Global
Highlights Our out-of-consensus call on oil prices - Brent and WTI are expected to trade to $65 and $63/bbl, respectively, next year - has the most upside risk from unplanned production outages in Iraq and Venezuela. The potential for export losses from Libya, while not as acute, remains high. Downside price risks - e.g., a meaningful softening of demand, or sharply higher U.S. shale-oil production - are not as elevated as upside price risks, in our view. Favorable global macro conditions will continue to support the synchronized global upturn in GDP, keeping oil demand growth on track. The strained balance sheets of many U.S. shale-oil producers and deepwater-producing Majors likely will limit their ability to fund drilling, as recent earnings calls from oil-services companies attest.1 We continue to monitor global monetary conditions, particularly in the U.S. With global oil markets tightening as supply contracts and demand expands, the broad trade-weighted USD will become more of a factor in oil-price determination next year. Energy: Overweight. Our long $55/bbl WTI calls vs. short $60/bbl WTI call spreads in Jul/18 and Dec/18 recommended last week are up 9.3% and 5.8%, respectively. Base Metals: Neutral. Copper has been well bid, and is up 8.5% since the beginning of the month. The proximate cause of the price strength is investor optimism regarding global growth, particularly in China. However, following their biannual meeting earlier this week, the International Copper Study Group kept its projected 2017 deficit unchanged, and downgraded their 2018 projection to 105k MT, from 170k MT. Precious Metals: Neutral. Gold is under pressure as markets weigh the possibility President Trump will appoint a more hawkish Fed Chair to succeed Janet Yellen. Ags/Softs: Neutral. Following a backlash from Midwestern politicians, the Environmental Protection Agency (EPA) abandoned proposed changes to the U.S. Renewable Fuel Standard. The EPA also will keep 2018 renewable fuel volume mandates at or above current proposed levels. Corn gained 2.4% since this announcement last week. Our corn-vs.-wheat spread is up 1.6% since inception. Feature Our out-of-consensus call on Brent and WTI prices for next year has a significant amount of daylight between the prices we expect - $65 and $63/bbl for Brent and WTI, respectively - and price estimates we derive using the U.S. EIA's supply, demand and inventory expectations, which are $15.1 and $13.8/bbl lower (Chart of the week). Chart of the WeekPrices Derived Using BCA And EIA##BR##Global Balance Estimates Our bullish oil price call is predicated on stronger global demand growth than EIA and other forecasters' estimates (Chart 2 & Table 1), and an extension of the OPEC 2.0 production cuts to end-June 2018 (Chart 3).2 These fundamentals combine to sustain a supply deficit for the better part of 2018 (Chart 4), which results in stronger inventory draws in the OECD (Chart 5). Net, we expect OECD stocks to fall below their five-year average level by year-end 2018. Chart 2Stronger Global Demand Growth ... Chart 3...And Continued OPEC 2.0 Discipline... Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Chart 4...Produce A Supply Deficit For Most Of 2018... Chart 5...Leading To OECD Inventory Normalization Upside Price Risks Dominate In 2018 In assessing the "known unknown" risks to our call, those on the upside clearly dominate in 2018. Chief among these risks are unplanned production outages, which have been somewhat under control versus the past two years (Chart 6). Nonetheless, we believe the risk of unplanned outages within OPEC - in Iraq and Venezuela, in particular - are elevated. The potential for export losses from Libya, while not as acute, remains high (Chart 7). Chart 6Unplanned Outages Are Down ... Chart 7...But Key States Are At Risk The risk of unplanned outages is highest in Iraq, where production is running at ~ 4.5mm b/d in 3Q17 (Chart 7, panel 1). Exports on the Ceyhan pipeline from Iraq's northern Kurdish region through Turkey to the Mediterranean fell by more than half to as low as 225k b/d, following a non-binding independence referendum in Iraq's restive Kurdistan region at the end of September. This led to armed conflict between Iraqi and Kurdish forces.3 Independence for the semi-autonomous region was supported by more than 90% of Iraqi Kurds. However, the Iraqi government in Baghdad, along with its neighbors in Turkey and Iran, opposed the referendum, as did the U.S. This lack of support likely prompted the Kurdistan Regional Government's (KRG) offer to "freeze" the referendum this week, and to seek immediate cease-fire talks with Baghdad. Export flows from Kirkuk and the Kurdish region have been restored this week to ~ 300k b/d, or half of the volumes exported prior to the referendum, according to Bloomberg.4 Even with the offer to freeze the referendum - presumably, this means the semi-autonomous Kurdish government will abstain from pressing for independence if its offer is accepted and Baghdad agrees to negotiate an immediate cease-fire - this issue is far from settled. BCA's Geopolitical Strategy noted last month, the critical issue for the oil market remains sustained conflict between the Iraqi central government and the KRG. The question that cannot be answered yet is what "would (a conflict) do to future efforts to boost Iraqi production. Iraq is the last major oil play on the planet that can cheaply and easily, with 1920s technologies, access significant new production. If a major war breaks out in the country, it is difficult to see how Iraq would sustain the necessary FDI inflows to develop its fields to boost production, even if the majority of production is far from the Kurdish region. Given steady global oil demand, the world is counting on Iraq to fill the gap with cheap oil. If it cannot, higher oil prices will have to incentivize tight-oil and off-shore production."5 A huge "known unknown" resides in Venezuela, where we have production running at ~ 1.96mm b/d in 3Q17, sharply down from 2.4mm b/d during 2011-2015. The state oil company, Petroleos de Venezuela, SA, or PDVSA, is struggling to amass enough cash to meet critical near-term international interest and debt payment obligations, and can no longer afford to buy the chemicals and equipment required to make the country's heavy oil suitable for refining. This lack of cash is causing oil quality from Venezuela to deteriorate, as more exports are showing up with high levels of water, salt or metals. This is raising the odds refiners from the U.S. to China could turn barrels away in the near future unless the situation is reversed.6 Indeed, Reuters reported Phillips 66, a U.S. refiner, cancelled "at least eight crude cargoes because of poor oil quality in the first half of the year and demanded discounts on other deliveries, according to ... PDVSA documents and employees from both firms. The cancelled shipments - amounting at 4.4 million barrels of oil - had a market value of nearly $200 million." Venezuela's financial condition has steadily worsened following the collapse of oil prices at the end of 2014. Production is at its lowest level in 30 years, and banks have stopped extending letters of credit, which are critical to trading in the international oil market, in the wake of U.S. sanctions ordered by President Trump, as Reuters notes. In addition, PDVSA has been denied access to storage facilities in St. Eustatius terminal, because it owes the owner of the facility, Texas-based NuStar Energy, some $26 million in fees.7 Markets will be watching closely to see if Venezuela performs on $2 billion in USD-denominated bond payments, one of which is due tomorrow, and the other due next week (November 2). Venezuela missed debt coupon payments of some $350mm earlier this month, and has a total outstanding obligation for this year of $3.4 billion.8 In all likelihood, Venezuela will once again turn to Russia for additional financial support, which has stepped in as a "lender of last resort" replacing China.9 Venezuela owes Russia some $17 billion. Of this, Rosneft Oil Co., a Russian oil company, has loaned PDVSA $6 billion.10 In Libya, where we have production at 910k b/d in 3Q17 (Chart 7, panel 3), the risk of unplanned production outages is not as acute as the risks in Iraq and Venezuela, but important nonetheless. As a failed and fractured state, Libya faces particular challenges in maintaining production. Wood Mackenzie believes Libyan production likely has plateaued. The oil consultancy believes Libya's max production is limited to 1.25 million b/d.11 However, "Reaching this would be quite an achievement, given ongoing challenges, including international oil companies' reluctance to recommit capital and expertise, a national oil company starved of funding - and, not least, the propensity for violence to flare up and armed groups to hinder oil output." Downside Price Risks Less Daunting In 2018 Chart 8The USD Will Become More Important##BR##As Oil Markets Tighten Next Year Downside price risks - e.g., a meaningful softening of demand, or sharply higher U.S. shale-oil production - are not as elevated as risks to the upside, in our view. The favorable global macro conditions we discussed in last week's forecast will continue to support the synchronized global upturn in GDP. This will keep global oil demand growing at ~ 1.67mm b/d on average in 2017 and 2018, based on our estimates. We expect U.S. shale production to increase to 5.17 mm b/d in 2017 and to 6.09 mm b/d next year, as higher prices incentivize renewed drilling activity. However, the strained balance sheets of many shale-oil producers and a renewed - although perhaps only temporary - push from equity investors for shale producers to focus on improving economic returns rather than merely pursuing maximal production growth, likely will limit their ability to fund drilling, as recent earnings calls from oil-services companies attest. Away from fundamentals, we are monitoring U.S. monetary policy closely, given the potential for the USD to become a headwind once again for commodity prices generally, and oil prices in particular. As we noted last week, we expect the tightening of oil markets globally to restore the linkage between the USD and oil prices - i.e., the inverse correlation between them (a stronger USD is bearish for crude oil prices, and vice versa). The transitory noise surrounding the next Fed Chair will dissipate within the next few weeks, allowing the U.S. central bank and markets to focus on the evolution of monetary policy next year, following a widely expected rate hike in December. During the transitional phase the oil market is currently passing through - falling supply and stout demand are tightening the market globally - the USD's importance will increase as a determinant of oil prices (Chart 8). Bottom Line: Our oil-price call for next year - $65/bbl for Brent and $63/bbl for WTI - is predicated on stronger global demand growth, and an extension of the OPEC 2.0 production cuts to end-June 2018. These fundamentals will produce stronger inventory draws in the OECD, and bring stocks below their five-year average by year-end 2018. In our view, upside price risks clearly dominate in 2018. Chief among these risks are unplanned production outages in key OPEC states - Iraq, Venezuela and Libya - which account for ~ 7.4mm b/d of production at present. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant HugoB@bcaresearch.com 1 Please see BCA Research's Energy Sector Strategy Weekly Report "Oilfield Service Quarterly Update: U.S. Stagnation," published October 25, 2017. It is available at nrg.bcaresearch.com. 2 OPEC 2.0 is the producer coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia. Please see last week's feature article in Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten," for a discussion of our assumptions, models and estimates. It is available at ces.bcaresearch.com. 3 Please see "Update 2 - Iraqi Kurdistan faces first major oil outage since referendum," published by uk.reuters.com October 18, 2017. See also "Iraq's NOC vows to maintain Kirkuk oil flows after ousting Kurds," published by S&P Global Platts October 17, 2017, for additional background. 4 Please see "Iraqi Kurds Offer To Freeze Independence Referendum Results," published October 25, 2017, by Bloomberg.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report "Iraq: An Emergent Risk," p. 23 in the September 20, 2017 issue. It is available at gps.bcaresearch.com. 6 Please see "Venezuela's deteriorating oil quality riles major refiners," published by reuters.com October 18, 2017. 7 Please see "Exclusive: PDVSA blocked from using NuStar terminal over unpaid bills," published by uk.reuters.com October 20, 2017. 8 Please see "Venezuela is blowing debt payments ahead of a huge, make-or-break bill," published by cnbc.com on October 20, 2017. 9 Please see "Special Report: Vladimir's Venezuela - Leveraging loans to Caracas, Moscow snaps up oil assets," published by reuters.com on August 11, 2017. 10 Rosneft's majority owner is the Russian government. See "Glencore sells down stake in Russia's Rosneft," published by telegraph.co.uk on September 8, 2017. Glencore's 14.6% stake in Rosneft was sold to CEFC China Energy, according to the Telegraph. 11 Please see "WoodMac: Libya's oil production might have reached near-term potential," in the October 20, 2017, issue of Oil & Gas Journal. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016
