Monetary
Highlights The credibility of ECB QE is set to diminish, one way or another. Stay long euro/dollar. Expect a continued compression in the German Bund yield spread versus the U.S. T-bond. Until the U.K. Supreme Court provides further legal clarity about the Brexit process, expectations for a softer Brexit should prop up the pound. In which case, the Eurostoxx600 will outperform the FTSE100 and the FTSE250 will outperform the FTSE100. Feature Nobody saw Brexit coming on June 23, and few saw a President Trump coming on November 8. Just as in the days after June 23, financial markets are trying to regain a footing after another political earthquake. The dust will settle. Our geopolitical strategists will provide a post-election analysis in a separate report. In this report, we would like to look through the immediate haze and focus on three major institutions whose policy options and degrees of freedom were becoming constrained, irrespective of the U.S. election shock. The institutions are: the ECB, the Federal Reserve, and the U.K. government. Chart of the WeekExpected Policy Rate Differential Drives ##br##The German Bund Yield Spread Versus The U.S. T-Bond The ECB Is Facing A Lose-Lose Decision Central bank quantitative easing (QE) remains one of the most misunderstood concepts within economics and finance. Contrary to the popular myth, it is not the central bank's asset purchases per se that matter. If the central bank's act of buying assets works at all, it is because QE signals a long period of ultra-low interest rates ahead.1 This then reduces the yields on other financial assets through the so-called "portfolio balance channel." Chart I-2Through 2011-13 Markets Interpreted A Lower ##br##Flow Of QE As A Monetary Tightening As Fed Chair Janet Yellen succinctly explains, once there is ample liquidity in the banking system: "QE has no discernible economic effects aside from those associated with communicating the central bank's commitment to the zero interest rate policy" The fundamental point is that the precise amount and asset-class composition of a QE program does not matter. The program just has to be large enough to demonstrate a credible commitment to ultra-low rates. But once a central bank establishes a monthly purchase amount, for example, the current €80bn for the ECB, the flow becomes an anchor. Financial markets then interpret a decrease in that monthly flow as a weakening commitment to ultra-low rates: in effect, a monetary tightening (Chart I-2). On the other hand, if the monthly asset-purchase promise goes on indefinitely, it also loses credibility. The financial markets know full well that there is only a finite pool of safe-assets that the central bank can buy, as the recent experience of the Bank of Japan testifies. For the ECB, the so-called "degrees of freedom" are even more limited than for the Bank of Japan. Asset purchases are constrained by politically determined upper-limits to individual euro area country exposure and by liquidity determined upper-limits to individual financial asset exposure. Hence, the ECB now faces a lose-lose decision. If it signals an intention - even a delayed intention - to taper its €80bn monthly flow of QE, the financial markets will interpret it as a de facto tightening. But if it does not signal an intention to taper it will have to use more and more smoke, mirrors, and chicanery to justify how it can keep delivering on its promise to buy. Bottom Line: one way or another, the credibility of ECB QE is set to diminish. The Federal Reserve's Track Record In Predicting Its Own Policy Is Abysmal To take a position on the euro/dollar exchange rate or the yield differential between German Bunds and U.S. T-bonds, we must now consider the other central bank in the equation: the U.S. Federal Reserve. When it comes to predicting the stance of its own monetary policy, the track record of the Federal Reserve is nothing short of abysmal. The Federal Reserve's famous dot forecasts have consistently missed the mark. In fact, they have not even come close to the mark. Just two years ago, the median Fed dot was predicting ten rate hikes by now (Chart I-3). Yes, seriously - ten! Chart I-3Two Years Ago, The Median Fed Dot Was Predicting Ten Rate Hikes By Now In its own defence, the Fed might respond that its monetary policy is "data-dependent" or even "events-dependent", and that this contingency prevented it from hiking the ten times that it had forecast. That's fine. But it then raises a bigger question about credibility. If central bank policy is contingent, then is it really possible to give credible forward guidance on the level of interest rates stretching out years ahead? We think not. Indeed, by publishing dots that turn out to be so consistently and deeply wrong, the central bank is seriously damaging its own credibility and authority. Rather than relying on Federal Reserve dots or market forecasts, investors must make up their own minds about the likely path of the Fed funds rate. For bond investors, the medium-term question is: at what level will the policy rate peak in this tightening cycle? This is because at the peak of the tightening cycle, the 0-10 year yield curve tends to be more or less flat (Chart I-4). In other words, the 10-year bond yield ends up eventually trading at the same level at which the policy rate peaks. After the election shock, the knee-jerk response has been a higher 10-year T-bond yield, and this direction may continue in the near-term. But further out, the question is: will the Fed funds rate peak above or below where today's 10-year T-bond yield of 1.9% implies that it will peak? We think below. Note that a first and second interest rate hike interspersed by a full year is unprecedented in modern economic history. And now, even the intended second hike in December might be in jeopardy. Given that the Fed has struggled to get two 25bps hikes through in two years, the idea that it will succeed in hiking another four or five times in this tightening cycle really does not seem credible to us. Bottom Line: Combined with the diminishing credibility of ECB QE, stay long euro/dollar (Chart I-5); and expect a continued compression in the German Bund yield spread versus the U.S. T-bond. In other words, maintain the pair-trade: long T-bonds, short German bunds (currency hedged) (Chart of the Week). Chart I-4At The Peak Of A Tightening Cycle, ##br##The 0-10 Year Yield Curve Is Flat Chart I-5Expected Policy Rate Differential##br## Drives Euro/Dollar The U.K. Government Has Had Its Wings Clipped The U.K. Government is another institution that has suffered a huge blow to its credibility and authority. Prime Minister Theresa May brazenly thought that she could start the legal process to exit the EU using the so-called 'royal prerogative', the power granted to governments to make certain decisions without a vote from parliament. But as we presciently warned two weeks ago in The Pound: Next Stop $1.10 Or $1.35,2 the U.K. High Court has judged the government does not have the authority to overturn domestic law - in this case, the European Communities Act (1972) and European Union Act (2011) - without obtaining parliamentary approval. The irony is that the sovereignty of the U.K. Parliament is the very thing that Brexiteers supposedly are fighting for. The High Court has clipped the U.K. Government's wings by deferring the Article 50 trigger to parliament. The government is appealing the High Court decision at the Supreme Court whose verdict is expected in January. But given that the government itself concedes that the Article 50 trigger will irrevocably change domestic law, it is hard to see how the government will win the appeal. Hence, there is a high likelihood that Members of Parliament will get to scrutinise the government's negotiating hand before it is allowed to fire the Brexit starting gun. Given that the precise form of Brexit has huge implications for British people's economic future and legal rights, parliament could water down or delay Brexit before voting it through. Bottom Line: Until the Supreme Court provides further legal clarity3 in January, expectations for a softer Brexit should prop up the pound. In which case: the Eurostoxx600 will outperform the FTSE100; the FTSE250 will outperform the FTSE100; U.K. retailers, travel and real estate equities will outperform the U.K. market; but U.K. goods exporters will underperform (Chart I-6 and Chart I-7). Chart I-6A Soft Or Hard ##br##Brexit... Chart I-7...Determines The Prospects ##br##For Most U.K. Assets Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Because while an asset-purchase program is underway, it would be difficult to raise rates. 2 Published on October 27 2016 and available at eis.bcaresearch.com 3 The Supreme Court will judge the government's appeal against the High Court decision. If the appeal is lost, it may also judge what type of parliamentary approval is required to trigger Article 50: a full Bill or a simple Resolution. Fractal Trading Model* This week's recommended trade is to go long U.K. healthcare versus the market. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Bond yields have room to move higher in the near run, but a move above 2% would represent a buying opportunity. U.S. elections are too close to call. Even if Trump wins, we caution that federal fiscal spending programs will have to work hard to offset the ongoing drag from sluggish state and local spending. Economic and inflation data will not stand in the way of a Fed rate hike in December. But heightened market volatility associated with the elections could still derail their plans. Feature October was a tough month for Treasuries, as the 10-year climbed 25 basis points since October 1. The sell-off puts Treasury yields closely in line with our bond strategists' estimate of fair value. This week, we review the factors that argue for or against a further rise in bond yields. Our conclusion is that the Treasury sell-off is likely to continue in the near run. Yields above 2% would represent a buying opportunity. The primary bearish driver for Treasuries in the next two months is the Fed. As we discuss below, recent economic data has been decent enough to meet the Fed's threshold for a rate hike and inflation indicators are moving towards the Fed's 2% target. Indeed, the FOMC statement released last Wednesday sent a mildly hawkish signal by highlighting that growth has improved, while both inflation expectations and realized inflation are tracking higher. The statement very much keeps a December rate hike in play, but it does not elevate the odds. In the FOMC meeting just prior to last year's rate hike, the Fed specifically mentioned the "next meeting" as a possibility for a rate increase. The Fed did not go as far this time around1 as policymakers are no doubt wary of spooking the markets when uncertainty is running high ahead of the U.S. election. Whether the Fed actually pulls the trigger in December will continue to hinge on the incoming economic data and the behavior of the markets following the election, but our base case remains that the Fed will follow through with a rate hike. The market is currently priced for a 65% chance of a rate move before the end of the year. This is roughly the same as the probability of a 2015 rate hike at this time last year (Chart 1). As long as the economic data remain reasonably firm, as we expect, then rate hike probabilities should follow last year's path and move to 100% by the December 13-14 FOMC meeting. Last year, the revision in the rate hike probability from November-December corresponded with a 35 bps rise in the 10-year Treasury. Chart 1Room For Expectations To Move Higher Since last year, the Fed has drastically downgraded its long-term rate projections. Recall that ahead of the