Policy

Highlights Monetary Policy: The Fed wants to maintain accommodative financial conditions, and will therefore deliver another rate cut this year if it is expected by the market. This creates a supportive environment for spread product. Ultimately, stronger global growth will lead rate expectations higher over the next 12 months. Keep portfolio duration low. Money Markets & Fed Balance Sheet: Investors shouldn’t worry about last week’s chaotic action in money markets, and should pay less attention to the Fed’s balance sheet policy in general. Yes, the Fed will start growing its balance sheet again in the coming months, but this is much less important than what it decides to do with the fed funds rate. Global Economy: Leading indicators suggest that the global manufacturing downturn is near a trough, but the coincident PMI data have not yet bottomed. Treasury yields won’t move significantly higher until the Global Manufacturing PMI reverses course. Feature Chart 1Fed Dots Versus Market Expectations Fed Dots Versus Market Expectations Fed Dots Versus Market Expectations Fed Chairman Jerome Powell had his work cut out for him at last week’s FOMC press conference. First, he had to craft a coherent message about the Fed’s reaction function following a meeting where three voting members dissented from the committee’s decision to lower the funds rate by 25 bps. One dissenter, St. Louis Fed President James Bullard, wanted a 50 bps reduction. The other two, Boston Fed President Eric Rosengren and Kansas City Fed President Esther George, preferred to leave rates unchanged. Not only that, but Powell also had to field questions about the recent turmoil in money markets. Turmoil that caused the overnight repo rate to spike and the effective fed funds rate to briefly print outside the Fed’s target band (see section titled “Repo Madness” below). Chart 2Tracking Financial Conditions Tracking Financial Conditions Tracking Financial Conditions How did he perform? On all accounts we give the Chairman top marks. He managed to articulate a reaction function that didn’t commit to any near-term policy action, but most importantly, he did so in a way that prevented a sharp tightening of financial conditions. As we have argued in past reports, Chairman Powell’s most important job is to ensure that financial conditions remain accommodative so that the economic recovery can continue for long enough to bring long-dated inflation expectations back up to target.1 Chart 2 shows that, even after a tricky Fed meeting, financial conditions remain significantly more accommodative than they were earlier in the month: Credit spreads are tighter (Chart 2, panel 2) The yield curve has un-inverted (Chart 2, panel 3) TIPS breakeven inflation rates have widened (Chart 2, panel 4) The trade-weighted dollar has weakened (Chart 2, bottom panel) All this with only 7 out of 17 FOMC participants agreeing with the market’s assessment that one more 25 bps rate cut before year-end will be appropriate (see Chart 1). All in all, Powell did exactly what he needed to do. Investment Implications Table 1What's Priced In For The Rest Of 2019? What's Up In U.S. Money Markets? What's Up In U.S. Money Markets? As mentioned above, the market is priced for roughly one more 25 bps rate cut before the end of the year. More specifically, the fed funds futures market is split 50/50 on whether that rate cut occurs at the October or December FOMC meeting (Table 1). The market currently sees only a 4% chance of a rate cut at both meetings, and zero chance of no rate cut at all. We think the market’s view of the next two FOMC meetings is roughly correct, though we would not discount the possibility that global economic data improve enough that further rate cuts are avoided (see section titled “Still Searching For A Bottom” below). Ideally, the Fed wants the economic data to lead rate expectations higher so that it can avoid cutting rates without shocking the market and tightening financial conditions. Conversely, if the market starts to fully price-in an October rate cut in the next few weeks, then the Fed will likely deliver. This reaction function is extremely supportive for credit spreads, and we recommend sticking with an overweight allocation to spread product versus Treasuries. Chart 3Treasury Returns Track Rate Expectations Treasury Returns Track Rate Expectations Treasury Returns Track Rate Expectations As for portfolio duration, we continue to abide by our Golden Rule framework.2 If the Fed delivers less than the 57 bps of easing that the market expects over the next 12 months, then the Bloomberg Barclays Treasury index will likely underperform a position in cash (Chart 3). We see better odds of zero or one rate cut over that timeframe, and therefore recommend a below-benchmark duration stance. Bottom Line: The Fed wants to maintain accommodative financial conditions, and will therefore deliver another rate cut this year if it is expected by the market. This creates a supportive environment for spread product. Ultimately, stronger global growth will lead rate expectations higher over the next 12 months. Keep portfolio duration low. Repo Madness What Happened? Chart 4What Happened Here? What Happened Here? What Happened Here? As mentioned above, overnight U.S. interest rates spiked dramatically last week, grabbing headlines and causing many to question the stability of financial markets. The commotion peaked last Tuesday when the overnight general collateral repo rate closed at just under 7% and the effective fed funds rate ended the day above the upper limit of the Fed’s target band (Chart 4). Why Did This Happen? Chart 5Looking For The Culprit Looking For The Culprit Looking For The Culprit The turmoil’s proximate cause is that dealer banks found themselves short of cash. They therefore scrambled to borrow in money markets, driving overnight rates higher. Dealer banks were short on cash for a number of reasons. Many corporations withdrew funds to pay tax bills, and there was an unusually large amount of Treasury issuance in September, along with few redemptions (Chart 5). Dealer banks must purchase Treasury debt at auction, and of course require cash on hand to do so. But setting the proximate cause aside, the more important question is: Why don’t dealer banks have sufficient cash to weather such periods, which are bound to occur from time to time? The answer to this question has to do with the quantity of reserves being supplied to the banking system, which is ultimately a result of the Fed’s balance sheet policy. The Fed’s Balance Sheet & The Supply Of Bank Reserves Table 2Simplified Fed Balance Sheet What's Up In U.S. Money Markets? What's Up In U.S. Money Markets? Table 2 shows an abridged version of the Fed’s balance sheet as of last Wednesday, September 18. Notice that the Fed’s securities holdings appear on the asset side of the balance sheet, while the Fed’s liabilities include: (i) currency in circulation, (ii) the Treasury department’s cash account and (iii) bank reserves. Reserves are a liability on the Fed’s balance sheet, but appear as an asset on the consolidated balance sheet of the U.S. banking system. In other words, the banking system’s supply of liquid reserves is always equal to the Fed’s assets less the amount of currency in circulation and the Fed’s other “non-reserve liabilities”. Put simply, if dealer banks don’t have enough cash, it is because the Fed is not holding enough securities. Chart 6The Fed's Balance Sheet Over Time The Fed's Balance Sheet Over Time The Fed's Balance Sheet Over Time In fact, the Fed has been steadily draining the supply of bank reserves since 2014 (Chart 6). Initially, it did so passively by keeping its securities holdings constant and allowing reserves to decline by the amount of increase in currency-in-circulation and other “non-reserve liabilities”. Then, between October 2017 and July of this year, it actually shrank its portfolio, causing reserves to leave the system even more quickly. In August, the Fed returned to a policy of keeping its securities holdings constant, slowing the rate of decline in bank reserves.   