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020   Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2   Recent data from Sweden have been somewhat soft: Headline CPI fell from 1.8% in May to 1.3% in June. The core measure also fell from 2.1% to 1.6% but was better than expectations. The core core measure came in at 0.9% as expected. The SEK was the weakest G10 currency this week, falling by 0.7%. A disappointment in Swedish inflation is a surprise, given the inflationary overshoots we are seeing elsewhere. As Sweden is a small, open economy, inflation there will pick up (via imported inflation), which will lift expectations that the Riksbank will normalize policy. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020   Footnotes 1The theory was proposed by Stephen Jen, a former IMF economist and now a hedge fund manager at Eurizon SLJ Capital in London. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Global oil demand will remain betwixt and between recovery and relapse through 3Q21, as stronger DM consumer spending and increasing mobility wrestles with persistent concerns over COVID-19-induced lockdowns in Latin America and Asia. These concerns will be allayed as vaccines become more widely distributed, and fears of renewed lockdowns – and their associated demand destruction – recede.  Going by US experience – which can be tracked on a weekly basis – as consumer spending rises in the wake of relaxed restrictions on once-routine social interactions, fuel demand will follow suit (Chart of the Week). OPEC 2.0 likely will agree to return ~ 400k b/d monthly to the market over the course of the next year and a hal. For 2021, we raised our average forecast to $70/bbl, and our 2H21 expectation to $74/bbl. For 2022 and 2023, we expect Brent to average $75 and $78/bbl. These estimates are highly sensitive to demand expectations, particularly re containment of COVID-19. Feature For every bit of good news related to the economic recovery from the COVID-19 pandemic, there is a cautionary note. Most prominently, reports of increasing demand for refined oil products like diesel fuel and gasoline in re-opening DM economies are almost immediately offset by fresh news of renewed lockdowns, re-infections in highly vaccinated populations, and fears a new mutant strain of the coronavirus will emerge (Chart 2).1 In this latter grouping, EM economies feature prominently, although Australia this week extended its lockdown following a flare-up in COVID-19 cases. Chart of the WeekUS Product Demand Revives As Economy Reopens US Product Demand Revives As Economy Reopens US Product Demand Revives As Economy Reopens Chart 2COVID-19 Infection And Death Rates Keep Markets On Edge Demand Dictates Oil Price Expectations Demand Dictates Oil Price Expectations Our expectation on the demand side is unchanged from last month – 2021 oil demand will grow ~ 5.4mm b/d vs. 2020 levels, while 2022 and 2023 consumption will grow 4.1 and 1.6mm b/d, respectively (Chart 3). These estimates reflect the slowing of global GDP growth over the 2021-23 interval, which can be seen in the IMF's and World Bank's GDP estimates, which we use to drive our demand forecasts.2 Weekly data from the US seen in the Chart of the Week provide a hint of what can be expected as DM and EM economies re-open in the wake of relaxed restrictions on once-routine social interactions. Demand for refined products – e.g., gasoline, diesel fuel and jet fuel – will recover, but at uneven rates over the next 2-3 years. The US EIA notes the recovery in diesel demand, which is included in "Distillates" in the chart above, has been faster and stronger than that of gasoline and jet fuel. This is largely because it reflects the lesser damage done to freight movement and activities like mining and manufacturing. The EIA expects 4Q21 US distillate demand to come in 100k b/d above 4Q19 levels at 4.2mm b/d, and to hit an all-time record of 4.3mm b/d next year. US gasoline demand is not expected to surpass 2019 levels this year or next, in the EIA's forecast. This is partly due to improved fuel efficiencies in automobiles – vehicle-miles travelled are expected to rise to ~ 9mm miles/day in the US, which will be slightly higher than 2019's level. Jet fuel demand in the US is expected to return to 2019 levels next year, coming in at 1.7mm b/d. Chart 3Global Oil Demand Forecast Remains Steady Global Oil Demand Forecast Remains Steady Global Oil Demand Forecast Remains Steady Quantifying Demand Risks We use the recent uptick in COVID-19 cases as the backdrop for modelling demand-destruction scenarios in this month’s oil balances (Chart 2). We consider different scenarios of potential demand destruction caused by the resurgence in the pandemic (Table 1). Last year, demand fell by 9% on average, which we take to be the extreme down move over an entire year. In our simulations, we do not expect demand to fall as drastically this time. Table 1Demand-Destruction Scenario Outcomes Demand Dictates Oil Price Expectations Demand Dictates Oil Price Expectations We modelled two scenarios – a 5% drop in demand (our low-demand-destruction scenario) and an 8% drop in demand (our high-demand-destruction scenario). A demand drop of a maximum of 2% made nearly no difference to prices, and so, we did not include it in our analysis. In both cases, demand starts to fall by September and reaches its lowest point in October 2021. We adjusted changes to demand in the same proportion as changes in demand in 2020, before making estimates converge to our base-case by end-2022. The estimates of price series are noticeably distinct during the period of the simulation (Chart 4). Starting in 2023, the low-demand-destruction prices and base-case prices nearly converge, as do their inventory levels. Prices and inventory levels in the high-demand-destruction case remain lower than the base-case during the rest of the forecast sample. OPEC 2.0 and world oil supply were kept constant in these scenarios. World oil supply is calculated as the sum of OPEC 2.0 and Non-OPEC 2.0 supply. Non-OPEC 2.0 can be broken down into the US, and Non-OPEC 2.0, Ex-US countries. Examples of these suppliers are the UK, Canada, China, and Brazil. OPEC 2.0 can be broken down into Core-OPEC 2.0 and the cohort we call "The Other Guys," which cannot increase production. Core-OPEC 2.0 includes suppliers we believe have excess spare capacity and can inexpensively increase supply quickly. Chart 4Brent Forecasts Rise As Global Economy Recovers COVID-19 Demand Destruction Scenarios Brent Forecasts Rise As Global Economy Recovers COVID-19 Demand Destruction Scenarios Brent Forecasts Rise As Global Economy Recovers COVID-19 Demand Destruction Scenarios OPEC 2.0 Remains In Control We continue to expect the OPEC 2.0 producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia to maintain its so-far-successful production policy, which has kept the level of supply below demand through most of the COVID-19 pandemic (Chart 5). This allowed OECD inventories to fall below their pre-COVID range, despite a 9% loss of global demand last year (Chart 6). We expect this discipline to continue and for OPEC 2.0 to continue restoring its market share (Table 2). Chart 5OPEC 2.0 Production Policy Kept Supply Below Demand OPEC 2.0 Production Policy Kept Supply Below Demand OPEC 2.0 Production Policy Kept Supply Below Demand Chart 6...And Drove OECD Inventories Down ...And Drove OECD Inventories Down ...And Drove OECD Inventories Down Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Demand Dictates Oil Price Expectations Demand Dictates Oil Price Expectations Our expectation last week the KSA-UAE production-baseline impasse will be short-lived remains intact. We expect supply to be increased after this month at a rate of 400k b/d a month into 2022, per the deal most members of the coalition signed on to prior to the disagreement between the longtime GCC allies. This would, as the IEA notes, largely restore OPEC 2.0's spare capacity accumulated via production cutbacks during the pandemic of ~ 6-7mm b/d by the end of 2022 (Chart 7). It should be remembered that most of OPEC 2.0's spare capacity is held by Gulf Cooperation Council (GCC) states, which includes the UAE. The UAE's official baseline production number (i.e., its October 2018 production level) likely will be increased to 3.65mm b/d from 3.2mm b/d, and its output in 2H21 and 2022 likely will be adjusted upwards. As one of the few OPEC 2.0 members that actually has invested in higher production and can increase output meaningfully, it would, like KSA, benefit from providing barrels out of this spare capacity.3 Chart 7OPEC 2.0 Spare Capacity Will Return Demand Dictates Oil Price Expectations Demand Dictates Oil Price Expectations As we noted last week, we do not think this impasse was a harbinger of a breakdown in OPEC 2.0's so-far-successful production-management strategy. In our view, this impasse was a preview of how negotiations among states with the capacity to raise production will agree to allocate supply in a market starved for capital in the future. This is particularly relevant as US shale producers continue to focus on providing competitive returns to their shareholders, which will limit supply growth to that which can be done profitably. We see the "price-taking cohort" – i.e., those producers outside OPEC 2.0 exemplified by the US shale-oil producers – remaining focused on maintaining competitive margins and shareholder priorities. This means maintaining and growing dividends, and returning capital to shareholders will have priority as the world transitions to a low-carbon business model (Chart 8).4 For 2021, we raised our average forecast to $70/bbl on the back of higher prices lifting the year-to-date average so far, and our 2H21 expectation to $74/bbl. For 2022 and 2023, we expect Brent to average $75 and $78/bbl (Chart 9). These estimates are highly sensitive to demand expectations, which, in turn, depend on the global success in containing and minimizing COVID-19 demand destruction, as we have shown above. Chart 8US Shale Producers Focus On Margins US Shale Producers Focus On Margins US Shale Producers Focus On Margins Chart 9Raising Our Forecast Slightly Raising Our Forecast Slightly Raising Our Forecast Slightly Investment Implications In our assessment of the risks to our views in last week's report, we noted one of the unintended consequences of the unplanned and uncoordinated rush to a so-called net-zero future will be an improvement in the competitive position of oil and gas. This is somewhat counterintuitive, but the logic goes like this: The accelerated phase-out of conventional hydrocarbon energy sources brought about policy, regulatory and legal imperatives already is reducing oil and gas capex allocations within the price-taking cohort exemplified by US shale-oil producers. This also will restrict capital flows to EM states with heavy resource endowments and little capital to develop them. Our strong-conviction call on oil, gas and base metals is premised on our view that renewables and their supporting grids cannot be developed and deployed quickly enough to make up for the energy that will be foregone as a result of these policies. Capex for the metals miners has been parsimonious, and brownfield projects continue to dominate. Greenfield projects can take more than a decade to develop, and there are few in the pipeline now as the world heads into its all-out renewables push. In a world where conventional energy production is being forced lower via legislation, regulation, shareholder and legal decisions, higher prices will ensue even if demand stays flat or falls: If supply is falling, market forces will lift oil and gas prices – and the equities of the firms producing them – higher. As for metals like copper and their producers, if supply is unable to keep up with demand, prices of the commodities and the equities of the firms producing them will be forced to go higher.5 This call underpins our long S&P GSCI and COMT ETF commodity recommendations, and our long MSCI Global Metals & Mining Producers ETF (PICK) recommendation. We will look for opportunities to get long oil and gas producer exposure via ETFs as well, given our view on oil and metals spans the next 5-10 years.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish The US EIA expects growth in large-scale solar capacity will exceed the increase in wind generation for the first time ever in 2021-22. The EIA forecasts 33 GW of solar PV capacity will be added to the US grid this year and next, with small-scale solar PV increasing ~ 5 GW/yr. The EIA expects wind generation to increase 23 GW in 2021-22. The EIA attributed the slow-down in wind development to the expiration of a $0.025/kWH production tax credit at the end of 2020. Taken together, solar and wind generation will account for 15% of total US electricity output by the end of 2022, according to the EIA. Nuclear power will account for slightly less than 20% of US generation in 2021-22, while hydro will fall to less than 7% owing to severe drought in the western US. At the other end of the generation spectrum, coal will account for ~ 24% of generation this year, as it takes back incremental market share from natural gas, and ~ 22% of generation in 2022. Base Metals: Bullish Iron ore prices continue to trade above $215/MT in China, even as demand is expected to slow in 2H21. Supply additions from Brazil, which ships higher quality 65% Fe ore, have been slower than expected, which is supporting prices (Chart 10). Separately, the Chinese government's auction of refined copper earlier this month cleared the market at $10,500/MT, or ~ $4.76/lb. Spot copper has been trading on either side of $4.30/lb this month, which indicates the Chinese market remains well bid. Precious Metals: Bullish The 13-year record jump in the US Consumer Price Index reported this week for the month of June is bullish for gold, as it produced weaker real rates and sparked demand for inflation hedges. Fed Chair Powell continued to stick to the view that the recent rise in inflation is transitory. The Fed’s dovish outlook will support gold prices and likely will lead to a weaker US dollar, as it reduces the possibility that US interest rates will rise soon. A falling USD will further bolster gold prices (Chart 11). Chart 10 BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI)RECOVERING BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI)RECOVERING Chart 11 Gold Prices Going Down Gold Prices Going Down     Footnotes 1     We highlighted this risk in last week's report, Assessing Risks To Our Commodity Views, which is available at ces.bcaresearch.com. Two events – in the Seychelles and Chile, where the majority of the populations were inoculated – highlight re-infection risk. Re-infections in Indonesia along with lockdowns following the spread of the so-called COVID-19 Delta variant also are drawing attention. Please see Euro 2020 final in UK stokes fears of spread of Delta variant, published by The Straits Times on July 11, 2021. The news service notes that in addition to the threats super-spreader sporting events in Europe present, "The rapid spread of the Delta variant across Asia, Africa and Latin America is exposing crucial vaccine supply shortages for some of the world's poorest and most vulnerable populations. Those two factors are also threatening the global economic recovery from the pandemic, Group of 20 finance ministers warned on Saturday." 2     Please see the recently published IMF World Economic Outlook Reports and the World Bank Global Economic Prospects. 3    If, as we suspect, KSA and the UAE are playing a long game – i.e., a 20-30-year game – this spare capacity will become more valuable as investment capex into oil production globally slows. Please see The $200 billion annual value of OPEC’s spare capacity to the global economy published by kapsarc.org on July 17, 2018. 4    Please see Bloomberg's interview with bp's CEO Bernard Looney at Banks Need ‘Radical Transparency,’ Citi Exec Says: Summit Update, which aired on July 13, 2021. In addition to focusing on margins and returns, the company – like its peers among the majors – also is aiming to reduce oil production by 20% by 2025 and 40% by 2030. 5    This turn of events is being dramatically played out in the coal markets, where the supply of metallurgical coals is falling as demand increases. Please see Coal Prices Hit Decade High Despite Efforts to Wean the World Off Carbon published by wsj.com on June 25, 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Image

