Monetary
Executive Summary Liquidity Will Shrink Further In Hong Kong The HKD is facing its most critical test in several decades. While the peg is likely to survive (Feature Chart), the economic costs for Hong Kong SAR will be far reaching. Critically, monetary policy in Hong Kong SAR is being tailored behind a hawkish Fed, while economic ties with China increasingly warrant easier policy settings. This tug of war will be resolved via a reset in domestic spending and asset prices. Equity shares have been the first shoe to drop. Real estate values and consumer spending will be next. A hypothetical delinking of the peg will see the HKD depreciate since it is expensive on a real effective exchange rate basis. Longer term, the rising use of the RMB in Hong Kong SAR will render the peg a relic. It will also fit with China’s aims to internationalize the RMB.. Bottom Line: The HKD peg is likely to survive in the near term, but the economic repercussions from maintaining the linked exchange-rate system will trigger a rethinking by the Hong Kong Monetary Authority (HKMA) and mainland authorities. Eventually, HKD could be replaced by the CNY. For now, HKD interest rates are slated to rise further, which will have ramifications for domestic spending and asset prices. Feature Chart 1HKD Has Been Tracking Interest Rates The Hong Kong dollar (HKD) has been trading on the weak side of its convertibility band since May. In theory, this suggests there is intense pressure for the peg to be delinked, which should lead to a much weaker exchange rate. In practice, interest rates in Hong Kong have failed to keep up with the surge in US rates, which has led to widening interest rate differentials between Hong Kong and the US. As a result, investors have embarked on a massive carry trade, funding USD purchases with HKDs (Chart 1). HKD’s weakness has raised questions about whether the exchange rate could face a crisis of confidence. This will be a severe blow to the HKMA whose sole role is currency stability, with the HKD being the underlying bedrock of Hong Kong’s financial system. In this report, we suggest that the HKD will survive this crisis, just as it has navigated previous shocks since 1983. The brunt of the adjustment will be domestic, first from Hong Kong equities, but spreading to real estate and consumer spending. Longer term, the HKD might become a relic as transactions in Hong Kong are increasingly conducted in RMB. Will The Peg Be Sustained? Historically, currency pegs more often than not fail. Specific to the HKD, the peg is facing its most critical test in decades but is likely to survive for a few reasons. First, every HKD that the region of Hong Kong has ever printed is backed by USD reserves, to the tune of 1.8 times. Quite simply, FX reserves are much higher than the Hong Kong monetary base (Chart 2). This suggests the HKMA’s “convertibility promise” remains credible. Second, Hong Kong also ranks favorably when looking at the ratio of broad money supply to FX reserves. Every 42.3 cents of broad money creation can be backed by foreign currency, a ratio much higher than China and on par with Singapore (Chart 3). With a monetary base fully backed by FX reserves and a broad money-to-FX reserve ratio largely in line with other linked exchange rate systems, our bias is that the peg will remain in place at least over a cyclical horizon (12-18 months). Chart 2In Theory, The HKMA Can Defend The Peg Chart 3The HKMA Ranks Favorably To The PBoC This credibility will come at a huge cost to the domestic economy, however. By having a fixed exchange rate system and an open capital account, Hong Kong has given up control over domestic monetary policy. Consequently, it must import monetary policy from the US. As interest rates rise in the US, demand for US dollar deposits from Hong Kong concerns goes up, putting downward pressure on the exchange rate. To maintain the convertibility ratio, the HKMA must drain the system of Hong Kong dollars to lift domestic interest rates. This is quite visible not only from the drop in foreign exchange reserves, but also the drawdown in the aggregate balance of domestic banks parked at the HKMA (Chart 4). From May 11 through August, the HKMA has absorbed a total of HKD 213 billion, shrinking the aggregate balance in the banking system by more than 60%. Chart 4Liquidity Will Shrink Further In Hong Kong Historically, the aggregate balance has had to drop much more to restore an equilibrium between interest rates in the US and Hong Kong SAR. The implication is that liquidity will continue to be drained from the system to ultimately defend the peg, and local interest rates will rise. There is one important caveat: Hong Kong SAR’s net international investment position stands at 580% of GDP, much higher than broad money supply. As such, the Hong Kong SAR does not have a solvency problem. What it faces is too much domestic liquidity, which is pushing HKD interest rates lower (Chart 5). Chart 5The HKD Is Facing A Liquidity, Rather Than A Solvency Crisis Ramifications Of The USD Peg When the HKD was tied to the US dollar in 1983, it made economic sense. Hong Kong SAR’s economy was more linked via trade to the US, compared to China (Chart 6). As such, stability vis-à-vis the US dollar was a vital appeal for traders, financiers, and all industries tied to the Hong Kong hub. Since then, there has been a tectonic shift in economic dependence. Exports to China now account for almost 60% of the total, while those to the US have fallen well below 8%. Quite simply, Hong Kong SAR still imports monetary policy from the US, while it is increasingly dependent on the Chinese economy. Nonetheless, there have been a few adjustments. The use of the RMB in Hong Kong SAR has been gradually gaining momentum. RMB deposits have risen to over HKD 800bn. As a share of narrow money supply (M1), it is almost 50% (Chart 7). There are also over 140 licensed banks in Hong Kong allowed to engage in RMB-based business. Chart 6Hong Kong And China Are Tied To The Hip Chart 7Hong Kong Is Transitioning Into A Defacto RMB System These links extend beyond just banking turnover. First introduced in 2014, the southbound trading links between China and Hong Kong SAR have become a major conduit for mainland investors to gain exposure to foreign firms. The China-Hong Kong stock connect has now handled over 2.6tn RMB in cumulative flows. This represented as high as 40% of the equity turnover in Hong Kong SAR (Chart 8). Capital account transactions have also been progressively relaxed, and the issuance of RMB bonds has been rising rapidly since 2008. Chart 8Lots Of Financial Links Between The HKD and RMB Hong Kong SAR’s strengthening ties with China comes with some good news. The increase in Chinese domestic liquidity is lowering the cost of capital for local enterprises. At the same time, it might also be fuelling very low domestic interest rates, forcing locals to chase higher rates elsewhere. This does not affect the peg if people sell the RMB to buy other currencies, including the dollar or maybe even the HKD. The bad news is that Hong Kong has now become a high-beta play on China as both economies are inexorably interlinked. Chart 9 shows that consumers in Hong Kong SAR tend to have much more volatile spending patterns compared to China, especially when economic growth is about to slow. One reason is that Hong Kong concerns are highly levered notably to the property market (Chart 10). For example, the debt service ratio in Hong Kong SAR sits at 32% of disposable income, much higher than China or other indebted economies (Chart 11). This makes the economy very vulnerable to rising interest rates. Chart 9Hong Kong Is Economically More Volatile Than China Chart 10Hong Kong Cannot Escape A Hard Landing (Part 1) Chart 11Hong Kong Cannot Escape A Hard Landing (Part 2) The bottom line is that as the HKMA withdraws domestic liquidity, this will reassert downward pressure on business activity and asset prices, particularly real estate. With private consumption a whopping 65% of GDP, household deleveraging will also prove to be a formidable headwind for domestic spending. Outside interest rates, Hong Kong SAR remains a trade hub. If global trade slows down meaningfully, this will lead to a deterioration in the current account. This triple whammy from slowing global trade, rising interest rates and consumer deleveraging could prove indigestible for Hong Kong assets. Policy Options Chart 12The Government Could Bail Out Hong Kong As highlighted above, the HKD peg will remain in place for the foreseeable future, but this will come at a huge cost. The advantage of the HKD peg is that the choice of the nominal anchor, the US dollar, renders it credible. As a financial hub, this is crucial for Hong Kong. Meanwhile, such an anchor also imposes fiscal discipline since government deficits cannot be monetized by money printing. In the case where the government tries to be profligate, the rise in inflation will lower real rates and lead to capital outflows. This will force the HKMA to sell US dollars and absorb local currency. Indeed, over the past several years, government debt in Hong Kong has been close to nil (Chart 12). The drawback of a fixed exchange-rate regime is that Hong Kong SAR has relinquished control over independent monetary policy. Such a union was justified when the economic cycles between the US and Hong Kong SAR were in sync, but now the region needs easier policy settings. The roadmap of the late 1990s could be what is in store for Hong Kong SAR. In short, the peg survived but the region went through a severe internal devaluation. During the Asian crisis, property prices fell by more than 60%. If that were to occur today, it would herald a prolonged period of high unemployment and stagnant wages to realign the region’s competitiveness with its trading partners. Hong Kong SAR stocks have already borne the brunt of an internal adjustment and are trading at very cheap multiples (Chart 13). The MSCI Hong Kong stock index is composed of mostly financials (47% of market cap) and property stocks (21% of market cap). As HKD rates are rising, loan growth in Hong Kong SAR is contracting and net interest margins have collapsed (Chart 14). This does not bode well for the near-term performance of financials. Chart 13Markets Have Already Discounted A Pessimistic Scenario For Hong Kong Shares Chart 14Banks In Hong Kong Are Facing A Tough ##br##Reckoning The good news is that similar to the late 1990s, banks are unlikely to go bust. Hong Kong SAR banks are well capitalized and delinquency rates are quite low, suggesting a banking crisis is unlikely to be a source of pain for the HKD peg (Chart 15). In fact, Hong Kong SAR banks rank favorably among their global peers in terms of capital adequacy (Chart 16). Chart 15Banks In Hong Kong Are Well Capitalized (Part 1) Chart 16Banks In Hong Kong Are Well Capitalized (Part 2) Specific to the currency, Hong Kong is also running recurring current account surpluses. This is boosting its FX reserves (Chart 17). That lends credibility to the peg in the near term. The bad news is that as the domestic economy slows down, and global trade comes close to a standstill, these surpluses could evaporate. One cost to Hong Kong is that the peg to the US dollar has made HKD incrementally expensive. Our model shows that the real effective exchange for HKD is about 2.5 standard deviations above fair value (Chart 18). Our view on the US dollar is that we could see depreciation over a 12-to-18-month horizon, but an overshoot in the near term is quite likely. A drop in the US dollar will help realign competitiveness in the HKD. Meantime, the market has also been pushing the currency towards the weaker side of its convertibility band. Chart 17Balance Of Payments Remain Favorable For The HKD Chart 18The HKD Is Expensive Longer term, as Hong Kong SAR continues to become more entwined with China, a peg to the CNY will make sense. This process will be the initial step in the region’s official embrace of the RMB system. That said, the process will be gradual since the US dollar remains very much a reserve currency, and the relevance of Hong Kong SAR as a financial center hinges upon easy access to the USD. What is more likely is that any re-pegging to the RMB will come many years down the road, when the yuan has become a fully convertible currency. The de-pegging of the HKD from the USD or adjusting the peg is as much a political discussion as an economic one. Political conditions for this change are not yet present given such a change will have major ramifications for the economy of Hong Kong SAR and will likely also reverberate through financial asset prices. One can imagine a scenario where HKD yields are forced to adjust to a new nominal anchor. Investors have been convinced through almost 30 years of history to treat the HKD as a proxy for the US dollar. That said, the economic pain associated with maintaining the HKD-USD peg will ensure authorities accelerate the use of RMBs in Hong Kong, with a goal of eventually adopting the yuan as the de facto currency. Adopting a currency board akin to Singapore is another option that makes sense, especially since this would give the HKMA scope to link to cheaper currencies, such as the yen and euro. That said, this is unlikely to be politically palatable, especially for Beijing. A link to the yuan that already does this job makes sense. Finally, there is always the option to fully float the peg, but this would probably increase currency volatility. This is unlikely in the near term. The Goldilocks scenario for policymakers is when the US dollar eventually depreciates against major currencies, easing financial conditions for Hong Kong SAR concerns. This will dovetail nicely with the goals of the monetary authorities, maintain credibility while easing financial concerns for a very levered economy. Investment Conclusions The HKD peg will remain in place, but the financial dislocations will lead to significant internal devaluation in Hong Kong SAR. As US interest rates rise, the HKD will be under considerable pressure. The HKMA will have no choice but to allow HKD interest rates to rise. This will tip the property market and thrust the economy into deflation and a recession. Chinese bonds are the best hedge against this risk. Avoid property and financial shares for the time being. Were the peg to break today, the HKD will depreciate according to our valuation models. This suggests markets are right to push the HKD-linked rate towards the weaker end of the convertibility band. Despite the economic and financial pain, the HKMA will not abandon the peg. That means carry trades will continue to make money. Using the HKD as a funding currency still makes sense in the near term. In long run, the economic pain associated with maintaining the HKD-USD peg will make authorities in Beijing accelerate the use of the RMB in Hong Kong’s special administrative region. The eventual goal will be for Hong Kong SAR to adopt the yuan as its currency. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com