It is also worth mentioning that the rate of decline in bank reserves was recently exacerbated by a sharp increase in the Treasury department’s cash holdings (Chart 6, bottom panel). The Treasury department needed to rebuild its cash balance after having run it down in advance of the last debt ceiling deadline. Like currency-in-circulation, the Treasury department’s cash holdings are a liability on the Fed’s balance sheet. All else equal, an increase in the Treasury’s cash holdings leads to a decline in the supply of bank reserves. Next Steps Chart 7The Fed's Floor System The Fed's Floor System The Fed's Floor System This year the Fed has been navigating through a process of “balance sheet normalization” where it seeks to reduce its asset holdings while still supplying enough bank reserves to ensure the effective operation of monetary policy. The Fed has already decided to operate monetary policy using a “floor system”, in contrast to the “corridor system” it employed prior to the financial crisis. In a corridor system, the Fed keeps the supply of bank reserves scarce, and then engages in daily repo transactions to ensure that it supplies just enough bank reserves to prevent the overnight rate from breaking through the top of its target range. In contrast, to operate a floor system the Fed must supply more reserves than the banking system demands. The excess supply of reserves forces the overnight rate down toward a floor set by the Fed’s overnight reverse repo facility (ON RRP). Essentially, the Fed sets the ON RRP rate at a level near the bottom of its target range, and pledges to pay that rate to any banks with excess cash (Chart 7). The fact that interest rates broke out above the top-end of the Fed’s target band last week suggests that the Fed is not supplying enough reserves to effectively operate its floor system. This means that we should consider the Fed’s “balance sheet normalization” process complete. In the coming weeks the Fed will roll out a plan to start growing its securities portfolio. It will do this by purchasing Treasuries with a maturity structure that roughly matches that of the outstanding debt load. The pace of Treasury purchases will either be set equal to the estimated rate of growth in non-reserve liabilities, a pace that would keep the supply of bank reserves flat and one that the Fed calls “organic growth”. Alternatively, the Fed might decide that the supply of reserves needs to rise for a time before leveling off. In that case, it would purchase Treasuries at a somewhat faster pace for a few months, before settling into an “organic growth” regime. The Fed will probably also roll out a standing repo facility in the coming months, with a rate set close to the upper-end of its target band. This will act as the mirror image of the current ON RRP, essentially capping the upside in interest rates by agreeing to lend overnight cash at a stated rate. The supply of bank reserves necessary for the Fed to maintain effective control of interest rates is much higher than during the pre-crisis.period  It will take at least a few weeks for the Fed to roll out its new balance sheet strategy and standing repo facility. In the meantime, the New York Fed will transact daily in the repo markets to ensure that enough reserves are supplied. This action represents a temporary return to a corridor system. Once the Fed starts growing its Treasury holdings again, it will be able to resume its floor system and the daily repo transactions will not be necessary. Some have probably already noted that the supply of bank reserves necessary for the Fed to maintain effective control of interest rates is much higher than during the pre-crisis period (see Chart 6). This is purely the result of the new post-crisis regulatory environment (see Box). Box - New Regulations Mean Banks Want More Reserves Two new regulations, specifically, have increased the amount of reserves that banks wish to hold. The first is the liquidity coverage ratio (LCR). The LCR mandates that banks hold sufficient high-quality liquid assets (HQLA) to cover 30 days of cash outflows in a stressed scenario. Bank reserves qualify as HQLAs, as do Treasury securities. Some other securities can also count as  HQLAs after a haircut is applied. While banks can opt to hold Treasuries instead of reserves and still maintain compliance with the LCR. A St. Louis Fed report from March showed that large U.S. banks are using reserves to cover 20% - 65% of their net outflows.3  The second relevant regulation is the resolution plan, or living will, that large banks are now forced to file with regulators. While the criteria here are more opaque, banks must demonstrate to regulators that they have enough short-term liquidity to cover demands from counterparties and other stakeholders in the event of material financial distress. Regulators likely put a greater emphasis on reserves than Treasury securities during such stress tests, since during a period of financial turmoil there may be doubts about how quickly a bank can convert a Treasury security into cash in the repo market.  Is This The Return Of QE? The answer really depends on how you want to define QE. If you want to call any increase in the Fed’s securities holdings QE, then yes the Fed will soon re-start QE. If you want to define QE as an expansion in the supply of bank reserves, then the Fed might briefly engage in QE for a few months, before reverting to an “organic growth” policy that keeps the reserve supply stable. In any event, unless you are active in money markets, we would advise investors to pay much less attention to the Fed’s balance sheet policy. The goal of its balance sheet policy is to ensure that interest rates remain within its target band, and the Fed will move that target band around independently of what is happening with its balance sheet. Changes in the Fed’s target interest rates are what matter for financial markets. Still Searching For A Bottom For reasons articulated in prior reports – notably, accommodative financial conditions and resolute service sector growth – we remain convinced that the current global manufacturing slowdown is near a trough.4 However, we must also point out that the 10-year U.S. Treasury yield tends to track the broad swings in the Global Manufacturing PMI, and a significant rebound in the 10-year yield is unlikely without a corresponding PMI upswing (Chart 8). Chart 8No PMI Rebound Yet... No PMI Rebound Yet... No PMI Rebound Yet... Chart 9...But Leading Indicators Are Hooking Up ...But Leading Indicators Are Hooking Up ...But Leading Indicators Are Hooking Up On that note, September Flash PMI data for the U.S. and Eurozone were released yesterday, and were at best a mixed bag. The Eurozone Manufacturing PMI fell from 47.0 in August to 45.6 in September (Chart 8, bottom panel) while its U.S. counterpart ticked higher from 50.3 to 51.0 (Chart 8, panel 3). In general, it is too early to say that the global PMI data have bottomed, especially with the CRB Raw Industrials index – a broad commodities benchmark – still in free fall (Chart 8, panel 2). Global Leading Economic Indicators paint a somewhat rosier picture than the PMIs. In fact, our Global LEI appears to have bottomed, and should eventually lead the Global PMI higher if prior correlations hold (Chart 9). We also observe that the U.S. economic data are once again beating expectations, an occurrence that usually corresponds with higher yields (Chart 9, bottom panel). In general, it is too early to say that the global PMI data have bottomed. Bottom Line: Leading indicators suggest that the global manufacturing downturn is near a trough, but the coincident PMI data have not yet bottomed. Treasury yields won’t move significantly higher until the Global Manufacturing PMI reverses course.