Fixed Income
Highlights While we are bearish on the US dollar in the long run, the greenback is primed for a rebound in the near term. Consistently, commodities prices will relapse and EM currencies will depreciate versus the US dollar. Global growth stocks will correct further because they are overbought/over-owned and expensive. The rest of the equity market will relapse because its fundamentals are poor, especially given the renewed rise in new infection cases across Europe and the US. Feature Global financial markets are in the process of a reset. Several segments have been through very sharp and considerable movements in recent months, and these movements are starting to partially unwind. The US dollar will rebound, commodities prices will correct and global equities will continue selling off. In brief, EM risk assets and currencies are entering a period of weakness, which will eventually lead to buying opportunities. Inter-Linkages Between Fixed-Income, Currencies And Commodities Chart I-1A Reset In US Inflation Expectations And Real Rates Is Overdue US inflation expectations have risen meaningfully, and US TIPS (real) yields have plummeted since April (Chart I-1). Consistent with plunging US real rates, the US dollar has sold off sharply (Chart I-1, bottom panel). Although our bias is that US inflation will rise in the coming years, for now, the rise in inflation expectations seems excessive. Given the tight correlation between oil prices and US breakeven inflation, as illustrated in the top panel of Chart I-1, lower crude prices will cause a drop in inflation expectations. Moreover, the absence of another large US fiscal stimulus will also lead to a downgrade in growth and inflation expectations. US nominal bond yields will likely remain largely range bound, and a drop in breakeven inflation will lead to higher real yields. The latter will help the US dollar to rebound from oversold levels, and EM currencies will depreciate against the dollar. In turn, a rebound in the greenback will be associated with lower commodities prices. Notably, investors’ net long positions in copper have become very elevated (Chart I-2). Investor sentiment on commodities in general is quite positive. Hence, from a contrarian perspective, commodities prices are primed for a pullback. In addition, Chinese imports of commodities will slow in the near term, reinforcing the correction in resources prices. China has evidently been stockpiling commodities, as its commodities imports have been considerably stronger than its underlying final demand. In particular, Chart I-3 demonstrates that mainland imports of copper, crude oil, steel and iron ore have been surging. Chinese imports of crude and industrial metals are likely to drop temporarily. Chart I-2Long Copper Is A Crowded Trade Chart I-3China Has Been Stockpiling Commodities China’s booming intake of commodities in recent months was stipulated by the country’s previously depleted commodity inventories, low prices and the availability of cheap bank financing. Granted commodity inventories have been replenished and resource prices are no longer low, Chinese imports of crude and industrial metals are likely to drop temporarily. That said, from a cyclical perspective, China’s economic recovery will continue, and final demand for resources will expand. Thus, we will see a material correction, not a crash, in commodities prices. EM credit spreads inversely correlate with commodities prices and currencies – EM sovereign and corporate credit spreads are shown as inverted on both panels of Chart I-4. As commodities prices retreat and the US dollar rebounds, EM credit markets will sell off. Chart I-4EM Credit Markets Will Weaken As EM Currencies And Commodities Sell Off EM local currency bond yields might slightly back up as EM currencies depreciate and US real yields rebound. However, economic conditions in many EM countries outside China remain extremely weak, and inflation is very subdued. Hence, any back up in EM domestic bond yields will be limited. Bottom Line: While we are bearish on the US dollar in the long run, the greenback is primed for a rebound in the near term. Consistently, commodities prices will relapse and EM currencies will sell off versus the US dollar. Notably, oil prices, as well as several EM and DM currencies, have rolled over at technical levels which typically herald a major reversal (Chart I-5A and I-5B). Chart I-5AFacing A Major Resistance Chart I-5BFacing A Major Resistance Finally, EM fixed-income markets will experience a correction that will provide a buying opportunity. The Equity Correction: More To Go The correction in global share prices has further to run. Market leaders – growth stocks – remain overbought, and it is reasonable to expect that they will at least retest their 200-day moving averages. Meanwhile, the parts of the global equity universe hardest-hit during March have failed to break above their 200-day moving average. This can be interpreted as an indication that they have not yet entered a bull market. These include: EM ex-TMT1 and global value stocks as well as the US Value Line Geometric Composite Index (Chart I-6). In short, growth stocks will correct further because they are overbought/over-owned and expensive; the rest of the equity market will relapse because its fundamentals are poor, especially given the renewed rise in new infection cases across Europe and the US. Chart I-6These Stocks Have Not Entered A Bull Market Yet Chart I-7Downside Risks To EM Equities In addition, the following indicators also point to further selloff in EM and DM share prices. Our Risk-On / Safe-Haven currency ratio2 has been falling since June and continues pointing to lower EM share prices (Chart I-7). The EM and DM advance-decline lines have relapsed below zero indicating a deteriorating equity market breadth (Chart I-8). This heralds lower stock prices. As EM corporate bond yields rise due to either weaker EM currencies or lower commodities prices, as we argued above, EM share prices will tumble (Chart I-9). Chart I-8Deteriorating Breadth Points To Lower Share Prices Chart I-9Rising EM Corporate Bond Yields Will Reinforce EM Equity Selloff Bottom Line: Global and EM share prices are in a correction that has not run its course. Investment Strategy A meaningful setback in their EM currencies will lead us to recommend switching from receiving long-term rates to buying their cash local currency bonds (taking currency risks as well). EM Domestic Bonds: We continue recommending receiving 10-year swap rates in Mexico, Colombia, Russia, India, China, Korea and Malaysia. A meaningful setback in their EM currencies will lead us to recommend switching from receiving long-term rates to buying their cash local currency bonds (taking currency risks as well). EM Equities: Absolute-return investors should be cautious at the moment as EM share prices are set to deflate further. Within a global equity portfolio, we continue recommending a neutral allocation to EM. Better equity valuations in EM than in the US will be offset by a rebound in the US dollar, warranting a trading range in EM versus DM relative equity performance. Our country equity allocation within the EM universe is always presented at the end of our report (please refer to page 10). EM Exchange Rates: Even though we expect a meaningful rebound in the nominal broad trade-weighted US dollar, we believe the safe-haven currencies – such as the JPY, CHF and the euro – will outperform EM currencies. As such, we reiterate our strategy of shorting a basket of EM currencies versus an equally-weighted basket of JPY, CHF and the euro. Our short EM currency basket consists of BRL, CLP, ZAR, TRY, PHP, KRW and IDR. Finally, we recommend a neutral allocation to EM credit markets (US dollar bonds) versus US corporate credit. Absolute-return investors should accumulate this asset class on a weakness. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1Technology, media and telecom stocks excluding information technology (IT) sector before December 2018 and excluding IT, media & entertainment and internet & direct marketing retail as of December 2018 2Average of CAD, AUD, NZD, BRL, IDR, MXN, RUB, CLP & ZAR total return indices relative to average of JPY & CHF; rebased to 100 at January 2000 Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Bank credit 6-month impulses are plunging, and the pandemic is resurging. Maintain an overweight to growth defensives (technology and healthcare). In the short term, profits will be more resilient in a resurgent pandemic. In the long term, profits are well set to grow in an increasingly online, decentralised, remote-working, health-conscious world. The European stock market’s massive underweighting to growth defensives will weigh on its relative performance. Go underweight China economy plays. Fractal trade: Fractal analysis confirms that basic resources are vulnerable to a reversal. Within value cyclicals, tactically overweight financials versus basic resources. Feature Chart of the WeekThe Greatest Ever Monetary Stimulus Is Over... For Now Monetary stimulus, as measured by the increase in banks’ six-month credit flows, reached an all-time high during the summer months. But now, the greatest ever monetary stimulus is fading (Chart of the Week). In the US and China, the increase in banks’ six-month credit flows peaked at $700 billion and $800 billion respectively during May. In the euro area, the increase peaked at over $1 trillion during July. The combination constituted the greatest ever global monetary stimulus, trumping even the stimulus that followed the 2008 financial crisis (Charts I-2 - I-4). Chart I-2US Monetary Stimulus Is Fading Chart I-3China Monetary Stimulus Is Fading Chart I-4Euro Area Monetary Stimulus To Fade However, the increase in six-month credit flows has recently slumped to around $200 billion in both the US and China. The euro area has yet to update its data beyond July, but we expect it to fade too. The upshot is that the greatest ever monetary stimulus is over… for now. Bond Yields Are No Longer Stimulating Our preferred metric for assessing the transmission of monetary stimulus on an economy is the increase in the banks’ six-month credit flows. In turn, this depends on the six-month deceleration in the bond yield – meaning, the bond yield decline in the most recent six months must be greater than the decline in the previous six months. At first glance, this seems counterintuitive. Why focus on the bond yield’s deceleration rather than its plain vanilla decline? Box 1 explains how it follows from a fundamental accounting identity of GDP statistics. Box 1 Why The Bond Yield’s Deceleration Matters GDP is a flow statistic. It measures the flow of goods and services produced in a period. Hence, the GDP flow receives a contribution from the bank credit flow in that period. In turn, the bank credit flow is established by the decline in the bond yield (Chart I-5). Chart I-5The Decline In The Bond Yield Establishes The Bank Credit Flow It follows that GDP growth receives a contribution from bank credit flow growth. Which, in turn, receives a contribution from the bond yield deceleration. In other words, the bond yield decline in the most recent period must be greater than the decline in the previous period. Finally, our preferred period is six months because it empirically equals the time to fully spend a bank credit flow. A quarter is too short: a year is much too long. Admittedly, during this year’s pandemic recession and rebound, the link between monetary stimulus and the real economy has weakened. Fiscal stimulus has played a more important role. Even when it comes to bank credit, much of the recent increase was not due to new loans. It was due to firms tapping pre-arranged credit lines, which they used to reinforce cash buffers, rather than to spend. Nevertheless, some impact of monetary stimulus will reach the real economy. This means that while this year’s earlier deceleration of bond yields was good news for the economy, the more recent acceleration of bond yields is bad news (Chart I-6). Chart I-6The Recent Acceleration Of Bond Yields Is Bad News Tactically Underweight China Plays Through the summer months, 10-year bond yields flipped from sharp six-month decelerations to sharp accelerations. But the reversals were much more extreme in China and the US than in the euro area. Seen in this light, it is hardly surprising that the increase in six-month bank credit flows has already slumped in China and the US, and could soon turn negative. If so, they would be a contractionary force on the economy. One tactical investment conclusion is to underweight China economy plays. Specifically, with China’s bank credit six-month impulse in freefall, the 40 percent outperformance of basic resources versus financials is vulnerable to a sharp reversal (Chart I-7). This is also confirmed by fractal analysis (see later section). Chart I-7With China's Bank Credit 6-Month Impulse In Freefall, Basic Resources Are Vulnerable Stay underweight cyclicals. But within cyclicals, tactically overweight financials versus basic resources. A Resurgent Pandemic Will Force People Back Into Their Shells A resurgence of the pandemic will create a further headwind to the economy, irrespective of whether governments impose fresh lockdowns or not. This is because most of us have an instinct for self-preservation as well as protecting our loved ones. In response to a resurgent pandemic, we will go back into our shells. Shunning public transport, shopping, and other crowded places, some might even think twice about letting their children go to school. But if this cautious behaviour is voluntary, then why do governments need to impose lockdowns? The answer is that while the majority behaves responsibly, a minority behaves irresponsibly. In the pandemic, this is critical because less than 10 percent of infected people are responsible for creating 90 percent of all Covid-19 infections. If this tiny minority of so-called ‘super-spreaders’ is left unchecked, then the pandemic will let rip. At first glance, it appears that the lockdown is causing the recession. In fact, this is a classic confusion between correlation and causation. The true cause of the recession is the pandemic, which forces people into their shells. But to the extent that severity of the lockdown correlates with the severity of the pandemic, many people confuse the correlated lockdown with the underlying cause, the pandemic. The ultimate proof comes from Scandinavia. Sweden imposed no lockdown, while its neighbour Denmark imposed the most extreme lockdown in Europe. If it was the lockdown that caused the recession, then the economy of no-lockdown Sweden should have fared much better than that of lockdown Denmark. In fact, the two Scandinavian economies suffered identical 9 percent recessions (Chart I-8). Chart I-8No-Lockdown Sweden Suffered An Identical Recession To Lockdown-Denmark Focus On Sectors That Can Thrive In The New World Tactically we have recommended an underweight to stocks versus bonds since July 9, and this tactical position is broadly flat. Stick with it for now.1 A crucial question is: can bond yields go significantly lower? It is a crucial question because it was the collapse in bond yields earlier this year that saved the aggregate stock market. As long-duration bond yields plunged by 1 percent, the forward earnings yield of long-duration technology and healthcare stocks also plunged by 1 percent (Chart I-9). This surge in the valuation of the growth defensive sectors compensated for the collapsed profits of the value cyclical sectors – banks, basic resources, and oil and gas (Chart I-10). A resurgent pandemic combined with the end of the greatest ever monetary stimulus means that this playbook may get a rerun in the coming months. Chart I-9The Collapsed Bond Yield Explains The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare Chart I-10Tech And Healthcare Saved The Aggregate Stock Market The worry is that, from current levels, long-duration bond yields will struggle to plunge by another 1 percent and provide the same boost to valuations that they did in the first wave of the pandemic. In which case, the outlook for stocks and sectors will hinge more on their profits. On this basis, we still favour the growth defensives – which we define as technology and healthcare – both for the short term and the long term. In the short term, their profits will be more resilient in a resurgent pandemic. In the long term, their profits are well set to grow in an increasingly online, decentralised, remote-working, health-conscious world. One unfortunate consequence is that the European stock market’s massive underweighting to the growth defensives sectors will weigh on its relative performance, both in the short term and in the long term. Fractal Trading System* Supporting the fundamental analysis in the main body of this report, fractal analysis confirms that basic resources are vulnerable to a reversal versus financials. Hence, this week’s recommended trade is to go long financials versus basic resources. One way of implementing this is: long XLF, short XLB. Set the profit target and symmetrical stop-loss at 3.5 percent. In other trades, long ZAR/CLP reached the end of its holding period flat, and is now closed. The rolling 1-year win ratio now stands at 58 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Expressed as short DAX versus 10-year T-bond. Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Bond Yields & Growth: Developed market bond yields have ignored improving cyclical economic data over the past few months, remaining stuck in narrow trading ranges at low levels. That broken correlation will persist until central banks become less concerned about supporting pandemic-ravaged economies and begin worrying more about rising inflation, financial stability or the size of their balance sheets. That shift will not happen anytime soon. Inflation-Linked Trades: Our models suggest US TIPS breakevens are now at fair value. We are taking profits on our tactical long US 10-year inflation breakevens trade for a return of 2.88%. Stay long 10-year breakevens in Italy and Canada until we see further shrinkage in the gap between inflation breakevens and model-implied fair value and watch for a selling opportunity in UK 10-year breakevens. Feature Do bond investors even care about economic growth anymore? This is a valid question to ask, given how government bond yields in the developed markets have stayed in very narrow trading ranges over the past few months, even as economic data has rebounded from the global COVID-19 recession in the first half of 2020. Investors should get used to the current backdrop of rock-bottom interest rates and bond yields, which is unlikely to change anytime soon. Chart of the WeekBond Yields Are Responding To Inflation, Not Growth For example, the benchmark 10-year US Treasury yield has stayed between 0.65% and 0.75% since June 11, even though the US ISM Manufacturing index rose from 43 in May to 56 in August. Yields are also ignoring the ups and downs of the equity market. The 10-year Treasury yield now sits at 0.66% - the same level as on September 2 even though the NASDAQ equity index has fallen 12% from the all-time peak seen on that day. Our own Global Duration Indicator, comprised of cyclical measures like the global ZEW index and our global leading economic indicator, has surged to the highest level since 2008 (Chart of the Week). Given the usual lead time between broad turns in the Duration Indicator and the level of global bond yields (around 6-9 months), this suggests that yields have bottomed and should soon begin rising. Yet the reality is that the usual factors that typically drive yields higher during a cyclical upturn – namely, rising inflation expectations and a clearly understood signal from central banks that such a move would lead to tighter monetary policy – are not currently in place. Investors should get used to the current backdrop of rock-bottom interest rates and bond yields, which is unlikely to change anytime soon. Four Potential Triggers For A Rise In Bond Yields Chart 2A Breakdown Of The PMI/Yield correlation The breakdown of the positive correlation between growth and bond yields is not just visible in the US. For example, yields on German Bunds and UK Gilts also remain stuck at low levels despite sharp improvements in the German and UK manufacturing PMIs (Chart 2). Yet in China – where there is no zero interest rate policy (ZIRP) or large-scale quantitative easing (QE) programs - bond yields have steadily risen since the China manufacturing PMI bottomed back in April (bottom panel). What could change this backdrop? We see four potential catalysts, ranked below in our own subjective order of importance: Inflation Sustainably Returning Back To Central Bank Targets It may seem obvious, but it still needs to be said – dovish central bank policies are the biggest reason why developed market bond yields have de-linked from economic growth. That includes not only ZIRP or QE, but also forward guidance on future changes in interest rates. Central banks are telling markets they will not raise rates for a period measured in years, and will continue to expand their balance sheets to purchase assets and support bank lending, all in an effort to push undershooting inflation back to policy targets. This is a different message than bond investors have grown accustomed to hearing from central banks, most notably in the US. The Fed is trying to do something that it has never intentionally done before – erode some of its hard-earned inflation fighting credibility. The Fed is trying to do something that it has never intentionally done before – erode some of its hard-earned inflation fighting credibility. The recent shift by the Fed to an Average Inflation Targeting framework – where above-target inflation would be tolerated if inflation was below target for an extended period – is intended to change the perception that the Fed will hike rates preemptively based on a forecast of inflation, as they have done in the past. Chart 3Latest FOMC Projections Justify Years Of 0% Rates The latest set of Fed economic projections is consistent with this new framework (Chart 3): the unemployment rate is forecasted to fall back to the FOMC median estimate of full employment (4.1%) by 2023; headline PCE inflation is also projected to climb back to 2% by 2023; the fed funds rate is projected to stay unchanged near 0% until at least 2023. In many ways, the Fed is trying to atone for the mistakes made while normalizing policy after the extraordinary easing measures taken after the 2008 crisis. From signaling a slowing of QE bond purchases in 2013, to the 250bps of rate hikes and tapering of its balance sheet during 2016-18, the Fed moved aggressively relative to what was actually happening with US inflation. Core PCE inflation only inched above 2% for a few months in 2018 – towards the end of the normalization process - as did market-based inflation measures like TIPS breakevens (Chart 4). The Fed ended up raising the real fed funds rate during that tightening cycle to above its own estimate of neutral (r-star), even with inflation still not close to its target. Unsurprisingly, real US bond yields also rose during that same period, which tightened monetary conditions even further by boosting the value of the US dollar. No wonder US inflation could not stay at the 2% target for very long. This time around, the Fed is sending a much different signal to markets – that it wants to see inflation rise before raising rates, thus keeping real policy rates in negative territory for an extended period. If the Fed is looking for a real world case study of such an approach, it can look across the Atlantic to the Bank of England (BoE). On the surface, the BoE has been acting like a typical inflation-targeting central bank over the past several years, turning more hawkish in its commentary when the UK economy was improving and becoming more dovish when the economy was languishing. Yet since the 2008 crisis, the BoE has kept the Bank Rate in a range of 0.1% to 0.75%, well below realized UK inflation. While it has been difficult for the BoE to attempt to raise rates given the Brexit uncertainty since 2016 – which has also weakened the British pound, helping boost UK inflation - real UK policy rates have now been negative for 12 years (Chart 5). The result: steadily declining UK real bond yields with inflation expectations rising to levels well above the BoE 2% inflation target. Chart 4The Fed Is Trying To Erode Its Hard-Earned Credibility Chart 5Lessons From The BoE On How To Not Be Credible The experience of the ECB provides a cautionary tale for central banks not appearing dovish enough, even when policy settings are already extraordinarily accommodative. The message from central banks on future rate increases – namely, that there will not be any without sustainably higher inflation – must change before bond yields can have any hope of climbing higher. Chart 6Does The ECB Have Any Credibility Left? Inflation expectations have stayed below the ECB’s “just below 2%” target since 2013 (Chart 6), which forced the central bank into cutting nominal rates into negative territory while aggressively expanding its balance sheet through QE and long-term bank liquidity provision (i.e. LTROs). Yet the ECB has always put an expiration date on each of these programs, which sent a message to the markets that the central bank was not fully committed to keeping policy easy until inflation was back to target – however long that would take. In sum, the message from central banks on future rate increases – namely, that there will not be any without sustainably higher inflation – must change before bond yields can have any hope of climbing higher. A Shift From Central Banks To Concerns About Asset Price Bubbles Chart 7When Will CBs Start Worrying About Financial Market Valuations? Policymakers are paying lip service to the notion of the “financial stability” risks inherent in their new promises to keep rates low for a lot longer while intervening in financial markets more aggressively through asset purchase programs. Given the signs of froth in many important asset classes like US equities or global corporate debt, policymakers should at least be somewhat concerned that easy money policies are fueling asset bubbles (Chart 7). A big enough decline could erode confidence and spill over into the real economy, defeating the original purpose of easy money policies. However, given the still fragile state of much of the global economy that remains dependent on fiscal support amid ongoing COVID-19 restrictions, concerns over asset values will take a backseat to maintaining adequate monetary stimulus. Asset bubbles would have to become much larger before a central bank would even consider turning more hawkish to prick them through higher policy rates that would push up bond yields. The Announcement Of A Trustworthy COVID-19 Vaccine That Is Ready For Widespread Distribution Markets have already