Listen to a short summary of this report Executive Summary GIS Projection For The EUR/USD We went long the euro early last week, as EUR/USD hit our buy limit price of $0.99. Despite a near cut-off of Russian gas imports, European gas inventories have reached 84% of capacity – above the 80% target that the EU set for November 1st. The latest meteorological forecasts suggest that Europe will experience a warmer-than-normal winter. This will cut heating usage, likely making gas rationing unnecessary. Currencies fare best in loose fiscal/tight monetary environments. This is what Europe faces over the coming months, as governments boost income support for households and businesses, while ramping up spending on energy infrastructure and defense. For its part, the ECB has started hiking rates. Since mid-August, interest rate differentials have moved in favor of the euro at both the short and long end. Rising inflation expectations make it less likely that the ECB will be able to back off from its tightening campaign as it did in past cycles. A hawkish Fed is the biggest risk to our bullish EUR/USD view. We expect US inflation to trend lower over the coming months, before reaccelerating in the second half of 2023. However, as the August CPI report highlights, the danger is that any dip in inflation proves to be shallower and shorter-lived than previously anticipated. Bottom Line: Although significant uncertainty remains, the risk-reward trade-off favors being long EUR/USD. Our end-2022 target is $1.06. Dear Client, I will be meeting clients in Asia next week while also working on our Fourth Quarter Strategy Outlook, which will be published at the end of the month. In lieu of our regular report next Friday, you will receive a Special Report from my colleague, Ritika Mankar, discussing the sources of US equity outperformance over the past 14 years and the likely path ahead. Best Regards, Peter Berezin, Chief Global Strategist It’s Just a Clown Chart 1Investors Are Bullish The Dollar, Not The Euro The scariest part of a horror movie is usually the one before the monster is revealed. No matter how good the special effects, the human brain can always conjure up something more frightening than anything Hollywood can dream up. Investors have been conjuring up all sorts of cataclysmic scenarios for the upcoming European winter. In financial markets, the impact has been most visible in the value of the euro, which has tumbled to parity against the US dollar. Only 23% of investors are bullish the euro at present, down from a peak of 78% in January 2021 (Chart 1). Conversely, 75% of investors are bullish the US dollar. More than half of fund managers cited “long US dollar” as the most crowded trade in the latest BofA Global Fund Manager Survey (“long commodities” was a distant second at 10%). As we discuss below, the outlook for the euro may be a lot better than most investors realize. While my colleagues, Chester Ntonifor, BCA’s chief FX strategist, and Mathieu Savary, BCA’s chief European strategist, are not quite ready to buy the euro just yet, we all agree that EUR/USD will rise over the long haul. Cutting Putin Loose Natural gas accounts for about a quarter of Europe’s energy supply. Prior to the Ukraine war, about 40% of that gas came from Russia (Chart 2). With the closure of the NordStream 1 pipeline, that number has fallen to 9% (some Russian gas continues to enter Europe via Ukraine and the TurkStream supply route). Yet, despite the deep drop in Russian natural gas imports, European natural gas inventories are up to 84% of capacity – roughly in line with past years and above the EU’s November 1st target of 80% (Chart 3). Chart 2Despite A Sharp Drop In Imports Of Russian Natural Gas… Chart 3...Europeans Managed To Stock Up On Natural Gas For The Winter Season Europe has been able to achieve this feat by aggressively buying natural gas on the open market. While this has caused gas prices to soar, it sets the stage for a retreat in prices in the months ahead. European spot natural gas prices have already fallen from over €300/Mwh in late August to €214/Mwh, and the futures market is discounting a further decline in prices over the next two years (Chart 4). Chart 4The Futures Market Is Discounting A Further Decline In Natural Gas Prices Chart 5Futures Prices Of Energy Commodities Provide Some Limited Information On Where Spot Prices Are Heading Follow the Futures? Futures prices are not a foolproof guide to where spot prices are heading. As Chart 5 illustrates, the correlation between the slope of the futures curve and subsequent changes in spot prices in energy markets is quite low. Nevertheless, future spot returns do tend to be negative when the curve is backwardated, as it is now, especially when assessed over horizons of around 12-to-18 months (Table 1). Table 1Energy Commodity Spot Price Returns Tend To Be Negative When The Futures Curve Is Backwardated Our guess is that European natural gas prices will indeed fall further from current levels. The latest meteorological forecasts suggest that Europe will experience a milder-than-normal winter (Chart 6). This is critical considering that natural gas accounts for over 40% of EU residential heating use once electricity and heat generated in gas-fired plants are included (Chart 7). Chart 6Meteorological Models Suggest Above-Normal Temperatures In Europe This Winter Chart 7Natural Gas Is An Important Source Of Energy For Heating Homes In The EU A warm winter would bolster the euro area’s trade balance, which has fallen into deficit this year as the energy import bill has soared (Chart 8). An improving balance of payments would help the euro. Europe is moving quickly to secure new sources of energy supply. In less than one year, Europe has become America’s biggest overseas market for LNG (Chart 9). A new gas pipeline linking Spain with the rest of Europe should be operational by next spring. Chart 8Soaring Energy Costs Have Pushed The Euro Area Trade Balance Into Deficit Chart 9Europe Is America's Largest LNG Customer In the meantime, Germany is building two “floating” LNG terminals. It has also postponed plans to mothball its nuclear power plants and has restarted its coal-fired power plants, a decision that even the German Green Party has supported. France is aiming to boost nuclear capacity, which had fallen below 50% earlier this summer. Électricité de France has pledged to nearly double daily production by December. For its part, the Dutch government has indicated it will raise output from the massive Groningen natural gas field if the energy crisis intensifies. Fiscal Policy to the Rescue On the policy front, European governments are taking steps to buttress household balance sheets during the energy crisis, with nearly €400 billion in support measures announced so far (and surely more to come). Although these support measures will be offset with roughly €140 billion of windfall profit taxes on the energy sector, the net effect will be to raise budget deficits across the region. However, following the old adage that one should “finance temporary shocks but adjust to permanent ones,” a temporary spike in fiscal support may be just what the doctor ordered. The last thing Europe needs is a situation where energy prices fall next year, but the region remains mired in recession as households seek to rebuild their savings. Such an outcome would depress tax revenues, likely leading to higher government debt-to-GDP ratios. Get Ready For a V-Shaped Recovery Stronger growth in the rest of the world should give the euro area a helping hand. That would be good news for the euro, given its cyclical characteristics (Chart 10). The European economy is especially leveraged to Chinese growth. It is likely that the authorities will loosen the zero-Covid policy once the Twentieth Party Congress concludes next month, and new anti-viral drugs and possibly an Omicron-specific booster shot become widely available later this year. That should help jumpstart China’s economy. More stimulus will also help. Chart 11 shows that EUR/USD is highly correlated with the Chinese credit/fiscal impulse. Chart 10The Euro Is A Cyclical Currency Chart 11EUR/USD Is Highly Correlated With The Chinese Credit & Fiscal Impulse All this suggests that the prevailing view on European growth is too pessimistic. Even if Europe does succumb to a technical recession in the months ahead, it is likely to experience a V-shaped recovery. That will provide a nice tailwind for the euro. Loose Fiscal/Tight Monetary Policies: The Winning Combo for Currencies Chart 12Fiscal Policy Has Eased Structurally In The Euro Area More Than In Other Advanced Economies A tight monetary and loose fiscal policy has historically been the most bullish combination for currencies. Recall that the US dollar soared in the early 1980s on the back of Paul Volcker’s restrictive monetary policy and Ronald Reagan’s expansionary fiscal policy, the latter consisting of huge tax cuts and increased military spending. While not nearly on the same scale, the euro area’s current configuration of loose fiscal/tight monetary policies bears some resemblance to the US in the early 1980s. Even before the war in Ukraine began, the IMF was forecasting a much bigger swing towards expansionary fiscal policy in the euro area than in the rest of the world (Chart 12). The war has only intensified this trend, triggering a flurry of spending on energy and defense – spending that is likely to persist for most of this decade. The ECB’s Reaction Function After biding its time, the ECB has joined the growing list of central banks that are hiking rates. On September 8th, the ECB jacked up the deposit rate by 75 bps. Investors expect a further 185 bps in hikes through to September 2023. While US rate expectations have widened relative to euro area expectations since the August US CPI report (more on that later), the gap is still narrower than it was on August 15th. Back then, investors expected euro area 3-month rates to be 233 bps below comparable US rates in June 2023. Today, they expect the gap to be only 177 bps (Chart 13). Real long-term bond spreads, which conceptually at least should be the more important driver of currency movements, have also moved in the euro’s favor. In the past, ECB rate hikes were swiftly followed by cuts as the region was unable to tolerate even moderately higher rates. While this very well could happen again, the odds are lower than they once were, at least over the next 12 months. Chart 13Interest Rate Differentials Have Moved In Favor Of The Euro Since Mid-August Chart 14Euro Area: Inflation Expectations Have Risen Briskly For one thing, median inflation expectations three years ahead in the ECB’s monthly survey have risen briskly (Chart 14). The Bundesbank’s own survey paints an even more alarming picture, with median expected inflation over the next five years having risen to 5% from 3% in mid-2021 (Chart 15). Expected German inflation over the next ten years stands at a still-elevated 4%. Whether this reflects Germans’ heightened historical sensitivity to inflation risks is unclear, but it is something the ECB cannot ignore. Structurally looser fiscal policy has raised the neutral rate of interest in the euro area, giving the ECB more leeway to lift rates. A narrowing in competitiveness gaps across the currency bloc has also mitigated the need for the ECB to set rates based on the needs of the weakest economies in the region. Chart 16 shows that collectively, unit labor costs among the countries most afflicted by the sovereign debt crisis a decade ago have completely converged with Germany. Chart 15German Inflation Expectations Are Elevated Chart 16Europe's Periphery Has Closed The Competitiveness Gap With Germany While Italy is still a laggard in the competitiveness rankings, the ECB’s new Transmission Protection Instrument (TPI) – which allows the central bank to buy sovereign debt with less stringent conditionality than