Highlights Global "Low-flation" Vs. Oil Reflation: Investors who believe that inflation is dead will be surprised by the breakout of global oil prices in 2018 toward the mid-$60 level anticipated by our commodity strategists. This will help drag both realized and expected inflation higher across the developed world. Fed Tightening Vs. Trump Easing: The trade-off between a full-employment Trump fiscal stimulus and a slowly tightening Federal Reserve next year will first result in higher inflation expectations and a bear-steepening Treasury curve, and eventually lead to more aggressive rate hikes and a bear-flattening curve later in 2018 Strong Growth Vs. Modest Inflation In Europe: The ECB will signal a reduction in the pace of its asset purchases this week, in response to the continued strength of the Euro Area economy. Current moderate rates of inflation will not derail a "taper", but will be enough to push off any ECB interest rate hike until late 2019. Feature The bull market in global risk assets continued last week, with the S&P 500 hitting yet another all-time record and other major bourses in both Developed Markets and Emerging Markets hitting multi-year highs. This is a sensible reflection of the strength and persistence of the current coordinated global economic upturn, which is boosting corporate profit growth worldwide. At the same time, the health of the current expansion has dampened risk-aversion among investors. This is helping to keep market volatility at depressed levels with only modest changes expected for both inflation and monetary policy. Yet there are storms brewing on the horizon that have the potential to shake up this low-volatility, risk-seeking backdrop. Specifically, a potentially less stable outlook for global inflation, amidst uncertainty over the direction of fiscal policy in the U.S. and monetary policy at the Fed and European Central Bank (ECB), could pose a threat to the current Goldilocks environment for risk assets (Chart of the Week). In this Weekly Report, we discuss some macroeconomic "trade-offs" that investors will have to grapple with over the next 6-12 months, and how to position bond portfolios accordingly. Chart of the WeekMarkets Not Worried About The Fed Or ECB Trade-Off #1: "Low-flation" Vs. Rising Oil Prices Chart 2Global Inflation Pressures Are Slowly Building Realized inflation data across the major developed economies is showing no imminent threat of breaching, or even just reaching, central bank targets. This is occurring despite a robust, coordinated global economic expansion that is generating some of the fastest growth rates seen since the Great Recession. With nearly ¾ of the countries in the OECD now with unemployment rates below the estimates of the full employment NAIRU, subdued inflation readings remain a puzzle for both investors and policymakers (Chart 2). The term "low-flation" has been used to describe this backdrop of inflation rates remaining low seemingly regardless of what is happening with growth. Bond investors have reacted to this by keeping market-based inflation expectations at levels below central bank inflation targets, suggesting a potential problem with the credibility of policymakers. Yet a fresh challenge to the low-flation thesis will soon come from the global oil markets. Last week, our colleagues at BCA Commodity & Energy Strategy upgraded their oil price targets for the fourth quarter of 2017 and all of 2018.1 Their estimates for global oil demand were revised upward based on the improving economic momentum, as evidenced by the IMF recently boosting its own forecasts for world GDP growth to 3.6% for all of 2017 and 3.7% for 2018. Combined with continued discipline on output from the so-called "OPEC 2.0" coalition of Russia & Saudi Arabia - currently responsible for 22% of the world's oil production - the global oil market is expected to see demand exceeding supply until late 2018 (Chart 3). The positive demand/supply balance should lead the Brent oil price benchmark to average just over $65/bbl in 2018 (Table 1), which would be a 13% increase from current levels. This is a move that global bond markets are likely to notice, given the strong correlation that still exists between market-based inflation expectations and oil prices in the developed economies. Chart 3A Positive Fundamental Backdrop For Oil Table 1Upgrading The BCA Oil Price Forecasts In Charts 4 & 5, we show the market-based pricing on inflation expectations at the 10-year maturity for the U.S. (using TIPS breakevens), the U.K., Germany, Japan, Canada and Australia (using CPI swaps). For each country, we also show the Brent oil price denominated in local currency terms. We add one additional data point to the charts, shown as an asterisk, incorporating the 2018 average Brent oil price expectation converted at current exchange rates versus the U.S. dollar. As can be seen, the higher oil price that our commodity strategists are expecting should act to put upward pressure on the inflation expectations component of government bond yields in the major developed markets. Chart 4Upward Pressure On Inflation Expectations ... Chart 5... From Higher Oil Prices In 2018 Of course, the unchanged currency assumption made in Charts 4 & 5 is unrealistic. Yet given the significant increase in oil prices that we are expecting next year (+13%), it is also unrealistic to expect enough currency appreciation in any country to fully offset the inflationary impact from oil. In fact, given the BCA view that the U.S. dollar should enjoy one last cyclical boost next year as the Fed delivers more rate hikes than the market is currently discounting, inflation expectations may actually rise by more than we are showing in our charts in non-U.S. countries (given that oil is priced in U.S. dollars). In Table 2, we show the forecast for the local-currency Brent oil price for 2018 and the date that oil prices were last at that level in each country (all in 2015 after the cyclical peak in oil prices that began in 2014). We also present the data on 10-year government bond yields, the 2-year/10-year slope of yield curves, market-based inflation expectations, and realized headline and core inflation rates for the major developed economies. We show the current levels for all those variables, plus the levels that prevailed the last time oil was at the levels we are forecasting. The major differences that stand out are: Table 2Bond Markets Now Vs. The Last Time Oil Prices Were In The Mid-$60s Yield levels are not dramatically different than where they were in 2015 in the U.S., Canada and Australia, but are lower now in the U.K., Euro Area and Japan thanks to central bank asset purchase programs. Yield curves are much flatter now in the U.S., U.K., Canada and Japan, but are steeper in the Euro Area and Australia. Market-based inflation expectations now are very close to the levels that prevailed in 2015, except in Japan where they are much lower. Headline inflation rates are much higher now everywhere except Australia, while core inflation rates are a lot higher in the U.K., a touch higher in the U.S. and Euro Area, and lower everywhere else. The conclusion from Table 2 is that there is potential for bond yields to rise as oil prices head higher in the U.S., U.K. and Euro Area given that inflation expectations are at the same levels as 2015 but realized inflation rates are higher. This would suggest that owning inflation protection in these countries is a sensible way to play the "low-flation vs. oil reflation" trade-off - trades that we already have in place in our Tactical Trade Overlay by being long Euro Area CPI swaps and owning U.S. TIPS versus nominal U.S. Treasuries and (see table on page 16). We are reluctant to add U.K. inflation protection to this list, however, and may even look to go the other way given the likelihood that the currency-fueled surge in U.K. inflation is in the process of peaking out. In sum, bond markets will be unable to ignore a combination of strong global growth (still called for by rising global leading economic indicators), tightening labor markets and rising oil prices in 2018. As investors come to grips with oil trading with a 60-handle for the first time since 2015, inflation expectations should widen out in all developed market countries that are at, or beyond, full employment. This should put upward pressure on nominal bond yields as well, and potentially trigger bear-steepening of yield curves if central banks do not respond to higher oil-driven inflation with a faster tightening of monetary policy. Bottom Line: Investors who believe that inflation is dead will be surprised by the breakout of global oil prices in 2018 toward the mid-$60 level anticipated by our commodity strategists. This will help drag both realized and expected inflation higher across the developed world. Trade-Off #2: Fed Tightening Vs. Trump Easing Last Friday, the U.S. Senate passed President Trump's budget plan by the slimmest of margins (51 to 49), allowing for an increase in federal deficits of up to $1.5 trillion over the next decade. Trump immediately put pressure on the U.S. House of Representatives to also pass the Senate plan, and the initial comments from House Republican leadership was that they would also endorse the Senate budget proposal which included significant tax cuts for corporations and some households. This is unsurprising given that the Republicans need a major, economy-boosting legislative victory to present to voters in next year's U.S. Midterm elections. The U.S. Treasury market responded to this news on Friday in a fashion that we believe to be sensible - the curve bear-steepened, with the 2-year/30-year spread widening 4bps on the day. We have written about the interaction between budget deficits, Fed policy and the slope of the Treasury curve in past Weekly Reports this year, most recently at the beginning of this month.2 Chart 6 is taken from that most recent report, and we feel that it is important to go through our logic once again after last week's events. Chart 6UST Curve: Bear-Steepener First, Bear-Flattener Later The Treasury curve typically steepens during periods when the U.S. federal budget deficit is widening (top panel). The Treasury curve is typically negatively correlated to the real fed funds rate, steepening when the real rate is falling and vice versa. Budget deficits usually are widening during periods of soft economic growth, when tax receipts are slowing and counter-cyclical fiscal spending is increasing. This is also typically correlated to periods when spare capacity in the U.S. economy is opening up and inflation pressures are diminishing (middle panel), hence giving the Fed cover to lower interest rates and putting steepening pressure on the Treasury curve. The current backdrop is atypical, as a fiscal stimulus is being proposed at a time when the economy is already at full employment with little sign of slowing. At the same time, the Fed is in a tightening cycle - albeit a slow one because of relatively subdued inflation - which usually does not occur during periods of widening budget deficits. This represents another difficult "trade-off" for investors to process. A so-called "full employment" fiscal stimulus should be inflationary at the margin, by definition, if it boosts economic growth to an above-potential pace. That would steepen the Treasury curve as longer-term inflation expectations rise, until the Fed steps in with rate hikes to offset the impact of the fiscal stimulus. If the Fed felt that the greater fiscal deficit was becoming a problem for medium-term inflation stability, then there could be a faster pace of rate hikes that would boost the real funds rate and put flattening pressure on the Treasury curve. A more straightforward way to describe that would be a scenario where the Trump tax cuts end up boosting U.S. real GDP growth to something close to 3% next year, which results in the U.S. unemployment rate falling to a "3-handle". This would likely put upward pressure on U.S. realized inflation and steepen the Treasury curve as the market prices in higher inflation - IF the Fed is slow to respond to that inflation pickup. When inflation rises by enough to threaten the Fed's 2% inflation target, perhaps even rising above that level, then the Fed would step in with more rate hikes. The result: a higher real fed funds rate and a flatter Treasury curve. That scenario is how we envision the next year playing out. Various FOMC members have already noted that they cannot account for any fiscal stimulus in their economic projections until they see the details. Furthermore, many members of the FOMC are expressing concern that the downdraft in inflation was enough of a surprise to raise questions about the Fed's understanding of the underlying inflation process. This suggests that the Fed will want to see inflation, both realized and expected, rise first before increasing the pace of rate hikes beyond current projections. Net-net, we see the Trump fiscal stimulus steepening the Treasury curve in 2018 before the Fed flattens it with tighter monetary policy. One caveat for the latter is the upcoming decision on the next Fed Chair. President Trump, ever the reality game show host, noted last week that the finalists for this season's episode for "The Apprentice: FOMC" are now down to Jerome Powell, John Taylor and current Chair Janet Yellen. Both Powell and, of course, Yellen would represent a continuation of the current cautious FOMC framework, while Taylor would likely be more hawkish given his public comments on Fed policy decisions (and the output of his own Taylor Rule!). If Taylor were to be appointed by Trump as the new Fed Chair, the Treasury curve may not steepen much on the back of fiscal easing if the markets begin to discount a more aggressive Fed. Bottom Line: The trade-off between a full-employment Trump fiscal stimulus and a slowly tightening Federal Reserve next year will first result in higher inflation expectations and a bear-steepening Treasury curve, and eventually lead to more aggressive rate hikes and a bear-flattening curve later in 2018. Trade-Off #3: Strong European Growth Vs. Mild Inflation The ECB meets later this week, and is expected to make a decision on the size and scope of its asset purchase program for next year and beyond. The latest Bloomberg survey of economists is calling for a cut in the monthly pace of asset purchases from €60bn/month to €30bn/month, but with an extension of the program until September 2018.3 The same survey calls for the ECB to deliver a hike in the deposit rate in Q1/2019, with a hike in the benchmark interest rate in Q2/2019. We agree with the former, although we think there will be no rate hikes of any kind until the 4th quarter of 2019, at the earliest. Chart 7Why Would The ECB NOT Taper? The trade-off between robust European growth and still modest rates of core inflation are the reason we expect the ECB to be very late to begin hiking policy rates after the asset purchase program is completed. It is clear from a variety of data, from almost all countries in the Euro Area, that the economy is expanding at a robust, above-potential pace (Chart 7). Headline inflation has increased steadily off the 2015 lows and now sits at 1.5%, still below the ECB's target of "just below 2%". The ECB has played down this pickup in inflation, given that is has largely been driven by the rise in oil prices since the 2015 lows. There is certainly a strong correlation between the annual change of oil prices (denominated in euros) and Euro Area headline inflation (middle panel), and the ECB expects fading oil price momentum to result in Euro Area headline inflation drifting back to 1% in early 2018. Yet the oil price increase that our commodity strategists are calling for next year would boost the year-over-year growth rate to a pace around 40%, which has in the past been consistent with 2% headline inflation outcomes. A rising euro would help mitigate the impact from oil, but as mentioned earlier, we see more potential for some modest depreciation of the euro versus the U.S. dollar after the run-up seen in 2017. Despite the pickup in headline inflation already underway, core inflation in Europe remains benign at 1.1%. Our measure of the "breadth" of the rise in core inflation across 75 individual subsectors - the Euro Area core inflation diffusion index - sits right around the "50 line" suggesting that just as many components of Euro Area core inflation are rising as are falling. Yet with broad Euro Area unemployment approaching 8%, and with some measures of wage inflation starting to awake as a result, the odds are increasing that continued strong growth will result in additional upward momentum in core inflation. The ECB is already forecasting a return of core inflation to 1.9% in 2019, which is why some reduction in the pace of asset purchases will be announced this week. The entire asset purchase program was only put in place in 