begun to worry about the “second wave” of the coronavirus that health officials had warned would happen in the cooler autumn months. The development of an effective, and safe, vaccine would thus be a game-changer for financial markets, particularly after the recent surge in new COVID-19 cases in Europe and the still elevated level of new cases in the US (Chart 8). Chart 8A Second Wave Of COVID-19 BCA Research’s Chief Global Strategist, Peter Berezin (a big fan of interesting data sets!), noted in his most recent report that, according to The Good Judgement Project, around 60% of “superforecasters” now expect a vaccine ready for mass distribution to be available by Q1/2021 (Chart 9).1 A vaccine appearing that rapidly – much faster than the usual multi-year process leading to a vaccine declared safe for use – would help boost business and consumer confidence and raise the odds of a return to pre-virus levels of economic activity. Bond yields would likely get a lift, as well, as markets would price in a shorter period of super low policy rates and a faster return of inflation to central bank targets. Yet even if a vaccine is presented to the world by next spring, there is no guarantee that a large enough share of the population will deem the vaccine safe enough to take to ensure “herd immunity”. A recent Economist/YouGuv survey noted that only 36% of American adults would choose to get vaccinated when a COVID-19 vaccine becomes available, 32% would not get vaccinated, while 32% were unsure (Chart 10). Thus, a vaccine would be a bond-bearish development only if it is trusted to be safe to use – the mere announcement of a vaccine will not be enough to declare an “end” to the pandemic. Chart 9High Odds Of A Vaccine In 6-To-12 Months Chart 10Will Enough People Take The Vaccine? Central Banks Slowing QE Purchases Relative To Increased Fiscal Issuance Chart 11Still Room For The Fed, ECB and BoE To Expand QE Right now, it is easy for the major central banks to aggressively expand their balance sheets and provide additional monetary stimulus through asset purchases. Yet there may come a point where a capacity constraint is reached on buying government bonds if it impairs market functionality. That is currently the case in Japan, where the Bank of Japan now owns 49% of the Japanese government bond (JGB) market after years of aggressive QE purchases of JGBs. This has damaged the day-to-day liquidity of JGBs, where there have been instances of days where no single JGB has traded in the secondary market. A move by central banks to buy fewer bonds because they own too many of them could potentially push bond yields higher by worsening the demand/supply balance for government bonds - assuming private investors do not pick up the slack and buy more bonds, of course. Currently, the Fed only owns 22% of the US Treasury market with little evidence suggesting that its purchases are impairing the trading of Treasuries (Chart 11). The BoE and ECB own much larger shares of the UK and euro area government bond markets – 37% and 38%, respectively – suggesting that those central banks are closer to a BoJ-like capacity constraint. However, given the rising budget deficits and surging government bond issuance seen in Europe (and the US) so far in 2020, the odds of a capacity constraint soon being reached that could result in slower QE purchases are low. Bottom Line: Developed market bond yields have ignored improving cyclical economic data over the past few months, remaining stuck in narrow trading ranges at low levels. That broken correlation will persist until central banks become less concerned about supporting pandemic-ravaged economies and begin worrying more about rising inflation, financial stability or the size of their balance sheets. That shift will not happen anytime soon. Reviewing Our Tactical Inflation Breakeven Trades Back in June, we initiated a series of recommended inflation-focused trades in our Tactical Overlay portfolio. Specifically, we went long 10-year inflation breakevens in the US, Italy, and Canada by buying on-the-run inflation-linked bonds and selling government bond futures.2 We chose those trades based on the output of our fundamental valuation models for 10-year inflation breakevens in eight inflation-linked bond (ILB) markets: the US, UK, France, Italy, Japan, Germany, Canada, and Australia. Our fair value models use two inputs for all regions: a) a long-run moving average of headline inflation, representing the medium-term trend that anchors inflation expectations; and b) the annual percentage change of the Brent oil price in local currency terms, which creates shorter-term deviations from the trend to account for moves in oil and currencies. There looks to be little remaining upside to our tactical long TIPS breakeven position. The past few months have seen a sharp rise in global inflation expectations, owing to the extraordinary monetary policy actions taken by the major developed market central banks and recovering growth prospects coming out of the COVID-19 recession. This has led to a convergence between 10-year inflation breakevens and their model-implied fair values in the aforementioned ILB markets (Chart 12). Most notably, breakevens in the US are now at fair value, while breakevens in the UK and Australia are trading above fair value. In the US, 10-year breakeven inflation rates are now back to the long-run average of realized headline inflation, while the -8% decline in the Brent oil price so far this month has lowered the model-implied fair value (Chart 13). Therefore, there looks to be little remaining upside to our tactical long TIPS breakeven position with most of the easy gains following the pandemic-induced collapse having already been realized. Chart 12Global Inflation Breakevens Have Moved Higher Our colleagues over at BCA Research US Bond Strategy have reached a similar conclusion, noting that the Fed’s Jackson Hole announcement of the move to Average Inflation Targeting supercharged the rising trend in TIPS breakevens.3 Chart 13US Breakevens Are At Fair Value Although they also note the likelihood of stronger US CPI prints over the next few months should keep US breakevens well supported heading into year-end. The time horizon for trades that enter our Tactical Overlay portfolio is limited to no longer than six months. Thus, with TIPS breakevens reverting back to fair value after just three months in the trade, we are choosing to take profits on our long 10-year US inflation breakeven trade for a total return of 2.88%. Chart 14UK Breakevens Are Above Fair Value In other ILB markets, UK breakevens are now an intriguing case, and not only for the monetary policy driven interplay between UK real yields and breakevens discussed earlier in this report. The overshoot of UK breakevens relative to our fair value model may be related to growing market speculation that the BoE will move to negative interest rates – an outcome we deem to be unlikely, as we discussed in a recent report.4 Alternatively, the higher breakevens may be a reflection of UK political uncertainty. The risk of a hard Brexit has resurfaced as UK Prime Minister Boris Johnson’s Conservatives have now backed a bill that includes powers for the government to override its withdrawal agreement with the European Union; understandably, this has caused a sell-off in the pound. Within our fundamental fair value framework, the UK 10-year breakeven inflation rate has overshot both the 3-year moving average of headline inflation and the growth of GBP-denominated oil prices, leaving breakevens 0.72 standard deviations expensive (Chart 14). One possible explanation is that markets are pricing in a significant further depreciation in the pound given this resurfacing of Brexit risk. Within our model, GBP/USD impacts the fair value of breakeven inflation via Brent oil prices, which are denominated in local currency terms. Thus, we can back out an implied change in GBP/USD that would make the model-derived fair value breakeven rate equal to the actual 10-year UK inflation breakeven rate, holding all other variables in the model constant. This does produce some extreme results during periods of very rapid moves in UK breakevens, but we can standardize the data to use as an indicator of ILB market-implied views on the currency (Chart 15). With that in mind, pound bearishness in ILB markets is nearing levels where it has historically troughed. A favorable development in Brexit negotiations could cause a reversal in this pound-bearish trend and a sharp downward correction in UK inflation breakevens. We see a potential opportunity to play for narrower UK breakevens if our view on Brexit and negative rates in the UK prove to be correct. On that front, BCA Research’s Chief Geopolitical Strategist, Matt Gertken, sees a no-deal Brexit by year-end as the less likely outcome, with odds of only 35%, given the political calculus that PM Johnson faces with the decision.5 Polls show that the UK public does not support a no-deal Brexit (Chart 16), which would severely