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see U.S. Bond Strategy Weekly Report, “Act As Appropriate”, dated August 27, 2019, available at usbs.bcaresearch.com 2  Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 3  https://www.stlouisfed.org/on-the-economy/2019/march/banks-demand-reserves-face-liquidity-regulations 4  Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “Where’s The Positive Carry In Bond Markets?”, dated August 20, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Dear Client, Owing to BCA’s 40th Annual Investment Conference in New York City next week, we will not be publishing a report on Friday, September 27. We will return to our regular publishing schedule on Friday, October 4, when we will be sending out our quarterly Strategy Outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights The spike in oil prices underscores the vulnerability of key Saudi oil facilities. The fact that OPEC spare capacity is on the low side is an added source of concern. Fortunately, if oil prices do rise again, the impact on the global economy will be mitigated by the following: 1) the amount of oil necessary to produce one unit of real GDP is much lower than in the past; 2) oil prices are currently nowhere near restrictive levels; 3) higher oil prices will boost investment in the energy sector; and 4) unlike in the past, central banks will not need to hike rates to quell oil-induced inflationary pressures. The Federal Reserve is likely to cut rates once more in October and then keep rates on hold through 2020. The Fed will also begin expanding the size of its balance sheet to alleviate tensions in funding markets. Investors should remain overweight equities relative to bonds and start tilting exposure towards EM assets and cyclical stocks later this year. Feature All Aboard The Crude Oil Roller Coaster Chart 1A Price For The Books A Wild Ride For Oil Prices A Wild Ride For Oil Prices After gapping up by nearly 20% to $72/barrel on Monday morning – the biggest one-day spike in history – Brent oil prices have retreated to the $64-$65 range, representing a markup of around 7% over last Friday’s close (Chart 1). The near-term direction of oil prices will be governed by how quickly the Saudis are able to restore lost output. Brent fell by over $3/barrel on Tuesday following news reports quoting key Saudi sources saying that state-run Saudi Aramco would be able to bring production back to normal in the next two-to-three weeks. Bob Ryan, BCA’s chief commodity strategist, is skeptical of this reassurance. He notes that the drone attacks destroyed highly sophisticated “one-of-a-kind” equipment that had been specially built for the Abqaiq facility. Beyond the near-term impact, the longer-term question is whether Sunday’s pre-dawn strike is the start of a new violent trend. The fact that much of Saudi Arabia’s oil infrastructure is densely concentrated in the eastern part of the country makes it vulnerable to further attacks. The proliferation of drone technologies is also a source of concern since such devices can be used to wreak significant havoc at minimal cost.  Chart 2Limited Availability Of Spare Capacity To Offset Outages A Wild Ride For Oil Prices A Wild Ride For Oil Prices Chart 3Key Strategic Petroleum Reserves Key Strategic Petroleum Reserves Key Strategic Petroleum Reserves Iran’s apparent involvement in the attack further complicates matters. As Matt Gertken, BCA’s chief geopolitical strategist, has argued, the drone strike may have been orchestrated by hardliners in Iran who regard President Rouhani’s efforts to restart negotiations with the United States as evidence of appeasement (some of these hardliners are also profiting from the sanctions by smuggling crude out of the country). President Trump’s decision to sack John Bolton over Bolton’s opposition to making any deal with the Iranians may have created a sense of urgency among the hardliners. In this respect, attacking Iran would probably give the hardliners what they want. All this has occurred at a time when OPEC spare capacity – the difference between what the cartel is capable of producing and what it is actually producing – is below its historic average (Chart 2). Crude oil reserves have also been trending lower within the OECD. Saudi Arabia’s own reserves have fallen by over 40% since peaking in 2015 (Chart 3). Oil And The Economy: How Big A Risk? While a major spike in oil prices is not our base case, it cannot be ruled out completely. If the price of crude were to increase significantly, how much damage would this do to the global economy? History is certainly not encouraging: Every single U.S. recession since 1970 has been preceded by  a large jump in oil prices (Chart 4). Chart 4Oil Spikes And Recessions Oil Spikes And Recessions Oil Spikes And Recessions Chart 5The Global Economy Is Less Oil Intensive The Global Economy Is Less Oil Intensive The Global Economy Is Less Oil Intensive The fact that we are dealing with a potential supply disruption only makes things worse. It is one thing if oil prices are rising in response to stronger global growth; it is quite another if prices rise at a time, such as the present, when global growth is under pressure. Despite these concerns, there are four reasons to be optimistic that higher oil prices will not precipitate a major global economic downturn. First, the global economy is less reliant on oil than in the past. Chart 5 shows that the amount of oil necessary to produce one unit of real GDP has fallen by half since 1990. Second, oil prices are still quite low by historic standards. Even after this week’s jump, Brent is still 24% below where it was last October (Chart 6). In real terms, both Brent and WTI are more than 60% below their 2008 highs. Chart 6Oil Prices Are Well Off Their 2008 Peak Oil Prices Are Well Off Their 2008 Peak Oil Prices Are Well Off Their 2008 Peak Third, if oil prices do stay elevated, this will encourage investment in the oil patch, which will eventually bring prices back down. It is worth remembering that rising oil prices reduce aggregate demand in part by shifting wealth from oil consumers, who tend to spend most of their disposable income, to oil producers, who are often inclined to save the windfall from higher oil prices in such entities as sovereign wealth funds. However, if higher oil prices cause producers to expand production, the positive “investment effect” could offset much of the negative “consumption effect” on aggregate demand. Ironically, this means that a transfer of production from easily accessible oil deposits, such as those in Saudi Arabia, to less accessible shale or deep-sea deposits has the effect of increasing overall energy-sector capital spending, even if it does entail a loss of average efficiency. Fourth, higher oil prices today are unlikely to dislodge long-term inflation expectations. This represents a critical difference between the 1970s, 80s, and early 90s when central banks often felt the need to hike rates in the face of rising oil prices (Chart 7). These days, central banks are more likely to see oil price increases – especially those due to supply-side disruptions – as negative income shocks. Such shocks warrant looser, rather than tighter, monetary policy. Chart 7Core Inflation No Longer Driven By Oil Prices Core Inflation No Longer Driven By Oil Prices Core Inflation No Longer Driven By Oil Prices Core Inflation No Longer Driven By Oil Prices Core Inflation No Longer Driven By Oil Prices FOMC Cuts Rates As Expected This brings us to this week’s Fed meeting. As widely expected, the Fed cut rates by 25 basis points. It also lowered the projected policy rate path. Compared to the Summary of Economic Projections released in June – which suggested no rate change in 2019, one rate cut in 2020, and one rate hike in 2021 – the median dots in the September Summary of Economic Projections released this week show two cuts in 2019, no rate change in 2020, one rate hike in 2021, and one rate hike in 2022. Seven out of 17 participants penciled in a projected third cut for 2019. Judging from the tone of his post-meeting press conference, Jay Powell, dressed in his trademark bipartisan purple tie, was likely among those advocating for further easing. While it is far from a done deal, an additional rate cut in October appears more likely than not. In total, we expect 75 basis points in cuts, equivalent to the amount of easing orchestrated during both the 1995/96 and 1998 mid-cycle slowdowns (Chart 8). The Fed appears to be using these two episodes as a template for its current thinking. Chart 8Will The Fed Follow The 1990s Template Of 75 Bps Of Mid-Cycle Easing? Will The Fed Follow The 1990s Template Of 75 Bps Of Mid-Cycle Easing? Will The Fed Follow The 1990s Template Of 75 Bps Of Mid-Cycle Easing? The Fed is also likely to start expanding the size of its balance sheet starting in November. The spike in funding rates this week, while not at all related to the sort of counterparty risk that prevailed during the financial crisis, still underscored the fact that bank reserves are becoming increasingly scarce. To the extent that the Fed creates bank reserves when it purchases assets, this would help alleviate funding pressures. We are assuming that rate cuts beyond 75 basis points in total are possible. However, this would require a significant deceleration in U.S. growth, which looks unlikely. Real personal consumption spending is on track to increase by 3.1% in Q3, according to the Atlanta Fed’s GDPNow (Chart 9). While business capex spending