2015 to fight a deflation threat after oil prices collapsed in 2014, and that has now passed with inflation steadily grinding higher. So the "trade-off" for investors in Europe, between strong growth and moderate inflation, will be resolved by the ECB shifting to a less-accommodative monetary policy stance. In terms of the impact on Euro Area bond yields, however, the change in the pace of bond buying matters even more than the size of the asset purchases. In Chart 8, we show the ECB's monetary base and three scenarios for how it will evolve through asset purchases until the end of 2018: Base Case: The ECB slows the pace of bond buying to €30bn/month starting in January 2018 until September 2018, then cuts that down to €15bn/month for the remainder of 2018 and stops the program completely at year-end. Dovish Scenario: The pace of bond buying is maintained at €60bn/month until the end of 2018, with no commitment to end the program then. Hawkish Scenario: The ECB tapers its purchases by €10bn/month for the first six months of next year, then ends the program in July 2018. In the bottom two panels of Chart 8, we show the year-over-year growth rate of the ECB's balance sheet, with those three scenarios, and compare them to the benchmark 10-year German Bund yield and our estimate of the German term premium. In all three scenarios, even the dovish one where the ECB keeps on buying at the current pace, the growth rate of the monetary base will decelerate in 2018. As can be seen in the chart, that growth rate has been highly correlated to yields and the term premium during the life of the ECB's asset purchase program. The conclusion here is that central bank asset purchase programs need to increase in size versus previous years to maintain the same impact on bond yields over time. Put another way, asset purchases represent a signaling mechanism ("forward guidance") from a central bank to the markets about future changes in interest rates when they are already at the zero bound. Increasing the size of the purchases sends a more powerful message than simply keeping the pace of buying unchanged. This is especially true if the underlying economy is growing and inflation is rising, which would typically cause investors to price in a higher expected path of interest rates into the government bond yield curve. So, unless the ECB takes the highly unlikely step of increasing the size of its asset purchases for next year, then there are no outcomes from this week's ECB meeting that should be expected to be sustainably bullish for longer-dated European government bonds. At the same time, there will be no signals given on future changes in short-term interest rates, as the ECB has maintained for some time that rates will not be touched until "some time" after the asset purchase program has ended (Q4/2019, in our view). Hence, Euro Area yield curves are likely to eventually see some bear-steepening pressure on the back of this week's ECB meeting. The story is similar for Peripheral European government bonds and Euro Area investment grade corporate credit. In Chart 9, we show the same growth rates of the ECB monetary base with our scenario projections versus the 10-year Italy-Germany spread, 10-year Spain-Germany spread, 10-year Portugal-Germany spread and the Barclays Bloomberg Euro Area Investment Grade corporate spread. While the correlations are not as clear as that for German yields, a slower pace of ECB asset purchases would be consistent with some spread widening in Peripheral European and in corporate credit. Chart 8ECB Bond Buying:##BR##Watch The Pace, Not The Level Chart 9European Credit Spreads##BR##Set To Widen Post-ECB? Bottom Line: The ECB will signal a reduction in the pace of its asset purchases this week, in response to the continued strength of the Euro Area economy. Current moderate rates of inflation will not derail a "taper", but will be enough to push off any ECB interest rate hike until late 2019. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Commodity & Energy Strategy Weekly Report, "Oil Forecast Lifted As Markets Tighten", dated October 19th 2017, available at ces.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "The Case For Steeper Yield Curves", dated October 3rd 2017, available at gfis.bcaresearch.com. 3 https://www.bloomberg.com/news/articles/2017-10-22/draghi-seen-going-for-ecb-bond-buying-limit-in-qe-s-last-hurrah The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights The uptick in world oil demand in the wake of a strengthening global upturn - the first since the Global Financial Crisis (GFC) - coupled with continued production discipline by OPEC 2.0, will accelerate inventory draws, and lift prices above our previous expectation. Even though we expect - and model for - U.S. shale producers to step up drilling as a result, we are lifting our base case forecast for 2018 Brent and WTI to $65.15/bbl and $62.95/bbl, respectively. These estimates are up $5.51 and $5.98/bbl from our forecast last month.1 Energy: Overweight. Given our view (discussed below), we are taking profits on the long Dec/17 WTI call spread we recommended June 15 - long $50/bbl calls vs. short $55/bbl calls - on the close tonight. This position was up 116% Tuesday. We will replace this spread with long $55/bbl WTI calls vs. short $60/bbl WTI calls in Jul/18 and Dec/18. Base Metals: Neutral. We closed our short Dec 2016 copper trade last week, after our trailing-stop of $3.10/lb was elected, with a 0.75% return. Our trade was up 6% by the end of September, however bullish data in October - including an earthquake in Chile and worries over a potential metal shortage in China - lifted prices back up. Chinese copper import data showed a 26.5% year-on-year (yoy) jump in September. Even so, we expect copper imports to end 2017 with a yoy decline. Precious Metals: Neutral. Palladium continues to trade premium to platinum following its breakout at the end of September. We expect this to continue, given the supply-demand fundamentals we highlighted in June.2 Ags/Softs: Neutral. The USDA's latest World Agricultural Supply and Demand Estimates (WASDE) is supportive of our grains view - projections for 2017/18 wheat ending inventories were revised upward, while corn and soybeans stock estimates were lowered. Our long corn vs. short wheat position recommended October 5 is up 1.5% (please see p. 8 for further discussion.) Feature The global uptick in GDP growth noted this month by the IMF, along with continued production discipline from OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - will lift 2018 average Brent and WTI prices to $65.15/bbl and $62.95/bbl, respectively. These estimates are up $5.51 and $5.98/bbl from our forecast last month (Chart of the Week). Chart of the WeekHigher Demand, Lower Supply,##BR##Tighter Inventories Lift Prices We expect the fortuitous combination of fundamentals - for oil producers, that is - to accelerate the drawdown in oil inventories globally, which also will be supportive for prices (Chart 2). This, in turn, will set off a new round of U.S. shale-oil production, which will temper the price rise we expect, but still force inventories to draw harder than expected (Chart 3). Our base case calls for OPEC 2.0 to extend its 1.8mm b/d production cutting deal to end-June 2018, and for compliance within the KSA-Russia-led coalition to remain strong. OPEC 2.0 member states compliance with self-imposed quotas stood at 106% of agreed cuts, according to a state-by-state tally published by S&P's Global Platts earlier this month.3 Iraq continues to flaunt its OPEC 2.0 production quota, at 4.54mm b/d by our estimate, or 153k b/d over its quota. OPEC as a whole is producing 32.74mm b/d of crude oil, by our reckoning, vs. Platts' estimate of 32.66mm b/d. We have Libya and Nigeria, which are not parties to the OPEC 2.0 Agreement, producing 930k b/d and 1.71mm b/d last month, vs. Platts' estimates of 910k b/d and 1.84mm b/d, respectively (Table 1). KSA and Russia continue to lead OPEC 2.0 by example, with the former's crude oil production coming in at 9.97mm b/d in September, vs. 9.95mm b/d in August; the latter's total liquids production was 11.12mm b/d, vs. 11.13mm in August (Chart 4). Chart 2Market Will Get##BR##Tighter Sooner Chart 3BCA Expects Sharper##BR##Inventory Draw Than EIA Chart 4KSA And Russia Continue##BR##Providing Leadership To OPEC 2.0 Global GDP, Oil Demand Growth Strengthens The IMF earlier this month raised its forecast for global GDP growth this year to 3.6% and to 3.7% for next year, up 0.1% for each year vs. previous forecasts. In its analysis, the Fund drew attention to: Notable pickups in investment, trade, and industrial production, coupled with strengthening business and consumer confidence, are supporting the recovery. With growth outcomes in the first half of 2017 generally stronger than expected, upward revisions to growth are broad based, including for the euro area, Japan, China, emerging Europe, and Russia. These more than offset downward revisions for the United States, the United Kingdom, and India.4 On the back of the IMF's revised global growth estimates, we lifted our 2017 and 2018 oil demand expectation to just under 47.5mm b/d on average for the OECD and to just under 52mm b/d for non-OECD economies (Table 1). This translates into global demand growth of 1.65mm b/d in 2017 and 1.69mm b/d in 2018. Notably, we expect global demand to exceed 100mm b/d on average next year in our base case. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Our estimated demand is driven by global growth projections, particularly for EM economies, which make up the bulk of demand and growth in our balances estimates (Table 1). And, as before, our estimates remain above the EIA's (Chart 5). The indicators we look at to confirm or refute our demand assessment - global trade, particularly EM imports, and manufacturing - remain strong. Global trade continues to expand, particularly in EM ex-Middle East and Africa, as does manufacturing globally, both of which supports the IMF's assessment of growth generally (Charts 6 and 7). Rising incomes lead to rising trade, and also to increased oil and base metals consumption in EM economies. Chart 5We Continue To##BR##Estimate Higher Demand Than The EIA Chart 6Rising Trade Volumes##BR##Support Growth Story ... Chart 7... Expanding Manufacturing##BR##Does, Too Higher Prices, Greater USD Risk Expected In 2018 Given the upward revisions to global growth and our expectation OPEC 2.0 compliance will remain fairly stout, our baseline forecast now calls for WTI prices to average $56.40/bbl in 4Q17 and $62.95/bbl in 2018. Brent is expected to average $58.40/bbl in 4Q17 and $65.15/bbl next year (Chart 1 and Table 2). These estimates are up from last month's averages of $54.89 and $57.44/bbl for 4Q17 and 2018 WTI, and $56.67 and $59.17/bbl for 4Q17 and 2018 Brent.5 Our increasing bullishness is tempered by the risk of a stronger USD, particularly the broad trade-weighted USD index, which captures EM currency weakness. With the Fed set on a course to lift rates - our House view anticipates a Dec/17 rate hike and two or three hikes next year - and the oil market getting fundamentally tighter, we have seen the oil-USD linkage being re-established recently (Chart 8). Table 2Upgrading Our##BR##Price Forecasts Chart 8Expect The USD To Be Less##BR##Determinant For Oil Prices The persistent negative correlation between oil prices and the USD broke down following the global asset sell-off in 1Q16. However, this relationship converged to its long-term equilibrium in recent months. In our view, this reflects market participants' increasing conviction - expressed in market-cleared prices - that OPEC 2.0 will maintain its supply-management accord for an extended period, and that supply is now stabilizing. With demand remaining robust as the global synchronized upturn continues, the fundamental side of price determination has stabilized, and financial variables once again will strongly influence oil prices at the margin. Given our view the USD will trade off interest-rate differentials going forward, and our expectation that U.S. rates are set to increase relative to other systemically important rates, the USD likely will appreciate over the next 12 months. This will be a headwind for oil prices, and may be an additional factor OPEC 2.0 member states have to account for in 2018. Bottom Line: We are raising our price forecast for 4Q17 and 2018 in line with our expectation for stronger global growth and continued strong compliance from OPEC 2.0. With markets getting tighter, we expect the USD to become more important to the evolution of oil prices in 2018. Ag Update: Stay Long Corn, Short Wheat Global grain fundamentals continue to be supportive to our long corn vs. short wheat position, recommended October 5. The USDA's latest WASDE are projecting higher 2017/18 ending wheat inventories, while corn and soybeans stock estimates were lowered (Chart 9).6 Chart 9Fundamentals Support Long Corn##BR##Vs. Short Wheat Trade The USDA lowered its expected global corn stocks-to-use ratio, and increased its wheat stocks-to-use ratio for the current crop year. Revisions to the estimates for the 2016/17 crop year also reflect similar dynamics. We expected this going into the WASDE report at the beginning of the month when we published our Special Report on the Ag markets, and got long corn vs. short wheat. December 2017 corn futures traded on CME are up 0.14% since October 5, while wheat futures are down 1.36%. This brings the return on our long corn/short wheat trade to 1.5%, to date. Highlights from the current WASDE include: Upward revisions to wheat production from India, the EU, Russia, Australia, and Canada more than offset greater projected global demand, most notably from India and the EU. Overall, global ending stocks were revised up by 4.99mm MT, and are projected to stand at 268mm MT by the end of the 2017/18 marketing year. Greater projected corn demand, most notably from the U.S. and China, more than offset the ~ 6mm MT upward revision to global production in the USDA's estimates. Higher projected Chinese demand reflects greater food and seed demand, and higher expected industrial use. Corn stocks are expected to end 2017/18 at 200.96mm MT - 1.51mm MT below September projections. Similarly, in its October Chinese Agricultural Supply and Demand Estimates, China's Agriculture Ministry increased its forecast for the 2017/18 corn deficit to 4.31mm MT from 0.89mm MT projected last month. The Ministry expects lower output and greater consumption on the back of stronger demand from ethanol plants.7 Furthermore, in a move towards market pricing, Heilongjiang - China's top corn province - will be reducing the subsidy it gives corn farmers from 153.92 yuan/mu last year to 133.46 yuan/mu. The province will reorient its subsidies to incentivize more soybean production.8 In soybean markets, USDA projections for ending stocks were reduced by 1.48mm MT to 96.05mm MT by end-2017/18, largely on the back of lower expected U.S. and Brazilian inventories in 2016/17. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Assistant HugoB@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Will Extend Cuts To June 2018," published September 21, 2017. It is available at ces.bcaresearch.com. 2 Please see "Precious Metals Update," in the June 29, 2017 issue of BCA Research's Commodity & Energy Strategy Weekly Report "EM Trade Volumes Continue Trending Higher, Supporting Metals". It is available at ces.bcaresearch.com. 3 Please see S&P Global Platts OPEC Guide published October 6, 2017. 4 Please see Chapter 1 of the IMF's World Economic Outlook for October 2017, which is available online at https://www.imf.org/en/Publications/WEO/Issues/2017/09/19/world-economic-outlook-october-2017. 5 Our base case continues to call for an end-June 2018 extension of the OPEC 2.0 production deal. Should the deal be extended to end-December 2018, we estimate 2018 WTI prices would average $67.35/bbl, while Brent prices would average just under $70.00/bbl. We are becoming increasingly confident OPEC 2.0 will become a durable production-management coalition, given the increasing cooperation and mutual investment between KSA and Russia. We will be exploring this further in future research. Please see "King Salman Goes To Moscow, Bolsters OPEC 2.0," published October 11, 2017, by BCA Research's Energy Sector Strategy. It is available at nrg.bcaresearch.com. 6 Please see Commodity & Energy Strategy Special Report titled "Ags In 2017/18: Move To Neutral," dated October 5, 2017, available at ces.bcaresearch.com. 7 Please see "China Raises Forecast For 2017/18 Corn Deficit On Lower Output," dated October 12, 2017, available at reuters.com. 8 Please see "Top China Corn Province Cuts Subsidy For Farmers Growing the Grain," dated October 16, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016