under the Outright Monetary Transactions (OMT) program – should keep a lid on sovereign spreads. This, in turn, will allow the ECB to raise rates more than it otherwise could. Hawkish Fed is the Biggest Risk to Our Bullish EUR/USD View Chart 17Supplier Delivery Times Have Fallen Sharply Tuesday’s hotter-than-expected August US CPI report pulled the rug from under the euro’s incipient rally, pushing EUR/USD back to parity. We have been flagging the risks of high inflation for several years (see, for example, our February 19, 2021 report, 1970s-Style Inflation: Yes, It Could Happen Again). Our thesis is that inflation will follow a “two steps up, one step down” pattern. We are probably near the top of those two steps now, with the next leg for inflation likely to be to the downside, driven by ebbing pandemic-related supply side-dislocations. Perhaps most notably, supplier delivery times have fallen sharply in recent months (Chart 17). These pandemic-related dislocations extend to the housing rental market. Rent inflation dropped after rent moratoriums were put in place, only to rebound forcefully once the moratoriums were lifted and the labor market tightened. Although official measures of rent inflation will remain elevated for some time, owing to lags in how they are constructed, timelier data on new rental units coming to market already point to a sharp decline in rent inflation (Chart 18). This is something that the Fed is sure to notice. Ironically, falling inflation could sow the seeds of its own demise. Nominal wage growth is currently very elevated, yet because of high inflation, real wages are still shrinking. As inflation comes down, real wage growth will turn positive. This will lift consumer sentiment, helping to buoy consumption (Chart 19). A pickup in consumer spending will cause the economy to overheat again, leading to a second wave of inflation in the back half of 2023. Chart 18Timelier Measures Of Rent Inflation Have Rolled Over Chart 19Falling Inflation Will Boost Real Wages And Consumer Confidence As we discussed in our August 18th Special Report Dispatches From The Future: From Goldilocks To President DeSantis, the Fed will respond to this second inflationary wave by hiking the Fed funds rate to 5%. This will temporarily push up the value of the dollar, a process that will only stop once the US falls into recession in 2024 and the Fed is forced to cut rates again. Our projected rollercoaster ride for EUR/USD is depicted in Chart 20. We see the euro rising to $1.06 by year-end, peaking at $1.11 in the spring of 2023, falling back to $1.05 by late 2023, and then beginning a prolonged rally in 2024. Chart 20GIS Projection For The EUR/USD Chart 21The Dollar Is Very Overvalued Against The Euro Based On PPP Chart 21 shows that the dollar is 30% overvalued against the euro based on its Purchasing Power Parity (PPP) exchange rate. Thus, there is significant long-term upside to EUR/USD. Implications for Other Currencies and Regional Equity Allocation Chart 22Stock Markets Outside The US Tend To Fare Best When The Dollar Is Weakening The strengthening in the euro that we envision over the next six months or so will be part of a broad-based dollar decline. While BCA’s Foreign Exchange Strategy service sees more upside for the euro than the pound, GBP/USD will likely follow the same trajectory as EUR/USD. The yen is one of the cheapest currencies in the world and should finally gain some traction. If China abandons its zero-Covid policy and increases fiscal support for its economy, the RMB and other EM currencies should strengthen. Stock markets outside the US tend to fare best when the dollar is weakening. This includes Europe. As Chart 22 illustrates, there is a close correlation between EUR/USD and the relative performance of European versus US stocks. Thus, an above-benchmark exposure to international markets is appropriate during the coming months. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn & Twitter Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
In lieu of next week’s report, I will host the monthly Counterpoint Webcast on Thursday, September 22 (9:00 AM EDT, 2:00 PM BST). In this Webcast, I will discuss the near-term and longer-term prospects for all the major asset classes: stocks, bonds, sectors, commodities, currencies, and real estate. Please mark the date in your calendar, and I do hope you can join. Executive Summary Analysing the economy as the ‘non-linear system’ that it is leads to profound conclusions about how the economy and inflation are likely to unfold, and reveals that some outcomes are impossible to achieve. It is impossible to lift the unemployment rate by ‘just’ 1-2 percent. Therefore, it is impossible to depress wage inflation by ‘just’ 1 percent. The non-linear choice is to not depress wage inflation at all, or to make wage inflation slump. Presented with this non-linear choice, central banks will likely choose to make wage inflation slump, which will take core inflation well south of the 2 percent target within the next couple of years. The structural low in bond yields, the structural low in commodity prices, the structural high in stock market valuations, and the structural high in the US dollar are yet to come. It Is Impossible To Lift The Unemployment Rate By ‘Just’ 1-2 Percent Bottom Line: Inflation will slump to well below 2 percent within the next couple of years. Feature Our non-linear world often surprises our linear minds. If we discover that a small cause produces a small effect, we think that double the cause produces double the effect, and that triple the cause produces triple the effect. But in our non-linear world, double the cause could produce no effect, or half the effect, or ten times the effect. Just as important, in a non-linear world, some outcomes turn out to be impossible. In a non-linear system, some outcomes are impossible to achieve. As I will now discuss, analysing the economy as the non-linear system that it is leads to profound conclusions about how the economy and inflation are likely to unfold, and reveals that some outcomes are impossible to achieve. In A Non-Linear System, Some Outcomes Are Impossible A good physical example of a non-linear system that we can apply to inflation is to attach an elastic band to the front of a brick. And then to try pulling the brick across a table at a constant speed, say 2 mph. It’s impossible! First, nothing happens. The brick is held in place by friction. Then, at a tipping point of pulling, it starts to accelerate. Simultaneously, the friction decreases, self-reinforcing the acceleration to well above 2 mph. Meanwhile, your response – to stop pulling – happens with a lag. The result is that, the brick refuses to budge, and then it hits you in the face. Try as you might, it is impossible to pull the brick at a constant 2 mph (Figure 1 and Figure 2). Figure 1The Forces On A Brick Pulled By An Elastic Band Figure 2The Net Forces On A Brick Pulled By An Elastic Band In mathematical terms, the reduction in friction as the brick starts to move is known as ‘self-reinforcing feedback’. The lag in applying the brakes is called ‘delayed corrective feedback’. Their combined effect is to make it impossible to pull the brick at a constant 2 mph. Now, to model inflation, attach an elastic band to both the front and the back of the brick, and find a friend. Your task, ‘policy loosening’, is to accelerate the stationary brick to a steady 2 mph. The analogy being to run inflation at 2 percent. On the opposite side, your friend’s task, call it ‘policy tightening’, is what central banks are desperate to do now – to rein back an out-of-control brick heading towards your face at 10 mph. But without slowing it to a standstill, or worse, reversing direction. The analogy being to avoid outright deflation. You will discover that you can move the brick sharply forwards (and sharply backwards), but you cannot move it forwards at a steady 2 mph! The brick-on-an-elastic-band analogy explains why it is impossible for policymakers to run inflation at a constant 2 percent. Inflation either careers out of control, as now, or stays stuck below 2 percent, as it did through the 2010s. Inflation cannot run ‘close to 2 percent’. It Is Impossible To Lift The Unemployment Rate By ‘Just’ 1-2 Percent Central to the non-linearity of inflation is the non-linearity of the jobs market, in which some outcomes are impossible. Specifically, it has proved impossible to lift the unemployment rate by ‘just’ 1-2 percent. It has proved impossible to lift the unemployment rate by ‘just’ 1-2 percent. Through the past 75 years, whenever the US unemployment rate has increased by 0.6 percent, it has then gone on to increase by at least 2.1 percent from the trough. In no case has the unemployment rate risen by ‘just’ 0.6-2.1 percent. In other words, the unemployment rate nudges up by 0.5 percent or less, or it surges by 2.1 percent or more. There is no middle ground. Indeed, through more recent history the surge has been 2.5 percent or more (Chart I-1 and Chart I-2). Chart I-1It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent Chart I-2It Is Impossible To Lift The Unemployment Rate By 'Just' 1-2 Percent As with the brick-on-an-elastic-band, we can explain this non-linearity through the concepts of self-reinforcing feedback combined with delayed negative feedback. At a tipping point of rising unemployment, consumers pull in their horns and slow their spending, while banks slow their lending. This constitutes the self-reinforcing feedback which accelerates the downturn. Meanwhile, as it takes time for this downturn to appear in the data, policymakers respond with a lag, and when their response eventually comes, it also acts with a lag. This constitutes the delayed negative feedback, by which time the unemployment rate has surged, with every 1 percent rise in the unemployment rate depressing wage inflation by 0.5 percent (Chart I-3 and Chart I-4). Chart I-32001-02: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent Chart I-42008-09: Every 1 Percent Rise In The Unemployment Rate Depressed Wage Inflation By 0.5 Percent All of which brings me to a crucial point: The non-linearity in the jobs market implies a non-linearity in inflation control. Given that it is impossible to lift the unemployment rate by ‘just’ 2 percent, it is also impossible to depress wage inflation by ‘just’ 1 percent. The choice is to not depress wage inflation at all, or to make wage inflation slump. This presents a major dilemma for policymakers in their current battle against inflation. If they choose to not depress wage inflation at all, core inflation will remain north of 3 percent and destroy central banks’ already tattered credibility to achieve and maintain price stability (Chart I-5). In the medium term, this would un-anchor long-term inflation expectations, push up bond yields, and further destabilise the financial and housing markets. Chart I-5Wage Inflation Is Running Too Hot For The 2 Percent Inflation Target On the other hand, if central banks do choose to depress wage inflation, the non-linearity of the jobs market implies that wage inflation will slump, taking core inflation south of the 2 percent target. Central banks could pray that a surge in productivity growth might save their skins. If productivity growth surged, elevated wage inflation might still be consistent with 2 percent inflation, as it was in the early 2000s. But we wouldn’t bet on this outcome (Chart I-6). Chart I-6Don't Bet On A Repeat Of The Early 2000s Productivity Miracle Inflation Will Not Run ‘Close To 2 Percent’ To summarise then, the economy is a non-linear system, and should be analysed as such. In uniquely doing so in this report, we reach a profound conclusion. The non-linearity of the jobs market and inflation control means that it is impossible for core inflation to run ‘close to 2 percent’. Depending on which of the non-linear options that policymakers choose – to not depress wage inflation at all, or to make wage inflation slump – inflation will either remain well above 2 percent, or slump to well below 2 percent within the next couple of years. Which option will the central banks choose? My answer is that they will make wage inflation slump. This is not just to save their own skins, but a genuine belief that the worse long-term outcome for the economy would be if central banks’ credibility to maintain price stability was destroyed. To prevent this outcome, a recession is a price that they are willing to pay. Central banks will choose to make wage inflation slump. Not just to save their own skins, but because the worse long-term outcome for the economy would be if price stability was destroyed. But what if I am wrong, and they choose not to depress wage inflation? In this case, long-term inflation expectations would become un-anchored, pushing up bond yields, and crashing the financial and housing markets. In turn, this would unleash a massive deflationary impulse which would end up creating an even deeper recession. So, we would end up at the same place, albeit later and via a more circuitous route. All of which confirms some long-held views. The structural low in bond yields, the structural low in commodity prices, the structural high in stock market valuations, and the structural high in the US dollar are yet to come. Chart 1Hungarian Bonds Are Oversold Chart 2Copper Is Experiencing A Tactical Rebound Chart 3US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started To Reverse Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 