continues to be weighed down by the manufacturing recession, rays of light are emerging. Industrial production rose by 0.6% in August, well above the consensus forecast of 0.2%. Despite an ongoing drag from the auto sector, manufacturing output rose by a solid 0.5%. Chart 9Inventories And Net Exports Have Subtracted From Growth A Wild Ride For Oil Prices A Wild Ride For Oil Prices Chart 10Easier Financial Conditions Will Boost Global Growth Easier Financial Conditions Will Boost Global Growth Easier Financial Conditions Will Boost Global Growth Globally, the growth picture remains shaky. Looking out, the sharp easing in financial conditions should boost activity (Chart 10). The nascent de-escalation in trade tensions, if sustained, should also help. As such, we continue to expect global growth to stabilize in the coming months and accelerate into year-end. Investment Conclusions Oil prices are likely to rise over the next 12 months. Geopolitical tensions could contribute to any upward pressure on the price of crude, but most of the increase in prices will probably be driven by stronger global growth. If global growth does pick up, the dollar will probably weaken (Chart 11). A weaker dollar will further boost oil prices, along with other commodity prices (Chart 12). Chart 11The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 12A Weaker Dollar Bodes Well For Commodities A Weaker Dollar Bodes Well For Commodities A Weaker Dollar Bodes Well For Commodities Stronger global growth, rising commodity prices, and a weaker dollar will hurt safe-haven government bonds but boost stocks. EM and cyclical equity sectors should gain disproportionately.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Strategy & Market Trends MacroQuant Model And Current Subjective Scores A Wild Ride For Oil Prices A Wild Ride For Oil Prices Strategic Recommendations Closed Trades

Dear Client, Owing to BCA’s 40th Annual Investment Conference at the Grand Hyatt in New York City next week, there will be no report on Wednesday, September 25. We will return to our regular publication schedule on Wednesday, October 2. I look forward to meeting China Investment Strategy clients in person at our conference. Please do not hesitate to say hello. Best regards, Jing Sima China Strategist Highlights China’s economy should bottom as a result of the pickup in credit that occurred earlier this year, but the circumstances surrounding the ongoing slowdown are unprecedented in nature. This raises the risk that policymakers will have to do more in order to stabilize growth. Optimism surrounding recent Chinese policy announcements is misguided. For now, Chinese policymakers are not upping the pace of stimulus, which underscores the risk to our forecast that growth will soon stabilize. A more meaningful shot of reflation will occur in the coming few months if the economy slows further, but policymakers will be reactive rather than proactive. Barring a successful (even if temporary) trade deal, we expect more weakness in the RMB as a passive source of reflation to aid the economy. But currency devaluation is a double-edged sword, and cannot be counted on to single-handedly stabilize China’s economy. Over a 6-12 month time horizon, investors should continue to overweight Chinese stocks versus the global benchmark in currency hedged terms, but the risk of further underperformance over the near-term is high. Feature Chinese economic growth continues to weaken. The Caixin manufacturing PMI for August, along with the New Export Orders component of the manufacturing PMI released by China’s National Bureau of Statistics, registered small gains in August from July. However, any hopes pinned on this being an emerging sign of turnaround in the Chinese economy soon faded. A slew of August data showed continued sluggishness in exports, an even worse domestic-demand picture, and further deflation in ex-factory producer prices. Most importantly, we continue to witness “half-measured” stimulus. In explaining past and existing economic weakness, many investors point to the trade war with the U.S. However, Charts 1 and 2 serve as an important reminder that domestic weakness predates U.S. protectionism. The trade war tensions and tariffs are magnifying this weakness, but China’s slowdown is, at its core, policy driven. Chart 1Weakness In Chinese Economy Predates The Trade War... Weakness In Chinese Economy Predates The Trade War... Weakness In Chinese Economy Predates The Trade War... Chart 2…And Has Been A Byproduct Of Financial De-Risking Campaign ...And Has Been A Byproduct Of Financial De-risk Companion ...And Has Been A Byproduct Of Financial De-risk Companion Given this, investors should be more focused on identifying signs of a major reversal in policy. So far Chinese policymakers have been firmly holding their line in keeping credit growth somewhat in check.  Policy-Induced Economic Stabilization: A Tough Forecast To Make Our baseline view is that the current scale of stimulus should be sufficient to stop economic growth from decelerating further.  Two factors support our baseline view: The direct impact from tariffs on the Chinese economy is limited. Growth in China’s exports to the U.S. in 2019 is likely to be somewhere close to a 9% contraction, down from the 10.8% increase registered in 2018. Based on a simple calculation with all else being equal, this is likely to shave 1.6 percentage points off China’s total export growth and 0.3 percentage points off nominal GDP growth in 2019. This is not trivial, but arguably not devastating to China’s aggregate economy either. There is anecdotal evidence suggesting some Chinese exports have been re-routed to peripheral countries such as Vietnam and Taiwan in order to avoid the U.S. import tariffs on Chinese goods (Chart 3). This suggests that real growth in Chinese exports to the U.S. could be stronger than the current data suggests. Chart 3Exports Finding Alternative Routes? Exports Finding Alternative Routes? Exports Finding Alternative Routes? Chart 4Bottoming in the economy In Sight? Bottoming in the economy In Sight? Bottoming in the economy In Sight? Credit growth has picked up since the beginning of this year. Based on the historical relationship between China’s credit impulse (measured by the 12-month change in BCA’s adjusted total social financing as a percentage of nominal GDP) and domestic demand, the economy should bottom out at some point before the end of the year (Chart 4). Although, import growth, a key measure of China’s domestic demand, remains in deep contraction, some of its components that usually lead industrial activities are showing signs of improvement (Chart 5). Chart 5Early Signs of Improved Domestic Demand Early Signs of Improved Domestic Demand Early Signs of Improved Domestic Demand Chart 6Manufacturing Investment Growth In Contraction Manufacturing Investment Growth In Contraction Manufacturing Investment Growth In Contraction However, our level of confidence that the existing stimulus will be sufficient to stabilize economic growth is lower than it otherwise would be. This is due to the fact that the challenges facing the Chinese economy are unprecedented in nature.  For one, the indirect impact of the trade war on China’s economy through business sentiment and manufacturing investment has yet to be fully revealed in the data. As Chart 6 shows, manufacturing investment is already deteriorating, particularly in export-intensive sectors. The ultimate impact on investment from the trade war is still uncertain, and can pose significant downside risks to the Chinese economy in the coming year. More importantly, as Chart 7 suggests, a weak credit impulse will at best lead to a very subdued economic recovery even if growth does indeed bottom. In terms of the link between policy and the economy, Chart 8 points out a key difference between the current slowdown and previous down cycles: Monetary conditions have been ultra-loose for more than a year, but current economic conditions remain on a downward trend – much more so than in the previous cycles. This huge gap and lag in economic response to monetary stance can only be explained by an impaired policy transmission mechanism. An expansionary monetary stance has not proportionally translated into credit expansion or economic recovery. This challenges the effectiveness and timeliness of future monetary loosening in terms of its ability to revive the Chinese economy. Chart 7Current Pace Of Credit Growth Will Lead To A