In lieu of next week’s report, I will be presenting the quarterly Counterpoint webcast titled ‘Where Is The Groupthink Wrong? And How To Profit From It.’ I do hope you can join. We will then take a summer break, so our next report will come out on August 5. Highlights The quantum theory of finance describes the strange quantum effects of ultra-low inflation, of ultra-low interest rates, and of ultra-low probabilities. The key finding of the quantum theory of finance is that when inflation and interest rates get ultra-low, inflation becomes completely insensitive to monetary policy, while risk-asset valuations become hyper-sensitive to monetary policy. The hyper-sensitivity of $500 trillion of global risk-assets to bond yields means that the ultimate low in the US T-bond yield is still to come. Given the hyper-sensitivity of equity valuations to bond yields and the demand for US assets during bond market rallies, it also means that the structural bull market in equities and the structural bull market in the US dollar are both still intact. Feature Feature ChartNear The Lower Bound In Bond Yields, Potential Losses Are Greater Than Potential Gains Near The Lower Bound In Bond Yields, Potential Losses Are Greater Than Potential Gains Near The Lower Bound In Bond Yields, Potential Losses Are Greater Than Potential Gains When things get ultra-small, the laws of physics undergo a radical shift. Classical physics breaks down, and we must to turn to an alternative theory to explain and predict the physical world. That theory is the quantum theory of physics. In this updated Special Report we propose that, just as there is the quantum theory of physics, there is The Quantum Theory Of Finance. When inflation and interest rates get ultra-low, the laws of economics and finance undergo a radical shift. And we must turn to the alternative theory to explain and predict the economic and financial world. In the physical world, the allowable values of a physical system appear to be continuous, with all values permitted. In fact, the permitted values occur in discrete ‘quanta’. At ultra-small scales, these quantum effects become the dominant driver of physical systems and form the foundation of the quantum theory of physics. Likewise, in the economic and financial world of ultra-low inflation and interest rates, quantum effects become the dominant drivers of the system. These quantum effects take three forms: The quantum effects of ultra-low inflation. The quantum effects of ultra-low interest rates. The quantum effects of ultra-low probabilities. The Quantum Effects Of Ultra-Low Inflation Even though inflation is continuous mathematically, we do not perceive it as such psychologically. Instead we perceive inflation as ‘quantum states’ of either price stability or price instability. A recent IFO paper points out that households’ inflation perceptions are “more in line with the imperfect information view prevailing in social psychology than with the rational actor view assumed in mainstream economics.”1 And in Real-Feel Inflation: Quantitative Estimation of Inflation Perceptions, Michael Ashton confirms that “it would be challenging for a consumer to distinguish 1 percent inflation from 2 percent inflation – that fine of a gradation in perception would be extremely unusual to find.”2 There are several reasons why we perceive inflation imprecisely: We do not recognise quality change and substitution adjustments. We tend to feel inflation asymmetrically, noticing goods whose prices are rising, but noticing less goods whose prices are falling. This is the classic attribution bias: higher prices are inflation, lower prices are “good shopping.” Items whose prices are volatile tend to draw more attention, and give more opportunities for these asymmetries to compound. We notice the price changes of small, frequently purchased items more than the price changes of large infrequently purchased items. We perceive the cost of homeownership as the monthly mortgage payment, and not the imputed cost of owners’ equivalent rent (OER). Yet OER is the largest single item in the US core CPI basket, weighted at 30 percent. The result of these biases is that we perceive inflation intuitively, as a quantum state rather than as a precise number within a continuum. The quantum effects of ultra-low inflation mean that policymakers can take an economy from the state of price instability to the state of price stability, and vice-versa, but they cannot sustainably hit an arbitrary inflation target within the quantum state, such as 2 percent (Chart I-2). Chart I-2Mission Impossible: 2 Percent Inflation Mission Impossible: 2 Percent Inflation Mission Impossible: 2 Percent Inflation The Quantum Effects Of Ultra-Low Interest Rates Policymakers accept that there exists an interest rate, at around -1 percent, below which there would be an exodus of bank deposits. Hence, this marks the lower bound of policy interest rates. When policy interest rates are at, or near, this lower bound, central banks can turn to a second strategy: they can promise to keep the policy rate ultra-low for an extended period. Thereby they can pull down the long bond yield towards the lower bound too. To do this, they must convince the market that their promise is genuine. Enter quantitative easing (QE) which, in the words of the ECB’s former Chief Economist Peter Praet, is nothing more than “a signalling channel which reinforces the credibility of forward guidance on (ultra-low) policy rates.” Once forward guidance plus QE has taken bond yields close to their lower bound, we start to see the quantum effects of ultra-low interest rates. Specifically, the bond investor is left with a highly asymmetric payoff – the bond price can fall much more than it can rise. Witness the performance of Swiss bonds through the past three years. The worst drawdowns have far exceeded the best gains (Feature Chart, Chart I-3 and Chart I-4). Chart I-3Swiss Bonds Offer Small Potential Gains... Swiss Bonds Offer Small Potential Gains... Swiss Bonds Offer Small Potential Gains... Chart I-4...But Big Potential Losses ...But Big Potential Losses ...But Big Potential Losses This asymmetric payoff is technically known as negative skew and it starts to take effect when bond yields decline to around 2 percent above their lower bound. So, if the lower bound for the 10-year T-bond yield is -0.5 percent, the negative skew in its payoffs would start to take effect at around 1.5 percent. One important implication of the quantum effect of ultra-low interest rates is that the asymmetry of bond payoffs becomes very similar to the asymmetry of equity and other risk-asset payoffs (Chart I-5). This is important because, as we describe in the next section, it is the skew of an asset’s payoff that establishes its absolute and relative riskiness. Chart I-5Equities Can Suffer Bigger Short-Term Losses Than Short-Term Gains (Negative Skew) Equities Can Suffer Bigger Short-Term Losses Than Short-Term Gains (Negative Skew) Equities Can Suffer Bigger Short-Term Losses Than Short-Term Gains (Negative Skew) The Quantum Effects Of Ultra-Low Probabilities We are very bad at comprehending low probabilities. For example, we cannot distinguish a 1 in a 1000 risk from a 1 in a 100 risk, even though the second risk is ten times greater than the first. This is what Daniel Kahneman’s and Amos Tversky’s Nobel prize winning Prospect Theory called the ‘quantal effect’ of ultra-low probabilities. Kahneman and Tversky discovered that our fears and hopes come in quanta rather than in a continuum, with the result that we overweight the tail-events in a payoff distribution. “Because people are limited in their ability to comprehend and evaluate extreme probabilities, highly unlikely events are either ignored or over-weighted.” If the payoff distribution is symmetric, then our overweighting of the positive and negative tails cancels out, meaning there is no impact on the value of the payoff (Figure I-1). However, if the payoff distribution is skewed, then the longer tail dominates our perceived value of the payoff. Figure I-1In A Symmetric Payoff, We Overestimate The Big Gain And the Big Loss Equally, So It Cancels Out The Quantum Theory Of Finance (Part 2) The Quantum Theory Of Finance (Part 2) A lottery payoff has an extreme positive skew. There exists a miniscule chance of winning a fortune. As we overweight this highly unlikely event, we overvalue the lottery ticket relative to its expected payoff (Figure I-2). And this explains the existence of the multi-billion dollar lottery industry. Figure I-2In A Positively-Skewed Payoff (Lottery), We Overestimate The Big Gain, So We Overpay The Quantum Theory Of Finance (Part 2) The Quantum Theory Of Finance (Part 2) Conversely, the payoff from equities has a negative skew. As we overweight the tail-event of losing a lot of money, we undervalue this negatively skewed payoff (Figure I-3). In other words, we demand a higher return from a negatively skewed payoff relative to a symmetrical payoff, such as the payoff from bonds when yields are not ultra-low. And this explains the existence of the so-called ‘equity risk premium.’ Figure I-3In A Negatively-Skewed Payoff (Risk-Assets), We Overestimate The Big Loss, So We Demand A ‘Risk Premium’ The Quantum Theory Of Finance (Part 2) The Quantum Theory Of Finance (Part 2) Crucially though, at ultra-low bond yields – when both equity and bond payoffs carry the same negative skew – we no longer demand a higher return from equities versus bonds. As the equity risk premium compresses, the return demanded from equities and other risk-assets collapses to the ultra-low bond yield. Put another way, the valuation of risk-assets soars. The Quantum Theory Of Finance, The Past And The Future The key finding of the quantum theory of finance is this. When inflation and interest rates get ultra-low, inflation becomes completely insensitive to monetary policy, while risk-asset valuations become hyper-sensitive to monetary policy. This is the story of the past decade, and most likely the story of the coming years. For over a decade now, central banks have fixated on hitting their 2 percent inflation targets when the quantum effects of ultra-low inflation make such a target unachievable. In their misguided fixation, the unleashing of trillions of dollars of QE has taken bond yields to unprecedented lows which has driven risk-asset valuations to unprecedented highs, and made them hyper-sensitive to the slightest move in bond yields (Chart I-6 and Chart I-7). Chart I-6Real Estate Prices Have Massively Outperformed Rents Real Estate Prices Have Massively Outperformed Rents Real Estate Prices Have Massively Outperformed Rents Chart I-7Equity Prices Have Massively Outperformed Profits Equity Prices Have Massively Outperformed Profits Equity Prices Have Massively Outperformed Profits Yet to be clear, though policymakers cannot consistently hit the 2 percent inflation target, they could certainly take the economy back to price instability – if they pursued ultra-loose monetary policy combined with ultra-loose fiscal policy aggressively enough for long enough. But if a major economy were to take this road – intentionally or accidentally – the $500 trillion valuation of global risk-assets that is premised on ultra-low inflation and ultra-low interest rates would collapse. As we have previously written, this means that The Road To Inflation Ends At Deflation and the ultimate low in the T-bond yield is still to come. Alternatively, another deflationary shock could take us to this ultimate low in the T-bond yield more directly. Given the hyper-sensitivity of equity valuations to bond yields and the massive portfolio inflows into US assets during shocks, this also means that the structural bull markets in equities and the structural bull market in the US dollar are both still intact. Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Please see Households’ Inflation Perceptions and Expectations: Survey Evidence from New Zealand, IFO Working Paper, February 2018 available at https://www.ifo.de/DocDL/wp-2018-255-hayo-neumeier-inflation-perceptions-expectations.pdf 2 Please see Real-Feel Inflation: Quantitative Estimation of Inflation Perceptions by Michael Ashton, National Association for Business Economics available at https://link.springer.com/content/pdf/10.1057/be.2011.35.pdf Fractal Trade Update We are pleased to report that long USD/CAD achieved its 3.7 percent profit target, and short building materials (PKB) versus healthcare (XLV) achieved its 15 percent profit target. Combined with other successes, this lifts the 6-month win ratio to an all-time high of 76 percent, comprising 12.3 winners versus just 3.9 losers. This week, we present two new candidates for countertrend reversal. First, the strong recent rally in Australian 30-year bonds has reached fragility on its 65-day fractal structure. The recommended trade is to short Australian versus Canadian 30-year bonds, setting the profit-target and symmetrical stop-loss at 3.9 percent. Second, the strong recent rally in lead versus platinum has also reached fragility on its 65-day fractal structure. The recommended trade is to short lead versus platinum, setting the profit-target and symmetrical stop-loss at 6.4 percent. Chart I-8Short Australian Vs, Canadian 30-Year Bonds Short Australian Vs, Canadian 30-Year Bonds Short Australian Vs, Canadian 30-Year Bonds Chart I-9Short Lead Vs. Platinum Short Lead Vs. Platinum Short Lead Vs. Platinum Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area   Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations   Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations    