Highlights Year One Performance: The GFIS recommended model bond portfolio returned 1.1% (hedged into USD) in its first year of existence, slightly underperforming the custom benchmark index by -2bps. Our bearish duration tilts were a drag on performance, while our overweights to U.S. corporate debt were a major contributor. Risk Management Lessons: The maximum overweight to low-beta, but low-yielding, Japanese Government Bonds was a drag on performance by reducing the portfolio yield. This highlights the classic bond management trade-off between controlling portfolio risks, like duration or tracking error, and maximizing sources of return, like interest income. Future Drivers Of Returns: Over the next 6-12 months, we expect the model portfolio returns to again benefit mostly from our below-benchmark duration stance (as global bond yields grind higher) and from our overweight stance on U.S. corporates (as the U.S. economy maintains a solid pace of growth). Feature In September of 2016, we introduced a new element to the BCA Global Fixed Income Strategy (GFIS) service - our recommended model bond portfolio.1 This represented a bit of a departure from the usual macroeconomic analysis and forecasting of financial markets that has been the hallmark of BCA. Yet we felt that it was important to add an actual portfolio, with specific allocations and weightings, given the needs and constraints faced by our readers. With so many of our clients being traditional fixed income managers (or multi-asset managers) who measure investment performance versus benchmark indices, we felt that it was important to have a way to communicate our views within a framework akin to what they deal with each day. Even for clients who are not professional bond managers, the model portfolio can be useful as a way to express how much we prefer one bond market (or sector) versus others. It also gives us a forum to discuss portfolio management issues as an addition to the macro analysis. So far, the reception from clients to this new addition to the GFIS service has been a warm one, and we look forward to additional feedback in the months and years ahead. With the model portfolio just passing its first birthday, we are dedicating this Weekly Report to an overview of the final Year One performance numbers. We will evaluate our winning and losing recommendations, look back at the lessons learned as the model portfolio framework has evolved, and identify what we expect will be the biggest drivers of performance in Year Two based on our current views. Year One Model Portfolio Performance: Winners & Losers Chart 1GFIS Model Portfolio Performance The GFIS model portfolio produced a total return of 1.09% (hedged into U.S. dollars) over first full year since inception on September 20, 2016 (Chart 1). This essentially matched the performance of our custom benchmark index, with the model portfolio lagging by a mere -2bps.2 In terms of the breakdown between government bonds and credit (spread product), the former underperformed the benchmark by -18bps while the latter outperformed by +16bps. A more traditional period to evaluate investment performance is on a calendar year-to-date basis. We also show the 2017 year-to-date (YTD) numbers in Chart 1, measured from January 1st to October 3rd. Over that time period, the total returns are much higher - the model portfolio has returned 2.78%, lagging the index by -6bps. This higher absolute return is mostly due to the strong outperformance of corporate bond markets and the decline in government bond yields seen since March. Broadly speaking, that breakdown of returns lines up with what were our largest strategic market calls: to be underweight overall portfolio duration and overweight U.S. corporate bond exposure (bottom panel). This is obviously a welcome property to see in our returns, which we hope will always line up with our desired tilts! When looking at the detailed decomposition of the returns on the government bond side of the portfolio (Table 1), however, a few points stand out: Table 1A Detailed Breakdown Of The GFIS Model Portfolio The underperformance on the government bond side of the portfolio (Chart 2) came from underweight positions at the long-end (maturities beyond seven years) of yield curves in the U.S. (-4bps), U.K. (-5bps), Germany (-5bps) and, most notably, France (-18bps). Chart 2GFIS Model Portfolio Government Bond Performance Attribution By Country The underweight position in Italy, across the curve, generated another -7bps of underperformance, although this was paired against an overweight to Spanish government bonds that positively contributed to returns (+3bps). Overweights to bonds in the middle and shorter ends of yields curves (maturities less than seven years) positively contributed to returns in the U.S. (+6bps), Germany (+2bps) and France (+2bps). Our significant overweight to Japanese government bonds, intended as a way to reduce portfolio duration by increasing exposure to a market with a low beta to global bond yields, also helped boost performance (+8bps). The conclusion? By concentrating our recommended duration underweights on longer-maturity bonds, and raising the weightings on shorter-maturity government debt, we imparted a bearish curve steepening bias on top of the reduced duration exposure. It is no surprise that our recommended government bond allocations underperformed during the bull-flattening move in global yield curves seen earlier this year. By contrast, the returns on the credit (spread) product allocations within the GFIS model portfolio tell a more positive story (Chart 3): Chart 3GFIS Model Portfolio Spread Product Performance Attribution The outperformance came from our overweight allocations to U.S. Investment Grade (IG) corporate debt, focused on Financials (+14bps) and Industrials (+4bps), and U.S. High-Yield (HY), concentrated on Ba-rated (+13bps) and B-rated (+8bps) bonds. U.S. Mortgage-Backed Securities (MBS) were a laggard during the first year of the model bond portfolio (-12bps), which largely came from an ill-timed tactical move to overweight in the 4th quarter of 2016. More recently, our underweight stance on MBS has been only a modest drag on the total return of the portfolio since the peak in U.S. bond yields back in March. Our decisions to reduce exposure to Euro Area IG (-5bps) and HY (-2bps) corporate debt earlier in the year, and our more recent decision to downgrade Emerging Market (EM) sovereign (-1bp) and corporate debt (-4bps), were both small negative contributors to performance. Summing it all up, our spread product allocations performed well because of the overweight to U.S. IG and HY corporates. The underweights in Euro Area and EM credit were set up as relative value allocations versus U.S. equivalents, so the underperformance versus the benchmark should be viewed against the substantial outperformance from U.S. corporates. The MBS underperformance was small on a YTD basis, but we see an opportunity for that to soon turn around, as we discuss later. Bottom Line: The GFIS recommended model bond portfolio returned 1.1% (hedged into USD) in its first year of existence, slightly underperforming the custom benchmark index by -2bps. Our bearish duration tilts were a drag on performance, while our overweights to U.S. corporate debt were a major contributor. Lessons Learned On Risk Management As the first year of the GFIS model portfolio progressed, we added elements to the framework to help us manage the overall risk of the portfolio. Specifically, we began to include a tracking error calculation to show the relative volatility of the portfolio to its benchmark.3 When we first introduced that tracking error back in April, we were running far too little risk in the portfolio given the relatively modest position sizes (Chart 4). Rather than be an "index hugger", we decided to increase the sizes of all our relative tilts (Chart 5), and the tracking error rose accordingly from a mere 25bps to over 60bps. This is still below the 100bps limit that we decided to impose on the relative volatility of the model portfolio, but we were comfortable not running less-than-maximum risk given that valuations on many spread products were not extraordinarily cheap. The time to max out a risk budget is early in the credit cycle when spreads are wide, not when the cycle is far advanced and spreads are relatively tight. Yet one lesson that was learned in Year One was that too much focus on tracking error can result in lost opportunities to boost the performance of the portfolio. As part of our strategic call to maintain a below-benchmark overall duration stance, we upgraded Japan to maximum overweight in the model portfolio back on July 4th.4 With Japanese Government Bonds (JGBs) having such a low beta to yield changes in the overall Developed Markets (Chart 6), adding more Japan exposure was a way to get more defensive on duration in a way that would also boost our desired tracking error (since we were adding more of an asset less correlated to the other government bonds in the portfolio). Chart 4Tracking Error Of##BR##The Model Portfolio Chart 5Allocations Between##BR##Government Bonds & Spread Product Chart 6Are JGBs The##BR##Optimal Duration Hedge? Yet by increasing the allocation to low-beta JGBs, we were also adding exposure to "no-yield" JGBs. The overall yield of the model portfolio suffered as a result, fully offsetting the bump to the portfolio yield from the increase in allocations to spread product in April (Charts 7 & 8). With the benefit of hindsight, increasing the allocation even more to something like U.S. HY corporate bonds would have a been a more prudent way to redirect government bond exposure to a low-beta market that would have boosted the overall portfolio yield (Chart 9). Chart 7Too Much Japan##BR##In The Portfolio ... Chart 8... Offsetting The Yield Pick-Up##BR##From Spread Product Chart 9There Is Not Enough Yield##BR##In The Model Portfolio Going forward, we will pay more attention to managing the portfolio yield more actively as another piece of our model bond portfolio framework that can help boost expected returns. Bottom Line: The maximum overweight to low-beta, but low-yielding, Japanese Government Bonds was a drag on performance by reducing the portfolio yield. This highlights the classic bond management trade-off between controlling portfolio risks, like duration or tracking error, and maximizing sources of return, like interest income. The Outlook For The Next Year Looking towards the next twelve months, the biggest expected drivers of returns in our model bond portfolio are expected to come from the following allocations: Below-benchmark overall duration exposure: We are sticking to our guns on the future direction of global bond yields, which have more room to rise over the next 6-12 months. The coordinated global economic upturn is showing little sign of slowing, with leading indicators still rising and pointing to upward pressure on real bond yields (Chart 10). At the same time, inflation expectations in the developed economies remain too low relative to current levels of inflation (bottom panel). Thus, we expect government bond yield curves to bear-steepen as central banks will respond slowly to the rise in inflation. This will benefit the steepening bias we have in the model portfolio from the underweights in longer maturity buckets in the U.S., Europe and the U.K. (Chart 11). Chart 10Future Drivers Of Performance:##BR##Below-Benchmark Duration Chart 11An Unexpected##BR##Bull Flattening This Year Overweight U.S. corporate bonds (both IG and HY): Looking over the indicators from our U.S. Corporate Bond Checklist, the backdrop is not yet pointing to a period of expected underperformance for U.S. corporates (Chart 12). While balance sheet fundamentals do appear stretched, as indicated by our Corporate Health Monitor (2nd panel), the overall stance of U.S. monetary conditions is neutral (3rd panel), while bank lending standards are not yet restrictive (4th panel). We expect the Fed to deliver another 25bp rate hike in December, and at least another 2-3 hikes in 2018, which will shift monetary conditions into more restrictive territory. A very rapid rise in the U.S. dollar would worsen this trend, but we expect only a moderate grind higher in the greenback as the Fed slowly delivers additional rate hikes and non-U.S. growth remains robust. While the solid global economic backdrop should benefit all growth-sensitive assets like corporate debt, we see more attractive relative valuations on U.S. corporates versus Euro Area or EM equivalents. The upcoming tapering of asset purchases by the European Central Bank (ECB) also represents a major risk to Euro Area corporate debt, as the ECB will be slowing the pace of its corporate bond buying. One other sector that can potentially boost the portfolio performance in Year Two versus Year One is U.S. MBS. Our colleagues at our sister service, U.S. Bond Strategy, now see MBS valuations as looking attractive to other U.S. spread product like IG corporates (Chart 13).5 The relative option-adjusted spreads (OAS) on MBS and U.S. IG are a good leading indicator of the relative performance of the two asset classes and current spread levels should lead to a better return profile for MBS over IG. Another factor benefitting MBS is the continued rising trend in U.S. bond yields (and mortgage rates) that we expect over the next 6-12 months, which will reduce mortgage prepayments that would weigh on MBS returns (bottom panel). Chart 12Future Drivers Of Performance:##BR##Overweight U.S. Corporates Chart 13Upgrade U.S. MBS##BR##To Neutral This week, we are upgrading our MBS allocation to neutral from underweight in our model portfolio. However, given that our allocations to U.S. corporates are already fairly significant, we are choosing to "fund" the MBS upgrade by lowering our weighting on U.S. Treasuries (see the model portfolio allocations on Page 14). Bottom Line: Over the next 6-12 months, we expect the model portfolio returns to again benefit mostly from our below-benchmark duration stance (as global bond yields grind higher) and from our overweight stance on U.S. corporates (as the U.S. economy maintains a solid pace of growth). We are also now more constructive on valuations on U.S. MBS, thus we are upgrading our allocation to neutral at the expense of U.S. Treasuries. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Model Special Report, "Introducing Our Recommended Global Fixed Income Portfolio", dated September 20th, 2016, available at gfis.bcaresearch.com. 2 The GFIS model portfolio custom benchmark index can most simply be described as the Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very highly-rated spread product. We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 3 Please see BCA Global Fixed Income Strategy Special Report, "Adding A Risk Management Framework To Our Model Bond Portfolio", dated June 20th 2017, available at gfis.bcareseach.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Central Banks Are Now Playing Catch-Up", dated July 4th 2017, available at gfis.bcaresearch.com. 5 Please see BCA U.S. Bond Strategy Weekly Report, "Dollar Watching: Yet Another Debate", dated October 10th 2017, available at usbs.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Appendix - Selected Sectors From The GFIS Model Portfolio Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Duration: The global economic recovery is more synchronized than at any time since 2011. This suggests that foreign demand will be less of an impediment to the bond bear market and that Treasury yields will rise once U.S. data start to surprise on the upside. Stay at below-benchmark duration. MBS: Agency MBS option-adjusted spreads have widened significantly and no longer look expensive. With Treasury yields moving higher and mortgage refinancings likely to stay depressed, we advise upgrading MBS from underweight to neutral. Economy & Inflation: The U.S. economic data are starting to outperform beaten-down expectations. Survey data point to further GDP acceleration in the second half of this year and we expect inflation will soon follow growth higher. Feature Chart 12-Factor Treasury Model The relationship between the global breadth of economic growth, the value of the dollar and the outlook for Treasury yields has been a running theme in this publication.1 To summarize, stronger global growth pressures bond yields higher (and vice-versa). But how that growth is distributed across different countries matters as well. For example, if global growth is mostly concentrated in the U.S., then yield spreads will widen between the U.S. and the rest of the world and the dollar will appreciate as money pours in from overseas. Investors then respond to a stronger dollar by downgrading their U.S. growth and rate hike expectations. This caps the upside in long-dated U.S. Treasury yields. Conversely, if global growth is more evenly spread out throughout the world, then the dollar will come under less upward pressure when U.S. growth accelerates and Treasury yields can rise further. We developed a simple two-factor model to show how the trade-off between global growth and the exchange rate impacts the U.S. 10-year Treasury yield (Chart 1). The model uses the Global Manufacturing PMI as its proxy for global growth and a survey of bullish sentiment toward the dollar as its proxy for growth synchronization. So far this year, the Global PMI has moved higher and sentiment toward the dollar has become less bullish. Both developments have bond-bearish implications and our model now pegs fair value for the 10-year Treasury yield at 2.65%, 28 bps above the current 10-year yield. In Sync The Global PMI came in at 53.2 in September, the same as in August, but still a strong reading compared to recent history (Chart 2). But the most stunning detail of the September PMI releases is that 33 out of the 36 countries we track had PMIs above the 50 boom/bust line. As a result, our Global PMI Diffusion Index hit 90% for only the second time since 2011 (Chart 2, panel 1). The elevated reading of our diffusion index leads us to two market related observations. First, stronger growth outside of the U.S. explains why the 10-year Treasury yield is only 8 bps lower than at the start of the year despite U.S. economic data that have severely undershot expectations (Chart 2, bottom panel). Second, it suggests that when U.S. economic data inevitably start to surprise on the upside - a process which is only now beginning (see Economy & Inflation section below) - the dollar will appreciate by less than it would have when our PMI diffusion index was near 50. This removes a huge impediment from the bond bear market. In Chart 3 we see that the recent peak in 7-10 year U.S. bond yields occurred at 2.54% on Dec 16th. On that same date the spread between 7-10 year U.S. bond yields and average 7-10 year yields in the rest of the world was 178 bps, and bullish sentiment toward the dollar was above 80%. With the global recovery now more synchronized than it was last year, we anticipate that by the time U.S. yields take out that prior peak, the yield spread and dollar bullish sentiment will still be lower than they were last December. This means that less foreign capital will be encouraged into the U.S. and yields will rise even further. Chart 2Broad Based Recovery Chart 3Spreads Less Of A Constraint Where Is Growth Coming From? Considering the major economic blocs, the biggest change during the past year has been the surging Eurozone PMI (Chart 4). The U.S. PMI is still firmly above the 50 boom/bust line but has actually moderated in 2017. The Japanese PMI is similarly entrenched above 50 and while the Chinese PMI was weak earlier this year, it has rebounded during the past four months. At roughly 20%, China carries the largest weight in the Global PMI. The outlook for the Chinese economy is therefore crucial for the path of bond yields. On that note, while the Chinese PMI has been strong in recent months, a couple of warning signs are beginning to flash (Chart 5). Chart 4Global Manufacturing PMIs Chart 5Chinese Monetary Conditions Commodity prices - which correlate strongly with Chinese PMI - have declined since early September, although they remain above levels seen last year and do not yet pose a major risk. What's more important is that monetary conditions are starting to tighten (Chart 5, panel 2). If tighter monetary conditions persist, then we should expect growth to slow. The mild tightening in monetary conditions that has already occurred will probably lead to some near-term moderation in Chinese growth. But our China Investment Strategy service thinks it's unlikely that monetary conditions will tighten enough to cause a meaningful slowdown.2 Our China strategists note that with GDP growth within the government's target range, inflation exceedingly low and signs that financial excesses have been reigned in, there should not be much appetite for draconian policy tightening. We would also add that the causes of this year's tightening in monetary conditions have been relatively benign. The monetary conditions index shown in Chart 5 has fallen because the trade-weighted RMB is no longer depreciating and because real interest rates have moved a tad higher. Crucially, the RMB has only stabilized, it is not appreciating in trade-weighted terms. Also, the nominal policy rate remains flat at a low level. The increase in real interest rates resulted purely from weaker consumer price inflation. Bottom Line: The global economic recovery is more synchronized than at any time since 2011. This suggests that foreign demand will be less of an impediment to the bond bear market and that Treasury yields will rise once U.S. data start to surprise on the upside. Stay at below-benchmark duration. Buy The News In MBS Last week we upgraded our allocation to Agency MBS from underweight to neutral, noting that spreads had become more attractive during the past few months. In all likelihood this is the result of the market pricing in the wind-down of the Fed's balance sheet.3 With the Fed's plans now well known (and unlikely to change), there is an opportunity to increase MBS exposure from a more attractive starting point. After having sold the rumor, we think it's time to buy the news. The Value Proposition Chart 6OAS Look Attractive To be clear, we are not forecasting stellar excess returns from Agency MBS. But with spreads compressed across the entire U.S. fixed income universe, we would note that the option-adjusted spread (OAS) differential between conventional 30-year Agency MBS and investment grade corporate bonds (in duration-matched terms) has risen back to levels last seen in 2014 (Chart 6). The lagged OAS differential is a decent predictor of relative returns between MBS and corporate credit, and at current levels it suggests that MBS could even outperform corporate bonds at some point during the next 12 months (Chart 6, panel 2). This year's decline in Treasury yields has also biased OAS differentials between MBS and corporate bonds wider. Because of negative convexity, MBS duration is positively correlated with yields (Chart 6, bottom panel). If yields rise from here, as we expect they will, then MBS duration will also extend. This means that MBS OAS will start to appear less and less attractive relative to duration-matched comparables. In other words, MBS are less likely to cheapen relative to other spread product in an environment of rising Treasury yields. The Drivers Of MBS Spreads A simplified formula for excess MBS returns, relative to duration-matched Treasuries, could be written as follows: Excess Return = Starting OAS - Duration*(Change in nominal spread) + 0.5*Convexity*(Change in yield) 2 That is, OAS is the correct measure of MBS carry because it adjusts for expected losses due to prepayments. However, it is the change in the nominal spread (not the OAS) that will determine capital gains and losses during the investment horizon. On that note, we observe that nominal MBS spreads have rarely been tighter during the past 30 years (Chart 7). However, it is also hard for us to see a catalyst for significantly wider nominal spreads during the next 6-12 months. The two factors that correlate most closely with nominal MBS spreads are credit spreads and mortgage refinancings. Chart 7Nominal MBS Spreads Are Driven By Credit Spreads And Refinancings On credit spreads, we have repeatedly outlined why they are unlikely to widen materially in the absence of more significant inflationary pressure.4 As for refis, we are also hard pressed to see much upside for three main reasons: First, changes in mortgage rates are the number one driver of refinancings (Chart 8). Refis only increase when mortgage rates fall, making the proposition of refinancing more attractive. As yields rise during the next 6-12 months, refis will stay low. Second, the distribution of outstanding mortgages across the coupon stack impacts how sensitive refis are to changes in rates. The second panel of Chart 8 shows our measure of "moneyness", aka the dispersion of outstanding mortgages around the current coupon rate.5 Given today's dispersion levels we can calculate that even if the current coupon mortgage rate falls back to its recent low of 2.24%, our measure of moneyness would not get back to its late-2016 peak. For our moneyness indicator to rise back to 2013 levels the current coupon mortgage rate would have to fall all the way to 1.68%. Needless to say, we would characterize that risk as low. Third, the final factor that can impact the pace of mortgage refinancing is the seasoning of outstanding mortgages. Typically, we think of mortgages between 30 and 60 months old as being the most likely to refinance. Given that net mortgage origination was close to zero between 30 and 60 months ago and that mortgage purchase applications were at multi-year lows (Chart 9), most of the outstanding mortgage universe probably falls outside of this zone. Chart 8Refis Will Stay Low Chart 9Most Mortgages Are Not Yet Seasoned Bottom Line: Agency MBS option-adjusted spreads have widened significantly and no longer look expensive. With Treasury yields moving higher and mortgage refinancings likely to stay depressed, we advise upgrading MBS from underweight to neutral. Economy & Inflation Bring On The Upside Surprises As was alluded to in the opening section of this report, after have disappointed expectations year-to-date, we are just now starting to see U.S. economic data surprise to the upside (see Chart 2). The most recent datapoints that caught our eye were the ISM manufacturing and non-manufacturing PMIs.6 Our inclination is to mostly ignore last Friday's employment report as an outlier due to the recent hurricanes.7 The ISM non-manufacturing survey jumped to 59.8 in September, its highest level since 2005. Taken together with other survey indicators that tend to track GDP growth - the BCA Beige Book Indicator and the BCA Composite New Orders Indicator - the case is quite strong for further GDP acceleration in the third and fourth quarters (Chart 10). Of course the pressing issue for bond markets is whether that growth acceleration translates into higher inflation. On that note, we would suggest that the weak inflation we have seen during the past six months was a reaction to the growth slowdown witnessed in 2015 and the first half of 2016. The stronger ISM manufacturing index, in particular, sends a powerful signal that inflation is poised to put in a bottom (Chart 11). Chart 10Survey Indicators Of U.S. Growth Chart 11Inflation Lags Growth Bottom Line: The U.S. economic data are starting to outperform beaten-down expectations. Survey data point to further GDP acceleration in the second half of this year and we expect inflation will soon follow growth higher. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: Another Update", dated January 31, 2017, available at usbs.bcaresearch.com 2 Please see China Investment Strategy Special Report, "On A Higher Note", dated October 5, 2017, available at cis.bcaresearch.com 3 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Return Of The Trump Trade", dated October 3, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down", dated September 26, 2017, available at usbs.bcaresearch.com 5 For each coupon bucket in the Bloomberg Barclays Conventional 30-year Agency MBS index we calculate the squared deviation between its coupon and the current coupon rate. We then weight those squared differences by the market capitalization of each coupon bucket. 6 These are different than the Markit PMI that is included in our 2-factor Treasury model. 7 Please see BCA Daily Insights, "U.S. Jobs Report: All Noise, No Signal", dated October 6, 2017, available at din.