Fragile Recovery, At Best Current Pace Of Credit Growth Will Lead To A Fragile Recovery, At Best Current Pace Of Credit Growth Will Lead To A Fragile Recovery, At Best Chart 8An Impaired Monetary Policy Transmission An Impaired Monetary Policy Transmission An Impaired Monetary Policy Transmission The scale and timing of the current stimulus measures have been “behind the curve.” Therefore, the historical relationship between China’s credit impulse and the turning points in the economy may not apply to the current cycle. Bottom Line: China’s economy should bottom as a result of the pickup in credit that occurred earlier this year, but the circumstances surrounding the ongoing slowdown are unprecedented in nature. This raises the risk that policymakers will have to do more in order to stabilize growth. An Unusually Prudent Policy Bias For some, the recent slew of announcements on upcoming stimulus qualified as a major shift in policy bias. Our analysis suggests otherwise. The bank reserve requirement ratio (RRR) cuts announced late in August have been among the most cited policy announcements, with the PBoC stating that the new cuts will release RMB 900 billion of fresh liquidity.1 In our view, this measure is more about maintaining liquidity in China’s large commercial banks than adding to it (on a net basis). Chart 9RRR Cuts May Not Be That Stimulative RRR Cuts May Not Be That Stimulative RRR Cuts May Not Be That Stimulative Chart 9 shows that, in previous episodes of meaningful RMB depreciation against the U.S. dollar, in order to prevent the RMB from falling at an undesirable pace, PBoC has had to intervene in the spot market by selling U.S. dollars. The selling of U.S. dollars in this round of RMB depreciation has been much more muted than in 2015-2016, but we suspect some intervention has taken place following each bout of escalation in the trade war. This has had a liquidity tightening effect on banks, as selling central bank foreign-exchange reserves reduces liquidity in the banking system. It is very likely that following the PBoC’s defense of the RMB in the last two months, the RRR cuts were a measure aimed at preventing a liquidity crunch ahead of the September tax season. If true, this hardly qualifies as net new stimulus for the economy. There were also two important announcements that came out of the September 5th State Council meeting: The entire 2019 quota for local government special project bonds must be issued by the end of September, and all money raised from the bonds must be disbursed to projects by the end of October. This too is not exactly “stimulative,” as over 90% of the 2019 local government special-project bond quota has already been issued. This leaves less than 10% of the quota outstanding, an 80% decline from what was issued last September. On a quarterly basis, special-bond issuance in the third quarter of 2019 will end up being 30% lower than the same period last year.   It was also announced that, in order to meet the local needs for construction of key projects, part of 2020’s special bonds quota will be allocated in advance to ensure that the funds are available for use at the beginning of next year.2  While the announcement did not indicate how much in the way of special-purpose bonds local governments are allowed to frontload through the remainder of this year, we maintain our view that this is not a policy shift towards materially larger stimulus than we have seen so far this year: Without an additional quota, local government special-purpose bond issuance would essentially fall to zero in the fourth quarter as the 2019 target would be hit by the end of September. Thus, the frontloading of next year’s bond issuance will only “fill the gap” between now and year-end. As special-purpose bond issuance only accounts for 15% of total funding for local governments’ infrastructure spending, the new measure alone is unlikely to meaningfully accelerate investment growth.3  We have noted in previous reports that in order for local governments to accelerate spending within the current fiscal budget framework, one of three things must occur: more direct funding from the central government, an acceptance by policymakers of more shadow bank lending, or a larger quota for bond issuance. So far we have not seen any of the above-mentioned shifts in policy. Chart 10Local Governments Tightening Belt This Year Local Governments Tightening Belt This Year Local Governments Tightening Belt This Year The only positive sign for local government spending has been a pickup in land sales in Q2, which makes up more than 70% of local government revenues. But, it is far from making up the shortfalls in local governments’ budgets (Chart 10). Local governments are facing considerable fiscal pressure as annual tax revenue growth has fallen to near zero. Critically, the government’s regulatory stance on local government budgets has continued to tighten: Local governments have been ordered by the Ministry of Finance to liquidate state-owned assets to fund their budget deficits this year.4 This austerity measure is also being met with explicit reiteration from the Ministry of Finance on the central government not bailing out local governments, and that local government officials are held responsible for their own borrowing and spending.5   Bottom Line: Optimism surrounding recent Chinese policy announcements is misguided. For now, Chinese policymakers are not upping the pace of stimulus, which underscores the risk to our forecast that growth will soon stabilize. A more meaningful shot of reflation will occur in early 2020 if the economy slows further in Q4, but policymakers will most likely continue their reactive approach rather than proactive. RMB Depreciation: A Plus Or Peril? The RMB’s renewed depreciation since August initially raised fears among global investors that an uncontrolled decline might occur, but these fears have subsided over the past several weeks. Even though the USD-CNY exchange rate has broken the psychological 7 threshold, it is not forming a linear downward trend. Unlike after the August 2015 devaluation, it appears that the PBoC can successfully enact countercyclical measures to guide the RMB’s value higher following each large depreciation (Chart 11). Chart 11PBoC Not Panicking Over RMB Depreciation PBoC Not Panicking Over RMB Depreciation PBoC Not Panicking Over RMB Depreciation Fears of uncontrolled capital outflows following the depreciation are also abating. We presented a dashboard for monitoring short-term capital outflows from China in our March 20 Special Report,6 and an update of these indicators suggests that China’s heightened capital controls are holding – i.e., outflows have not escalated as they did in 2015 (Chart 12). Chart 12No Major Capital Outflow No Major Capital Outflow No Major Capital Outflow Chart 13RMB Depreciation Partially Offsets Tariffs RMB Depreciation Partially Offsets Tariffs RMB Depreciation Partially Offsets Tariffs Thus, the conclusion is that Chinese policymakers appear to be in control of the currency. The reduced risk of an uncontrolled decline has allowed policymakers to (passively) provide meaningful stimulus to the domestic economy via depreciation. Indeed, the RMB has not only depreciated against the USD, but also against many Asian currencies including direct trade competitors such as Vietnam and Taiwan (Chart 13). This is helping offset the negative impact of U.S. tariffs on Chinese exporters. But currency devaluation can come with a price tag – in particular for corporations that have borrowed heavily in U.S. dollar-denominated debt. We estimate that $440 billion of U.S. dollar debt will be maturing over the coming two years, for Chinese companies and banks in the aggregate.7 A 12% depreciation in the RMB since April 2018 means that debt servicing costs will be 12% higher for unhedged debtors. This is particularly painful for real estate and financial services companies, two of the largest holders of U.S. dollar-denominated loans, and the weakest sectors in the current economic downturn. Most importantly, while currency devaluation ease the slowdown, it cannot be counted on to stabilize Chinese economic activity on its own. For example, while our earnings recession model suggests that the decline in the RMB since May has reduced the odds of a major decline in economic activity by roughly 20%, the model also shows that such an event is still highly probable (current odds are roughly at 70%). Bottom Line: Barring