Highlights The August 1 deadline for Congress to raise the debt ceiling will come and go but the looming debt showdown will not replay the 2011-13 crisis. It is not a major risk to the bull market.  The Biden administration still has the political capital to pass a signature piece of legislation via budget reconciliation by end of year.  The tax component of the plan may bring a negative surprise but the market is likely to be more concerned over inflation expectations, eventual Fed rate hikes, and the 2022 fiscal cliff.  The Delta variant of COVID-19 is spreading rapidly in Republican-leaning states but the existence of effective vaccines presents an immediate solution. Any substantial new jitters over the pandemic will increase monetary and fiscal stimulus.  Stay long value over growth stocks despite near term risks and setbacks. Reassess if technical support is broken. Feature The Democratic Party is attempting to achieve two major things before Congress goes on recess in early August. The first is a $1.2 trillion bipartisan infrastructure package – which will take longer than that and may never pass. The second is a $2-$6 trillion budget resolution that will contain reconciliation instructions to enable the Senate to pass President Joe Biden’s proposed $2.5-$4.1 trillion American Jobs and Families Plan with 51 votes. Democrats may very well achieve this resolution before going on recess but that is the very problem when it comes to negotiations with Republicans. Even though divisions within Republican ranks make bipartisanship more likely to succeed than usual, investors should not bet on it. A partisan reconciliation process virtually guarantees both that Democrats pass their next spending bill without major disappointments for the market and that the debt ceiling is not a substantial risk to the bull market. The real risk for investors is that the markets have mostly priced the Democrats’ stimulus spending and will increasingly turn to tax hikes and especially Fed rate hikes. While we expect dovish surprises from the Fed, the strong 4.5% year-on-year growth in core consumer prices, in the context of booming consumer sentiment (Chart 1), suggests the opposite. Chart 1Consumer Confidence Still Rebounding Consumer Confidence Still Rebounding Consumer Confidence Still Rebounding The Debt Ceiling Is Not A Significant Risk To The Bull Market Investors are increasingly concerned about the US debt ceiling, or statutory limit on the national debt, which comes due on August 1. But the debt ceiling does not pose a significant risk to the bull market this time around. The US is not in the same political context as it was in 2011-13 when debt showdowns roiled markets. Investors’ concerns are understandable, of course. In the wake of the Great Recession, congressional Democrats and Republicans quarreled over the debt ceiling, resulting in notable disinflationary episodes in which stocks fell while Treasuries and the dollar rallied (Chart 2). A close look at the debt showdowns of summer 2011 and winter 2012-13 reveals that the “risk off” phase occurred immediately in the first case and over the succeeding month in the second case (Chart 3). The implication is that the whole period from September to December of 2021 could be at risk from any new debt showdown. To understand why risk is not substantial this year one needs to understand what the debt ceiling is. Chart 2ABiden Will Fare Better Than Obama On Debt Ceiling Biden Will Fare Better Than Obama On Debt Ceiling Biden Will Fare Better Than Obama On Debt Ceiling Chart 2BBiden Will Fare Better Than Obama On Debt Ceiling Biden Will Fare Better Than Obama On Debt Ceiling Biden Will Fare Better Than Obama On Debt Ceiling Chart 3A Close Look At Debt Ceiling Showdowns, 2011-13 A Close Look At Debt Ceiling Showdowns, 2011-13 A Close Look At Debt Ceiling Showdowns, 2011-13 The debt ceiling is a legislative instrument intended to constrain the US’s public debt. Congress must authorize a higher debt limit to enable the Treasury Department to make debt payments. Legislating a higher debt ceiling is not the same as legislating government spending. Congress spends money through the annual appropriations process. Government spending amidst recurring budget deficits requires new debt issuance to provide the funds to be spent. But debt in excess of the statutory limit must be authorized by raising the limit. The last time Congress expanded the debt ceiling was in August 2019, leaving August 1, 2021 as the next deadline. Theoretically it is unpopular for congressmen to increase the allowance for their own profligate policies and as such the debt ceiling acts a curb on deficits and debt. In reality the two political parties usually pull together the 60 votes needed in the Senate to raise or suspend the limit and prevent the federal government from defaulting on debt payments that come due. The reason is that, if the debt limit were not raised, the government would default on debt payments and be forced to halt social security payments, civil servant wages, and other essential payments. A failure to write checks to seniors and military veterans would be extremely unpopular and both the president’s party and the opposition party would suffer for it (Chart 4). Chart 4ABoth President And Congress To Suffer From Any Debt Showdown The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries Chart 4BBoth President And Congress To Suffer From Any Debt Showdown The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries This does not mean that 10 Senate Republicans can easily be found to join 50 Democrats, thus reaching 60 votes in the Senate to raise the debt limit. The battle is likely to extend well into the fall, pushing up against Treasury Secretary Janet Yellen’s warning that the Treasury could run out of funds before Congress returns in mid-September. The battle will likely extend into October and create fears of a default.  Getting 10 Republicans is difficult. It will not occur as part of a compromise infrastructure package, even though this package already has 11 Republicans supporting it. First, the bipartisan infrastructure deal may fail anyway because Republicans know that Democratic leadership, whether they admit it or not, will tie the deal to the passage of their larger budget reconciliation bill later this fall. Since Republicans oppose the reconciliation bill they may not be able to save face if they vote for an infrastructure deal that enables it. And Democrats do not have any reason to compromise on a bipartisan deal if they think it will destroy their larger reconciliation ambitions. Second, if a bipartisan infrastructure deal comes together, Republicans will insist that the debt ceiling is kept separate. They will not want to link themselves and their infrastructure spending with the bulging national debt. Rather they will want to force the Democrats to link their massive social spending with the national debt. Democrats may accept this trade off since the Biden administration wants a bipartisan deal – as long as they are given guarantees from moderate Senate Democrats that the latter  will support the reconciliation bill. Public opinion is not generally distressed when it comes to federal budget deficits and the national debt. Only 3% of Americans cite these as the most important problem facing the country today – obviously people are more concerned with the general economic recovery and unemployment (Chart 5). However, voters clearly believe debt is one of the country’s problems, with 43% saying they are “very concerned” about debt growth, including 45% of independents. Republicans are under significant pressure on these issues, which is why only moderates would conceivably vote to raise the debt limit and even then would only raise it if forced to choose between doing so and triggering a national default (Chart 6). Brinkmanship is to be expected. Chart 5Voters Say Recovery More Important Than Debt The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries Chart 6Yet Concern About Debt Is Not Negligible The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries While public opinion generally favors infrastructure spending, support for infrastructure falls when it is explicitly linked to increases in national debt. Only 39% of voters, and 30% of independents, think it is acceptable to increase the debt to pay for infrastructure, according to a recent Ipsos/Reuters poll (Chart 7). About 60% of Democrats agree with this statement and 22% of Republicans. The implication – as we have long argued – is that investors should not bet on a bipartisan deal. They should bet on the partisan reconciliation process. Chart 7Democrats Support More Debt For Infrastructure … Others Do Not The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries Support for extreme deficit spending is likely to wane as the economy recovers and the sense of crisis abates. Support for emergency COVID-19 fiscal relief was very high early this year (Chart 8). Yet even at the height of the lockdowns there was a non-negligible group of voters who claimed to care about deficits (Chart 9). Fortunately for the Biden administration, the window of opportunity has not yet closed. The rise in the Delta variant of COVID-19 is generating higher hospitalization rates and renewed concerns about the pandemic, which will help support additional stimulus measures (Table 1). There is still time to pass a major spending bill on infrastructure and/or social welfare before the end of the year. Chart 8Support For COVID Relief Was Very High The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries Chart 9Yet Voters Showed Some Concern About Deficits Even At Height Of Crisis The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries Table 12022 Swing States Struggling With COVID-19 The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries Ultimately Democrats control both chambers of Congress and will be able to vote with party discipline on raising the debt ceiling. They can raise the debt ceiling with a simple majority vote if they include it in their upcoming budget reconciliation bill. This is the main reason why investors should look through any financial market jitters: there is a clear escape hatch if Republicans obstruct. The only reason we do not exclude the possibility of Republican cooperation entirely is that Republicans are in such desperate need of a lifeline following President Trump’s defeat and the post-election riot on Capitol Hill. Indeed, the last time Republicans saw anywhere near such low levels of partisan identification was in 2013, after House Republicans brought the US to the brink of defaulting on its debt (Chart 10). The Senate Republicans are divided, not unified in willingness to trigger a default, and we can count at least 10 Senate Republicans who will capitulate if necessary to prevent a default. Chart 10Republicans Need A Lifeline … Infrastructure May Be It The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries Of course, Senate Republicans could refuse to raise the debt ceiling anyway. But the crucial difference is that Congress is not gridlocked. Democrats, as the ruling party, would suffer in the event of a default and they have the reconciliation process to prevent that from happening. (We have also maintained that they will eventually water down or abolish the Senate filibuster, which would open another way to lift the debt ceiling, although so far they have not succeeded in doing so.) Bottom Line: There are reasons for investors to be increasingly risk averse – tax hikes, eventual Fed rate hikes, the 2022 fiscal cliff, global growth sputters – but the debt ceiling is not one of them. Any major stock market jitters that emerge because of the debt ceiling should be ignored if they are not attended by more significant risks. Biden’s Political Capital Still Sufficient For One More Big Bill All year we have maintained that President Biden will get at least one signature bill passed in addition to the huge COVID-19 relief bill, the American Rescue Plan, passed at the beginning of the year. This view is based in our reading of his political support and capability, as evinced in our Political Capital Index, which we update weekly in the Appendix. This view is on track and we maintain high conviction. Nevertheless readers should be aware that Biden’s support will wobble over the coming months and US economic policy uncertainty will rebound from post-pandemic lows. This week’s update of the Political Capital Index shows some chinks in Biden’s armor that will likely get wider over the coming months, though we do not expect them to prevent the bill from passing. First, while political polarization has subsided from recent peaks in 2020, our polarization indicators are starting to rebound from post-election lows. Our polarization proxy (the gap in partisan approval of the president) will eventually find a floor considering the historically high structural polarization in the country. Meanwhile economic sentiment polarization and the Philly Fed Partisan Conflict Index climbed from their respective lows in the first half of the year, as Congress bickered over Biden’s next reconciliation bill (Chart 11). The upcoming partisan battles over infrastructure, the debt ceiling, budget appropriations, voting rights, guns, the Hyde amendment (abortion), a possible government shutdown, and the midterm elections will revive polarization even if it does not surpass 2020 peaks. Partisanship will ensure the passage of a reconciliation bill but then it will reduce Biden’s ability to pass legislation afterwards.    Chart 11Polarization Still Historically Elevated Polarization Still Historically Elevated Polarization Still Historically Elevated Second, Biden’s approval rating is rebounding a bit in July from its low point in June but the legislative process – as well as looming foreign policy challenges and other negative surprises – will weigh on his approval, at least until his infrastructure bill passes (Chart 12). Over the medium term, strong consumer sentiment and a recovering economy will prevent Biden’s approval rating from falling to President Trump’s levels, at least until a major mistake or negative shock occurs. Nevertheless presidents tend to have low approval ratings in the modern era due to partisanship and so far Biden is no exception. Chart 12ABiden Approval Will Suffer Till Infrastructure Passes The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries Chart 12BBiden Approval Will Suffer Till Infrastructure Passes The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries Third, while small business continues to be more concerned with wages and inflation than with Biden’s legislative agenda, concerns about higher taxes are gradually emerging. The business community may finally be internalizing Biden’s American Jobs Plan, which will include a corporate tax hike and possibly also individual tax hikes (Chart 13). The stock market is unlikely to ignore Biden’s corporate tax hikes forever, even if they only cause a one-off hit to earnings of 8%-10%. We expect negative tax surprises from the reconciliation process. The small business community’s opposition to Biden’s agenda is well known, and limited in impact, but it will increasingly detract from his political capital on the margin. Fourth, the economy is beginning to decelerate albeit from a very high rate of growth. The manufacturing PMI and its employment component have fallen from their highs in the first half of the year while the ratio of new orders to inventories was flat in June. The non-manufacturing sector showed the same trend with non-manufacturing business activity and new orders-to-inventories coming down from earlier heights. Non-manufacturing employment ticked down though it will likely rebound soon as enhanced federal unemployment benefits expire (Chart 14). Capex intentions softened a bit. Chart 13Small Biz Wakes Up To Inflation, Tax Hikes Small Biz Wakes Up To Inflation, Tax Hikes Small Biz Wakes Up To Inflation, Tax Hikes Chart 14Economy To Decelerate From Highs Economy To Decelerate From Highs Economy To Decelerate From Highs Still, the unemployment rate continued its decline in June and household and business balance sheets are strong as the economic recovery continues. Biden’s ability to pass his spending plans will ensure that the government contribution to growth remains robust in the coming years, after a soft patch in 2022 as the infrastructure plan is gradually rolled out. Most of these indicators show improvement relative to November, which gives Biden a store of political capital.  