hurt a UK economy that remains fragile due to the coronavirus, and would raise the odds of a new independence referendum in Scotland in 2021. Chart 15UK Breakevens Already Discount A Big Fall In GBP Chart 16Only 25% In The UK Think A No-Deal Brexit Is A Good Outcome We will monitor the situation closely in the coming weeks, but we see a potential opportunity to play for narrower UK breakevens if our view on Brexit and negative rates in the UK prove to be correct. Finally, although the majority of the gains from our long inflation breakeven trades in Canada and Italy have likely been realized, there are still some chips left on the table. Canadian breakeven inflation rates have risen in lockstep with Brent prices but have yet to converge with the long-run moving average of inflation (Chart 17). In Italy, the increases in oil prices in euro terms has outstripped the rise in breakevens, pushing up the model-implied fair value and leaving breakevens remain more than one standard deviation under fair value (Chart 18). We will look for the gap between breakevens and fair values to shrink further in these two countries before closing these trades, even though we are substantially in the green on both (see the Tactical Overlay table on page 19). Chart 17Canadian Breakevens Are Just Below Fair Value Chart 18Italian Breakevens Are Well Below Fair Value Bottom Line: Our models suggest US TIPS breakevens are now at fair value. We are taking profit on our tactical long US 10-year inflation breakeven trade for a return of 2.88%. Stay long 10-year breakevens in Italy and Canada until we see further shrinkage in the gap between inflation breakevens and model-implied fair value and watch for a selling opportunity in UK 10-year breakevens. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 Please see BCA Global Investment Strategy Weekly Report, "Pivot To Value", dated September 18, 2020, available at gis.bcaresearch.com. You can also learn more about The Good Judgement Project here: https://goodjudgment.com/about/ 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresearch.com. 3 Please see BCA Research US Bond Strategy Portfolio Allocation Summary, "The Fed’s New Framework Is Bond Bearish…But Not Yet", dated September 8, 2020, available at usbs.bcaresearch.com. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Assessing The Leading Candidates To Join The Negative Rate Club", dated August 26, 2020, available at gfis.bcaresearch.com. 5 Please see BCA Research Geopolitical Strategy Weekly Report, "The End-Game For Trump And Brexit", dated September 18, 2020, available at gis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Kenya: An Incomplete Adjustment The Kenyan shilling will depreciate by 15-20% in the next 12 months. The downward pressure on the currency stems from the country’s sizeable current account deficit. In addition, Kenya needs lower local interest rates and a weaker exchange rate to boost nominal growth and stabilize public debt dynamics. Kenya has gone through an extensive macro adjustment since 2015 when the current account deficit was 10% of GDP and the primary fiscal deficit was 8% of GDP. Since then the current account deficit has narrowed to 6% of GDP as the private sector deleveraged and fiscal policy tightened substantially over the past 3-years (Chart I-1, top panel). Remarkably, the primary fiscal deficit has narrowed to a mere 0.4% of GDP as of June 2020 (Chart I-1, bottom panel). Yet, the macro adjustment is incomplete with a lingering current account deficit and public debt on an unsustainable path. Further, economic growth is extremely weak (Chart I-2). Crucially, core inflation is at 2% - an all-time low, suggesting that low inflation/deflationary pressures is the main problem in Kenya (Chart I-3). Chart I-1Kenya: The Twin Deficits Remains Large Chart I-2Kenya: Tame Domestic Growth In this context, the optimal policy choice for Kenya is to reduce local interest rates, while allowing the currency to depreciate. This will reduce the interest burden on public debt, boost both economic activity (real growth) and inflation as well as make exports more competitive. Balance Of Payments Strains Persist Kenya’s balance of payments will weigh on the currency in the next 6-9 months. While improving, its exports will remain tame over the next 6-12 months. The volume of tea, horticulture and coffee exports, which account for about 50% of total Kenyan exports, has rebounded. Yet, their prices have failed to rebound meaningfully. Meanwhile, substantial fiscal tightening – an 11% drop in government non-interest nominal expenditures – has led to a collapse in imports (Chart I-4). If and when fiscal policy is relaxed, it will boost imports weighing on the trade balance. Chart I-3Kenya Suffers From Low Inflation Chart I-4Tight Fiscal Policy = Weak Domestic Demand Chart I-5Kenya Is Losing Market Share In Export Markets The biggest headwind to the balance of payments has been the drastic fall in both tourism revenues and remittances. Combined, they represent around $4 billion (4.2% of GDP). It is unlikely that international travel will resume in the next six months. Remittances will also remain subdued in the coming months as unemployment rates remain elevated worldwide. Kenya has been losing its export market share in neighboring countries such as Uganda and Tanzania (Chart I-5). Hence, this nation needs to improve its competitiveness via tolerating a cheaper currency and undertaking structural reforms to bolster productivity growth. FDI inflows have been subdued. In the near term, FDI inflows will be discouraged by very weak domestic demand. Critically, the outlook for Chinese FDI inflows into the country remains uncertain due to the debacle with previous China-financed projects in Kenya. In particular, Kenyan courts declared the construction contract awarded to the China Road and Bridge Corporation for the Nairobi-Mombasa railway illegal.1 This impasse between Kenyan courts and Chinese companies could for now dissuade financing and investment from China. In the medium term, international organizations such as the IMF and World Bank could step in to fill in for Chinese investments. As recent financing by the World Bank and IMF of $1.74 billion (1.9% of GDP) to Kenya suggest, the US might be enticed alongside European nations to step in to fill the vacuum left by the withdrawal of China’s financial backing. However, this might take some time and there will be shortage in foreign financing in the coming months. Chart I-6Kenya Lacks Foreign Exchange Reserves Finally, another risk is the considerable amount of foreign debt obligations (FDOs) and the lack of foreign currency reserves at the central bank to meet these obligations (Chart I-6). Kenya’s FDOs in the next 12 months are about $6 billion, while the central bank has only $8.8 billion of foreign exchange reserves. In this case, FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. Bottom Line: The exchange rate will continue facing depreciation pressures. The optimal policy for the central bank will be to allow the currency to weaken meaningfully and to reduce interest rates rather than use high interest rates or deplete its foreign exchange reserves to defend the exchange rate. Public Debt Sustainability Despite substantial fiscal tightening, Kenya’s public debt trajectory remains worrisome. Two prerequisites for capping the rise in the public debt-to-GDP ratio are (1) running continuous primary fiscal surpluses and (2) for local government borrowing costs to be below nominal GDP growth. Neither of these two are presently satisfied in Kenya. Crucially, interest payments are taking up a quarter of overall government revenues (Chart I-7). This necessitates considerably lower domestic interest rates to reduce this ratio. In brief, public debt sustainability hinges on the central bank reducing local borrowing costs, which will both boost nominal growth/government revenues and lower interest costs of public debt. The government of President Uhuru Kenyatta announced a new budget in June (for the period of July 1, 2020 to June 30, 2021) with a projected primary deficit of -3% and -1.8% of GDP, for 2020/21 and 2021/22 respectively (Chart I-1, bottom panel on page 1). Meanwhile, the new budget’s nominal annual growth projections for 2020/21 and 2021/22 are 10.6% and 11.5%, respectively. Chart I-8presents both the government’s as well as our projections for public debt dynamics until the end of 2022 based on assumptions for nominal GDP, government expenditures and revenues for the next two fiscal years. The public debt-to-GDP ratio will reach 75% of GDP in our scenario and 66% in the government’s scenario. Chart I-7Public Debt Servicing Costs Are High Chart I-8Kenya: Public Debt Will Continue To Rise The key difference between the two projections are expectations for nominal GDP and government revenue growth. If fiscal and monetary policy remain tight, nominal output growth will disappoint. Notably, broad money supply growth is tame (Chart I-9). Sluggish nominal growth risks