December 2015 FOMC meeting, the Fed projected that the Fed funds rate would reach 1.4% in 2016. Since then, the Fed has revised downward its interest rate forecast to two rate hikes in 2017. Assuming the Fed does not revise these forecasts, it is unlikely that Treasuries respond as negatively as they did in 2015. Moreover, as we noted above, at 1.8% today, Treasuries are already roughly at fair value. During last year's sell-off, bond yields were starting from a substantially overbought level. This argues for a somewhat more muted reaction to a Fed rate hike, although we still expect yields could move higher. Beyond December, i.e. once the rate hike is priced in, our base case is that yields trend sideways for a time. The Fed's forecast for growth in 2017 is 2.0%, which would represent an increase of 0.5% from the first three quarters of 2016. If economic growth meets the Fed's expectation of 2%, then it is reasonable to expect that policymakers would increase twice next year, i.e. in line with their current forecasts. As shown in Chart 1, the Treasury market is not yet priced for this outcome: market participants currently assign only 80% odds to one rate hike by the end of 2017. The message is that the Fed, even with a reasonable (for the first time in years!) forecast for growth, will end up being a source of upward pressure on bond yields beyond 2017. There is nonetheless an important mitigating factor for bond yields: the U.S. dollar. A stronger currency represents a tightening of financial conditions that acts to depress expectations of future economic growth. This can spell trouble for risk assets and also lower the market-implied odds of future rate hikes. Indeed, a central bank can tighten monetary conditions, but does not have control over how much of the tightening comes via interest rates and how much through currency appreciation. In the current environment, the Fed knows that the process of normalizing interest rates will trigger bouts of volatility, because its actions will be exaggerated by movements in the currency. The bottom line is that we expect the Fed to tighten in December, followed by two more quarter-point hikes in 2017. Given that the bond market is not yet priced for this, the recent sell-off in bond yields will continue, perhaps to as high as 2%. Thereafter, we would expect Treasuries to trade in a fairly narrow range, with 2% representing the higher end of the band. A Coin Toss Election In the very near term, the U.S. elections pose an important risk to the view expressed above. For the past several months, market odds of a Trump Presidency have been positively correlated with the uncertainty index and negatively correlated with Treasury yields (Chart 2 and Chart 3). On the eve of the election, the race is once again too close to call. Our expectation has been that any flight-to-quality related to a Trump victory will be short-lived. However, with equity market multiples stretched and the earnings outlook still leaving much to be desired, equity markets are ripe for a correction. Chart 2Bond Market Tracks Uncertainty Chart 3Trump And Uncertainty In our September 26 Weekly Report, we warned that investors may be assigning too low odds of a Trump Presidential win. We posited that if the polls remained tight, the potential for further volatility was high. We followed up in mid-October, advising clients how to implement portfolio insurance against downside market risks, and specifically against a Trump election win. One recommended vehicle for insurance that we highlighted was the U.S. dollar, which is part of our Protector Portfolio (Chart 4 and Chart 5). We believe the currency will rally due to the combination of coming fiscal expansion and risk aversion flows on the back of a Trump win. True, this strategy has not held up in recent days, as the U.S. dollar has softened while Trump improves in the polls and risk assets have corrected. Still, the dollar's reputation as a safe-haven currency is well-deserved. It has consistently outperformed during times of crisis - even when the U.S. itself was the source, as most recently demonstrated during the summer 2011 budget impasse. Chart 4Protector Portfolio Components Chart 5Protector Portfolio Returns In a recent report,2 our geopolitical strategists outline several things to watch for on November 8, the day of the election, and in its immediate aftermath. The immediate developments most relevant for investors are anything that prolongs the period of uncertainty regarding voting. For example, the 2000 election is a reminder that the results may not be clear immediately. Although the 2000 election was held on November 7, the official result was not declared until November 26; Al Gore did not concede until December 12. This time, any number of things could delay declaring a winner, including a tie in the electoral college, or a "faithless elector," i.e. an electoral college member that does not cast his/her ballot for the candidate chosen by popular vote, and therefore causes the Supreme Court to intervene. A delay in declaring the election result would increase uncertainty and therefore be negative for risk assets. Longer term, the margin of victory has become important for policy. It is now clear that a Clinton win, if it were to happen, will be a narrow one. According to our Geopolitical Strategy team, it is almost guaranteed at this point that the chances of a Democratic sweep in the House of Representatives are zero. This is a positive development for the market as a Democratic sweep would mean a slew of anti-business regulation out of Congress. Nonetheless, a narrow win - with sub-50% of the vote - would give Hillary Clinton an extremely weak mandate. The probability of a compromise between the White House and GOP in Congress is therefore declining and puts in jeopardy any possibility of modest fiscal stimulus under a Clinton White House, or of corporate tax reforms. The likelihood of more fiscal spending in 2017 has become common lore among investors. Thus, a disappointment on that front would be negative for risk assets. Post-Election Government Spending Throughout the twists and turns of the U.S. election campaign, one higher conviction view that has endured at BCA is that popular sentiment is shifting away from fiscal austerity and that 2017 would feature more ambitious spending programs. That would be quite welcome, given that real government consumption and investment - at all levels of government - has been a drag on growth during most of the recovery since the Great Recession. Ongoing weakness at the Federal level is due to restraint in defense expenditure, while state and local spending has been weak due to a significant downtrend in tax revenues. It is notable that the decline in state tax revenues is not confined to oil-producing states. A recent report by the Rockefeller Institute compiled state tax revenue forecasts for 2017 and concludes that the decline in tax revenues from all sources (sales, income and corporate) will be slow to recover next year.3 Remember that states can only spend what they take in outside of infrastructure spending. If state and local governments can manage to cut the drag on real GDP to 0%, that would still leave a major onus for government spending on the federal government. Assuming the contribution to real GDP from state and local spending is zero, it would require a 6% annual growth in federal spending to return total government spending as a contribution to GDP back to its historic average of 0.4% (Chart 6). As Chart 7 shows, fiscal spending of that magnitude rarely occurs outside of recession. Chart 6(Part 1) How Much Fiscal Spending? Chart 7(Part 2) How Much Fiscal Spending? Importantly, how much long-term effect a fiscal boost will deliver depends on how well fiscal multipliers - which measure how much a dollar of increased government spending or reduced taxes raises output - are working. Indeed, the magnitude of fiscal multipliers continues to be a massive source of disagreement in policy circles. Recent work by the IMF suggests that the multiplier, in some economies and under certain interest rate settings, could be as high as four: for each dollar the U.S. government spends, it will generate another $4 dollars of GDP!4 Other academics put the fiscal multiplier at less than 0.5. The wide range of forecasts is due to several factors, but there are nonetheless some generally held principles: Fiscal stimulus tends to be more effective when the output gap is large: when output is well below its potential, the monetary policy response to an increase in spending is likely to be limited. In other words, fiscal multipliers are larger in recessions than in expansions.5 The type of fiscal stimulus matters, a lot. Table 1 shows a range of CBO estimates for different types of government activity. For example, income tax cuts on high income earners tend to have a low multiplier effect (well below 1), while direct spending by government, e.g. infrastructure outlays, tends to have a much higher multiplier (above 1). Multiplier effects tend to last no more than eight quarters when output is close to potential. Fiscal stimulus tends to have a more impressive impact, although short-lived (four quarters) when the output gap is large. Table 2 shows the CBO-estimated effect of an increase in demand over eight quarters under two different economic scenarios. The first is when monetary policy is constrained, and the second is when monetary policy responds to the increase in demand from government stimulus. Our guess is that we are currently somewhere in between the two economic scenarios presented: there is still an output gap and monetary policy is already off the zero bound. Thus, the fiscal multiplier is likely a little above than one, meaning that government spending does not "crowd out" private spending. Table 1Ranges For U.S. Fiscal Multipliers Table 2The Effect Of A $1 Increase In Aggregate Demand Over Eight Quarters Overall, government expenditures will contribute positively to GDP next year, though the amount of fiscal expansion is dependent on the political configuration in Washington after the elections. Similarly, the impact of any spending will depend on what form new fiscal measures takes. CBO research suggests that the fiscal multiplier will be slightly above 1. Business Sentiment: Neither Euphoria Nor Misery Without further participation from the government sector, the economy is likely to achieve above 2% real GDP growth. A more optimistic scenario could unfold if capex improves substantially and/or a Trump win significantly opens the fiscal taps. Recent private sector data shows that businesses are continuing on a mild expansion path. The ISM surveys of business confidence were little changed in October - sentiment among manufacturers is broadly unchanged, while respondents from the service sector were slightly less optimistic than the previous month (Chart 8). Still, the major indices remain above their boom/bust lines and respondents' comments suggest neither euphoria nor misery. Meanwhile, payrolls increased by 161,000 in October. Although this was slightly below the consensus forecast of 175,000, there was a cumulative 44,000 in upward revisions to the prior two months. Elsewhere, wages accelerated more than expected and average hourly earnings rose 0.4% m/m, pushing the annual growth rate to a new cyclical high of 2.8% (Chart 9). Chart 8ISM Surveys Are Steady Chart 9Wage Growth Is Perking Up To paraphrase from this week's FOMC statement, the employment report provides some further evidence that the U.S. economy is progressing towards the Fed's dual mandate. In itself, it reinforces the case for the Fed raise interest rates in December. It seems now that the only thing that could derail the Fed is an election surprise and related heightened market volatility. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/press/monetary/20151028a.htm 2 Please see Geopolitical Strategy Special Report "It Ain't Over 'Till The Fat Man Sings," dated November 1, 2016, available at gps.bcaresearch.com 3 http://www.rockinst.org/pdf/government_finance/state_revenue_report/2016-09-21-SRR_104_final.pdf 4 https://www.imf.org/external/pubs/ft/wp/2014/wp1493.pdf 5 "How Powerful Are Fiscal Multipliers In Recessions? Alan Auerbach and Yuriy Gorodnichenko, NBER Reporter 2015, http://www.nber.org/reporter/2015number2/auerbach.html