Bottom Line: Polarization and policy uncertainty are likely to rebound as the economy decelerates, albeit from rapid growth. Ultimately Biden is likely to pass a signature government spending plan by the end of the year, which will give his approval rating a boost. But given thin margins in Congress, and the looming 2022 midterm elections, Biden’s political capital will largely be exhausted after the second half of this year. Fiscal policy will likely be frozen in place for several years after that. Investment Takeaways The debt ceiling is not a major risk to the bull market, though congressional brinkmanship is inevitable. We are prepared for more volatility and near-term equity setbacks but jitters arising solely from the debt ceiling should be looked through.. Investors should stay focused on the high likelihood that Biden and the Democrats will pass a reconciliation bill that will add about $1.3-$2.5 trillion to the budget deficit over eight years. Disappointments in the bill (higher taxes, lower spending) pose a greater risk to the stock market than the debt ceiling. This bill will solidify the economic recovery but also exact a one-off toll on corporate earnings and hasten concerns over rising inflation expectations and Fed rate hikes. Furthermore a fiscal cliff looms in 2022 as budget deficits normalize from extreme levels. Until new stimulus is secured, this fiscal cliff poses a much greater risk than debt ceilings or a possible government shutdown. The Delta variant of the COVID-19 virus is threatening to clog hospitals and thus poses a risk of forcing authorities to tighten social restrictions, especially in Republican-leaning states where vaccination rates are lower (Chart 15). However, we expect vaccinations to rise – and meanwhile highly vaccinated areas will remain free to conduct business. As long as vaccines remain effective, any scare over variants of the virus will be limited. A selloff is possible but would trigger new bouts of monetary and fiscal stimulus. Chart 15Red States Will Have To Increase Vaccination The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries We will maintain our cyclical orientation of favoring value stocks over growth stocks, although this trade faces an immediate and critical test that could trigger a revaluation (Chart 16). Tactically it should be clear from this report that rising policy uncertainty and other near-term risks are abounding. Chart 16A Test For Value Versus Growth A Test For Value Versus Growth A Test For Value Versus Growth   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com Appendix Table A1USPS Trade Table The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries Table A2Political Risk Matrix The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries Chart A1Presidential Election Model The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries Chart A2Senate Election Model The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries Table A3Political Capital Index The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries Table A4APolitical Capital: White House And Congress The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries Table A4BPolitical Capital: Household And Business Sentiment The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries Table A4CPolitical Capital: The Economy And Markets The Debt Ceiling Is The Least Of Your Worries The Debt Ceiling Is The Least Of Your Worries Footnotes  

Highlights Duration: The recent decline in Treasury yields is overdone. Economic growth is no longer accelerating, but it hasn’t slowed enough to justify the strength in bonds. Stronger employment data will pressure bond yields higher this fall, once labor supply constraints ebb. Ultimately, we expect the 10-year Treasury yield to reach a range of 2% to 2.25% by the end of 2022 when the Fed is ready to lift rates. Maintain below-benchmark portfolio duration. Employment: The static unemployment rate and sub-50 readings from ISM employment indexes will prove to be short-lived phenomena driven by labor supply constraints. These constraints will vanish in the fall when schools re-open and expanded unemployment benefits lapse. Yield Curve: Remain positioned in yield curve flatteners. We specifically like shorting the 5-year bullet versus a duration-matched 2/10 barbell. We expect that the next significant move in Treasury yields will be a bear-flattening of the curve prompted by strong employment data this fall. Feature Last week was another dramatic one in the bond market. Bond yields fell sharply as doubts emerged about the pace of economic recovery and the economy’s progress back to full employment. The 10-year Treasury yield started the week at 1.44% before hitting an intra-day low of 1.25% on Thursday. It then rebounded somewhat to end the week at 1.36%. One catalyst for the move was Tuesday morning’s ISM Non-Manufacturing report that printed at 60.1, below consensus expectations of 63.5. But in truth, economic momentum had already been slowing for several months before that release. The 10-year Treasury yield peaked at 1.74% on March 31st, right around the same time that the New York Fed’s Weekly Economic Index and both the ISM Manufacturing and Non-Manufacturing indexes leveled-off (Chart 1). Last week simply saw the “slowing growth” narrative pick up steam. One noteworthy feature of last week’s market action is that the Treasury curve flattened as yields fell. While the 10-year yield is now at its lowest since February, the 2-year yield remains higher than it was just prior to the June FOMC meeting (Chart 2). This suggests that part of the drop in long-maturity bond yields is due to a fear that the Fed will over-tighten in the face of slowing growth. This fear likely stems from the Fed’s apparent hawkish pivot at the June FOMC meeting.1 Chart 1"Peak Growth" Hits The Bond Market "Peak Growth" Hits The Bond Market "Peak Growth" Hits The Bond Market Chart 2A Flatter Curve Since March A Flatter Curve Since March A Flatter Curve Since March   It’s also worth mentioning that the bulk of last week’s drop in yields was concentrated in long-maturity real yields (Chart 2, bottom 2 panels). TIPS breakeven inflation rates have fallen somewhat since the end of March. But, at 2.3% and 2.23% respectively, the 10-year and 30-year TIPS breakeven inflation rates are not that far below the Fed’s 2.3% - 2.5% target range. Chart 3Bond Rally Not Confirmed By Commodities Bond Rally Not Confirmed By Commodities Bond Rally Not Confirmed By Commodities Finally, many have suggested that “technical factors” are responsible for last week’s bond market strength. That is, factors related to the supply and demand for bonds but unrelated to economic fundamentals conspired to push yields lower. This is a difficult thesis to prove or disprove, but we will point out that the 10-year Treasury yield has diverged significantly from the CRB Raw Industrials / Gold ratio (Chart 3). The 10-year yield and the CRB/Gold ratio tend to track each other very closely but, in contrast to yields, the CRB/Gold ratio has actually increased since March 31st. This lends some credence to the argument that last week’s drop in yields is not purely a reflection of economic weakness, and it could be an overreaction to weaker-than-expected data that was exacerbated by extreme short positioning in the market (Chart 3, bottom panel). Three Reasons Why The Decline In Treasury Yields Is Overdone We do in fact think that the recent decline in Treasury yields is overdone, and we continue to see the 10-year Treasury yield reaching a range of 2% - 2.25% by the end of next year when the Fed is ready to lift rates. We present three reasons why the recent drop in Treasury yields is overdone. First, the bond market is making too much of the “slowing growth” narrative. Yes, it’s certainly true that the economic indicators shown in Chart 1 are no longer accelerating, but in level terms they remain consistent with a robust economic recovery where GDP growth is well above trend. This sort of growth environment is consistent with a falling unemployment rate that will eventually bring Fed rate hikes into play. Bond yields will move higher as this tightening cycle approaches. Second, it is not just the pace of economic growth that matters for bond yields. The output gap matters as well.2 That is, the same rate of economic growth will coincide with higher bond yields when the unemployment rate is 5% than it will when the unemployment rate is 10%. With that in mind, we observe that the output gap has closed significantly during the past year. The prime-age employment-to-population ratio is 77%, up from a 2020 low of 70%. Similarly, capacity utilization is 75%, up from a 2020 low of 64% (Chart 4). Unless we expect economic growth to slow enough for progress on these two fronts to reverse, then we should see significantly higher bond yields this year compared to last year. This makes it difficult to see how Treasury yields can fall much further from current levels. Another way to conceptualize the relationship between the output gap and long-maturity bond yields is to look at how long-dated yields move relative to short-dated yields. Since the Fed moves the funds rate in response to changes in the output gap, we can model the 10-year Treasury yield relative to the fed funds rate and expectations for near-term changes in the fed funds rate to get a sense of how well the output gap explains changes in long-maturity bond yields. Chart 5 presents a simple model of the 10-year Treasury yield relative to the fed funds rate and the 24-month fed funds discounter. It shows that last week’s decline in the 10-year yield caused it to diverge significantly from the model’s fair value. Chart 4The Output Gap Matters The Output Gap Matters The Output Gap Matters Chart 5Long-Maturity Yields Are Too Low Long-Maturity Yields Are Too Low Long-Maturity Yields Are Too Low   Third, the Fed’s pledge to keep rates at the zero-lower-bound at least until the labor market reaches “maximum employment” means that the labor market outlook is critical for bond yields. Our view is that the labor market is on the cusp of a rapid recovery that will cause the Fed to lift rates before the end of 2022. However, recent labor market data have been mixed and there is considerable uncertainty in the market about the future pace of employment gains. The next section delves deeper into the outlook for the labor market. Making Sense Of The Employment Data Chart 6ISM Employment Below 50 ... ISM Employment Below 50 ... ISM Employment Below 50 ... Overall, it seems safe to say that the labor market data have been disappointing in recent months. Yes, nonfarm payroll growth has averaged a robust +543k this year, but the minutes of the June FOMC meeting revealed that “some participants” viewed employment gains as “weaker than they had expected”. The recent dips in the employment components of both the ISM Manufacturing and Non-Manufacturing indexes to below the 50 boom/bust line only add to the sense of pessimism about the labor market. Historically, sub-50 readings from the ISM employment indices (particularly from the non-manufacturing ISM) have coincided with slowing employment growth (Chart 6). This time, however, we don’t see the ISM employment indexes staying below 50 for very long. The more demand-focused components of the ISM indexes – production, new orders and backlog of orders – remain elevated (Chart 7). This tells us that demand is strong and that hiring is only weak because of labor supply constraints, a topic we have covered repeatedly in this publication.3 Our view is that by September, once schools re-open and expanded unemployment benefits lapse, we will see a surge in hiring and a jump in the ISM employment components as people are enticed back into the workforce. A clearer picture of the labor market will then emerge, and it will catalyze a jump in bond yields. It’s not just weak ISM employment readings that are giving investors doubts about the labor market. The unemployment rate’s decline has also slowed markedly in recent months (Chart 8). Our adjusted measure of the U3 unemployment rate currently sits at 6.1%, above the headline U3 measure of 5.9% and significantly above the range of 3.5% to 4.5% that the Fed estimates is consistent with full employment. Chart 7... But Demand Indicators Are Elevated ... But Demand Indicators Are Elevated ... But Demand Indicators Are Elevated Chart 8Slow Progress On Unemployment Slow Progress On Unemployment Slow Progress On Unemployment Chart 9Labor Supply Is The Problem Labor Supply Is The Problem Labor Supply Is The Problem We adjust the U3 unemployment rate to include a number of people that are currently being classified as “employed but absent from work” when they should be classified as “temporarily unemployed”. The number of people describing themselves as “employed but absent from work” jumped sharply in March 2020 and has remained elevated. This is the result of workers that were placed on temporary furlough during the pandemic and who should be counted as unemployed. We make our adjustment by taking the difference between the number of people that are “employed but absent from work for other reasons” each month and a baseline calculated as that month’s average between 2015 and 2019. We then add this excess amount to the number of temporarily unemployed. This gives us adjusted readings for both the U3 unemployment rate and the temporary unemployment rate (Chart 8, top 2 panels). The Appendix of this report updates our scenarios for the average monthly nonfarm payroll growth required to reach “maximum employment” to consider both this new adjustment and June’s employment figures. Technical adjustments aside, the main takeaway for investors is that progress toward “maximum employment” has been relatively slow during the past few months. This is particularly true if we look at the unemployment rate excluding those on temporary furlough (Chart 8, panel 3) and the labor force participation rate (Chart 8, bottom panel). This slow progress toward “maximum employment” is undoubtedly a reason why bond yields remain low. But, once again, we think it’s only a matter of time before labor supply constraints ease and the unemployment rate falls rapidly, catching up to indicators of labor demand that have already surpassed pre-COVID levels (Chart 9). Bottom Line: The recent decline in Treasury yields is overdone. Economic growth is no longer accelerating, but it hasn’t slowed enough to justify the strength in bonds. The labor market also continues to make progress toward maximum employment (and Fed rate hikes) though that progress has slowed during the past few months. We anticipate that stronger employment data will pressure bond yields higher this fall, once labor supply constraints ebb. Ultimately, the economy will reach full employment in time for the Fed to lift rates in 2022. We expect that the 10-year Treasury yield will be in a range of 2% to 2.25% by then. Maintain below-benchmark portfolio duration. A Quick Note On The Yield Curve Chart 105y5y Still Close To Fair Value 5y5y Still Close To Fair Value 5y5y Still Close To Fair Value While we view the recent drop in the level of bond yields as an overreaction, we are less inclined to view recent curve flattening as temporary. To see why, let’s look at the 5-year/5-year forward Treasury yield relative to survey estimates of the long-run neutral fed funds rate. We like to think of the 5-year/5-year forward Treasury yield as a market proxy for the long-run neutral fed funds rate, so a range of estimates of that rate is a logical fair value target. The 5-year/5-year forward Treasury yield has fallen a lot during the past few weeks. But, at 2%, it is still within the range of neutral rate estimates from the New York Fed’s Survey of Market Participants and only just outside of the same range from the Survey of Primary Dealers (Chart 10). The fact that the 5-year/5-year yield remains relatively close to its fair value range tells us that there is very limited scope for curve steepening. Recent periods of significant curve steepening have tended to coincide with one of the following two developments: The Fed is cutting rates (coincides with a bull-steepening) The 5-year/5-year forward Treasury yield moves into its fair value range after starting out well below it (coincides with a bear-steepening) This second sort of curve steepening occurred during the 2013 taper tantrum, after the 2016 presidential election and again after the 2020 presidential election. It’s conceivable that the yield curve could re-steepen somewhat during the next few months, if the 5-year/5-year forward yield moves back to its prior highs. But we expect the next major move in the Treasury market to be a bear-flattening as the rest of the yield curve catches up to the 5-year/5-year. This is the sort of curve flattening that occurred in 2017 and 2018 when the Fed was lifting rates (Chart 10, bottom 2 panels). A bear-flattening of the yield curve is also the most likely outcome if we start to see significant positive employment surprises later this year, as we anticipate. These employment surprises would bring forward the timing and pace of rate hikes but wouldn’t necessarily cause investors to question their views about the long-run neutral fed funds rate. Bottom Line: Remain positioned in yield curve flatteners. We specifically like shorting the 5-year bullet versus a duration-matched 2/10 barbell. We expect that the next significant move in Treasury yields will be a bear-flattening of the curve prompted by strong employment data this fall. Appendix: How Far From “Maximum Employment” And Fed Liftoff? Chart A1Defining “Maximum Employment” Defining "Maximum Employment" Defining "Maximum Employment" The Federal Reserve has promised that the funds rate will stay pinned at zero until the labor market returns to “maximum employment”. The Fed has not provided explicit guidance on the definition of “maximum employment”, but we deduce that “maximum employment” means that the Fed wants to see the U3 unemployment rate within a range consistent with its estimates of the natural rate of unemployment, currently 3.5% to 4.5%, and that it wants to see a more or less complete recovery of the labor force participation rate back to February 2020 levels (Chart A1). Alternatively, we can infer definitions of “maximum employment” from the New York Fed’s Surveys of Primary Dealers and Market Participants. These surveys ask respondents what they think the unemployment and labor force participation rates will be at the time of Fed liftoff. Currently, the median respondent from the Survey of Market Participants expects an unemployment rate of 3.5% and a participation rate of 63%. The median respondent from the Survey of Primary Dealers expects an unemployment rate of 3.7% and a participation rate of 63%. Tables A1-A4 present the average monthly nonfarm payroll growth required to reach different combinations of unemployment rate and participation rate by specific future dates. For example, if we use the definition of “maximum employment” from the Survey of Market Participants, then we need to see average monthly nonfarm payroll growth of +484k in order to hit “maximum employment” by the end of 2022. Table A1Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4.5% By The Given Date Overreaction Overreaction Table A2Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 4% By The Given Date Overreaction Overreaction Table A3Average Monthly Nonfarm Payroll Growth Required For The Unemployment To Reach 3.5% By The Given Date Overreaction Overreaction Table A4Average Monthly Nonfarm Payroll Growth Required To Reach “Maximum Employment” As Defined By Survey Respondents Overreaction Overreaction Chart A2 presents recent monthly nonfarm payroll growth along with target levels based on the Survey of Market Participants’ definition of “maximum employment”. This chart helps us track progress toward specific liftoff dates. For example, if monthly nonfarm payroll growth continues to print at the same level as last month, then we could anticipate a Fed rate hike by June 2022. We will continue to track these charts and tables in the coming months, and will publish updates after the release of each monthly employment report. Chart A2Tracking Toward Fed Liftoff Tracking Toward Fed Liftoff Tracking Toward Fed Liftoff Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “How To Re-Shape The Yield Curve Without Really Trying”, dated June 22, 2021. 2 For a description of the five macro factors that determine bond yields please see US Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019. 3 Please see US Bond Strategy Weekly Report, “Making Money In Municipal Bonds”, dated April 27, 2021.   Fixed Income Sector Performance Recommended Portfolio Specification

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

Highlights Over the short term – 1-2 years – the pick-up in re-infection rates in Asia and LatAm states with large-scale deployments of Sinopharm and Sinovac COVID-19 vaccines will re-focus attention on demand-side risks to the global recovery (Chart of the Week). The UAE-Saudi impasse re extending the return of additional volumes of OPEC 2.0 spare capacity to the oil market over 2H21 will be short-lived.  The UAE's official baseline production will be increased to 3.8mm b/d from 3.2mm b/d presently, and its output in 2H21 will be adjusted accordingly.  Over the medium term – 3-5 years out – the risk to the expansion of metal supplies needed for renewables and electric vehicles (EVs) will rise, as left-of-center governments increase taxes and royalties, and carbon prices move higher. Rising metals costs will redound to the benefit of oil and gas producers, and accelerate R+D in carbon- and GHG-reduction technologies. Longer-term – 5-10 years out – the active discouragement of investment in hydrocarbons will contribute to energy shortages. In anticipation of continued upside volatility in commodity prices and share values of oil, gas and metals producers, we remain long the S&P GSCI and COMT ETF, and long equities of producers and traders via the PICK ETF. Feature Our conversations with clients almost invariably leads us to considering the risks to our long-standing bullish views for energy and metals. This week, we reprise some of the highlights of these conversations. In the short term, our bullish call on oil is underpinned by the assumption of continued expansion in vaccinations, which we believe will lead to global economic re-opening and increased mobility, as the world emerges from the devastation of COVID-19. This expectation is once again under scrutiny. On the supply side, the very public negotiations undertaken by the UAE and the leaders of OPEC 2.0 – the Kingdom of Saudi Arabia (KSA) and Russia – over re-basing the UAE's production reminds investors there is substantial spare capacity from the coalition available for the market over the short term. The slow news cycle going into the US Independence Day holiday certainly was a fortuitous time to make such a point. Chart of the WeekWorrisome Uptick Of COVID-19 Cases Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views KSA-UAE Supply-Side Worries The abrupt end to this week's OPEC 2.0 meeting was unsettling to markets. Shortly after the meeting ended – without being concluded – officials from the Biden administration in the US spoke with officials from KSA and the UAE, presumably to encourage resolution of outstanding issues and to get more oil into the market to keep crude oil prices below $80/bbl (Chart 2). We're confident the KSA-UAE impasse re extending the return of additional volumes of spare capacity to the oil market over 2H21 will be short-lived. The UAE's official baseline production number (i.e., its October 2018 output level) will be increased to 3.8mm b/d from 3.2mm b/d presently, and its output in 2H21 will be adjusted accordingly. Coupled with a likely return of Iranian export volumes in 4Q21, this will bring prices down into the mid- to high-$60/bbl range we are forecasting. Chart 2US Pushing For Resolution of KSA-UAE Spat US Pushing For Resolution of KSA-UAE Spat US Pushing For Resolution of KSA-UAE Spat Longer term, markets are worried this incident is a harbinger of a breakdown in OPEC 2.0's so-far-successful production-management strategy, which has lifted oil prices 200% since their March 2020 nadir. At present, the producer coalition has ~ 6-7mm b/d of spare capacity, which resulted from its strategy to keep the level of supply below demand. A breakdown in this discipline – in extremis, another price war of the sort seen in March 2020 or from 2014-2016 – could plunge oil markets into a price collapse that re-visits sub-$40/bbl levels. In our view, economics – specifically the cold economic reality of the price elasticity of supply – continues to work for the OPEC 2.0 coalition: Higher revenues are realized by members of the group as long as relatively small production cuts produce larger revenue gains – e.g., a 5% (or less) cut in production that produces a 20% (or more) increase in price trumps a 20% increase in production that reduces prices by 50%. Besides, none of the members of the coalition possess the wherewithal to endure another shock-and-awe display from KSA similar to the one following the breakdown of the March 2020 OPEC 2.0 meeting. We also continue to expect US shale-oil producers to be disciplined by capital markets, and to retain a focus on providing competitive returns to their shareholders, which will limit supply growth to that which maintains profitability. Until we see actual evidence of a breakdown in the coalition's willingness to maintain its production-management strategy, we will continue to assume it remains operative. Worrisome COVID-19 Re-Infection Trends Reports of increased re-infection rates in Latin American and Asia-Pacific states providing Chinese Sinopharm and Sinovac COVID-19 vaccines will re-focus attention on demand-side risks to the global recovery. Conclusive data on the efficacy of these vaccines is not available at present, based on reporting from Health Policy Watch (HPW).1 The vast majority of these vaccines were purchased in Latin America and the Asia-Pacific region, where ~ 80% of the 759mm doses of the two Chinese vaccines were sold, according to HPW's reporting. This will draw the attention of markets to this risk (Chart 3). Of particular concern are the increases in re-infection rates in the Seychelles and Chile, where the majority of populations in both countries were inoculated with one of the Chinese vaccines. Re-infections in Indonesia also are drawing attention, where more than 350 healthcare workers were re-infected after receiving the Sinovac vaccination.2 The risk of renewed global lockdowns remains small, but if these experiences are repeated globally with adverse health consequences, this assessment could be challenged. Chart 3COVID-19 Returning In High-Vaccination States Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views Transition Risks To A Low-Carbon Economy Over the medium- to long-terms, our metals views are premised on the expectation the build-out of the global EV fleet and renewable electricity generation – including its supporting grids – will require massive increases in the supply of copper, aluminum, nickel, and tin, not to mention iron ore and steel. This surge in demand will be occurring as governments rush headlong into unplanned and unsynchronized wind-downs of investment in the hydrocarbon fuels that power modern economies.3 The big risk here is new metal supplies will not be delivered fast enough to build all of the renewable generation, EVs and their supporting grids and infrastructures to cover the loss of hydrocarbons phased out by policy, legal and boardroom challenges. Such a turn of events would re-invigorate oil and gas production. Renewable energy and electric vehicles are the sine qua non of the drive to achieve net-zero carbon emissions by 2050. However, the rising price of base metals will add to already high costs of rebuilding power grids to make them suitable for green energy. Given miners’ reluctance to invest in new mines, we do not expect metals prices to drop anytime soon. According to Wood Mackenzie, in 2019 the cost of shifting just the US power grid to renewable energy over the next 10 years will amount to $4.5 trillion.4 Given these cost and supply barriers, fossil fuels will need to be used for longer than the IEA outlined in its recent and controversial report on transitioning to a net-zero economy.5 To ensure that fossil fuels can be used while countries work to achieve their net zero goals, carbon capture utilization and storage (CCUS) technology will need to be developed and made cheaper. The main barrier to entry for CCUS technology is its high cost (Chart 4). However, like renewable energy, the more it is deployed and invested in, the cheaper it will become, following the trend seen in the development of renewable energy and EVs, which were aided by large-scale subsidies from governments to encourage the development of the technology. These cost reductions are already visible: In its 2019 report, the Global CCS Institute noted the cost of implementing CCS technology initially used in 2014 had fallen by 35% three years later. Chart 4CCUS Can Be Expensive Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views Metals Mines' Long Lead Times In 2020 the total amount of discovered copper reserves in the world stood at ~ 870mm MT (Chart 5), according to the US Geological Service (USGS). As of 2017, the total identified and undiscovered amount of reserves was ~ 5.6 billion MT.6 The World Bank recently