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Slowing global money growth, export orders, and a downgrade in earnings revisions of cyclical relative to defensive equities points to a mild slowdown in non-U.S. growth. This slowdown is not worrisome, but could become so if the U.S. dollar rallies significantly. This risk should be kept in mind by investors. Short AUD/USD at 0.79 ¢. EUR/USD is trading at a premium and is over-owned. Conditions are emerging for investors to upgrade their view of the Fed relative to the ECB. EUR/USD has downside risk. Feature Chart I-1Global Growth Is Booming The world economy is on a roll. Nearly all of the world's PMI indexes are in expansionary territory, suggesting we are experiencing a rare global synchronized expansion. A key bellwether of global trade, Korean exports, are surging at a 35% annual rate, confirming that the global economy is very strong (Chart I-1). When all looks great, it is the ideal time to wonder what could go wrong. At this point, the greatest risk to this global expansion may be the dollar. A strengthening dollar would tighten global financial conditions, especially for EM borrowers, and exacerbate the impact of yellow flags that have already emerged. Yellow Flags Investors are in an ebullient mood these days, and for good reason: global growth is strong, and global policy is still very accommodative, even if some central banks have begun removing support for their economies. However, three yellow flags have emerged that in our view warrant some caution. To be clear, these are not grave signs and we do not foresee either a U.S. or a global recession until late 2019 at the earliest. With this in mind, what are the worrying signs that investors should monitor right now? The first yellow flag comes from global money supply growth. Narrow money has decelerated from a 12% annual growth rate to 9% today. Historically, this has been a leading indicator of global industrial production, global export growth and commodity prices (Chart I-2). While the surge in money growth in 2016 and 2017 was a key reason behind the rebound in global economic activity, especially outside the U.S., its recent slowdown points to an end of the economic upswing, though admittedly not toward a cataclysm. The second yellow flag comes from the U.S. ISM release. While the general tone of the report remains extremely positive, the export component has been in a downtrend since June. The key determinant of export growth for any country tends to be the vigor of its trading partners. Hence, it is not surprising that softness in the export component of the U.S. ISM manufacturing survey tends to be associated with weakening global trade and industrial activity (Chart I-3). The third yellow flag comes from earnings revisions. The earnings revision ratios of cyclical relative to defensive equities in the U.S. and globally have sharply rolled over. While still in positive territory, this development has historically been an early signal that improvements in global growth metrics are ebbing, a signal being flashed today (Chart I-4). Chart I-2Money And Global Growth: ##br##From Tailwind To Headwind Chart I-3A Blemish In An Otherwise##br## Bright Picture Chart I-4EPS Revisions: Cyclicals Have Turned ##br##Vis-A-Vis Defensives Bottom Line: The global economy is experiencing a synchronized upswing, which has left investors in an ebullient mood. However, slowing global money growth, ebbing export sentiment and weakening earnings revisions for cyclical relative to defensive equities suggest this broad-based upswing has reached its zenith. While a mild deceleration is likely to materialize soon, these indicators constitute yellow flags, not red ones. Conditions are still not in place to expect a major global growth slowdown. The Dollar Holds The Key While the factors above point to a mild slowdown, they do not yet indicate a dearth of growth that could prompt panic among investors, especially in the EM space. For this scenario to become reality, another ingredient is needed. In our view, this ingredient is a strong dollar. To begin with, the relationship between global growth and the dollar is well known in the investor community. When global growth is strong and broad-based, the dollar depreciates; when global growth is weak, the dollar appreciates (Chart I-5). The U.S. is a relatively closed economy, and is less exposed to global growth developments than the euro area, Japan or commodities producers (Chart I-6). Thus, when the global economy is in an upswing, the U.S. garners a smaller dividend than the rest of the world. Conversely, when the global economy hits a soft patch, the U.S. suffers less. Chart I-5Strong Global Growth Coincident ##br##With A Weak Dollar Chart I-6The U.S. Is Less Exposed ##br##To Global Growth Factors But the chain of causation is not only from growth to the dollar. The trend in the dollar also affects the trend in global growth. This is because in aggregate, the world remains short the dollar. According to the BIS, there is $27 trillion dollars of foreign-currency liabilities in the world, $14 trillion of which is denominated in U.S. dollars, with an extremely large proportion issued by EM borrowers. When the dollar weakens, the cost of borrowing among companies and banks that finance themselves in USD decreases, incentivizing further borrowing. This eases global liquidity conditions and decreases the cost of financing global trade, leading to increased economic activity and profits as well as expanding global capex. Meanwhile, when the dollar rises, the balance sheet of those foreign firms and governments that have borrowed in U.S. dollars becomes increasingly illiquid, resulting in strong headwinds for additional borrowing, curtailing economic activity, profits and capex. This explains why the dollar and commodities prices, the latter being extremely sensitive to growth and global capex, have displayed such a strong negative relationship over different time periods (Chart I-7). Chart I-7Rising USD Equals Declining Liquidity And Declining Commodity Prices Thanks to these dynamics, the weakness in the dollar this year has been a major boost to growth for the global economy. As Chart I-8 illustrates, the large easing in EM financial conditions was indeed related to the U.S. dollar's weakness. Therefore, as growth momentum could be peaking, a period of renewed strength in the greenback might inflict further damage to a key buttress of EM growth. Moreover, this time around, Chinese policymakers are unlikely to come to the rescue of the global economy as they did in 2015 and 2016. Back then, China was experiencing a deflationary spiral: producer prices were contracting at a 6% annual pace, profits were in free fall and outflows were growing exponentially. The People's bank of China and the central government pulled all the stops, increasing lending and fiscal expenditures and tightening capital controls. Monetary conditions eased massively (Chart I-9). Chart I-8The Falling Dollar Supported Global Growth Chart I-9Tightening Chinese Monetary Conditions Last weekend, the PBoC announced targeted cuts to reserve requirement ratios for banks extending lending to small companies. According to our China Investment Strategy sister publication, this is not a major easing.1 Instead, these are targeted measures aimed at helping small firms that are currently dependent on the predatory lending rates available in the shadow banking sector. Meanwhile, access to credit by large state-owned enterprises and the real estate sector will continue to be slowly curtailed. The mutation of deflation into inflation and the recovery of profit growth imply that China does not currently need the same shot to the arm that it did in 2015 and 2016. Thus, it is unlikely the country will initiate another round of massive credit easing that will boost investment by SOEs and the construction sector, the two main sources of capex and commodities demand. In an environment where global money growth has rolled over and where China is unlikely to press on the gas pedal as hard as it did two years ago, a strong dollar would thus have a nefarious impact on global financial conditions, global growth, and, in turn, EM currencies and commodities currencies. While we remain very negative on the yen for now, the Japanese currency could benefit from a meaningful slowdown in international growth, as such a slowdown would likely exert downward pressure on global bond yields, including in the U.S. Obviously, the rally in the USD will have to be much more pronounced than what has been experienced in the past month before its negative impact on growth begins to be felt in bond yields and the yen. Thus, we remain long USD/JPY for now. The AUD could prove to be a key victim of the developments highlighted above. The AUD is highly levered to global growth and EM financial conditions. Moreover, it is now very expensive on a long-term basis, having overshot terms of trade by a very significant margin (Chart I-10). Adding to the vulnerability in the Aussie, the Australian economy has been incapable of generating any inflationary pressures. The output gap remains very deep, the level of underemployment is still at a 37-year high, and wages continue to hover near record lows, limiting the capacity of the Reserve Bank of Australia to tilt to a hawkish stance (Chart I-11). Yet, investors expect rates to be 42 basis points higher 12 months from now. Finally, speculators are currently very long the AUD. Thus, we will use any rebound above 0.79 to short the AUD/USD, setting a limit-sell at this level with a target at 0.73. Chart I-10The AUD Is Vulnerable Chart I-11Litle Inflationary Pressures In Australia Bottom Line: While the three yellow flags highlighted do not represent a terminal danger to global growth, a stronger dollar at the hands of tightening global financial conditions, especially in EM economies, would be a much bigger threat to the global economy. We do anticipate the dollar to strengthen over the coming 12 months, but it will take a significant move before the USD puts enough of a brake on global growth to hurt global yields. We therefore remain positive on the USD/JPY. However, with this risk lurking in the background, we are implementing a short position on the AUD, a currency that is both expensive and over-owned, and underpinned by an economy full of slack. An Update On EUR/USD We continue to expect some downside to EUR/USD over the remainder of the year. As we have already highlighted, the euro has greatly overshot its implied interest rate parity (IRP) relationships. Our intermediate-term time model - an enhanced IRP model accounting for short- and long-term real rate differentials, global risk aversion, commodities prices and the trend in the pair - shows that EUR/USD remains near its largest premium to fair value since 2009. Confirming this assessment, the euro has also overshot its equilibrium implied by the level of interest rates five years out (Chart I-12). Valuations offer some insight on the potential size of the euro move, but they offer very little information in terms of timing. Instead, we should rely on technical and macro considerations. On this front, we have already highlighted that speculators are currently net long the euro by the largest margin since 2011. Philosophically, we often look at the euro as the anti-dollar, a highly liquid inverse bet on the dollar. Since EUR/USD constitutes 57.6% of the DXY, a short bet on this dollar index and a long bet on the euro are similar wagers. Currently, the sum of both bets is at a level normally followed by sharp drops in EUR/USD, suggesting that euro buying is hitting exhaustion levels (Chart 13). Meanwhile, with investors having very few short bets on the euro, especially when compared to the large stock of short bets on the DXY, a short squeeze in favor of the USD could emerge if European data disappoints relative to the U.S. (Chart I-13, bottom panel). Chart I-12Downside In EUR/USD Chart I-13Tactical Risk To EUR/USD On the macro front, a few developments have caught our eye. We are entering the window where based on historical lags, the euro area's industrial production is likely to start feeling the pain of the common currency's previous strength (Chart I-14). Compounding this worry for euro longs, euro area earnings revisions are lagging those in the U.S. by the greatest margin since 2014, suggesting the euro's strength has sapped some of the euro area's vigor and is in the process of redistributing it to the U.S. economy. Historically, this has led to a period of weakness in EUR/USD (Chart I-15). Chart I-14The Strong Euro ##br##Will Soon Be Felt Chart I-15Falling Relative EPS Revisions ##br##Equals A Weaker EUR/USD Confirming this insight are relative financial conditions. Euro area financial conditions have been tightening relative to the U.S. since the beginning of 2016 - a move that has become especially pronounced this year. The euro area's inflation outperformance vis-à-vis the U.S. this year was first and foremost a reflection of the previous easing in relative European financial conditions (Chart I-16). Thanks to these strong relative inflation dynamics, investors have brought forward the first rate hike expected from the ECB, while simultaneously removing interest rate hikes out of the U.S. OIS curve. This move has been wildly euro bullish. However, the window of opportunity for this bet is closing; the tightening in European financial conditions now points to a reversal in relative inflation, with U.S. prices set to now take the lead over the euro area. This could force a repricing of the Fed relative to the ECB, implying that monetary divergences could once again play against EUR/USD. Catalonia is not a reason to be bearish on the euro. Marko Papic, BCA's Chief Political Strategist, argues that the northeastern region is unlikely to leave Spain.2 The vast majority of Catalonia still favors remaining part of Spain (Chart I-17). Moreover, the region has received immigrants from the rest of the country for many decades, reflecting its superior economic performance. As a result, only 31% of the population speaks Catalan as a first language. In aggregate, the independentists' victory last weekend only reflects a low turnout rate, as individuals who opposed leaving Spain stayed at home, like they did in 2014. Chart I-16The Fed Will Be Repriced ##br##Against The ECB Chart I-17Will Of The People: ##br##Catalonia Will Stay In Spain Bottom Line: The euro will exhibit downside risk in the coming months. EUR/USD is trading well above its fair value implied by its IRP relationship. Additionally, euro buying has hit nosebleed levels, and the dollar is unloved. Moreover, the euro's recent strength could begin to negatively affect growth, especially as European earnings revisions have collapsed versus the U.S. Finally, financial conditions point to a fall in euro area inflation relative to the U.S., highlighting the risk that the policy path for the Fed could be upgraded against that of the ECB. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see China Investment Strategy Special Report, titled "On A Higher Note", dated October 5, 2017, available at cis.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, titled "Is King Dollar Back?", dated October 4, 2017, and Geopolitical Strategy Monthly Report, titled "The Geopolitical Risks For The Equity Bull Market", dated May 14, 2014 at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S data has been strong this week: Markit and ISM Manufacturing PMIs beat expectations at 53.1 and 60.8 respectively; ISM Prices Paid rose sharply to 71.5 from 64.0; Markit Services and ISM Non-Manufacturing PMIs also beat expectations at 55.3 and 59.8 respectively; ADP employment change and continuing and initial jobless claims also came out better than expected; The DXY has rebounded meaningfully after a string of stronger data and growing hopes on the fiscal policy front recently. Bond markets have picked up on these developments, with the 10-year yield rising 30 basis points from its bottom last month. However, stronger U.S. inflation is needed in order for the greenback to meaningfully rally. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data has been mixed: The latest headline and core inflation readings for the euro area were weaker than expected, at 1.5% and 1.1% respectively; German retail sales also underperformed expectations, however, German unemployment rate decreased; Euro area manufacturing PMI also underperformed, while the services PMI outperformed; Euro area producer prices beat expectations, coming in at 2.5%. With U.S. data outperforming, the euro has softened versus the greenback, but has not displayed similar movements against other currencies. While it is true that European inflation is higher than a year ago, it is still not near the ECB's target. A stronger euro would further restrict inflationary pressures, which would be a cause for concern for ECB officials. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Japanese data has been mixed the past weeks: The jobs/applicants ratio came in at 1.52, underperforming expectations and decreasing from the previous month. Additionally, retail trade and overall housing spending yearly growth both disappointed, coming in at 1.7% and 0.6% respectively. However, on the bright side, Nikkei Manufacturing PMI outperformed expectations, coming in at 52.9. Overall, we continue to be bullish on USD/JPY, as yields in the U.S. will continue to rise vis-à-vis Japanese ones. Economic data has been tepid, and wages continue to contract or remain flat, even if some underlying pressures are slowly emerging. Furthermore we expect that the BoJ will continues its extreme measures of yield curve targeting in order to spur inflation expectations. Nevertheless, the yen could appreciate against carry currencies like the AUD or NZD if Chinese monetary conditions become tight enough. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Markit services PMI outperformed expectations coming in at 53.6, and increasing from last month's reading However, Markit manufacturing PMI came in under expectations at 55.9, and decreased from last month. Moreover Construction PMI unperformed, coming in at 48.1, the lowest level since July 2016. We would lean against any further strength of the pound against the U.S. dollar. The risks associated with Brexit still looms in the background, while data has been mixed, particularly when it comes to consumption and the housing market. Additionally, the market has already fully priced a rate hike by December. Thus, it seems that any good news for the pound are already in the price, as the BoE certainly has little incentives to follow a hawkish policy beyond removing its post-Brexit emergency measures. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was mixed: AiG Performance of Manufacturing Index decreased to 54.2 from 59.8; TD Securities Inflation came in at 2.5%, down from 2.6%; HIA New Home Sales increased by 9.1% MoM in August, up from the 15.4% contraction in July; Building permits are still contracting 15.5% annually, but better than the expected 16.2% contraction. This week, the RBA decided to leave rates unchanged at 1.5%. The monetary policy statement focused on the lack of wage pressures in the Australian economy and on the higher exchange rate, which is "expected to contribute to continued subdued price pressures in the economy", as well as "weighing on the outlook for output and employment", stating further that "an appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast." Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Last week the RBNZ decided to leave rates unchanged at 1.75%. The RBNZ continued with its dovish slant, arguing that monetary policy will remain accommodative for a considerable period. An important development, however, is that the central bank toned down its cautious tone about the kiwi. In previous instances, the RBNZ had been very aggressive in stating that the NZD was too expensive and an adjustment was needed. However, in its most recent statement the RBNZ was much less aggressive in its rhetoric, highlighting the fall in the NZD. Overall, we believe that the NZD will continue to have upside against the AUD, as domestic inflationary pressures are much stronger in New Zealand than in Australia. Meanwhile, global developments, such as a downturn in the Chinese industrial cycle would affect Australia much more than New Zealand. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was mixed: Industrial product price grew at a 0.3% monthly pace, less than the expected 0.5%; Raw materials increased by 1%, above the expected 0.3%; GDP stagnated in July on a monthly basis, below the expected 0.1% growth; Merchandise trade slipped even further into a deficit from CAD 2.6 bn to CAD 3.41 bn. Furthermore, Governor Poloz's September 27 speech sent the CAD tumbling, stating that "monetary policy will be particularly data dependent" and that it could be "surprised in either direction". Probability of a hike in October and December declined from 48% to 23%, and 75% to 63%, respectively. While growth is robust, inflation has been declining since January, which may be a cautious sign for the BoC. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Data in Switzerland has outperformed to the upside: The KOF Leading Indicator outperformed expectations, coming in at 105.8 and increasing from last month's reading. The SVME Purchasing Manager's Index also outperformed, coming in at 61.7 Finally, headline inflation also outperformed expectations, with a reading of 0.7%, increasing from 0.5% on August. This recent strength in the Swiss economy is most likely reflective of the sharp appreciation that EUR/CHF has experienced in recent months. However, despite the increase in inflation, the Swiss economy is still too weak for the SNB to stop intervening in the foreign exchange market or to remove their ultra-dovish monetary measures. Once we see both headline and core inflation climb closer to their historical averages, we will reassess this view. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Data in Norway has been mixed: Register unemployment came in line with expectations at 2.5%, decreasing from last month's 2.7% reading. However the credit growth issued by national institutions in Norway, decreased since last month, coming in at 5.6%. Finally, both retail sales and real retail sales yearly growth came below expectations, coming in at -0.6% and 0.2% respectively. These few data points are interesting given that both retail and real retail sales growth dipped into contractionary territory. This shows that the Norwegian economy is still too weak to sustain a higher krone and higher rates. For this reason we continue to be bullish on USD/NOK. This cross is more correlated with rate differentials than with oil. Thus even if oil continues to rise, rising rates in the U.S. will still put upward pressure on USD/NOK. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The 11-year ruling governor of the world's oldest central bank, Stefan Ingves, will now sit at the helm of the Riksbank for five more years, until 31 December 2022. While Sweden's economy is still performing above par with CPIF at 2.3%, our bullish case for the SEK is under threat by the extension of the governor's term, who introduced negative interest rates to Sweden and who is consistently vigilant over the SEK's appreciation, even threatening intervention if needed. EUR/SEK appreciated 0.6% on the news, but has since given up some those gains as economic data in Sweden rebounded sharply. The Riksbank will still likely hike, but the timing is now in question. It is likely that the tightening cycle will now coincide with the ECB's tapering program, which will limit the SEK's appreciation for now. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades
Highlights Oil Breakout: Bond markets have been slow to discount the impact of higher oil prices on global inflation, which should lead to steeper yield curves and additional increases in inflation expectations. Trump Trade: The proposed U.S. tax cut plan will result in wider budget deficits and, potentially, faster U.S. inflation with the U.S. economy already near full employment. The Fed is likely to respond to this with even tighter monetary policy, although not by enough to flatten the Treasury curve by as much as is currently discounted. ECB Taper: The ECB will announce a slower pace of asset purchases at the policy meeting later this month, which should bear-steepen European yield curves via widening term premia on longer-dated debt. Feature A More "Normal" Bond Market Chart of the WeekLike Deja Vu All Over Again Global bond yields have bounced very sharply off the September lows. The benchmark 10-year U.S. Treasury yield hit a 3-month intraday high of 2.37% yesterday, while the 10-year German Bund yield touched 0.5% last week. Bond markets have returned to focusing on traditional fundamentals, like growth and inflation, after spending a few weeks worrying about nuclear tensions with North Korea and other political matters. On that note, the global economic news continues to point towards continued solid growth, rising inflation pressures and, in response, less accommodative monetary policy. There is scope for additional increases in bond yields, as markets are still pricing in too much pessimism on inflation and too little hawkishness from central bankers. The latter is especially true in the U.S. where the Federal Reserve is sticking with its plans to deliver another 100bps of rate hikes by the end of 2018 if its growth and inflation forecasts are realized. The odds of that happening would increase substantially if the Trump Administration can successfully deliver tax cuts, which would represent a very rare occurrence of a fiscal stimulus coming at a time of full employment in the U.S. The announcement last week of the Trump tax cut proposals did send a whiff of the old "Trump trade" dynamic through financial markets. The U.S. Treasury curve bear-steepened, the U.S. dollar rallied, inflation expectations rose and the S&P 500 blasted through the 2500 level to hit a new all-time high. Stocks of companies that pay higher tax rates outperformed, just like they did after the election of President Trump nearly one year ago (Chart of the Week). Add in some additional reflationary pressure from Brent oil prices approaching $60/bbl, and it is no surprise that yield curves in most Developed Markets (not just the U.S.) steepened. With this reflationary backdrop, amid tight labor markets and a solid pace of coordinated global growth, we continue to recommend fixed income investors maintain a defensive duration posture, while favoring spread product over government bonds. Yields will continue to rise in the next 6-12 months, but led more by the long-end initially. In particular, we expect government bond yield curves to extend the recent trend of bear-steepening, for three reasons: rising inflation expectations, increased optimism on U.S. fiscal policy and what it means for the Fed, and the upcoming announcement of a tapering of bond purchases by the European Central Bank (ECB). Are Bond Investors Too Complacent On The Inflationary Impact Of Higher Oil Prices? We have received a surprisingly small amount of criticism from the BCA client base about our bearish strategic view on global government bonds in recent months. Perhaps that is because our clients also have a negative opinion on duration risk. At our annual investment conference in New York last week, we conducted polls which showed that a majority of the attendees expect the 10-year U.S. Treasury yield to rise to between 2.5% & 3% by this time next year. At the same time, only 1 in 4 respondents felt that being short duration in U.S. Treasuries was the "contrarian" trade that was most likely to succeed over next 12 months - perhaps because betting on higher yields is not really a contrarian opinion right now! Yet we wonder how aggressively investors in aggregate, and not just BCA clients, are positioned for a rising yield environment. The market is only discounting 40bps of Fed rate hikes over the next twelve months, even as the U.S. economic data flow continues to improve and the Trump Trade is coming back in style (Chart 2). Survey data shows that professional bond managers are running only small duration underweights, yet speculators are still running very net long positions in Treasury futures. In other Developed Markets, there are not a lot of rate hikes priced outside of Canada - where the central bank actually is tightening policy - despite our Central Bank Monitors all calling for policymakers to become less dovish, if not more outright hawkish, as we discussed last week.1 In their defense, bond investors have had a lot of non-economic factors to digest in the past couple of months - not the least of which is judging how much of an "apocalypse premium" to price into bond yields given the nuclear saber rattling between D.C. and Pyongyang. Yet when stepping back away from the headlines and tweets, bond markets have been noting the implications of rising oil prices in a typical manner - higher inflation expectations and steeper yield curves. Oil prices have risen over $10/bbl since the June lows, led by a combination of rising demand on the back of an expanding global economy and a diminished supply response that has seen excessive inventories start to be wound down (Chart 3). BCA's commodity strategists have been expecting such a move to unfold, and prices have already risen into the $55-60/bbl range (on Brent crude) that they were calling for towards year-end. While a move beyond $60/bbl is not currently expected, any additional upside surprises in global growth can only tighten the supply/demand balance in an oil-bullish direction. At a minimum, oil prices can consolidate recent gains, providing a floor to inflation expectations. Already, the breakeven rate on 10-year TIPS in the U.S. have risen 18bps off the June lows, which has prevented the slope of the Treasury curve from flattening even as the 2-year Treasury yield hit an 9-year high last week (Chart 4). We expect to see more bear-steepening of the Treasury curve in the next few months as realized inflation rates begin to grind higher and the Fed will be relatively slow to respond - they'll need to see the