a successful (even if temporary) trade deal, we expect more weakness in the RMB as a passive source of reflation to aid the economy. But currency devaluation is a double-edged sword, and cannot be counted on to single-handedly stabilize China’s economy if a further slowdown occurs. An Update On Corporate Earnings Against a backdrop of what may turn out to be insufficient policy support, the earnings picture is providing one modest positive for equity investors. While the growth rate in investable earnings per share has slowed significantly over the past year (Chart 14), it has merely fallen to zero and not deeply into negative territory, as what seemingly occurred in 2015-2016. In our view, the risk of a similar collapse in earnings per share (EPS) has been an important factor weighing on Chinese investable equities’ relative performance since June 2018. In reality, a closer examination of MSCI China Index earnings reveals that a huge decline in EPS this year was never really a threat, because the apparent collapse in 2015-2016 did not actually transpire. Changes to the composition in the MSCI China Index that took effect in November 2015 and June 2016 had the effect of depressing index EPS, due to the sizeable inclusion of a set of richly valued stocks. Chart 15 presents BCA’s calculation of “break-adjusted” EPS for Chinese investable stocks, which shows that EPS growth bottomed out at -10% in late-2016, as opposed to the -28% implied by the unadjusted series. Chart 14Investable EPS Has Yet To Contract Meaningfully Investable EPS Has Yet To Contract Meaningfully Investable EPS Has Yet To Contract Meaningfully Chart 15The Potential Downside For Earnings Is Less Than Many Fear The Potential Downside For Earnings Is Less Than Many Fear The Potential Downside For Earnings Is Less Than Many Fear Chart 16A Cyclical Recovery In Earnings Has Not Yet Begun A Cyclical Recovery In Earnings Has Not Yet Begun A Cyclical Recovery In Earnings Has Not Yet Begun The existence of less downside potential for earnings is certainly positive for investable stocks at the margin, but it does not alter the outlook for equity fundamentals over the coming year. We have shown in several previous reports that there is a strong and reliable link between investable EPS growth and China’s coincident economic activity,8 and the continued slowing in the latter does not suggest that a bottom in earnings is imminent. In addition, Chart 16 highlights that while net earnings revisions have recovered from their early-year lows, they remain in negative territory and have stopped rising over the past few weeks. Twelve-month forward EPS momentum, also presented on a break-adjusted basis, is modestly negative, and has recently weakened (panel 2). Bottom Line: The downside risk to earnings for Chinese investable equities is less than many investors fear. But absent stronger credit growth, it remains too early to confidently project a cyclical earnings recovery. Investment Conclusions The historical relationship between credit growth and economic activity suggests that the latter should soon stabilize, which is our base case view for the coming few months. Still, the risk of a further, meaningful deceleration in growth is elevated, given the unprecedented circumstances surrounding the ongoing slowdown. For equity investors, less potential downside risks to earnings than previously feared is a positive at the margin, but the fundamental outlook still hinges on a durable pickup in economic activity. Over a 6-12 month time horizon, this implies that one of two scenarios will unfold: The economy will stabilize in response to the easing that has already occurred (i.e. our base case view). The economy slows further in the near-term, prompting a more significant policy response that leads to an even sharper pickup in activity. Chart 17Investable Stocks: An Overshoot To The Downside? Investable Stocks: An Overshoot To The Downside? Investable Stocks: An Overshoot To The Downside? In the first scenario, investable stocks have probably overshot to the downside versus the global benchmark and thus will very likely outperform from current levels. Near-term performance is likely to be flat-to-down, as investors await hard evidence of a sequential improvement in growth (Chart 17). In the second scenario, investable stocks are at potentially acute near-term risk, but will likely eventually outperform global stocks once activity begins to pick up sharply. In this scenario, the outperformance of Chinese equities will commence later, but would likely still occur by the tail end of our cyclical investment horizon (6-12 months). As a final point, we are not ruling out the possibility of a temporary trade deal between the U.S. and China, as both sides have the incentive to avoid a further escalation and are now showing goodwill towards constructive negotiations. This may change our tactical view on Chinese stocks, but our cyclical view remains focused on China’s domestic policy and economic fundamentals.   Jing Sima China Strategist JingS@bcaresearch.com   Footnotes   1      PBC Official: The RRR Cut Aims at Bolstering Real Economy, September 6, 2019 2      China to accelerate the issuance and use of special local government bonds to catalyze effective investment, China State Council, September 4, 2019 3      Please see Emerging Markets Strategy Special Report, “Chinese Infrastructure Investment: A Ramp-Up Ahead?”, dated August 1, 2019, available at ems.bcaresearch.com 4      China’s Local Governments Sell Assets to Make Up for Revenue Loss, Caixin, September 3, 2019 5      http://www.mof.gov.cn/zhengwuxinxi/caizhengxinwen/201909/t20190906_3382239.htm?mc_cid=eb2b199651&mc_eid=9da16a4859 6      Please see China Investment Strategy Special Report, “Monitoring Chinese Capital Outflows”, dated March 20, 2019, available at cis.bcaresearch.com 7      Please see Emerging Markets Strategy Special Report, “China’s Foreign Debt, And A Secret Weapon”, dated September 12, 2019, available at ems.bcaresearch.com 8      Please see China Investment Strategy Weekly Report, “Threading A Stimulus Needle (Part 2):Will Proactive Fiscal Policy Lose Steam?”, dated July 24, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Fed: The Fed will cut rates by 25bps this week, accompanied by a balanced message on future moves given firm domestic U.S. growth amid global uncertainties. This could trigger additional near-term increases in Treasury yields if the market prices out future expected rate cuts. More likely, higher Treasury yields will manifest via higher inflation expectations, as investors price in Fed accommodation amid the recent acceleration of realized inflation. ECB: The ECB’s easing package last week fell short of market expectations, as policymakers face the operational constraints of cutting already-negative interest rates and restarting asset purchases. Portfolio Recommendations: Return to below-benchmark on overall interest rate duration on a tactical (0-3 months) basis, with global leading economic indicators bottoming and U.S.-China trade tensions easing. Within country allocation, maintain an underweight stance on U.S. Treasuries versus German Bunds on a USD-hedged basis. Feature Dear Client, Next week, we will be publishing a joint Special Report on the U.K. with our colleagues at BCA Foreign Exchange Strategy and BCA Geopolitical Strategy. The report will be sent to clients this Friday, September 20, on the regular publishing day of the other two services. Thus, Global Fixed Income Strategy clients will be receiving their next report a few days early. We will return to our usual publishing schedule on Tuesday, October 1. Best regards, Rob Robis Chart of the WeekA Fundamental Bottoming Of Bond Yields A Fundamental Bottoming Of Bond Yields A Fundamental Bottoming Of Bond Yields The bond market has been full of surprises over the past year, and the price action so far this month is no exception. The benchmark 10-year U.S. Treasury yield has climbed +42bps from the September 3 inter-day low of 1.43%, while the 10-year German Bund yield also rose by +23bps over that same period, even as the ECB announced a fresh set of policy easing measures last week. There are several possible reasons for this increase in yields: profit-taking in deeply overbought government bond markets; global central bankers delivering incrementally less dovish surprises; and hints of progress in the U.S-China trade negotiations. We prefer a more fundamental explanation – bond markets may be sniffing out an end of the 2019 global growth downturn. The message from the improving trend in both our global leading economic indicator (LEI) and our Duration Indicator is that global growth (Chart of the Week) is stabilizing, which should help boost government bond yields from current depressed levels. The recent attack on oil facilities in Saudi Arabia does represent a near term risk to this potentially more optimistic narrative on the world economy. Our colleagues at BCA Geopolitical Strategy do expect a military response from the U.S., although U.S. President Trump will attempt to keep it limited. A full-blown U.S.