estimated additional demand for copper would amount to ~ 20mm MT p.a. by 2050 (Chart 6).7 Glencore’s recently retired CEO Ivan Glasenberg last month said that by 2050, miners will need to produce around 60mm MT p.a. of copper to keep up with demand for countries’ net zero initiatives.8 Even with this higher estimate, if miners focus on exploration and can tap into undiscovered reserves, supply will cover demand for the renewable energy buildout. Chart 5Copper Reserves Are Abundant Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views Chart 6Call On Base Metals Supply Will Be Massive Out To 2050 Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views While recent legislative developments in Chile and Peru, which together constitute ~ 34% of total discovered copper reserves, could lead to significantly higher costs as left-of-center governments re-write these states' constitutions, geological factors would not be the main constraint to copper supply for the renewables energy buildout: Even if copper mining companies were to move out of these two countries, there still is about 570 million MT in discovered copper reserves, and nearly ten times that amount in undiscovered reserves. As we have written in the past, capital expenditure restraint is the principal reason the supply side of copper markets – and base metals generally – is challenged (Chart 7). Unlike in the previous commodity boom, this time mining companies are focusing on providing returns to shareholders, instead of funding the development of new mines (Chart 8). Chart 7Copper Prices Remains Parsimonious Copper Prices Remains Parsimonious Copper Prices Remains Parsimonious Chart 8Shareholder Interests Predominate Metals Agendas Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views Of course, it is likely metals miners, like oil producers, are waiting to see actual demand for copper and other base metals pick up before ramping capex. Sharp increases in forecasted demand is not compelling for miners, at this point. This means metals prices could stay elevated for an extended period, given the 10-15-year lead times for copper mines (Chart 9). For example, the Kamoa-Kakula mine in the Democratic Republic of Congo (DRC) now being brought on line took roughly 24 years of exploration and development work, before it started producing copper. Technological breakthroughs that increase brownfield projects’ productivity, or significant increases in the amount of recycled copper as a percent of total copper supply would address some of the price pressures arising from the long lead times associated with the development of new copper supply. Another scenario with a non-trivial probability that threatens the viability of metals investing is a breakthrough – or breakthroughs – in CCUS technology, which allows oil and gas producers to remove enough carbon from their fuels to allow firms using these fuels to achieve their net-zero carbon goals. Chart 9Long Lead Times For Mine Development Assessing Risks To Our Commodity Views Assessing Risks To Our Commodity Views Investment Implications Short-term supply-demand issues affecting the oil market at present are transitory, and do not signal a shift in the fundamentals supporting our bullish call on oil. Our thesis based on continued production discipline remains intact. That said, we will continue to subject it to rigorous scrutiny on a continual basis. Our average Brent forecast for 2021 remains $66.50/bbl, with 2H21 prices averaging $70/bbl. For 2022 and 2023 we continue to expect prices to average $74 and $81/bbl, respectively (Chart 10). WTI will trade $2-$3/bbl lower. Our metals view has become slightly more nuanced, thanks to our client conversations. One of the unintended consequences of the unplanned and uncoordinated rush to a net-zero carbon future will be an improvement in the competitive position of oil and gas as transportation fuels and electric-generation fuels going forward. This will be driven by rising costs of developing and delivering the metals supplies needed to effect the net-zero transition. We expect markets will provide incentives to CCUS technologies and efforts to decarbonize oil and gas fuels, which will contribute to the global effort to arrest rising temperatures. This suggests the rush to sell these assets – which is underway at present – could be premature.9 In the extreme, this could be a true counterbalance to the metals story, if it plays out. Chart 10Our Oil Price View Remains Intact Our Oil Price View Remains Intact Our Oil Price View Remains Intact     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish The monthly OPEC 2.0 meeting ended without any action to increase monthly supplies, following the UAE's bid to increase its baseline reference production – determined based on October 2018 production levels – to 3.8mm b/d, up from 3.2mm b/d. S&P Global Platts reported the UAE's Energy Minister, Suhail al-Mazrouei, advanced a proposal to raise its monthly production level under the coalition's overall output deal, while KSA's energy minister, Prince Abdulaziz bin Salman, insisted the UAE follow OPEC 2.0 procedures in seeking an output increase. We do not expect this issue to become a protracted standoff between these states. The disagreement between the ministers is procedural to substantive. Remarks by bin Salman last month – to wit, KSA has a role in containing inflation globally – and his earlier assertions that production policy of OPEC 2.0 would be driven by actual oil demand, as opposed to forecasted oil demand, suggest the Kingdom is not aiming for higher oil prices per se. Base Metals: Bullish Spot benchmark iron ore (62 Fe) prices traded above $222/MT this week in China on the back of stronger steel demand, according to mining.com (Chart 11). Market participants are anticipating further steel-production restrictions and appear to be trying to get out in front of them. Precious Metals: Bullish The USD rally eased this week, allowing gold prices to stabilize following the June Federal Open Market Committee (FOMC) meeting. In the two weeks since the FOMC, our gold composite indicator shows that gold started entering oversold territory (Chart 12). We believe gold prices will start correcting upwards, expecting investor bargain-hunting to pick up after the price drop. The mixed US jobs report, which showed the unemployment rate ticked up more than expected, implies that interest rates are not going to be raised soon. Our colleagues at BCA Research's US Bond Strategy (USBS) expect rates to increase only by end-2022.10 This, along with slightly higher odds of a potential COVID-19 resurgence, will support gold prices in the near-term. Ags/Softs: Neutral The USDA's Crop Progress report for the week ended 4 July 2021 showed 64% of the US corn crop was in good to excellent condition, down from the 71% reported for the comparable 2020 date. The Department reported 59% of the bean crop was in good to excellent shape vs 71% the year earlier. Chart 11 BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI) GOING DOWN BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI) GOING DOWN Chart 12 Sentiment Supports Oil Prices Sentiment Supports Oil Prices     Footnotes 1     Please see Are Chinese COVID Vaccines Underperforming? A Dearth of Real-Life Studies Leaves Unanswered Questions, published by Health Policy Watch, June 18, 2021. 2     According to HPW, the World Health Organization's Emergency Use Listing for these two vaccines "were unique in that unlike the Pfizer, AstraZeneca, Moderna, and Jonhson & Johonson vaccines that it had also approved, neither had undergone review and approval by a strict national or regional regulatory authority such as the US Food and Drug Administration or the European Medicines Agency. Nor have Phase 3 results of the Sinopharm and Sinovac trials been published in a peer-reviewed medical journal.  More to the point, post-approval, any large-scale tracking of the efficacy of the Sinovac and Sinopharm vaccine rollouts by WHO or national authorities seems to be missing." 3    Please see A Perfect Energy Storm On The Way, which we published on June 3, 2021 for additional discussion.  It is available at ces.bcaresearch.com. 4    Please refer to The Price of a Fully Renewable US Grid: $4.5 Trillion, published by greentechmedia 28 June 2019. 5    Please refer to the IEA's Net Zero By 2050, published in May 2021. 6    Please refer to USGS Mineral Commodity Summaries, 2021. 7     Please refer to Minerals for Climate Action: The Mineral Intensity of the Clean Energy Transition, published by the World Bank. 8    Please refer to Copper supply needs to double by 2050, Glencore CEO says, published by reuters.com on June 22, 2021. 9    Please see the FT's excellent coverage of this trend in A $140bn asset sale: the investors cashing in on Big Oil’s push to net zero published on July 6, 2021. 10   Please refer to Watch Employment, Not Inflation, published by the USBS on June 15, 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Image

Highlights Inflation is set to decelerate, job creation has a speed limit, and super-spreaders of new-variant Covid-19 infections will create speed bumps in the economy.  This means that in the second half of the year: Bonds will rally. The US dollar will rally. Growth stocks will outperform value stocks. US stocks will outperform non-US stocks. Fractal trade shortlist: Brazilian real, Saudi Tadawul All Share, and Marine Transportation.  Feature Chart of the WeekThe 60 Percent Correction In Lumber Shows What Happens When Supply Bottlenecks Ease. Are Used Cars Next? The 60 Percent Correction In Lumber Shows What Happens When Supply Bottlenecks Ease. Are Used Cars Next? The 60 Percent Correction In Lumber Shows What Happens When Supply Bottlenecks Ease. Are Used Cars Next? As Supply Bottlenecks Ease, Inflation Will Cool Since mid-March, US inflation has surged to 5 percent. Yet bond yields have drifted lower, by almost 50 bps in the case of the 30-year T-bond yield, equating to a handsome return of 12 percent. The seeming contradiction between rising inflation and declining bond yields has puzzled some people, but it shouldn’t. In 2009, the same pattern occurred in reverse. Inflation collapsed, culminating in a modern era low of -2 percent in July 2009. Yet while inflation was collapsing, bond yields rose sharply (Chart I-2 and Chart I-3). Chart I-2In 2009, Bond Yields Rose When Year-On-Year Inflation Fell In 2009, Bond Yields Rose When Year-On-Year Inflation Fell In 2009, Bond Yields Rose When Year-On-Year Inflation Fell Chart I-3In 2021, Bond Yields Fell When Year-On-Year Inflation Rose In 2021, Bond Yields Fell When Year-On-Year Inflation Rose In 2021, Bond Yields Fell When Year-On-Year Inflation Rose We can explain this seeming contradiction with an analogy from driving. The inflation rate is like your average speed over the past mile. But the bond market cares much more about your average speed over the next mile, or even over the next 5-10 miles. If you are driving at a constant speed, then your speed over the past mile is a good guide to your future speed. But if you have been driving unusually fast or unusually slowly, there is a more important predictor of your future speed. That important predictor is your acceleration – meaning, what is happening to your speed over successive hundred yards stretches. In the same way, during episodes of unusually low or unusually high inflation, the bond market focusses on the monthly rate of inflation, and specifically the moment that it stops decreasing, as in early-2009, or stops increasing, as in mid-2021. In 2008, after a long sequence of declining monthly rates of inflation that went deep into negative territory, the December 2008 print marked the first substantial increase. Hence, the bond yield also bottomed in December 2008 (Chart I-4), even though annual inflation did not bottom until July 2009. Chart I-4In 2009, Bond Yields Bottomed When Month-On-Month Inflation Bottomed In 2009, Bond Yields Bottomed When Month-On-Month Inflation Bottomed In 2009, Bond Yields Bottomed When Month-On-Month Inflation Bottomed Similarly, in 2020-21, after a six month sequence of increasing monthly rates of inflation, the May 2021 print marked the end of the rising trend. To the extent that this was anticipated, most of the decline in the bond yield has happened since mid-May (Chart I-5). Chart I-5In 2021, Bond Yields Topped When Month-On-Month Inflation Topped In 2021, Bond Yields Topped When Month-On-Month Inflation Topped In 2021, Bond Yields Topped When Month-On-Month Inflation Topped Since mid-May, the 60 percent crash in the lumber price shows what happens when supply bottlenecks ease. Other prices that are being supported by temporary supply constraints – such as used car prices – are likely to suffer the same fate (Chart of the Week). Hence, so long as the coming monthly prints confirm an ongoing deceleration in inflation, the current rally in bonds will stay intact. Jobs: The Hard Work Starts Now Staying on the theme of speed, there is a well-defined speed limit to every post-recession jobs recovery. In A Fed Rate Hike By Early 2023 Is Pie In the Sky, we pointed out the remarkable consistency in the pace of post-recession US jobs recoveries. The last five recessions had different causes, severities, durations and peak unemployment rates. Yet in the recoveries that followed each recession, the unemployment rate declined at a remarkably consistent pace of 0.4-0.5 percent per year (Table I-1). Table I-1After Every Recession, The Pace Of Recovery In The Jobs Market Is Near-Identical H2 2021: Speed Limits, Speed Bumps, And Super-Spreaders H2 2021: Speed Limits, Speed Bumps, And Super-Spreaders Reassuringly at the last FOMC press conference, Jay Powell supported this thesis: Most of the act of sort of going back to one's old job – that's kind of already happened. So, this is a question of people finding a new job. And that's just a process that takes longer. There may be something of a speed limit on it. You've got to find a job where your skills match, you know, what the employer wants. It's got to be in the right area. There's just a lot that goes into the function of finding a job. Powell’s comments lead to two further points: The act of going back to one’s old job for those on ‘temporary layoff’ is relatively straightforward. For job creation, this is the low hanging fruit, most of which has already been picked. Now comes the much harder part – finding jobs for those ‘not on temporary layoff’ whose numbers have barely declined from the peak (Chart I-6). Chart I-6For Job Creation, The Low Hanging Fruit Has Already Been Picked For Job Creation, The Low Hanging Fruit Has Already Been Picked For Job Creation, The Low Hanging Fruit Has Already Been Picked One way of encapsulating this is to observe that the unemployment rate – including those on temporary layoff – has already made 80 percent of the journey from its recession peak to the February 2020 trough, which makes it seem that the jobs recovery is largely done. However, the unemployment rate for those not on temporary layoff has made only 25 percent of the journey (Chart I-7). Moreover, this process is not a straight line, it is a curve. The first quarter of the journey is the easiest, then it gets harder. Chart I-7The Hard Part Is Finding Jobs For Those Unemployed 'Not On Temporary Layoff' The Hard Part Is Finding Jobs For Those Unemployed 'Not On Temporary Layoff' The Hard Part Is Finding Jobs For Those Unemployed 'Not On Temporary Layoff' As we, and Jay Powell, have pointed out, the process to reduce this unemployment rate has a remarkably consistent speed limit of 0.4-0.5 percent per year. Starting at the current rate of 2.5 percent and a target of 1.5 percent, this means full employment will not be reached before the second half of 2023. And even this assumes clear blue skies for the world economy through the next two years, which is a tall order. We conclude that the market pricing of a Fed funds rate lift-off in December 2022 is much too optimistic, making the December 2022 Eurodollar contract a good buy. The End Of Pandemic Restrictions Will Unleash Super-Spreaders On July 19, the UK will remove all its domestic pandemic restrictions – meaning no more facemasks, social distancing, and limits on the size of gatherings. This doesn’t mean that the pandemic is over in the UK. Far from it. The delta variant of the virus is rampant. Rather, with a large portion of the population vaccinated, the government is replacing state-imposed laws and regulations with a libertarian onus on personal responsibility. Given that Covid-19 is not going away, the UK strategy raises a fundamental question. Other than implementing a vaccination program, what role should a government take in containing the virus? In Who’s Right On The Pandemic – Sweden Or Denmark? we revealed two important findings: First, it is a misunderstanding that state-imposed restrictions cause the collapse in social consumption. This is a classic confusion between correlation and causation. The true cause of the recession is that a virulent disease focuses millions of people on self-preservation, shunning crowds and public places. But to the extent that the pandemic also leads to state-imposed restrictions, many people blame the slowdown on these correlated restrictions rather than on the underlying cause – the voluntary change in behaviour. Second, without state-imposed restrictions, the majority will voluntarily change their behaviour to avoid catching and spreading the virus, but a minority will not. When a virus is spreading, this is critical because a tiny minority of so-called ‘super-spreaders’ is responsible for most infections. Put simply, economic growth depends on the behaviour of the majority and in a pandemic the majority will voluntarily reduce their social consumption. This explains why libertarian Sweden and lockdown Denmark suffered similar contractions in their economies (Chart I-8). Chart I-8Libertarian Sweden Has Not Significantly Outperformed Lockdown Denmark... Libertarian Sweden Has Not Significantly Outperformed Lockdown Denmark... Libertarian Sweden Has Not Significantly Outperformed Lockdown Denmark... In contrast, containing the virus depends on restricting the minority of super-spreaders. Which explains why libertarian Sweden suffered a much worse outbreak of the disease than lockdown Denmark (Chart I-9). Chart I-9...But Libertarian Sweden Has Suffered Many More Covid-19 Casualties ...But Libertarian Sweden Has Suffered Many More Covid-19 Casualties ...But Libertarian Sweden Has Suffered Many More Covid-19 Casualties The worry now is that the end of state-imposed restrictions will unleash super-spreaders and super-spreading events. This will allow the virus to replicate, mutate, and create new variants which are potentially more transmissible and resistant to existing vaccines. Pulling together our three themes for the second half of the year, inflation is set to decelerate, job creation has a natural speed-limit, and super-spreaders of new-variant Covid-19 infections will create speed bumps in the economy. This means that:  Bonds will rally. The US dollar will rally. Growth stocks will outperform value stocks. US stocks will outperform non-US stocks Candidates For Countertrend Reversal This week, we present three candidates for countertrend reversal. First, the Brazilian real’s recent surge has hit expected resistance at 65-day fractal fragility. A good way to play a continued reversal is to short BRL/COP (Chart I-10). Chart I-10The Brazilian Real Is Correcting The Brazilian Real Is Correcting The Brazilian Real Is Correcting Second, within emerging markets, the strong rally in the Saudi equity market is vulnerable to a setback, especially versus other markets. A good way to play this is to short the Saudi Tadawul All Share index versus the FTSE Bursa Malaysia KLCI, given that the 260-day fractal structure is at the point of fragility that marked the major top in 2014 (Chart I-11). Chart I-11The Saudi Stock Market Is Vulnerable To A Setback The Saudi Stock Market Is Vulnerable To A Setback The Saudi Stock Market Is Vulnerable To A Setback Finally, coming full circle to short-term supply bottlenecks, one major beneficiary has been the Marine Transportation sector which, since February, has outperformed the world market by 70 percent. As the supply bottlenecks ease, this is vulnerable to correction, especially as the 260-day fractal structure is at the point of fragility that marked the major top in 2007 (Chart I-12). Chart I-12Underweight Marine Transportation Underweight Marine Transportation Underweight Marine Transportation Hence, this week’s recommended trade is to underweight Marine Transportation versus the market, setting the profit target and symmetrical stop-loss at 16.5 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area   Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations   Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Complementing the US Political Strategy Quantitative Presidential Election Model, we introduce our revised Quantitative Senate Election Model. Our senate election model measures the probability of the incumbent party (Democratic Party) to retain the Senate in the 2022 midterm election. The model predicts that Democrats are slightly favored to retain control of the Senate, though it is too early to call, which in combination with the high likelihood that the GOP will retake the House, points to a US political gridlock from 2023 to 2025. The “Blue Sweep” policy setting will end as early as the end of the year as Democrats pass Biden’s signature legislation. Post-midterm gridlock implies that taxes unlikely to rise further from 2023 while spending will not be subjected to cuts. While markets will not be alarmed if growth keeps up, near term surprises from potential tax hikes, rate hikes, and China’s slowdown warrants a more defensive positioning. Feature 2020 was not only the year of a highly contested US Presidential election, but also a close-knit battle for control of the US Senate, which had 351 seats up for reelection. The Republican party initially retained control of the Senate at the start of 2021 and the 117th congress, but this was short-lived. The Democrats secured victories in both run-off triggered Senate races in the state of Georgia, putting them at an even 50-50 hold with Republicans in the Senate. The inauguration of Vice President Kamala Harris who too became the Senate President, was the tie breaker the Democrats needed to take control of the Senate, and ultimately secure a “blue sweep” of holding the House of Representatives, the Senate and the White House. We recently introduced BCA US Political Strategy readers to our quantitative presidential election model. If you have not yet read it, you can access it here. In this week’s report we introduce our US Political Strategy Senate election model. We acknowledged that it was still early days in the presidential election cycle when we published our presidential election model but there were however some interesting takeaways from an early model forecast. For control of the Senate, however, the cycle is much shorter, with voting of one third of the Senate taking place every two years. The mid-term elections of 2022 are not that far-out, and with 34 seats up for reelection, we believe that introducing our readers to our Senate election model now will start to provide valuable insight going forward. Like our presidential election model, our Senate election model is a state-by-state model that uses both economic and political variables to predict the number of seats the incumbent party will win in the 2022 Senate election. Our Senate model covers a large sample size, consisting of 19 Senate elections (1984 to 2020), across 50 states, amounting to 950 observations. The Six Variables Our Senate model is based off a Probit regression that produces a probability that each state will remain under the control of the incumbent party. The dependent variable (classified as “elected”) is stated as follows: 1 = Incumbent party wins the Senate election in each state; or 0 = Incumbent party did not win the Senate election in each state. This method allows us to measure the probability that a state with certain characteristics will fall into one of two categories above. We can then predict the probability of the incumbent party winning all the Senate seat/s in each of the 50 states (although this is only relevant to one-third of the states that have a Senate seat up for election in 2022). State economic health. Specifically, we use the Federal Reserve Bank of Philadelphia State Coincident Index for each of the 50 states. The coincident index combines four of a given state’s economic indicators to summarize current economic conditions in a single statistic. The four indicators are nonfarm payroll employment; average hours worked in manufacturing by production workers; the unemployment rate; and wage and salary disbursements plus proprietors' income deflated by the consumer price index (US city average). In other words, it captures job growth, manufacturing wages, joblessness, and real household income. The incumbent party’s margin of victory in previous Senate elections in each state Senate race. This is measured as the incumbent party’s share of the popular vote minus the non-incumbent party’s share. If the incumbent party failed to secure a solid win in each state in the previous Senate election, the probability of securing a solid win in the current election becomes smaller. Moreover, the larger the margin of victory in a previous Senate election race, the more likely that incumbent party will win re-election in said state. Net average approval level of the incumbent president in a Senate election year. This is the difference between the incumbent president’s approval and disapproval level in a Senate election year, from the start of the year up until the end of October of that year – taken as an average. Generic congressional ballot (net support rate). The generic congressional ballot asks people which party they are likely to vote for in Congress. We take the average net support rate in a Senate election year (that being whichever party leads the other in congressional ballot polling). Democrats are usually favored in congressional generic ballot voting, so the net rate is more predictive than the gross rate Dummy variable for congressional ballot. A dummy variable is assigned to variable number four. For example, dummy takes the value of 1 when Democrats have a positive net support rate in generic congressional ballot voting, and 0 when Republicans have a net positive support rate. We assign only one dummy variable to avoid a dummy variable trap.2 A “time for change” variable, a categorical variable indicating whether the incumbent party has controlled the Senate for three or more terms (six or more years). If the Senate has been controlled for three or more terms, the model will “punish” the incumbent party, as we would expect to see a change in control of the Senate the longer one incumbent party controls it. Democrats Retain Control Of The Senate As it stands, our election model predicts that Democrats will retain control of the Senate in 2022 (Chart 1). The Democrats are predicted to win 49 seats, a gain of one seat over the 2020 Senate election outcome,3 and when coupled with the two seats of Independent Senators, give them a majority of 51 seats. Chart 1Quant Model Gives Democrats 54% Chance Of Retaining The Senate Introducing The US Political Strategy Quantitative Senate Election Model Introducing The US Political Strategy Quantitative Senate Election Model The additional seat for Democrats stems from our model allocating both North Carolina and Pennsylvania (which are currently occupied by Republicans) to the Democrats (+ two seats) and allocating one of Georgia’s seats occupied by Raphael Warnock4 back to Republican control. The Democrats overall probability of retaining control of the Senate is 54%, three percentage points higher than early market predictions (Chart 2). The market implied odds highlight another close battle between Democrats and Republicans to control the Senate in 2022. Chart 2Market Narrowly In Favor Of Democratic Senate Control Introducing The US Political Strategy Quantitative Senate Election Model Introducing The US Political Strategy Quantitative Senate Election Model North Carolina is the only toss-up state,5 with a 51% chance of a Democratic victory. Pennsylvania will switch to Democrats and Georgia to Republicans. Note that North Carolina and Pennsylvania are both currently under Republican control. Both incumbents have decided not to run again. While both Georgia Senate run-off races were won by Democrats earlier this year, the sum of first-round voting in November 2020 was higher for Republican candidates than for Democrats. There was also extra-ordinary voter turnout in favor of Democrats for both run-offs, which ultimately played a big role in Democrats securing victory. Voter turnout was largely spurred on by voting against Republicans, and ultimately Donald Trump. This may not be the case come 2022, if turnout for Democrats is unmatched to 2020/2021. Our model’s prediction will evolve over time as new data become available, which could produce more toss-up states, or swing the prediction in favor of the opposing party. For now, the model provides us with a preliminary prediction as we draw nearer to the 2022 midterm elections. Senate Races Of Interest Comparing our model’s prediction to online betting markets, we group nine races into a category of “interest”. All nine races have varying degrees of probability for a Democratic win, ranging from approximately 30% to 60%. Five races are overestimated, and four races are underestimated by consensus (Chart 3). The remaining 25 races are decidedly in favor of either Democrat or Republican control, according to our model, so are therefore excluded from this analysis. Betting markets are overestimating Nevada, Arizona, Pennsylvania, Georgia, and Wisconsin, while underestimating New Hampshire, North Carolina, Florida and Ohio. Chart 3Senate Odds Compared With The Bookies Introducing The US Political Strategy Quantitative Senate Election Model Introducing The US Political Strategy Quantitative Senate Election Model All nine of these races are precariously balanced, even at this stage of the mid-term election cycle. Small or local factors could ultimately decide the outcome. This is an important limitation on our macro model, highlighting our ultimate emphasis