11The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 12The Outperformance Of Tobacco Vs. Cannabis Is Ending Chart 13Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Executive Summary This report looks back at seven recent Fed tightening cycles and summarizes evidence concerning how the US Treasury curve behaves relative to the length and magnitude of the tightening cycle. We document a few consistent relationships. For example, the 10-year Treasury yield tends to peak 1-2 months before the last rate hike of the tightening cycle. We also notice that the Treasury slope is usually inverted by the time it troughs and that the 5-year/30-year slope tends to trough before the 2-year/5-year slope. Given our view that the peak fed funds rate may not occur until the second half of 2023, we expect another leg higher in bond yields before we reach the cyclical peak. We also anticipate further flattening of the 5-year/30-year Treasury curve. Timing Fed Tightening Cycles Bottom Line: Investors should keep portfolio duration close to benchmark for the time being and should position in 5-year/30-year curve flatteners by selling the 10-year bullet versus a duration-matched 5/30 barbell. While we maintain neutral portfolio duration for now, our bias is to be short duration on a medium-to-long run horizon and we may re-evaluate our recommended duration positioning after this month’s important CPI release and September FOMC meeting. Feature BCA’s Annual Investment Conference was held last week, and we heard a wide variety of views about the outlook for US bonds. Unsurprisingly, the main difference between those with bond-bullish and bond-bearish views was that the bullish panelists anticipated a much quicker end to the Fed’s tightening cycle prompted by a US recession starting late this year or early next year. This week’s report takes a more formal look at the historical linkages between Fed tightening cycles and trends in US Treasury yields. Our goal is to provide some firm evidence that investors can use to translate their views about the length and magnitude of the Fed tightening cycle into concrete positions across the US Treasury curve. Specifically, we look at seven Fed tightening cycles – the five most recent cycles and the two periods of tightening that occurred during the inflationary surge of the early-1980s. The 1977-80 Cycle Chart 1The 1977-80 Cycle The Fed raised the funds rate by 11.75% between August 1977 and March 1980 in response to sky-high inflation. Then, despite core CPI inflation still running at 12%, it cut rates by 5.5% in 1980 in response to an unemployment rate that had climbed above 6%. This proved to be only a brief reprieve from monetary tightening. With inflation still a problem, the Fed pivoted back to rate hikes later in 1980 even as the unemployment rate continued its ascent. Turning to markets, we see that the Treasury index lost 22% versus a position in cash during the 1977-80 tightening cycle and that index returns troughed in March 1980, around the same time as the last rate hike. The 10-year Treasury yield peaked one month before the last rate hike at 12.72%, 378 bps below the peak fed funds rate that would be attained one month later (Chart 1). As for the shape of the yield curve, the 2-year/10-year Treasury slope troughed at -201 bps one month before the last rate hike of the cycle (panel 4). The 2-year/5-year Treasury slope troughed at -132 bps in the same month as the peak in the funds rate and the 5-year/30-year slope troughed at -123 bps, one month before the last hike (bottom panel). The 1980-81 Cycle After a brief period of cuts in mid-1980, having still not conquered inflation the Fed changed course and lifted the funds rate to a new high in 1981. It did this even with the unemployment rate above 7%. One interesting aspect of this tightening cycle is that the bond market continued to sell off even after the Fed delivered its last rate increase. While the period of Fed tightening spanned from October 1980 until May 1981, excess Treasury index returns versus cash continued to fall until September 1981, losing 20% in the process (Chart 2). The 10-year Treasury yield also peaked four months after the last rate hike at 15.84%, 316 bps below the peak funds rate that was attained four months earlier. Chart 2The 1980-81 Cycle Looking at the Treasury curve, the 2-year/10-year slope troughed at -132 bps three months after the last rate hike (panel 4). The 2-year/5-year and 5-year/30-year slopes also troughed three months after the last rate hike, at -62 bps and -133 bps, respectively (bottom panel). The 1988-89 Cycle The Fed lifted rates from 6.5% in March 1988 to 9.8% in May 1989. Peak-to-trough, the Treasury index lost 7.7% versus cash during this period but returns did trough two months before the last rate hike. The 10-year Treasury yield peaked three months before the last rate hike at 9.32%, 48 bps below the peak fed funds rate (Chart 3). Chart 3The 1988-89 Cycle On the Treasury curve, the 2-year/10-year slope troughed two months before the last rate hike at -43 bps (panel 4). The 2-year/5-year and 5-year/30-year slopes also troughed two months before the last rate hike, at -20 bps and -42 bps, respectively (bottom panel). The 1994-95 Cycle The Fed doubled the funds rate from 3% in February 1994 to 6% in February 1995. Peak-to-trough, the Treasury index lost 9.4% versus cash during this period but returns did trough three months before the last rate hike. The 10-year Treasury yield peaked three months before the last rate hike at 7.91%, 191 bps above the peak fed funds rate (Chart 4). Chart 4The 1994-95 Cycle On the Treasury curve, the 2-year/10-year slope troughed two months before the last rate hike at +15 bps (panel 4). The 2-year/5-year and 5-year/30-year slopes also troughed two months before the last rate hike, at +14 bps and +6 bps, respectively (bottom panel). In contrast to earlier cycles, it’s notable that the yield curve never inverted during the 1994-95 tightening cycle and that the 10-year Treasury yield peaked at a level significantly above the fed funds rate. The most likely reason for this is that the Fed’s pivot from rate hikes to cuts in early 1995 occurred abruptly and came as a surprise to market participants. A quick look at the economic data makes it easy to see why. The core PCE and core CPI inflation rates were elevated at the time, at 2.3% and 3.0% respectively, and the unemployment rate was significantly down from a year earlier. The 1999-2000 Cycle The Fed lifted rates from 4.75% in June 1999 to 6.5% in May 2000. Peak-to-trough, the Treasury index lost 8.2% versus cash during this period but returns did trough four months before the last rate hike. The 10-year Treasury yield also peaked four months before the last rate hike at 6.68%, 18 bps above the peak fed funds rate (Chart 5). Chart 5The 1999-2000 Cycle On the Treasury curve, the 2-year/10-year slope troughed two months before the last rate hike at -47 bps (panel 4). The 5-year/30-year slope troughed one month before the last rate hike at -59 bps but the 2-year/5-year slope didn’t trough until three months after the last rate hike at -15 bps (bottom panel). The 2004-06 Cycle The Fed lifted rates in steady increments of 25 bps per meeting from 1% in June 2004 to 5.25% in June 2006. Peak-to-trough, the Treasury index lost 5.3% versus cash during this period and returns troughed around the same time as the funds rate reached its peak. The peak in the 10-year Treasury yield also occurred at the same time as the peak in the funds rate, though the peak 10-year was 10 bps below the peak funds rate (Chart 6). Chart 6The 2004-06 Cycle On the Treasury curve, the 2-year/10-year slope troughed five months after the last rate hike of the cycle at -16 bps (panel 4). The 2-year/5-year slope also troughed five months after the last rate hike at -20 bps, while the 5-year/30-year slope troughed much earlier, four months before the last rate hike at -10 bps (bottom panel). The 2015-18 Cycle Finally, in the most recent tightening cycle before the current one, the Fed lifted rates off the zero-lower-bound in December 2015, went on hold for 12 months and then delivered a string of rate hikes bringing the funds rate up to 2.5% by December 2018. Peak-to-trough, the Treasury index lost 6.7% versus cash during this period and returns troughed two months before the peak in the fed funds rate. The peak in the 10-year Treasury yield also occurred two months before the last rate hike at 3.15%, 65 bps above the peak funds rate (Chart 7). Chart 7The 2015-18 Cycle On the Treasury curve, the 2-year/10-year slope troughed eight months after the last rate hike of the cycle at 0 bps (panel 4). The 2-year/5-year slope also troughed eight months after the last rate hike at -17 bps, while the 5-year/30-year slope troughed much earlier, five months before the last rate hike at +23 bps (bottom panel). Summarizing The Evidence Tables 1 and 2 summarize the data from the seven tightening cycles that we examined. Four main points jump out. Table 1Timing Fed Tightening Cycles Table 2Fed Tightening Cycles: Peak And Trough Levels First, both the level of the 10-year Treasury yield and the Bloomberg Barclays Treasury Excess Return Index tend to hit inflection points around the time of the last rate hike of the cycle. On average, the 10-year Treasury yield peaks 1.3 months before the last rate hike of the cycle, and it has always hit its peak within a window spanning four months before the last hike and four months after. The timing of the trough in index excess returns versus cash looks similar. Second, the 2-year/10-year Treasury slope also tends to trough near the end of the Fed tightening cycle, but the timing of this inflection point varies a lot more than the timing of the peak in yields. In fact, during the last two cycles the 2-year/10-year slope didn’t trough until well after the last rate hike. Third, the 5-year/30-year Treasury slope always troughs at the same time or earlier than the 2-year/5-year Treasury slope. This is consistent with our intuition that the long end of the yield curve will respond more quickly to changes in the economic outlook than the front end of the curve, which remains more tied to the current policy rate. Fourth, there isn’t much consistency in where the 10-year Treasury yield peaks relative to the peak fed funds rate. On average, the 10-year yield tops out 120 bps below the peak fed funds rate, but there is a wide range of outcomes. The 10-year yield peaked 378 bps below the peak fed funds rate in the 1977-80 tightening cycle and it peaked 65 bps above the peak fed funds rate in the 2015-18 cycle. The same holds true for the slope of the Treasury curve. The trough in the slope exhibits a wide range of outcomes, though it is fair to say that we typically expect the slope to be negative when it bottoms. The 2-year/10-year Treasury slope only failed to invert in two tightening cycles (1994-95 and 2015-18) and in both of those cases the Fed was not expected to deliver a large number of rate cuts. In fact, it could have easily been argued that rate cuts were unnecessary based on the inflation and employment data at the time. Investment Implications In applying the lessons from this analysis to the current environment, the first conclusion we reach is that we should only look to extend portfolio duration to above-benchmark when we think that the last rate hike of the cycle will occur in 1-2 months. Currently, the market is priced for the fed funds rate to peak in June 2023 and we expect that peak could occur even later (Chart 8). For this reason, we anticipate another significant leg higher in Treasury yields before the cyclical peak is reached. Chart 8Rate Expectations Our historical analysis of past tightening cycles also supports our recommended short 10-year bullet, long 5-year/30-year barbell positioning along the Treasury curve.1 Given that the 5-year/30-year Treasury slope has always troughed within a window spanning five months before the last rate hike and three months after, it makes sense to position for another leg down. This is a particularly attractive trade on the 5-year/30-year portion of the curve because that slope remains in positive territory. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on this trade please see US Bond Strategy Weekly Report, “The Great Soft Landing Debate”, dated August 9, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns
Highlights Chart 1A Hot Labor Market The balance of data that’s come out during the past month points to a labor market that is not cooling very quickly. In fact, it is cooling much more slowly than we anticipated. First, nonfarm payroll growth of +315k in August is well above the +79k that is needed to maintain the unemployment and participation rates at current levels (Chart 1). Second, what had initially looked like a significant drop in job openings was revised away with the July JOLTS report. While the ratio of job openings to unemployed has leveled-off just below 2.0, it is no longer showing any signs of falling (bottom panel). Finally, the employment component of August’s ISM Manufacturing PMI jumped back above 50 and even initial unemployment claims have reversed their nascent uptrend. The conclusion we draw from this spate of strong employment data is that the Fed’s tightening cycle is not close to over. This means that the average fed funds rate that is priced into markets for 2023 is almost certainly too low. Feature Table 1 Recommended Portfolio Specification Table 2Fixed Income Sector Performance Table 3A Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* Investment Grade: Underweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 8 basis points in August, bringing year-to-date excess returns up to -267 bps. The average index option-adjusted spread tightened 4 bps on the month, and it currently sits at 145 bps. Our quality-adjusted 12-month breakeven spread ticked up to its 56th percentile since 1995 (Chart 2). A report from a few months ago made the case for why investors should underweight investment grade corporate bonds on a 6-12 month investment horizon.1 The main rationale for this recommendation is that the slope of the Treasury curve suggests that the credit cycle is in its late stages. Corporate bond performance tends to be weak during periods when the yield curve is very flat or inverted. Despite our underweight 6-12 month investment stance, we wouldn’t be surprised to see some modest spread narrowing during the next couple of months as inflation heads lower. That said, spread compression will be limited by the inverted yield curve and the persistent removal of monetary accommodation. A recent report dug deeper into the corporate bond space and concluded that investment grade-rated Energy bonds offer exceptional value on a 6-12 month horizon.2 That report also concluded that long maturity investment grade corporates are attractively priced relative to short maturity bonds. High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 28 basis points in August, dragging year-to-date excess returns down to -519 bps. The average index option-adjusted spread tightened 15 bps on the month and it currently sits at 494 bps, 125 bps above the 2017-19 average and 43 bps below the 2018 peak. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – increased modestly in August. It currently sits at 6.6% (Chart 3). As is the case with investment grade, high-yield spreads could stage a relief rally during the next few months as inflation falls and recession fears abate. However, the inverted yield curve will likely prevent spreads from moving much below the average level seen during the last tightening cycle (2017-19). All that said, even a move back to average 2017-19 levels would equate to a roughly 7% excess return for the junk index if it is realized over a six month period. This return potential is the main reason to prefer high-yield over investment grade in a US bond portfolio. While we maintain a neutral (3 out of 5) allocation to high-yield for now, we will downgrade the sector if spreads tighten to the 2017-19 average or if core inflation falls back to our 4% estimate of its underlying trend.3 MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 100 basis points in August, dragging year-to-date excess returns down to -144 bps. We discussed the outlook for Agency MBS in a recent report.4 We noted that MBS’ poor performance in 2021 and early-2022 was driven by duration extension. Fewer homeowners refinanced their loans as mortgage rates rose, and the MBS index’s average duration increased (Chart 4). But now, the index’s duration extension is over. The average convexity of the MBS index is close to zero (panel 3), meaning that duration is now insensitive to changes in rates. This is because hardly any homeowners have an incentive to refinance at current mortgage rates. With the duration extension trade over, the only thing preventing us from increasing exposure to the Agency MBS space is that spreads still aren’t sufficiently attractive. The average index spread versus duration-matched Treasuries is roughly midway between its post-2014 minimum and post-2014 mean (panel 4). Meanwhile, the option-adjusted spread has moved above its post-2014 mean (bottom panel), but at just 42 bps, it still offers less compensation than a Aa-rated corporate bond or a Aaa-rated consumer ABS. At the coupon level, we moved to a neutral allocation across the coupon stack last month, but this month we initiate a recommendation to favor high-coupon (3%-4.5%) securities over low coupon (1.5%-2.5%) ones. Given the lower duration of high coupon MBS, this position will profit from rising bond yields on a 6-12 month investment horizon. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Market bonds outperformed the duration-equivalent Treasury index by 156 basis points in August, bringing year-to-date excess returns up to -563 bps. EM Sovereigns outperformed the Treasury benchmark by 117 bps on the month, bringing year-to-date excess returns up to -677 bps. The EM Corporate & Quasi-Sovereign Index outperformed by 180 bps, bringing year-to-date excess returns up to -491 bps. The EM Sovereign index outperformed the duration-equivalent US corporate bond index by 111 bps in August. Meanwhile, the yield differential between EM sovereigns and US corporates moved deeper into negative territory (Chart 5). As such, we continue to recommend a maximum underweight (1 out of 5) allocation to EM sovereigns. The EM Corporate & Quasi-Sovereign Index outperformed duration-matched US corporates by 168 bps in August. The index continues to offer a significant yield advantage versus duration-matched US corporates (panel 4). As such, we continue to recommend a neutral (3 out of 5) allocation to the sector. China is the most important trading partner for most EM countries and thus represents a major source of economic growth. Consequently, Chinese import volumes are a useful gauge for the outlook of EM economies. The persistent contraction of Chinese import volumes (bottom panel) therefore sends a negative signal for EM bond performance. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 126 basis points in August, bringing year-to-date excess returns up to -44 bps (before adjusting for the tax advantage). We view the municipal bond sector as better placed than most to cope with the recent bout of spread volatility. As we noted in a recent report, state & local government revenue growth has been strong, but governments have been slow to hire (Chart 6).5 The result is that net state & local government savings are incredibly high (bottom panel) and it will take some time to deplete those coffers. On the valuation front, munis have cheapened up relative to both Treasuries and corporates since last year. The 10-year Aaa Muni / Treasury yield ratio is currently 82%, up from its 2021 trough of 55%. The yield ratio between 12-17 year munis and duration-matched corporate bonds is also up significantly off its lows (panel 2). We reiterate our overweight allocation to municipal bonds within US fixed income portfolios, and we continue to have a strong preference for long-maturity munis. The yield ratio between 17-year+ General Obligation municipal bonds and duration-matched US corporates is 80%. The same measure for Revenue bonds is 94%, just below parity even without considering municipal debt’s tax advantage. Treasury Curve: Buy 5/30 Barbell Versus 10-Year Bullet Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened in August as investors significantly marked up their 12-month rate expectations. Our 12-month Fed Funds Discounter – the market’s expected 12-month change in the funds rate – rose from 78 bps to 175 bps during the month and this caused the 2-year/10-year Treasury slope to flatten by 8 bps and the 5-year/30-year Treasury slope to flatten by 33 bps (Chart 7). We initiated a position in 5/30 flatteners (short 10-year bullet versus duration-matched 5/30 barbell) in our August 9th report.6 The main reason for this recommendation is our view that the Fed tightening cycle is not close to over. Therefore, it is too soon to position for a steepening of the 5-year/30-year Treasury slope. An analysis of past Fed tightening cycles shows that the 5-year/30-year Treasury slope tends to trough earlier than other segments of the yield curve. However, that trough has always occurred within a window spanning five months before the last Fed rate hike and three months after.7 On average, the 5-year/30-year slope troughs 1-2 months before the last Fed rate hike. Given our view that the Fed tightening cycle still has a lot of room to run, we think it makes sense to bet on a further flattening of the 5-year/30-year slope. This trade looks particularly attractive when you consider that a position short the 10-year bullet and long a duration-matched 5/30 barbell provides a yield pick-up of 12 bps (bottom panel). TIPS: Neutral Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 8 basis points in August, bringing year-to-date excess returns up to +264 bps. The 10-year TIPS breakeven inflation rate fell 5 bps on the month, moving back into the Fed’s 2.3% - 2.5% comfort zone (Chart 8). Meanwhile, our TIPS Breakeven Valuation Indicator shows that 10-year TIPS are close to fairly valued versus nominals. In a recent report we unveiled our Golden Rule of TIPS Investing.8 In that report we showed that TIPS of all maturities tend to outperform equivalent-maturity nominal bonds whenever headline CPI inflation exceeds the 1-year CPI swap rate during a 12-month period. The 1-year CPI swap rate is currently 2.77%, and we think this will turn out to be too low based on our modeling of headline CPI. While we see value in TIPS relative to nominals, especially at the front-end of the curve, we also suspect that more value will be created during the next few months as CPI prints come in soft. Therefore, we are reluctant to immediately upgrade TIPS to overweight. Instead, we recommend that investors initiate a 2-year/10-year TIPS breakeven inflation curve flattener. The 2/10 TIPS breakeven inflation curve has recently jumped into positive territory (bottom panel), but an inverted inflation curve is much more consistent with the current macro environment where the Fed is battling above-target inflation. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 27 basis points in August, bringing year-to-date excess returns up to -25 bps. Aaa-rated ABS outperformed by 19 bps on the month, bringing year-to-date excess returns up to -24 bps. Non-Aaa ABS outperformed by 76 bps on the month, bringing year-to-date excess returns up to -28 bps. Substantial federal government support caused US households to build up an extremely large buffer of excess savings during the past two years. This year, consumers are starting to draw down that savings and are even starting to take on more debt. The amount of outstanding credit card debt is still low relative to household income, but it is rising quickly in absolute terms (Chart 9). Elsewhere, consumers are still paying down their credit card balances at high rates (panel 4), but banks are no longer easing lending standards on auto loans or credit cards (panel 3). To us, the prevailing evidence suggests that it will be a long time before delinquencies are a serious problem for consumer ABS. This justifies our overweight recommendation. That said, given that the trend toward consumer re-leveraging is in full swing, it makes sense to turn more cautious at the margin. We therefore close our prior recommendation to favor non-Aaa over Aaa-rated consumer ABS and move to a neutral allocation across the consumer ABS credit curve. Non-Agency CMBS: Overweight Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 26 basis points in August, bringing year-to-date excess returns up to -150 bps. Aaa Non-Agency CMBS outperformed Treasuries by 20 bps on the month, bringing year-to-date excess returns up to -103 bps. Non-Aaa Non-Agency CMBS outperformed by 41 bps on the month, bringing year-to-date excess returns up to -280 bps. CMBS spreads remain wide compared to other similarly risky spread products and are currently close to their historic averages. However, the most recent Senior Loan Officer Survey showed tightening lending standards and weaker demand for commercial real estate (CRE) loans (Chart 10). This suggests a more negative back-drop for CRE prices and CMBS spreads and causes us to reduce our recommended allocation from overweight (4 out of 5) to neutral (3 out of 5). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 29 basis points in August, dragging year-to-date excess returns down to -44 bps. The average index option-adjusted spread held flat on the month, close to its long-term average (bottom panel). At 55 bps, the average Agency CMBS spread continues to look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 175 basis points of rate hikes during the next 12 months. Chart 11The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of September 1, 2022) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of September 1, 2022) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -7 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 7 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of September 1, 2022) Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Timper Research Analyst robert.timper@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. 2 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Looking For Opportunities In US & European Corporates After The Recent Selloff”, dated May 31, 2022. 3 For more details on this call please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. 4 Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 5 Please see US Bond Strategy Weekly Report, “Echoes Of 2018”, dated May 24, 2022. 6 Please see US Bond Strategy Weekly Report, “The Great Soft Landing Debate”, dated August 9, 2022. 7 In our analysis we examined seven Fed tightening cycles. The five most recent cycles and the two cycles that occurred during the inflation spike of the early 1980s. 8 Please see US Bond Strategy Special Report, “The Golden Rule Of TIPS Investing”, dated August 23, 2022. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns
Listen to a short summary of this report Executive Summary On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall without much loss in production or employment. Skeptics will argue that such benign disinflations rarely occur, pointing to the 1982 recession. But long-term inflation expectations were close to 10% back then. Today, they are broadly in line with the Fed’s target. Equities will recover from their recent correction as headline inflation continues to fall and the risks of a US recession diminish. Go long EUR/USD on any break below 0.99. Contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted Bottom Line: The US economy is entering a temporary Goldilocks period of falling inflation and stronger growth. The latest correction in stocks will end soon. Investors should overweight global equities over the next six months but look to turn more defensive thereafter. Dear Client, I will be attending BCA’s annual conference in New York City next week. Instead of our regular report, we will be sending you a Special Report written by Mathieu Savary, BCA’s Chief European Strategist, and Robert Robis, BCA’s Chief Fixed Income Strategist, on Monday, September 12. Their report will discuss estimates of global neutral interest rates. We will resume our regular publication schedule on September 16. Best Regards, Peter Berezin, Chief Global Strategist The Hawks Descend On Jackson Hole Chart 1Markets Still Think The Fed Will Start Cutting Rates Next Year Jay Powell’s Jackson Hole address jolted the stock market last week. Citing the historical danger of allowing inflation to remain above target for too long, the Fed chair stressed the need for “maintaining a restrictive policy stance for some time.” Powell’s comments were consistent with the Fed’s dot plot, which expects rates to remain above 3% right through to the end of 2024. However, with the markets pricing in rate cuts starting in mid 2023, his remarks came across as decidedly hawkish (Chart 1). While Fedspeak can clearly influence markets in the near term, our view is that the economy calls the shots over the medium-to-long term. The Fed sees the same data as everyone else. If inflation comes down rapidly over the coming months, the FOMC will ratchet down its hawkish rhetoric, opting instead for a wait-and-see approach. The Slope of Hope Could inflation fall quickly in the absence of a deep recession? The answer depends on a seemingly esoteric concept: the slope of the aggregate supply curve. Economists tend to depict the aggregate supply curve as being convex in nature – fairly flat (or “elastic”) when there is significant spare capacity and becoming increasingly steep (or “inelastic”) as spare capacity is exhausted (Chart 2). The basic idea is that firms do not require substantially higher prices to produce more output when they have a lot of spare capacity, but do require increasingly high prices to produce more output when spare capacity is low. Chart 2The Aggregate Supply Curve Becomes Very Steep When Spare Capacity Is Exhausted When the aggregate supply curve is very elastic, an increase in aggregate demand will mainly lead to higher output rather than higher prices. In contrast, when the aggregate supply curve is inelastic, rising demand will primarily translate into higher prices rather than increased output. In early 2020, most of the developed world found itself on the steep side of the aggregate supply curve. The unemployment rate in the OECD stood at 5.3%, the lowest in 40 years (Chart 3). In the US, the unemployment rate had reached a 50-year low of 3.5%. Thus, not surprisingly, as fiscal and monetary policy turned simulative, inflation moved materially higher. Goods inflation, in particular, accelerated during the pandemic (Chart 4). Perhaps most notably, the exodus of people to the suburbs, combined with the reluctance to use mass transit, led to a surge in both new and used car prices (Chart 5). The upward pressure on auto prices was exacerbated by a shortage of semiconductors, itself a consequence of the spike in the demand for electronic goods. Chart 3The Pandemic Began When The Unemployment Rate In The OECD Was At A Multi-Decade Low Chart 4With Supply Unable To Meet Demand, Goods Prices Surged During The Pandemic The supply curve for labor also became increasingly inelastic over the course of the pandemic. Once the US unemployment rate fell back below 4%, wages began to accelerate sharply. The kink in the Phillips curve had been reached (Chart 6). Chart 5Car Prices Went On Quite A Ride During The Pandemic Chart 6Wage Growth Soared When The Economy Moved Beyond Full Employment Chart 7Job Switchers Usually See Faster Wage Growth Faster labor market churn further turbocharged wage growth. Both the quits rate and the hiring rate rose during the pandemic. Typically, workers who switch jobs experience faster wage growth than those who do not (Chart 7). This wage premium for job switching increased during the pandemic, helping to lift overall wage growth. A Symmetric Relationship? All this raises a critical question: If an increase in aggregate demand along the inelastic side of the aggregate supply curve mainly leads to higher prices rather than increased output and employment, is the inverse also true – that is, would a comparable decrease in aggregate demand simply lead to much lower inflation without much of a loss in output or employment? If so, this would greatly increase the odds of a soft landing. Skeptics would argue that disinflations are rarely painless. They would point to the 1982 recession which, until the housing bubble burst, was the deepest recession in the post-war era. The problem with that comparison is that long-term inflation expectations were extremely high in the early 1980s. Both consumers and professional forecasters expected inflation to average nearly 10% over the remainder of the decade (Chart 8). To bring down long-term inflation expectations, Paul Volcker had to engineer a deep recession. Chart 8Long-Term Inflation Expectations Are Much Better Anchored Now Than In The Early 1980s Chart 9Real Long Terms Bond Yields Are Currently A Fraction Of What They Were Four Decades Ago Jay Powell does not face such a problem. Both survey-based and market-based long-term inflation expectations are well anchored. Whereas real long-term bond yields reached 8% in 1982, the 30-year TIPS yield today is still less than 1% (Chart 9). The Impact of Lower Home Prices Chart 10Supply-Side Constraints Limited Home Building During The Pandemic, Helping To Push Up Home Prices While falling consumer prices would boost real incomes, helping to keep the economy out of recession, a drop in home prices would have the opposite effect on consumer spending. As occurred with other durable goods, a shortage of building materials and qualified workers prevented US homebuilders from constructing as many new homes as they would have liked during the pandemic. The producer price index for construction materials soared by over 50% between May 2020 and May 2022 (Chart 10). As a result, rising demand for homes largely translated into higher home prices rather than increased homebuilding. Real home prices, as measured by the Case-Shiller index, have increased by 25% since February 2020, rising above their housing bubble peak. As we discussed last week, US home prices will almost certainly fall in real terms and probably in nominal terms as well over the coming years. Chart 11Despite Higher Home Prices, Households Have Not Been Using Their Homes As ATMs How much of a toll will falling home prices have on the economy? It took six years for home prices to bottom following the bursting of the housing bubble. It will probably take even longer this time around, given that the homeowner vacancy rate is at a record low and reasonably prudent mortgage lending standards will limit foreclosure sales. Thus, while there will be a negative wealth effect from falling home prices, it probably will not become pronounced until 2024 or so. Moreover, unlike during the housing boom, US households have not been tapping the equity in their homes to finance consumption (Chart 11). This also suggests that the impact of falling home prices on consumption will be far smaller than during the Great Recession. Inelastic Commodity Supply While inelastic supply curves had the redeeming feature of preventing a glut of, say, new autos or homes from emerging, they also limited the output of many commodities that face structural shortages. Compounding this problem is the fact that the demand for many commodities is very inelastic in the short run. When you combine a very steep supply curve with a very steep demand curve, small shifts in either curve can produce wild swings in prices. Nowhere is this problem more evident than in Europe, where a rapid reduction in oil and gas flows has caused energy prices to soar, forcing policymakers to scramble to find new sources of supply. Europe’s Energy Squeeze At this point, it looks like both the UK and the euro area will enter a recession. In continental Europe, the near-term outlook is grimmer in Germany and Italy than it is in France or Spain. The latter two countries are less vulnerable to an energy crunch (Spain imports a lot of LNG while France has access to nuclear energy). Both countries also have fairly resilient service sectors (Spain, in particular, is benefiting from a boom in tourism). The good news is that even in the most troubled European economies, the bottom for growth is probably closer at hand than widely feared. Despite the fact that imports of Russian gas have fallen by more than 60%, Europe has been able to rebuild gas inventories to about 80% of capacity, roughly in line with prior years (Chart 12). It has been able to achieve this feat by aggressively buying gas on the open market, no matter the price. While this has caused gas prices to soar, it sets the stage for a possible retreat in prices in 2023, something that the futures market is already discounting (Chart 13). Chart 12Europe: Squirrelling Away Gas For The Winter Chart 13Natural Gas Prices In Europe Will Come Back Down To Earth Europe is also moving with uncharacteristic haste to secure new sources of energy supply. In less than one year, Europe has become America’s biggest overseas market for LNG. A new gas pipeline linking Spain with the rest of Europe should be operational by next spring. In the meantime, Germany is building two “floating” LNG terminals. Germany has also postponed plans to mothball its nuclear power plants and has approved increased use of coal-fired electricity generators. Chart 14The Euro Is Undervalued France is seeking to boost nuclear capacity. As of August 29, 57% of nuclear generation capacity was offline. Electricité de France expects daily production to rise to around 50 gigawatts (GW) by December from around 27 GW at present. For its part, the Dutch government is likely to raise output from the massive Groningen natural gas field. All this suggests that contrary to the prevailing pessimistic view, Europe is heading for a V-shaped recovery. The euro, which is 30% undervalued against the US dollar on a purchasing power parity basis, will rally (Chart 14). Go long EUR/USD on any break below 0.99. Investment Conclusions Chart 15Falling Inflation Should Boost Real Wages And Buoy Consumer Confidence On the eve of the pandemic, most developed economies were operating at close to full capacity – the aggregate supply curve, in other words, had become very steep (or inelastic). Not surprisingly, in such an environment, pandemic-related stimulus, rather than boosting output, simply stoked inflation. Looking out, the inverse may turn out to be true: Just as an increase in aggregate demand did more to lift prices than output during the pandemic, a decrease in aggregate demand may allow inflation to fall with little loss in production or employment. Will this be the end of the story? Probably not. As inflation falls, US real wage growth, which is currently negative, will turn positive. Consumer confidence will improve, boosting consumer spending in the process (Chart 15). The aggregate demand curve will shift outwards again, triggering a “second wave” of inflation in the back half of 2023. Rather than cutting rates next year, as the market still expects, the Fed will raise rates to 5%. This will set the stage for a recession in 2024. Investors should overweight global equities over the next six months but look to turn more defensive thereafter. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn & Twitter Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Next week, on September 7-8, is the BCA New York Conference, the first in-person version since 2019. I look forward to seeing many of you there, and if you haven’t already booked your place, you still can! (a virtual version is also available). As such, the next Counterpoint report will come out on September 15. Executive Summary The 2022-23 = 1981-82 template for markets is working well. If it continues to hold, these are the major investment implications: Bonds: The 30-year T-bond (price) will trend sideways for the next few months, albeit with a potential correction that lifts the yield to 3.5 percent. However, bond prices will enter a sustained rally in 2023, in which the 30-year T-bond yield will fall to sub-2.5 percent. Stocks: A coordinated global recession will depress profits, causing the S&P 500 to test 3500. However, once past the worst of the recession, a strong rally will lift it through 5000 later in 2023. Sector allocation: Longer duration defensive sectors (such as healthcare) will strongly outperform shorter duration cyclical sectors (such as basic resources) until mid-2023, after which it will be time to flip back into cyclicals. Industrial metals: A tactical rebound in copper could lift it to $8500/MT after which the structural downtrend will resume, taking it to sub-$7000/MT in 2023. Oil: Just as in 1981-82, supply shortages will provide near-term support. But ultimately, demand destruction will dominate, depressing the price to, at best, $85, though our central case is $55 in 2023. If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price Bottom Line: The 2022-23 = 1981-82 template for markets is working well, and should continue to do so. Feature History doesn’t repeat, but it does rhyme. And the period that rhymes closest with the current episode in the global economy and markets is 1981-82, a rhyming which we first highlighted four months ago in Markets Echo 1981, When Stagflation Morphed Into Recession, and then developed in More On 2022-23 = 1981-82, And The Danger Ahead. In those reports, we presented three compelling reasons why 2022-23 rhymes with 1981-82: 1981-82 is the period that rhymes closest with the current episode in the global economy and markets. First, the simultaneous sell-off in stocks, bonds, inflation protected bonds, industrial commodities, and gold in the second quarter of 2022 is uniquely linked with an identical ‘everything sell-off’ in the second quarter of 1981. It is extremely rare for stocks, bonds, inflation protected bonds, industrial commodities, and gold to sell off together. Such a simultaneous sell-off has happened in just these 2 calendar quarters out of the last 200. Meaning a ‘1-in-a-100’ event conjoins 2022 with 1981 (Chart I-1 and Chart I-2). Chart I-1A 1-In-A-100 Event: The 'Everything Sell-Off' In 2022... Chart I-2...And The 'Everything Sell-Off' In 1981 Second, the Jay Powell Fed equals the Paul Volcker Fed. Now just as then, the world’s central banks are obsessed with ‘breaking the back’ of inflation. And now, just as then, the central banks are desperate to repair their badly battered credibility in managing inflation. Third, the Russia/Ukraine war that started in February 2022 equals the Iraq/Iran war that started in September 1980. Now, just as then, a war between two commodity producing neighbours has unleashed a supply shock which is adding to the inflation paranoia. To repeat, it is a 1-in-a-100 event for all financial assets to sell off together. This is because it requires an extremely rare star alignment. Inflation fears first morph to stagflation fears and then to recession fears. Leaving investors with nowhere to hide, as no mainstream asset performs well in inflation, stagflation, and recession. So, the once-in-a-generation star alignment conjoining 2022 with 1981 is as follows: Inflation paranoia is worsened by a major war between commodity producing neighbours, forcing reputationally damaged central banks to become trigger-happy in their battle against inflation, dragging the world economy into a coordinated recession. September 2022 Equals August 1981 If 2022-23 = 1981-82, then where exactly are we in the analogous episode? There are two potential synchronization points. One potential synchronization is that the Russia/Ukraine war which started on February 24, 2022 equals the Iraq/Iran war which started on September 22, 1980. In which case, September 2022 equals April 1981. But given that inflation is public enemy number one, a better synchronization is the Fed’s preferred measure of underlying inflation, the US core PCE deflator. Aligning the respective peaks in core PCE inflation, we can say that February 2022 equals January 1981. Meaning that our original report in May 2022 aligned with April 1981, and September 2022 equals August 1981 (Chart I-3 and Chart I-4). Chart I-3The Peak In Core PCE Inflation In ##br##February 2022 Chart I-4...Aligns With The Peak In Core PCE Inflation In ##br##January 1981 In which case, how has the template worked since we introduced it on May 19th? The answer is, very well. The template predicted that the long bond price would track sideways, which it has. The template predicted that the S&P 500 would decline from 4200 to 4000, which it has. The template predicted that the copper price would decline from $9250/MT to $8500/MT. In fact, it has fallen even further to $8200/MT. In the case of oil, the better synchronization is the starts of the respective wars. This template predicted that the Brent crude price would decline sharply from a knee-jerk peak in the $120s, which it has. Not a bad set of predictions! If 2022-23 = 1981-82, Here’s What Happens Next Assuming the template continues to hold, here are the major implications for investors: Bond prices will enter a sustained rally in 2023. Bonds: The 30-year T-bond (price) will trend sideways for the next few months, albeit with a potential tactical correction that takes its yield to 3.5 percent. However, bond prices will enter a sustained rally in 2023 in which the 30-year T-bond yield will fall to sub-2.5 percent (Chart I-5). Chart I-5If 2022-23 = 1981-82, Then This Is What Happens To Bond Prices Stocks: A coordinated global recession will depress profits, causing the S&P 500 to test 3500 in the coming months. However, once past the worst of the recession, a strong rally will lift it through 5000 later in 2023 (Chart I-6). Chart I-6If 2022-23 = 1981-82, Then This Is What Happens To Stock Prices Sector allocation: Longer duration defensive sectors (such as healthcare) will strongly outperform shorter duration cyclical sectors (such as basic resources) until mid-2023, after which it will be time to flip back into cyclicals (Chart I-7). Chart I-7If 2022-23 = 1981-82, Then This Is What Happens To Sector Allocation Industrial metals: A tactical rebound in copper could lift it to $8500/MT after which the structural downtrend will resume, taking it to sub-$7000/MT in 2023 (Chart I-8). Chart I-8If 2022-23 = 1981-82, Then This Is What Happens To The Copper Price Oil: Just as in 1981-82, supply shortages will provide near-term support. But ultimately, demand destruction will dominate, depressing the price to, at best, $85 (Chart I-9) though our central case is $55 in 2023. Chart I-9If 2022-23 = 1981-82, Then This Is What Happens To The Oil Price But What If 2022-23 Doesn’t = 1981-82? And yet, and yet…what if the Jay Powell Fed doesn’t equal the Paul Volcker Fed? What if central banks lose their nerve before inflation is slayed? Long bond yields could gap much higher, or at least not come down, causing a completely different set of investment outcomes. In this case, the correct template would not be 1981-82, but the 1970s. If central banks lose the stomach to slay inflation, then the consequent housing market crash will do the job for them. However, there is one huge difference between now and the 1970s, which makes that template highly unlikely. In the 1970s, the global real estate market was worth just one times world GDP, whereas today it has become a monster worth four times world GDP, and whose value is highly sensitive to the long bond yield. In the US, the mortgage rate has surged to well above the rental yield for the first time in 15 years. Simply put, it is now more expensive to buy than to rent a home, causing a disappearance of would be homebuyers, a flood of home-sellers, and an incipient reversal in home prices (Chart I-10). Chart I-10If Bond Yields Don't Come Down, Then House Prices Will Crash Hence, if long bond yields were to gap much higher, or even stay where they are, it would trigger a housing market crash whose massive deflationary impulse would swamp any inflationary impulse. The upshot is that the 2022-23 = 1981-82 template would suffer a hiatus. Ultimately though, it would come good, because a crash in the $400 trillion global housing market would obliterate inflation. In other words, if central banks lose the stomach to slay inflation, then the consequent housing market crash will do the job for them. Fractal Trading Watchlist As just discussed, copper’s tactical rebound is approaching exhaustion. This is confirmed by the 130-day fractal structure of copper versus tin reaching the point of extreme fragility that has consistently marked turning-points in this pair trade (Chart I-11). Chart I-11Copper's Tactical Rebound Is Exhausted Hence, this week’s recommendation is to short copper versus tin, setting the profit target and symmetrical stop-loss at 12 percent. Chart 1Expect Hungarian Bonds To Rebound Chart 2Copper Is Experiencing A Tactical Rebound Chart 3US REITS Are Oversold Versus Utilities Chart 4FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Chart 5Netherlands' Underperformance Vs. Switzerland Has Ended Chart 6The Sell-Off In The 30-Year T-Bond At Fractal Fragility Chart 7Food And Beverage Outperformance Is Exhausted Chart 8German Telecom Outperformance Has Started To Reverse Chart 9Japanese Telecom Outperformance Vulnerable To Reversal Chart 10The Strong Trend In The 18-Month-Out US Interest Rate Future Has Ended Chart 11The Strong Downtrend In The 3 Year T-Bond Has Ended Chart 12A Potential Switching Point From Tobacco Into Cannabis Chart 13Biotech Is A Major Buy Chart 14Norway's Outperformance Has Ended Chart 15Cotton Versus Platinum Has Reversed Chart 16Switzerland's Outperformance Vs. Germany Is Exhausted Chart 17USD/EUR Is Vulnerable To Reversal Chart 18The Outperformance Of MSCI Hong Kong Versus China Has Ended Chart 19US Utilities Outperformance Vulnerable To Reversal Chart 20The Outperformance Of Oil Versus Banks Is Exhausted Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Executive Summary Low-Yielding Countries Facing High USD Hedging Costs The US dollar will remain strong alongside continued Fed rate hikes. Interest rate differentials will remain positive for the greenback, alongside other USD-positive factors like slowing global growth and rising investor risk aversion. Relatively high US interest rates have made hedging away US currency risk very expensive for some of the largest holders of US Treasuries like Japan. US Treasury yields, on an FX-hedged basis, look unattractive relative to local currency denominated bonds across the developed world. Increased foreign demand for US Treasuries evident in the US TIC data appears to reflect a re-establishment of positions unwound by global hedge funds and mutual funds dating back to the 2020 “dash for cash” in global financial markets. UST yields must rise even further versus non-US yields to attract more fundamental buyers like Japanese and European institutional investors, given elevated volatility in both US Treasury prices and the dollar. Bottom Line: Global investors should continue to underweight US Treasuries in global bond portfolios, on both a currency-unhedged and USD-hedged basis. Feature Dear Client, The schedule for the next two Global Fixed Income Strategy reports will be impacted by the upcoming Labor Day holiday and next week’s BCA’s annual conference in New York (I hope to see you there!). This Friday, September 2, we will be publishing a joint report with our colleagues at Foreign Exchange Strategy discussing Japan. On Monday, September 12, we will be publishing another joint report with our colleagues at European Investment Strategy, covering estimates of global neutral interest rates. -Rob Robis The title of our report from four weeks ago was “Dovish Central Bank Pivots Will Come Later Than You Think.” This could have also been the title for Fed Chair Jerome Powell's Jackson Hole speech. He reiterated the Fed’s commitment to tighten policy further and “keep at it” until the US economy slows enough to bring down inflation. Other central bankers who spoke at the conference had a similar tone to Powell, talking up an ongoing inflation fight that will require much slower growth and higher unemployment. Related Report Global Fixed Income StrategyRecent USD Strength Is Not Bond Bullish By quickly and bluntly dispensing any notion that the Fed could soon pause its rate hiking cycle, Powell poured ice cold water on the risk asset rally that boosted the S&P 500 by nearly 17% between mid-June and mid-August. The S&P 500 plunged 3.4% after Powell’s speech, a tightening of US financial conditions that was likely welcomed by the Fed, as it helps their goal of slowing the US economy. Minneapolis Fed President Neil Kashkari even said he was “happy” to see the negative market reaction to Powell’s speech. Powell, Kashkari and the rest of the FOMC are probably happy over the strength of the US dollar, which is also helping tighten US financial conditions – while also having a major impact on global bond returns and currency hedging decisions for investors. A Collision Of A USD Bull Market & Global Bond Bear Market Chart 1A Big Move In The USD The current strength of the US dollar is becoming increasingly broad-based. The EUR/USD exchange rate has fallen below parity, while USD/JPY continues to flirt with the 140 level (Chart 1). The British pound is trading at a 2-year low versus the US dollar, many important emerging market (EM) currencies are struggling, and the Chinese renminbi is set to retest the 7.0 level. The strength of the US dollar is no recent phenomenon. The current uptrend dates back to the start of 2021, with the DXY dollar index up 21% since then. The dollar bull market has been supported by several factors, most critically rising US interest rates. The 2-year US Treasury yield started 2021 just above 0% and now sits at 3.4%. Higher US interest rates have raised the benefit of hedging currency risk into US dollars for global bond investors. The Bloomberg Global Aggregate Bond Index in USD-hedged terms has outperformed the unhedged version of the index by 6.3% over the past year, one of the largest such increases dating back to 2000 (Chart 2). This means that global bond investors have been paid handsomely to simply swap non-US bond exposures into US dollars – in some cases, making low-yielding assets like Japanese government bonds (JGBs), hedged from yen into dollars, comparable to US Treasury yields. Chart 2Big Gains From Hedging Global Bond Exposure Into USD This wedge between USD-hedged and unhedged bond returns is unlikely to reverse soon, as the fundamental drivers of the dollar remain biased to more dollar strength. The US dollar is not only supported by more favorable interest rate differentials versus other currencies (both in nominal and inflation-adjusted terms), but is also benefitting from its safe haven status at a time of considerable uncertainty on the future of the global economy (Chart 3). Global growth expectations are depressed and showing no signs of turning around anytime soon, particularly in Europe and the UK where electricity and gas prices are climbing at a record pace. The dollar not only typically appreciates during periods of slowing growth, but also during episodes of investor risk aversion. Investors remain cautious, according to indicators like the US equity put/call ratio which shows greater demand for downside protection via puts – an outcome that also typically coincides with a stronger US dollar. In this current environment of broad-based US dollar strength, the gap between hedged and unhedged bond returns has varied widely depending on the base currency of the investor. For a euro-based investor, the performance gap between the unhedged Global Aggregate index and the EUR-hedged index has been 6% over the past year (Chart 4). Chart 3USD Strength Supported By Key Fundamental Drivers Chart 4FX Hedging Decisions Mean Everything In A Global Bond Bear Market Chart 5Low-Yielding Countries Facing High USD Hedging Costs The gap has been even larger for yen-based investors, with the unhedged index beating the JPY-hedged index by a whopping 13% over the past twelve months. Although Japanese fixed income investors are not typically known for taking unhedged currency risk on foreign bond holdings, doing so would have turned an awful year of global bond returns into a great year, simply due to yen weakness. When looking at current levels of interest rate differentials versus the US, which are the main determinant of currency hedging costs, the low yielding currencies like the euro, yen and Swiss franc see the greatest gain on returns versus the high-yielding US dollar (Chart 5). Hedging euros into dollars results in an annualized pickup of 252bps, while hedging yen into dollars produces an even bigger gain of 327bps. At the same time, the USD-hedging gains for relatively higher yielders are much lower. Hedging Australian dollars into US dollars only produces an annualized gain of 48bps, while hedging Canadian dollars into US dollars produces an annualized loss of -18bps. These varying hedging costs matter for global bond investors, as they impact the attractiveness of an individual country’s bond yields, depending on the investor’s base currency. We show the unhedged yield levels, and currency-hedged yield levels for six main developed market base currencies (USD, EUR, JPY, GBP, CAD, AUD) in the tables on the next two pages. Table 1 shows 2-year government bond yields, Table 2 shows 5-year government bond yields, Table 3 shows 10-year government bond yields and Table 4 shows 30-year government bond yields. Unsurprisingly, hedging into euros and yen, where short-term interest rates are the lowest, produces the smallest yields. Meanwhile, hedging into higher-rate currencies like US dollars and Canadian dollars generates the highest yields. Table 1Currency-Hedged 2-Year Government Bond Yields Table 2Currency-Hedged 5-Year Government Bond Yields Table 3Currency-Hedged 10-Year Government Bond Yields Table 4Currency-Hedged 30-Year Government Bond Yields We take the analysis a step further in the next set of tables on pages 9-11. Here, we take the hedged yields for each currency and compare them to the yields of the base currency. For example, in Table 5, it can be seen that a 2-year US Treasury yield of 3.4%, hedged into euros, produces a yield of 0.82% that is -17bps below the 2-year German yield (which is obviously denominated in euros). In other words, from the point of view of a euro-based investor who wants to hedge away the currency risk in a global bond portfolio, he gets paid a bit more to own a German bond over a US Treasury. Table 5Currency-Hedged 2-Year Govt. Bond Yield Spreads Similar results are shown in the subsequent tables for 5-year yields (Table 6), 10-year yields (Table 7) and 30-year yields (Table 8). From these tables, we can make the following broad conclusions: Table 6Currency-Hedged 5-Year Govt. Bond Yield Spreads Table 7Currency-Hedged 10-Year Govt. Bond Yield Spreads Table 8Currency-Hedged 30-Year Govt. Bond Yield Spreads For USD-based bond investors, all non-US markets except Canada have a yield pickup over US Treasuries on an FX-hedged basis For EUR-based investors, all non-euro area markets except Australia produce yields lower than those of Germany on an FX-hedged basis For GBP-based investors, all non-UK bond markets except the US and Canada have yields greater than those of Gilts for maturities from 5-30 years (the results are more mixed across countries for 2-year yields) For JPY-based investors, euro area and Australian bonds are clearly more attractive than JGBs on an FX-hedged basis, while US Treasuries, UK Gilts and Canadian government bonds offer FX-hedged yields below puny JGB yields. This is true up to the 10-year maturity point, as 30-year JGB yields – which are not targeted by the Bank of Japan in its yield curve control program – are much higher than those on the rest of the JGB curve For CAD-based investors, hedging virtually all non-Canadian bonds into CAD results in yields that are higher than Canadian government bond yields, with the largest hedged yield advantage for euro area and Australian bonds For AUD-based investors, only euro area bonds offer a consistent yield pickup over Australian government bonds on an FX-hedged basis. Broadly speaking, government bonds in the euro area and Australia offer consistently attractive FX-hedged yield pickups over the unhedged bonds for all currencies shown in the tables. On the other hand, Canadian government bonds have consistently less attractive FX-hedged yields across all currencies shown. Perhaps most importantly, US Treasuries look unattractive on an FX-hedged basis to all but CAD-based investors – a result that has meaningful implications for the potential of foreign buying to help stem the rise of US bond yields. Bottom Line: The US dollar bull market is having a huge influence on global bond returns. US Treasury yields, on an FX-hedged basis, look unattractive relative to most local currency denominated bonds across the developed world. Who Are The Foreign Buyers Of US Treasuries? When simply looking at currency-unhedged yield spreads, US Treasury yields offer particularly inviting yields over low-yielding (and low “beta” to US yields) markets like Germany and Japan. The unhedged 10-year US-Germany spread is now 160bps, while the unhedged US-Japan spread is up to 286bps (Chart 6). Meanwhile, among high-beta markets, the US-Canada 10-year spread is flat on an FX-unhedged basis, while an unhedged Australian 10-year bond yields 56bps more than a 10-year US Treasury. Chart 6UST Yields Only Look Attractive In FX-Unhedged Terms Yet after factoring in the currency hedging costs shown earlier, US Treasuries look consistently unattractive versus the other major developed economy bond markets. Chart 7UST Yields Look Unattractive After Hedging Out USD Exposure A 10-year US Treasury hedged into euros now yields -77bps less than a 10-year German bund, at the low end of the historical range for this spread dating back to 2000 (Chart 7). A 10-year Treasury hedged into GBP and JPY also offers lower yields versus 10-year UK Gilts (-11bps) and 10-year JGBs (-50bps), respectively. The 10-year hedged US-Australia spread (with the US yield hedged into AUD) is also at a stretched negative extreme at -114bps (Chart 8). Despite these broadly unattractive hedged US yield spreads, the US Treasury market has seen significant foreign inflows this year, according to the US Treasury Department’s capital flow (TIC) data. Total net purchases of US Treasuries by foreign buyers accelerated to $470bn (on a 12-month rolling total basis) as of the latest data for June (Chart 9). When broken down by type of buyer, private buyers bought a net $619bn, while official buyers were net sellers to the tune of -$149bn. Chart 8No Compelling Yield Advantage To Owning FX-Hedged USTs When looking at the TIC data by country, China was an important net seller of -$18bn of Treasuries. This is consistent with the reduced demand for US dollar assets from China, where policymakers are actively targeting a weaker renminbi. Chart 9TIC Data Shows USTs Seeing Foreign Buying (Ex-China) There was also net selling from many EM countries that have seen reduced trade surpluses and, hence, fewer US dollars to recycle into Treasuries. Chart 10Even Higher UST Yields Needed To Entice Japanese & European Buyers The largest net buying (Chart 10) was seen from the UK (+$306bn) and Cayman Islands (+$154bn) – the latter being a large source of Treasury buying through hedge funds and offshore investment funds located there. Those two countries accounted for almost all of the net foreign inflows into Treasuries, despite the fact they only hold a combined 12% of all foreign US Treasury holdings. There was modest net buying from the euro area (+$37bn) and small net selling by the country with the largest stock of US Treasury holdings, Japan. The relatively subdued inflows from Europe, and lack of inflows from Japan, are consistent with the unattractive hedged US-Europe and US-Japan yield spreads shown earlier, particularly at a time of elevated US bond yield volatility. The huge inflows from the UK and Cayman Islands are harder to explain on a fundamental basis, but are likely due to a continued normalization of Treasury market liquidity after the spring 2020 “dash for cash”. In a report published back in January, Fed researchers analyzed foreign demand for US Treasuries around the worst of the COVID pandemic shock in 2020. The report concluded that the huge collapse in private inflows into Treasuries – from a peak of +$238bn at the start of 2020 to a trough of -$373bn at the end of 2020 – was the result of aggressive net selling by hedge funds and global mutual funds. These are exactly the types of investors that would be domiciled in the Cayman Islands and UK (London). Specifically, the Fed report noted that: “In short, two prominent reasons for the large sales are the unwind of the Treasury basis trade by hedge funds (including foreign-domiciled funds) and the sudden, massive investor outflows from mutual funds that caused these funds to sell their most liquid assets, U.S. Treasury securities, to meet these redemptions.” The “basis trade” mentioned likely involved buying cash Treasuries versus selling Treasury futures, attempting to exploit unsustainable price differences between the two. As market liquidity conditions dried up in the spring of 2020 during the first wave of global lockdowns, leveraged bond investors needed to frantically unwind positions. For Treasury basis trades, that would have involved selling cash Treasuries, which was likely what is being picked up in the TIC data from the Cayman Islands which showed a huge plunge in net buying in 2020. The mutual fund outflows were likely a global phenomenon, but given the large fund management presence in London, the huge net selling of Treasuries from the UK in 2020 were almost certainly related to global fund managers, not purely UK investors. As Treasury market liquidity conditions normalized in 2021 and 2022, those large sellers in the UK and Cayman Islands (and other offshore investment locations) have likely turned into big net buyers, as evidenced from the TIC data. However, the modest inflows from Europe, and outflows from Japan, tell a more important story about the fundamental demand for US Treasuries. Treasury yields must rise further, widening both currency-hedged and unhedged spreads versus non-US government bonds to more historically attractive levels, to entice more foreign buying. Bottom Line: UST yields must rise even further versus non-US yields to attract more fundamental buyers like Japanese and European institutional investors, given elevated volatility in both US Treasury prices and the dollar. Global investors should underweight US Treasuries in global bond portfolios, on both a currency-unhedged and USD-hedged basis. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com GFIS Model Bond Portfolio Recommended Positioning Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Tactical Overlay Trades