-Iran conflict would likely further raise the risk premium on global oil prices, potentially creating the kind of major spike that has preceded past global recessions – an outcome that Trump would prefer to avoid heading into an election year. For now, we prefer to heed the message from our cyclical indicators, which point to additional increases in bond yields in the next few months. For now, we prefer to heed the message from our cyclical indicators, which point to additional increases in bond yields in the next few months, led by some improvement in inflation expectations and a reduction in the amount of monetary easing discounted in markets – most notably, in the U.S. We now see less of a need for the cautious near-term view on overall duration exposure that we’ve maintained since the announcement of fresh U.S. tariffs on China in early August, especially given the recent easing of U.S.-China trade tensions ahead of the next round of talks in early October. Thus, we recommend shifting to a below-benchmark stance on overall portfolio duration on a tactical (0-3 months) basis, bringing that view back in line with our cyclical (up to 12 months) call, which has remained bearish on bonds (see the table on Page 12 for changes to our model bond portfolio). FOMC Preview: 25bps This Week, With No Promises After That While there is still a lot of investor angst over the underlying health of the global economy, the “recession narrative” appears to be receding. The New York Fed’s recession probability model, based on the slope of the U.S. Treasury curve, has seen the odds of a 2020 downturn fall from a peak of 42% in August to 32% today. At the same time, there has been a sharp drop in the number of Google searches involving the word “recession” (Chart 2). Chart 2Hold Off On That Inevitable Recession Hold Off On That Inevitable Recession Hold Off On That Inevitable Recession A similar message can be seen in financial markets, where classic risk-off/save haven assets like gold, and the VIX index have pulled back a bit from recent highs (Chart 3). Government bond volatility measures like the MOVE index remain elevated, though, as fixed income markets continue to price in expectations of low inflation and easier monetary policy – especially in the U.S. Chart 3Yields Discount A Lot Of Risk-Aversion Yields Discount A Lot Of Risk-Aversion Yields Discount A Lot Of Risk-Aversion This week’s FOMC meeting, including an update to the committee’s own growth and rate forecasts, will shed light on the Fed’s latest thinking. A modest downgrade of the Fed’s U.S. growth projections is likely given the downturn in the U.S. manufacturing sector. Yet with U.S. financial conditions easing (Chart 4) and the U.S. consumer remaining confident and willing to spend – purely a function of a robust labor market and despite media coverage of the growing threat of recession – the risk is that the Fed does not end up downgrading its growth projections much. Already, the annual growth rate of core U.S. retail sales is up to a solid 5.3%, after the nearly 10% (annualized) surge seen over the June-August period. Chart 4U.S. Domestic Economic Growth Is Rebounding U.S. Domestic Economic Growth Is Rebounding U.S. Domestic Economic Growth Is Rebounding Chart 5U.S. Inflation Is Accelerating Inflation Could Use A Boost U.S. Inflation Is Accelerating Inflation Could Use A Boost U.S. Inflation Is Accelerating Inflation Could Use A Boost A similar story exists in realized U.S. inflation measures, the majority of which are accelerating. Core CPI in August rose to 2.4% on year-over-year basis, after a surge of 3.4% annualized over the previous three months – the fast such rate over such a short window since May 2006 (Chart 5). Core PCE inflation has also picked up, and is now up 1.6% year-over-year and 2.2% – above the Fed’s 2% target – on a 3-month annualized basis. Wage growth, measured using average hourly earnings, continues to grow at a solid 3.6% year-over-year rate. Given these readings, combined with a persistently low unemployment rate, the FOMC is likely to make few (if any) changes to its inflation forecasts at this week’s meeting. Chart 6Stretched Treasury Yields Can Keep Climbing Stretched Treasury Yields Can Keep Climbing Stretched Treasury Yields Can Keep Climbing Given the underlying firm trends in the U.S. economic and inflation data, odds are low that the Fed will deliver an incremental dovish surprise to markets. The reverse is more likely. At the same time, the Fed is keenly aware of the fragility of non-U.S. economic growth, and U.S. financial markets, amid the persistent drag on U.S. manufacturing activity and business confidence from the U.S.-China tariff war. Once again, Fed Chair Jerome Powell will have to thread the needle with a message that sounds neither too dovish nor too hawkish. We fully expect another 25bp rate cut to be delivered this week. However, we also expect forward guidance to reflect a balanced outlook for a strong U.S. economy juxtaposed against concern for non-U.S. growth. In other words, the same message the Fed has been giving the markets since mid-year. Given the current stretched momentum of Treasury yields/prices, amid large overweight positioning according to measures like the J.P. Morgan client duration survey, any sign of a less dovish Fed should trigger some increase in Treasury yields (Chart 6). This is especially true with the U.S. Overnight Index Swap (OIS) curve still discounting 71bps of rate cuts over the next twelve months – an amount of easing that is unlikely to be delivered. In our view, though, the bigger near-term threat of rising Treasury yields will not come from the Fed being too hawkish, but from appearing too dovish amid accelerating inflation and firm U.S. economic growth. In our view, though, the bigger near-term threat of rising Treasury yields will not come from the Fed being too hawkish, but from appearing too dovish amid accelerating inflation and firm U.S. economic growth. Market-based inflation expectations remain depressed, with the 10-year TIPS breakeven rate now at 1.68%. That is well below levels consistent with the Fed’s 2% PCE inflation target despite the persistent tightness of the U.S. labor market and the acceleration seen in realized inflation measures. We recommend that clients shift back to a below-benchmark duration stance in the U.S. this week, while maintaining the maximum exposure to TIPS versus nominal Treasuries to position for higher inflation expectations that will also result in some steepening of the Treasury yield curve. Bottom Line: The Fed will cut rates by 25bps this week, accompanied by a balanced message on future moves given firm domestic U.S. growth amid global uncertainties. This could trigger additional near-term increases in Treasury yields if the market prices out future expected rate cuts. More likely, higher Treasury yields will manifest via rising inflation expectations, as investors price in Fed accommodation amid the recent acceleration of realized inflation. ECB: Take It To The Limit One More Time Last week’s much anticipated policy easing announcement by the European Central Bank (ECB) was comprehensive in scope, but disappointing in size. Short-term interest rates were cut, but only through a modest -10bp reduction in the overnight deposit rate. The Asset Purchase Program (APP) was restarted, but only at a pace of €20bn per month, well off the €80bn peak pace of the 2015-18 APP (Chart 7). Chart 7A Relatively Modest Easing Package From The ECB A Relatively Modest Easing Package From The ECB A Relatively Modest Easing Package From The ECB Those new initiatives fell short of the consensus forecast of a -20bp cut and €30bn of new APP. The ECB did introduce some tools to help struggling euro area banks - allowing some portion of banks’ excess reserves to Chart 8No Wonder There Is