inflation pick up first before delivering more rate hikes. This will result in higher market-based inflation expectations (i.e. wider TIPS breakevens) as investors price in a greater chance that inflation will sustainably return to the Fed's 2% target. While oil is not the only factor that matters for U.S. inflation, it is a lot harder for investors to believe that core PCE inflation can rise to 2% without higher oil prices. Chart 2A Revival Of The Trump Trade? Chart 3A Bullish Supply/Demand Backdrop For Oil Chart 4Oil Vs. The U.S. Yield Curve A similar dynamic is taking place in other countries. Inflation expectations (linkers or CPI swaps) are rising alongside rising energy prices in the Euro Area (Chart 5), U.K. (Chart 6), Canada (Chart 7) and Australia (Chart 8). The moves in expectations are largest in countries experiencing stronger growth (the Euro Area and Canada), and more modest where growth is mixed (the U.K.) and where realized inflation is still very low (Australia). Yield curves have generally steepened in response to the reflationary rise in oil prices except for Canada, where the central bank has already delivered two surprise rate hikes over the summer and markets have priced in nearly three more hikes over the next year. Yet even there, global reflation will put steepening pressure on the Canadian yield curve without additional hawkishness from the Bank of Canada. Chart 5Oil Vs. The German Yield Curve Chart 6Oil Vs. The U.K. Yield Curve Chart 7Oil Vs. The Canada Yield Curve Chart 8Oil Vs. The Australia Yield Curve Japan, as always, remains the outlier to global trends. While oil prices have been rising even in yen terms, inflation expectations have remained subdued and the JGB yield curve has stayed flat (Chart 9). With the Bank of Japan targeting a 0% yield on the benchmark 10-year JGB as part of its current monetary policy framework, the link between energy prices, inflation expectations and the slope of the yield curve will remain broken in Japan. This makes JGBs a very low-beta government bond market, and we continue to recommend an overweight stance on Japan given our bias toward a defensive portfolio duration posture. Chart 9Oil Vs. The Japan Yield Curve Net-net, we see oil as continuing to provide a steepening, reflationary bias to global bond yields in the next few months, as the impact of the rise in energy prices feeds through into faster rates of headline inflation. How central banks respond will determine what curves do beyond that but, for now, the bias is towards steeper curves. Bottom Line: Bond markets have been slow to discount the impact of higher oil prices on global inflation, which should lead to steeper yield curves and additional increases in inflation expectations. How Will The Trump Tax Plan Impact The Treasury Curve? Ask The Fed Another factor that will put steepening pressure on global yield curves, especially in the U.S., is the likelihood of the Trump fiscal stimulus coming to fruition. The White House has chosen to refocus its policy efforts on getting aggressive tax cuts implemented. This is low-hanging fruit for a president that needs a legislative victory after fighting a losing battle on health care reform. Last week, the latest Trump tax plan was unveiled, which is centered on delivering large cuts on corporate taxes, reducing the number of personal income tax brackets, eliminating many large tax deductions, allowing companies to fully expense investment spending at an accelerated rate, and introducing a territorial tax system that would exempt U.S. corporate taxes on the foreign earnings of U.S. companies. The Tax Policy Center unveiled its initial assessment of the Trump tax plan last Friday, which is expected to reduce U.S. federal tax revenue by $2.4 trillion over the next ten years and another $3.2 trillion in the following decade.2 The White House is betting on so-called "dynamic scoring" of the tax plan to recoup some of that lost revenue via higher economic growth, although that is filled with unrealistic expectations to prevent an unwanted surge in federal deficits. More likely, the Trump plan would result in a major increase in federal budget deficits over the next decade, similar to the levels estimated by Moody's last year in its own analysis of the Trump fiscal platform.3 In Chart 10, we show how periods of widening federal budget deficits typically coincide with periods of U.S. Treasury curve steepening. Usually, this is merely the business cycle at work, with deficits widening during economic downturns as tax revenues plunge and counter-cyclical government expenditure increases. What is also at work is the monetary policy cycle, with the Fed delivering rate cuts during recessions when the output gap is widening and inflation pressures are diminishing, thus bull-steepening the yield curve. Chart 10Forwards Pricing Too Much UST Curve Flattening Yet the current Trump tax proposal comes at a time when the U.S. economy is operating close to full employment with the output gap essentially closed (middle panel). This means that any impetus to U.S. economic growth from the fiscal easing can cause inflation pressures to build up in a manner different than typical periods of widening budget deficits. This should initially impart steepening pressures on the Treasury curve, but in a bearish fashion via higher longer-term inflation expectations. However, the eventual path for the Treasury curve will be determined by how much the Fed responds to the fiscal easing via tighter monetary policy. Typically, the slope of the Treasury curve is highly negatively correlated to the real fed funds rate (adjusted by headline inflation), with a higher real rate coinciding with a flatter curve and vice versa (bottom panel). Right now, the market is discounting only a modest rise in real U.S. policy rates, looking at the difference between forward Overnight Index Swap (OIS) rates and forward CPI swap rates. That market-implied "real rate" is expected to stay in a modest range between 0% and 1% until well into the next decade. The Fed is also forecasting a rise in the real funds rate to 0.75%, but over a much faster time horizon - within two years - than the market. This is in the context of U.S. core inflation sustainably returning to the Fed's 2% target, which will allow the Fed to eventually raise rates to its current "terminal" rate projection of 2.75%. Thus, when simply eyeballing the relationship between real rates and the slope of the curve in Chart 10, the risk is that real rates will be higher than the market expects over time, and the Treasury curve will be flatter, all else equal. Yet when looking at the slope of the Treasury curve that is currently priced into the forwards, as shown in the bottom panel of Chart 10, a substantial flattening is already discounted over the next decade. Admittedly, the correlation between the real funds rate and the slope of the curve has changed over past decades, and the curve can likely be flatter for a lower level of real yields than in years past. Yet, even allowing for that, the market does seem to be discounting a very aggressive rise in real interest rates over the coming decade - one that is unlikely to be realized unless the Fed delivers a much higher path of interest rates then they are currently projecting. Which brings us back to the Trump fiscal stimulus. If the corporate tax cuts do provide a boost to economic growth next year via increased investment spending and hiring activity, in a way that also overheats the U.S. economy and boosts core inflation, then the Fed may be forced to raise rates at a faster pace than planned. This would result in a much flatter yield curve and would raise the risks of a recession in 2019, which is a scenario we think is highly plausible, especially if there is a change at the top of the FOMC. Late last week, it was revealed that President Trump had interviewed several candidates for the position of Fed Chair. Former Fed governor Kevin Warsh and current governor Jerome Powell were the names that caught the market's attention. Warsh has been a vocal critic of the Fed's slow unwind from the unusual post-crisis monetary policies, and is thus considered a monetary hawk who would want to raise rates higher, and faster, than the current FOMC. Powell is more pragmatic and would likely maintain the status quo at the Fed. The possibility of a more hawkish Fed chair has shown up in online prediction markets, where the "prices" of candidates that are perceived to be more hawkish (Warsh, John Taylor) rose while the prices of the more dovish candidates (Janet Yellen, Gary Cohn) fell (Chart 11). Right now, the online punters have Warsh in the lead, but the intraday "trading" has been volatile. The intersection of U.S. fiscal policy and monetary policy will be critical to determine the future path of U.S. bond yields over the next year. Right now, it appears that there is too much flattening priced into the Treasury curve relative to the expected path of the funds rate and inflation, as the Fed is unlikely to raise real rates much beyond their current projections. That could change if the Trump tax cuts can deliver a faster pace of productivity growth and higher equilibrium real interest rates. Although the post-war history of the U.S. shows that tax cuts by themselves do not raise the potential growth rate of the economy unless they lead to a major increase in investment spending, and even then the impact takes years to be seen (Chart 12). Chart 11Will The Next Fed Chair Be A Hawk? Chart 12Tax Cuts Do Not Always Boost Growth For now, we think it makes more sense to bet against the substantial flattening in the forwards by positioning for a steeper Treasury curve. Bottom Line: The proposed U.S. tax cut plan will result in wider budget deficits and, potentially, faster U.S. inflation with the U.S. economy already near full employment. The Fed is likely to respond to this with even tighter monetary policy, although not by enough to flatten the Treasury curve by as much as is currently discounted. ECB Tapering: Steepening Yield Curves Through The Term Premium The other major factor that should steepen global yield curves in the next several months is the expectation of a change in policy from the ECB. The central bank has been gently preparing the market since the early summer for a shift to a less accommodative policy stance, in response to robust economic growth and slowly rising core inflation (Chart 13). A decision on the changes to the asset purchase program will take place at the October 26th ECB policy meeting. This will involve a reduction in the monthly pace of bond buying and, likely, some guidance as to when the asset purchase program will end. A change in short-term interest rates is highly unlikely before the bond purchases have been fully tapered, as this would go against the current forward guidance from the ECB that states that interest rates will remain at low levels well after the purchases have stopped. As we have discussed throughout this year, we see the ECB having no choice but to begin tapering its asset purchase program. The deflationary tail risks from 2014/15 have faded and, perhaps more importantly, the ECB is running into operational constraints on which bonds it can continue to buy. A likely outcome will be an announcement that the pace of bond buying will slow from the current €60bn/month to least ½ of that pace starting in January 2018. At mid-year, the policy will likely be reevaluated and, if the economy has not slowed materially and/or inflation rolled over, a full tapering of the bond buying would be announced, ending at the end of 2018 or in the first quarter of 2019. A rate hike would not take place until late 2019, which is where the market is currently priced. In the absence of rate hikes, most of the impact on Euro Area bond yields from the tapering will come from a widening of the term premium on longer-maturity bonds. If the pace of growth slows to zero, this could result in the benchmark 10-year German Bund yield returning all the way back to 1% (bottom two panels). This would still be a very low yield by historical standards, in line with structurally lower growth rates and high government debt levels in Europe. But the path to that 1% yield would be very damaging for bond returns as Euro Area yield curves bear-steepen. While the link between our estimates of the term premiums in the major developed markets is not airtight, there has been a loose correlation between them during the post-crisis "quantitative easing" era (Chart 14). If recent history is any guide, a slower pace of ECB bond buying should coincide with steeper global yield curves, all else equal. All else is likely NOT equal, as an unruly response of risk assets and currency markets to a tapering could alter the likely path of growth and inflation expectations and, eventually, interest rates. But, at this moment, an ECB taper is more likely to result in steeper global yield curves. Chart 13An ECB Taper Will Result In##BR##Higher Term Premia In Europe... Chart 14...And Perhaps In Other##BR##Bond Markets, As Well Bottom Line: The ECB will announce a slower pace of asset purchases at the policy meeting later this month, which should bear-steepen European yield curves via widening term premia on longer-dated debt. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "BCA Central Bank Monitor Chartbook: The Less Dovish Rhetoric Is Justified", dated September 26th 2017, available at gfis.bcaresearch.com. 2 http://www.taxpolicycenter.org/sites/default/files/publication/144971/a_preliminary_analysis_of_the_unified_framework_0.pdf 3 https://www.economy.com/mark-zandi/documents/2016-06-17-Trumps-Economic-Policies.pdf Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of September 29th, 2017. The model sharply reduced its allocation to the U.K. to a bare minimum in response to the tightening in liquidity condition as the Bank of England warned of a rate hike in "coming months." The funds are reallocated to the Spain and Germany. Other smaller changes are the reductions in Italy and Australia in favor of Sweden and Switzerland, as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed its benchmark by 44 bps in September. Both level 1 and level 2 models performed well, with level 2 outperforming its benchmark by 63 bps and level 1 outperforming its benchmark by 9 bps, as the underweight in Australia, U.S. and Japan versus the overweight in Italy, Germany and Netherland worked very well. Since going live in January 2016, the overall model has outperformed the benchmark by 341 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 743 bps. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of September 30, 2017. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live The model continues to be optimistic on global growth as seen by an increasing allocation to cyclical sectors. Additionally, the model has also reduced its underweight on consumer discretionary stocks, which is currently the only cyclical sector to have a below-benchmark allocation. Finally, the biggest shift was a downgrade in utilities from overweight to underweight. This was primarily driven by momentum. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com