on qualitative analysis. For example, it is not at all clear that Democrats will win Georgia. Our model gives Democrats a 43% chance of victory. Betting markets are a lot more optimistic, penning a 55% chance of a Democratic win. But even by our model’s standard, Georgia remains a toss-up. Georgia may not be as close of a race as it was in 2020/2021, if voters are not as motivated as they were to vote Democrat. Will turnout be as large in 2022? That remains to be seen. One or two races with unique makeup can contribute to maintaining or shifting the balance of power in the Senate come 2022. Back Testing Our Model Our Senate model performs at an acceptable level during in-sample and out-sample back testing. For in-sample testing, we test our model over our entire sample period (1984 – 2020) and find that 74% of Senate elections (control of the Senate) are correctly predicted, with the model predicting the outcome of the last five Senate elections correctly (Chart 4). Chart 4In-Sample Back Testing Results Introducing The US Political Strategy Quantitative Senate Election Model Introducing The US Political Strategy Quantitative Senate Election Model During out-sample back testing, we look at a sample period of 2000 – 2020, comprising of 11 Senate elections, where our model correctly predicts 73% of actual outcomes. The previous five Senate elections are predicted correctly too (Chart 5). Chart 5Out-Sample Back Testing Results Introducing The US Political Strategy Quantitative Senate Election Model Introducing The US Political Strategy Quantitative Senate Election Model In comparison to our presidential election model, prediction accuracy of our Senate model is lower across its sample period. Predicting control of the Senate can sometimes be more uncertain than that of the White House. Both statistical and event based (Senate elections) reasons give way to a lower accuracy rate in this case. For example, there could be several idiosyncratic state-level variables not captured by our model, which could have played a leading role in determining any one state’s Senate election outcome over our sample period, and ultimately, control of the Senate. Where To From Here? In comparison to the presidential election cycle, we are a lot closer to election day. That means that Senate races will begin to heat up as we move closer toward November 8, 2022 – the date of the midterm elections. For now, our model ratifies the current control of the Senate, that is, Democratic. Our Model also suggests that come 2022, the Democrats will retain control of the Senate. But this is all but an early forecast. If any long-standing conclusion can be drawn right now, it is that the battle for control of the Senate in 2022 will be highly contested. From a qualitative point of view, our model may be overestimating the Democrats’ odds in 2022 as things stand today. Midterm elections have historically seen the sitting president’s party lose seats in the Senate and House of Representatives. We already expect Republicans to retake the House after a poor showing by Democrats in 2020. This narrative may play into the Republicans taking the Senate too – and is plausible given how closely the battle for the Senate is wound. But congressional approval has ticked higher lately under a Democratic run congress (Chart 6). Most likely, the American public have largely approved of COVID-19 government relief, and the Democrats will pass at least one more major piece of legislation covering infrastructure. Republicans are deeply divided, so there is some chance that they underperform in 2022. Nevertheless, the historical pattern clearly favors the opposition. The takeaway is to expect the GOP to retake the house but to monitor the Senate closely with both quantitative and qualitative tools. Chart 6US Public Approving Of Congress ?!? Introducing The US Political Strategy Quantitative Senate Election Model Introducing The US Political Strategy Quantitative Senate Election Model Lastly, and importantly, we should note that in both the case of the presidential and Senate models, a probability between 50% and 55% for the incumbent party retaining control of the White House or Senate is indicative of an outcome “too close to call.” Both models are touting Democratic wins, but high conviction views about either the 2024 presidential election or 2022 Senate election are not warranted at this time. Investment Takeaway Unless 2022 is one of the rare cases of an incumbent party legislative victory after a national shock, like 1934 and 2002, Republicans will take the House at least. This is likely notwithstanding our model’s slight tilt in favor of Democrats in the Senate. This means that the “Blue Sweep” policy setting will cease as early as 2023, but de facto it would cease as early as the end of this year when Biden’s signature legislation is passed, since Congress will get little done in 2022. Our model suggests Republicans are slightly disfavored in the Senate. The truth is that as long as they gain one chamber of the legislature then US fiscal stimulus will virtually freeze. Taxes will no longer be able to rise from 2023 but spending will not be subject to cuts. Gridlock is reinforced by our presidential quant election model’s slightly higher odds of Democrats retaining the White House, which we think is underestimated at present. Hence Biden will retain veto power even if Democrats squander the Senate and House in 2022. Gridlock is thus looming from 2023 until at least 2025. The financial markets will not be alarmed by this forecast as long as growth keeps up. In the very near term, however, the clouds on the horizon of tax hikes, Fed rate hikes, and China’s tight-fisted economic policy pose rising headwinds to US equities in 2022 — and hence markets should respond negatively sooner than later. We are tactically growing more defensive.   Guy Russell Research Analyst GuyR@bcaresearch.com   Statistical Appendix Some clients may be curious as to how our US Political Strategy Senate election model differs from our Geopolitical Strategy model used in the 2020 elections, and where it has made improvements in its predictive accuracy. We discuss these improvements herein. Changes To The Geopolitical Strategy Senate Election Model A notable property in our dependent variable data requires a brief discussion. Our dependent variable classified as “elected” takes the form of a binary outcome. This data, however, is what’s called “unbalanced,” since incumbent Senators are re-elected approximately 80% of the time. This means that most outcomes in our dependent variable are coded as “1,” with fewer “0’s” because of the strong incumbency effect in Senate races. There are many data sets that exhibit this type of property, such as events like wars, vetoes, cases of political activism, or epidemiological infections, where non-events occur rarely. To alleviate this statistical property in the data, we estimate our model using a weighted maximum likelihood estimate as opposed to the ordinary maximum likelihood estimate usually used in a Probit regression.6 This method assigns more weighting to the unbalanced data, or what is known theoretically as “rare event” data, to aid the Probit regression in assigning higher probabilities to “0” outcomes. Through this process, we effectively deal with our unbalanced dependent variable data. The last update to the BCA Geopolitical Strategy Senate election model was published on January 6, 2021. Our model suggested that Republican’s would retain control of the Senate. Our model was limited in dealing with a unique twin Georgia run-off race that ultimately swung Senate control into the hands of the Democrats. The Geopolitical Strategy, which we will refer to as the 2020 model, only missed the Republican victory in Maine, but correctly predicted losses in Arizona and Colorado. The model missed both Georgia races, signaling they would remain red states – this was proven otherwise. Also, our model has become a better predictor in terms of in and out-sample forecasting (compared to our 2020 model). The 2022 version correctly predicts 74% (vs 72%) of in-sample and 73% (vs 70%) of out-sample outcomes. Methodology And Variables Our Senate model retains the methodology and suite of economic and political variables used in the model we first introduced in 2020. For long-time clients and those who are new to the US Political Strategy and Geopolitical Strategy service, the first version of our model can be found here. The one and only economic variable is now transformed by a six-month change to each state’s coincident index, capturing the improvement or deterioration of the state’s economy. The six-month change results in the best statistical fit for the overall model this time round. In the 2020 model, we transformed the variable by a three-month change. A fast-changing economic environment coupled with a then-higher statistical impact in our model led us to this decision. We still weight the transformation of our economic variable in the same manner as we did in last year’s updated model. We take a weighted average of the six-month change of all the monthly state coincident indices in the term preceding a Senate election. Later months are weighted heavier than earlier months as the most recent context will have a greater impact on voter opinion in the election. In terms of our political variables, they all remain the same as the 2020 model. Model Performance Classification The 2022 model correctly classifies predicted outcomes at a rate of exactly 81%. That is, when the model makes a prediction of a certain state’s Senate election outcome from 1984-2020, it is correct 81% of the time. This level of classification is higher than our 2020 model, which classified outcomes at a rate of 79% (Table 1). Table 1New Model Classifies Outcomes At A Higher Rate … Introducing The US Political Strategy Quantitative Senate Election Model Introducing The US Political Strategy Quantitative Senate Election Model Sensitivity And Specificity – Receiver Operating Characteristic Curve A Receiver Operating Characteristic (ROC) curve is a performance measurement for classification problems of binary modelled outcomes, among others. An ROC curve tells us how much the model is capable of distinguishing between classes. In our case, we have two classes: the dependent variable (classified as “elected”) is stated as 1 = Incumbent party wins the Senate election in each state; or 0 = Incumbent party did not win the Senate election in each state. The higher the area under the curve (AUC), the better our model is at predicting 0 classes as 0 and 1 classes as 1. A robust model has an AUC near to one. A poor model has an AUC near to zero, which means it has the worst measure of classifying classes correctly, labelling zeros as ones and vice versa. In fact, at a level of zero AUC, the model is reciprocating incorrect classes by predicting zeros as ones and ones as zeros. Statistically, more AUC means that the model is identifying more true positives while minimizing the number/percent of false positives. Chart 7Receiver Operating Characteristic Curve Of 2022 Model Introducing The US Political Strategy Quantitative Senate Election Model Introducing The US Political Strategy Quantitative Senate Election Model Table 2… Is A Better Fit … Introducing The US Political Strategy Quantitative Senate Election Model Introducing The US Political Strategy Quantitative Senate Election Model The ROC curve for our 2022 model has an AUC of 0.9609 (Chart 7), a higher AUC than our 2020 model (Table 2). This means that the true positive rate for classifying outcomes is high and the false positive rate is low, improving on our model’s robustness. F1 Scores A final grading of the 2022 model is by means of the F1 score. The F1 score is a measurement that considers both precision (specificity in the above ROC curve) and recall (sensitivity in the above ROC curve) to compute the score. The F1 score can be interpreted as a weighted average of the precision and recall values, where an F1 score reaches its best value at 1 and worst value at 0. The 2022 model produces a higher F1 score compared to our 2020 model (Table 3). Table 3… And Is More Accurate Than The 2020 Model Introducing The US Political Strategy Quantitative Senate Election Model Introducing The US Political Strategy Quantitative Senate Election Model Considering the improvement in forecast accuracy and overall better model specification over our 2020 model, we accept our 2022 model as our new base case Senate election model, premised on its improvement in accuracy at predicting election outcomes in the past, as well as its ability to correctly classify outcomes as they were realized. Appendix Tables Table A1USPS Trade Table Introducing The US Political Strategy Quantitative Senate Election Model Introducing The US Political Strategy Quantitative Senate Election Model Table A2Political Risk Matrix Introducing The US Political Strategy Quantitative Senate Election Model Introducing The US Political Strategy Quantitative Senate Election Model Chart A1Presidential Election Model Introducing The US Political Strategy Quantitative Senate Election Model Introducing The US Political Strategy Quantitative Senate Election Model Table A3APolitical Capital: White House And Congress Introducing The US Political Strategy Quantitative Senate Election Model Introducing The US Political Strategy Quantitative Senate Election Model Table A3BPolitical Capital: Household And Business Sentiment Introducing The US Political Strategy Quantitative Senate Election Model Introducing The US Political Strategy Quantitative Senate Election Model Table A3CPolitical Capital: The Economy And Markets Introducing The US Political Strategy Quantitative Senate Election Model Introducing The US Political Strategy Quantitative Senate Election Model Table A4Political Capital Index Introducing The US Political Strategy Quantitative Senate Election Model Introducing The US Political Strategy Quantitative Senate Election Model Footnotes 1     Two of which were open Senate seats for the state of Georgia. 2     A dummy variable trap is a scenario in which the independent variables are multicollinear — a scenario in which two or more variables are highly correlated; or, in simple terms, in which one variable can be predicted from the others. To avoid such a trap, we must exclude one of the categorical variables. Since there are two categorical variables that can be represented here (Republican or Democrat), we use k-1 (where k = the number of categorical variables). 3    In reference to the Senate election outcome after the Georgia run-off races which concluded in early January 2021. 4    This seat formed part of the 2020 special Senate election race which was decided by a run-off election between Raphael Warnock and Kelly Loeffler. The seat was always up for reelection in 2022 no matter which party won it in the 2020 special election. 5    Toss-ups are defined as having a probability between 45% and 55% according to our model. 6    Weighted maximum likelihood estimation is a reasonable approach in dealing with dependent variables that show significant imbalance in their data set. See: King, G. and Zeng, L., 2001. Logistic regression in rare events data. Political analysis, 9(2), pp.137-163.