Highlights Despite a tough week, the dollar bull market is intact. The U.S. economy's resilience to a strong dollar is growing. But, if Trump wins, the dollar could temporarily sell off against EUR, CHF, and JPY. Favor these currencies against EM and commodity currencies. Thanks to the High Court's Brexit ruling, the outlook for the pound is brightening. Wait for the appeal procedure to be over before implementing directional bets. Feature Despite this week's violent correction in the dollar, we remain dollar bulls. However, the recent reaction of the greenback to the rising probability of a Trump victory raises the need to hedge such an outcome. Still Bullish On The Dollar... The U.S. is unlikely to fall from its perch at the top of the distribution of G10 interest rates, a historically dollar-bullish environment (Chart I-1). Chart I-1Dollar Tailwinds The hidden slack in the U.S. labor market has dissipated. The amount of workers outside of the labor force who do want a job is at 6.2%, a level in line with the readings recorded between 2000 and 2007, when hidden slack was low (Chart I-2). Moreover, wages and salary continue to grow in the national income. Skewing the income distribution away from profits and rents is akin to a redistribution of income away from the top 1% of households, who derive nearly 50% of their income from profits. Importantly, middle-class households have a much higher marginal propensity to consume than rich ones. So great is the difference that since 1981, the 10% increase in the share of national income accruing to the top 1% of households has helped depress consumption by 3%. As a result, income redistribution will depress the U.S. savings rates going forward (Chart I-3). Since 70% of household consumption is geared toward the service sector, a component of the economy where productivity growth is hard to come by, increasing consumption is likely to directly result in job creation. Chart I-2U.S. Wages Can Rise Chart I-3The U.S. Savings Rate Has Downside With the unemployment gap being closed, consumption growth will cause wage growth to accelerate, further supporting consumption. Hence, the Fed can increase rates more aggressively than the 70 basis points priced into the OIS curve until the end of 2019. These kinds of dynamics have historically been very dollar bullish (Chart I-4). Moreover, the feedback loop linking the dollar and financial conditions to the economy is weakening. Not only is the economy increasingly driven by household expenditures, but the weight of commodity and manufacturing capex in the economy has collapsed in response to the dollar's strength (Chart I-5). Even if the sensitivity of these sectors to the dollar and financial conditions is unchanged, their impact on the broad economy has diminished. Chart I-4A Virtuous Circle##br## For The Dollar Chart I-5Lower Impact Of Manufacturing ##br##And Commodities Outside of the U.S. some key factors will prevent a normalization of policy rates in the major economies. Euro area rates will stay depressed for much longer. Conditions to generate inflation are absent. The output gap remains wide and negative, unemployment is significantly above NAIRU, and fiscal austerity, while diminished, is still de rigueur (Chart I-6). While the IMF pegs the output gap at 1.2% of GDP, the ECB estimates it to stand at 6% of GDP. Additionally, the European credit impulse is likely to roll-over. European bank stock prices have led European credit growth. They now point to slowing loan growth (Chart I-7). Even if loan growth were only to stabilize, this would imply a fall in the impulse. Chart I-6Inflationary Pressures##br## In Europe Chart I-7Downside Risk To The##br## Euro Area Credit Impulse These forces will weigh on the euro. The SNB floor under EUR/CHF remains credible and exercised. Therefore, USD/CHF will mostly stay a function of EUR/USD. For Japan, as we highlighted in the September 23 and October 28 reports, conditions are falling into place to see rising wages and inflation expectations. Rates being pegged at 0% until inflation greatly overshoots 2% will lower Japanese real rates along with the yen. Bottom Line: The 12-18 months outlook for the dollar remains bright. The resilience of U.S households will lead to stronger wage growth and an economy powered by consumption. The Fed will surprise markets with more rate hikes than anticipated. Meanwhile, European and Japanese real rates are unlikely to rise much if at all. ...But The Short-Term Outlook Is Bifurcated Yet, the short-term outlook is murky. BCA believes that a Trump presidency is likely to supercharge any dollar rally. Not only would his presidency imply huge infrastructure projects, his trade tactics should put upward pressure on wages and inflation, prompting an even more hawkish Fed than we anticipate. However, if recent dynamics are any clue, a Trump victory next week could also cause an immediate but temporary knee-jerk sell-off in the dollar. Since the FBI announced a re-examination of the Clinton emails affair, Trump's probability of winning has skyrocketed. While USD/MXN has rallied, so has EUR/USD, driven by a favorable move in interest rate differentials (Chart I-8). This raises the specter of a bifurcated move in the dollar over the next month or so. On the one hand, the dollar could rise against EM currencies and commodity producers, but suffer against EUR, CHF, and JPY. Why would the dollar rise against EM and commodity currencies? Cyclically and tactically, the stars are lining up against this set of currencies. The economic situation in EM and China is as good as it gets right now. The Keqiang index is near cyclical highs, suggesting that the upswing in Chinese industrial activity is unlikely to strengthen further, especially as loan demand remains tepid (Chart I-9). Chart I-8A Trump Indigestion Chart I-9China: As Good As It Gets Worryingly, Chinese fiscal stimulus is dissipating, which will act as a drag on the nation's investment and industrial activity. Chinese authorities panicked in 2015 as the Chinese economy was moving toward a hard landing. The government direct fiscal spending impulse surged (Chart I-10). Also, private-public partnerships originally expected to invest $1.2 trillion in infrastructure over three years were deployed in six months. As these tactics caused the economy to deviate from Beijing's stated goal to rebalance China away from investment, they are now being rolled back. Additionally, Chinese deflationary pressures are likely to resurface. Our bullish stance on the dollar implies a negative view on commodity prices. PPI will suffer if the dollar rallies given that Chinese producer prices are highly correlated with commodity prices (Chart I-11). This increases the likelihood that industrial activity in China will slow again. Chart I-10Vanishing Fiscal##br## Support Chart I-11Chinese PPI And Commodity Prices:##br## Brothers In Arms These risks are not priced in by EM assets and related plays. Risk reversals on EM currencies are priced in for perfection. Slowing Chinese growth would represent a negative surprise for EM debt, EM currencies, and commodity currencies (Chart I-12). An additional worry for EM currencies is momentum. A paper by the BIS shows that momentum continuation strategies are very profitable in EM FX.1 Hence, if EM currencies begin to fall, this fall will prompt further weaknesses. Finally, a Trump presidency is another headwind for EM and commodity currencies. In an earlier Special Report, we argued that a key factor that boosted the profitability of FX carry strategies was the rise of globalization (Chart I-13).2 This growing global trade mostly benefited small open economies, EM economies, and commodity producers, the so-called "carry-currencies". Trump's rhetoric promises a roll-back of this trend, a move that will disproportionally hurt such currencies. Compounding this risk, this cycle, the performance of FX carry trades has been inversely correlated to global bond yields (Chart I-14). BCA's underweight duration represents another problem for EM and commodity currencies. Chart I-12EM Plays Are Priced For Perfection Chart I-13Carry Trades Love Globalization Chart I-14Rising Yields Hurt Carry Currencies However, what could temporarily lift the euro, the Swiss franc, and the yen despite a negative cyclical outlook? Risk aversion and a global equity market correction prompted by a Trump victory. In short, a flight to safety amid uncertain times. These currencies are underpinned by current account surpluses ranging from 3% of GDP for the euro area to 10% for Switzerland. They therefore export investments abroad. This capital usually displays a strong home bias when global risks spike, and EUR, CHF, and JPY strengthen when global equities weaken. Finally, our current negative predisposition toward carry trades would also support funding currencies, currencies with deeply negative rates like EUR, CHF, or JPY. Bottom Line: In the direct aftermath of a Trump victory, the dollar could suffer from some temporary downward pressure against the EUR, CHF, and JPY. However, it will strengthen against EM and commodity currencies. On a cyclical basis, the USD will be stronger against these latter currencies than against European currencies. Key Investment Recommendations We are opening long EUR/AUD and short CAD/JPY positions. The EUR is less sensitive to EM downside than the AUD. Deteriorating EM currencies' risk reversals often coincide with a stronger EUR/AUD (Chart I-15). Also, the euro is cheaper than the Aussie, trading at a 5% discount to PPP. Additionally, EUR/USD could appreciate in the event of a Trump presidency, but its negative impact on EM economies and global trade will drag down AUD. The CAD/JPY position is primarily a Trump hedge. CAD will sell off if Trump wins as investors ponder the future of NAFTA. Meanwhile, the yen will benefit from safe-haven flows and from the eradication of any probability of MoF interventions (Chart I-16). Japan already meets two of the three criteria to be labeled a currency manipulator by the U.S. Treasury. Under a Trump presidency, such a label will have very real consequences. Chart I-15A Fall In EM Assets Would##br## Support EUR/AUD Chart I-16If Trump Wins, The MoF ##br##Will Not Intervene Moreover, CAD/JPY is also negatively affected by a deterioration of EM risk reversals. However, we are more worried for the JPY's long-term outlook than the EUR's. This is because of the more aggressive policy stance taken by the BoJ. Thus, this trade is more tactical than the EUR/AUD bet. Finally, investors wanting to play a Trump victory using European currencies should consider going long CHF/SEK. Sweden, a small open economy with deep trade links with EM, has been a key beneficiary of globalization. It will be a big loser if global trade shrinks. Meanwhile, CHF is likely to rally. Critically, this trade is for very nimble traders. At EUR/CHF 1.06, the SNB will intervene with all its might. The U.K.'s Über Thursday Yesterday, not only did the Bank of England announce its monetary policy decision and economic forecasts, but also, the High Court ruled that the Article 50 process preceding Brexit requires a vote from Parliament. While we expect Parliament to follow the popular vote and engage in Brexit, a parliamentary vote is much more likely to result in negotiating a "soft Brexit" rather than a "hard Brexit". In a "soft Brexit", the U.K. would retain access to the common market, and passporting of financial services would be allowed. However, freedom of movement would have to be maintained and the U.K. would have to contribute to the EU's purse. Unsurprisingly, the government is appealing the decision. Practically, this means it is still too early to aggressively bid up the pound. If the government wins its appeal, GBP/USD will move toward 1.10. If the government loses its appeal, FDI flows in the U.K. could regain some composure and help finance the large British current account deficit. This would lift GBP/USD toward 1.30 - 1.40. Probabilities are skewed toward the government losing its appeal. Economics, too, warrants caution. While the household sector's resilience has been a surprise to the Bank of England, it is unlikely to continue for long. First, the U.K. household credit impulse has rolled over and is now contracting at a GBP 1 billion pace, pointing to slowing growth. Second, in line with falling capex intentions, employers are paring their hiring intentions (Chart I-17). A slowdown in household nominal income growth should ensue. British households' real income will soon be squeezed, especially as the BoE increased it inflation forecast to 2.7% for 2018 due to the pass-through from the 15% fall in the trade-weighted GBP (Chart I-18). Additionally, the RICS survey points to further weakness in house prices. Chart I-17Deteriorating U.K. Labor Market Outlook Chart I-18Mechanics Of A Real Income Squeeze Hence, the BoE is on hold for a longer time than was anticipated in August. Moreover, Chancellor Hammond has made it clear that while the fall budget will loosen the fiscal austerity penciled in under the Osborne budgets, it is too early for investors to expect a large fiscal easing from the government. This suggests that risks remain tilted toward further easing by the "Old Lady." Bottom Line: Until we get clarity on the results of the government's appeal of yesterday's High Court Brexit ruling, we are inclined to fade strength in the pound. Any move above GBP/USD 1.25 would create a tactical shorting opportunity. A strangle with strikes at 1.27 and 1.15 and a January maturity makes sense for investors wanting to play the volatility around the ultimate ruling on the government's appeal. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Lukas Menkhoff, Lucio Sarno, Maik Schmeling and Andreas Schrimpf, "Currency Momentum Strategies", BIS Working Papers (2011). 2 Please see Foreign Exchange Strategy Special Report, "Carry Trades: More than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Policy Commentary: "The Committee judges that the case for an increase in the federal funds rate has continued to strengthen but decided, for the time being, to wait for some further evidence of continued progress toward its objectives" - FOMC Statement (November 2, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Policy Commentary: "[On ECB Stimulus]...the initial date set to end the buying program is March, but the most advisable action is that it be a process that's as slow as possible" - ECB Governing Council Member Luis Maria Linde (October 28, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Policy Commentary: "[On wether the BOJ would buy regional domestic bonds]..Regional domestic bonds are issued by the various local governments, and are traded separately. There are various factors that would make it difficult to consider them for monetary policy, but we will give the suggestion due consideration" - BoJ Governor Haruhiko Kuroda (November 2, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Policy Commentary: "...indicators of activity and business sentiment have recovered from their lows immediately following the referendum and the preliminary estimate of GDP growth in Q3 was above expectations. These data suggest that the near-term outlook for activity is stronger than expected three months ago" - BOE Monetary Policy Report (November 3, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Policy Commentary: "In Australia, the economy is growing at a moderate rate. The large decline in mining investment is being offset by growth in other areas, including residential construction, public demand and exports. Household consumption has been growing at a reasonable pace, but appears to have slowed a little recently" - RBA Statement (November 1, 2016) Report Links: USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Policy Commentary: "There are unconventional monetary policies that give us more room to maneuver than previously believed...These include pushing interest rates below zero or buying longer-term bonds to compress long-term yields" - BoC Governor Stephen Poloz (November 1, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Policy Commentary: "In Switzerland the negative interest rate is currently indispensable, owing to the overvaluation of the Swiss franc and the globally low level of interest rates" - SNB President Thomas Jordan (October 24, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Recommended Allocation Central Banks Still In The Driving Seat Markets continue to obsess about every move from the three major DM central banks. With two of them (the Fed and the ECB) likely to withdraw accommodation cautiously over the coming 12 months, the upside for risk assets is limited. The Fed is signaling that it will probably hike in December and the futures market is pricing in a 70% probability of that happening (roughly the probability one month before the rate rise in December last year). Inflation expectations have picked up recently (Chart 1) and core PCE inflation ticked up to 1.7% in August, within "hailing distance", as Fed vice-chair Stanley Fischer put it, of the Fed's 2% target. There is a political angle, too: having forecast four rate rises for the year, the Fed would endanger its credibility (and risk an audit from Congress) if it failed to deliver even one. At the same time, with growth in the Eurozone running a little above trend, the ECB is likely to announce in December an extension to its asset purchase program beyond March 2017 but eventually at a slower pace (a "tapering"). Reflecting these factors, government bond yields have moved up in recent months (Chart 2), and the trade-weighted dollar has strengthened by 4% since mid-August. None of these moves are good for risk assets, which have consequently moved sideways since August. But neither do they presage a big selloff since central banks will err on the side of caution. Inflation in the U.S. is unlikely to jump: wage growth will be kept under control by a gradual rise in the participation rate, which will prevent unemployment falling much further (Chart 3). The Fed's leaders continue to sound dovish. Janet Yellen even raised the question in a recent speech of "whether it might be possible to reverse these adverse supply-side effects [from the 2007-9 Global Financial Crisis] by temporarily running a 'high-pressure economy'", though she emphasized this was a suggestion for further economic research not her view. More practically, the FOMC will have a more dovish tilt in 2017, as the three regional Fed presidents who voted for a hike in September rotate out. Chart 1Have Inflation Expectations Bottomed? Chart 2Bond Yields Moving Higher Chart 3Core Workers Reentering The Labor Force Meanwhile, economic data remain somewhat sluggish. The U.S. manufacturing and non-manufacturing ISMs both rebounded sharply in September, suggesting that the very weak August prints were, as we suggested, an anomaly. Q3 U.S. real GDP growth come in at 2.9%, but the New York Fed's NowCast points to a slowdown to 1.4% in Q4. The Citi Economic Surprise Index (Chart 4) has also turned down again recently, with notable weakness in consumer spending and housebuilding. We expect this sluggish pace to continue through 2017: consumption should hold up as wage rises come through, but it is hard to forecast a strong recovery in capex, given the low capacity utilization rate (Chart 5), even if investment in the mining and energy sectors bottoms out next year. Eurozone growth could stutter too. It is driven substantially by credit growth, but historically European banks have tended to curtail lending after their share prices have fallen, as has been the case recently (Chart 6). Chinese growth has stabilized (at least in the GDP data, which seems to come in regularly at 6.7%, bang in the middle of the government's target range), thanks to the government's reflation policy from earlier this year. While the Chinese authorities have now reined back a little on stimulus, given their worries about the run-up in house prices,1 they offer an option since they would undoubtedly reflate again should growth slow. Chart 4Data Surprising Negatively Again Chart 5Hard To See More CAPEX Indeed Chart 6Share Prices Influence Lending All this suggests that returns from investment assets will be low, but positive, over the coming 12 months. With economic growth anemic but stable, bond yields prone to drift up, and equities expensive (but not as expensive as bonds), we expect risk-adjusted returns from the major asset classes to be broadly similar. We continue to recommend therefore a neutral weighting between bonds and equities, and suggest that investors look to pick up extra return through tilts to investment-grade corporate credit, inflation-linked over nominal bonds, and alternative assets such as real estate and private equity. Equities: Our preference remains for U.S. equities over European ones in USD terms. The dollar is likely to strengthen further, and the worst is not over for Eurozone banks - the time to buy into them will be at the point of maximum pain, which may come if German or Italian banks have to be bailed out by their governments. We continue to recommend a small (currency-hedged) overweight on Japan. The Bank of Japan's new policy to cap 10-year government bond yields at 0% has worked so far: the yen has weakened to JPY 104 to the dollar and equities have risen moderately. We expect further fiscal or wage-control measures from the government to give inflation an extra push. We remain wary of EM equities: earnings growth is negative, loan growth has started to slow (with the credit impulse having a high correlation with earnings and economic growth), and there is still little sign of structural reform. Some sectors in EM - notably IT and Healthcare - are attractive, however. Fixed Income: U.S. Treasury bond yields are likely to rise further - our model suggests fair value is a little below 2% (Chart 7) - and so we remain underweight duration. A moderate pickup in inflation suggests that TIPs will outperform nominal bonds (as described in detail in our recent Special Report).2 We lowered our recommendation in high-yield corporate debt to neutral last month because, at 65 BPs, the default-adjusted spread no longer offers sufficient return to justify the risk. At the start of the year it was 400 BPs (Chart 8). We continue to like investment-grade debt, where the spread over government bonds is 120 BPs in the U.S. and 100 BPs in the Eurozone, higher than at any point in 2005-2006 during the last expansion. Chart 7Treasury Yields Could Rise Further Chart 8Junk No Longer Offers Enough Return Currencies: We expect the U.S. dollar to continue to appreciate given the differential in growth and monetary conditions between the U.S. and other developed economies. The dollar looks expensive, but is nowhere near the over-bought levels it got to at the peak of previous rallies in 1985 and 2002 (Chart 9). China seems likely to allow a further weakness of the RMB against the dollar, repegging it to a trade-weighted currency basket. This could push down other emerging market currencies too particularly if, like Brazil recently, they try to cut rates to boost growth. Chart 9USD Not As Overvalued As In The Past Commodities: Oil has probably overshot in the short-term on expectations that Saudi Arabia and Russia will cap, or even cut, production. We think this talk has been overhyped and that the OPEC meeting in November could prove a disappointment. Nonetheless, we still see the equilibrium level for crude over the next two years at USD 50 a barrel, the marginal cost for U.S. shale producers. Industrial commodities are likely to fall further (they peaked in June) if we are right that the dollar appreciates. We continue to like gold as an inflation hedge, but short-term are nervous because it, too, is negatively correlated with the dollar. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see China Investment Strategy "Housing Tightening: Now And 2010" dated October 13, 2016, available at cis.bcaresearch.com 2 Please see Global Asset Allocation Special Report "TIPS For Inflation-Linked Bonds," dated October 28, 2016, available at gaa.bcaresearch.com Recommended Asset Allocation Model Portfolio (USD Terms)
Highlights The appearance of two virtuous circles will cause the real broad trade-weighted dollar to strengthen by 10% over the next 12 months. The Fed's efforts to run a "high pressure" economy will create a self-reinforcing cycle where accelerating wage growth boosts household spending, leading to faster wage growth and even more spending. Stronger growth will prompt the market to price in more rate hikes over the coming years, propelling the dollar higher. A rising dollar will boost activity in the euro area and Japan. An improved economic outlook will push up inflation expectations in these economies, causing real rates to fall. This, in turn, will usher in a second virtuous circle in which lower real rates put further downward pressure on the euro and the yen, leading to even faster growth. Global equities are likely to struggle in the near term, as investors discount a more aggressive path for Fed tightening. Once the dust has settled, however, higher beta markets such as Europe and Japan should outperform in local-currency terms. We are closing our long Treasurys/short German bunds trade for a gain of 18%. Feature The Dollar Is Heading Higher Chart 1Most Forecasters Expect Household ##br## Spending Growth To Slow The appearance of two virtuous circles will cause the real broad trade-weighted dollar to strengthen by 10% over the next 12 months. The first virtuous circle will push up real yields in the U.S., while the second will push down real yields in key economies such as Europe and Japan. Taken together, this will cause real yield differentials to widen sharply in favor of the U.S., sending the greenback higher. Virtuous Circle #1: Accelerating wage growth boosts U.S. consumption, leading to even faster wage growth and more spending. This forces the Fed to hike rates more than what the market is currently discounting. Real personal consumption has grown by 3% since mid-2013, even as the rest of the economy has expanded by a middling 0.7%. Most analysts expect consumption growth to decelerate next year to around 2.4%, based on Bloomberg estimates (Chart 1). There is no shortage of reasons for why consumer spending may slow. The drop in energy prices since mid-2014 has saved households an annualized $120 billion at the pump, and an additional $30 billion in the form of lower utility bills - equivalent to around 1% of disposable income. This has given households scope to increase spending on other items. Now that oil prices appear to have bottomed, this windfall will cease to grow. Rising asset prices have also stoked consumption. The S&P/Case-Shiller 20-City home price index has risen by 37% since early 2012, while the Wilshire 5000 index has gained 54% (Chart 2). Largely due to these developments, household net worth has increased from 538% of disposable income to 637% over this period, according to the Fed's Flow of Funds accounts. Looking out, we expect U.S. equities to deliver only 2%-to-3% real total returns over the coming decade. Home price appreciation should also flatten out, now that real home prices have moved back above their pre-bubble levels (Chart 3). Chart 2Rising Asset Prices Have Inflated Household Net Worth Chart 3U.S. House Prices Are Not Cheap Anymore Meanwhile, banks are starting to tighten lending standards in some consumer credit categories (Chart 4). Most notably, auto loan standards have tightened markedly, following a number of years of sharp easing. This could pose a headwind to vehicle sales in the coming year. Growth in aggregate hours worked has also decelerated over the past five quarters (Chart 5), a trend that should persist. We expect payroll growth to slow to around 100,000 a month in the next few years, as remaining labor market slack is absorbed. However, therein lies the upside for consumer spending. As the labor market begins to overheat, wage growth is likely to accelerate further (Chart 6). A one percent increase in wage growth boosts aggregate household income by as much as 120,000 additional jobs per month. Chart 4Consumer Lending ##br##Standards Are Starting To Tighten Chart 5Deceleration In ##br##Aggregate Hours Worked Chart 6Diminished Labor Market Slack ##br##Should Boost Wages Our sense is that the U.S. labor market is now approaching full employment. Granted, the employment-to-population ratio for prime-aged workers is still 2.3% below its pre-recession levels. However, as Chart 7 illustrates, this particular metric was trending lower even before the Great Recession began, suggesting that much of its decline is structural in nature. The data seems to bear this is out. Among the 23 million Americans between the ages of 25-to-54 who are currently out of the labor force, only 10.6% report wanting a job. This number is not much higher than before the crisis (Chart 8). The vast majority of nonparticipants are either homemakers, taking care of dependents, in school, claim they are ill or disabled, or have taken early retirement (Chart 9). Chart 7A Structural Downtrend In Labor ##br##Market Engagement Chart 8Not Many Potential ##br##Workers On The Sidelines Chart 9Most Who Do Not Work ##br##Choose Not To Work If the late 1990s is any guide, an overheated labor market is likely to push up labor's share of national income, allowing household earnings to grow more quickly than GDP. Back then, growth in aggregate wages and salaries among private-sector workers reached nearly 10% (Chart 10). Such blockbuster gains are improbable this time around owing to both lower structural productivity and slower labor force growth. Nevertheless, nominal wage growth could still rise to 5%-6% from the current lackluster pace of 3.7%, helping to bolster consumer spending. In addition, the experience of the 1990s suggests that a tight labor market will particularly benefit less-skilled workers (Chart 11).1 This is simply because less-educated workers are typically the first to be fired, and the last to be hired. Since poorer households tend to spend a larger share of their incomes, this will have a disproportionately large impact on consumption. Chart 10Lesson From The 1990s Chart 11The Real Beneficiaries Of A Tight Labor Market Would higher wage growth cause firms to reduce investment spending? The evidence says otherwise. Business investment has grown sluggishly in this economic recovery, even though profit margins have risen sharply. Thus, high corporate profitability is not a precondition for greater investment spending. If anything, business capex tends to increase during periods when the labor share of income is rising (Chart 12). This reflects the fact that business investment represents what economists call "derived demand." Firms typically expand capacity only when they feel that final demand for their goods or services will increase. Put differently, if consumers spend more, firms will invest more. Chart 12Firms Invest More When Workers Earn More The end result could be the emergence of a virtuous circle in which rising wages push up consumer spending, causing firms to hire more workers and invest in new capacity leading, in turn, to even faster wage growth. In fact, it is possible that the Fed's decision to let the economy run hot for a while pushes it towards an equilibrium where both aggregate demand and the neutral rate of interest - r* - are permanently higher. Chart 13 shows how such multiple equilibria can arise. Chart 13Double-Crossed: Multiple Equilibria In A Keynesian Demand Model Of course, at some point, the Fed would need to step in to cool things down by hiking rates more quickly than inflation is rising. This would translate into an increase in real interest rates, the consequence of which would be a stronger dollar. This is not just a theoretical possibility: The dollar has, in fact, tended to strengthen meaningfully whenever the labor share of income is rising and the jobless rate has fallen below its full employment level (Chart 14). Virtuous Circle #2: A stronger dollar boosts activity in the euro area and Japan. This pushes up inflation expectations in those economies, causing real rates to fall. Lower real rates put downward pressure on the euro and the yen, leading to even faster growth. How can stronger growth lead to higher real rates in the U.S. but lower real rates in Europe? The answer stems from the economics of liquidity traps. As discussed above, the U.S. economy is nearing full employment. As such, the Fed is no longer constrained by the zero lower bound on nominal interest rates. In contrast, inflation is well below target in both the euro area and Japan (Chart 15). This means that neither the ECB nor the BoJ will raise rates, even if growth picks up. What stronger growth will do in both economies is eat away at deflationary pressures. The upshot will be higher inflation expectations, lower real rates, and a weaker euro and yen. Chart 14Virtuous Dollar Circle #1 In Action Chart 15ECB And BoJ: In No Position To Tighten Admittedly, high levels of unemployment in Southern Europe will limit the extent to which stronger demand in those economies translates into higher inflation. Nevertheless, the region will still benefit from a weaker euro - and the boost to external competitiveness that this brings. Moreover, with the German unemployment rate at a 25-year low, a cheaper currency will generate more meaningful inflation in Europe's largest economy. This would help erode Germany's gigantic 8% of GDP current account surplus, which has been a key force in propping up the euro. It would also facilitate the "internal devaluation" that Southern Europe has to undertake without the need for grinding deflation in that region. We doubt that either the BoJ or the ECB would do anything to abort this virtuous circle. For his part, Governor Kuroda has stated that he wants inflation to rise above 2% in order to make up for the fact that inflation has consistently run short of the BoJ's target. To back up this pledge, the BoJ is giving the Ministry of Finance a blank check by promising to undertake unlimited bond purchases while keeping the 10-year yield pegged at zero. Thus, not only does the Japanese government need not worry about paying any interest on its debt, it also does not have to worry about repaying the principal, since the BoJ is buying more bonds than the government is issuing. Mario Draghi is also likely to lean into any inflationary tailwind. We expect the ECB to extend its asset purchase program at its December meeting for another six months, which is currently set to end in March 2017. The Governing Council may also signal that it will consider expanding the eligibility rules for bond purchases and modifying the existing capital key allocation. Investment Conclusions Two weeks ago, we argued that in the absence of Fed tightening, U.S. growth could reach 2.8% next year on the back of a turn in the inventory cycle, a pickup in business investment, and increased fiscal spending at the federal, state, and local levels.2 Consistent with Chair Yellen's desire to run a "high pressure" economy, the Fed would welcome faster growth, even if this pushes core inflation temporarily above 2%. However, memories of the 1970s have not fully gone away. Many of Yellen's FOMC colleagues, including former doves such as John Williams and Eric Rosengren, are already clamoring for higher rates. This means that if growth does pick up, the Fed will continue emptying the punch bowl. We expect the FOMC to raise rates twice next year, in addition to the 25 basis-point hike we are penciling in for December. This pales in comparison to the mere 54 basis points in hikes the market is pricing in through to end-2018 (Chart 16). Chart 16Market Rate Expectations Further Out Remain Muted Chart 17 shows that rate differentials between the U.S. and its trading partners have widened over the past four months, even as the dollar has traded sideways. Thus, even if rate differentials remain broadly constant, a case can be made for a stronger dollar over the coming months. The analysis above, however, suggests that rate differentials are likely to widen further. This should turbocharge any dollar rally. A 10% appreciation in the real broad trade-weighted dollar index may sound like a lot, but keep in mind that the dollar has weakened by 2% since January. Thus, we are only talking about a rise of 8% from where it was earlier this year. As Chart 18 shows, this would still leave the greenback 3% and 15% below its 2002 and 1985 peaks, respectively. Chart 17U.S. Rate Hikes Will Push Up The Dollar Chart 18Still Far From Past Peaks Chart 19Japanese And European Stocks Tend To Outperform In A Rising Yield Environment The current high sensitivity of the dollar to changes in interest rate differentials means that most of the tightening in financial conditions that the Fed will need to achieve over the next few years is likely to come through a stronger currency rather than higher bond yields. Nevertheless, yields are likely to drift higher. Consistent with the views of our Global Fixed Income Strategy service,3 at this point, we see more upside for Treasury yields than for yields in most other developed markets. With that in mind, we are closing our long Treasurys/short German bunds trade for a gain of 18%. Turning to equities, the need for the market to price in a more aggressive path for Fed tightening poses near-term downside risks to global stocks. We remain tactically cautious. Once the dust has settled, however, higher beta equity markets are likely to outperform. As my colleague Anastasios Avgeriou has highlighted, European and Japanese stocks generally do well in a rising yield environment (Chart 19). Moreover, as Chart 20 illustrates, such an environment could benefit global banks shares, which remain among the most despised sectors of the market.4 Chart 20AHigher Yields Would Benefit Banks... Chart 20B... As Would Steeper Yield Curves Our bullishness does not fully extend to emerging markets. An appreciating dollar could hurt EMs in three ways. First, a stronger dollar could weigh on commodity prices. Second, it could punish EM borrowers with significant dollar liabilities. Third, Fed rate hikes are liable to reduce global dollar liquidity, making it difficult for a number of emerging economies to attract enough foreign capital to finance their current account deficits. Some emerging markets rank higher on this list of vulnerabilities than others. China, for instance, ranks relatively low, given its current account surplus, moderate levels of external debt, and its status as a net commodity importer. As such, while we expect the RMB to weaken against the dollar, it is likely to strengthen on a trade-weighted basis. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 For example, see Harry J. Holzer, Steven Raphael, and Michael A. Stoll, "Employers In The Boom: How Did The Hiring Of Less-Skilled Workers Change During The 1990s?," The Review of Economics and Statistics, Vol. 88:2 (2006), pp. 283-299. 2 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. 3 Please see Global Fixed Income Strategy Weekly Report, "Return Of The Bond Vigilantes," dated October 18, 2016, available at gfis.bcaresearch.com. 4 Please see Global Alpha Sector Strategy , "The Great (Debt) Wall Of China," dated May 27, 2016, available at gss.bcaresearch.com. Strategy & Market Trends* Tactical Trades Strategic Recommendations Closed Trades
Highlights ECB Monetary Policy: Euro Area inflation will likely remain below the European Central Bank (ECB) 2% target for the next few years due to persistent excess capacity in Europe. The ECB will signal this at the December monetary policy meeting, providing the justification to extend their quantitative easing (QE) asset purchase program beyond the current March 2017 expiration date. ECB QE Changes: The constraints imposed on the ECB's bond purchases are self-imposed, and can be easily altered in the event of potential "shortages" of available debt for the QE program. Fears of a potential taper of ECB buying because of those constraints, which have bearish implications for Euro Area bond yields, are overstated. Country Allocation: Move to an above-benchmark stance on core European government debt, which are a low-beta safe haven in the current environment of a cyclical rise in global bond yields. Feature After spending the past couple of months fretting over the next move by the U.S. Federal Reserve or the Bank of Japan, investors' attention shifted to Europe last week. With the current European Central Bank (ECB) government bond quantitative easing (QE) program set to expire in March of next year, the markets were seeking any sort of guidance on whether the ECB will end the program as scheduled, or extend the program beyond March - perhaps with a reduction ("taper") in the size of the bond buying. ECB President Mario Draghi provided no new information at the post-meeting press conference last Thursday, leaving bond investors in limbo until the December meeting when the results of the ECB's assessment of their QE program will be published. Some alterations of the program will likely be announced, but it is too soon for the ECB to consider ending their QE program. With regards to the title of this Weekly Report - the most likely outcome is that the ECB will extend the QE program past March 2017, but will tinker with the rules of QE in an effort to pretend that the central bank is still following a prudent logic for its purchases. Fears of an early taper are overstated, and this makes core European government debt a potential oasis of safety while global bond yields remain in a bear phase. Plenty Of Reasons For The ECB Not To Taper This talk of a tapering of ECB asset purchases following the scheduled end of the current QE program seems premature. After all, neither the ECB's own economic forecasts, nor those of its Survey of Professional Forecasters, are calling for inflation to get close to the 2% target until at least 2018 (Chart of the Week). The ECB staff will prepare a new set of forecasts for the December policy meeting that will include projections for 2019 - perhaps these new estimates will have inflation finally reaching the 2% goal. But in the absence of a credible forecast of inflation returning to target, the ECB will be hard pressed to signal any move to a less-accommodative monetary policy. Headline Euro Area inflation is currently only 0.4%, despite a recent increase in the oil price denominated in Euros, which has been a reliable directional indicator for Euro Area inflation (Chart 2). Chart of the WeekNo Need For An ECB Taper Chart 2European Inflation Is Stubbornly Low The steady decline in the Euro Area unemployment rate over the past three years has coincided with a move higher in overall labor compensation, but this has been purely a "volume" effect resulting from steadily increasing employment growth. With the entire region not yet at full employment, there has been minimal upward pressure on wages or inflation in domestically focused sectors like services (bottom panel). In other words, the lack of Euro Area inflation is a direct function of the excess capacity in Euro Area product and labor markets. According to the IMF, the Euro Area output gap will not close until 2020, which will limit any rise in inflation over the rest of the decade (Chart 3). It will take a more prolonged period of above-trend economic growth to close the output gap, reducing the Euro Area unemployment rate below the full employment NAIRU level, before any recovery in wages or core inflation can take place (bottom panel). This lack of realized inflation is weighing on Euro Area inflation expectations and creating some potential credibility problems for the ECB. As we have discussed in earlier Weekly Reports, inflation expectations in much of the developed economies seem to follow an "adaptive" process, where expectations are formed in lagged response to actual inflation.1 If central banks are fully credible in their ability to use monetary policy to fight inflation (and demand) shortfalls, then those forward-looking expectations should eventually gravitate towards the central bank inflation target. However, if there is a large and persistent shock to realized inflation, then inflation expectations can deviate from the central bank target for an extended period. Using a 5-year moving average of realized headline CPI inflation as a proxy for inflation expectations is a reasonably good (albeit simple) approximation of this adaptive process (Chart 4). The current 60-month moving average for Euro Area headline inflation is 0.6%, not far from the 5-year Euro Area CPI swap rate of 0.9%. However, if the ECB's inflation forecasts for the next two years come to fruition (1.2% in 2017, 1.6% in 2018), then the 5-year moving average will continue to decline, as those higher inflation figures would not offset the sharp fall in inflation witnessed over the past few years. Chart 3Excess Capacity Holding Inflation Down Chart 4Inflation Expectations Will Stay Low Simply put, the ECB's current projections are not consistent with inflation expectations hitting the 2% target by 2018, and likely even beyond that. The ECB will be presenting new projections in December, but it would take a significant upgrade of their growth and inflation forecasts to "move the needle" on longer-term inflation expectations. Perhaps a move away from fiscal austerity across the Euro Area could trigger an upgrade on growth expectations, as that would imply a faster pace of growth and a more rapidly narrowing output gap. However, while the topic of greater fiscal spending has been heating up in the halls of governments in Washington, London and Tokyo, there has been little sign that Euro Area governments are about to open the fiscal spigots anytime soon (and certainly not before elections in Germany and France in 2017). Chart 5European Banks Getting More Cautious? ECB Still Needs To Support Loan Growth The state of Euro Area banks, and what it means for future lending activity, is another factor for the ECB to consider before contemplating any move to a less-accommodative monetary policy. The current growth rates of money and credit are showing no signs of significant deceleration (Chart 5). The latest ECB Euro Area bank lending survey, released last week, did show a modest decline in the net number of banks reporting easier lending standards to businesses, as well as a reduction in the number of banks reporting increasing loan demand from firms. The ongoing hit to European bank profitability from the current negative interest rate environment could be playing a role in the banks moving to a less easy environment for lending. As can be seen in the bottom panel of Chart 5, there is a reliable leading relationship between Euro Area bank equity prices and the growth in bank lending to businesses. The downturn in Euro Area bank stocks in 2016, which has been driven by declining profit expectations, could pose a risk to credit growth in the months ahead. According to a special question asked within the ECB's bank lending survey, a net 82% of respondents reported that the ECB's negative deposit rate has damaged banks' net interest income over the past six months.2 In that same survey, a net 12% of banks reported a boost to loan demand from the ECB's negative interest rate policy, and a net 15% of banks reported that the additional liquidity provided by the ECB bond purchases went towards extending loans to businesses. So while negative interest rates may be hurting bank profit margins, the impact of the ECB's QE is helping offset that to some degree by providing banks with capital gains on their bond portfolios that can be used to finance lending. So without any sign that inflation will soon approach the ECB's target, thus requiring a potential tapering of QE or even a move away from negative interest rates, the prudent course for the ECB to take to support Euro Area credit demand, and economic growth, is to continue with the QE program beyond the March 2017 expiration date. That will require some changes to the ECB's rules of the program, but, in the end, these are only self-imposed constraints. Bottom Line: Euro Area inflation will likely remain below the ECB 2% target over the next few years due to persistent excess capacity in Europe. The ECB will signal this at the December monetary policy meeting, providing the justification to extend their quantitative easing asset purchase program beyond the current March 2017 expiration date. The ECB Has Some Policy Options To Avoid A Taper Tantrum Core European bond yields have been depressed by the ECB's QE program, which have acted to push down both the future expected path of interest rates and the term premium (Chart 6). This has helped anchor real bond yields in negative territory, even with inflation expectations at such low levels. But any signs of potential slowing of the pace of QE buying could quickly unwind this effect, which makes the ECB's next steps so critical for the path of global bond yields. In Chart 7, we show the level and growth rate for the ECB's monetary base, along with five potential future scenarios: The ECB ends their QE program in March 2017, as currently planned; The ECB extends QE for six months to September 2017, at the current pace of €80bn in bond buying per month; The ECB extends QE program for twelve months to March 2018, at a pace of €80bn per month; The ECB extends QE to September 2017, but reduces the pace of purchases to €60bn per month; The ECB extends QE to March 2018, but cuts to €60bn per month. Chart 6ECB QE Still Holding Down Yields Chart 7ECB Needs To Keep The Monetary Base Growing As can be seen in the bottom panel of Chart 7, the growth rate of the ECB's monetary base (and the asset side of their balance sheet) will decelerate sharply in 2017 & 2018 if the ECB does end the QE program as scheduled next March. Extending the program, however, does push out the rapid deceleration phase for monetary base into 2018. This is of critical importance for the Euro Area bond market, as both the outright level and term premium component of German Bund yields have been broadly correlated with the growth rate of the monetary base (Chart 8). In other words, extending the ECB QE program into the future is most important to prevent a "taper tantrum" in European bonds, by signalling to the markets that the ECB wishes to maintain low interest rates for longer. The ECB could even announce a reduction in the pace of purchases, along with an extension, and bond yields should remain well-behaved. This will also help prevent an unwanted appreciation of the Euro, the value of which currently reflects the far easier monetary stance in Europe (Chart 9). Chart 8An ECB Taper Would Be Bad For Bunds Chart 9An Easy-For-Longer ECB Will Weigh On The Euro Given the persistent debates within the ECB (and between the ECB and some Euro Area governments) about the long-run merits of QE, the combination of both an extension and reduction in QE purchases could be the compromise option that satisfies all parties. Alternatively, the ECB could choose to maintain the pace of bond purchases but alter the selection rules governing the program. Given the recent concerns in bond markets that the ECB is "running out of bonds to buy", changing the rules of the QE program is a sensible way for the central bank to free itself from the self-imposed shackles on its bond purchases. There are three options that the ECB can consider: Moving away from strictly allocating the bond purchases according to the ECB "capital key", which essentially weights the bond purchases by the size of each economy; Raising the issuer limits on QE, which limits the ECB to holding no more than 33% of any single issuer or individual bond issue; Reducing the current yield floor on QE, which prevents the ECB from buying any bonds with yields below the ECB deposit rate, which is currently -0.4%; We think option 1 is the least likely to occur, as this would imply buying a greater share of countries with more problematic debt profiles, like Italy or Portugal. There is little chance of such a strategy being well received by the governments in Berlin and Brussels, and the ECB would likely wish to avoid a major political confrontation by allowing larger deviations from the capital key Option 2 is an easier solution to implement. The 33% issuer constraint was always an arbitrary level that was aimed more at bonds with so-called "collective action clauses", where a majority of bondholders can force a decision on all bondholders in the event of a debt restructuring. It is understandable why the ECB would not want to become to decision-making counterparty in the event of a future messy bond restructuring in Europe. However, the ECB's ownership percentages within each Euro Area country are nowhere near the 33% limit at the moment (Chart 10) and, at the current pace and composition of buying, that 33% limit will not even be reached for Germany anytime soon.3 There is room for the ECB to raise the issuer limits, as it has already done for some other parts of its asset purchase programs, like bonds issued by European Union supranationals.4 Chart 10ECB Holdings Are Far From The 33% Issuer Limit Chart 11Lowering The Yield Floor For QE Makes Sense Option 3 is the most binding constraint of all on the ECB purchases, as very large shares of the European government bond market are now trading below the ECB's -0.4% deposit rate (Chart 11). In the case of Germany, nearly 70% of all QE-eligible debt is trading below the ECB's yield floor, which has raised investor concerns that the ECB will soon be unable to buy enough German debt at the current pace of purchases. However, that yield floor constraint is completely arbitrary - there is nothing stopping the ECB from buying bonds trading at a yield below the deposit rate, other than (we suspect) a desire to impose some sort of price discipline on the QE buying to make the ECB appear more credible with its purchases. Chart 12The QE Yield Floor Can Be Changed If the ECB decided to lower the yield floor below the current -0.4% deposit rate, this would open up a greater share of the core European bond markets to QE buying (Chart 12). This would also change the current market narrative that the ECB will soon run out of German bonds to buy. In the end, the most likely path the ECB will take following its December re-assessment of its QE program is a combination of lowering the yield floor on QE bond purchases below -0.4% and raising the issuer limits above 33%. There appears to be plenty of leeway for the ECB to alter their purchases, but without necessarily reducing the monthly pace of buying. Combined with an extension of the end-date of the QE program beyond March, this should alleviate any concerns that the ECB will soon hit a wall with its asset purchases. Bottom Line: The constraints imposed on the ECB's bond purchases are self-imposed, and can be easily altered in the event of potential "shortages" of available debt for the QE program. Fears of a potential taper of ECB buying because of those constraints are overstated. Investment Implications: Move To An Above-Benchmark Stance On Core European Bonds With the ECB having no need to end its QE program early, the case for moving to an overweight stance on core Europe is a strong one. As we noted in our last Weekly Report, favoring bond markets of countries with the lowest inflation rates is a logical investment strategy in the current environment of a modest cyclical upturn in global growth and inflation.5 That justifies our current below-benchmark recommendation on U.S. and U.K. government debt, as both realized inflation and expected inflation are rising in both countries. That leaves the Euro Area and Japan as possible candidates to move to above-benchmark weightings, given their defensive properties as low-beta bond markets. Although with the Bank of Japan now pegging the Japanese government bond (JGB) yield curve with a 10-year yield at 0%, we do not see a compelling investment case for overweighting JGBs as a defensive trade. If an investor wants safety at a 0% yield - with no chance of a capital gain from a decline in yields - than owning T-bills, or even gold, is just as viable as owning JGBs. We recently upgraded Japan to neutral in our recommended portfolio allocation, and we see no reason to move from that. Thus, core European bonds stand out as the candidate to upgrade as a defensive trade during the current bond bear phase, which we expect will continue until at least December when the Fed is expected to deliver another rate hike in the U.S. We see a case for moving to above-benchmark for both Germany and France, but especially so in the latter. The beta of bond returns between France and both the U.S. (Chart 13) & U.S.(Chart 14) is very low, making French bonds a good market to favor at the expense of U.S. Treasuries and U.K. Gilts in currency-hedged bond portfolios. Chart 13French Bonds Are Low Beta To USTs... Chart 14...And To U.K. Gilts Bottom Line: Move to an above-benchmark stance on core European government debt, which are a low-beta safe haven in the current environment of a cyclical rise in global bond yields. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Why Are Global Inflation Expectations Still So Low", dated March 1, 2016, available at gfis.bcaresearch.com. 2 The Q4 2016 ECB Euro Area Bank Lending Survey can be found at https://www.ecb.europa.eu/stats/pdf/blssurvey_201610.pdf. 3 Please note that the denominator in the percentages shown in Chart 10 include only bonds with maturities that are eligible for ECB QE purchases, omitting bonds that will mature in less than 2 year and more than 30 years. 4 For more details on that change to the supranational issuer limits, please see https://www.ecb.europa.eu/mopo/implement/omt/html/pspp-qa.en.html. 5 Please see BCA Global Fixed Income Strategy Weekly Report, "Return Of The Bond Vigilantes", dated October 18, 2016, available at gfis.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Duration: Treasury yields will continue to rise as a December Fed rate hike is priced in. A surge in bullish dollar sentiment between now and December would cause us to back away from our below-benchmark duration stance. Spread Product: Maintain a neutral allocation to spread product, favoring convexity over credit risk. A surge in bullish dollar sentiment between now and December would cause us to downgrade spread product relative to Treasuries. TIPS: The increased sensitivity of TIPS breakevens to core inflation argues for a continued overweight position in TIPS relative to nominal Treasuries. Sovereign Debt: Continue to favor U.S. corporate credit over USD-denominated sovereign government debt within a neutral allocation to spread product. Feature About one month ago, we outlined how we expected our investment strategy to evolve over the remainder of this year and into 2017.1 Our continued expectation that the Fed will lift rates in December leads us to maintain below-benchmark portfolio duration and a neutral allocation to spread product2 until a December rate hike has been fully discounted by the market. Chart 1Dollar Sentiment: A Key Indicator Beyond December, our investment strategy will depend largely on how the dollar responds to an upward re-rating of rate expectations. Strong dollar appreciation would likely cause us to reverse our below-benchmark duration stance and become even more cautious on spread product. Conversely, a tame dollar could mean that the sell-off in bonds and rally in spreads have further to run. The dollar has appreciated by close to +2% since early September and bullish sentiment toward the dollar has also edged higher (Chart 1). However, so far the increases appear muted compared to the rapid dollar appreciation that occurred in the run-up to last December's rate hike. The reason we care about the dollar is that a stronger currency represents a tightening of financial conditions that acts to depress expectations of future economic growth. This can spell trouble for risk assets and also lower the market-implied odds of future rate hikes. For example, spread product was performing well last year until rate hike expectations started to move higher in late October. As the market began to anticipate a December Fed rate hike, it did not take long for the combination of higher rate expectations and increasingly bullish dollar sentiment to weigh on risk assets (Chart 2). The Market Vane survey of bullish sentiment toward the dollar surged above 80% last December, and this tightening of financial conditions is what prompted the sell-off in spread product and sharp decline in Treasury yields that kicked off 2016. Chart 2More Bullish Dollar Sentiment Is A Risk For Spread Product With last year's example in mind, the relevant question for current investment strategy is: How much dollar appreciation can the market tolerate before Treasury yields reverse their uptrend and credit spreads start to widen? To answer that question we make an assessment of U.S. and global growth relative to this time last year. All else equal, if U.S. growth is improved compared to last year, then it should require a greater dollar appreciation to have a similar impact on yields and spreads. Relatedly, if the growth outlook outside of the U.S. is improved, then it would mean that the dollar's reaction to rising U.S. rate expectations might not be as strong. On this note, there is some evidence pointing toward a more resilient U.S. and global economy than at this time last year. In the U.S., our preferred leading indicators suggest that growth contributions from capital spending, housing, net exports, government spending and inventories should all move higher in the coming quarters (Chart 3). This should act to offset a likely moderation in consumer spending growth (Chart 4). All in all, the domestic U.S. growth outlook appears similar to - if not slightly better than - what was seen at this time last year. There is more cause for optimism in the global growth indicators. The aggregate global PMI and LEI are tracking close to levels seen last year, but rising diffusion indexes suggest that further increases are likely (Chart 5). Already, manufacturing PMIs in all the major economic blocs have entered clear uptrends (Chart 5, bottom two panels). This suggests that the global growth outlook is actually much brighter than at this time last year, and improved diffusion indexes suggest that the global recovery has also become more synchronized. Chart 3U.S. Growth Outlook Improving... Chart 4...Outside Of Consumer Spending Chart 5Global Growth On The Upswing The implication of a U.S. economic outlook that is broadly similar to last year and an improved outlook for global growth is that the U.S. dollar may not react as strongly to rising Fed rate hike expectations in 2016 as it did in 2015. If this turns out to be the case, then the performance of spread product should also be more resilient and the uptrend in Treasury yields is less likely to reverse. Bottom Line: We continue to track the dollar and dollar sentiment closely to inform our near-term investment strategy. While dollar sentiment has edged higher, it has not yet reached the elevated levels seen last year. A more synchronized global growth recovery makes such a spike in bullish dollar sentiment less likely this time around. What Is A High Pressure Economy? Chart 6What A "High Pressure Economy" Looks Like Fed Chair Janet Yellen introduced a new buzzword to the market two weeks ago when she suggested in a speech3 that "it might be possible to reverse the adverse supply-side effects [of the financial crisis] by temporarily running a 'high-pressure economy' with robust aggregate demand and a tight labor market." Some investors took this to mean that the Fed would be increasingly tolerant of inflation overshooting its 2% target. We think this interpretation is incorrect, although we do think that Yellen's description of a "high pressure economy" provides a lot of information about the Fed's reaction function. More than anything, Yellen's speech was a response to recent trends in the labor market. The downtrend in the unemployment rate started to abate late last year, even though the economy has continued to add jobs at an average pace of just under +200k per month. A sharp rebound in the labor force participation rate has prevented the unemployment rate from falling, despite robust job growth (Chart 6). It is this dynamic that Yellen refers to when she talks about a "high pressure economy". Essentially, her theory suggests that, despite the low unemployment rate, the economy might be able to continue to add jobs without inflation spiking higher. Put differently, the unemployment rate might be less useful as an input to the Fed's forecast of future inflation than in past cycles. The key implication for investors is that if the Fed doesn't trust the unemployment rate to provide a signal about future inflation, then it is forced to rely on the actual inflation data for guidance. In our view, core PCE and core CPI inflation are now the two most important inputs to the Fed's reaction function. On that note, while last week's September core CPI release was soft, both core CPI and core PCE remain in uptrends that began in early 2015. Further, diffusion indexes suggest that these uptrends will persist (Chart 7). The Fed's increased focus on core inflation also has implications for our TIPS call. The sensitivity of TIPS breakevens to realized core inflation has shifted higher since the Great Recession (Chart 8). In our view, this has occurred because of how the zero-lower-bound on interest rates has constrained the Fed's ability to influence investor expectations. Chart 7The Inflation Uptrend Is Intact Chart 8TIPS Breakevens & Core Inflation When the fed funds rate was well above the zero-lower-bound, investors could reasonably assume that the Fed would act to offset any temporary price shocks. As such, long-maturity TIPS breakevens remained in a relatively narrow range and were mostly influenced by perceptions about the stance of Fed policy. In a zero-lower-bound world, investors can reasonably question whether the Fed has the ability to offset a deflationary price shock. As such, inflation expectations are increasingly driven by the actual inflation data rather than the Fed. With the Fed and the market both increasingly taking their cues from the actual inflation data, it means that the Fed will likely remain sufficiently accommodative for core PCE to return to target and also that TIPS breakevens will move higher alongside the trend in realized inflation. Bottom Line: The increased sensitivity of TIPS breakevens to core inflation argues for a continued overweight position in TIPS relative to nominal Treasuries. Sovereign Credit: A Dollar Story Chart 9Sovereign Debt & The Dollar As noted above, in the current environment the path of the U.S. dollar takes on increased importance for our entire portfolio strategy. However, there is one sector of the fixed income market where the dollar is always paramount - USD-denominated sovereign debt. Specifically, we refer to the Barclays Sovereign index which consists of the U.S. dollar denominated debt of foreign governments, mostly emerging markets.4 In the long-run, the performance of sovereign debt relative to equivalently-rated and duration-matched U.S. corporate credit tends to track movements in the dollar and bullish sentiment toward the dollar (Chart 9). When the dollar appreciates it makes USD-denominated debt more expensive to service from the perspective of a foreign issuer, and therefore causes sovereign debt to underperform domestic alternatives. As stated above, we do not anticipate a near-term spike in the dollar, like what was witnessed near the end of last year. However, given that the Fed is much further along in its tightening cycle than other major central banks, the long-run bull market in the U.S. dollar should remain intact. This will continue to be a major headwind for sovereign debt. Further, the recent performance of sovereign debt relative to U.S. credit has bucked its traditional correlations with the dollar. Notice that the beta between sovereign excess returns and the dollar has moved into positive territory (Chart 9, bottom two panels). Historically, the correlation does not remain at these levels for long and sovereign debt should underperform as the more typical negative correlation is re-established. At present, there is not even an attractive valuation argument for sovereign debt relative to U.S. credit. The spread differential between the Sovereign index and an equivalently-rated, duration-matched U.S. credit index is well below zero (Chart 10), and only the USD-debt of Hungary, South Africa, Colombia and Uruguay offer spreads that appear attractive relative to the U.S. Credit index (Chart 11). Chart 10No Spread Pick-Up In Sovereigns Chart 11USD-Denominated Sovereign Debt By Issuing Country Bottom Line: Continue to favor U.S. corporate credit over USD-denominated sovereign government debt within a neutral allocation to spread product. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching", dated September 13, 2016, available at usbs.bcaresearch.com 2 We favor negatively convex assets (MBS) over credit within a neutral allocation to spread product, on the view that negatively convex assets will outperform as yields head higher in advance of a December rate hike. In anticipation of a December Fed rate hike we are also maintain a short position in the December 2017 Eurodollar futures contract as well as positions in 2/10 and 10/30 curve flatteners. The three trades have returned: +20bps, -23bps and +4bps respectively. 3 http://www.federalreserve.gov/newsevents/speech/yellen20161014a.htm 4 The largest issuers in the Barclays Sovereign Index are: Mexico (22%), Philippines (14%) and Colombia (11%). Fixed Income Sector Performance Recommended Portfolio Specification