derailing government revenue projections. Notably, recent comments by finance minister Ukur Yatani suggests that revenues have already begun underperforming government expectations in the first two months of the new fiscal year. On the whole, public debt will rise by more than what the government expects over the next two years as borrowing costs remain above nominal GDP growth (Chart I-10). Chart I-9Kenya: Weak Policy Response To Low Growth Chart I-10Kenya: Local Rates Are Above Nominal Growth Faced with the prospect of rising public debt dynamics over the next two years, the economically less painful response for policymakers is for the central bank to lower interest rates and to instruct domestic commercial banks to buy government domestic debt. This will boost nominal GDP growth and push local interest rates below nominal GDP growth. There is scope for the central bank to cut interest rates and allow the currency to depreciate without feeding into runaway inflation. Notably, core consumer price inflation excluding fuel and food items is presently at an all-time low, running below the lower bound of the central bank’s inflation target (Chart I-2 on page 2). Higher inflation also feeds into higher nominal growth, which is good for public debt dynamics. A weaker currency will augment the cost of servicing foreign debt. The latter accounts for 52% of public debt and 32% of GDP. However, a large share (65%) of foreign debt is owed to bilateral and multilateral creditors. This debt can be renegotiated/restructured, which would in turn benefit private creditors. Bottom Line: To stabilize public debt dynamics, local interest rates should be lowered considerably. This will increase nominal GDP and government revenue growth as well as lower debt servicing costs. In this scenario, currency will depreciate a lot. Investment Implications Faced with very depressed economic growth, very low inflation, unsustainable public debt dynamics and a wide current account deficit, the optimal policy for Kenya is to ease monetary policy dramatically and tolerate material currency depreciation. So long as the central bank does not reduce interest rates, the economy will continue to underwhelm, public debt dynamics will be worrisome and share prices will stumble (Chart I-11). Critically, as the public debt-to-GDP ratio continues rising, sovereign credit will underperform (Chart I-12). Chart I-11Weak Domestic Dynamics = Lower Share Prices Chart I-12Rising Public Debt Burden = Sovereign Credit Underperformance If and when the central bank brings interest rates down substantially, nominal growth will improve and share prices will fare well. Lower domestic borrowing costs and higher nominal GDP growth will help stabilize public debt dynamics. In such a scenario, EM sovereign credit portfolios should overweight the nation’s US dollar bonds. The Kenyan shilling also is set to depreciate materially. If the government embarks on this macro adjustment early, currency depreciation could be gradual. If the government delays this macro adjustment and resists currency weakness by tolerating high interest rates, the exchange rate depreciation could be delayed, but will be abrupt and disorderly. Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Nigeria: Devaluation As The Least-Worst Policy Choice Chart II-1Nigeria: Poor BoP Position The Nigerian naira is facing a considerable risk of major devaluation stemming from strains on its balance of payments (BoP). That said, the risk of a sovereign default is very low over the next 12-18 months. Nigeria suffers from large external imbalances in an environment of low oil prices and dreadful FDI inflows. The nation’s current account deficit is wide at 5% of GDP and its foreign currency (FX) reserves are low (Chart II-1). Importantly, oil prices have hit a critical technical resistance – their 200-day moving average – and have relapsed (Chart II-2). Global oil demand weakness stemming from some renewed tightening of lockdown measures will result in lower crude prices. We at BCA’s Emerging Markets Strategy team expect Brent prices to be in a trading range of $35-$45 over the next 12 months.2 An Optimal Macro Adjustment A low oil price environment creates a dillemma for Nigeria’s policymakers given their limited FX reserves. They can either (i) draw down FX reserves to support the exchange rate, or (ii) preserve FX reserves and allow a major currency devaluation. So far, Nigerian authorities have avoided these options by resorting to strict capital controls and limiting imports. Yet, capital controls are derailing much needed foreign capital inflows in general and FDIs in particular. These capital account controls are also restricting the ability of domestic firms to access US dollars to service their foreign debt payments, undermining the confidence of foreign investors and multilateral creditors. Allowing currency depreciation is the least-worst macro policy solution. Propping up the currency by administrative restrictions amid low oil prices will foster various imbalances impeding the nation’s structural adjustments and its potential growth rate. Remarkably, Nigeria’s current account excluding oil has been structurally wide, a sign of weak domestic productivity and a non-competitive currency (Chart II-3). Chart II-2A Relapse In Oil Prices Is Likely Chart II-3Nigeria Has A Current Account Deficit Ex-Oil Bottom Line: Capital controls and import restrictions are impeding FDIs and productivity growth in this most populous African country (Chart II-4). While a steep devaluation will spur inflation in the short run, a cheapened currency and the abolishment of import and capital controls will help to attract foreign capital that the nation desperately needs. Running Out Of FX Reserves Critically, the Central Bank of Nigeria (CBN) is running out of FX reserves: Nigeria’s foreign exchange (FX) reserves are very low at $35.6 billion. That compares with foreign debt obligations (FDOs) of $28 billion in the next 12 months and foreign funding requirements of $47 billion in the next 12 months (Chart II-5). Chart II-4Nigeria: Weak FDI = Low Productivity Chart II-5Nigeria: Large Foreign Funding Required In Next 12 Months FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. Meanwhile, foreign funding requirements is the sum of the current account deficit and FDOs. FDI inflows were a mere $2.5 billion in 2019 compared with a $20 billion current account deficit. Along with foreign portfolio inflows, FDI inflows will remain depressed so long as capital controls persist. The FX reserves-to-broad money ratio currently stands at 0.4. A ratio below one indicates foreign currency reserves do not entirely cover currency in circulation and local currency deposits. How much should the exchange rate be devalued versus the US dollar for this ratio to reach 1? For the broad money supply coverage ratio to be equal to 1, the currency must depreciate by 56% against the US dollar. Bottom Line: CBN’s FX reserves are insufficient to maintain the current de-facto crawling currency peg in the long run. No Worries About Sovereign Credit For Now Chart II-6Nigeria: Low Public Debt Burden While the Nigerian government is reeling from lower oil prices, the likelihood of a sovereign default is presently low. Public debt is low, currently standing at 22.5% of GDP. Notably, foreign debt represents nearly 30% of overall public debt or 6.5% of GDP. Moreover, only 40% of external debt (3% of GDP) is owned to private foreign investors (Chart II-6). The rest is split between bilateral and multilateral creditors. Foreign bilateral and multilateral debt is easier to renegotiate. While overall (domestic and foreign) debt servicing costs have risen to 55% of government revenues, foreign currency debt servicing costs only represent 2% of overall revenues. Provided foreign public debt servicing is minimal, even a large currency depreciation will not make public debt dynamics unsustainable. Crucially, a substantial currency devaluation will ameliorate the fiscal position. A large share (about 55%) of fiscal revenues come from oil, i.e., they are in US dollars. Conversely, expenditures are in local currency terms. As a result, currency depreciation will boost revenues but not expenditures, narrowing the budget deficit. According to the newly revised budget for the 2020 fiscal year, fiscal spending will grow by 8.7% in nominal terms but most likely contract in real terms (Chart II-7). Overall, the fiscal balance will widen to 3.65% of GDP in 2020 according to government projections. In nutshell, policymakers refrained from large fiscal stimulus amid lockdown measures earlier this year. This is bad for the economy but positive for the trajectory of public debt. Finally, public debt dynamics are presently not worrisome with nominal GDP growth above local interest rates (Chart II-8). Chart II-7Nigeria Will Run Tight Fiscal Policy Chart II-8Nigeria: No Public Debt Sustainability Problem Bottom Line: The risk of a sovereign default is low in the coming years. The low starting points in both public debt levels and debt servicing costs will allow the government to boost fiscal spending to support the economy. Investment Implications Overall, a currency devaluation will help restore balance of payment dynamics without causing a major stress for sovereign credit. A 25-30% devaluation over the next 12 months will be the least-worst policy choice. Currency forwards are currently pricing a 20% depreciation in the naira versus the US dollar in next 12 months (Chart II-9). Yet, the average black market exchange rate, currently at around 470, implies almost a 25% discount from the current official rate. Sovereign credit spreads are presently tight (Chart II-10). Investors should consider buying Nigerian sovereign credit only after a substantial devaluation takes place. Chart II-9Naira Forwards Discount Will Widen With Lower Oil Prices Chart II-10Nigeria: Buy Sovereign Credit After Devaluation Finally, equity investors should continue avoiding the local bourse. Due to capital controls, the latter is uninvestable for now. Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 The standard gauge railways project built between the port city of Mombasa and its capital Nairobi has been heavily scrutinized by Kenyan authorities. After only three years of operation, the Kenyan Railways Company (KRC) has already defaulted on its loan from Chinese lenders. Kenyan courts have been arguing that Kenyan government and state-owned enterprises are facing sovereign risk over Chinese debt overhang. More than half of Kenya’s loans from China are attached to the construction of the Mombasa-Nairobi railway project. 2 This differs from BCA Commodity and Energy Strategy service’s expectation that Brent prices will average $65 in 2021.
BCA Research's US Bond Strategy service concludes that US dollar weakness will be bearish for bonds during the next 6-12 months. As long as the global economic recovery is maintained, the dollar will weaken further and bond yields have room to rise. We like…
Highlights Monetary Policy: The Fed will keep rates at the zero bound at least until inflation is above 2% and it will maintain an accommodative policy stance until long-dated TIPS breakeven inflation rates move above 2.3%. Remain overweight spread product versus Treasuries and stay in nominal yield curve steepeners. Bond Yields & The Dollar: US dollar weakness will be bearish for bonds during the next 6-12 months. As long as the global economic recovery is maintained, the dollar will weaken further and bond yields have room to rise. EM Sovereigns: Remain underweight USD-denominated EM Sovereigns in a US bond portfolio, with the exception of Mexico. Economy: August’s poor retail sales figures strengthen our conviction that further fiscal stimulus is required to sustain the economic recovery. Our base case outlook is that Congress will deliver that stimulus in the coming weeks, and that yields will be higher in 6-12 months. But the risk of no deal is too great to ignore. Keep portfolio duration close to benchmark for now. Fed Adopts Explicit Forward Guidance, But Leaves Many Questions Unanswered Chart 1Fed And Markets Agree: No Rate Hike Until 2024 Following last month’s adoption of an average inflation targeting regime, the next logical step was for the Fed to translate its new policy framework into more explicit forward rate guidance.1 The Fed took that step at last week’s FOMC meeting by adding the following language to its post-meeting statement: The Committee decided to keep the target range for the federal funds rate at 0 to ¼ percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.2 Chart 2A Long Way From 2% The new guidance says that the funds rate will not rise off the zero bound until three criteria are met: The labor market must be at “maximum employment” Inflation must be at or above 2% Inflation must be “on track to moderately exceed 2%” Notice that the criteria of “maximum employment” and inflation that “moderately exceeds 2%” are quite vague. In fact, Fed Chair Powell stated in his post-meeting press conference that “maximum employment” refers to a range of different labor market indicators, not just the unemployment rate. He also refused to provide more detail on how much of an inflation overshoot would qualify as “moderate”. This means that, practically, the only actionable information that the Fed gave investors is the promise that the funds rate won’t rise at least until inflation is at or above 2%. This is important info that can be easily visualized on a chart (Chart 2). We can plainly see that core inflation has a long way to go before it reaches the Fed’s target, and also that the Fed will not be making the same hawkish policy mistake it made in 2015, when it lifted rates with year-over-year core PCE inflation at 1.2%. Monetary policy will remain accommodative and supportive for risk assets until TIPS breakeven inflation rates return to well-anchored levels. For their part, FOMC participants don’t expect inflation to reach the 2% target for quite a while. The median participant doesn’t see core inflation reaching 2% until sometime in 2023, and only 4 out of 17 participants expect to lift rates before 2024. This is consistent with market pricing. The overnight index swap curve doesn’t price-in a full 25 basis point rate hike until September 2024 (Chart 1). Investment Implications We know that the Fed wants inflation to overshoot 2% for some period of time. Now, based on last week’s new guidance, we also know that no rate hikes will occur until inflation is above 2%. However, we still don’t know how much or how long of an inflation overshoot the Fed is targeting. For this reason, we think investors would be wise to keep in mind that the goal of the Fed’s new framework is to ensure that inflation expectations return to well-anchored levels. Our sense is that “well anchored” can be defined as a range of 2.3% to 2.5% for long-maturity TIPS breakeven inflation rates (Chart 3). Chart 3Inflation Expectations: The Fed's Real Target We see monetary policy staying accommodative and supportive for risk assets until TIPS breakeven inflation rates reach those levels. This argues for maintaining an overweight 6-12 month allocation to spread product versus Treasuries. This also argues for staying overweight TIPS versus nominal Treasuries, and for positioning in nominal yield curve steepeners. The Fed will maintain its firm grip on the front-end of the curve for a long time yet, but the market will eventually start to price-in liftoff at the long end. A Weaker Dollar Will Be Bearish For Bonds, Bullish For EM Sovereign Spreads The broad trade-weighted US dollar is 8% off its 2020 peak, and the BCA house view is that the dollar will weaken further during the next 12 months. This section explores what that will mean for Treasury yields and for USD-denominated Emerging Market Sovereign debt. The Dollar And Treasury Yields Bond yields and the dollar are intimately related, but the relationship is more complex than a simple coincident correlation. We like to think of the relationship as a feedback loop between the exchange rate, bond yields and global economic growth (Chart 4). Chart 4The Dollar/Bond Feedback Loop Since the dollar is currently falling, let’s start at the left-hand side of the feedback loop shown in Chart 4. The dollar’s current weakness is both a reflection of improving global economic growth and a catalyst for even stronger global economic growth. It is reflective because, compared to the rest of the world, the US is a large and stable economy. Firms and investors will respond to a positive global growth environment by sending capital overseas in search of higher returns. This puts downward pressure on the dollar. Dollar weakness also boosts global economic growth by making US dollars cheaper to acquire in global markets. This is particularly important for emerging markets, where a weaker dollar gives policymakers leeway to boost domestic growth via easier monetary and fiscal policies, without sacrificing the purchasing power of their currencies. Higher yielding countries tend to have less economic slack than low yielders. Moving to the top of the loop, stronger global economic growth (aka global reflation) will obviously impart upward pressure to bond yields. What’s less obvious is that US yields will rise by more than yields in the rest of the world. Chart 5 shows 3-year trailing yield betas for several major developed bond markets. Notice that the highest-yielding countries (US and Canada) also have the highest yield betas. This means that their yields rise the most when global bond yields are rising and fall the most when global bond yields are falling. This pattern holds because higher yielding countries tend to have less economic slack than low yielders. In other words, the high yielders will be quicker to price-in eventual monetary tightening when global growth is on the upswing. The high yielders also have more room to fall when growth ebbs. Chart 5High Yielding Bond Markets Are The Most Cyclical Initially, global reflation sends US bond yields higher. But eventually, US yields will become too high relative to the rest of the world. At that point, the US dollar will respond to wide interest rate differentials and start to appreciate. This dollar appreciation will eventually lead to slower economic growth (“global deflation”), which will cause bond yields to decline. Finally, just as US bond yields rise more than non-US yields during the global growth upswing, they also fall more during the downswing. Eventually, the tightening rate differentials lead to US dollar depreciation and the cycle repeats. Where are we situated in the cycle right now? As of today, we contend that rate differentials between the US and the rest of the world have fallen a lot, and we are at the stage of the loop where the dollar is weakening in response (Chart 6). This means that dollar weakness has further to run, and we should expect that it will eventually lead to global reflation and higher US bond yields. In fact, Chart 7 shows that sentiment toward the dollar has already soured considerably, and that increasingly bearish dollar sentiment has a habit of leading to higher bond yields. Chart 6Rate Differentials Signal More Downside For Dollar Chart 7Bearish Dollar Sentiment Leads To Higher Bond Yields Eventually, US yields will rise too much compared to the rest of the world and the dollar’s depreciation will stop. But for now, dollar weakness is bearish for bonds. The Dollar And USD-Denominated EM Sovereign Spreads USD-denominated Emerging Market Sovereigns are an obvious sector that benefits from a weaker US dollar. Since the debt is denominated in US dollars but the country collects tax revenues in its local currency, any dollar weakness makes the issuer’s debt easier to service, and presumably leads to tighter sovereign spreads. Most of the dollar’s weakness this year has come against other developed market currencies, not against EMs. Despite this relationship, we are reluctant to advocate an overweight allocation to EM Sovereigns. First, most of the dollar’s weakness this year has come against other developed market currencies, not against EMs (Chart 8). Chart 8EM Currencies Have Lagged Second, an environment of US dollar depreciation and global reflation is also a good environment for US corporate bonds and, with a couple exceptions, US corporate spreads are more attractive than EM Sovereign spreads. The vertical axis of Chart 9 shows the spread differential between the USD-denominated bonds of several EMs relative to a position in US corporate bonds with identical duration and credit rating. After differences in duration and credit rating are considered, only Turkey, Colombia, South Africa, Mexico and Russia offer a spread advantage over US corporate credit. The horizontal axis of Chart 9 shows each country’s export coverage of its foreign debt obligations. Greater coverage should make that country’s currency less vulnerable to depreciation, and vice-versa. In our view, the Turkish, Colombian and South African currencies are simply too risky. But Mexico and Russia present more interesting opportunities. Chart 9EM Sovereign Spread Over US Credit Versus Currency Vulnerability We recommend an overweight allocation to Mexican Sovereigns because they offer a spread advantage relative to US corporates, and because the currency has been on an appreciating trend versus the dollar that still has further to run to get back to pre-COVID levels (Chart 8, panel 3). Despite the small spread pick-up, we would avoid Russian Sovereigns, at least until after the US election. The Ruble has been depreciating versus the dollar since mid-year (Chart 8, bottom panel) and a Democratic sweep in November will likely lead to the imposition of fresh US sanctions on Russia.3 Bottom Line: Remain underweight USD-denominated EM Sovereigns in a US bond portfolio. Despite the outlook for US dollar weakness, US corporate bonds offer more value and will deliver better returns. Mexican debt is the sole exception. Mexican spreads are attractive and the peso has room to appreciate. Economic Update: Signs Of Weakness In Consumer Spending Chart 10A Warning From Retail Sales In last week’s report, we warned that without a fresh round of fiscal stimulus, the 12-month outlook for US consumer spending is dire.4 Then, last Wednesday, we received August’s retail sales figures – the first month of spending data since the expiry of the CARES act’s income support provisions – and learned that spending contracted on the month, after having rebounded sharply in May, June and July when the CARES act was in full force (Chart 10). There had been some hope that US consumers might be able to compensate for the lack of income by deploying some of the savings they had built up in the spring, thus keeping spending at decent levels for at least a few months. But August’s weak retail sales report challenges that narrative, as does the fact that consumer sentiment surveys have not improved very much since April (Chart 10, panel 3). Still low consumer sentiment suggests that households remain cautious and that they will be reluctant to spend with the same abandon they showed prior to COVID. We also note that, while weekly initial jobless claims continue to fall, the pace of improvement has significantly tapered off during the past few weeks and initial claims are still coming in about 4 times higher than they were last year (Chart 10, bottom panel). Bottom Line: While significant strides have been made, the US economy is not out of the woods. Our base case view is that Congress will deliver sufficient household income support in the coming weeks, allowing the economic recovery to continue. But the risk that they won’t is too great to ignore. Keep portfolio duration close to benchmark for now, and position for higher yields on a 6-12 month horizon via less risky duration-neutral yield curve steepeners. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 1Performance Since March 23 Announcement Of Emergency Fed Facilities Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For a more detailed examination of the Fed’s new average inflation targeting regime please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/monetarypolicy/files/monetary20200916a1.pdf 3 Please see Geopolitical Strategy / Emerging Markets Strategy Special Report, “US-Russia: No Reverse Kissinger (Yet)”, dated July 3, 2020, available at gps.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Feature In last week’s US Bond Strategy report, we presented the results of a scenario analysis on consumer spending.1 The goal of that analysis was to assess how much additional federal government income support is required to achieve consumer spending growth targets that won’t disappoint markets. The calculations regarding the amount of additional stimulus required to hit different spending targets are correct. However, a typo in our code (in fact, a missing letter “c”) caused us to specify the wrong targets. Last week, we targeted -3% 12-month over 12-month consumer spending growth for the period between March 2020 and February 2021. The rationale being that -3% was the worst spending growth seen during the 2008 Great Recession and would likely be the minimum that markets could tolerate this time around. As shown in the second panel of Chart 1, this number should have been -1.9%. Chart 1Consumer Spending Driven By Income & The Savings Rate We also considered spending growth targets for the 12-month period between August 2020 and July 2021. Last week we set our target range for that period at between 2% and 6%, the growth rates seen during the recovery years that followed the Great Recession. That range should have been set at 2.5% to 5%. We present revised results from our scenario analysis in Table 1 and Table 2. These tables are identical to the ones presented last week, except that they now have the correct consumer spending targets. Table 1Without More Stimulus COVID's Impact On Consumer Spending Will Be Worse Than The GFC Table 2At Least $600 Billion More Government Income Support Is Needed Our conclusion remains similar, though our corrected numbers suggest that more income support from the federal government will be required to hit reasonable spending targets. Last week, we concluded that extra income support on the order of $500 - $800 billion is the minimum that will be required. Our corrected numbers suggest that more stimulus will be necessary, on the order of $600 billion to $1 trillion. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com
BCA Research's US Bond Strategy service assess the tech stock sell off and its implications on bonds. Bond yields correlate most strongly with: The performance of cyclical equities over defensive equities. The ratio of CRB Raw Industrials over gold. These…
BCA Research's US Bond Strategy service concludes that without additional household income support from Congress of $500 to $800 billion, consumer spending will massively disappoint expectations over the next 6-12 months. The CARES act played an essential…