Disagreement With The ECB No Wonder There Is Disagreement With The ECB No Wonder There Is Disagreement With The ECB avoid the negative deposit rate (a.k.a. “tiering”) and extending the maturity of the TLTRO III program announced earlier this year from two to three years. Nonetheless, the overall stimulus package fell short of a “big bazooka” that did not break new ground on policy instruments (like buying equities in the APP). The biggest change from previous ECB easing initiatives was by making these new programs “open-ended”, with no specific expiration date. Instead, the asset purchases and lower interest rates would be maintained until euro zone inflation sustainably converged to the ECB’s inflation target of just under 2%. With the ECB’s newly revised forecasts calling for headline inflation to only climb to 1.5% by 2021, the new program has already been mockingly branded “QE Forever” by those who do not expect inflation to ever return to 2%. A big reason why the ECB was unable to deliver a bigger package was the disagreement within the ECB Governing Council on the need for more aggressive stimulus. Prior to last week’s meeting, several ECB officials publically voiced their reluctance to restart asset purchases and deliver deeper interest rate cuts, believing that they would have little impact on future euro area growth and inflation. While the opposition to fresh bond buying came from predictable sources like Germany and Austria, there was also an unprecedented level of public dissent after the ECB meeting, with the heads of the Dutch, Austrian and French central banks publically expressing doubts on the effectiveness of the new easing measures. This came after outgoing ECB President Mario Draghi noted in his post-meeting press conference last week that the consensus on restarting APP within the Governing Council was so broad that “there was no need to take a vote.” Given the diverging economic and inflation trends within the euro area, it should not be a surprise that a broad consensus within the Governing Council was hard to produce. For example, Germany is suffering through a much deeper manufacturing downturn than the other major euro area countries, judging by the trends in manufacturing PMIs (Chart 8). At the same time, Germany has a much lower unemployment rate and higher inflation rates than Italy and Spain. Focusing only on the German manufacturing downturn when setting monetary policy may produce results that are too stimulative – especially when the services sides of euro area economies appear in better shape (most notably in Germany). The ECB will run into some difficulties on running a “QE Forever” program of asset purchases given the current self-imposed constraints on the APP. Looking ahead, the ECB will run into some difficulties on running a “QE Forever” program of asset purchases given the current self-imposed constraints on the APP. The ECB cannot own more than 33% of the outstanding pubic debt of any single country (counting both sovereign debt and government agency bonds). At the moment, the ECB ownership shares are below that 33% threshold for the largest countries, based on our calculations that are presented in Chart 9. Chart 9"QE Forever" Is Not Credible Under Current Constraints The World Is Not Ending: Return To Below-Benchmark Portfolio Duration The World Is Not Ending: Return To Below-Benchmark Portfolio Duration However, that 33% limit will be threatened by the end of 2020 in several countries: the ECB will buy €15bn per month of government bonds under the new APP1 the ECB continues to allocate its bond buying in line with the size of each country (as determined by the ECB Capital Key) the stock of debt eligible for the APP expands at the same rate as consensus forecasts of nominal GDP growth Draghi also noted in his press conference that there was “relevant headroom to go on for quite a long time at this rhythm without the need to raise the discussion about limits.”2 We disagree, as our calculations show that the 33% threshold will be at threat of being reached by the end of next year in Germany, Spain, the Netherlands, Finland & Ireland (see the gray bars of Chart 9). If the ECB truly wants to commit itself to buying bonds until inflation returns to just under 2%, however long that takes, then one of three things must happen: the ECB must raise the issuer limit from 33% the ECB must allocate its bond buying using different weights than the Capital Key the supply of available government debt must increase through easier fiscal policy. Chart 10The ECB Will Have To Raise Issuer Limits To BoJ Levels The ECB Will Have To Raise Issuer Limits To BoJ Levels The ECB Will Have To Raise Issuer Limits To BoJ Levels Of those three options, altering the country weights away from the Capital Key is the most politically contentious, as it would involve more purchases from countries with weaker government finances, like Italy and Spain. Raising the issuer limit from 33% is a more realistic option, as that is a completely self-imposed rule with no economic grounds, although it raises the risk of the ECB bond ownership approaching Bank of Japan type levels (Chart 10). Solving the ECB’s “headroom” constraint by issuing more government debt through fiscal expansion is the one option that could truly help Europe get out of its low inflation trap. Yet that is also an option fraught with political tension in places like Germany where keeping low levels of government debt has been a politically popular choice. With the new ECB President, Christine Lagarde, set to take over from Draghi in November, the policy debate within Europe will turn toward the need for more fiscal stimulus. Already, there have been media reports suggesting the German government is considering new stimulus measures to boost a Germany economy that is now in a technical recession. Solving the ECB’s “headroom” constraint by issuing more government debt through fiscal expansion is the one option that could truly help Europe get out of its low inflation trap. Chart 11Inflation Expectations & Bund Yields Are Stabilizing Inflation Expectations & Bund Yields Are Stabilizing Inflation Expectations & Bund Yields Are Stabilizing If the ECB’s APP capacity issues are not eventually resolved, then the market will soon come to the realization that there can be no “QE Forever”. Combined with the known limitations on pushing policy rates deeper into negative territory - for fears of reaching a “reversal rate” that will cause banks to horde cash and make fewer loans - there is limited scope for additional declines in euro area bond yields from the deeply depressed current levels under the new policy announcements made last week. For now, we continue to favor overweighting core euro area government debt in global fixed income portfolios, on a currency-hedged basis. Despite the persistent negative yields on offer, those can be transformed into positive-yielding assets when the currency exposure is swapped into U.S. dollars. Furthermore, the so-called “convexity buying” of longer-dated euro area government bonds by asset-liability managers like insurers and pension funds will continue to anchor the long-end of euro area yield curves (Chart 11) – although that same factor can potentially hyper-charge a rise in yields as convexity buying turns into convexity selling if the economic fundamentals were to swing in a bond-bearish fashion (which is a topic we plan on covering in a future report). Bottom Line: The ECB’s easing package last week fell short of market expectations, as policymakers face the operational limits of cutting already-negative interest rates and restarting asset purchases. Yet for now, the economic/inflation backdrop in Europe remains bond friendly. Maintain a strategic overweight stance on Germany versus the U.S. in global government bond portfolios, with Bunds still supported by ECB buying and with USD-hedged Bund yields continuing to offer a yield pickup over Treasuries.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The other €5bn per month is assumed to go towards the purchases of corporate debt. 2 The full transcript of Draghi’s press conference can be found here: https://www.ecb.europa.eu/press/pressconf/2019/html/ecb.is190912~658eb51d68.en.htm The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The World Is Not Ending: Return To Below-Benchmark Portfolio Duration The World Is Not Ending: Return To Below-Benchmark Portfolio Duration Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns